Brookings Institute Event on Financial Regulation

“Financial Regulation – A Post-Crisis Perspective”

The Brookings Institute

Participants

Key Topics and Takeaways

  • Changes to Regulations: Gruenberg said he specifically opposed removing central bank exposures, treasury securities, and initial margin from the calculation of the enhanced supplementary leverage ratio, and opposed lowering the leverage ratio generally. He described these changes as “at odds with the purpose of the leverage ratio” that could potentially reduce the leverage capital requirements for the eight U.S. globally systemically important banks (GSIBs) by amounts ranging from 25% – 50%
  • Tenure as Chairman: In response to a reporter’s question, Gruenberg said he would remain in his post as Chairman of the FDIC until a successor is confirmed, as he is allowed to do by statute.

Remarks

Gruenberg began his remarks by urging regulators and market participants to “guard against the temptation to be complacent about the risks facing the financial system.” He discussed the economic outlook in 2005, when he joined the FDIC, and noted that banks then were benefiting from benign economic conditions, loan growth was strong, and bank earnings had set six records between 2001-2006. Gruenberg also noted that in 2006, the FDIC had gone 2.5 years without a bank failure. However, these figures obscured the “significant buildup” in risk in the banking sector and that regulators did not provide adequate safeguards. Gruenberg specifically criticized excessive leverage, inadequate capital at large financial institutions, the large volume of securitization, and the growth of an opaque derivatives network as unseen risks that created the “catastrophic” crisis of 2008.

Gruenberg then discussed the prudential regulations created in the aftermath of 2008, which were mainly directed at large financial institutions, and outlined several specific reforms he believed were most important. The first of these was risk based-capital requirements, which he said have strengthened the amount and quality of capital held by banks, and that reassure bank counterparties about institution health. Gruenberg also touched on the supplementary leverage ratio (SLR) and the enhanced supplementary leverage ratio (eSLR).

Pivoting to the liquidity coverage ratio (LCR), Gruenberg defended this tool as necessary to improve liquidity and funding capability for large financial institutions in stressed periods. Gruenberg also discussed the Volcker Rule, which he argued would have prevented banks’ creation of and participation in the collateralized debt obligation (CDO) market. The last tool he covered was the margin rules for uncleared swaps, which now require the posting of collateral, which he argued reduces the systemic risks created by large derivatives positions. Gruenberg specifically criticized the buildup of uncleared swap positions as a major contributor to the rapid unraveling of the financial system in 2008.

The next topic discussed was the resolution of systemically important financial institutions (SIFIs). Gruenberg noted that before 2008, regulators had not deemed large institution failures as likely given their well-diversified businesses and had not developed the legal frameworks for dealing with their collapse. Gruenberg said this was a key objective of the Dodd-Frank Act (DFA) which required the creation of living wills (which he called “enormously helpful” to both firms and regulators). He also discussed Orderly Liquidation Authority (OLA) and the Federal Reserve’s requirements that certain institutions hold unsecured long-term debt that can be converted into equity through the total-loss absorbing capacity (TLAC) regime. Gruenberg argued that bankruptcy and OLA in tandem can help regulators responsibly wind down a collapsing SIFI without taxpayer assistance, all while ensuring that shareholders, creditors, and “culpable management” are held accountable. Gruenberg noted that other jurisdictions have undertaken similar resolution innovations and that there has been a major push to foster cross-border resolution cooperation.

Gruenberg described all the above reforms as “strongly in the public interest” and noted that banks now operate with roughly twice the capital and twice the liquidity relative to their size as compared to pre-crisis levels.  He also outlined several statistics that show health in the banking sector today, including healthy earnings, high net income, and strong return on assets. He noted that the banking sector’s health is despite significant post-crisis headwinds and chronically low interest rates (and commented that higher interest rates will likely improve bank earnings). Gruenberg also argued that the banking sector is “meeting the credit needs” of the US economy, as evidenced by strong loan growth. He also posited that large US banks’ higher capital levels are a comparative strength over their European counterparts and that US regulations are not weakening the competitiveness of the industry globally. He also pointed out that strong performance has been documented across bank sizes, including in the community bank sector. Gruenberg argued that, while the economic expansion has been the 3rd longest in US history (which has also been positive for banks) all expansions eventually end and financial shocks can come from unexpected sources at any time.

Gruenberg then discussed possible risks to the financial sector, one of which stems from monetary policy. Central banks are currently transitioning from highly expansionary monetary policies to more traditional ones, and the Federal Reserve is reducing its balance sheet (which he noted has not generated a major market impact yet). Gruenberg stressed that changes in the interest rate environment could have negative economic affects, particularly in industries that have become heavily indebted. He also noted that stock prices relative to earnings are very high, bond maturities have lengthened (making bond prices more sensitive to interest rate risks) and said that commercial real estate prices are high for the revenue generated by buildings. Together, these factors could also create economic issues and that while banks are better capitalized today than they were before 2008, “they are certainly not invulnerable.” Gruenberg said that while the FDIC has been part of discussion to tailor regulations for small banks, he stressed that regulators should remain vigilant that regulations not “cross the line” and lead to dangerous rollbacks in capital and other regulatory requirements. Gruenberg said that the largest financial institutions are not “voluntarily” holding more capital and noted that a relaxation in standards could push the entire industry to a lower level of capital.

Gruenberg closed his remarks by arguing that regulators should aim to create a framework for banks to provide a sustainable volume of well-underwritten credit to support the economy. He also said he specifically opposed removing central bank exposures, treasury securities, and initial margin from the calculation of the enhanced supplementary leverage ratio, and opposed lowering the leverage ratio generally. He described these changes as “at odds with the purpose of the leverage ratio” that could potentially reduce the leverage capital requirements for the eight U.S. globally systemically important banks (GSIBs) by amounts ranging from 25% – 50%, for some institutions. He also criticized the impact of these changes on the eSLR.

The moderator opened the question and answer period by asking Gruenberg for his thoughts about the recently released proposal negotiated by Senate Banking Committee Chairman Mike Crapo (R-Idaho) and several Banking Committee Democrats. Gruenberg declined to comment, as the proposal does not contain legislative text.

The next moderator question concerned whether U.S. economic growth is being “bottled up” by a reduction in credit supply. Gruenberg pushed back on this idea, arguing that lending activity is strong and meeting market demand, and that he did not see “any supply issue” for credit and that the problem is one of demand.

The moderator then asked Gruenberg for his views on the impact of a U.S. “retreat” from its position as a global leader on financial regulation. Gruenberg noted that the financial sector today is deeply interconnected and that this trend is irreversible. Gruenberg also stressed the need for coordination from regulators, especially on resolution.

The next question concerned the FDIC’s creation of single-point-of-entry (SPOE) and asked how the FDIC came up with SPOE, and how he squares SPOE’s existence with its lack of explicit authorization in DFA. Gruenberg noted that the Federal Deposit Insurance Act of 1933 did not create the purchase and assumption strategy for handling the failure of banks, but that this strategy has been used for “thousands” of banks.

Gruenberg then fielded an audience question about the relative importance of risk-weighted capital requirements and the leverage ratio. He said that risk-based capital is important but that regulators can get the risk weights wrong, so a risk-insensitive metric should also be used.

The next question came from a Politico reporter who asked Gruenberg whether he supported an exemption to the Volcker Rule for banks with under $10 billion in assets and little trading activities. She also asked if he would stay on the FDIC board when his term as chairman expires. Gruenberg said he would remain chairman until a successor is appointed and confirmed. On Volcker, he said he supported a safe harbor for certain financial institutions, provided the safe harbor was structured in a proper way.

Another audience member asked if the U.S. was still committed to Basel and if the U.S. would support the completion of Basel. Gruenberg said he believes the international community is “closing in” on an agreement and that he believed the U.S. would honor that agreement.

In response to an audience question related to tailoring capital requirements for banks of different sizes, Gruenberg said that he has focused on simplifying the regime for small bank capital requirements, and that for some small, non-complex financial institutions there is room for changing capital regulations.

Following Gruenberg’s remarks, there was a panel discussion on financial regulations featuring a variety of industry representatives.

For more information on this event, please click here.