Office of Financial Research (OFR) – Financial
Stability Oversight Council (FSOC) 2015 Fourth Annual Conference
Evaluating Macro-Prudential Tools: Complementarities and Conflicts
Friday, January 30, 2015
Key Topics & Takeaways
- Internal Stress Tests: Stefan Walter from the European Central bank suggested that the ECB should build on the new supervisory reporting framework and expressed a need to review banks’ internal stress-testing methodologies and processes. For this, Walter recommended the validation of banks’ qualitative results because “institutions can pass quantitatively, but fail qualitatively.”
- Hybrid Approach to Stress Tests: Walter emphasized that future stress tests should neither be run solely by banks, nor carried out by just the central banking authorities without the involvement of the institutions. Instead, the Walter recommended a hybrid approach for future stress tests.
- Assessing Liquidity Risks: Traclet from the Bank of Canada said that liquidity risks are a “bit more innovative” and more information is needed to “better understand how shocks are transmitted and what makes banks susceptible to risk.”
- Pros and Cons to Stress Tests: According to Tsatsaronis from the Bank for International Settlements, stress tests are very effective in characterizing weaknesses in bad economic times, saying there is a “danger of sticking to the neighborhood of current conditions rather than trying to break the bank.”
- TLAC and Enhanced International Regulation: Cohen concluded that the TLAC requirement is important for enhanced international regulation and allows banks to absorb losses and provides adequate capital cushion. He also advocated for an accelerated effective date.
- Stefan Walter, Director General, Micro-Prudential Supervision I, European Central Bank
- Virginie Traclet, Assistant Chief, Financial Institutions Division, Bank of Canada
- Arthur Murton, Director, Office of Complex Financial Institutions, Federal Deposit Insurance Corporation
- H. Rodgin Cohen, Senior Chairman, Sullivan & Cromwell
- Wallace Turbeville, Senior Fellow, Demos
- Ceyla Pazarbasioglu, Deputy Director, Monetary and Capital Markets Department, International Monetary Fund
- Til Schuermann, Partner, Oliver Wyman
- Kostas Tsatsaronis, Head of Financial Institutions, Bank for International Settlements
- Jainaryan Sooklal, Senior Vice President, Head of Funding & Liquidity Risk Management, Federal Reserve Bank of New York
- Joseph Abate, Senior Vice President, Barclays Capital
- Daniel Janki, Senior Vice President and Treasurer, GE and GE Capital
- Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University Graduate School of Business
- Sean Campbell, Associate Director, Research and Statistics, Board of Governors of the Federal Reserve System
- Murray Pozmanter, Managing Director, Depository Trust & Clearing Corporation
- Haoxiang Zhu, Assistant Professor of Finance, MIT Sloan School of Management
- Andreas Lehnert, Deputy Director, Office of Financial Stability Policy and Research, Board of Governors of the Federal Reserve System
- David Nebhut, Senior Deputy Comptroller for Economics, Office of the Comptroller of the Currency
- Governor Daniel Tarullo, Board of Governors of the Federal Reserve System
- Jack Reidhill, Acting Associate Director of the Center for Financial Research, Federal Deposit Insurance Corporation
- Mark Flannery, Chief Economist, Securities and Exchange Commission
Session One: Stress Testing – Where to go from here?
Stefan Walter from the European Central Bank (ECB) provided the “referee perspective” and said that stress tests are conducted to try to identify trends, potential risks, and vulnerabilities within a firm. He described this “micro-prudential exercise” as a way to strengthen banks’ balance sheets. Next, Walter described four main features of the “macro-financial” stress testing scenario including: 1) abrupt reversal in risk aversion; 2) further weakening of European Union (EU) real economic activity; 3) stalling policy reform; and 4) lack of necessary balance sheet repair.
Walter explained that the stress tests faced both institutional and technical challenges. He said the stress tests were a “massive logistical undertaking” and that the ECB’s complex governance structure is due to the vast number of stakeholders across 130 banks and 19 countries. Walter also outlined four technical challenges including: 1) combined results from asset utility review; 2) lack of long, comparable and granular time series in Europe; 3) methodological issues with banks under restructuring plans; and 4) extensive data requests at a time when banks were shifting to the new Basel III regime.
Walter said the ECB does not plan to conduct stress tests of this scale this year, but “will look at the supervisory review process” and will conduct stress tests next year when enough time has passed to act on lessons learned from this year’s tests. He suggested that the ECB should build on the new supervisory reporting framework and that it is more important to review the banks’ internal stress-testing methodologies and processes. For this, Walter recommended the validation of banks’ qualitative results because “institutions can pass quantitatively, but fail qualitatively.” He added that they also “spent a lot of time asking what these institutions were doing” and that more information about operational risks, liquidity risk, and supervisory benchmarks for non-interest income would be helpful when identifying risks. He emphasized that future stress test should neither be run solely by banks, nor carried out by just the central banking authorities without the involvement of the institutions. Instead, the Walter recommended a hybrid approach for future stress tests.
Virginie Traclet from the Bank of Canada said that “we are not at the end of the road” and “many questions remain.” She emphasized that it is important to remember that stress tests are “just one tool to assess systemic risk.” In her view, this tool can be used on the banking sector to examine shocks across the system and can capture various sources of risk, but credit risk and liquidity risk also need to be taken into account.
She explained that stress tests can be used to determine the interconnectedness of the system. However, Traclet said that liquidity risks are a “bit more innovative” and more information is needed to “better understand how shocks are transmitted and what makes banks susceptible to risk.” She continued, “it is very complicated to update the liquidity position of banks over the long horizon.” Since banks can react by selling securities in the market, she said, this behavior can directly affect their balance sheets, making the problem of contagion difficult to track. Therefore, Traclet concluded that stress tests are just one part of a broader tool kit that must be integrated with other models for assessing risk.
Til Schuermann from Oliver Wymann contended that stress testing can be used for strategic planning. He explained, “stress testing requires dynamic projections of revenue, income, expenses, balance sheets, and regulatory ratios.” With many different models, he said it is important to ask how the structure of liabilities will evolve and how the asset and liabilities can be modeled. Based on his experience with Oliver Wyman, he said it is hard to overstate the impact that stress testing and formal capital planning have on U.S. banks. He said banks’ staff often say, “the frequency and quality of discussion with my CEO and the board is totally different now than from before the crisis.” With this input in mind, he is concerned that capital planning “devolves into a compliance exercise.” Schuermann said the stakes are high and if the focus is on process, rather than “passing,” then banks are forced to determine strengths and weaknesses along with the resources needed to support them. In conclusion, Schuermann said the banks that are comfortable with the capital planning will actively apply it to strategic planning.
Kostas Tsatsaronis from the Bank for International Settlements (BIS) said that “stress tests are good tools, but not without problems.” He cited the following pros to stress tests: 1) specific scenarios that are better understood than abstract statistical notions; 2) the ability to compare notes and debate the results; and 3) two-way links between bank and aggregate picture. He also highlighted the following cons: 1) partial analysis; 2) reliance on risk models; and 3) the art of scenario construction and getting “buy-in.”
Tsatsaronis added that big shocks are difficult to map out in advance and the “key is to see how people behave when their backs are against the wall.” In his opinion, stress tests are very effective in characterizing weaknesses in bad economic times, and there is a “danger of sticking to the neighborhood of current conditions rather than trying to break the bank.” In order to conduct a “good stress test,” Tsatsaronis said it is “not very different from good supervision that must be challenging to the conventional wisdom, intrusive, and constructive.” He concluded that this process of risk management is important, but also “does not come cheap.”
Question and Answer
Biggest Challenge to Stress Tests
The moderator asked the panelists to explain the biggest challenge to stress testing. Walter said that conducting stress tests is hardest in countries with the most shock to the system where it is challenging to gather the data banks’ interconnectedness. Traclet agreed with Walter. Schuermann said it is important to have banks with a supervisory role design their own process in order to more easily assess their vulnerabilities.
Session Two: Resolution and Recovery – Next Steps
Arthur Murton from the Office of Complex Financial Institutions at the Federal Insurance Corporation (FDIC) said that in 2008 policymakers were faced with “bankruptcy or bailout.” He noted that since the Dodd-Frank Act put in place a new regulatory framework for systemically important financial institutions (SIFIs), firms are now required to submit living wills to “demonstrate that firms could be resolved without disruption to the economy.” According to Murton, the largest 11 firms received letters from the FDIC in August 2014, which required firms to address liquidity and provide accountability for creditors and shareholders. He reported that the FDIC is working to make this authority operational through the following actions: 1) the FSB consultative paper on total loss absorbing capacity (TLAC) as an international standard for liquidity in resolution; 2) the new derivatives protocol to eliminate early termination in resolution; and 3) new authorities for key jurisdictions. Based on these changes, Murton said the FDIC has made progress but said it has more to do to provide policymakers with a better choice in a future financial crisis.
H. Rodgin Cohen from Sullivan & Cromwell contended that the need for a resolution regime is a “lose-lose dilemma.” He explained that with the new TLAC requirement for financial institutions, the eight U.S. globally systemically important banks (G-SIBs) would be required to meet capital ratios of 20%, which is well above the regulatory minimum for viability, even after absorbing losses. Cohen said the TLAC requirement is “admittedly designed for a reasonable worst case scenario” but that “any historical analysis must incorporate legitimate comparability.” In his view, the “losses specializing in high risk loans are not relevant to the G-SIBs analysis.” Instead, Cohen argued it is important to “work out eligibility, precise calibration, inclusion, and the rules of the road.”
Cohen urged for the strongest possible terms and said that “finalizing TLAC should be the highest priority.” In addition, Cohen recommended consideration of an accelerated effective date for the TLAC requirement. Cohen suggested that the TLAC requirement should accomplish the following: 1) allow for proper resolution of institutions and reduce the need for resolutions; 2) promote the safety and soundness of the system without aiming to level the playing field; and 3) formalize international resolutions through more legally binding treaties. He concluded that the TLAC requirement is important for enhanced international regulation and allows banks to absorb losses and provide adequate capital cushion.
Ceyla Pazarbasioglu from the Monetary and Capital Markets Department at the International Monetary Fund (IMF) agreed that an international liquidity standard is needed, but added that many details have to be worked out. She described three key areas that must addressed: 1) ensure that national resolution regimes are harmonized across jurisdictions with tools for cooperation; 2) reach an agreement that there will be firm specific resolution plans with living wills and resolvability assessments; and 3) deal with bank failures. Pazarbasioglu said it will be difficult to reach a comprehensive approach to the supervisory framework and that the interconnectedness of the system brings efficiency, but also risk.
Wallace Turbeville from Demos said it is important to “make sure that we recognize that any system does not win here.” He said that resolution is often discussed now, but in the event of a financial crisis, the system may be so complex that a resolution plan will be “made up then.” He highlighted that Title II of Dodd-Frank is beneficial if it provides reassurance to the marketplace in a ways that avoids panic from setting in across the banking system. He asked, “the goal is to avoid the cascading affect of fire sales, but if we have a run on institutions, how is it possible to isolate the incident in one institution?” Tuberville continued that in reality, a major goal was to avoid moral hazard, but a new moral hazard may be created through treatment of operating subsidiaries. Therefore, Tuberville said it is important to think about who holds the required debt and whether the regulatory regime can be flexible at the time of a crisis. He also questioned whether a regulatory regime can eliminate the conditions that allow a bailout to occur.
Question and Answer
Accountability to Losses
The moderator asked the panelists what a resolution plan should look like. Murton said that a resolution should result in accountability and losses should be “born by those that took on the risk, not the taxpayers.” Pazarbasioglu said it’s critical to have trust among supervisors, institutions, and the system.
The moderator asked the panelists how to address moral hazard. Pazarbasioglu said regulators can require holders of risk to specify, but that banks are very sophisticated and always find ways to go around regulation. He said it is important to understand where the risk is held.
Keynote: Governor Tarullo
Daniel K. Tarullo, Board of Governors of the Federal Reserve System, delivered a keynote address that described priorities for regulators.
Tarullo stated that policymakers must be specific on how a macroprudential perspective will inform financial regulation. He explained three objectives that should be incorporated into policy agenda: 1) continue the task of making sure very large, complex financial institutions do not threaten financial stability; 2) develop policies to deal with leverage risks and the susceptibility to runs in markets that are not prudentially regulated; and 3) address vulnerabilities associated with central counterparties.
Tarullo then explained three priority areas for applying macroprudential tools:
- A set of strengthened capital standards, including capital surcharges for systemically important firms and stress testing. Stating that stress testing provides a forward-looking assessment of losses during negative economic situations, while risk-weighted capital surcharges might reduce the distress or failure of global systemically important institutions (G-SIBs) more than other firms.
- A new set of quantitative liquidity requirements, to include the liquidity coverage ratio (LCR) and the international net stable funding ratios (NSFR), which will soon be considered for adoption in the U.S. by banking regulators. He added that both the LCR and NSFR were created due to the systemic liquidity “squeeze” during the economic crisis.
- Regulatory measures to address systemic risks from the potential failure of large financial institutions, including the orderly liquidation authority and the availability of debt that can be converted into equity if an institution fails.
Tarullo recommended policymakers identify priority areas to focus on when developing a set of regulations informed by macroprudential considerations and said priority should be given to activities that create significant risk of investor flight. He specifically noted that short-term wholesale funding and the liquidity and redemption risks that could present in asset management activities should be given priority.
Tarullo explained that the Fed has advocated for and the Financial Stability Board (FSB) has now proposed minimum margins to be required for certain forms of securities financing transactions (STFs) that involve extending credit to parties that are not prudentially regulated financial institutions. He noted that it is important for the FSB’s framework to be applicable in all major financial markets due to how easily such transactions can move across borders.
Tarullo continued that a key regulatory priority in the U.S. and internationally since the economic crisis has been to promote more derivatives and other financial transactions to be cleared through central counterparties (CCPs). However, if the financial system is going to receive these benefits, he said, the CCPs must be sound and stable. Tarullo stressed that “considerable” work has been done to ensure CCPs are safe in the international and domestic sector and that principles in place will provide strong, consistent, heightened oversight of those designated as systemically important.
Tarullo concluded that not even the best macroprudential policies can make up for risks created by key macroeconomic or financial conditions, but that these risks should force the thought of issues like correlated risks and responses.
Question and Answer
An audience member asked Tarullo what the benefits are to keeping private entities private. Tarullo answered that the implicit preference of various international and domestic discussions is for the strengthening and adaptability of private entities. He continued that achieving this takes significant development building out of regulatory regime.
Another audience member asked if banks can have too much capital, and what the optimal level for bank capital is. Tarullo explained that the levels regulators are proposing in the notice of proposed rulemaking are a result of a set of analyses coordinated in the Basel Committee. He continued that there is a range of capital surcharges where there is a reasonable understanding of the impact they may have on financial intermediations. Tarullo stressed that: 1) with respect to surcharges, they are applicable only to the most systemically important banks; and 2) higher capital requirements could produce less risky behavior or more risky behavior, which is why there is ongoing supervision and regulatory requirements that supplement and provide a second set of protections.
Session Three: Liquidity Regulation-How much is enough, or too much?
Jainaryan Sooklal from the Federal Reserve Bank of New York said liquidity regulations in place before the economic crisis were vaguely defined and that stress testing at the largest financial institutions was “fundamentally really poor” and “very rudimentary.” He continued that most previous ratios were defined by looking at bank entities, but that risk was being taken outside of the bank system. He stated that with new liquidity regulation came more supervision activities, including data driven supervision and that industry practices have to changed. He concluded that the goal is to develop a financial system that is more resilient and less complex.
When asked about Treasury bills (T-bills), he stated that there is no need to worry about the liquidity of T-bills because holders are going to be guaranteed the value. Sooklal noted that bank assets will not be allowed to be calculated in the liquidity buffer. He added that regulation is requiring banks to build cash levels against short term wholesale funding and said short term funding being used to fund emerging market debt is a problem. He stated that the objective of the LCR was to get the financial system to hold more cash or cash-like instruments.
Joseph Abate from Barclays Capital stated that liquidity discussions have focused on bank liquidity, but not liquidity in other areas. He said that a financial market crisis can be averted with “thicker” liquidity cushions, but had “no idea” how much liquidity is sufficient for banks. Abate continued that the current 30 day cushion, based off stress outflows, is “good” but that it is not clear whether doubling the number would create twice as much insurance. He stated that the focus on liquidity at banks misses a key element – the shadow banking sector – where liquidity is just as important. Abate continued that money market funds in particular need to maintain very high levels of liquidity.
Daniel Janki, Senior Vice President and Treasurer at GE and GE Capital, stated that other countries have not had liquidity ratios with a micro-prudential focus but that the U.S. should look at how other countries regulate prudential liquidity and capital. He stated that some of the shortcomings of liquidity requirements include the Basel system viewing liquidity requirements as an “add-on,” independent of default risk, under an assumption that liquidity shocks “happen randomly.” He described a model that looks at liquidity risk more fundamentally and pointed out that cash has important advantages when it comes to managing default risk. He explained that unlike capital, cash is not “fiction;” it is real.
Session Four: Margins and Haircuts – Limits to Leverage and Potential Unintended Consequences
Sean Campbell, Associate Director of Research and Statistics at the Federal Reserve, said that repos and derivatives, while distinct, are “integrally linked.” He explained that repos provide levered exposure to assets and that they connect banks, hedge funds, insurance companies, and asset managers. Taking these interconnections into account, Campbell noted that the instability of a large repo lender or borrower can pose a threat to financial stability.
Campbell pointed out that government collateral will not be subject to margin requirements for repo transactions, but that this collateral will have margin requirements in derivatives markets. He noted that this will allow market participants to take the same exposure in the repo market at a lower cost and stressed the need to look holistically at the financial system to determine the impact of having different regulatory regimes on different parts of the market, and how this will drive behavior.
Murray Pozmanter, Managing Director at the Depository Trust & Clearing Corporation (DTCC), agreed with Campbell that there are many similarities between the repo market and derivatives. He said that bifurcation in the marketplace is now “based strictly on counterparties” which can exacerbate pro-cyclical effects.
Pozmanter said that margining within CCPs provides an element of predictability and allows a clearing house to be more reactive to market events. He also noted that having all types of securities financing transactions (SFT) in a cleared regime would lend stability to the market and reduce the risk of fire sales.
Haoxiang Zhu, Assistant Professor of Finance at MIT Sloan School of Management, noted that having better transparency in the markets is already a useful tool of regulation. He stressed that fire sale risk should be thought about in conjunction with secondary market liquidity risk and that both problems should be solved simultaneously. He then said that the Volcker Rule may have made it more difficult to liquidate covered bond portfolios by reducing liquidity in that marketplace.
Zhu also said that CCPs should contribute enough of their own equity in the default waterfall of a clearing member’s default to “align the incentives” of the clearing house with the incentives of the “entire system.”
Question and Answer
When asked what would happen if margin requirements are set too high, Zhu said that certain hedgers may be unwilling to enter the market if costs are too high. He added that CCPs should tighten margin standards if they “sense a problem is coming.”
When asked how the default waterfall approach impacts a CCP and its members, Campbell said there is somewhat of a “shell game” in how a default works at a CCPs. He explained that the primary stakeholders in CCPs are also its shareholders, so the losses are mutualized when the CCP puts its equity in the waterfall. He said the waterfall discussion comes up because “nobody wants to take a loss” but said the “first order” is for all participants to understand they are “in this together.” Pozmanter said he agreed to a certain extent but that CCP ownership structure is important to have proper alignment of interest.
A member of the audience asked what the implications are for banks’ use of the repo market if Basel III rules become a binding constraint. Campbell said that non-bank players in the repo market will get bigger if banks have more constraints put on them.
Campbell then noted that regulators and policymakers should be devoting resources to figuring out the ultimate economic impacts of the large number of new regulations that have been put in place. He said this focus on the economy is more important than looking at trading volume data for any specific markets.
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