Enhancing Prudential Standards in Financial Regulations

Franklin Allen

University of Pennsylvania – Finance Department; European Corporate Governance Institute (ECGI)

Itay Goldstein

University of Pennsylvania – The Wharton School – Finance Department

Julapa Jagtiani

Federal Reserve Banks – Federal Reserve Bank of Philadelphia

William W. Lang

Federal Reserve Bank of Philadelphia

FRB of Philadelphia Working Paper No. 14-36

Abstract:

The financial crisis has generated fundamental reforms in the financial regulatory system in the U.S. and internationally. Much of this reform was in direct response to the weaknesses revealed in the precrisis system. The new “macroprudential” approach to financial regulations focuses on risks arising in financial markets broadly, as well as the potential impact on the financial system that may arise from financial distress at systemically important financial institutions. Systemic risk is the key factor in financial stability, but our current understanding of systemic risk is rather limited. While the goal of using regulation to maintain financial stability is clear, it is not obvious how to design an effective regulatory framework that achieves the financial stability objective while also promoting financial innovations. This paper discusses academic research and expert opinions on this vital subject of financial stability and regulatory reforms. Specifically, among other issues, it discusses the impact of increasing public disclosure of supervisory information, the effectiveness of bank stress testing as a tool to enhance financial stability, whether the financial crisis was caused by too big to fail (TBTF), and whether the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) resolution regime would be effective in achieving financial stability and ending TBTF.

Enhancing Prudential Standards in Financial Regulations – Introduction

The Federal Reserve Bank of Philadelphia, the Wharton Financial Institutions Center, and the Journal of Financial Services Research jointly held a conference on enhancing prudential standards in financial regulations on April 8–9, 2014. Despite the extensive regulation and supervision of U.S. banking organizations, the U.S. and the world financial systems were shaken by the largest financial crisis since the Great Depression, largely precipitated by events within the U.S. financial system. The Great Recession that followed the financial crisis has generated substantial changes in financial regulation within the U.S. as well as internationally.

Prevention of systemic risk and the maintenance of financial stability are the central goals of recent reforms of financial regulation, including the Dodd–Frank Wall Street Reform and Consumer Protection Act (DFA) enacted in the U.S. in July 2010. This shifted the emphasis of financial regulation away from the monitoring of risk taking at an individual institution to a “macroprudential” approach. The new approach focuses on risks arising in financial markets broadly as well as the potential impact on the financial system that may arise from financial distress at one or more systemically important financial institutions.

Federal Reserve Governor Daniel Tarullo clearly articulated this new approach in a 2014 speech:

Beyond the basic reaction that prudential regulation needed to be stronger and less subject to arbitrage, considerable support grew for the formerly minority view that regulation also needed to be firmly grounded in a macroprudential perspective explicitly directed at the stability of the financial system as a whole, not just at each regulated firm individually.

While the goal of using regulation to maintain financial stability is clear, it is less obvious how to design a regulatory framework that achieves this objective while also promoting an efficient and innovative financial sector. The objective of the conference was to engender a robust exchange and discussion of leading scholars, regulators, and market participants on this vital subject of financial stability and regulatory reforms.

The DFA has been a landmark piece of legislation — the most sweeping reform of U.S. financial regulations since the Great Depression. While the DFA is a specific U.S. regulation, the Basel Committee on Banking Supervision has also enacted reforms intended to refocus financial regulation on containing systemic risk and maintaining financial stability. The DFA made promotion of financial stability an explicit goal for the Federal Reserve and created the Financial Stability Oversight Council as an interagency body responsible for oversight of U.S. financial stability. The DFA also expanded the scope of bank-like regulation to systemically important nonbank financial institutions and markets. The new regulatory regime includes enhanced prudential standards for systemically important financial institutions (SIFIs) that include requirements for stress testing, expanded regulatory reporting, and increased public disclosure of supervisory assessments of SIFIs. The new regulations also aimed to end the too-big-to-fail (TBTF) policy by giving regulators new authorities to resolve failing SIFIs.

The following are fundamental questions/concerns in the process of regulation reform:

  • Can we anticipate systemic risk events and can regulatory reform effectively combat systemic risk? How can we determine whether a financial institution or a group of financial institutions are systemically important? Will the current changes in financial regulation be effective in enhancing financial stability? Are they sufficient or should monetary and fiscal policy tools be used as well?
  • Is increasing the scope, intensity, and complexity of financial regulation the right approach or should we simplify regulation, increase transparency, and place greater reliance on market discipline?
  • The new financial regulatory regime includes greater public disclosure by SIFIs as well as greater disclosure of supervisory assessments. For example, there is substantial disclosure of the results from supervisory stress tests. Does increased public disclosure of supervisory information enhance financial stability or generate greater instability?
  • Stress testing has become a central component of the supervision of SIFIs. Are stress tests an effective method for enhancing financial stability? Would a stress-testing regime have prevented the mortgage and financial crises?

Financial Regulations

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