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Board of Governors of the Federal Reserve System
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Federal Reserve Board of Governors

Statement by Governor Daniel K. Tarullo

June 7, 2012

While rigorous capital requirements are not a sufficient condition for a strong, resilient financial system, they are surely a necessary one. A bank with a strong capital position can absorb losses from unexpected sources, whether an external shock to the economy, the insolvency of important counterparties, or a failure of risk management within the firm. Strong capital buffers help ensure that losses are borne by shareholders of the bank, not by taxpayers either directly through some form of bailout, or indirectly through a major negative effect on the economy resulting from the bank's failure.

Uncertainty about the capital positions of large financial firms was a major factor in the turmoil that beset the country in the fall of 2008. Subsequent increases in capital at our major banks, along with the information provided by the stress tests in 2009, were important factors in stabilizing the system. Pre-crisis capital requirements were too low in general, had risk weights that were especially inadequate for certain securitized and other traded instruments, were too easily met through capital instruments lacking the loss absorption capacity of common equity, and were focused almost exclusively on firm-specific, rather than economy-wide, risk.

The one final and three proposed rules before us this afternoon mark an important milestone on the road to a set of strong, complementary capital standards for banking organizations. We have already promulgated a rule for annual capital reviews of large bank holding companies, which are conducted against the backdrop of our annual stress tests. Last year the three federal banking agencies adopted a rule to implement the so-called Collins amendment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which provides that banks using the Basel II advanced approach must also meet capital requirements as calculated using the standardized method applicable to all banks. As staff will shortly explain, the final rule before us today would address inadequacies in trading book capital requirements, as agreed in the so-called Basel 2.5 revisions to the international market risk capital framework. The three proposed rules would increase both the quantity and quality of required capital, focusing squarely on common equity, as well as update both the standardized and advanced methods for calculating capital requirements.

While approval of today's proposals will mark major progress on the way to overhauling capital requirements, it does not signal the end of that effort. Clearly, of course, we will need to finalize the three proposed rules. Next, once refinements of the Basel framework on capital surcharges have been completed, we will need a regulation to apply surcharges to U.S. institutions with the largest systemic footprints.

Looking beyond these measures that are already in train, I hope that we and other regulators will also consider two ideas for capital reforms. First, depending on the results of the fundamental review of the trading book currently underway in the Basel Committee, we may want to return to market risk capital requirements at a later date. I, for one, am particularly interested in exploring possible standardized capital requirements for market risk as a back-up for model-derived risk weights, just as we now do for credit risk. Second, we may want to consider changes in capital requirements to ensure that there would be adequate subordinated debt or similar liabilities on the balance sheets of the largest banking firms to help ensure they could be successfully resolved under Title II of Dodd-Frank through the conversion of debt to equity.

The reason for the multiplicity of capital requirements, which also include a new leverage ratio, is that every individual capital measure has limitations and is subject to regulatory arbitrage. However, it is important to note that the full set of these requirements would be applicable only to the largest institutions. Smaller banks are not covered at all by the stress testing, capital review, and surcharge requirements. Nor will they be subject to the new Basel III leverage ratio or counter-cyclical buffers. Nor are they likely to be affected by most of what is in the market risk requirements or, of course, to the changes in the advanced approaches risk weights. For smaller banks, there will still be only two applicable capital requirements the traditional leverage ratio and the standardized risk-weighted approach that is being updated in one of today's proposed rules.

All four of the rules before us today are the product of joint rulemaking with the FDIC and OCC. Most of the content of those rules was also the subject of the Basel 2.5 and Basel III international capital frameworks. I should note that Board staff provided significant leadership in the Basel discussions over the past several years. They also spent many hours drafting the rules before us today as interagency negotiations eventually yielded agreement or compromise on individual points. Anna Lee Hewko, in particular, has been indefatigable in bringing this work to a conclusion.

I mention this not just to give kudos to Anna Lee, Mike Gibson, Norah Barger, Pat Parkinson, and others deserved as they are but also to underscore the fact that these are consensus rules, the product of extended negotiating and collective drafting efforts. Left to my own devices, I would not have written everything the way it is in these rules. Indeed, I doubt anyone staff or principal at any of the three agencies would have done so. We will, of course, have ample opportunity to consider the comments on the proposed rules with respect to items that the agencies have added to international standards, to consider alternatives. All of that being said, I want to reiterate unqualifiedly that the package as a whole will be a major contribution to achieving a strong financial system.

Last update: August 2, 2013