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

Opening Statement by Governor Daniel K. Tarullo

Thank you, Mr. Chairman.

The proposal before us today marks an important advance in prudential regulation because, for the first time, large banking organizations would be subject to a quantitative liquidity rule. Since financial crises usually begin with a liquidity squeeze that further weakens the capital position of vulnerable firms, it is essential that we adopt liquidity regulations to complement the stronger capital requirements, stress testing, and other enhancements to the regulatory system we have been putting in place over the past several years.

Most recently, of course, after a long period of abundant liquidity in the global financial markets, the liquidity positions of large financial firms came under severe stress in 2008. Creditors formerly willing to lend to financial firms on a short-term, unsecured basis fled. Creditors formerly willing to lend to financial firms on a short-term, secured basis with low collateral haircuts suddenly raised haircuts substantially or became unwilling to lend at all against a wide range of assets. Many global financial firms faced substantial draws on previously extended liquidity facilities and credit lines and substantial collateral calls on derivatives.

Liquidity-strained firms found themselves forced to sell positions, which set off adverse feedback loops of falling asset prices, increased margin calls, and more deleveraging. Today's LCR proposal is designed to mitigate these sorts of destabilizing dynamics by helping to ensure that major banking firms have a pool of high-quality liquid assets with which to address potential short-term net cash outflows.

I would like to draw attention to several features of today's proposal.

First, the LCR will become a part of the Federal Reserve's comprehensive liquidity risk oversight program for large banking firms. In addition to the coming quantitative liquidity regulations, the Board has sought public comment on enhanced liquidity risk management standards for large banking firms as part of our Dodd-Frank section 165 proposal. Under our 165 proposal, large banking firms would--among other things--be required to conduct internal liquidity stress tests and to maintain liquid assets sufficient to meet expected net cash outflows under the stress tests. And we have already begun conducting in-depth horizontal reviews of the liquidity risk management and liquidity positions of the most systemically important banking firms.

Second, the proposed LCR would sustain the progress that has been made by banks and regulators over the past four years in improving the liquidity positions of large banking organizations. This rule would help ensure that the liquidity positions of our banking firms do not weaken as memories of the crisis fade.

Third, the proposed LCR we review today is "super-equivalent" to the Basel Committee's LCR standard. That is, the proposal is more stringent in a few areas, such as the transition timeline, the definition of high-quality liquid assets, and the treatment of maturity mismatch within the LCR's 30-day window.

Fourth, the proposed LCR is tailored to the systemic footprint of different U.S. banking firms. Bank holding companies with less than $50 billion of assets--below the Dodd-Frank Act's enhanced prudential standards line--will not be covered by the proposal. Bank holding companies that have $250 billion or more of assets or have substantial international operations will be subject to the full LCR proposal. Firms in the middle range will be subject to a less stringent version of the LCR. This tailored approach is consistent both with good public policy and with the gradation requirements in section 165.

While the LCR is an important step forward in prudential regulation, it is not sufficient to address potential liquidity problems at large banking firms. That is one of the reasons for the set of Section 165 measures I described a moment ago. We must also continue work on the Net Stable Funding Ratio (NSFR). Because the LCR creates only a 30-day liquidity requirement, and because liquidity strains can last considerably longer, the NSFR is a complementary measure that would create a one-year structural funding requirement. The Basel Committee approved an initial version of the NSFR in December 2010, and is now well along in creating a final product. We anticipate proposing in the future a U.S. rule consistent with the final product of that work.

Also, it is important to recognize that the risks associated with short-term wholesale funding are as much or more macroprudential as they are firm-specific, whereas the LCR has a principally microprudential focus, focused as it is on the liquidity of each firm individually. For example, with its focus on matching inflows and outflows at individual firms, it does not address the fire sale externalities and other financial stability risks created by the large matched books of securities financing transactions at large banks. I believe that among our highest remaining priorities should be more macroprudentially informed regulatory measures to address the tail risk event of a generalized liquidity stress by forcing some internalization of the systemic costs of this form of financial intermediation.

Last update: October 24, 2013