Fed Governor Brainard Discusses New Tailored Regulatory Approach for Large Banks

In a recent public address, Federal Reserve Governor Lael Brainard examined the fundamental changes in the country's framework of regulation that came about as a result of the financial crisis that was aimed at ensuring the safety and soundness of America's financial system.

In her keynote address at an event titled "Dodd-Frank at Five: Looking Back and Looking Ahead" hosted by the Bipartisan Policy Center and Managed Funds Association Thursday in Washington, D.C., Brainard said now, five years after the passage of Dodd-Frank, is an "opportune time" to ask much progress has been made in achieving the basic imperative of imposing tougher rules on banks that are "too big to fail."

The previous regulatory framework took a homogeneous approach with a narrow focus on the safety and soundness of an institution, the reforms use a tailored approach to address risks that an institution poses to the safety and soundness of the entire system.

"The Dodd-Frank Act requires the Board to adopt enhanced prudential standards for large banking organizations, as well as for nonbank financial companies that have been designated as systemically important, and to tailor the standards so that their stringency increases in proportion to the systemic footprint of the institutions to which they apply," Brainard said. "In addition, rigorous planning and operational readiness for recovery and resolution are required to ensure that big, complex institutions are subject to the same market discipline of failure as other normal companies in America."

The first line of defense within the framework is to "require big, complex institutions to maintain a very substantial stack of common equity in order to enhance loss absorbency and to induce the institutions to internalize the associated risks to the system," Brainard said.

A capital surcharge proposed by the Fed in December for eight U.S. banks that the Financial Stability Oversight Council designated as global systemically important banks is aimed at building additional resilience and lessening the chances of an institution's failure in proportion to risks the institution poses to the broader U.S. economy. The surcharge is "clearly calibrated to the size and complexity of an institution," Brainard said.

The second change to the regulatory framework is requiring large banking institutions to undergo a forward-looking Comprehensive Capital Analysis and Review (CCAR) and supervisory stress test annually to determine if they hold enough capital to continue operations through severely adverse macroeconomic conditions. All banks with assets of more than $50 billion are subject to the CCARs and stress tests, but the tests are now tailored for the eight U.S. banks designated as globally systemically important to include a counterparty default scenario and also a global economic shock for those six institutions with significant trading activities.

The third change to the framework is the addition of a simple, non-risk-adjusted ceiling on leverage designed "not to bind under most circumstances while providing a robust cushion as a backstop," Brainard said. Had this been in place in 2007 before the crisis, most large banks could have been required to hold, on the average, common equity of up to 14 percent of risk-weighted assets, which was approximately twice their common equity holdings at that time.

Other changes include the requirement of large banks to develop "robust operational and legal frameworks" in order to maintain provision of shared or outsourced services, so that critical operations can be maintained during the resolution process; amending financial contracts to provide for a "stay of early termination rights of external counterparties, recognizing that the triggering of cross-default provisions proved to be a major accelerant of contagion at the height of the crisis and greatly impeded cross-border cooperation"; and a clean top-tier holding company structure – and to maintain enough long-term debt at that top-tier holding company that "could be converted into equity to recapitalize the institution's critical operating subsidiaries so as to prevent contagion," Brainard said.

To view a video of the event, including Brainard's keynote address, click here.