The Financial Stability Board (FSB) is an international body that plays an important role assessing global financial vulnerabilities and promoting improvements to international financial regulation and supervision. In June, the FSB issued a consultative report on its evaluation of too-big-to-fail (TBTF) reforms and sought public comment on its preliminary findings. The report said banks worldwide are more resolvable and resilient largely because of stronger capital and resolution planning. Further, the report noted that market-based pricing and other measurements suggest these reforms have credibility in addressing TBTF.
The Financial Services Forum welcomes the FSB’s transparent approach to evaluating these reforms and has submitted a comment letter. In this post, we outline our key comments, including the need to differentiate between jurisdictions and to acknowledge the tremendous progress made in the United States to address TBTF.
U.S. regulators and the U.S. Global Systemically Important Banks (GSIBs) have instituted dramatic improvements over the past decade, addressing the systemic and moral hazard risks related to TBTF. While the FSB clearly describes the substantial advancements on a global level, the full array of advancements in the U.S. are distinctly positive and need to be better recognized in the final report. Consistent with the views of many prominent policymakers and economists, available evidence continues to show that both the probability and impact of a U.S. GSIB’s failure has been reduced significantly. The Forum comments also point to the uniquely stringent stress testing program in the United States, which adds an additional buffer on top of reforms that, in many cases, already exceed internationally agreed-upon standards. Improvements to funding stability have also increased the resiliency of the Forum member institutions.
The strength and safety of the nation’s largest banks has been on display during the COVID-19 pandemic, in conjunction with powerful policy responses in support of the economy. As Federal Reserve Chairman Powell said when asked about the resiliency of the banking sector in testimony last week: “It's a completely different and much better situation than we faced in 2008. … our banks so far have really been a source of strength.”
The FSB report understandably takes an international perspective to its findings, but an international scope should also cite clear and important differences among jurisdictions. Relative to foreign jurisdictions, the U.S. has clearly made better progress in addressing TBTF, particularly the implementation of a single-point of entry (SPOE) resolution strategy to resolve a large bank, one that works without taxpayer support and minimizes contagion within the financial system.
Consistent with the above point, a steady stream of research now shows that TBTF reforms in the U.S. are having measurable success. Two specific research papers deserve special mention in this regard. First, “The Decline of Too Big To Fail” by Darrell Duffie from Stanford University and co-authors from Australian National University uses recent data on U.S. GSIBs and finds “large post-Lehman reductions in market-implied probabilities of government bailout, along with big increases in debt financing costs for these banks after controlling for insolvency risk. The data are consistent with significant effectiveness for the official sector's post-Lehman G-SIB failure-resolution intentions, laws, and rules. G-SIB creditors now appear to expect to suffer much larger losses in the event that a G-SIB approaches insolvency.” Second, in the paper “Resolving Too Big to Fail,” researchers from the Federal Reserve Bank of New York analyzed the impact of U.S. resolution planning requirements on the debt costs of U.S. GSIBs. They found that these requirements increased the debt funding costs of U.S. GSIBs. Specifically, the authors found that debt costs for U.S. GSIBs increased by roughly $38 billion and concluded that this impact is large and points to a reduction in too-big-to-fail subsidies.
Both of these studies are important because they provide evidence-based analysis from academic experts on the success of TBTF policies in the U.S. While these studies are cited briefly in the report, their findings and the implications for the effectiveness of TBTF policies in the U.S. should be more substantively addressed.
As noted, TBTF reforms have achieved their objectives of substantially reducing systemic and moral hazard risk in the U.S. At the same time, the resulting framework has certain negative, unintended consequences that can be mitigated without undermining the original goals. One important unintended consequence of the reform program has been the movement of financial intermediation outside of the regulatory perimeter. In particular, we note that research from the Federal Reserve Board and the University of Chicago documents that recent regulation intended to improve bank resiliency may be impairing the ability of large banks to provide liquidity to financial markets. Specifically, the authors state that “regulatory reforms that build the resilience of the ﬁnancial system may increase balance sheet costs for global banks to intermediate dollar funding, which could undermine the eﬀectiveness of U.S. monetary policy implementation.” In addition, Randal Quarles, Vice Chair for Supervision at the Federal Reserve Board and chair of the FSB, recently gave a speech in which he argued that the financial stresses that have occurred during the COVID-19 pandemic emanated from outside the banking sector. As a result, Chair Quarles has charged a senior group of market regulators to develop a holistic review of the stresses that were seen in March in nonbank finance. This review is expected to be delivered to the G20 in November. Accordingly, we agree with the FSB that it should continue to monitor the movement of activities outside the banking sector and, more generally, should consider how unintended consequences of TBTF reforms are influencing this trend.
Reforms in the United States have been broader and more substantial than elsewhere, and recent studies show that market participants no longer perceive U.S. GSIBs as TBTF. Key U.S. policymakers have publicly recognized this progress, and independent, academic research buttress their findings. The achievements on TBTF in the United States relative to other jurisdictions should be clearly addressed in the FSB’s final report. In addition, the FSB should comprehensively consider the impact of regulations on other important aspects of financial stability, such as the migration of activities outside the regulated perimeter, to ensure that the report takes a holistic view of the impact of regulation on the economy and financial stability.