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“Making Regulatory Reform Work” Richard H. Neiman Superintendent of Banks for the State of New York before the Institute of International Bankers Annual Washington Conference

March 1, 2010

A. Introduction

I look forward to this IIB conference every year. This is a premier forum for policymakers in international finance, which also has special meaning for me. I participated in this conference on my very first day as Superintendent, exactly three years ago.

Today we are hearing a variety of views on regulatory reforms that will have long-term consequences for the stability of the global financial system. I hope to add value by sharing my perspective as a state regulator. New York has a unique role. We supervise a wide range of institutions, including community and regional banks, large and complex institutions such as Goldman Sachs, and most of the foreign banking organizations operating in the US.

In order to sort through the many compelling proposals on regulatory reform, we need a framework for evaluation. A helpful way for me to approach this is through the lens of two fundamental criteria or questions:

  1. Is the proposed reform forward-thinking, or is it merely a reactionary response to yesterday’s crisis?
  2. Does the proposed reform cause unintended negative effects? Like doctors tending a patient, reforms to the financial system should first do no harm.

In other words, while we need change, we don’t need change for change’s sake -- we need regulatory reforms that work. In my remarks this morning, I would like to apply these criteria for effective change to three hot topics on the reform agenda:

B. Regulatory architecture

Addressing regulatory architecture is an important part of the reform process, but not because there is any one optimal approach. As you know all too well, no country was spared from the financial crisis, notwithstanding diverse agency structures. However, we need to eliminate the potential for abuses, especially where there were attempts to avoid oversight through regulatory arbitrage. For example, competition between the OTS and the OCC for larger institutions became the occasion for destructive charter-shopping. Therefore, I support the Obama Administration’s plan to merge these two agencies.

Some earlier proposals discussed in the Senate went farther, however, to create a single monolithic bank regulator. This would strip the Federal Reserve and the FDIC of all exam authority. I have serious reservations about such complete consolidation: it undermines the dual banking system by creating disincentives to the state charter, and increases the risk of regulatory capture. It would also needlessly sacrifice a successful model of joint supervision with the states over the vast majority of foreign banking organizations active in the U.S. Further, in my opinion, the overall quality of supervision is enhanced by having more than one agency’s opinion on regulatory standards. I compare this to the Olympics using multiple judges to achieve a fair outcome.

So I am glad to see the debate moving away from a monolithic agency. The dialogue is transitioning into a more analytical consideration of the proper roles for the Fed and the FDIC.

There are many issues to consider in deciding whether a functional supervisor, which is focused on operations of a lead subsidiary, is better suited to regulate holding companies in place of the Fed. Also, there are pros and cons to having the FDIC as the sole federal regulator for state-chartered domestic banks. This morning I would like to focus on another issue that may be overlooked. But it is of particular relevance for you as international bankers. And that is the future of our model for supervising branches and agencies of non-U.S. banks.

Until the International Banking Act of 1978 gave authority to the OCC, only the states could license branches and agencies of non-U.S. banks. Today, the overwhelming majority of foreign bank licenses remain state licenses.  As of June 30, 2009, there were 253 branches and agencies of foreign banks in the U.S. Only 50 of them were licensed by the OCC; the remaining 203 are licensed by the states. These state-licensed branches are supervised in partnership with the Federal Reserve. That oversight model is in jeopardy if the Fed’s exam powers are cut.

The New York State Banking Department has a long and successful history of partnering with the Fed to supervise these foreign bank branches and agencies.  New York is responsible for more than half of the state licenses, representing over 80% of the total assets of all foreign branches and agencies in this country.  Foreign entities appreciate the quality supervision we have implemented, which adds value to their business model.

The Fed’s participation in global monetary and regulatory initiatives also gives our partnership unique insights into international banks’ business model. This has practical application in dollar clearing, the payments system, and international monetary flows. And regulating the U.S. operations of foreign banking institutions gives the Fed an important window into systemic risks worldwide.

Based on our extensive collaboration, I can say first-hand that partnership between the Fed and the states is a model that works and, in order to avoid doing harm, should be retained.

C. Systemic risk and resolution authority

The second point on the regulatory reform agenda that I will highlight today relates to the complex issue of Too Big to Fail. I see Too Big to Fail as a catch-all name. Under this rubric there are a number of systemic weaknesses. These weaknesses could leave us vulnerable to a future crisis due to the size, complexity, or interconnectedness of firms.

Taming the Too Big to Fail problem demands that we formalize our process for supervising and resolving systemically significant financial institutions. It is ironic that actions that were necessary to address the financial crisis actually made some institutions larger and more complex.

I believe that the Fed, as the current nerve center of our regulatory system, is well-positioned to take the lead in systemic risk regulation. Having one agency as the primary systemic risk regulator reduces uncertainty in the decision-making process. The Fed’s independence also insulates that process from political pressures. However, regardless of the final form that systemic risk regulation takes, we need to ensure that the Fed’s extensive data and experience are not marginalized.  

A resolution process for the orderly unwinding of nonbanks is critical in ending the moral hazard associated with implicit guarantees as well. Some suggest that an expanded resolution authority creates new forms of moral hazard instead. In reality though, a resolution process is a strong signal to the markets that failures will be allowed and even expected. That signal in turn serves as a deterrent to risky behavior, making failures less likely to occur.

D. The Volcker Rule

These issues around moral hazard and systemic risk raise deeper questions about the nature of financial services firms in our society. We cannot bring closure to this period of unprecedented public support for the financial system --  and we cannot effectively prevent future crises -- without serious soul-searching about the dual nature of banks as risk-takers and as providers of a social utility.

I consider the Volcker rule restricting proprietary trading, hedge fund, and private equity activities to be an important solution in properly resolving this tension. It is true that these activities did not cause the current crisis. But the proposal is strongly forward-thinking because it addresses the core residual issue from the crisis. That issue is the scope of the federal safety net through explicit and implicit guarantees. Excessive risk-taking through activity unrelated to client business is incompatible with taxpayer guarantees.

Some contend that existing firewalls are sufficient to protect insured deposits from high-risk proprietary trading activity conducted at the holding company level. But this overlooks the symbiotic relationship among parents, subsidiaries and affiliates. The market's perception does not distinguish between the parent holding company and the bank. As a result, negative events at the holding company can create a lack of confidence in the depository subsidiary. Likewise, the benefits of explicit and implicit guarantees, as well as funding advantages afforded to the bank, can enrich the bank holding company. These benefits may even subsidize the proprietary activities of nonbank affiliates.

The Volcker rule also reduces the likelihood of failure by curtailing speculative activities, and prevents the growth of institutions to the extent they are being driven by those activities. The key challenge will be to draw the right line, while “doing no harm” by continuing to allow for banks’ appropriate role in market-making.

E. War gaming

But there is another necessary component in preventing future crises, to complement the work of regulatory reform and help ensure that the reform effort meets its objective. And unfortunately one that is not included in any of the current regulatory reform proposals. We need a mechanism to identify and address problems on the horizon before it is too late. For all the well-intentioned discussion about taking a forward looking approach to prevent the next financial crisis, we are still too focused on the rearview mirror. Therefore, just as the military looks at emerging risks worldwide and plots preemptive scenarios, so must the financial system. We need a “financial war gaming center” that reports to, but is not made up of, financial policy makers and regulators.

Made up of thought leaders from the private sector, think tanks, and academia, I envision a threefold mission for the center-

  1. Advanced risk detection. The first mission would be to identify potential market risks by providing a continuous and broad horizontal look at the financial system’s many components. Special attention should be paid to risks that could give rise to high impact events, including those with low-probability such as “black swans.”  Some potential risks that deserve particular monitoring include rapidly rising asset prices, very high leverage, fiscal and monetary imbalances, financial infrastructure failures, and extensive dependence on financial modeling. 
  2. Identification of regulatory gaps. The second mission would be to identify risks of regulatory failure, including gaps in oversight among US agencies and globally, and instances of regulatory capture.  Despite even the best of intentions, the right perspective on regulatory risk requires appropriate distance. By quickly identifying cracks in supervision our defenses against emerging threats can be fortified.
  3. Strategic solutions. Finally, the center would lay out options for policy makers, regulators, and market participants to respond to emerging risks. Armed with impartial analysis and a call to action, all stakeholders – government and industry alike – would be more empowered to address problems on the horizon before it is too late. Ideally, industry would self-correct based on this enhanced information and eliminate the need for government intervention.

Although it is impossible to make fully accurate predictions about the likelihood of future events, especially when rare and potentially catastrophic, making such predictions is not the goal.  Rather, the goal is to be aware and think creatively, with the best information available, about the range of developing risks and consider solutions well in advance.

Conclusion In conclusion, we need to remain forward-thinking in determining optimal regulatory reforms. There is a natural tendency to retreat when faced with a crisis. But that road leads to missed opportunities and ultimately ends in financial protectionism. Our approach to preventing future crises should leverage the collective strength at the federal and state levels, as well as across broad and diverse global markets. I strongly believe that international banks in New York and across the U.S. will make important contributions to reestablishing the financial stability upon which our mutual prosperity depends. Thank you, and I would be pleased to answer any questions.



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