International Regulatory Reform: Implications for the U.S. and China
RICHARD H. NEIMAN
SUPERINTENDENT OF BANKS FOR THE STATE OF NEW YORK
COLUMBIA BUSINESS SCHOOL, CHINA BUSINESS INITIATIVE
GLOBAL SUMMIT, BEIJING
July 17, 2010
Good morning. Thank you for that warm welcome and for the privilege to serve on the Advisory Board of Columbia Business School’s China Business Initiative (CBI). I am honored to join such a diverse group of thinkers and talent towards contributing to CBI’s work in fostering international partnerships and cooperation.
Some of us from the West like to borrow the Chinese saying: “You can’t clap with one hand only.” English translation probably does insufficient justice to this old proverb, but the core message remains, and it is truer today as we begin our work than ever. I am confident we will all benefit from each other’s perspective over the next few days in order to overcome today’s challenges and to create new opportunities.
It is appropriate that our first Board meeting is also a Global Summit Forum and that it is being held here in China. I am fortunate that this is my second trip to China over the past year. I visited last Fall to attend a banking regulators “supervisory college,” a unique forum I will be describing in more detail later in my remarks. I am delighted to be back- I have found that even in this internet age I learn so much more from face to face interaction with foreign colleagues and friends.
In my remarks today, I would like to focus on two of the areas where I see bridges between New York and China in terms of banking and financial services:
- The role of New York as an international supervisor of financial services firms and our oversight of Chinese banks; and,
- Regulatory reform and the impact on international banking and the global economy.
II. The Role of New YorkWall Street needs no introduction, but what may be less well known is the role that New York State plays as a significant financial services regulator.
The New York State Banking Department is the oldest bank regulator in the country. 1851 is ancient in the United States. The agency oversees about 100 state-chartered banks which include large banks like Bank of New York Mellon, our oldest bank, and our newest Goldman Sachs Bank, as well as many community and regional banks. We supervise hundreds of non-depository institutions as well, such as mortgage bankers and brokers; check cashers; money transmitters and others involved in consumer finance.
Unique to New York is that we also license the vast majority of foreign banking organizations that are active in the U.S., representing over 80% of the foreign bank assets in the United States. It is this international perspective that makes New York a unique financial center. Our strength in this area is also a function of the positive working relationships we have developed with other supervisors from over 20 countries. From jurisdictions in Europe to Asia and South America, we have regulatory partners around the world.
These international partnerships have expanded during my tenure as Superintendent, in particular through our licensing of branches for three leading Chinese banks: China Merchants Bank, Industrial and Commercial Bank of China, and China Construction Bank. These were the first banks from mainland China to open U.S. branches in seventeen years.
These new branches are significant milestones in several respects. First, the opening of international branches of Chinese banks is evidence of economic growth. With increased privatization, banks have additional capital to expand their activities. The approval from the state and the Federal Reserve to open these branches demonstrates the progress China has made in standard setting as part of the move toward greater privatization. China became a signatory to the Basel Capital Accords in 2009, and provided further evidence of establishing corporate governance and sound regulatory, accounting, and audit practices.
Further, from New York’s perspective, these new branches demonstrate confidence in New York as the regulator of choice for international banks looking to enter the US market. Banks have a choice between a federal and a state license. We refer to this as the dual banking system in the US. Many in the world have a more centralized supervisory framework and regulatory consolidation is a global trend, but in the U.S. we are more decentralized. The U.S. did consider creation of a monolithic, single federal regulator as part of the current reform process, but opted largely to retain the checks and balances in our existing system. I wholeheartedly endorse the concept that multiple regulators improve the system, much as multiple judges are used in the Olympics for fair results.
Finally, these new branches reflect the importance of growing trade between China and the U.S. This is important not only for economic growth but also to foster partnerships between New York, Beijing, Shangai and other cities that are leading financial centers around the world. These connections that we form at the local level have a positive effect that can increase stability of the global financial system.
III. Regulatory Reform
So far I have highlighted the good news, but of course the past few years have also been marked by turmoil in financial markets. The need for regulatory reform has been made painfully clear, and these reforms will have global implications that will impact China as well.
Since the financial crisis began in the US mortgage market, some who have seen the US as a model have told me that “the teacher has failed us.” While the U.S. has offered examples of successful financial innovations, we also have to learn from our mistakes and those of fellow nations. I believe that those mistakes, as well as our actions and changes in the U.S. in response, are yielding lessons that can be of benefit to the international community.
The current financial crisis was born as a crisis of confidence: in our financial institutions, in the ability of our regulators, and in the international financial system. That is why our response to the crisis needs to be one of rebuilding-
- Rebuilding confidence in individual financial institutions;
- Rebuilding confidence in our legal and regulatory framework; and,
- Establishing confidence in cooperative international structures.
1. Rebuilding Confidence in Financial Institutions
The financial crisis was due in large part to a loss of confidence in individual financial institutions, which led to extraordinary spreads in interbank markets and a near-shutdown of liquidity.
The major actions taken by the U.S. early in the crisis, including the Federal Reserve’s various new liquidity facilities and Treasury’s Troubled Asset Relief Program, were designed to break this funding freeze. The FDIC also prevented a liquidity shortage from causing bank runs through its expansion of deposit insurance and creation of asset guarantee programs.
On the supervisory level, these support programs were complemented by stress tests of our largest 19 banks, to ensure those banks would have adequate capital buffers should market conditions continue to deteriorate. It was an unprecedented move when the results of these supervisory stress tests were made public, but the resulting increase in market confidence was substantial. The success of the stress testing process also highlights that transparency and accountability are indispensible in restoring trust.
2. Restoring Confidence in the Legal and Regulatory Framework
The steps taken to restore confidence in institutions can be thought of as the first emergency response. A longer-term task is restoring confidence in the legal and regulatory framework that failed to prevent this market disruption from occurring. How can we assure that our structures will be robust enough to address systemic risk and avoid future crises?
I see five broad areas that point the way forward:
- Consumer protection;
- Financial standards;
- Systemic risk regulation;
- Resolution authority; and,
Congress is in the final stages of a major regulatory reform effort, of a scope not seen since the days of President Franklin Roosevelt when the SEC and FDIC were created and Glass-Steagall was enacted to separate commercial and investment banking. These reforms from the era of the Great Depression were designed to restore confidence and build a safety net to maintain confidence in the face of future economic downturns. The items on Congress’ reform agenda today likewise address the roots of the market meltdown while again rebuilding public and investor confidence.
A. Consumer Protection
The current financial crisis had its origins in the U.S. housing market, and a lack of adequate and uniform consumer protections was a root problem. To restore public confidence and reduce the risk of future crises, Congress recognized the need to strengthen consumer protections. Consumer protection has clear systemic consequences for the stability of the financial system.
Creation of a dedicated consumer protection bureau within the Federal Reserve is a major part of the agenda in the U.S. Here is an example of where the U.S. is applying lessons learned from other countries that have also adopted a “Twin Peaks” approach to supervision. The new consumer bureau will write rules and conduct enforcement over a wide range of financial services providers, including non-banks. In addition to the challenges inherent in this important mission, probably the greatest challenge will be to assure appropriate coordination with prudential regulators and balance concerns relating to safety and soundness and credit availability.
B. Financial Standards
Building on improved consumer protections and improved loan underwriting, other strengthened prudential standards are a remedy that the global financial community needs to adopt. I am encouraged by the work of the Basel Committee to develop new standards for capital buffers, leverage, liquidity and risk management. Such measures are intended to be countercyclical weights that would help both to reduce the build-up of systemic risk and to increase resilience during economic downturns.
C. Systemic Risk Oversight
We also need to rebuild confidence in our regulatory framework, including the ability to manage risk on both a micro and a macro-prudential level. In the U.S., that is why the regulatory reform bill is curbing risky behavior that could undermine financial stability, such as the Volcker Rule to ban proprietary trading and the move to push certain risky swaps transactions out of the bank. We are also working to level the playing field by creating new structures to oversee systemically significant nonbanks that have gained an increasing market share.
It is an interesting comparison that banks in the U.S. are responsible for about half of corporate financing, with the other half provided by the capital markets. Whereas in China, close to 90% of intermediated financing comes from banks. This growing non-bank market share in the U.S. created what has been referred to as a “shadow” banking system.
The U.S. is working toward reforms that would bring major non-banks into a more comprehensive regulatory regime and address systemic risk. The bill would create a Financial Stability Oversight Council, composed of federal regulators and led by the Treasury Secretary, to monitor the system as a whole. The Council could determine that a non-bank, including a hedge fund, should be regulated by the Federal Reserve if they pose systemic risk. The Council would also have the authority to impose higher capital requirements on such firms, or require them to divest holdings if their structure posed a grave threat to financial stability.
While the non-bank sector may not present the same degree of risk in China today, with increased capital markets activities it may be an area for growth. In the future there may be issues around coordination of functional regulators for large and complex firms in China, and our U.S. experience with integrating a Financial Oversight Council into the supervisory framework may be relevant.
D. Resolution Authority
Tackling systemic risk and rebuilding confidence in the regulatory infrastructure also involves the related problem of institutions considered “Too Big to Fail.” The U.S. and China both have large and complex institutions that can create moral hazard when they are not subject to appropriate market discipline. Reforms in the U.S. include new resolution tools to allow for an orderly wind-down of systemically significant firms that operate in multiple countries. International cooperation is vital in allowing such firms to fail without endangering broader financial stability.
The Memorandum of Understanding signed in May between the CBRC and the FDIC is a model for the kind of international agreements we need in this area. It is particularly important that the CBRC and the FDIC have an understanding to work cooperatively on issues that would be vital in an emergency situation, beyond the resolution process, such as liquidity, solvency and contingency funding plans.
There are other tools to tackle the systemic risks, including counterparty risk, that can flow from the size, interconnectedness, or asset concentrations of international banks. In the U.S. we have taken additional steps to facilitate transparency and accountability on derivatives trades through the use of clearinghouses and trade repositories.
New York played a lead role in the early stages of this process through chartering of ICE Trust U.S. (ICE), a subsidiary of the Intercontinental Exchange, as a state-chartered trust company. ICE serves as a central clearing facility for credit default swaps and has already cleared $10 trillion in gross notional value, which increases transparency, reduces counterparty default risk and decreases the net amount of swaps outstanding.
3. Establishing Confidence in Cooperative International Structures
Because of the globalization of financial institutions and the risk of regulatory arbitrage, there is clear recognition that international supervisors need to increase our cooperation and reinforce mutual accountability. Whether it is in fighting terrorist financing or ensuring prudential standards are met, supervisors need to have clear expectations of each other. The Basel process and the G-20’s framework for financial stability are critical guideposts.
The need for effective supervision brings me back to a point I mentioned earlier- the role of supervisory colleges. Supervisory colleges are working groups composed of the relevant regulators of an international banking organization, coordinated by the home country supervisors. Key functions of a supervisory college include information sharing, assessment of cross-border risk exposures, and coordinated inspections and examinations. This supervisory cooperation is increasingly important as banks continue to organize their operations by business lines, with the result that risk management for a New York activity may be located in the home office.
The same type of cooperation that the G-20 is striving for on the macro level needs to hold true on the front lines of bank examination as well. I look forward to meeting with officials from the China Banking Regulatory Commission (CRBC) during my visit. Enhancing risk management processes is a shared goal in our approach to effective cross-border supervision.
IV. Impact on Global Economies
I can’t overemphasize the importance of getting it right in our efforts in financial reform and international cooperation and harmonization of standards. The financial sector’s impact on the real economy is tremendous, as the recession that grew out of the financial crisis demonstrates, and its reach is global. We need banks as engines of economic growth, to ensure that credit is available for entrepreneurs and expanding businesses to create jobs and support global trade. Without the financial intermediation that fuels entrepreneurship, we might be looking to inheritance as the primary means of wealth transfer. And as a result, growth could stagnate.
With its economic expansion, China will have an increasing role to play in developing robust international financial markets. As a major regulator of international institutions, we in New York look forward to deepening ties with Chinese regulators and working closely to help ensure the stability of the global financial system.E. Challenges going forward
As the U.S. implements its reforms over the next several years, and as China continues to move toward market-based approaches and build on its supervisory structure, there are many issues and open questions that will deserve close attention by both of us, such as:
- To what extent will the regulatory environment in the U.S. or in China impact financial innovation and global competitiveness?
- Whether and to what extent should certain securities and trading activities be permitted for commercial banks?
- What is the impact of moral hazard on risk-taking by banks, given that they are subject to varying degrees of implicit and explicit support by governments worldwide?
- How should we balance the tension between the potential benefits of financial innovation and the need for appropriate government review to assure adequate risk controls?
- Can improved corporate governance and compensation policies better align incentives and reduce risk, while still attracting top talent?
- What will be the impact of regulatory reforms, both in the U.S. and internationally, on credit availability and pricing?
- How should we balance competing interests when governments maintain an ownership interest in a financial firm, whether it is a Chinese bank or a U.S. institution like Fannie Mae or AIG?