Federal Reserve Bank of Kansas City President Esther George said regulators must eliminate too-big-to-fail policies that bail out large financial institutions during times of crisis.
“The critical and defining question for us is how to break this pattern of growing safety nets and escalating crises, while restoring much-needed market discipline to the financial system,” George said in a speech today in New York.
To achieve those goals, George said, regulators must not view stress tests, or other forms of quantitative analysis and models used by supervisors, “as being a substitute or replacement for examiners and onsite supervision.”
The Fed said last month that 15 of the 19 largest U.S. banks could maintain adequate capital levels even in a severe recession scenario that assumes they continue to pay dividends and buy back stock.
The results of the so-called stress tests showed that nearly three years of economic expansion have helped U.S. banks raise profits, rebuild capital, and increase liquidity after the collapse of Lehman Brothers Holdings Inc. in 2008 nearly toppled the financial system.
“The breakdown we have seen in models-based approaches suggests that we should not develop a false sense of security from the stress tests and other new supervisory tools we are now putting in place,” George said at the 21st Annual Hyman P. Minsky Conference organized by the Levy Economics Institute of Bard College.
Regulators must tackle the “challenge” of dealing with financial innovation in areas such as the derivatives market, George said in response to an audience question. “We have to have more transparency,” including in the clearing and pricing of derivatives, she said.
The Fed started the most recent test and review of banks’ forward-looking capital strategy in November, saying they should have “credible plans” to meet tougher standards required by new regulations and to continue lending even in period of financial stress.
“Policy makers and regulators can face substantial pressure to back off from implementing tighter oversight, especially if such oversight interferes with financial institutions going back to their usual operating parameters,” George said. “Signs of this are already occurring with the efforts by financial institutions and others to weaken or delay stronger capital standards and other provisions of the Dodd-Frank Act.”
U.S. stocks ended a five-day decline as Alcoa Inc. opened the earnings season with an unexpected first-quarter profit. The Standard & Poor’s 500 Index advanced 1 percent to 1,372.91 at 10:48 a.m. in New York as Alcoa rallied 8.5 percent.
The long transition period to new capital rules means that regulators will “allow the payout of capital at the same time we’re asking banks to build it,” George said in response to an audience question. “My objective would be to systematically build high-quality capital in our banks sooner rather than later,” she said.
George was the Kansas City Fed’s No. 2 official under Thomas Hoenig, who retired last year. She joined the Fed in 1982, spent much of her career in bank supervision and became first vice president in 2009.
From 2001 to 2009, she was senior vice president in charge of the Division of Supervision and Risk Management, overseeing regulation of the Kansas City Fed district’s 170 state-chartered member banks and almost 1,000 bank and financial holding companies. She worked in Washington in 2009 as acting director of bank supervision for the entire Fed system.