To fully end "too-big-to-fail" we need to make our financial system safer for failure. We cannot rely on the hope of perfect foresight—whether by regulators, or by managers of firms, private sector gatekeepers, or other market participants. Financial activity involves risk, and no one will be able to identify all risks or prevent all future crises.
However, robust capital, leverage and liquidity requirements can prevent the build-up of risk, ex ante, and insulate the system from unexpected shock events, ex post. Imposing higher prudential standards on the largest, most interconnected firms will require them to internalize the risks they impose on the system by virtue of their size and complexity. The largest and most interconnected firms cause more damage to the system when they fail, so they need to hold more capital against risk. That is based on a principle of fairness and also of economic efficiency. It internalizes their costs of failure and provides incentives for firms to limit their size and reduce their leverage.
Internationally, we are working to raise capital requirements so that financial firms can withstand future crises as severe as the one we have just gone through, and do so without government support. In the Basel III negotiations, we are pushing hard to set minimum capital ratios at a level that will represent a significant increase in firms' requirements. These new requirements include the creation of a capital conservation buffer above the minimums, which if breached will restrict firms' ability to pay dividends or buy back stock. Such restrictions will help shore up a firm's capital base before it reaches a point of no return.
Not only are we raising the ratios, but just as importantly, we are raising the standards on the quality of capital that underlie them. The new capital requirements will focus on common equity, excluding other liabilities that did not act as a buffer to absorb losses in the crisis. There will be strict limits on minority interests, as well as on the aggregate contribution of investments in other financial institutions, mortgage servicing rights and deferred tax assets.
In addition to increasing the quality of the capital that firms hold, we are increasing the capital required for banks' riskiest activities, such as their trading positions and their counterparty credit exposures. Capital calculations for trading exposures will now have to be based on stressed market conditions, and the charges for securitization exposures will be increased substantially. In both derivatives and secured lending transactions, firms will now also be subject to a capital charge for losses associated with a deterioration in the credit worthiness of their counterparties.
Under Basel III we will also be introducing a new, internationally applied, leverage ratio requirement that, for the first time, includes firms' off balance sheet commitments and exposures.
The combination of these changes—higher capital ratios, new capital requirements, tougher and more extensive measurement standards—will help ensure that firms have sufficient capital to weather the next crisis.
In addition to new capital requirements, we will be instituting explicit quantitative liquidity requirements for the first time, to ensure that financial firms are better prepared for liquidity strains. Under the new rules, firms will have to hold enough highly liquid assets to meet potential net cash outflows over a 30-day stress scenario. Through the Basel Committee we are also working on developing a liquidity requirement that will require a minimum amount of stable funding over a one year time period, relative to a firm's assets, commitments and obligations. These liquidity requirements will be crucial in helping to mitigate severe strains like those that we saw on the financial sector at the time of the collapse of Bear Stearns and Lehman Brothers during 2008.
Taken together, these heightened standards will provide positive incentives for major financial firms to reduce their size, leverage, complexity and interconnectedness.
The financial crisis has shown that a narrow supervisory focus on the safety and soundness of individual firms can result in a failure to detect and thwart emerging threats to financial stability that may cut across many institutions or have other systemic implications. Under these reforms, federal financial regulators will have the responsibility to supervise our major financial firms in a manner that is designed to protect overall financial stability. The federal financial regulators will engage in a searching review of the bank and nonbank subsidiaries of our major financial firms.
Regulators must supplement existing approaches to supervision with mandatory "stress tests," credit exposure reporting and "living wills," so that they can adequately assess the potential impact of the activities and risk exposures of these firms on each other, on critical markets, and on the broader financial system.
When, despite reforms, a major financial firm fails, the government simply must have the necessary tools to wind-down a failing financial firm without exposing taxpayers to losses and without pushing the economy to collapse. While we have long had a tested and effective system for resolving failed banks, there was no effective legal mechanism to resolve a large nonbank financial institution or bank holding company. The Dodd-Frank Act fills this gap in our legal framework by providing an emergency tool modeled on our existing system under the Federal Deposit Insurance Act—a tool that replaces the untenable choice between taxpayer bailouts and market chaos. Resolution authority is a linchpin of ending "too-big-to-fail."
Both our financial system and this crisis have been global in scope. So our solutions have been and must continue to be global. International reforms must support our efforts at home, including strengthening the capital and liquidity frameworks, improving oversight of global financial markets, coordinating supervision of internationally active firms and enhancing crisis management tools. We have not waited for the international community to act before building a new foundation in the Dodd-Frank Act, and we will not accept an international race to the bottom on regulatory standards.
These reforms will help us restore market discipline to a financial system distorted by the moral hazard associated with "too-big-to-fail." And that process is already underway.
Let me give you a brief introduction to the steps taking place over the next several months.
We are already hard at work. The agencies involved in implementing financial reform are in the process of establishing timelines for moving forward on the scores of studies, regulations and other regulatory actions required by the Dodd-Frank Act. In some critical areas, the agencies are already drafting proposed rules for public comment.
We are going to move quickly to begin shaping reforms of the derivatives market. In this process, we will work with the Fed, the SEC and the CFTC to develop specific quantitative targets and timelines for moving the standardized part of the over-the-counter derivatives business onto central clearing houses. And we must accelerate the international effort to put in place common global standards for transparency, oversight and the prevention of manipulation and abuse of these critically important markets.
We're going to stand-up the Office of Financial Research, which in the coming months will work closely with regulators and market participants to assess the financial data reporting needs and challenges for better monitoring of firm-specific and systemic risk, to streamline current regulatory data reporting requirements imposed on financial firms, to improve data sharing among regulators, and to enhance the utility of existing data sources.
As I mentioned, we are now finalizing an international agreement that will require financial firms to hold both more and higher quality capital than they did before the crisis. Those are some of the key areas regarding prudential reforms where we—the Treasury, the financial regulators—will be focused in the coming months. I'd also like to briefly highlight our work on consumer protection.
We are moving quickly to give consumers simpler disclosures, so that they can make better choices, borrow more responsibly, and compare costs.
For example, in place of the two separate, inconsistent and overly complicated federal mortgage disclosure forms that borrowers receive today, there should be one clear, simple, user-friendly form.
In addition, we will be inviting public comment on new national underwriting standards for mortgages, so that we can begin to shape the reforms of the mortgage market.
And we are working quickly to get the CFPB up and running, to consolidate rule-making, supervision and enforcement responsibilities that today are split, inefficiently and ineffectively, among seven different regulatory agencies.
On all fronts, we are committed to moving with speed, with transparency, and with a commitment to ensuring that our financial system remains the most competitive financial system in the world.
Michael Barr is the Treasury Assistant Secretary for Financial Institutions.
