Fed Governor Jeremy Stein: Regulators have addressed TBTF but more work remains

126px-US-FederalReserveSystem-Seal.svgFederal Reserve Governor Jeremy C. Stein said during a Wednesday speech that while regulators have made significant progress in regard to fixing America’s “too big to fail” problem, much work remains.

Stein said increased capital requirements, stress testing provisions and enhanced liquidity requirements “should help to materially reduce the probability of a systemically important financial institution finding itself at the point of failure,” pointing to the Dodd-Frank Act’s Orderly Liquidation Authority as an additional safeguard.

“Perhaps more to the point for TBTF, if a SIFI does fail, I have little doubt that private investors will in fact bear the losses–even if this leads to an outcome that is messier and more costly to society than we would ideally like,” Stein said in remarks prepared for a conference sponsored by the International Monetary Fund. “Dodd-Frank is very clear in saying that the Federal Reserve and other regulators cannot use their emergency authorities to bail out an individual failing institution. And as a member of the Board, I am committed to following both the letter and the spirit of the law.”

Stein also said, however, that regulators are “quite a way from having fully solved the policy problems associated with SIFIs.”

“For one thing, the market still appears to attach some probability to the government bailing out the creditors of a SIFI; this can be seen in the ratings uplift granted to large banks based on the ratings agencies’ assessment of the probability of government support,” Stein said. “While this uplift seems to have shrunk to some degree since the passage of Dodd-Frank, it is still significant. All else equal, this uplift confers a funding subsidy to the largest financial firms. Moreover…even if bailouts were commonly understood to be a zero-probability event, the problem of spillovers remains. It is one thing to believe that a SIFI will be allowed to fail without government support; it is another to believe that such failure will not inflict significant damage on other parts of the financial system. In the presence of such externalities, financial firms may still have excessive private incentives to remain big, complicated, and interconnected, because they reap any benefits–for example, in terms of economies of scale and scope–but don’t bear all the social costs.”

Stein said regulators should not abandon current reform but should instead adhere to the current policy path and “ratchet” up its forcefulness through the implementation of a substantive senior debt requirement at the holding company level to facilitate resolution under the OLA and “an increase in the slope of the capital-surcharge schedule…applied to large complex companies.”

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