Welcome and Monday Morning Keynote: Michael S. Barr
The opening event for FMC 2024 featured welcoming remarks from Atlanta Fed president Raphael Bostic and a keynote address from Michael S. Barr, vice chair for supervision of the Federal Reserve Board of Governors. Atlanta Fed executive vice president and director of research Paula Tkac introduced Barr.
Transcript
Raphael Bostic: Welcome to our Bank's 28th Financial Markets Conference. This has always been one of the most interesting times of the year and interesting programs that I get the privilege of attending, and so it's really nice to look out and see all of you here in the room. I also want to add a "welcome" to those who are watching via the live stream. It's good to have you join us as well, and I want to thank you for tuning in.
Every year, we aim to make this event timely and substantive, and I think we generally succeed. I was at breakfast earlier today and someone was mentioning that a couple of years ago, we had a whole segment on AI. I think about where we are today and how it is coming and I think it's a good sign for how we're doing and how we're really trying to think hard about creating a program that will be relevant in the moment, but also moving forward.
I'm confident that this year's conference is going to meet that standard as well. The US macroeconomy and labor market remain broadly healthy, and financial markets are generally stable as well. So, you might think, "Well, then, what is there to talk about?" But there's plenty to talk about, and we have the ongoing risks that merit close monitoring, including inflation, policy uncertainty, geopolitical risks.
There are also questions concerning the transmission of monetary policy and relatedly whether a restrictive, nominal fed funds rate is as effectively restrictive as the FOMC, or Federal Open Market Committee, intends. This is a question I get increasingly: Is your policy able to do what we want it to do? This is actually going to receive a pretty thorough hearing here. I'm looking forward to the comments on that because these are critical questions to help us have a sense of whether the Committee is going to be able to continue to bring inflation down to our 2 percent objective.
The readings this year actually demonstrate how important this question is. Last year's rapid disinflation has slowed. For me, my base outlook is still that we're going to be able to get to 2 percent. It's just going to take a lot longer than I think most had anticipated.
In our time together, we will also explore the Fed's essential and ever-evolving role as lender of last resort. Later this morning, we will be treated to a presentation of research that examines whether, in the wake of the pandemic, global supply chains will undergo the sweeping realignment that many observers have predicted. This afternoon we're going to give you a break, so I hope you enjoy this beautiful island, or relax or catch up on emails—that's what I'm going to do—but then come back for this evening.
We will cap off the day with a presentation that I'm actually very, very excited about. I love cities; how I got into economics was really around noticing that cities are vibrant places where innovation happens and growth and energy are present. It's going to be a pleasure to hear from one of our country's leading experts on the development and the economics of cities, Ed Glaeser of Harvard University. Ed will discuss the future of cities in the post-pandemic world and then take your questions. It's going to be really interesting and, again, I'm looking forward to it. Please be there; it should be nice.
Tomorrow, we will hear from a number of folks. It's a longer day tomorrow and we're talking about a lot of topics. There'll be a panel on inflation and crises, which are both timely. Another topic is the global role of the US dollar. We're lucky to have a distinguished international panel to discuss the history of the dollar's essential role in global markets, the costs and benefits associated with that role, and the extent to which the Federal Reserve is or should be the lender of last resort in an international context.
My colleagues and I hope that you find the next two days thought-provoking and enlightening. I want you to engage, ask questions using the event app—there are instructions on the tabletops here if you have questions. We're going to try...in our Bank, we actually do questions using apps now; we don't hand mics around. We're using a new one, but please do that. We want to have your thoughts influence how this conversation goes.
At a conference like this we have really tried to bring together an illustrious, smart, and influential group of people. As you're here together, try to meet some people you don't know. Engage with folks; this is really an opportunity for us to broaden our networks and to make sure that we leave here much richer and better prepared to do our jobs as when we came.
I'm going to step aside in a moment, but before I do that I want to thank the dozens of staff from my Bank, the Atlanta Fed, along with the people here at the Omni Amelia Island Resort. They've actually done all the work to make this happen.
I get to host; it's a great pleasure. Y'all have thanked me for being here and the invitation, but I didn't do anything. I just showed up like you did. It was really our team that did all the hard work of putting this program together, and making sure that the experience is one that everyone will talk about for weeks and months to come. So, thank you for your work. I'm going to congratulate you for a job well done. And with that, I'm going to turn the stage over to Paula Tkac, who will introduce our first speaker.
Paula Tkac: It is my distinct pleasure to kick off this conference with a man who I guess needs no introduction, and will talk about very timely things: Michael Barr, the vice chair of Supervision for the Federal Reserve Board of Governors.
Michael S. Barr: Thank you, Paula. Good morning, everyone. It's great to be able to be with you here today. I'm going to give some formal remarks, and then Paula and I will have a chance to chat, with your questions very much in mind. I look forward to that part of the conversation, too.
As many of you know, I have two roles at the Federal Reserve: my role as a governor of the Board and a member of the FOMC, where I participate in developing and setting monetary policy, and my role as vice chair for Supervision, where I oversee our supervision and regulation of the banking sector. In keeping with the interdisciplinary spirit of this conference, I'll touch on these different roles and how they both promote a healthy economy.
To start, I'll share a couple of observations about the current stance of monetary policy. Then I'll discuss the conceptual framework that underpins the key components of prudential bank regulations. As part of this discussion, I'll also offer some observations about adjustments to our regulatory framework that we are exploring, including as a result of lessons learned from the bank stress in the spring of 2023.
Starting with recent economic developments, I see the performance of our economy as strong. Labor demand is being met with rising supply, from both improved labor force participation and immigration. We have solid growth and low unemployment. The unemployment rate has been below 4 percent for 27 months—the longest stretch of unemployment that low in more than 50 years. I'm strongly committed to meeting the mandate that Congress has given us to achieve maximum employment and price stability. We are doing well on the employment component of our mandate, and we have also made tremendous progress over the past two years on the inflation component.
Inflation has fallen from its peak of 7.1 percent to 2.7 percent today, but we are not yet all the way to our target of 2 percent. As noted in the FOMC's statement following our meeting earlier this month, inflation readings in the first quarter of this year were disappointing. These results did not provide me with the increased confidence that I was hoping to find to support easing monetary policy by reducing the federal funds rate. This means that we will need to allow our restrictive some further time to continue to do its work. I think we are in a good position to hold steady and closely watch how conditions evolve. I remain vigilant to the risks to achieving both components of our mandate. I believe that the current approach is a prudent way to manage those risks.
Evaluating risk is also fundamental to my other role as vice chair for Supervision. In the same way that the public depends on monetary policy to support a healthy economy, the public also depends on a strong and stable financial system. I'd like to spend the remainder of my time discussing the prudential regulatory framework the Fed uses to oversee banks and promote financial stability.
The prudential regulatory framework for the banking system is crucial to supporting an economy that works for everyone. As I have spoken about before, banks play a critical role in the economy in taking deposits and providing credit to households and businesses.
Distress in the banking system can impose widespread costs on society. The government and taxpayers support the banking system through deposit insurance and other forms of government support. The system relies on banks having the capacity to remain resilient and continue lending to households and businesses through times of stress.
I will focus on three components that underlie the resilience of the banking system: capital, liquidity, and resolution resources. Each component plays a distinct role in fostering a safe and stable banking system by promoting the resilience of banks and limiting the impact of their distress or failure on the broader economy.
The three elements work together: capital absorbs the impact of unanticipated losses, liquidity enables a bank to meet funding withdrawals and provide time to right itself from a bout of stress, and resolution resources facilitate an orderly wind down of a failing bank, which promotes financial stability and limits damage to the economy. Capital is a core source of resilience, and common equity is the core of capital. Common equity provides the greatest degree of loss absorbency and it is the first line of defense against the risks of bank runs. Sufficient capital makes a bank resilient, both to cyclical economic downturns and unexpected shocks like those we saw in March 2023.
Capital can absorb losses no matter the source, so it is an effective defense against a wide range of risks that banks face. We use different models to set capital requirements because no one approach can fully capture the range of risks. These models include a leverage ratio, a static risk-based capital rule, and a forward-looking stress test.
Liquidity regulation complements capital regulation by ensuring that a bank has adequate resources to meet potential outflows. Liquidity can also support an orderly resolution. Requiring banks to hold high-quality liquid assets that are commensurate with the size and likelihood of sudden funding outflows is a form of self-insurance against unanticipated funding shocks. While no amount of liquidity can fully guarantee that a bank will survive a run, in combination with ample capital, liquidity resources can help stabilize an individual bank and limit the potential for stress to spread.
A third element of the prudential regulatory structure that I will describe is resolution resources in the form of long-term debt and resolution planning. Unlike the other elements of the regulatory structure that enable banks to manage through stressful times and continue operating, long-term debt requirements in the United States are intended to provide resources that can be drawn down in the resolution of a failed bank.
In concert with requirements that large banks develop "living wills," or strategies for orderly resolution in the event of material financial distress or failure, long-term debt provides loss absorption resources after a bank fails, which can be used to capitalize a bridge bank, provide time for an orderly bidding process, or for the preparation for sale of the failed bank's assets and liabilities. Moreover, long-term debt can reduce the likelihood of a run by increasing market confidence that there will be sufficient resources for an orderly wind down.
These three elements of our regulatory regime are tiered so that larger firms that pose a greater risk to financial stability are subject to stronger requirements. This tiering runs through all of our regulation and supervision and reflects the diversity of banks that support our economy. For example, a small community bank is subject only to a simple leverage ratio and no liquidity or resolution requirements, consistent with its small systemic footprint. On the other hand, a global systemically important bank, or G-SIB (the largest and most complex bank), is subject to multiple measures of capital adequacy, long-term debt requirements, and liquidity rules.
Prudential regulation was substantially enhanced after the global financial crisis, providing the foundation for a strong, stable, and prosperous US banking system. Capital regulation was thoroughly redesigned, and the Federal Reserve now conducts an annual stress test of large banks. Quantitative liquidity requirements were put in place and have greatly strengthened the liquidity positions of large banks. Capital liquidity and long-term debt and resolution planning have reduced the likelihood that banks experience distress and have limited the harm that the distress or failure of one of the largest, most systemically important banks would do to the US economy.
The work to reform capital requirements after the global financial crisis is not done yet. The Basel Endgame proposal represents the final step in addressing the regulatory weaknesses revealed by that crisis. It is targeted at ensuring that the risk weights that underpin the capital regime accurately measure a bank's risk. The Federal Reserve has received a large number of comments on our proposal and we're focused on carefully working through these comments. We also undertook a special data collection from large banks to better estimate the impact of the rule on banks' capital requirements. I expect we will make broad and material changes to the proposal on the basis of the comments we received.
Basel Endgame will finish the work of responding to the global financial crisis, but the financial system is dynamic and continues to evolve. Regulators must ensure that the rules adequately keep pace with these developments. Last spring, the distress and failure of Silicon Valley Bank, Signature Bank, and First Republic imparted important lessons about the functioning of all three parts of the regulatory framework.
SVB was a highly vulnerable bank and its vulnerabilities left the bank exposed to the specific combination of rising interest rates and slowing activity in the technology sector that materialized in 2022 and early 2023. Once the public appreciated the bank's risks, the bank was viewed as insolvent. SVB faced a run of uninsured depositors that was unprecedented in its speed and its severity.
There were signs of distress at other banking organizations, particularly those with a heavy reliance on uninsured deposits. Signature Bank experienced a deposit run that resulted in the bank's failure that same weekend. First Republic also had significant unrealized losses on loans and securities and it failed a few months later. Depositors at these banks withdrew funding at rates that greatly exceeded the assumptions made in our current, standardized liquidity requirements, although these firms were not even subject to those requirements.
In addition to facing historically fast deposit outflows, SVB and Signature Bank faced impediments to monetizing their assets, including even highly liquid assets. This was especially true for securities that had lost value, and if sold would require the firm to recognize these losses. Securities can be monetized through repo markets, but firms may be limited by their counterparty relationships in these markets and the typical tendency of counterparties to reduce exposures when there are signs of stress.
Both SVB and Signature Bank learned about these limitations the hard way. Of course, there is one source of liquidity that solvent banks can rely on to provide funding against a broad range of assets—the Federal Reserve's discount window. Yet, while the discount window can be an important source of liquidity, firms need to be prepared to access it. Ultimately, SVB and Signature Bank were resolved after the Board and the FDIC recommended to the Treasury Department that it evoke the systemic risk exception, allowing the FDIC to guarantee these banks' deposits.
The systemic risk exception is an extraordinary tool that is rarely used. Its two prior uses since its creation in 1991 occurred during the global financial crisis. The Federal Reserve also used its emergency authorities, together with a backstop from the Treasury Department, to establish the Bank Term Funding Program. These actions were able to limit the contagion in the banking sector. However, additional regional banks still saw deposit outflows and came under stress.
We are working to address the lessons learned from these events in three areas. On capital, I've already mentioned our Basel 3 Endgame proposal and its role in completing the post-global financial crisis regulatory reforms. With respect to the acute problems we saw last year, the proposal would also extend the requirement to reflect the impact of unrealized losses on capital to all large banks. Currently, only the largest banks, the G-SIBs, are required to reflect those losses in their capital. Our proposal would better reflect interest rate risk in capital, a problem that played a major role in both SVB and First Republic's failures.
To address the lessons about liquidity learned last spring, we are exploring targeted adjustments to our current liquidity framework.8 Over the last year, many firms have taken steps to improve their liquidity resilience, and the regulatory adjustments we are considering would ensure that all large banks maintain better liquidity risk management practices going forward.9 They would also complement the capital requirements by improving banks' ability to respond to funding shocks.
First, we are exploring a requirement that banks over a certain size maintain a minimum amount of readily available liquidity, with a pool of reserves, and preposition collateral at the discount window, based on a fraction of their uninsured deposits. Uninsured deposits often represent cash needed to meet near-term needs, like paying bills or making payroll, and we have seen depositors act quickly to withdraw these funds if their availability is in doubt. It is vital that uninsured depositors have confidence that their funds will be readily available if needed, and this confidence would be enhanced by a requirement that large banks have readily available liquidity to meet requests for deposits.
Incorporating the discount window into a readiness requirement would also reemphasize that supervisors and examiners view use of the discount window as appropriate and unexceptional, under both normal and stressed market conditions. Given the important role of the discount window, we're also actively working to improve its functionality. As part of these efforts, we are seeking feedback from banks. This feedback will help us to further prioritize operational improvements.
Second, we are considering a restriction on the extent of reliance on held to maturity assets in large banks' liquidity buffers, such as those held under the liquidity coverage ratio and the internal liquidity stress test requirements, to address the known challenges with their monetization and stress conditions. Third, we are reviewing the treatment of a handful of types of deposits in the current liquidity framework. Observed deposit withdrawals from high-net-worth individuals and companies associated with venture capital or crypto-asset-related businesses suggest the need to recalibrate deposit outflow assumptions in our rules for these types of depositors.
As we saw during the stress of a year ago, these types of deposits can flee banks much more quickly than previously anticipated. Finally, we are revisiting the details of the application of our current liquidity framework for large banks.
Turning to long-term debt, the bank failures and broader stress last spring show that we have more work to do so that large banks that fail can be resolved without negative spillovers. These events also underscore the important role loss-absorbing resources could play in managing the failure of a large bank, even one not designated as systemically important.
Unlike capital, which is likely to be depleted by the time a bank fails, long-term debt is available upon failure to absorb losses, providing better protection for depositors, and limiting the potential cost of the resolution to the deposit insurance fund. Long-term debt can further support the orderly resolution of a failed bank by enhancing the attractiveness of the bank or its businesses to buyers and maintaining the value of the bank's franchise. This in turn would likely limit the extent to which the FDIC would have to rely on the deposit insurance fund to support the resolution.
Long-term debt also complements our liquidity framework. An adequate amount of long-term debt can reduce the likelihood of depositors running, facilitate resolution options that would not be otherwise available, and reduce the possibility that emergency authorities would need to be deployed to stem contagion in the banking system. Long-term debt can also improve the stability of a bank's funding profile by reducing the bank's need to rely on less stable forms of funding.
Last August, the bank regulatory agencies invited comment on a proposal to require large banks to issue and maintain a minimum amount of long-term debt. The comment period for the proposal closed earlier this year, and we are reviewing the comments received. Many commentators agreed that having long-term debt would improve the resolvability of large banks. Commenters also provided feedback on potential adjustments to the proposal, all of which we are carefully considering.
In conclusion, capital, liquidity and resolution resources are three legs of the stool of the post-financial crisis regulatory framework. The recent stress from last March has only underscored the importance of each leg of this stool, how each reinforces the others, and how weaknesses in one could render the others less effective. As a result, we are carefully considering changes to capital, liquidity, and resolution requirements to increase the resilience of large banks.
We're attentive to the interaction across these proposals, as well as the potential burden. But ensuring that each of these three components is properly calibrated will help to ensure that banks remain strong and able to maintain their crucial role in providing credit to US households and businesses under a wide range of conditions.
Thank you very much.
Tkac: Thank you, Michael; lots to talk about. We've got some good questions here. I'm going to start with a couple of my own. Everyone, keep putting your questions in here. We've got plenty of time to get to them.
I want to start where you started: You wear two hats. You're an FOMC member, and you're the vice chair for Supervision. How do you think about the intersection of those two roles? In particular, I'm thinking about the role of liquidity regulation—you mentioned potentially bigger buffers with reserves—and how that plays into a discussion of the size of the balance sheet.
Barr: Well, let me say, in a bigger picture way, the roles are really quite complementary. When I'm in the FOMC, I am thinking about the structure of the banking system, the transmission of monetary policy through that system, whether the pipes are working appropriately, ways in which stress in the banking system can alter the provision of credit in the economy, which is an important way we think about financial conditions. All of those things really fit quite well together.
The question about the balance sheet is also one that brings these two things together. We are in the process right now of continuing the runoff of our balance sheet, but we've made a decision to slow the pace of that runoff. One of the reasons that we decided to do that is to ensure that as we're reducing the asset side of our balance sheet we're also paying appropriate attention to the liability side of the balance sheet.
In particular, we want to ensure that there are ample reserves in the system. Right now, we have what is technically called "abundant reserves" in the system. We're working our way down to a level that is, we hope, above ample with a sufficient buffer but so that we know there are enough reserves in the system that banks need and demand in order to be able to be stable, to serve their clients and their customers. When we think about liquidity rules, I'm also thinking about not only the reserve aspect of bank liquidity, but also high-quality liquid assets, and the way in which liquidity is managed by the firm. Those things together, as well as the way in which banks prepare to use the discount window, are ways of thinking about their resilience to funding shocks.
Tkac: Do you have in your own mind a working definition of "ample" versus "abundant?"
Barr: The monetary policy framework that the Fed established has a framework for understanding what ample reserves are. Ample reserves are the reserves essentially that the system demands in order to conduct payments, in order to have precautionary reserves in the event of distress. It's a function of not only the reserves at individual institutions, but how reserves are redistributed in the system. "Ample" is a level that lets all those things happen without in any way interfering with the effective implementation of monetary policy.
If we have a level of reserves that is too low, frictions in liquidity provision can mean that it's harder to control the effective funds rate. If we're in a realm where we can't do that effectively, we're clearly not in an ample reserve regime. We don't want to get anywhere close to that.
Tkac: Got it. Let's go to the most voted on question here on everyone's mind and tangentially in your wheelhouse: Is the Fed concerned about the movement of billions of dollars of private credit from the banking system, where transparency and regulatory oversight exist, into the private credit markets, where little or no transparency and oversight exist, and the risks resulting from that?
Barr: We look at this question of the regulatory perimeter all the time. It's a classic question in banking. When I'm back in academia and teaching my banking regulation class, this is just a core question you can't get rid of. It's just present. You always have something inside the regulatory perimeter, and something that's not in the regulatory perimeter.
We do look very carefully at this question: What's inside the banks, what's outside the banks? It is true that private credit—the market that people call private credit—has grown significantly in the last number of years. If you look at it globally, private credit is about $1.7 trillion today. About $1.1 trillion of that is essentially in the US. Most of that $1.1 trillion is funding that is associated with the private equity sector, and in particular leveraged buyouts, so it's a pretty focused part of the market.
It does compete with broadly syndicated bank loans. Broadly syndicated bank loans, as you all know in this audience, are not only bank loans. They're funded in large part by the nonbank sector already, but there is competition in that space.
One of the things that we see in the current structure of the private credit market is that most of the funds themselves are not highly levered entities. Today, at least, they are in a form that faces no run risk, so the investors in those funds can't exit. They're closed-end funds. Those two factors are quite stabilizing in terms of the structure of the market.
Now, that being said, we've seen lots of markets start off kind of safe and targeted and evolve in ways that are not productive. If we see the private credit market moving towards an open-end structure, a retail, open-end structure, where there's run risk, that would be a sign of concern. If we see increased leverage in the funds themselves, that would be a sign of concern. The deals they're investing in are leveraged deals. The funds themselves aren't, but we could see the funds become more leveraged if we see open-end structures. That would be more concerning than the current structure today.
Tkac: I'm thinking of the analogy, in the extreme: money funds?
Barr: Correct.
Tkac: We used to call it shadow banking, and now it's nonbank financial institution.
Barr: Nonbank financial institution. Shadow banks is a totally fine metaphor, too. If you have structures that have maturity transformation in them and that have credit transformation in them, you can have risk. Figuring out how to manage that risk is the core function of prudential regulation.
Tkac: Next question: Given the March 2023 episode...
Barr: Is this the least voted on? [laughter]
Tkac: No, this is the second. No, we're not anywhere close to the least. Given the March 2023 episode, what are your views on introducing a capital charge, specifically for interest rate risk in the banking book?
Barr: It's a very good question, and it's one that has been looked at—again, as those of you in the room that have been in this space a long time know—it has been looked at many, many times. Some other important jurisdictions have explicit charges for interest rate risk. In our system, we've chosen a much more targeted approach, so unrealized losses and gains flow through to capital charges for the G-SIBs.
As I mentioned, in our proposal we have proposed extending that to basically large banks over $100 billion in size. Among the many comments we got on the Basel 3 Endgame proposal, it was interesting that there was pretty strong support across the board for doing that, even from the banks that would be affected by it. When I talked to banks about this, they believe that the market is going to make them do this anyway, so it'd be better to have a uniform regulatory requirement to do it.
When we've looked at doing a more quantitative charge more broadly—historically, when we've looked at that—the Fed has had a hard time coming up with a rule that we think actually would be effective in that space beyond the AOCI [Accumulated other comprehensive income] pass-through provision. We are looking at ways that we might strengthen our interest rate risk guidance to be more explicit about the way in which we expect banks to stress test their portfolios for that kind of risk, and we have included in the exploratory scenarios for the stress test this year an explicit funding shock as a way of thinking about how interest rate plays through on the funding side of the book. That's a long answer to your question. That's how I think about it.
Tkac: Awesome. I think that probably got to the questioner's needs. I'm going to combine two questions here on the discount window, because they're very related. One is: Are you considering how access to the discount window should factor into the regulatory requirements for liquidity management, specifically to address the problem of stigma? Following on: Does the ample reserve framework reinforce stigma of using liquidity facilities, as having a buffer over reserve demand means that the liquidity facilities would not be expected to be tapped unless something was wrong?
Barr: Both really good questions. We are looking very much, as I mentioned in my remarks, at the discount window. Broadly, we're looking at it from the perspective of how to improve discount window operations internally and we've made good progress on that over the last year. We have now about $3 trillion pre-pledged to the discount window, which is a trillion more than we had before the March bank stress. We've made some operational improvements, such as introducing an online portal for transactions, but we have more work to do internally on that.
I mentioned that we are considering a discount window preparedness and testing requirement, and part of what we hope will happen if we have in place a discount window. I realize when I look over there, you can't hear me, so I'll stop looking at you to look into my mic. We're introducing this idea of a discount window preparedness requirement. Partly what we're hoping is that that requirement of discount window preparedness, prepositioning of collateral, and testing, will help to reduce stigma, because we're obviously sending the signal that we want banks to use the discount window.
The other thing we're doing is in all my public remarks I make it very clear that it's fine for banks to use the discount window. If it's an appropriate thing for the bank to use, given the range of pricing in the market and availability of liquidity, banks should use that. We're sending that message to supervisors as well.
That also relates to the second question; I don't think that having an ample reserves framework is designed to or would increase stigma or reduce stigma. It really is about making sure that our monetary policy framework is effective, and that means that in most times we don't want banks to have a stress in their ability to access liquidity. If there's too much stress in the system, obviously, that could affect our ability to control rates. We're not going to get anywhere close to that. That's a separate factor from discount window preparedness.
Tkac: A follow-on question: Can banks count on using the discount window or standing repo facility to monetize their HQLA [High-quality liquid assets] in their internal liquidity stress tests?
Barr: There is a limited ability to do that now; banks can use these facilities as part of both the LCR [Liquidity Coverage Ratio] and the LST, but with essentially a factor that adjusts for the run risk of those facilities. So, there is an ability to use it, but there's a limited ability to use it.
Tkac: Again, moderator's prerogative. I'm curious: To the extent that we understand stigma—that we have an idea of what that is, related especially to the discount window—do you see differences across the banking sector, in terms of stigma? Whereas you think about encouraging use and preparedness, I think of the preparedness tension maybe is usually, I would assume, with smaller banking organizations. I'm curious how we think about addressing different aspects of stigma from the largest institutions down to the smallest institutions.
Barr: We actually haven't seen systematic differences across size. In the spring of last year we had some very large institutions that should have been prepared to use the discount window, not adequately prepared, not having tested in a timely way, having very little pre-pledged to the discount window in advance, not having the internal system to be able to move collateral quickly to the discount window. Those were not community banks. Those were large banks that were not ready to use the discount window.
I do think this is an issue really across the size spectrum. We want banks to be able to use the discount window when they need it, and that necessitates testing and having the operational systems in place, having the legal agreements in place. We now have 5,000 depository institutions, banks and credit unions, who have signed the necessary legal agreements to use the discount window, which is an improvement from a year ago; 3,000 of those 5,000 have pre-pledged collateral to the discount window.
Progress has been made, but I think it's important, as I mentioned, we're considering a regulatory requirement in this space because it's important to get good practices really across the system and to lock in good behavior.
Tkac: Do you agree that sharply limiting held to maturity accounting would have many benefits? What is your view of the downside of curtailing it?
Barr: We're not in our proposals thinking about touching held to maturity accounting. First of all, accounting rules are not, strictly speaking, the province of the Federal Reserve. Those are matters for the SEC to set forth. Let me take it up a level: What does it mean to be a bank? To be a bank means that you can take deposits and make loans, and we want banks to be able to hold assets to maturity. That's part of what it means to be a bank. We're not considering fundamental changes to that basic structure.
Tkac: Does the Fed have estimates, bank by bank, on mark-to-market losses from interest rate increases and commercial real estate losses?
Barr: We do, through the supervisory process, have a very good insight into the capital position of all the banks that we supervise, both on a regulatory capital basis and on the basis of estimates of mark-to-market valuations. We do use those mark-to-market valuations in talking to banks about the risks that they face. We are aware of those estimates on a bank-by-bank basis, and where there are significant risks we are very much working with banks to alleviate those risks.
Tkac: Okay, let's turn to the Basel Endgame on everyone's mind. Any sense of a time frame for changes to the Basel Endgame proposal?
Barr: I don't have a sense of time frame. We got serious and thoughtful comments on the proposal, really across all three elements of the proposal: operational risk, credit risk, and market risk. We're working our way through those comments now; we've made substantial progress on that, but we're not finished going through the substance. Until we're done with the substance, we're not yet thinking about what the right process to use is. Until we figure out the process, I can't really tell you very much about timing. So, the answer is, "I don't know yet, but we're working really hard at it."
Tkac: Okay. Follow-up question: Some in the banking industry argue that the Fed's stress test and stress capital buffer should be revised alongside the Basel 3 Endgame to minimize overlap. Is that something you're willing to consider under the broad and material changes that you mentioned?
Barr: What we're looking at right now are changes to the Basel 3 framework. We, of course, periodically look at the stress test and make adjustments to the stress test over time. As I think about the framework, these are trying to do two very different things. The Basel 3 Endgame proposal is about "what are our static, risk-weighted approaches to thinking about risk?" and we use those to set regulatory minimums. The stress test itself is a dynamic test designed to set the buffer above those minimums. We're looking at different parts of the capital stack.
We have that, and we also have a leverage ratio that is a different way of thinking about risks that banks face. Those three kinds of capital requirements together produce a more resilient financial system—one that is more robust to model failure, more robust to not being sure what the right way of measuring risk is. Those approaches are quite complementary.
Tkac: Thinking back to, again, the episode in March of 2023 and your report that came out on lessons learned: I think yourself and the other banking regulators mentioned a lot of lessons learned about being nimble in the face of a changing external financial system and environment. Could you speak to how you think about operationalizing that great but sort of vague idea into a system of supervision and regulation?
Barr: It's a great question, and something we've been working on quite a bit. I said in that report, and I've been saying frequently since, that we want supervisors to be able to act with speed, force, and agility appropriate to the risks in front of them. You don't always need to act with speed, force, and agility, but speed, force, and agility appropriate to the risk. Part of that is about empowering supervisors to do that, so having a tone from the top that says "this is what my expectations are for supervision" actually does help set the way in which the supervisory system responds.
The second thing is we want to make sure that supervisors have the tools they need. We are looking at, for example, improving the speed through which we ourselves provide for escalating enforcement actions through the system. That historically has been a slow process at the Federal Reserve, so we're looking at making sure that we are also adjusting our escalation framework appropriate to the risks involved. Sometimes it's okay for things to go slowly through time that is appropriate to the risk; but if you have an acute risk you need addressed, let's make sure that those get addressed quickly.
The third thing that we're doing is making sure that our risk analytic tools are having the appropriate impact on the supervisory process. We have across the Federal Reserve System lots of really smart, talented people working on forward-looking risk analytics. We want to make sure that that forward-looking work is brought directly into the supervisory process so that supervisors are focused on the most material risk in a very timely way.
Tkac: Building on the forward looking: How are you thinking about getting the supervisory framework, and the people, ready for AI? Or maybe we're already there, and it's not getting ready for it but responding to it, but to attempt to look forward to risks that aren't yet there at the same time as you're looking at lessons learned from risks that we currently address.
Barr: It's a great point, Paula, and it comes up in lots of different ways. For example, we have instituted across the System a novel supervisory group, and that group is designed to help supervisors on the ground of institutions of all sizes, better grapple with bank fintech partnerships that are using approaches that maybe need extra care and feeding in terms of risk management or are engaged in crypto-related activities. We want banks that are engaged in these activities to have the right risk management in place before getting involved with them, not figure out the risk management after it's too late.
With respect to AI in particular, we're seeing banks engaged in this space, but they're doing it, generally speaking, in a cautious way. We're seeing, in particular, its use alongside a human in customer service as sort of the earliest application of that. Banks are generally being much more careful in other areas.
Where banks use generative AI in the same way that we expect when they're using other forms of AI, or machine learning, or basic statistical techniques, we expect models to be validated. We expect with their customer-facing interactions that decisions that come out of a model are explainable. We expect that the use of that does not result in discriminatory outcomes, that there's no bias in the model. All of those kinds of basic blocking and tackling we expect to come from banks today also apply to generative AI techniques.
That being said, we do want to begin to think about ways in which generative AI might extend further into our economy where it could have quite significant effects, or in the banking system, so we're doing work internally to stay on top of these things. I was out in California last year, talking with generative AI experts to make sure that I understood the direction they thought the sector was going in.
These are all steps we want to take to make sure that we're staying current with the way in which this sector may evolve. My sense is that in the very short term things are moving more slowly than people think. In the medium term, things are going to move much, much faster than people think. We really have some time now to get on top of it, but things I think will move very rapidly. We need to stay ahead of that curve.
Tkac: Following on this theme of rapid movement: If I think back just over the last year, several events bring up the notion and the importance of increased speed. There was the speed of the bank runs; there's a move now to 24/7 instant payments. How are you thinking about, again, how to operate a supervisory framework where in addition to new things coming up, new risks, new things that you have to fold into that framework, just the fact that the pace is getting quicker?
Barr: Paula, we certainly saw that last spring, and you can see it everywhere in the economy: speed is everywhere. Speed also relates back to AI. I think we're going to see increasingly as AI comes into use in the financial sector, a combination of speed, the potential for ubiquity—that is, use of models everywhere—and possibly the elimination of humans from the decision chain, so automaticity. That combination of ubiquity, automaticity, and speed can be very destabilizing. That's a risk that we are watching out for.
With respect to deposits, last spring we saw deposit outflows much, much faster than we had seen in prior experiences. We actually saw in some ways an extremely slow bank failure in the form of Credit Suisse eventually being merged into UBS, and a very, very fast bank failure in the form of SVB essentially failing in an afternoon. That kind of speed is in part what is driving us towards thinking, on the liquidity front, that we need to update our rules with respect to deposit outflows, held to maturity securities, and discount window preparedness. Those are in part recognizing that you can have acute stress where speed really just takes over. You want banks to be ready to work their way through such an event and also be able to move quickly in the event that that happens.
This problem of speed is, in some ways, inconsistent with the way that most of supervision is conducted in the sense that we go through a regular process with financial institutions. We have a regular system for writing down the results of those, communicating them, conveying them, escalating...and that pace is a very different pace than the pace that can happen when you have a bank under acute stress.
Tkac: Is one of the potential mitigants or solutions to that just more use of technology, and reworking processes inside the supervisory house, so to speak?
Barr: Technology is part of the answer to that. We use technology now in lots of ways to look at rifts across the financial sector. Technology might be part of that, but it's also our processes and our training and our instincts. We need to make sure that we're ready to act with speed when we need to. You saw, with the failure of SVB last March, the Federal Reserve acted extremely quickly, once the event hit, to stabilize the banking system. We were able to set up the emergency facility, invoke the systemic risk exception with the FDIC and Treasury, and set up the bank term funding program over the weekend. We can act quickly when we need to, but it'd be better if we could act quickly in advance of that kind of stress in the system.
Tkac: Why not have the Fed provide liquidity to all comers via repo, rather than just banks, as this could enhance financial stability in the stress times we were just talking about?
Barr: There are cases in emergencies where the Federal Reserve has the authority under 13(3) of the Federal Reserve Act to provide facilities that are broader than just for banks. It has done that. It did that, obviously, in the global financial crisis, and with the onset of the pandemic. In normal times, we lend to banks. That's our job.
Tkac: What do you see as the benefits and costs of requiring banks to have long-term debt to support orderly resolution versus simply requiring more common equity?
Barr: Common equity is really essential, and that's sort of why I started my speech with it. It is the essential backdrop for stability in the banking system. The advantage of a long-term debt requirement, the way we have structured that in the United States, is that it's available after the institution gets itself into resolution. You could argue, well, if you have more capital, then the bank is less likely to get to the point of failure. That is true, and that's why I'm for robust capital requirements in the system.
At some point, if you have a bank that gets under stress, it's very hard to put a bank under stress into resolution while it still has capital in it, in any meaningful sense. The buffer that you get after resolution is one that you know is there and can be converted to equity upon resolution. That recapitalizes the institution and lets it either be sold or go back into the market as a functioning institution, or it gives you time to sell its assets and liabilities while counterparties can still conduct business with it. It is a quite useful tool in addition to capital.
Tkac: All economic models have been challenged by the pandemic. That includes models used for stress testing. Are you providing guidance or best practices to banks for how to manage these challenges? I'll tack on: Inside of the system, how are we thinking about our stress test modeling?
Barr: Let me just say, no model is perfect. You start from the basic fact that models in risk in the financial sector, or models more generally, all have some flaws to them. One of the checks that you have against that is not to rely too much only on one model.
One of the reasons that we've started this process of using multiple exploratory scenarios in the stress test, is understanding that in the stress test itself we're only modeling one set of risks in the system. Having multiple kinds of modeling makes sense. All the large banks do multiple models of their own risk. They don't rely on one stress event. Similarly, when we are working internally, one of the things that it's important for us to do is to imagine this bank has failed. How did it fail? Think about the ways in which that institution might be vulnerable, and then work your way backwards to: Is the bank appropriately managing that set of vulnerabilities?
Challenging our own thinking about how risk could propagate in the system is really important. Human beings are really great at pattern recognition. It's one of our strengths and it's really useful in helping us see risks. If you look in front of you and you see a puddle in the street, you don't step into the puddle. We recognize that might get our feet wet, if we step in the puddle. If we look around and we only see the patterns that we're familiar with, then we might miss risks that are out there that we should be seeing. Challenging ourselves to be more creative in thinking about the kinds of risks that might be out there is also an important mitigant to the model failure that you described.
Tkac: Awesome. That brings us to the end of our session. Thank you for all the great questions. Thank you for all the great answers.
Barr: It's my pleasure.
Tkac: Please join me in thanking Michael for his time here. We're going to take a super-short break, just to get the other speakers up here for the next session, so everyone please stay tuned.