U.S. Financial Regulation, Five Years After Dodd-Frank

The Federal Reserve's Daniel K. Tarullo joins Jeffrey E. Garten, professor of international trade, finance, and business at the Yale School of Management, to discuss U.S. financial regulations. Tarullo begins by assessing the extent to which the Dodd-Frank regulatory reforms that were put into place after the financial crisis of 2008 succeeded in altering the U.S. regulatory structure. Tarullo additionally addresses challenges to the existing regulatory framework and stresses the need for an adaptive regulatory system.

The C. Peter McColough Series on International Economics brings the world's foremost economic policymakers and scholars to address members on current topics in international economics, such as outsourcing, monetary policy, and competition policy. This meeting series is presented by the Corporate Program and the Maurice R. Greenberg Center for Geoeconomic Studies.

GARTEN: I'm Jeffrey Garten, and it's my great pleasure to moderate this session with Dan Tarullo. This is part of the C. Peter McColough series on international economics and we plan to proceed this way, I'm going to have a discussion with Dan for about a half hour, and then we're going to open it up to questions from the audience.

Dan, as many of you know, has been at the very center of the Fed's were for a considerable period of time now. I think you're the longest standing governor in Washington since 2009, am I right?

TARULLO: Right.

GARTEN: And I'm going to the focus of my discussion with him on regulatory matters, since the he is really been at the center of all the big decisions that have been made when it comes to the regulatory response to the financial crisis.

Dan, you know, I think in three weeks we come to the fifth anniversary of Dodd-Frank, and I would like to ask you maybe to start with some thoughts about when you think about Dodd-Frank, what are the achievements? What are the achievements, say the three or four major achievements that are in your mind over these last five years?

TARULLO: Well, I'd say, Jeff, I think with Dodd-Frank in some respects the most important thing that it did was to reverse the direction of regulatory structure. Essentially we had had 30 years of deregulation of the financial services industry prior to the crisis, and in the first instance, and perhaps at its core, what Dodd-Frank did was to say we now need to put in place a regulatory structure to replace the various regulations which had been either eroded through practice or outright repealed over time.

And, you know, I want to give a little context for that because the history of what happened in those 30 years actual matters a lot for thinking about how we're going to regulate now. This was not a case in which, you know, a group of people in Washington just sat down in the 1970s and said, hey, let's deregulate the banking sector because that's what they'd like us to do.

People—and there are many in this room who were active in that industry in the '70s, and people will recall that traditional commercial banking was under enormous stress on both sides of the balance sheet. In terms of what I'm going to call the supply side, which is to say getting funds in order to intermediate those funds, the growth of money market funds and other investment vehicles had reduced the proportion of funds going into markets that were coming from traditional deposits. And of course, banks were always the biggest beneficiary of those deposit flows.

And on the other side, the demand side - who is asking for money from banks—the growth of capital markets had also reduced the demand for the services of banks. As capital markets grew, the size of the company that was necessary in order to get access to a corporate bond market, for example, went down. The growth of commercial paper and other instruments meant that there were other ways for companies to get funding.

So the banks were in that squeeze which threatened their profitability and viability, and thus were—and that was of concern to government officials because, obviously, the banks then, as today, continue to be the backbone of the financial system, the payment system, and where most Americans go for their intermediation services.

So the deregulation that began de facto in that period was in some sense a response to what was perceived to be that—the business squeeze on the banks to allow commercial banks to get into other activities or to affiliate with other kinds of financial services companies or to move across geographic boundaries. And what we have today, of course, is the legacy of those changes with some very large geographically spread out and in terms of business lines, very complicated financial services firms.

What did not happen during that, though, was to develop a new approach to regulating financial institutions, particularly large financial institutions. If you are going to pull away restrictions on geographic movement or affiliation with other kinds of firms or activities and allow a much broader range of conduct by the banks in order to allow them compete effectively in—with capital markets players, one needs a different approach to regulation, and that was not put in place.

And so the legacy that we all inherited was a regulatory system that had sort of have been eroded from underneath, with nothing coming in at the sides or on top in order to re-stabilize the system and keep watch over the activities of particularly the largest institutions.

And so at its root, what Dodd-Frank did was to put in place, or in many instances, to instruct the Fed and other regulatory agencies to put in place, the system that would deal with the evolution the financial services industry.

I think the second thing Frank did—and it's related to that first point—the second it did is put the focus squarely on what were called the Too Big to Fail institutions. That if you look at all of Title I that really is what—and Title II, Titles I and II really dominantly about the too big to fail institutions. The intent of Congress that there not be too big to fail institutions, that any institution in the United States is—can be resolved without a government bailout, without the injection of public capital, and that again was a very clear focus which had not been attended to in the—in the preceding couple of decades.

And third, I would say that the Dodd-Frank Act, unlike virtually all financial regulatory legislation since the Depression, had focused on the financial system. Most financial regulation, whether it was deregulatory or even in the case of the legislation following the savings and loan crisis which actually did put in place some new regulatory requirements, but whether it was deregulatory or regulatory, it focused—the legislation focused dominantly on particular institutions and not on the financial system.

Now, the New Deal Legislation—you could say, Glass-Steagall, Federal Deposit Insurance Act those were by their—by their very nature directed at the financial system as a whole. Dodd-Frank, we counted it up, there's a couple of hundred references, either to financial stability or systemic risk in Dodd-Frank. And the mandate there to the Fed and all the other regulatory agencies who are members of the FSOC is to look at the financial system as a whole not just in a siloed fashion the stability or safety of a particular institution.

And that makes a considerable difference in how we think about regulation, for us at the Fed, particularly in the case of the largest institutions, which is why we've changed in a pretty basic way the manner in which we supervise them today.

GARTEN: So on the other side of the balance sheet, I mean, Dodd-Frank is not without its controversies, obviously. If you had to identify two or three areas where you think there's a lot of work to be done, or to put it less euphemistically, where there are some problems that need to be fixed, or there are some areas that need to be addressed. So looking—we're at the fifth anniversary, you know, let's say we were coming up to the eighth anniversary, what two or three things would you want to see happen?

TARULLO: Well, I—as I mentioned a moment ago, I mean, one of the—one of the focal points of Dodd-Frank are, or is, the set of very—the very largest institutions, the Too Big to Fail institutions, those which were at the center of public attention in and in the period after the crisis. What got less direct attention in Dodd-Frank was the set of actual and potential risk to financial stability that come from sources other than the largest financial institutions.

And to the degree that we are effective in putting in place capital liquidity and other forms of regulation that will make those largest institutions safer and sounder, it stands to reason that more activities may migrate out of the perimeter, outside the perimeter of regulated institutions, into other markets and other institutions and other kinds of financial activities.

So that—what I think what I think we need is something that in another context I've called prudential market regulation, meaning that we look to see whether there are risks to financial stability that arise not from the size, scope, reach of activities of a particular institution, but through the nature of particular business models or business activities.

Much of—much of the activity outside the regulated sector will be very healthy, and there's a risk that people in a kind of knee-jerk fashion say, gee, if it is any kind of intermediation outside of the banks it must be bad, we must regulate. I don't think we want to approach things that way, I think we want to look to see instances in which the combination of leverage and vulnerability of funding create the potential for runs and problems in the financial sector, regardless of whether the institutions are themselves very big institutions, or regardless of whether they are chartered as commercial banks.

And I think that's going to be an ongoing challenge, first because one has to take some care to differentiate between activities which are best left alone, you know, to be regulated for purposes of investor protection and market functioning but not prudentially, as opposed to activities that do pose that—those kinds of risks.

And secondly, we have to recognize this is going to be a dynamic - a dynamic undertaking because the financial markets, as they are want to do, will constantly be adapting and changing and so regulators are going to have to make those judgments on an ongoing basis, as opposed to saying OK, we're to put in place a bunch of regulations, put it in the Code of Federal Regulations, and sit back and enforce it. And I think that is going to be a challenge, both parts of that are going to be a challenge on an ongoing basis.

GARTEN: And Dodd-Frank, of course, is national legislation. We live in a global financial market. To what degree have other countries, or have the international institutions reinforced what we are trying to do with Dodd-Frank, or to put it another way, to what degree is there—is there a global framework that is keeping pace with all of the activity that is here?

TARULLO: So—yeah...

GARTEN:  How do we think about the interaction between what we're doing in the U.S. and what is happening abroad?

TARULLO: Well, I think, just as there is a widespread view that the need for rigorous financial regulation had been underappreciated in the United States. There is a similar recognition around the world, and in the—in the wake of the crisis, the international structures for addressing financial stability, financial regulatory issues, were substantially built up.

I think the Basel committee redirected a lot of its work to create a—the Basel III changes, which were a very important set of changes to up capital requirements for all internationally active banks. The—you've now seen more activity from IOSCO, which I think has been motivated to get more involved in issues because of some the things I mentioned earlier, the potential risks in market activities as opposed to particular institutions.

And of course, you've got the financial stability board as well which grew out of the financial stability forum which was kind of a talk shop that seemed to have talked about a lot of things, but didn't talk about the growing risks to the—to the international financial system. And it's now been converted into something with a bit more of the formal structure to try to survey the international financial system to see if there are areas that are not being addressed by any of the specific standard setters, where some sort of international action is called for.

I mean, I don't think you need international action on every financial regulatory issue, but where you do have globally active institutions or where you do have markets that are de facto international, where people can arbitrage across national boundaries quite without much cost, there you do need international cooperation. And I think the track record has been pretty good so far.

I mean, take a couple of examples. Dodd-Frank called for stricter capital requirements, among others, for systemically important institutions and we, of course, are—we the Fed are moving forward with the implementation of a series of capital surcharges for those institutions.

But internationally we and some of our like-minded colleagues from other parts of the world were able to forge an agreement for those capital surcharges on all globally active financial institutions which are of global systemic importance. And that—that's being implemented right now. So there's one example.

Second example is in the resolution arena, and here again, Dodd-Frank put into place Title II, which allows the FDIC to resolve non-bank financial institutions whose failure might be disorderly and pose a risk to the financial system. There again—that—I think Dodd-Frank catalyzed similar legislation or regulatory change in other parts of the world, and right now, a lot of the international focus is on trying to assure that the resolution plans and possibilities for large, globally active institutions would actually work cross-border as well as at home.

So I—there's been quite a bit of adaptation, I think, to the post crisis needs. What—you know, the challenges that remain there are probably in working through the relationships among the various actors. I mean, there are a lot of international committees that are now involved in activities. There—on some of these issues you have four different international groups that are—it's a little bit like our domestic situation with many agencies working on the same thing, many international committees working on the same issue as well.

Just the growth of these committees, the fact that quite rightly we have more representation from more countries in the world, is going to necessitate some change in how issues are developed and moved forward because you can't do it any longer in sort of a table of this size with a dozen people around it, you've now got to take into account a much broader set of countries and interests. And that just calls for a different form of—a different kind of process. It's—we're not going backwards and we shouldn't try to go backwards, but that process I think, is important.

The other thing, which I've mentioned before but I keep mentioning it because I think it doesn't get fully understood, as we've moved internationally to do, you know, more frameworks, more agreements, more code-like things, the capital liquidity resolution, a lot of these other measures, there's some risk that the international activity ends up being mostly about negotiating these things.

And we lose that—we then lose sight of the need for—indeed, the imperative of genuine supervisory cooperation among the major and secondary financial jurisdictions in the world. You know, at root, we all share the same mission of trying to assure the safety and soundness of our own financial systems, which requires a safe and sound global financial system.

None of us can get our arms around what our own financial institutions are doing in all of their details abroad, or what other financial institutions are doing, which may have ripple effects on our own financial system. So we do need that kind of cooperation. The origins of the Basel Committee way back in the '70s were to try to create that kind of cooperation among senior supervising and regular—the heads of agencies really, from around the world, to get to know one another. to buttress their common mission and to get their subordinates working well together again in the joint task of supervising globally active institutions.

I think some of that is been lost over—you know, if you to talk to be like John Hyman (ph) or Paul Volcker, who were there either at or near the beginning, they will tell you how much the nature of the Basel Committee is changed. It's much more technical, much more oriented towards getting details of rules, and less oriented towards building up that sense of a common mission. And I think we need to look for ways—again, in the context of more countries involved and more codes and rules and the like, we need to work—look for ways of doing that, so that were not always negotiating rules, we're actually jointly engaged in the supervisory process as well.

GARTEN: So trying to bring these things together, I hear a lot of concern that there has been a lot of regulation, certainly a lot of thought going into that, but no one who's added up the pieces.

And the argument sometimes focuses on liquidity, that when you take the—take into account the Volcker Rule, capital requirements, liquidity requirements, if there were to be a crisis, let's say in the bond market, a lot of the players that once existed, a lot of the potential buyers wouldn't be there. And thus there is a need to take account of all of the regulations holistically to see what they would do to the system in a crisis.

How have you thought about that, and what can you say that gives us a sense of what kind of work is being done in this holistic way?

TARULLO: Well, I think, certainly, the October 15th episode got people's attention and has provoked a lot of work, both interagency in the U.S. government and also at the Fed. But I'd say a couple of things by way of context, Jeff.

First, I mean, you mentioned what will happen in a crisis, and I think we need to distinguish between available liquidity in normal times and the illiquidity that's available under conditions of stress.

Ten years ago, there was an enormous amount of liquidity sloshing around the markets. Much of that liquidity proved to be illusory in the sense that when there was an exogenous shock that produced a lot of uncertainty about the value of underlying assets, the buyers, in many instances, just withdrew from the market. It was not a price issue; it was just a withdrawal from the market until things settled down enough that people thought they could price the assets again.

There's the—you know, everybody's heard the phrase, "unwillingness to catching the falling knife," and I—and I think that's a lot of what we saw and, again, understandably so. It's self-protection.

Some of the biggest broker dealers during that period would try to find buyers for their clients' assets, but they had some reluctance to take those assets onto their balance sheet. So we shouldn't equate the existence of large balance sheets in normal times with a buffer against stress in the sense that those balance sheets will be available to buy the assets that people are trying to unload during a period of stress and uncertainty.

There may be some correlation, but it's certainly not inevitable or direct, and I think our experience during the crisis suggested that it may not be very direct at all.

So that—having said that, there does seem to be something different in markets, even operating in non-crisis, non-stress periods, as we are at the present. By some metrics, things like bid-ask spreads, doesn't seem to be too—too very much different. By some other metrics—market depth, the anecdotal information you hear about the—more difficulty, perhaps, in moving large positions—something may—does seem to have changed.

So I think we first need to understand what has contributed to that change, and it's difficult to disentangle all the factors. It's clear that there's been change in market structure—who are the buyers and sellers, greater—greater role of asset managers than in the pre-crisis period in buying a lot of these assets, the growth of high-frequency trading, which has clearly had an effect in markets. There are changes in the regulatory environment, for sure.

Those things are presumably contributing, but I think it's a little difficult. And I must say, having had a lot of conversations with, I think, very fair-minded people from within the industry, from within markets, academics and the like, I don't think there's a—there's at this point, a very precise and convincing explanation of exactly what has happened. We do need to understand that, and we need to understand whether those changes are posing more financial stability risks and, if so, then see what would be the appropriate response.

So I—I'm trying to suggest that I think it's an issue that everybody needs to be thinking about assessing more. There may be action needed at the end of the day. But I wouldn't jump to the conclusion that a big balance sheet equates with better financial stability. That—I think history, recent history has shown that that's not necessarily the case.

GARTEN: OK. So I think we will open it up to questions. Please just state your name and affiliation. Yes?

Well, let me just say—excuse me—I focused the discussion so far on regulatory matters, but you're very welcome to discuss other aspects of the Fed or the financial system, the economy.

QUESTION: Jamie Stewart from Financial Guarantee Insurance Company. It seems to me that the process that is going on now in regulation assumes that the bad actors are low-level people in the foreign-exchange desk or the LIBOR desk. But the senior management, the board of directors are assumed to be unaware or not responsible for what's going on at that level.

How do you restore trust in the system until people at higher levels are held responsible for some of this activity?

TARULLO: I think—I think you've actually—I think we've actually got to address both the individuals who are involved directly in the activity and the corporate or firm structures that, by inaction, at least, permit that activity.

With respect to the—to the former, I do think that in the end, there's no substitute for punishing and seriously punishing individuals who have transgressed the law.

You know, if you think back to the 1960s when antitrust in the United States was just getting a burst of energy and vitalization that ended up working some major changes in how business was conducted in the United States, that—I think the watershed moment was the moment at which some—now, these are executives, so this may make your point—some executives went to jail, and within a very short period thereafter, every major U.S. corporation had a very robust antitrust compliance program.

Now, these individuals, even though they were higher up the chain, had been directly involved in the price-fixing activities. But I think there really is no substitute for, where appropriate, criminal prosecution for us, the Fed, the other regulatory agencies, using our ability to ban people from the industry when they are found to have engaged in illegal or otherwise seriously detrimental activities.

But as you quite rightly point out, once you've had, you know, the issues around consumer protection or lack of protection over the course of a number of years, when you've had the LIBOR problems, when you've had the 4X problems, it's difficult to say, "Gee, we've just a few bad apples down there somewhere."

There's something which is permitting—there's a—again, through inaction or through maybe signaling in other ways, there has been a—an environment developed in which this kind of conduct keeps arising, and so it is the responsibility of management and the board, as appropriate, to put in place mechanisms within their own firms that assure that all the agents of the firm, and every employee is the agent of a firm, are complying with the law. I mean, that's not a lot to ask, to comply with the law.

And I think you would find—you know, many people from financial firms would acknowledge that there was less attention paid to that certainly 10 years ago and even more recently. And I hope that the series of problems, the recurrence of things on the front page of the papers, has now impressed on firms that they need to do something about this, and I do think a number of them are taking steps to try to change the incentives and the punishments that exist within the firm.

For our part, as regulators, I don't want us trying to go in and in some granular way try to regulate the culture of a firm. I think it's really hard to figure out the culture of any organization.

But what we can regulate is output. And when there are repeated problems, we're—we are going to bring to bear our enforcement capacities on the firms precisely because they have not been taking the steps necessary to assure that their firm. the employees are complying with the law and applicable safety and soundness regulations.

And at some point, at some point, one has to look at senior management or a board and say, "Look, you may—whether or not you knew about the specifics that were going on, you're failing to assure that the firm is obeying the law. And just as a failure to assure that you've got adequate capital leads to consequences and a failure to assure that you've got that you're complying with, you know, whatever—there's environmental laws or any other laws that are applicable have consequences, this has to have consequences as well."

GARTEN: Yes? Yes?

QUESTION: Bhakti Mirchandani, 1 William Street. Thank you for your comments.

As the—as regulations on banks and capital restrictions increase, and more funding of our economy switches from bank loans to capital markets get—driven, for example, housing is increasingly funded by alternative investment vehicles, what are the implications for the next crisis?

TARULLO: Yes, that—I was alluding to that, but in sort of an abstract way in response to one of Jeff's introductory questions.

So, you know, this is not just a post-crisis development. I mean, the term shadow banking was very much in existence pre-crisis, which is to say the intermediation of funding through mechanisms other than the regulated commercial banking sector. I think that, as I said earlier, it's not only expected but in—in many respects, healthy to have a variety of funding mechanisms for activities—business activities and consumer lending or borrowing needs in the United States.

So we shouldn't start with any presumption that there's a problem that things are being funded outside of charted national banks or state banks. Where there may be a problem is when there is a lot of leverage or—and/or a lot of runnable funding involved. And as I was—as I was noting earlier, that's where I think that the challenge is to come over the coming years for—in a couple of respects.

One, making those analytic distinctions that I was alluding to earlier. But second, I—identifying who, if at all—if anyone within the U.S. government has authority to do something about an issue, that is who has jurisdiction. The Fed does not have supervisory and regulatory jurisdiction over a lot of capital market actors, the SEC has some jurisdiction for disclosure purposes, and with respect to some kinds of actors it has more plenary jurisdiction but respect others it doesn't at all. And there are some who probably aren't subject in a very strong way to any form of federal regulatory oversight.

So it—a part of that—part of the purpose of the—specified purpose of the FSOC, Financial Stability Oversight Council, created by Dodd-Frank, was to identify areas that may reflect regulatory lacunae, and to—if either recommend to agencies that might have authority to take action, or where no agency would have authority, and there's a real tangible risk to financial stability to recommend changes to the Congress.

So—so this is—you know, this again, in an answer to Jeff's question this is what you would expect it's almost got a dialectic process. You have an under regulated sector, that sector gets more regulated, it becomes safer and sounder for sure. At least some activity migrates out of that sector, perhaps in a healthy way, perhaps in a way that replicates some of the problems that one found originally. That third step—that—that—that third step along the way is the one that may lead to situations in which it's not clear who, if anybody, has regulatory authority.

But, again, I want to emphasize it doesn't—this should not be understood to mean every time something migrates out of the regulated sector, it should be regulated. You have to identify the risk to financial stability before you can, I think, you can justify that form of regulation for actors that, you know, do not have insured deposits and do not have access to the discount window.

QUESTION: Excuse me, Marshall Sonenshine (ph), Sonenshine Partners in Columbia University.

You mentioned at the beginning of your talk about Dodd-Frank that it—at the—at its inception was designed to address in part the problem too big to fail. And I think the bet that Dodd-Frank made was that it could handle the part of that phrase that is about failure—failing as opposed to the part that is about big, because as we now will know in the almost a decades since Dodd-Frank, the banks have gotten much bigger and we're betting on her ability to adequately supervise that.

If we have a problem of compliance, maybe it's a cultural problem and culture is hard to regulate, I understand that, but if we have a problem of compliance and if we are not willing, as we are not yet willing, to create a rule of law premised on the criminalizing failure to supervise, then do you worry sometimes that maybe Dodd-Frank is broken at the inception?

That it has made a bet on our ability to supervise adequately ever increasingly large and complex banks all over again in a culture in which compliance problems persist, and the willingness to use the ultimate tool of criminalization from the top does not?

Do we have that problem in this regulatory regime?

GARTEN: I think—I think it's—I wouldn't—I wouldn't put it in that way. I mean, first—first off to be clear, we are almost five years not 10 years into Dodd-Frank, number one. Number two, the—the implementation of Dodd-Frank in the broadest sense, not just the sense of getting a reg in place, but getting that reg fully implemented and complied with, is ongoing. And one of the important areas in which it is ongoing is in the resolvability of the largest financial institutions.

In just a week, we will be receiving the revised resolution plans of most of the largest financial institutions the—the group at the very top in the United States in—in response to guidance that we and the FDIC jointly gave last year and supplemented with early this year. We are expecting to see significant changes and plans for changes, in things like the legal structure of the firms, the intro—intertwined sharing of services, all of the things that would prevent a resolution authority or bankruptcy judge from being able to, with some confidence, resolve the institution and know that the resolution would not result in substantial financial fallout in the rest of the system.

I will also say that, you know, you got to remember that a lot of the capital regulations, including the surcharge are, you know, we haven't yet finalized the surcharge, we've got the proposed reg out, but although firms are thinking about its implementation, and—and planning for they haven't yet fully implemented it.

And I know that many firms are having to confront the fact that with capital charges more as—closely aligned with the riskiness of certain kinds of activities, that the firms may need to be rethinking their level of involvement in some activities.

And—and although, you know, you're quite right that the financial firms are bigger than they were a decade ago, some of them have actually shrunk some, some of that increase in size, you know, we just got to be honest with one another, some of that increase in size was as a result of the crisis itself, where failing firms were taken over by existing firms because the government at that time felt it had no other options.

So—so I think in the period since the crisis, we're putting in place a set of capital requirements, resolution measures which will more, I think, directly incentivize the firms to ask themselves the question, are these—are these activities ones that we can profitably engage in, given the potential social costs as reflected by the regulations?

And I should add probably a word about the stress test here as well. You know where—we now have five sets of—of the CCAR exercise, plus the original stress test during the crisis, which has become a very important tool for us in supervising these institutions, where we are able to get more risk sensitivity, because we use a supervisory model to determine all of the largest firms what kind of losses they would in endure in a highly stressed scenario.

And I—I think there, again, you now see that firms are having to think about their business activities based on the kinds of capital requirements, leverage ratio, and stress tests that are now in effect, that were not in effect four, five, six years ago.

As—as you have seen in the papers probably already were taking this opportunity to—to—five years of stress testing—or five years of CCAR, to step back and ask whether we want to make some on changes other than the incremental changes we make every year, to take more account of scenarios, to take more account of the structure of the organizations, as well as to just see if we can make it more efficient for everybody.

So I think—that the—what all this answer distills to, is a sense that were still in process here, even though the contours of the new regulatory system, I think, are now apparent. The implementation and internalization of that system are still ongoing, and I think are still going to have some impacts on firms planning—plans and directions over the coming years.

GARTEN: Yes?

QUESTION: Hi, good morning. My name is Nili Gilbert, I am a co-founder and portfolio manager of Matarin Capital. Thank you very much for sharing your ideas with us this morning.

I'd like to dig a bit deeper on the subject of macro prudential regulations, which you raised earlier. One common critique of our regulatory systems is that they are backward looking by their very nature and reactive.

When it comes to macro prudential regulation, do you think it makes sense to be forward looking and thinking about potential regulations, especially to the extent that—that that may involve a certain amount of forecasting, or even push on the idea of the efficient market hypothesis, which I know is a challenge for some economists?

If you do think it is appropriate, are there any building risks in the system that you think it may make sense eventually to act on preemptively?

TARULLO: So I can come back to the stress test in beginning an answer to that question. Why is the stress test such an important supervisory innovation? Well,it's important because in our terms it's horizontal, meaning we look at all the firms at the same time, but it's also dynamic and forward-looking.

What we do is to develop scenarios that are not likely but also not implausible, and adverse or severely adverse, and stress the assets and the earning potential of the firm in light of those scenarios. That forward-looking element of the stress test is what distinguishes it from all prior capital regulation. And I think that—you know it's one of the reasons why stressing I think is a better way to do risk sensitive capital regulation, than some of the older, and like the internal-ratings based approach.

When you get outside of the regulated financial institutions and all and that's what a lot of people sometimes mean by macro prudential, that you know, that poses several issues. First it poses the issue of how much confidence you have in your ability to identify unsustainable say, asset appreciation in a particular area. You know, I've been I've been struck by the fact that over the last five years, there's been a flurry of concern about a number of areas, number of asset classes, and then they sort of die—you know, the prices change, it kind of dies down and there is at least some risk that people want to react to quickly to every change.

There is also of course that the risk that there really is something fundamental going on, and I think housing market in the United States 10 years ago, would've been a good example of it, which was unsustainable, which was funded with an awful lot a leverage and in a very runnable fashion, where you think here you need to of been some set of regulations or supervise reactions in place to inhibit that.

I think given the involvement of major financial institutions that would've been possible with our existing regulatory system, but if, as some of the prior questions have suggested you have a good bit of migration out of that system it is—it certainly is possible that you would have the buildup of leverage with quite fragile funding that could pose, if it became broad enough, not limited to a single asset class but could pose financial stability risks to the whole country.

This actually gets us—yes it's an economic question, it's a question of how well we think we can predict the forecast problems, it also gets to a bit of a question of you know, which side you want to err on? Should you tamp down activity a little bit now as a kind of insurance policy against a really big blowup, even though you know that sometimes you can have some false positives. But there's also a very important question I think of political theory, but—but sort of government, and governance, democratic accountability. Who should be who should be exercising that kind of authority if it does exist?

Do you want to put it into counsel format, we have a number of different agencies involved? Do you want to give it to an existing agency that already has a lot of powers?

But I think those questions of separation, or concentration of authorities and powers and democratic accountability, are actually a quite important piece of this set of issues that's sometimes lost in the technical discussions of you know, how well can we predict asset bubbles?

But all of you know that if it comes down to taking action, the action is going to be is going to have ripple effects through the political system, it's going to effect actual people, businesses, households, and so we got to think through beforehand, I believe, we want making these kinds of decisions as well as how much authority we want to get to someone to make these decisions.

QUESTION: Ben Steil, Council on Foreign Relations.

Dan, I'd like to keep you on the issue of capital structure. All of us to take introductory finance learn the famous Modigliani Miller theorem, which says that absent capital market distortions or policy distortions, firms should be indifferent between equity and debt financing.

One thing we know for sure is that they're anything but indifferent. Now obviously there are distortions that come from the (inaudible) regime, there is a taxation preference and favor of a debt.

I like to ask you first how significant you think that is and whether we could possibly make some progress in addressing that on the policy side?

But what do you think are the other distortions that perhaps have been under considered, that lead to this inherent, powerful preference for debt financing that we're struggling to control?

GARTEN: Let me just say, it is a great question, we have very little time, so...

TARULLO: So, I would give—so it's going to have to be a suggestive answer rather than a full answer for just that reason. I would say, you're absolutely right, Ben, there is anything but indifference and I think obviously a lot of that has to do with the tax system, but it also appears to have something to do with signaling effects, it may have something to do with compensation arrangements as well. When you have people incentivized with equity, as opposed perhaps to incentivized with a basket of corporate instruments debt, as well as equity.

Interesting—you know, there is this question of, well given the additional requirements, given the additional safety and soundness measures we're taking, should for example the desired or expected or needed return on investment for some of these firms have declined? And I think it's declined some, that is the expectation of what kind of ROE you're going to get, but it surely has not declined as much as one might think given the judgments a lot of people.

Ratings agencies, outside observers as to how much safer the financial institutions are, and I've had discussions with analysts and representatives of investors in which they basically said, you know, there is a limit, there is a limit to all of this.

And so there almost kind of suggesting that they—in their day-to-day activities they haven't internalize Modigliani. And I think a full understanding of that even if I had 15 minutes to answer, I would not give you an answer that either you or I would find wholly satisfactory, I think a full understanding of that is actually pretty important going forward as we think about the incentives that firms have under the new capital regimes.

GARTEN: So what I take away from that—this enormous regulatory push is a is a massive work in progress. That is, that we may be at the fifth anniversary of Dodd-Frank, and there may be a lot of international activity that is consistent with that. But it would be the ultimate mistake to say, that there is a point at which the regulatory system is set, that it is going to continue to evolve in many different ways.

And so, if we were to have this discussion five years from now, you would—10th anniversary you would say we still have a lot to do.

TARULLO: Well yes, I mean, if you have a dynamic financial system, which we hope always to have a dynamic financial system, you need to have an adaptive regulatory system in order to try to assure the basic stability on that innovative dynamic financial system. You know, the position we're in now, Jeff, as I was suggesting at the outset, is in a sense one of a lot of catching up from decades of not really facing the implications of the integration of conventional banking with capital markets, which I think was the single biggest change that was not taken account of.

So—you know, we have to catch up put that sort of regulatory structure in place, and as I said I think we now have the outlines of the architecture of that system for our regulated prudentially regulated financial institutions. The adaptation is going to be over time asking whether the regs that are in place with respect to those institutions are adequate, or in some cases now, need to be modified.

And also, and probably more of a challenge is what several people asked about, which is the non-prudentially regulated sector, that's where I think the adaptation is can be analytically challenging, and whereas I would trying to suggest in response to one of the earlier questions where it's going to raise some political—political, you know, in the broader sense issues as well, because we're going to have to—we meaning Congress and political branches of government, are going to have to think about whether they want to give authority to more, is as the lady was suggesting a moment ago, to—to look forward more, and in a sense make a prediction and then act on that prediction.

And that you know that's that's a power which ultimately resides with the Congress under Article I, Section 8 of the Constitution and the political branches are going to have to decide whether they want to delegate that to somebody.

Thank you very much.

GARTEN: OK, thanks. Thanks, everybody. Thanks, that was great, OK.