Ten years ago, the failure of Lehman Brothers ushered in the worst recession since the Great Depression and touched off a financial crisis that damaged the economy and impacted people’s lives in the U.S. and abroad. Since then, the financial system has undergone significant and important changes that have dramatically improved the safety, soundness, and resiliency of the sector. In particular, banks and Forum members have made dramatic changes to their resiliency, liquidity, funding stability, and resolvability. At the same time, they have increased the provision of lending and financial services to businesses and households. In addition, other improvements have been made outside the banking system that support its strength and resiliency. In this post, we review some of the most significant changes to the financial system and the important effects they have had in the past 10 years. We also discuss how we should review the past 10 years of accumulated experience to improve financial regulation.
The financial system has undergone significant and important changes that have dramatically improved the safety, soundness, and resiliency of the sector. In particular, banks and Forum members have made dramatic changes to their resiliency, liquidity, funding stability, and resolvability. “
Forum members support appropriate regulation to ensure a stable and sound financial system. It is important that regulation is appropriately set to support both the stability of the financial system and the ability of financial institutions to meet the needs of businesses, households, and communities.
It may seem that touting all the advances that have been made in the past 10 years while at the same time suggesting that regulators revisit aspects of the regulatory landscape are at odds. But that is not the case. The Forum and its members are supportive of the significant achievements that have been made by regulators and financial institutions over the past 10 years. At the same time, after a period of such significant change, it only makes sense to take time to review, observe how various rules interact with each other, and make adjustments as needed. Such action would prudently serve to improve regulatory efficiency and best promote economic growth without sacrificing safety and soundness.
Getting the regulatory system right is vital. The Forum’s member firms support economic growth by lending to consumers, businesses, and other financial institutions, and help foster deep and liquid capital markets that allow government and private institutions to finance public spending and investment. For example, in the second quarter of 2018, Forum institutions held more than $4 trillion in loans, accounting for 43 percent of total lending to businesses and households. Changes to the regulatory framework that improve efficiency will enhance the ability of our members to serve as a leading source of support for the U.S. economy.
Perhaps the clearest measurement of greater resiliency in the banking system is the increase in capital over the past decade. Capital is, of course, a clear indicator of resiliency as it stands ready to absorb losses so that banks can continue operating in the face of financial shocks. As shown in Figure 1, Forum members have increased their common equity Tier 1 capital (CET1), the most loss-absorbing form of capital, to $800 billion, an increase from roughly $475 billion in 2009. As a percentage of risk-weighted assets, Forum members have more than doubled their CET1 to 12% from 5% in 2009.
In addition to this significant increase in the quantity of capital, it is also important to recognize the improvements in the quality of capital in the system. Importantly, and as shown in Figure 2, the fraction of total equity capital accounted for by Tier 1 capital at Forum member institutions has risen steadily to 85% of total equity capital, up 10 percentage points since 2009. This increase is important because investors and the public need to have confidence in both the quantity and quality of capital maintained by the banking system.
These improvements in capital have had a significant impact on the safety and soundness of Forum members. In a recent research paper, Darrell Duffie of Stanford University estimates that the solvency ratio – a measure of a bank’s capital relative to the risk of its assets – of large banks has increased five-fold in the past decade.
This estimated improvement in solvency points to the significant gains that have been achieved over the past decade, gains that are being recognized by academics like Professor Duffie, analysts, and the general public.
Robust capital is an important source of strength in the banking system, but it should not be viewed as the only, or necessarily the most important, source of resiliency. Banks also require liquid resources that can be deployed quickly as needed and transformed into cash for transactions at low cost. Liquidity can contribute as much or more to stabilizing a financial institution as capital. When creditors demand to be repaid, an institution with sufficient liquid resources is able to meet those demands without costly delays while signaling to investors and other institutions that it is strong and able to operate without disruption.
Forum members have greatly increased their holdings of high quality liquid assets (HQLA). As shown in Figure 3, Forum members have increased their holdings of HQLA – such as cash, reserves, and U.S. Treasuries – by nearly $1.4 trillion since 2009, more than doubling liquid asset holdings. This increase also has important capital implications because liquid assets are low risk and in many cases, as in the case of cash and reserves, are risk-free. As a result, a dollar of liquid asset holdings raises the efficacy of a dollar of capital because the risk profile of a bank declines with each additional dollar of low-risk assets that are added to its balance sheet.
Our liquidity discussion has focused on asset liquidity. In addition to asset liquidity, it is important to consider funding stability as well. In particular, the kind of run-type behavior that was observed during the financial crisis is ultimately caused by creditors demanding repayment and being unwilling to fund the banking system. Large amounts of short-term liabilities increase the prospect for this type of destabilizing behavior.
Figure 4 details how Forum members have changed their funding profile in the past decade. The figure shows the fraction of total liabilities accounted for by deposits (left scale) as well as the fraction of total liabilities accounted for by short-term liabilities (right scale). As shown in the figure, Forum members’ deposits as a fraction of all liabilities have increased steadily to 58% of all liabilities from 37% in 2007. Deposits are generally more stable and less prone to runs than other short-term liabilities such as commercial paper, which are largely held by nimble institutional investors and do not benefit from any explicit insurance or support. Figure 4 also shows that the fraction of total liabilities accounted for by short-term liabilities has steadily declined to 21% from 38% in 2007. The changes documented in Figure 4 are important and buttress the asset liquidity improvements discussed earlier. Together, improvements in funding stability and asset liquidity have significantly improved the ability of Forum members to withstand liquidity shocks.
In addition to the significant improvements in capital, liquidity, and funding stability – or, the resiliency of financial institutions – a number of steps have been taken in the past decade to improve resolvability. Enhanced resolvability of financial institutions improves financial stability because more resolvable institutions can be allowed to fail without imposing large economy-wide costs.
Importantly, large banks now engage in an ongoing resolution planning process. This “living will” process is intended to create an actionable plan to resolve a large financial institution. These plans detail a bank’s most significant and material operating entities as well as funding sources, liquidity sources, and roadmaps for the wind-down and sale or disposal of certain legal entities and assets. Forum members’ living wills are reviewed and assessed by the Federal Reserve and FDIC. As of the most recent review in December 2017, all Forum members’ resolution plans have met regulatory requirements.
Further, the banks themselves have taken measurable steps to improve their resolvability. One such important change is the reduction in complexity of banks’ legal entity structures. One clear and transparent measure of organizational complexity – documented by research conducted at the Federal Reserve Bank of New York – is the total number of subsidiaries within a holding company. As shown in Figure 5, Forum members have substantially streamlined their legal entity structures and have reduced the total number of unique subsidiaries within their holding companies by nearly 50% in the aggregate since 2009. This change has led to simplified and streamlined legal structures that would support a more feasible and less costly resolution.
Finally, the Dodd-Frank Act created a new backup resolution regime that is designed to facilitate the resolution of a large financial firm if it was deemed that bankruptcy was not viable. The creation of this backup resolution regime means a large financial institution would be allowed to fail without resulting in significant spillover costs to the rest of the economy. Moreover, it should be noted that the increase in long-term funding liabilities that was discussed earlier supports this change to the resolution regime as long-term creditors would see their debt contracts converted into equity to fund the re-capitalized entity in the event of such a resolution.
Improvements to the Rest of the Financial System
So far, we have reviewed some significant improvements that have been made to the banking system in the past decade. These improvements are critical, but important changes to other aspects of the financial system should not be overlooked. There are a large number of such improvements, but three are especially noteworthy because of their nexus with the banking system.
Derivatives Market Reform: Clearing and Margin
The structure and regulation of the derivatives market have been transformed in the past decade. These structural and regulatory changes are important because large banks, including Forum members, play an integral role in these markets. Two key changes are (1) the substantial increase in central clearing of over-the-counter (OTC) derivatives and (2) the mandated exchange of initial and variation margin on all OTC derivatives that are not centrally cleared. Central clearing is an important reform because clearing brings transparency and strict risk-management standards to derivative trading. As a result, the rise in central clearing has measurably reduced the scope for systemic risk to emanate from derivative markets.
Figure 6 shows the increase in the central clearing of credit default swaps (CDS) since 2009. The fraction of centrally cleared CDS has grown to more than half of the market from roughly 12% in 2010. Central clearing of interest rate swaps, by far the largest segment of the OTC derivative market, has also grown significantly. According to the Bank for International Settlements, as of the end of 2017, more than three-quarters of the interest rate swap market is centrally cleared.
A measurable portion of OTC derivatives is not suitable for clearing because certain derivatives are highly customized. These “bilateral” derivatives are now subject to strict margining requirements, which help to ensure that large credit exposures are not allowed to build in a way that could present risk to the financial system. According to ISDA estimates, large dealer banks are now holding $130 billion in initial margin against bilateral OTC exposures with each other, which represents a substantial increase over the past decade.
Money Market Mutual Fund Reform
Money market mutual funds (MMFs) are an important source of funding to the banking system and changes to their structure have improved financial stability. Importantly, institutional prime money funds must now be quoted on a floating net asset value (NAV) basis, which creates more transparency and market discipline. Moreover, the market has shifted away from such prime money funds toward MMFs that are backed by fully guaranteed U.S. government securities. As these MMFs are generally more stable than prime funds, this represents an important improvement in the stability of this segment of the financial sector. As seen in Figure 7, prime fund assets have declined to roughly $675 billion at the end of June 2018 (the most recent data available) from roughly $1.75 trillion in 2014. All of this decline has been offset by the growth of U.S. government-backed money funds.
Tri-Party Repo Market Reform
Repo markets, which facilitate borrowing and lending on a secured basis, is another important part of the financial system. One important source of funding for the banking system is the “tri-party” repo market, in which large banks use a third-party intermediary to facilitate secured borrowing and lending. Prior to the financial crisis, this market operated by extending large amounts of uncollateralized, intraday credit.
An industry-led effort that was organized and supported by the Federal Reserve Bank of New York resulted in several key improvements to the tri-party repo market that have largely reduced the provision of uncollateralized, intraday credit. As shown in Figure 8, this shift resulted in a dramatic decline in intraday credit, resulting in the tri-party repo market operating in a more stable and secure way, which has led to an improvement in the safety and stability of the banking system.
Looking to the Future
The past 10 years have been marked by a number of important initiatives that have significantly improved the safety and soundness of our financial system and fundamentally changed the banking business model. Forum members have been prime contributors to these improvements. Today, Forum members are strong, stable, resilient, and ready to support economic growth by providing lending and other financial services to a wide range of households, businesses, and communities.
The past 10 years have been marked by a number of important initiatives that have significantly improved the safety and soundness of our financial system and fundamentally changed the banking business model. Forum members have been prime contributors to these improvements.”
Forum members support appropriate regulation to ensure a stable and sound financial system. At the same time, Forum members also want to ensure that regulation is appropriately calibrated and tailored to support a stable financial system that is also able to meet the financial needs of businesses, households, and communities. Regulations that are not appropriately tailored and do not recognize the need to support economic growth will unduly restrict Forum members’ ability to support lending, investment and, ultimately, economic growth.
Much has been learned in the past decade about how financial regulations interact with each other and how financial regulations impact the ability of financial institutions to meet the needs of their customers in a cost-effective manner. In light of the past 10 years of experience, the regulatory system should be reviewed to assess its efficacy and efficiency. As a specific example, the Forum along with colleagues at the Bank Policy Institute have argued that the capital surcharge for our institutions should be re-examined in light of the effects of recent and successful regulatory initiatives.
In this post, we have demonstrated several dimensions along which the banking system has become safer and more stable: more and better capital, more liquidity, more stable funding, increased resolvability, and greater resilience in other key parts of the financial system. As we look forward to the next 10 years, regulators and the public should be asking how all of these changes fit together and whether the portfolio of changes that have been made make sense from a system-wide perspective. Doing so will improve the financial system and help support continued economic growth and stability.
Sean Campbell is the Executive Vice President, Director of Policy Research, at the Financial Services Forum.
 The current 12% CET1 value is taken from the Q2:2018 FR Y-9C while the 5% CET1 value is taken from the Federal Reserve’s Supervisory Capital Assessment Program: Overview of Results and is as of 12/31/2008. The quoted percentage amounts are total asset weighted averages of each Forum member’s CET1 capital ratio.
 Our definition of HQLA follows the definition employed by the Federal Reserve’s Liquidity Coverage Ratio rule.
 For the purposes of this post we define short-term liabilities to be all borrowed money with a maturity of one year or less, commercial paper, federal funds, and trading liabilities.