Retired Fed regulator defends stress tests, warns against Dodd-Frank repeal

Republicans in Congress are coming for the Dodd-Frank Act. Now, Daniel Tarullo, just retired from an eight-year stint as one of the Federal Reserve’s top regulators, is hoisting the old maxim about those who cannot remember the past.

“There’s a lot of talk these days of changing the financial regulations that were put in place following the [2008] financial crisis … But I think it’s important to remember why all these regulatory changes were put in place,” Tarullo said.

Tarullo, who spoke on campus April 26, is serving a two-week appointment as a distinguished fellow at MIT’s Golub Center for Finance and Policy. He served as a member of the Fed’s Board of Governors since 2009, stepping down earlier in April.

In his talk, Tarullo said the annual supervisory stress tests of the nation’s 30 largest banks — required by Dodd-Frank — is one of the most important financial regulatory moves since the 2008 financial crisis.

Tarullo said stress tests, more than point in time capital requirements, can evaluate the ability of banks to absorb losses in major economic downturns, while still remaining viable financial intermediaries.

“As citizens and as taxpayers, your antennae should be up when you hear proposals to … relax stress test assumptions, or give banks the supervisory model for the stress tests, or worse, to de-link stress test results from capital requirements,” he said. “[I have] found that liberals and conservatives often come together in their concern about moral hazard in ‘too big to fail.’ And they generally agree that there should be robust capital requirements, particularly for the largest banks.”

The Fed’s stress tests involve creating unlikely, but plausible, severe economic scenarios, and then modeling the likely impact of those scenarios on both bank assets and bank earnings. The scenarios change from year-to-year, and the Fed’s supervisory model can be modified as new products are introduced and as correlations among asset classes change, Tarullo said.

“Banks subject to the stress test have generally found it to be their binding capital constraint, and this is as it should be. Insofar as stress testing is meant to help set capital requirements for when they will most be needed — that is, in a serious economic downturn,” he said.

Regulation “hasn’t hamstrung the whole economy”

Tarullo said it may be premature to assess the post-crisis reforms, as many of the Dodd-Frank regulations are still being implemented. Banks are also still adjusting to the changes in the financial industry, he said.

But, over the past several years, commercial bank lending has been growing at about 5.6 percent, which is a “pretty healthy pace of lending,” Tarullo said. It’s not the “breakneck” speed of 2005-2006, but poorly underwritten lending will result in defaults, foreclosures, and bankruptcies, he said.

Additionally, the U.S. commercial banking system saw record profits in 2016.

“Return on equity for the most systemically important banks has fallen somewhat short of the 10 percent number that many think will be the benchmark in the post crisis period, since no one expects that the 15 percent pre-crisis number will return,” Tarullo said. But this trend, too, has been favorable, he added.

“And with adjustments in business models and transitions to the new regulatory regime still in progress, there are reasonable grounds for believing that return on equity will move up further in the future,” he said.

By most measures, market liquidity has also been healthy.

“I think the overall numbers — bank profitability and lending — argue against the suggestion that post-crisis regulation has somehow hamstrung the whole economy or crippled the banking industry,” Tarullo said.