ECONOMIC REPORT OF THE PRESIDENT

consumer and investor protections. These include reforms designed to
improve risk management, governance and transparency of the financial
system by strengthening banks’ transparency and disclosures, improving
consumer protections, and better regulating credit rating agencies. These
three categories of longer-run reforms are the focus of this section.
Increasing the Safety and Soundness of Individual Financial
Institutions
The crisis revealed clear fault lines in the financial system. Many
financial firms lacked the ability to absorb losses because they had inadequate
levels of capital or lacked the ability to survive runs because they
lacked sufficient liquid assets. In fact, these two issues are related because
fears about solvency or insufficient liquidity can lead to runs. Moreover,
many firms engaged in excessively risky trading and lending activity while
at the same time enjoying the benefits of federally insured deposits and
access to borrowing at the Federal Reserve. Financial reform has helped
make the financial system more secure by requiring financial firms to have
less unstable funding, more liquid assets, higher capital levels, and reduced
risk-taking.
Capital Levels
An important step toward increasing the safety and soundness of
individual financial institutions was the publishing of the Basel III recommended
reforms in December 2010. These reforms recommended both
higher minimum capital ratios and capital buffers for banks and a stronger
definition of what counts as regulatory capital. In July 2013, the Federal
Reserve implemented important parts of the Basel III recommendations
by finalizing rules that strengthened the definition of regulatory capital,
mandated that common equity tier 1 capital must be 4.5 percent of riskweighted
assets, and introduced a capital conservation buffer of 2.5 percent
of risk-weighted assets.6 The Federal Reserve’s final rules implementing
Basel III also usefully constrained the role of bank internal models in the
bank regulatory capital framework.
Dodd-Frank-required stress testing is a means for regulators to assess
whether the largest bank holding companies (BHCs) have enough capital to
weather another financial crisis. The Federal Reserve uses the results of the
6 Tier 1 capital consists primarily of common stock and retained earnings, but may also include
certain types of preferred stock. Risk-weighted assets are the bank’s assets or off-balancesheet
exposures weighted according to risk. For example, a corporate bond would typically
have a higher risk weight than a government bond reflecting the higher risk of default. A
capital conservation buffer is extra capital built up when business conditions are good so that
minimum capital levels are less likely to be breached when business conditions are bad.
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