Pianalto Calls for Broadening Stress-Tests, Enhancing Financial Info

WASHINGTON — Cleveland Federal Reserve Bank President Sandra Pianalto Friday called for "enhanced" information about financial institutions to promote stability in the system, pointing to the positive effect that increased transparency has had in the conduct on monetary policy.

In remarks prepared for a conference in Washington co-sponsored by the Cleveland Fed and the U.S. Treasury Department's Office of Financial Research, Pianalto did not discuss the economy nor the Fed's $85 billion a month in asset purchases aimed at boosting the economy.

The 2010 Dodd-Frank Act gave bank regulators greater authority to address potential risks to the financial system, and Pianalto argued that there are lessons to be learned from the great strides made in the overhaul of the Fed's communication regarding monetary policy.

"Today, we all recognize the critical role that transparency has come to play in conducting monetary policy. Going forward, transparency can also play a critical role in conducting financial stability policy," she said.

Pianalto noted that over the past 20 years, the evolution of edicts issued by the policymaking Federal Open Market Committee "has made our monetary policy more effective by providing more information about the Committee's future actions."

"For the same reasons, I believe that providing enhanced information about financial firms and clearer expectations for the future actions of financial regulators can also make our financial stability policies more effective," she said.

"Supervisors and markets will be better able to limit risks to the financial system and support overall financial stability when they have access to accurate information," she added.

Pianalto said that while the financial stability mandate conveyed on the regulators by the Dodd-Frank Act is non-specific, she believes it will become "more meaningful" if regulators make it more explicit over time.

She blamed a lack of a lack of "information transparency" — from banks, and a lack of "regulatory transparency" for playing a major role in the 2008 financial crisis.

"Information transparency should reveal the risks in financial firms and markets, and regulatory transparency should communicate how supervisors will respond to situations that threaten the financial system," Pianalto said.

She added that having greater transparency on both sides would boost discipline in the financial markets, she said, which in turn would increase the likelihood that financial institutions — "and, where appropriate, their uninsured creditors" — bear the costs of taking on excessive risk.

Going forward, Pianalto said one way to improve information transparency is through broadening the stress tests. She suggested that the tests could be broadened to explicitly consider the effects of a bank's stress on its most important counterparties.

Another suggestion, to improve information transparency, is to provide the public with more information about the quality of bank assets, as well as requiring the disclosure of the distribution of FICO scores in a bank's consumer loan portfolio.

"By requiring banks to make such disclosures, banking supervisors can promote information transparency on individual firms," she said.

Pianalto also called for continued progress in the area of living wills for large banks. Citing market distrust that a living will could safely unwind a failing bank without sparking financial stress, Pianalto argued that "successfully addressing the 'Too Big To Fail' problem requires the establishment of a credible resolution process."

She said that such a resolution process must appear capable of safely managing the failure of systemically important financial institutions in times of distress.

"Achieving this credibility will, in turn, require a fair amount of informational and regulatory transparency," Pianalto said.

"Credibility accumulates when there is public confidence and market confidence that rules are clear and are being followed — by the supervisors as well as by the financial firms," Pianalto concluded.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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