WASHINGTON (MNI) – The following are excerpts from Federal Reserve
Gov. Daniel Tarullo’s remarks Friday prepared for the Washington
Univesity Center for Law, Economics and Finance Conference:

As you know, inquiries into the extent of, and culpability for,
these problems are currently being conducted by banking regulators,
other federal agencies, and state attorneys general. Regardless of the
findings that emerge, and the steps that servicers and others may take
to correct their mistakes, this episode has again drawn attention to
what can only be described as a perverse set of incentives for
homeowners with underwater mortgages. Homeowners who try to get a
modification of the terms of their mortgages are all too frequently
subject to delay and disappointment. On the other hand, those who simply
stop paying their mortgages have found that they can often stay in their
homes for a year or more, rent free, before the foreclosure process
moves ahead.

This simply is not a good outcome from any broad perspective — not
for the revival of housing markets, not for the banks and investors that
hold the delinquent mortgages, and in the longer run, not even for the
homeowners themselves, who will ultimately have to move out, taking with
them a dark cloud over their creditworthiness.

Several possible explanations have been suggested for this untoward
state of affairs — the lack of servicer capacity to execute
modifications, purported financial incentives for servicers to foreclose
rather than modify, what until recently appeared to be easier execution
of foreclosures relative to modifications, limits on the authority of
securitization trustees, and conflicts between primary and secondary
lien holders. Whatever the merits and relative weights of these various
explanations, the social costs of this situation are huge. It just
cannot be the case that foreclosure is preferable to
modification — including reductions of principal–for a significant
proportion of mortgages where the deadweight costs of foreclosure,
including a distressed sale discount, are so high. While some banks and
other industry participants have stepped forward to increase the rate of
modifications relative to foreclosures, many have not done enough. I
would hope that both servicers and ultimate holders of the mortgages
will take this occasion not just to correct documentation flaws and to
contest who should bear the losses of mortgages gone bad, but to
invigorate the modification process.

—

Basel III is not a perfect agreement, of course. There are things
we would have done differently if we were writing a capital regulation
on our own. There will surely be some technical challenges in
implementing it. It does not really address some pre-crisis problems in
capital regulation such as pro-cyclicality. But it is a major step
forward for capital regulation. It will raise minimum requirements
substantially, ensure that regulatory capital is truly loss absorbing,
and discourage some of the risky activities for which the pre-crisis
regime required far too little capital.

Basel III was also a major step forward in international
cooperation. In all candor, as recently as this past spring I was
concerned that we might be unable to agree in Basel on such key issues
as a distinct common equity requirement. However, under the strong
leadership of Nout Wellink in the Basel Committee and Jean-Claude
Trichet in the GHOS, we concluded a good agreement in timely fashion. I
believe that another factor in turning things around was that, unlike at
some times in the past, the U.S. banking agencies spoke with a single,
unified voice in Basel.

Obviously, the benefits of Basel III for financial stability will
be realized only if they are implemented rigorously. In this regard, it
is important to draw a distinction between, on the one hand,
implementation in the sense of enacting national regulations that
incorporate the Basel standards and, on the other, implementation in the
sense that firms are actually holding the amounts of capital called for
by the internationally agreed rules.

The Basel Committee must be able to monitor effectively
implementation of, and compliance with, these new capital standards. A
number of market analysts have noted that, even under current market
risk capital rules, there is considerable apparent variation in the
riskweightings apparently applied by different banks. We are urging the
Committee to explore mechanisms for ensuring that these strengthened
capital standards lead to a consistency in application, as well as in
the provisions of relevant domestic regulations.

Along these lines, we have heard complaints from a few other
countries that Basel II is not yet operative for our large,
internationally active banking organizations in the United States. As we
have explained, despite the substantial resources devoted by both
banking organizations and supervisors to the tasks of developing and
validating the Advanced Internal Ratings-Based Approach in those
institutions, we continue to encounter significant difficulties. The
suggestion that U.S. banking organizations have thereby gained a
competitive advantage is misplaced, however. For one thing, we required
significant capital increases as part of the SCAP and the Troubled Asset
Relief Program repayment processes last year. Also, we note that the
required capital levels for some foreign banks adopting Basel II
apparently declined from Basel I levels.

—

Before closing, I want to address requests for renewed or increased
dividends by our large bank holding companies, an issue in which there
has been substantial recent interest. During the crisis, dividends were
eventually suspended or reduced to minimal levels by all the banking
organizations covered by the SCAP. As the financial system has
stabilized, some firms have indicated an interest in resuming or
increasing dividends, or repurchasing shares. We have been concerned
with the safety and soundness implications of resuming or increasing
capital distributions in the absence of a strong, forward-looking
demonstration that the capital position of a firm would be protected
even under stressed conditions. Until Basel III was completed and
Dodd-Frank enacted, it was obviously difficult for any firm to make that
kind of demonstration, since its future capital needs and potential
business model changes were obviously unknown. While there continues to
be a relatively high degree of uncertainty about near- to medium-term
economic prospects, the basic questions surrounding capital and
regulatory reform have now been answered. We anticipate that some firms
with high capital levels that have been retaining solid earnings for
several quarters will be interested in increasing or resuming dividends.
In response to these anticipated requests, we will soon be issuing
supervisory guidelines applicable to such requests from the largest
holding companies for the first quarter of next year.

Although the details of these guidelines are still being finalized,
I can say that our approach to considering such requests will be a
conservative one. We will expect firms to submit convincing capital
plans that demonstrate their ability to absorb losses over the next two
years under an adverse economic scenario that we will specify, and still
remain amply capitalized. We also expect that firms will have a sound
estimate of any significant risks that may not be captured by the stress
testing, such as potential mortgage putback exposures, and the capacity
to absorb any consequent losses. The firms will also be asked to show
how, even with their proposed capital distributions, they will readily
and comfortably meet the Basel III requirements as they come into
effect, as well as to accommodate any business model changes that might
be necessitated by Dodd-Frank.

** Market News International Washington Bureau: 202-371-2121 **

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