Systemic stability is first order of business in regulatory reform

The immediate focus in financial regulatory reform is to designate someone to watch out for systemic stability. The current crisis has revealed yawning cracks in the regulatory structure because none of the watchdog agencies felt responsible for the financial system as a whole. “I’ve talked to several regulators and none of them felt that systemic stability was in their inbox,” says one regulatory attorney in Washington.

Critics

Barney Frank, chairman of the House Financial Services Committee, wants to give this task to the Federal Reserve, despite reservations by some, including former Fed chairman Paul Volcker, that expanded regulatory responsibilities could impinge on the central bank’s main duty of managing monetary policy. Frank countered those critics in a press briefing on Thursday. He told reporters that the Fed has been able to take an active role in the current crisis, intervening more than many would have thought possible. “That does not appear to have impinged upon their monetary policy,” he said.

The Massachusetts Democrat has mounted a full schedule of hearings for the rest of this month that will in great part deal with creating a “strongly empowered systemic risk regulator.” The house panel will examine various aspects of regulatory restructuring in hearings on March 17, 20, 24 and 26. Frank said the committee has been concentrating the last few months on working with two administrations on measures to stabilize the financial system. “It is now essential that we continue to work on our reform agenda and address the need for financial regulatory restructuring to diminish systemic risk and to enhance market integrity,” Frank said.

Congress

The initial stab at regulatory reform is more likely to come from Congress than from the administration, as a badly understaffed Treasury tries to deal with the stimulus, the budget, the bank bailout and a program to stem home foreclosures. This week saw two of Treasury Secretary Timothy Geithner’s picks for top posts, including former SEC commissioner Annette Nazareth as deputy secretary, withdraw their names from consideration. Nazareth, a longtime SEC staffer before her stint on the Commission itself, would have been well placed to lead administration efforts on regulatory reform.

Frank’s focus on the Fed as stability regulator is more pragmatic than anything else. The congressman does not believe we have the leisure to create a new agency for the purpose (“I don’t think we can stop the world long enough for that to happen,” he says) and another frequently mentioned option, using a committee of regulators like the President’s Working Group on Financial Markets, would also be problematic (“It’s not been my experience that committees of existing regulators work well,” Franks says). A top industry representative echoed these sentiments in congressional testimony this week.

Inefficiency and waste

Tim Ryan, CEO of the Securities Industry and Financial Markets Association and a former director of the Office of Thrift Supervision, told a House subcommittee that it might take years to start up a new agency from scratch. As for the committee option, he said, “This model has the potential to perpetuate the risk of continued gaps, duplication, inefficiency and waste compared to a single oversight body.” The Federal Reserve, by contrast, already has many of the attributes required in a systemic risk regulator, including the ability to act as a lender of last resort. But, Ryan concedes, there are worries that adding these duties to the Fed would concentrate too much power in one institution. Also, the Fed itself has not been blameless in overlooking warning signs ahead of the current crisis, Ryan said.

The fact is that the model offered by a single, consolidate financial regulator such as the UK’s Financial Services Authority has also been largely discredited by the current crisis. The FSA, with the principles-based regulation so envied by U.S. industry, was not any more effective in spotting the buildup of leverage and risk in the UK banking system than our own widely criticized hodge-podge of overlapping bank regulators. Ditto for the single regulators in Germany and Japan. The type of supervisor seems less important than the type of supervision. The banking systems that have fared better in the crisis, such as Canada and Spain, are those where the supervisory agency or central bank keeps the banks on a tight leash. In Canada, for instance, banks have tight restrictions on types and amounts of lending. In Spain, the national bank introduced an innovative and very effective system of “dynamic provisioning” that forced the banks to create higher reserves as lending increased, serving the dual purpose of putting a brake on credit expansion and giving the banks a bigger cushion against losses. This countered the “pro-cyclicality” fostered by the Basel II capital requirements, which is blamed in part for the weakened condition of many European banks. The impending Group of 20 summit in London on April 2 is lending further momentum to the discussion on a systemic risk regulator. This meeting, to follow up on an initial G20 summit in Washington last November to deal with the crisis, aims to coordinate various national measures on regulatory reform. The International Monetary Fund weighed in this week with its recommendations for international regulation of hedge funds, private equity funds and other institutions that could potentially pose a systemic risk across national borders.

Intense pressure on G20

Previous efforts to bring hedge funds under tighter regulation have foundered on opposition from some regulators – particularly in the U.S. and most particularly former Fed chairman Alan Greenspan – who subscribed to an ideology of laissez-faire with regard to many of these large and sophisticated market participants. Partly to alleviate U.S. concerns, the IMF’s Jaime Caruana, who heads the banking and capital markets department at the multilateral agency (and who ironically was the Spanish central bank governor who initiated that country’s dynamic provisioning policy), told journalists they are recommending tighter regulation only for the very big groups, with a more lenient policy on funds that do not pose a systemic risk. Caruana also cautions against a rush to regulation, partly because we don’t really understand fully the causes of the current crisis. But the G20 may feel more intense pressure this time around to actually come up with some concrete proposals, after the somewhat unsatisfactory non-result from the November meeting, which came awkwardly during the presidential transition in the U.S. Perhaps the notion of a “college of regulators” – grouping the top regulators in participating countries – will gain some traction as at least a transitional group to coordinate global efforts on monitoring systemic risk.

This could take the form of a new group, or, more realistically, an expanded version of the existing Financial Stability Forum to include at least the large emerging economies such as China, India and Brazil from the G20. But there may be little concrete coming out of this meeting, after all. The U.S. Treasury, due to the understaffing and work load already noted, has now let it be known that it will not in fact have any detailed recommendations in time for the meeting, but only some principles.

Darrell Delamaide reports exclusively on financial regulation news and trends for FinReg21. Darrell is a veteran financial journalist who has worked for Dow Jones, Bloomberg, Institutional Investor, among others. He is based in Washington, D.C.