Do We Need A Systemic Risk Regulator, And If So, Who Should It Be?

In late March, in the wake of the worst financial crisis since the Depression, Secretary of the Treasury Timothy Geithner outlined the first installment of the Obama Administration’s plans to reform laws and regulations governing the financial industry. Each of the elements of this initial plan was advanced in the service of a common objective: to reduce the exposure of the financial system and the economy to systemic risk.

This hardly came as a surprise. It was the fear of systemic risk, after all, that induced the Treasury (enabled by the Congress), the Federal Reserve, and the FDIC to take a series of extraordinary measures to protect the creditors of a number of well-known financial institutions that failed during this crisis. Given the huge cost of these operations, there seems to be broad agreement that something ought to be done to reduce systemic risk in the future, although consensus does not yet appear to exist on exactly what those measures should be.

The most extreme option favored by some is to have the government proactively nationalize the large weak, banks, strip out the toxic assets, and then break them up before selling the healthy shells back to the private sector. The main purpose would be to prevent systemic risk in the future by constraining the size of the financial institutions themselves.

We may eventually get to some significant number of nationalizations – if the economy continues to weaken and/or the banks’ true worth is publicly recognized – but even a major bust-up campaign will not totally solve the systemic risk problem. Even if banks above a certain size are not permitted to merge, lawmakers or regulators cannot stop their internal growth. Over time, successful institutions would then grow into becoming systemically important. Meanwhile, other large financial institutions that do not fall into the government’s web already may pose systemic threats of their own, risks that will grow over time.

More is clearly needed. One additional measure would be to implicitly “tax” – through higher capital and liquidity requirements – financial institutions above a certain size or degree of financial interconnectedness. Such a regulatory tax would help offset the “systemic risk externality” such institutions impose on the economy. In light of recent events, it is unlikely that such a systemic risk tax would be greater than the expected cost (magnitude times probability) of having to bail out the creditors of these institutions in future crises.

Another sorely needed reform is to extend the system of prompt corrective action we now have to curtail the taxpayer cost of resolving troubled banks to large, systemically important non-banks. The Treasury’s proposal in this regard – to give it, the Fed and the FDIC authority to make this determination, and the FDIC the authority to carry it out – is a sensible way to do this.

Regulatory enforcement options

The question then becomes: who would administer and enforce a more rigorous regulatory regime for systemically important financial institutions (SIFIs)? The basic choices comes down to vesting this authority in a single regulator; in a collection or body of regulators, such as the banking, securities and futures regulators represented currently on the President’s Working Group on Financial Markets; or in each of the various current financial regulators separately (federal and state, in the case of insurance).

Choosing a single regulator has several advantages. There are likely to be both economies of scale and scope in identifying and specially regulating SIFIs, which argues in favor of having one agency do the job. Splitting up the regulation and supervision of SIFIs among the different agencies that currently regulate financial institutions would run the risk of inconsistent and potentially conflicting rules or outcomes. Giving the authority to regulate SIFIs to a college of regulators entails a different set of risks: the need to obtain a consensus would likely slow and water down meaningful oversight, while creating ample opportunities for finger-pointing when things go wrong. Decision by committee also violates Harry Truman’s “The Buck Stops Here” principle: when many agencies or individuals or responsible for action then no one is.

Which single agency should have the systemic risk regulatory responsibility? In my view, it would be best to consolidate all federal financial regulatory agencies into two – one for solvency and the other for consumer protection – and then to give SIFI oversight to the solvency regulator. This is the most logical approach, and one that would draw on the financial expertise of the solvency regulator to specially regulate and oversee SIFIs as part of the regulators’ overall mission.

During his last year in office, former Treasury Secretary Henry Paulson suggested the consolidation of financial regulatory oversight into two agencies, but urged that the Fed have “free safety” powers to step in any where and at any time it saw fit. This kind of authority is both too vague and too sweeping, and a recipe for jurisdictional conflict between the Fed and the agencies. If Congress were to muster the political will to implement the rest of Paulson’s idea – consolidation into two regulators – then it could still involve the Fed in other ways. The solvency regulators should give the Fed the same data on SIFIs that the solvency regulator collects and at the same time, and even give the Fed a formal role as an adviser on regulatory and supervisory policy with respect to such institutions.

I am not holding my breath, however, for Congress to enact anything like the regulatory consolidation envisioned by the Paulson Treasury, and thus to give systemic risk regulatory authority to a new uber-solvency regulator. If this reform does not come to pass, then the sensible second-best option is simply to charge the Fed with being the systemic risk regulator.

This is not as far-fetched as some critics of the Fed assuming this role have made out. After all, in creating the Fed as a lender-of-last-resort, the Congress already has recognized that the Fed is the only institution we have for preventing a meltdown of the financial system. As it is now, the only tools the Fed now has to fulfill this mandate are its monetary policy and lending activities. Giving the Fed added regulatory tools – specifically supervisory oversight of SIFIs – would give it more ammunition to prevent systemic risks from arising in the first place. Rather than conflicting with its monetary policy functions, systemic risk regulatory authority thus would unburden the Fed from having only to rely on loose money to ward off a systemic threat, and thus would complement the Fed’s existing monetary functions.

Worst choice scenario

The least desirable choice of a systemic risk regulator, in my view, would be to create yet another regulator charged only with this mission. There are already too many cooks in the financial regulatory kitchen and adopting this option would make it worse. It would also replicate much of the expertise that already resides within existing financial regulatory bodies.

Admittedly, designating a systemic risk regulator and imposing a more rigorous regulatory regime for SIFIs will not eliminate all systemic risk. Asset price bubbles are an inherent part of capitalism: break-through technologies typically attract a lot of capital and entrepreneurs at the outset, followed by a shakeout. Think of the railroad, auto, and Internet bubbles, among others, as examples of this process.

Nonetheless, there is no excuse for not doing a better job insulating our largest financial institutions whose failure could cripple the financial system from failure when their balance sheets or income statements are shocked by external events, such as the recent collapse of housing prices. In this way, regulators at least can mitigate the fallout – financial and economic – when the inevitable bubbles do pop.

Nonetheless, but not surprisingly, there is already opposition to establishing a systemic risk regulator. One obvious objection is that by publicly identifying SIFIs, the government will create or worsen moral hazard, by eliminating incentives of short-term and possibly longer-term creditors (all those who would be bailed out if the firm failed) to monitor the health of the SIFIs, and thus incentives for the managers of these firms to act prudently. Some advocates of systemic risk regulation would meet this objection by not publicizing the SIFI list. This approach is unrealistic, since most SIFIs (with the exception of large hedge funds) are publicly held companies, and thus any more stringent capital and liquidity (or other) standards to which they would be held would be readily evident from their financial statements.

Ensuring market discipline

The best answer to the concern about moral hazard is that precisely because SIFIs, by definition, pose a systemic risk if they fail, they would be regulated and supervised more closely than is the case for other financial institutions. Higher capital and liquidity standards, in particular, thus would be designed to offset any possible moral hazard effect. In addition, policy makers can further constrain risk-taking by large, publicly held SIFIs by requiring them to back a set percentage of their assets by long-term, unsecured debt – or the kinds of instruments that the government need not protect if the institutions run into financial trouble. Such a requirement would ensure some continuing role for market discipline.

A second objection to vesting systemic risk regulation in a single agency is that it would concentrate too much power in that agency, especially if the designated agency were the Fed, which already has enormous power by virtue of its control over monetary policy. One answer to that concern is to point to the clearly inferior alternatives. Wait for the next explosions to occur and then spend trillions more cleaning them up? Splitting up regulatory authority in a college of supervisors where no single agency has a final say, which is a recipe for inaction or delay? A second answer is that if excessive concentration of power is a serious concern, then Congress should exercise oversight over the activities of the systemic risk regulator.

If these two answers do not suffice, then consider a third: we concentrate tremendous power in the hands of a single individual, the President, to launch war, nuclear if necessary, against foreign threats to our national security (I know that technically only Congress has the Constitutional authority to declare war, but in a nuclear emergency in particular, everyone knows there is no time for Congress to deliberate and vote on a response). SIFIs, if not properly constrained, can threaten our domestic economic security. It hardly seems inappropriate, therefore, to designate one agency with the authority at least to reduce the magnitude of that threat, especially given that we already have an agency – the Fed – we trust with rescuing us from financial disaster when the threats become too real.

A final objection is that we are being short-sighted if we think that a systemic risk regulator will protect against all future systemic meltdowns. But that erects an impossible test for any policy reform to meet. A set of reforms that helps prevent institutions from posing systemic risks, even if it does not eliminate all systemic risk, would leave us in a better position than we are now in. The perfect cannot be the enemy of the good.

In short, we must do a better job protecting our financial and economic system from systemic risk. Assigning that role to a single agency, with clear instructions of the types of authority it is expected to exercise, is the best way to assure that protection.

Arthur bio