Issues for Systemic Risk Regulation

At the end of last month, Treasury Secretary Timothy Geithner laid out an ambitious agenda for regulatory reform. The agenda seeks to address many of the perceived weaknesses in the United States regulatory structure that have been thought to have contributed to the ongoing global economic slowdown. In doing so, the Treasury’s agenda demonstrates a meticulous approach to the issues posed by the financial crisis.

With respect to the issue of managing systemic risk – the first component of the Geithner agenda – however, there are already competing visions of how best to implement reform. The challenge to enacting successful reform will be to ensure that whatever proposal is chosen, the regulator or regulators have full supervisory powers over financial institutions on a consolidated basis.

In its March 26 press release, the Treasury Department stated that “Comprehensive Regulatory Reform” would have four broad components:

• Addressing Systemic Risk
• Protecting Consumers and Investors
• Eliminating Gaps in Our Regulatory Structure
• Fostering International Coordination

The press release then outlined a six-point program for addressing systemic risk, by: assigning responsibility for all systemically important firms to a single independent regulator; requiring higher capital and risk management standards for systemically important firms; requiring SEC-registration of all hedge fund advisors with assets under management above a certain threshold; instituting a comprehensive framework of oversight for the OTC derivatives market; imposing new requirements on money market mutual funds; and creating a stronger resolution authority to protect against the failure of complex institutions. Each of these six points responds to the principal issues raised by the failure of Lehman Brothers and the government’s intervention into the affairs of AIG in September 2008.

In the short period of time since the Treasury’s announcement, there have been many questions raised about the first point – the single, independent systemic risk regulator: Who will that regulator be? Does it have the means to effect appropriate regulation? And can it regulate systemically without compromising other functions?

The obvious candidate is the Federal Reserve Board because it is the current supervisor of traditional bank holding companies as well as the “new” bank holding companies, those broker-dealers and other firms that became bank holding companies in the wake of Lehman and AIG. The Federal Reserve Board has a long history of mandating “comprehensive consolidated supervision” for companies under its purview and it is central to the functioning of the U.S. payment and settlement systems.

Certain critics, however, have raised practical issues with making the Federal Reserve Board assume this role. They note that the Federal Reserve Board’s role in the regulatory system has grown by leaps and bounds in the last six months, and question how many additional supervisory resources it has at its disposal. They also argue that the proposal could pose dangers for the Federal Reserve Board’s reputation over time: a single regulator charged with protecting against systemic risk would suffer a significant loss of prestige if another Lehman Brothers occurred on its watch. There is also a concern that magnifying the power of the Federal Reserve Board will almost certainly increase the political pressures that the institution must bear, particularly in the current environment, thus undermining its independence as a central bank.

For these reasons (and others), some, like Connecticut Senator Christopher Dodd have suggested that the Federal Deposit Insurance Corporation is better suited for the role of systemic risk regulator, although this idea has not necessarily been welcomed by the FDIC itself. Comptroller of the Currency John Dugan, an FDIC board member, for one, recently expressed reservations about the FDIC being charged with the resolution of failing systemically important financial institutions, even thought resolving bank failures is the FDIC’s principal area of expertise.

Other approaches to systemic risk regulation appear to make use of the third component of the Treasury’s comprehensive regulatory reform agenda – eliminating gaps in the regulatory system. Senator Susan Collins recently proposed legislation that would, in addition to establishing an inter-agency government council of regulators, the Financial Stability Council, as the systemic risk overseer, merge the Office of Thrift Supervision (OTS), which has been criticized for the Indymac and Washington Mutual failures, into the Office of the Comptroller of the Currency (OCC) and give the OCC the OTS’s powers over thrifts and thrift holding companies.

If such legislation moved forward, a better result would give the OCC supervisory authority over thrifts only, and the Federal Reserve Board supervisory authority over thrift holding companies, since the Federal Reserve Board is the banking agency that is expert in holding company regulation. Doing so would, in one fell swoop, make the Federal Reserve Board the consolidated supervisor of AIG, as well as a number of substantial insurance companies that either owned thrifts under the pre-Gramm-Leach-Bliley Act unitary thrift holding company loophole or acquired thrifts in order to participate in the TARP.

At the end of the day, whatever approach is chosen, it will be important for all systemically important financial institutions to be subject to comprehensive, consolidated supervision by a federal regulator with appropriate powers. The Federal Reserve Board has set forth the requirements of this type of supervision; namely, the supervisor must:

• Ensure that the financial institution has adequate procedures for monitoring and controlling its activities worldwide
• Obtain information on the condition of the financial institution and its subsidiaries and offices outside the home country through regular reports of examination, audit reports, or otherwise
• Obtain information on the dealings and relationship between the financial institution and its affiliates, both foreign and domestic
• Receive from the financial institution financial reports that are consolidated on a worldwide basis, or comparable information that permits analysis of the financial institution’s financial condition on a worldwide, consolidated basis
• Evaluate prudential standards, such as capital adequacy and risk asset exposure, on a worldwide basis 

Such comprehensive, consolidated supervision is necessary if foreign offices and affiliates of systemically significant U.S financial institutions are to be appropriately monitored, and significant losses such as those generated by AIG Financial Products’ London office avoided in the years to come.

Mandating comprehensive, consolidated supervision for all systemically important financial institutions may require regulatory powers similar to (and perhaps greater than) those the Federal Reserve Board currently exercises under the Bank Holding Company Act. For example, the Federal Reserve Board now has the authority to set capital standards for bank holding companies consistent with international supervisory accords, and the Fed also regularly examines and assigns ratings to particular bank holding companies’ risk management practices. Other Federal Reserve Board powers and responsibilities include the ability to issue written agreements, cease-and-desist orders, and more onerous penalties in egregious situations, as well as to approve mergers and acquisitions of bank holding companies, where the Fed must consider the “financial and managerial resources” of the acquiror. For this reason, the Federal Reserve Board has the legal authority to impose higher capital and risk management standards on bank holding companies and to limit their growth by acquisition if those standards are not met. The Federal Reserve’s examination authority into nonbank subsidiaries of bank holding companies, however, is limited to subsidiaries that “could have a materially adverse effect on the safety and soundness of any depository institution subsidiary of the holding company,” and such a power could be required to be extended to nonbank subsidiaries that pose systemic risk. Comprehensive supervisory powers will be necessary if systemic risk regulation is to work well in practice, regardless of who the regulator is.

The Treasury’s regulatory reform proposal has thus begun an interesting, and necessary, conversation on systemic risk, but it is only the beginning. The debate over systemic risk issues in the weeks and months to come will require investigation into the core functions and abilities of each of the nation’s principal financial regulatory agencies, and in order to be successful, the path chosen must reflect core regulatory competencies and provide adequate regulatory powers.

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