Congress Wrestles With Systemic Risk Regulator

The House Financial Services Committee last week held the first of what will inevitably be many hearings to define exactly what a systemic risk to the financial system is, and how regulators should police against it.

Committee Chairman Barney Frank (D-Mass.) said he hopes that by early May Congress can start the “lengthy process” of drafting legislation that will be the basis for overhauling the U.S. regulatory structure. The final form of that legislation is still anyone’s guess, but it will almost certainly expand regulators’ powers and will have profound consequences for companies in the financial sector.

Frank

A parade of consumer, labor, and financial-services industry spokesmen appeared at last week’s hearing to give their input on the need for a “systemic risk regulator” to monitor market-wide risk. Lawmakers seemed divided even on the need for such a body, with some Republicans cautioning against adding yet another layer of regulation to the financial services sector.

Creating a systemic risk regulator will not be easy. Congress will need to define what a systemic risk is, what powers a regulator monitoring such risks should have, and how that regulator would enforce its rules against companies it oversees. As remarks during the hearing demonstrated, all of those issues are still very murky.

Yingling

Typical were the comments of Edward Yingling, CEO of the American Bankers Association. He described a systemic regulator as “sitting on top of Mount Olympus looking out over the land … looking for fires.”

Systemic regulation shouldn’t “rely on a crisis management approach or focus on flagging a handful of large institutions as too big to fail.”

— Travis Plunkett,

Legislative Director,

Consumer Federation of America

Timothy Ryan, head of the Securities Industry & Financial Markets Association, said the mission of such a regulator should include “monitoring systemic risks across firms and markets … assessing the potential for practices or products to increase systemic risk; and identifying regulatory gaps that have systemic impact.” Ryan also said such a regulator should have a “tie breaker” role in instances where there are conflicts between federal functional regulators.

Bartlett

More cautious was Steve Bartlett, CEO of the Financial Services Roundtable. His group supports the idea of a systemic risk regulator, but he said that regulator should be “nose in, fingers out,” and should only identify risks and work with primary regulators, not replace them outright.

Meanwhile, Travis Plunkett, legislative director for the Consumer Federation of America, said systemic regulation shouldn’t “rely on a crisis management approach or focus on flagging a handful of large institutions as too big to fail.” Rather, he said, the focus should be on reducing the likelihood of a systemic failure. And Damon Silvers, associate general counsel for the AFL-CIO, said systemic risk regulation should be the responsibility of a coordinating body of regulators led by the chairman of the Board of Governors of the Federal Reserve.

Paying for Failure?

Silvers

Silvers also said a systemic regulator shouldn’t identify specific banks or financial institutions as “too big to fail.” Riskier firms should have higher capital requirements and pay higher insurance premiums than those that are less likely to fail, he said. He also called for a separate consumer protection agency for financial services.

TOO BIG TO FAIL

Below is an excerpt from a recent speech by Fed Chairman Ben Bernanke, on the need to regulate systemic risks more vigorously.

Achieving more effective supervision of large and complex financial firms will require a number of actions. First, supervisors need to move vigorously—as we are already doing—to address the weaknesses at major financial institutions in capital adequacy, liquidity management, and risk management that have been revealed by the crisis. In particular, policymakers must insist that the large financial firms that they supervise be capable of monitoring and managing their risks in a timely manner and on an enterprise-wide basis. In that regard, the Federal Reserve has been looking carefully at risk-management practices at systemically important institutions to identify best practices, assess firms’ performance, and require improvement where deficiencies are identified. Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management, and financial condition, and be held to high capital and liquidity standards. In light of the global reach and diversified operations of many large financial firms, international supervisors of banks, securities firms, and other financial institutions must collaborate and cooperate on these efforts.

Second, we must ensure a robust framework—both in law and practice—for consolidated supervision of all systemically important financial firms organized as holding companies. The consolidated supervisors must have clear authority to monitor and address safety and soundness concerns in all parts of the organization, not just the holding company. Broad-based application of the principle of consolidated supervision would also serve to eliminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors.

Third, looking beyond the current crisis, the United States also needs improved tools to allow the orderly resolution of a systemically important non-bank financial firm, including a mechanism to cover the costs of the resolution. In most cases, federal bankruptcy laws provide an appropriate framework for the resolution of non-bank financial institutions. However, this framework does not sufficiently protect the public’s strong interest in ensuring the orderly resolution of non-depository financial institutions when a failure would pose substantial systemic risks. Improved resolution procedures for these firms would help reduce the too-big-to-fail problem by narrowing the range of circumstances that might be expected to prompt government intervention to keep the firm operating.

Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task. Models do exist, though, including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008. Both models allow a government agency to take control of a failing institution’s operations and management, act as conservator or receiver for the institution, and establish a “bridge” institution to facilitate an orderly sale or liquidation of the firm. The authority to “bridge” a failing institution through a receivership to a new entity reduces the potential for market disruption while limiting moral hazard and mitigating any adverse impact of government intervention on market discipline.

Source

Ben Bernanke’s Speech (March 10, 2009).

One concern, raised at the hearing’s outset by Alabama Republican Spencer Bachus, is that a systemic risk regulator would simply prop up ailing institutions at taxpayers’ expense. Bachus said he wouldn’t support a systemic regulator unless it does not have the power to commit “billions or hundreds of billions of dollars of taxpayer money to bailing out the so-called too-big-too-fail institutions.”

If one of those institutions fails, he said, the regulator’s chief role should be to “advance an orderly resolution” such as a sale or a bankruptcy filing.

Wallison

Bachus was not alone. Peter Wallison a fellow at the American Enterprise Institute think-tank, warned that a regulator with the power to prop up failing institutions has the “potential to destroy competition” because the market would view such firms as having an implicit government guarantee.

Another issue: whether the power to oversee systemic risks should go to the Federal Reserve or some other existing agency, or to create a new regulator from scratch. Federal Reserve Chairman Ben Bernanke has publicly called for a systemic regulator, although he hasn’t said those powers should go specifically to the Fed. Some panelists at the hearing, however, said his corner of government is a logical place to put them.

Bartlett, for example, noted that the Fed has the “breadth and scope and institutional knowledge of economy and markets” that make it suited to serve as a market stability regulator. Yingling also said it “makes sense to look within the parameters of the current regulatory system,” and doubted lawmakers would have the “luxury” amid the current crisis to build new system from scratch.

Others warned that an even more powerful Fed would create new regulatory conflicts that would have to be addressed. Plunkett said lawmakers would have to address the Fed’s “lack of transparency and accountability and the potential for conflicts between roles of setting monetary policy and regulating for systemic risks.”

Wallison, meanwhile, said the Fed would be the “worst choice” for systemic regulator because it could bail out the companies it supervises without Congress’ approval, and its regulatory responsibilities would conflict with its central banking role.