Monday, December 7, 2009

Systemic Risk Controls Will Require Statutory Integration

Author: David Schwartz David Schwartz

Many free-market economists and politicians are concerned about the potential for loss of sovereignty when agreeing to international cooperation at a level never before considered. It may well be that the first test for many countries will be during the legislative process, when decisions must be made about enacting the recommendations of the international regulatory bodies. The United States will not move precipitously, if past experience with the Basel capital reforms can serve as a precedent.

Legislation must Precede Regulatory Reform

U.S. Federal Reserve: Although regulators can do a great deal on their own to improve financial oversight, the Congress also must act to fix gaps and weaknesses in the structure of the regulatory system and, in so doing, address the very serious problem posed by firms perceived as “too big to fail”. No firm, by virtue of its size and complexity, should be permitted to hold the financial system, the economy, or the American taxpayer hostage. To eliminate that possibility, a number of steps are required. 

Systemic Risk-Contributors must be Regulated

First, all systemically important financial institutions, not only banks, should be subject to strong and comprehensive supervision on a consolidated, or firmwide, basis. Such institutions should be subject to tougher capital, liquidity, and risk-management requirements than other firms – both to reduce their chance of failing and to remove their incentive to grow simply in order to be perceived as too big to fail. Neither AIG, an insurance company, nor Bear Stearns, an investment firm, was subject to strong consolidated supervision. The Federal Reserve, as the regulator of bank holding companies, already supervises many of the largest and most complex institutions in the world. That experience, together with our broad knowledge of the financial markets, makes us well suited to serve as the consolidated supervisor for systemically important nonbank institutions as well. In addition, our involvement in supervision is critical for ensuring that we have the necessary expertise, information, and authorities to carry out our essential functions of promoting financial stability and making monetary policy. 

Taxpayers must be Protected from Systemic Risks

Second, when a systemically important institution does approach failure, government policymakers must have an option other than a bailout or a disorderly, confidence-shattering bankruptcy. The Congress should create a new resolution regime, analogous to the regime currently used by the FDIC for failing banks, that would permit the government to wind down a troubled systemically important firm in a way that protects financial stability but that also imposes losses on shareholders and creditors of the failed firm, without costs to the taxpayer. Imposing losses on creditors of troubled, systemically critical firms would help address the too-big-to-fail problem by restoring market discipline and leveling the playing field for smaller firms, while minimizing the disruptive effects of a failure on the financial system and the economy. 

Emerging Risks must be monitored

Third, our regulatory structure requires a better mechanism for monitoring and addressing emerging risks to the financial system as a whole. Because of the size, diversity, and complexity of our financial system, that task may exceed the capacity of any individual agency. The Federal Reserve therefore supports the creation of a systemic oversight council, made up of the principal financial regulators, to identify developments that may pose systemic risks, recommend approaches for dealing with them, and coordinate the responses of its member agencies.[1]

[1] Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve System, at the Economic Club of Washington DC, Washington DC, 7 December 2009.