In response to the financial crisis of 2007-2009, Congress created the Financial Stability Oversight Council (FSOC), a committee of the chiefs of the U.S. regulatory agencies, chaired by the Treasury Secretary, to monitor and secure the stability of the financial system. Critical to this task is the FSOC’s authority to designate nonbanks as “systemically important financial institutions” (SIFIs).
On November 17, the U.S. Treasury issued a report assessing the FSOC’s designation process. Treasury calls on the FSOC to adopt a strategy that prioritizes the regulation of activities or functions—affecting whole sectors of the financial industry—over regulation based on entity or legal form (such as the designation authority). For the most part, we find this sensible, as this focus reduces the scope for regulatory arbitrage that an entities-only approach may foster (see here).
However, we doubt that activities-based regulation alone will be sufficient to limit systemic risk. Our overall conclusion is that the Treasury’s approach sets the bar for FSOC designation too high, diminishing its deterrence effect on undesignated nonbanks. In the end, a sensible focus on both entities and activities is needed to fulfill one of FSOC’s key objectives—to restore market discipline. Adopting the Treasury’s proposed framework will not meet the goal, set out in the President’s Core Principles for Regulating the U.S. Financial system (see Executive Order 13772), of preventing taxpayer-funded bailouts.... Read More
More than six years after the Dodd-Frank Act passed in July 2010, the controversy over how to end “too big to fail” (TBTF) remains a key focus of financial reform. Indeed, TBTF—which led to the troubling bailouts of financial behemoths in the crisis of 2007-2009—is still one of the biggest challenges in reducing the probability and severity of financial crises. By focusing on the largest, most complex, most interconnected financial intermediaries, Dodd-Frank gave officials a range of crisis prevention and management tools. These include the power to designate specific institutions as systemically important financial institutions (SIFIs), a broadening of Fed supervision, the authority to impose stress tests and living wills, and (with the FDIC’s “Orderly Liquidation Authority”) the ability to facilitate the resolution of a troubled SIFI. But, while Dodd-Frank has likely made the U.S. financial system safer than it was, it does not go far enough in reducing the risk of financial crises or in ensuring credibility of the resolution mechanism (see our earlier commentary here, here and here). It also is exceedingly complex.
Against this background, we welcome the work of the Federal Reserve Bank of Minneapolis and their recently announced Minneapolis Plan to End Too Big to Fail (the Plan). While the Plan raises issues that require further consideration—including the potential for regulatory arbitrage and the calibration of the tools on which it relies—it is straightforward, based on sound principles, and focuses on cost-effective tools. In this sense, the Plan represents a big step forward... Read More
In June 2015, a committee of Federal Reserve Bank Presidents conducted a “macroprudential tabletop exercise”—a kind of wargame—to determine what tools to use should risks to financial stability arise in an environment when growth and inflation are stable. The conventional wisdom—widely supported in policy pronouncements and in a range of academic studies—is that the appropriate tools are prudential (capital and liquidity requirements, stress tests, margin requirements, supervisory guidance and the like). Yet, in the exercise, the policymakers found these tools more unwieldy and less effective than anticipated. As a result, “monetary policy came more quickly to the fore as a financial stability tool than might have been thought.”
This naturally leads us to ask whether there are circumstances when central bankers should employ monetary policy tools to address financial stability concerns. Making the case for or against use of monetary policy to secure financial stability is usually based on assessing the costs and benefits of a policy that "leans against the wind" (LAW) of financial imbalances... Read More
Last week, a Federal District Court overturned the Financial Stability Oversight Council’s (FSOC) designation of MetLife—the nation’s largest insurer by assets—as a systemically important financial intermediary (SIFI). Until the Court unseals this decision, we won’t know why. If the ruling is based on narrow grounds that the FSOC can readily address, it will have little impact on long-run prospects for U.S. financial stability.
However, if the Court has materially raised the hurdle to SIFI designation—and if its ruling holds up on appeal—“too big to fail” nonbanks could again loom large in future financial crises, making them both more likely and more damaging... Read More
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (hereafter, DF), the most sweeping financial regulatory reform in the United States since the 1930s. DF explicitly aims to limit systemic risk, allow for the safe resolution of the largest intermediaries, submit risky nonbanks to greater scrutiny, and reform derivatives trading.
How to celebrate its fifth birthday? Well, if you are like us, it will be a sober affair, reflecting serious worries about the continued vulnerability of the financial system.
Let’s have a look at the most noteworthy accomplishments and the biggest failings so far. Starting with the successes, here are our top five: Read More
If there were a regulatory Richter scale that measured the shaking of the financial system, the 2010 Dodd-Frank Act would register about 8, while the 2011 Basel III framework might be a bit above 7. (For reference, the 1906 San Francisco earthquake was a 7.8). Fortunately, this shaking is mostly for the better – helping to make the financial system more resilient in the long run.
The new “Bailout Prevention Act” of Senators Vitter and Warren also might be an 8 on the shaking scale, but it would be a true disaster, because it undermines the Fed’s role as crisis lender of last resort. In contrast, the Senate Banking Committee’s new discussion draft of a “Financial Regulatory Improvement Act of 2015” is probably a 2 or a 3. If enacted, it will be “felt slightly by some people” but probably won't do much damage... Read More
A recent open letter from an SEC Commissioner reminded us of several absurdities of the U.S. financial regulatory apparatus. The Commissioner railed against the Treasury Office of Financial Research (OFR) report on Asset Management and Financial Stability. At the request of the Financial Stability Oversight Council (FSOC), the OFR sought to analyze activities in the asset management industry that could pose risks to the broader financial system... Read More
The Financial System Oversight Council (FSOC) is considering whether any asset managers should be designated as systemically important financial intermediaries (SIFIs), making them subject to supervision by the Federal Reserve. In the same vein, the Financial Stability Board recently proposed a framework for determining whether an asset manager is a global SIFI.
The question itself is highly controversial... Read More