In the aftermath of the financial crisis of 2007-2009, the U.S. Congress created the Financial Stability Oversight Council (FSOC – pronounced “F-Sock”)—a panel of the heads of the U.S. regulatory agencies—“to identify risks to the financial stability of the United States”; “to promote market discipline” by eliminating expectations of government bailouts; and “to respond to emerging threats” to financial stability.
Despite these complex and critical objectives, the law limited FSOC’s authority to the designation of: (1) specific nonbanks as systemically important financial intermediaries (SIFIs), and; (2) critical payments, clearance and settlement firms as financial market utilities (FMUs). Nonbank SIFIs are then supervised by the Federal Reserve, which imposes stricter scrutiny on them (as it does for large banks), while FMUs are jointly overseen by the Fed and the relevant market regulators.
At the peak of its activity in 2013-14, the FSOC designated four nonbanks as SIFIs: AIG, GE Capital, MetLife, and Prudential Insurance. Following the Council’s October 16 rescission of the Prudential designation, there are no longer any nonbank SIFIs. Not only that, but by making a future designation highly unlikely, Treasury and FSOC have undermined the deterrence effect of the FSOC’s SIFI authority. In short, by taking the sock out of FSOC, recent actions seriously weaken the post-crisis apparatus for securing U.S. (and global) financial stability. In the remainder of this post we review the Treasury’s revised approach to SIFI designation in the context of the Prudential rescission…. Read More
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
Securities lending (SL) is one of the less-well-publicized shadow banking activities. Like repurchase agreements (repo) and asset-backed commercial paper, SL can be a source of very short-term wholesale funding, allowing a shadow bank to engage in the kind of liquidity, maturity and credit transformation that banks do. And, like other short-term funding sources, it can suddenly dry up, making it a source of systemic risk. When funding evaporates, fire sales and a credit crunch follow.
Indeed, SL played a supporting role in the 2007-09 financial crisis, being partly responsible for the collapse of the large insurance company AIG when the market seized in September 2008 (see chart). While SL has not garnered the attention of capital and liquidity regulation or central clearing, or even repo markets, it is still worth understanding what securities lending is and the risks it poses. That is the purpose of this post... Read More
If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. [Full disclosure: one of us joined a panel organized by the film’s economic consultant to view and discuss it with the director.]
But we're not film critics, The movie—along with some misleading criticism—prompts us to clarify what we view as the prime causes of the financial crisis. The financial corruption depicted in the movie is deeply troubling (we've written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven't addressed these properly....
Eight years after the financial crisis began, the regulatory reforms it spawned continue apace. Over the past year, regulators introduced total loss absorbing capacity (TLAC) and the liquidity coverage ratio (LCR) to make banks more resilient. And, with an eye toward strengthening market function, authorities continue to push for central clearing of derivatives (CCPs).
Overlapping with these goals—and extending to nonbanks—is the recent move to establish standards for margin requirements in securities transactions: that is, the maximum amount that someone can borrow when using a given security as collateral... Read More