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Responding to Systemic Risk: Restoring the Balance

The recent financial crisis made clear that insufficient attention was paid to sources of systemic risk that can threaten the stability of the financial system and, with it, the real economy. Moreover, the crisis showed that it is critical for government officials to have and be able to use the tools necessary to prevent and mitigate systemic threats.

This paper analyzes several key changes that Congress made to address systemic risk in the wake of the crisis. It then makes five specific recommendations that both Congress and financial regulatory agencies should take to ensure a more effective response to future financial panics and crises. These recommendations address: Federal Reserve emergency lending powers, Federal Deposit Insurance Corporation (FDIC) emergency debt guarantees, broker- dealer access to collateralized lending from the Federal Reserve to ensure necessary liquidity in the financial system, Financial Stability Oversight Council (FSOC) authorities and transparency, and tailored regulation and supervision by the Federal Reserve.

In the years preceding the crisis, high levels of risk accumulated within the financial system. Poor underwriting, systematic mispricing of risk, fraud, and a fundamental lack of discipline were among the factors that contributed to broad declines in asset prices, including sharp declines in some prices during the financial panic, and the loss of confidence that ultimately threatened to bring down the entire financial system. These factors, combined with high levels of leverage, gave some financial institutions—both regulated and unregulated—little margin for error. The systemic implications of this accumulation of risk were not adequately recognized or understood by management, investors, regulators, supervisors, policymakers, and stakeholders. The nature and extent of practices that led to that accumulation of risk likewise were not adequately understood.

Part of this failure to identify and understand the buildup of risk stemmed from the fact that there was no government entity, or coordinated group of entities, expressly responsible for overseeing financial stability or identifying potential threats to the broad financial system. This lack of so-called “macro-prudential supervision” made it possible for each financial regulatory agency to take false comfort in thinking that certain problems were someone else’s job. This problem was compounded by data that were incomplete and not standardized, leading to situations where different agencies had different, partial, or unclear views of what was happening in real time. Further, regulators did not use existing authority to limit or prevent some kinds of risk from building within the financial system.

Adding to the problem, money-like liabilities accumulated in nonbank financial institutions, which were not subject to the same supervisory oversight as banks, and for which there were fewer regulatory tools to address run risk. In particular, nonbank broker-dealers like Lehman Brothers, Bear Stearns, and Merrill Lynch, as well as a proliferation of structured investment vehicles (SIVs), held large quantities of what later proved to be mispriced and poorly underwritten assets, while relying on short-term funding sources that ran or threatened to run with the onset of the crisis.

Government authorities found their traditional tools to address run and liquidity problems to be inadequate and not designed to address problems occurring outside traditional banks. Faced with a potential economic catastrophe, the Federal Reserve and the FDIC were forced to use their existing authority in creative ways in an effort to stabilize markets and avoid panic. For example, they guaranteed the debt of certain financial institutions and provided liquidity to otherwise solvent nonbank institutions.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) was Congress’s primary response to the crisis. It addressed the regulatory gaps that had allowed the buildup of systemic risk in a number of constructive ways:

  • Enhanced prudential standards, such as higher levels of capital and liquidity, were mandated for systemically important financial institutions (SIFIs)—whether “bank SIFIs” or “nonbank SIFIs”—in order to make these institutions safer and better able to withstand shocks and losses without failing;
  • Enhanced resolution authority was given to the FDIC which, along with mandated resolution planning, will make it far more possible for the federal government to allow the largest financial firms to fail in an orderly manner without damaging the broader financial sector;
  • A new council of regulators, the FSOC, was created specifically to coordinate financial regulation and supervision and to monitor systemic risk, aided by another new body, the Office of Financial Research (OFR);
  • The FSOC was provided with the authority to designate any U.S. nonbank financial company as a nonbank SIFI if the FSOC determines by a two-thirds vote of its members that the company “could pose a threat to the financial stability of the United States.” Designation authority allows the FSOC to bring systemically important nonbanks “within the perimeter” of increased federal oversight that in the past has applied primarily to traditional banking organizations;
  • The Consumer Financial Protection Bureau was created to establish a single set of rules for consumer financial products and to enhance consumer financial protection; and
  • Derivatives activities were made subject to more centralized clearing and greater transparency.

These and other provisions of Dodd-Frank have helped make the U.S. financial system safer and more stable than before the crisis.

Certain provisions of Dodd-Frank, however, are cause for concern, because they unnecessarily restrict the ability of the Federal Reserve and the FDIC to provide short-term liquidity to the financial system to mitigate the real-economy impact of a financial panic or crisis and they also restrict the ability to guarantee the debt of healthy financial companies in similar circumstances. In addition, Dodd-Frank did not adequately address the provision of temporary liquidity to certain nonbanks that, in a modern financial system, hold substantial quantities of runnable liabilities that are not bank deposits. The Act did attempt to address the issue of macro-prudential oversight in part by creating the FSOC, but it did not give the FSOC sufficient authority to carry out the duties assigned to it. Finally, although Congress wisely realized the importance of tailoring the regulation and supervision of the newly designated nonbank SIFIs by the Federal Reserve, there are restrictions on and concerns about the Federal Reserve’s ability to achieve these goals. This paper addresses each of these concerns.

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