Geithner Seeks Fed-Centric Unified Regulation of Global Commercial and Investment Banks
NY Fed President Timothy Geithner has called for the uniform and consolidated regulation of global commercial banks and investment banks with the Fed playing a central role in the new framework. In remarks at the Economic Club in NYC, he said that the Fed will work closely with domestic and international regulators as part of the new regime to provide a stronger form of unified regulation with appropriate capital and liquidity requirements, as well as enhanced risk management. Presently, the Fed has broad responsibilities for financial stability not matched by direct authority. The SEC regulates global investment banks under its consolidated supervised entity regime, under which the Commission oversees, not only the U.S.-registered broker-dealer, but the consolidated entity, which may include banks and derivatives dealers.
In Mr. Geithner’s view, current US financial regulation must be completely overhauled since that system is a confusing mix of diffused accountability, regulatory competition, and a complex web of rules that creates perverse incentives and leaves huge opportunities for arbitrage and evasion. It also has created the risk of large gaps in the knowledge and authority of financial regulators.
Further, although regulation has to focus first on the stability of the core of financial institutions, it cannot be indifferent to the scale of leverage and risk outside the regulated institutions. That said, the Fed official does not believe it would be either desirable or feasible to extend capital requirements to hedge funds or private equity firms. But, at the same time, regulators cannot be indifferent to the scale of leverage and risk that exists outside the regulated financial institutions.
Thus, he believes that regulation must ensure that counterparty credit risk management in the regulated institutions contains the level of overall exposure of the regulated to the unregulated. In his view, prudent counterparty risk management, in turn, will work to limit the risk of a rise in overall leverage outside the regulated institutions that could threaten the stability of the financial system
More specifically, regulators must focus on inducing higher levels of margin and collateral in normal times against derivatives and secured borrowing in order to better cover the risk of market illiquidity. Greater product standardization and improved disclosure can also help, he added, as will changes to the accounting rules that govern what risks reside on and off balance sheets.
In addition, banking and other regulators have to look much more carefully at the interaction between accounting, tax, disclosure and capital requirements, and their effects on overall leverage and risk across the financial system. Capital requirements alone are rarely the most important constraint.
The NY Fed chief also wants risk management practices and regulators to focus much more attention on strengthening shock absorbers within institutions and across the infrastructure against very bad financial outcomes, however implausible they may seem in good times.
In his opinion, risk management, as well as financial regulators, currently focuses too much on the idiosyncratic risk that affects an individual firm and too little on the systematic issues that could affect market liquidity as a whole. He attacked the conventional risk-management framework as caring too much about the threat to a firm from its own mistakes and too little on the potential for mistakes to be correlated across firms.