Monday, August 25, 2008

Fed Chair Seeks Legislation on Macro Prudential Regulation of Systemic Risk to Financial System

Citing the Bear Stearns experience, Federal Reserve Board Chair Ben Bernanke asked Congress to adopt a regulatory macro-prudential regime capable of dealing with systemic risk to the financial markets. In remarks at the Fed’s annual economic symposium, he also asked Congress to give the Treasury the duty and resources to intervene in cases in which an impending default by a major investment firm is judged to carry significant systemic risks. These remarks were similar to the chair’s recent testimony before the House Financial Services Committee in which he said that legislation is needed to authorize strong holding company oversight of large investment banks currently regulated under the SEC’s consolidated supervised entity regime. He also urged Congress to provide new tools for ensuring the orderly liquidation of a systemically important investment firm that is on the verge of bankruptcy.

In his view, the critical question for regulators and policy makers is what the Fed official called "the appropriate field of vision." Under current safety-and-soundness regulation, the focus is on the financial conditions of individual institutions in isolation. The system-wide or macro-prudential oversight envisioned by the Fed Chair would broaden the mandate of regulators to encompass consideration of potential systemic risks and weaknesses. Under macro-prudential regulation, federal agencies would determine the risks imposed on the system as a whole if common exposures significantly increase the correlation of returns across institutions. But the Fed chief assured that, in warning against excessive concentrations or common exposures across the system, regulators would not make a judgment about whether a particular asset class is mispriced, although he admitted that rapid changes in asset prices or risk premiums could increase the level of regulatory concern.

A system-wide focus for financial regulation would also increase attention on how the incentives and constraints created by regulations affect behavior, especially risk-taking. For example, risk concentrations that might be acceptable at a single institution in a period of economic expansion could be dangerous if they existed at a large number of institutions simultaneously.

More ambitiously, macro-prudential regulation would involve the development of a more fully integrated overview of the entire financial system. This approach is well justified, he said, since the financial system has become less bank-centered and because activities or risk-taking not permitted to regulated institutions have a way of migrating to other financial firms or markets. But he also cautioned that this approach would be technically demanding and possibly very costly both for the regulators and the firms they supervise.

It would likely require at least periodic surveillance and information-gathering from a wide range of nonbank institutions, such as securities industry participants. For example, increased coordination would be required among the private and public sector supervisors of exchanges and other financial markets to keep up to date with evolving practices and products and to try to identify those which pose risks outside the purview of each individual regulator. International regulatory coordination, already quite extensive, would also need to be expanded.

Another aspect of macro-prudential regulation would be stress testing across a range of firms and markets simultaneously. In his view, wide-ranging stress testing might reveal important interactions that are missed by stress tests at the level of the individual firm. For example, such an exercise might suggest that a sharp change in asset prices would not only affect the value of a particular firm's holdings but also impair liquidity in key markets, with adverse consequences for the ability of the firm to adjust its risk positions or obtain funding.

System-wide stress tests might also highlight common exposures that would not be visible in tests confined to one firm. Again, however, the technical and information requirements of conducting such exercises effectively must not be underestimated. Financial markets move swiftly, he noted, firms' holdings and exposures change every day; and financial transactions do not respect national boundaries. Thus, the information requirements for conducting comprehensive macro-prudential surveillance could be daunting.

The senior official also cautioned that macro-prudential regulation presents communication issues. For example, the expectations of the public and of financial market participants would have to be managed carefully, he reasoned, since such an approach would never eliminate financial crises entirely. Indeed, an expectation by financial market participants that crises will never occur would create its own form of moral hazard and encourage behavior that would make financial crises more likely.