Friday, July 30, 2010

IMF Praises Dodd-Frank But Laments Failure to Streamline Regulation

While praising the overall financial reforms achieved by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the IMF lamented the Act’s failure to consolidate US financial regulation. Although the Act did eliminate the Office of Thrift Supervision, it left intact the OCC, FDIC, and the Fed with significant and overlapping oversight responsibilities. In a first report on the Dodd-Frank legislation, the IMF also noted that, since the SEC and CFTC have similar and converging market oversight and conduct-of-business missions, a merger of the two agencies would have properly addressed the seeming artificiality of the present separation between securities and futures oversight, as well as end the complexities of reporting to two separate Congressional oversight committees which, in the IMF’s view, has led to inefficiencies and jurisdictional disputes.

Several systemic financial intermediaries are classified as both SEC-registered securities broker-dealers and CFTC-registered futures commission merchants, subject to overlapping rules. The Dodd–Frank Act introduces yet another designation, the major swaps participant, with securities swaps and commodities swaps to fall under SEC and CFTC jurisdiction, respectively.

In the IMF’s view, there remains a good case for defining one banking agency with safety-and-soundness responsibility for national banks, federal thrifts, state member banks, state nonmember banks, and state thrifts, in the latter cases serving as joint primary supervisor along with the applicable state regulators. This would free the Fed to focus on monetary policy, macro financial oversight, and consolidated regulation
and supervision, and the FDIC on insurance and resolution.

The recommendation was contingent upon the Fed gaining separate oversight authorities over systemically important payment, clearing, and settlement systems, including those chartered as state member banks. The team also felt, on balance, that the Fed should retain some responsibility for the consolidated supervision of non-systemic BHCs, even as broad back-up supervisory authorities spanning all insured banks and thrifts would
suffice for the FDIC’s resolution planning and deposit insurance responsibilities. Several systemic financial intermediaries are classed as both SEC-registered securities

The IMF praised Congress for creating a new framework for macro prudential oversight by the new Financial Stability Oversight Council, which will identify and address systemic risks, with powers and duties to gather information, designate systemically
important nonbank financial firms for consolidated regulation and supervision by the Fed,
make broad recommendations to its member agencies, and report to Congress.

The Council will bring together the Treasury, the Fed, the SEC and essentially all financial regulators, backed by a dedicated Office of Financial Research. Bearing the financial stability mandate, the Council is authorized to demand information from any member agency or regulated or unregulated financial firm, deem any nonbank financial firm potentially systemic for enhanced regulation, deem financial market utilities and payment, clearing, or settlement activities potentially systemic, and approve the break-up of systemic financial firms deemed by the Fed to pose a grave threat to financial stability.

According to the IMF, a pre-eminent, hands-on role for the Fed backed by binding enforcement authorities is wholly appropriate given its existing expertise, broad understanding of the financial sector, and role as lender of last resort. In the IMF’s view, successful systemic risk regulation will require a more muscular approach to consolidated regulation and supervision, quite likely involving less deference to functional regulators of nonbank subsidiaries, in order to effectively identify and act upon emerging systemic risks. The FSOC will also need to define systemically risk-sensitive prudential norms for capital, leverage, and liquidity.

The new Act also vests the FSOC with responsibility to designate as systemic any payment, clearing, or settlement activity or financial market utility to be subject to heightened and uniform risk management standards, including on margin, collateral, capital, and default policies, to mitigate systemic risk.

Since the FSOC will be composed of ten voting members, noted the IMF, it is imperative that the Council achieve consensus and coordinate timely responses to emerging risks. It is also critical that data and information be timely available, which will require investment in systems and commitment to inter-agency information sharing. Council members must develop or adjust a range of regulations to focus more on systemic risk mitigation, combining automatic triggers with room for discretionary action. The IMF also emphasized that there must be accountability and a will to act on the part of all
Agencies, which should be underpinned by transparency and communication, ideally to include policies governing the release of minutes of FSOC proceedings

Actions taken by the Council, many of which are enumerated in the Dodd–Frank Act, could include penalizing size, complexity, and interconnectedness through measures such as liquidity and capital surcharges, anti-cyclical provisioning, leverage ratios, contingent capital, resolution fees, or insurance schemes; encouraging financial firms to build capital buffers in good times; tightening risk exposure limits on rapidly expanding asset classes; and limiting the impact of corporate governance and compensation policies on risk-taking.

The IMF also urged the Council to address the risks posed by the shadow banking system along the regulatory perimeter. The Council could require money market funds to make real-time disclosures of their actual, as opposed to stabilized, net asset values and subject conduits and asset-backed securities issuers to stringent disclosure, as well as restructuring the tri-party repo system to make it more resilient to stress.

The reform legislation will formalize most crisis management arrangements under the FSOC. The IMF said that this should build on the regular process for macro-prudential surveillance already envisaged for the FSOC, but will require enhanced arrangements for coordination, information sharing, and decision making in crisis. Such arrangements should be tested periodically in simulation exercises similar to those currently employed by the agencies to check the resilience of business continuity arrangements.

The IMF said that the new orderly liquidation authority for systemic financial firms created by the Dodd–Frank Act should substantially fortify the U.S. resolution toolkit, although it deemed unfortunate the decision to drop a pre-funded special resolution fund. But application of the new authority swill not be easy, cautioned the IMF, since the crisis illustrated the speed with which large firms can lose access to wholesale funding and the pace at which difficult rescue operations need to be formulated. Moreover, contagion risks may require that short-term funding in repo and securities lending would need to be honored and the close-out of foreign exchange and derivative contracts avoided.

Under the new systemic resolution authority, repos, forwards, swaps and other similar transactions are defined as qualified financial contracts. The FDIC must decide within a day of intervening whether to transfer these contracts to another solvent entity, such as a bridge bank, or to leave them in the failed firm subject to termination and close out.

Moreover, although the special resolution mechanism breaks new ground, cross-border issues in the event of the future failure of a systemic international group will remain a challenge.