Wednesday, April 30, 2008

Treasury Blueprint Envisions Fed as Macro-Prudential Regulator for Financial Firms

The Treasury Blueprint’s role for the Federal Reserve Board as market stability regulator envisions macro-prudential regulation that may encompass the risk exposures of hedge funds and other financial firms, according to David Nason, Assistant Secretary for Financial Institutions. In remarks at a London seminar on new financial frontiers, he said that the market stability regulator should have the ability to require financial firms to undertake corrective actions to address financial stability problems, such as counterparty risk exposures and concentrations of asset exposures.

Similarly, the market stability regulator must have access to detailed information from all types of financial institutions, including data submissions and the ability to join in or initiate examinations. Treasury also envisions the market stability regulator having the authority to require additional disclosure by financial institutions so that market participants can better evaluate their risk profiles.

As the market stability regulator collects and analyzes this type of information, continued the official, it could publish aggregate information to highlight issues associated with potential risk exposure. Such actions, combined with enforcement authority, would provide a clear signal to market participants that the market stability regulator has identified some potential problems that should be addressed. Treasury expects that this action alone could have an impact on overall behavior.

Mr. Nason referred to this process as "leaning against the wind" in an attempt to prevent broad economic dislocations caused by potential excesses. It will not be an easy job. In addition to the difficulty of determining just where and when to lean against the wind, he reasoned, there could be a tendency of the market stability regulator to lean too heavily simply to avoid blame for any ensuing financial instability. Moreover, regulated entities could push back, alleging regulatory over-reach. But, at the end of the day, it is a process worth trying for anyone who wants to preserve innovative financial markets.

The Blueprint advocates a separation of responsibilities between a regulator looking at the system as a whole and another regulator focused on the health of individual institutions. A macro-stability regulator should not be concerned with the failure of an individual institution, he emphasized, while a micro-prudential regulator should be very concerned with individual institution failures, especially when the government safety net is involved.