Fed Must Be Given Powers as Market Stability Regulator Says Treasury Chief

With the Bear Stearns episode and current market turmoil placing in stark relief the outdated nature of the financial regulatory system, Treasury Secretary Henry Paulson said it is imperative to quickly consider how to give the Federal Reserve Board the authority it needs as the primary market stability regulator to access necessary information from complex financial institutions and the power to mitigate systemic risk in advance of a crisis. In remarks at a markets seminar in Washington, he also saw the need to strengthen practices and financial infrastructure in the OTC derivatives market and provide greater certainty around the mechanics of winding down the derivatives positions of a failed institution.

In recent years, credit default swaps and OTC derivatives have become integral for hedging credit, default and price risk. Due to innovation and demand, there has been a tremendous expansion in the scale, diversity and impact of these instruments and markets. As price volatility has surged, so have trading volumes. Market infrastructure needs to more sufficiently evolve to support this expansion. In response to this pressing need, Treasury recommends the establishment of a functional industry cooperative that can meet the needs of the OTC derivatives markets in the years ahead. Treasury is working with the Fed, SEC and other members of the President’s Working Group to get this done.

In its earlier blueprint for reform of financial regulation, Treasury suggested a regulatory structure in which the Federal Reserve would take on the role of market stability regulator. In response to the Bear Stearns collapse, the Fed acted to address market liquidity issues by giving primary dealers temporary access to the discount window. In light of this extraordinary action, Treasury is working with the Fed and SEC to decide what role the Fed should play now that it is a lender to investment banks.

The parties are working to formalize this role in a Memorandum of Understanding. The Fed must have information and access so that it can assess its potential borrowers and counterparties. A more difficult issue is how this newly formalized relationship evolves when these temporary facilities eventually close and how the MOU will be perceived by the marketplace. In this context, Treasury will consider how the SEC and the Fed should coordinate regarding capital and liquidity requirements for these firms.

While the Fed is essentially currently playing the role of market stability regulator, noted Paulson, it has neither the clear statutory authority nor the mandate to anticipate and deal with risks across the entire financial system. The current crisis shows that a wide range of financial institutions can potentially threaten the stability of the financial system.

Thus, the Fed might need to make liquidity available to a broader range of financial institutions under certain extraordinary circumstances. However, at the same time, the circumstances under which that liquidity is provided must be limited and focused on systemic risk that can impact the overall economy. In addition, it is imperative that market participants not have the expectation that lending from the Fed is readily available.

To act as market stability regulator, the Fed needs authority to proactively address systemic risks posed by a commercial bank, an investment bank, or a hedge fund. To perform this function, it is vital that the Fed have information and access across all types of financial institutions. But information gathering alone is not enough. The Fed must also be able to identify and constrain risk-taking that can detrimentally affect the financial system. This will require authority to intervene to prevent the build up of conditions that create significant risk to the stability of the financial system. It will be a regulatory balancing act of providing additional stability to the financial system on the one hand, while limiting moral hazard on the other.

In addition, the perception that some institutions are either too big or too interconnected to fail must be disabused. One way to do that is to strengthen market infrastructure and operating practices in the OTC derivatives market and clarify the resolution, or wind down, procedures for non-depository institutions. Creating a more stable environment will mitigate the likelihood that a failing institution can spur a systemic event.

Given the massive scale of the OTC derivatives market, he said, trade processing must be enhanced with more automation. He praised the NY Fed’s efforts to bring together institutions that account for a significant percentage of OTC derivatives trading into a cooperative to create the necessary protocols to bring more transparency and efficiency and reduce counterparty credit risk. It is imperative that this cooperative bring standardization not only to dealer transactions but to the broader community of counterparties, including hedge funds.

Finally, despite longstanding efforts to address the treatment of derivatives in the case of a failed financial institution, there still seems to be uncertainty surrounding the process by which a large complex institution is wound down and what impact that would have on the overall financial system. U.S. bankruptcy law was updated significantly in 2005 to address many issues associated with OTC derivatives contracts. The Working Group should evaluate whether the resolution, or winding down, process for large complex institutions should be modified to help mitigate disruption to the financial system and improve market discipline. This requires addressing a number of difficult questions, including whether a particular regulatory agency should be assigned to oversee resolutions and how any potential intervention is justified.