SEC Would Be Part of Systemic Risk Regulator in Senate Reform Bill

A bill introduced by Senator Susan Collins would create a new federal systemic risk regulator to monitor the financial markets and oversee financial regulatory activities. Eschewing the Federal Reserve Board for such a role, the Financial System Stabilization and Reform Act, S 664, would create an independent Financial Stability Council to serve as systemic-risk regulator. The Financial Stability Council would be composed of representatives from the Fed, the SEC, the CFTC, the FDIC and the National Credit Union Administration. The council would maintain comprehensive oversight of all potential risks to the financial system, and would have the power to act to prevent or mitigate those risks. The draft legislation would also regulate investment banks for safety and soundness and close the gap that has allowed credit default swaps and other financial instruments to escape federal regulation.

The new Financial Stability Council would be led by a chair nominated by the President and confirmed by the Senate, with the responsibility for the day-to-day operations of the council. The chair would be required to appear before Congress twice a year to report on the state of the country's financial system, areas in which systemic risk are anticipated, and whether any legislation is needed for the Council to carry out its mission of preventing systemic risks
As financial institutions speculated in increasingly risky products and practices leading to the current crisis, not one federal financial regulator was responsible for detecting and assessing the risk to the system as a whole. The financial sector was gambling on the rise of the housing market, yet no single regulator could see that everyone, from mortgage brokers to credit default swap traders, was betting on a bubble that was about to burst. Instead, each agency viewed its regulated market through a narrow lens, missing the total risk that permeated the financial markets.

In order to prevent this problem from recurring, Senator Collins envisions a single financial regulator tasked with understanding the full range of risks faced by the final system. This regulator will also be authorized to take proactive steps to prevent or minimize systemic risk. The legislation guarantees holistic regulation of the financial system as a whole, not just its individual components.

The bill rejects the idea of a single regulator, such as the Fed, being given systemic powers in favor of a body made up of the key federal financial regulators. This type of collaborative systemic risk oversight is gaining a following in Congress. Senate Banking Committee Chair Christopher Dodd recently expressed skepticism that the Fed would be the appropriate systemic risk regulator. Senator Collins said that the Federal Reserve already has enough on its plate, and does not need additional, heavy responsibilities. She added that nothing in the bill alters the Fed’s role with respect to monetary policy in any way. Former Senator John Sununu has reasoned that, since systemic risk can materialize in a broad range of areas within the financial system, it would be impractical, and perhaps a dangerous concentration of power, to give one single regulator the power to set or modify all standards relating to such risk.

Under the bill, whenever the Financial Stability Council believes that a risk to the financial system is present due to a lack of proper regulation, or by the appearance of new and unregulated financial products or services, it would have the power to propose changes to regulatory policy, using the statutory authority provided to existing federal financial regulators. The Council would also have the power to obtain information directly from any regulated provider of financial products and, in limited form, from state regulators regarding the solvency of state-regulated insurers.

The Council will also be able to propose regulations of financial instruments which are designed to look like insurance products, but that in reality are financial products which could present a systemic risk. But Senator Collins assured that the bill does not preempt state law governing traditional insurance products.

The measure empowers the Council to address the `too big to fail'' problem by adopting rules designed to discourage financial institutions from becoming ``too big to fail'' or to regulate them appropriately if they become systemically important financial institutions.

Under the legislation the Council would help make sure financial institutions do not become ``too big to fail'' by imposing different capital requirements on them as they grow in size, raising their risk premiums, or requiring them to hold a larger percentage of their debt as long-term debt. Senator Collins clarified that the Council’s power is not meant to restrict financial institutions from growing in size, but rather from becoming risks to the system as a whole.

The bill also authorizes the Council to address so-called regulatory ``black holes,'' created by new and imaginative financial instruments that do not fall within the jurisdiction of any federal financial regulator. Credit default swaps are an example of this problem. Prior to 2000, credit default swaps existed in a regulatory limbo. Neither the SEC nor the CFTC were willing to exert authority over the credit default swap market. As a result, they fell through the jurisdictional cracks. Congress then compounded the problem by explicitly exempting credit default swaps from regulation under the Commodity Futures Modernization Act of 2000

The draft legislation specifically addresses the credit default swap problem by repealing the exemption from regulation that Congress created for these instruments in 2000, and by setting up a government-regulated clearinghouse.

But beyond credit default swaps, risky new financial instruments could still avoid the reach of the regulatory system. For that reason, the draft provides the Council with the power to propose regulations governing the sale or marketing of any financial instrument which would fall into a ``black hole,'' and would otherwise present a systemic risk to the financial system if left unmonitored.

Finally, the bill would apply safety and soundness regulation to investment bank holding companies by assigning the Federal Reserve this responsibility. The SEC would be able to regulate the broker-dealer operations. Under the draft legislation, the Council's role as the systemic-risk regulator would support the critical importance of the Federal Reserve's safety and soundness duties.