SEC Chair Seeks Enhanced Financial Stability Council to Work with Systemic Risk Regulator

While accepting in principle that the Federal Reserve Board could be the new systemic risk regulator, SEC Chair Mary Schapiro said that the Financial Stability Oversight Council designed to work with the Fed must be strengthened beyond the framework set forth by the Administration’s legislative proposal. In testimony before the Senate Banking Committee, the SEC Chair laid out her vision of the Council as being armed with the tools it needs to identify emerging risks, to establish rules for leverage and risk-based capital for systemically-important institutions. She envisions a Council empowered to serve as a ready mechanism for identifying emerging risks and minimizing the regulatory arbitrage that can lead to a race to the bottom.

To balance the weakness of monitoring systemic risk through the lens of any single regulator, reasoned the SEC official, the Council would permit the assessment of emerging risks from the vantage of a multi-disciplinary group of financial experts with responsibilities that extend to different types of financial institutions, both large and small.

Recently, the Administration proposed legislation naming the Fed as the single regulator to police all systemically important firms and markets as a broad consensus develops on the need for Congress to create a systemic risk regulator. This systemic risk regulator would be authorized to take proactive steps to prevent or minimize systemic risk. The Administration also proposed that the systemic risk regulator should by a Financial Services Oversight Council, whose members would include Treasury, the SEC, the CFTC, and the FDIC. The Council would be authorized to facilitate information sharing and coordination, identify emerging risks, resolve jurisdictional disputes among regulators, and, advise the Fed on identifying firms whose failure could pose a threat to market stability.

The SEC Chair envisions the Council as being authorized to identify institutions, practices, and markets that create potential systemic risks and set standards for liquidity, capital and other risk management practices at systemically important institutions. The systemic risk regulator would then be responsible for implementing these standards. The Council also should provide a forum for discussing and recommending regulatory standards across markets, helping to identify gaps in the regulatory framework before they morph into larger problems. According to Ms. Schapiro, this hybrid approach can help minimize systemic risk in a number of ways.

For example, the Council would ensure different perspectives to help identify risks that an individual regulator might miss or consider too small to warrant attention. These perspectives would also improve the quality of systemic risk requirements by increasing the likelihood that second-order consequences are considered and flushed out. Moreover, the financial regulators on the Council would have experience regulating different types of institutions, including smaller institutions, so that the Council would be more likely to ensure that risk-based capital and leverage requirements do not unintentionally foster systemic risk. Such a result could occur by giving large, systemically important institutions a competitive advantage over smaller institutions that would permit them to grow even larger and more risky. In addition, the Council would include multiple agencies, thereby significantly reducing potential conflicts of interest, such as conflicts with other regulatory missions.

The SEC Chair also envisions the Council monitoring the development of financial institutions to prevent the creation of institutions that are either too-big-to-fail or too-big-to-succeed. She believes that insufficient attention has been paid to the risks posed by institutions whose businesses are so large and diverse that they have become, for all intents and purposes, unmanageable. Given the potential daily oversight role of the systemic risk regulator, it would likely be less capable of identifying and avoiding these risks impartially. Thus, in her view, the Council framework is vital to ensure that the desire to minimize short-term systemic risk does not inadvertently undermine the financial system’s long-term health.

More broadly, the SEC Chair expects both the Council and the systemic risk regulator to work with and through primary regulators of systemically important institutions. The primary regulators understand the markets, products and activities of their regulated entities. The systemic risk regulator can provide a second layer of review over the activities, capital and risk management procedures of systemically important institutions as a backstop to ensure that no red flags are missed.

If differences arise between the systemic risk regulator and the primary regulator regarding the capital or risk management standards of systemically important institutions, she averred, the higher and more conservative standard should govern. The systemic risk regulatory structure should serve as a brake on a systemically important institution’s riskiness, she reasoned, and should never be an accelerator.

In emergency situations, she continued, the systemic risk regulator may need to overrule a primary regulator, such as to impose higher standards or to stop or limit potentially risky activities. However, in order to ensure that authority is checked and decisions are not arbitrary, the Council should be where general policy is set, and only then to implement a more rigorous policy than that of a primary regulator. In the Chair’s view, this will reduce the ability of any single regulator to compete with other regulators by lowering standards, driving a race to the bottom.

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