Fed as Systemic Risk Regulator Haunts US Regulatory Reform Effort; While EU Opts for Council of Regulators with Central Bank in Key Role

There is a fierce debate raging at the center of the effort to pass financial regulatory reform in the US, while the EU has already crossed that Rubicon. It is over the issue of whether the Federal Reserve Board or a council of financial regulators will be given the role of systemic risk regulator. While the Obama Administration favors the Fed as systemic risk regulator, there is a growing consensus in Congress that the Fed is ill-suited for that role. Instead of the Fed being the sole systemic risk regulator, a number of voices are calling for a Council of Federal Financial Regulators, including the Fed and the SEC, to be placed in the position of systemic risk regulator.

While the US wrestles with this seminal question, the European Union has already decided that the systemic risk regulator will be a European Systemic Risk Board composed of the European Central Bank and other regulators. . The members of the central bank would elect the chair of the Systemic Risk Board. In September, the European Parliament will consider draft legislation creating the Systemic Risk Board. Recently, ECB Vice President Lucas Papademous, in what could be a model for the US, outlined how the central bank will function as part of the Systemic Risk Board.

There is growing bi-partisan sentiment on the Senate Banking Committee for a Council of Federal Financial Regulators to assume the role of systemic risk regulator. Committee Chair Christopher Dodd (D-CT) earlier endorsed a council of regulators for systemic risk Given the regulatory failures leading up to this crisis, Senator Dodd has concerns about systemic risk authority residing exclusively with any one body. Senator Richard Shelby (R-AL), the committee’s Ranking Member, said at a recent hearing that making the Fed the systemic risk regulator could be very dangerous, since the mixing of monetary policy and financial regulation has proven to be a formula for taxpayer-funded bailouts and poor monetary policy.

In Senator’s Shelby’s view, making the Fed ultimately responsible for the regulation of systemically important firms would provide further incentive for the Fed to hide its regulatory failures by bailing out troubled firms. It would grant the Fed authority to regulate any bank, securities firm, investment fund or any other type of financial institution that the Fed deems a systemic risk. The Fed would be able to regulate any aspect of these firms, even over the objections of other regulators. In effect, said the Ranking Member, the Fed would become a regulatory leviathan of unprecedented size and scope.

Similarly, Senator Mark Warner, has advocated the creation of a strong Council of Federal Financial Regulators, which would include the Fed and the SEC. Sen. Warner has serious concerns about making the Fed the systemic risk regulator, primarily because of the tension between the Fed’s monetary policy duties and its contemplated systemic risk oversight. He envisions a Council that would monitor the financial system to help prevent the accumulation of systemic risks.

Specifically, the Council would be authorized to review every bit of information the federal financial regulatory agencies possess, and require those agencies to collect information from the institutions that they regulate. It would also have an independent staff capable of analyzing this data, understanding how pieces of the regulatory system work together and identify weaknesses or gaps. During normal times, the Council determines how to regulate new products and markets in order to minimize regulatory gaps, arbitrage, and blind spots.

In Senator Warner’s view, the Council would not identify firms that are too large to fail, but instead would work to prevent firms from becoming too large to fail. It would do this in two ways. First, it would have the authority to establish system-wide counterparty exposure limits, increased capital requirements, reduced leverage and strengthened risk management requirements to discourage excessive size. Second, it would ensure that the resolution authority would be able to resolve any institution should it fail.

SEC Chair Mary Schapiro has said that the Commission favors a college of regulators for systemic risk rather than a single systemic risk regulator. Ms. Schapiro specifically made favorable mention of a bi-partisan bill, S 664, sponsored by Senator Susan Collins, that would create an independent Financial Stability Council to serve as the systemic risk regulator. The Financial Stability Council would be composed of representatives from the Federal Reserve Board, the SEC, the CFTC, the FDIC and the National Credit Union Administration. There is a related House bill, HR. 1754.

In recent remarks, Mr. Papademous listed the role a central bank would have in the functioning of a council of systemic risk regulators. It will be a key role, he said, given the wide-ranging and complex duties that the Systemic Risk Board will need to perform. He envisions the central bank providing the Board with analytical, statistical, and logistical support. In particular, the ECB will regularly assist the Board in the development and collection of relevant new statistical data. The central bank will also help the Board develop and maintain new analytical tools and methodologies for the identification and assessment of systemic risks and the issuance of early risk warnings.

This is a challenging task, emphasized the ECB VP, since the identification and assessment of systemic risks requires special skills and the further development of analytical tools. Models must be developed to help structure and analyze the vast amount of information collected for the risk assessment, he noted, and each model has its pros and cons, and serves different purposes.

Further, since financial stability and macro-prudential analyses are less developed than those in other policy areas, it is advisable to employ a multiplicity of approaches. More broadly, the ECB senior official pointed out that the inter-linkages between the financial system and the macro economy further strengthen the rationale for assigning to central banks the responsibility for macro-prudential analysis and the formulation of recommendations concerning macro-prudential policies.