WORD ON THE STREET: The financial crisis revealed that the risks facing our system can be correlated and crosscutting, and that they could affect multiple firms and markets simultaneously.
The crises laid bare the weaknesses of the financial regulatory infrastructure: insufficient coordination among regulators; limited tools to understand complex financial firms; inadequate authority to regulate for safety and soundness outside the core banking system; and no provisions for orderly resolution.
To preserve financial stability, it thus became essential to establish a regulatory structure that could properly assess the financial system as a whole, not simply its component parts – a regulatory structure in which the failure of one firm, or problems in one corner of the system, would not risk bringing down the entire financial system.
The Dodd-Frank Act responds to this need by creating a dynamic, forward-looking regulatory apparatus that seeks to restore market discipline. While we cannot predict precisely the threats that may face the financial system in the future, we can put in place a modern regulatory framework to help keep pace with financial-sector innovations and to safeguard financial stability.
The Financial Stability Oversight Council was created to require financial regulators to regularly convene to monitor financial stability. While each agency plays an important role in maintaining a stable and well-functioning system, the crisis revealed that no single agency had sufficient authority to manage a financial crisis on its own. Acting in the collective, the council's function is to identify risks to the financial stability of the U.S. and respond to emerging threats to the stability of the U.S. financial system.
The council was created to be the central point of coordination across the regulatory system. By statute, it must meet officially no less frequently than once a quarter. Thus far, it has met much more frequently. The council must also release an annual report that assesses the impact of significant financial market and regulatory developments on financial stability.
The council possesses both general duties and specific authorities. Among the council's general duties are to monitor the financial services marketplace to identify potential threats to financial stability. The monitoring duty is fulfilled partly by relying on the council's constituent agencies, but also by drawing on the work of the Office of Financial Research (OFR), which supports the council and its member agencies.
The OFR is charged with developing tools for risk measurement and monitoring; collecting data and providing these data to the council; and standardizing the types and formats of data reported and collected. The OFR's work will enable regulators to aggregate and analyze the data, to see more clearly the interaction between developments in our financial system and the global economy, and to understand the risks faced by financial firms, including their interconnectedness.
An example of the OFR's recent work is advancing the establishment of a legal entity identifier (LEI). The LEI aims to create a global standard for the identification of parties to financial transactions. This standard will improve data quality, allowing regulators and firms to better manage counterparty risk, improve the integrity of their business practices, and lower processing and transaction costs.
Two other general duties of the council are to facilitate information-sharing and coordination among the member agencies and other regulators, and to monitor financial regulatory proposals, identify gaps in regulations, and recommend supervisory priorities to agencies. Both sets of duties are core to the council's intended role as the central point of coordination across the financial regulatory infrastructure.
Financial stability requires conditions wherein system-wide financial intermediation is preserved and payment services are not disrupted. Some of the council's specific authorities go to addressing these two components of financial stability. The financial crisis taught us that the failure of one significant firm can destroy confidence in the financial system and disrupt financial intermediation.
Accordingly, the Dodd-Frank Act has given the council specific authority to designate non-bank financial companies for supervision by the Federal Reserve under enhanced prudential standards. In addition, financial market utilities provide market participants with the fundamental confidence that our system is safe and sound, and that the terms of their transaction obligations will be honored. Although this fact is often overlooked, the statute gives the council the authority to designate these utilities as systemically important for enhanced supervision.
The council has approved the final rule that lays out the criteria and process for designating certain non-bank financial companies. The council has now begun the three-stage designations process. In addition, the council issued a final rule in July 2011 establishing criteria by which financial market utilities may be designated for enhanced prudential standards. The designation process outlined by that rule is also under way.
Other major tools of the Dodd-Frank Act to strengthen system-wide oversight and mitigate threats to financial stability include stronger regulation of large bank holding companies, a comprehensive approach to oversight of the derivatives market, and, a new orderly liquidation authority for financial companies.
The crisis showed that in the midst of market stress, large bank holding companies are potentially vulnerable to major counterparty credit, liquidity, and other risks. Accordingly, the statute requires all bank holding companies with at least $50 billion in assets to be automatically subject to enhanced prudential standards by the Federal Reserve Board.
The Federal Reserve issued its notice of proposed rulemaking for enhanced prudential standards in January, and is currently collecting comments. The proposed standards will include more stringent regulations for liquidity and capital, single-counterparty credit limits, and overall risk management protocols, including risk committees and stress tests.
The crisis also showed that links between firms created by derivative contracts could exacerbate a crisis. The statute adopts a comprehensive approach to reform of the derivatives markets, which had previously lacked oversight. The flaws attendant to this area of financial transactions included the following: poor documentation such that, at critical times, neither supervisors nor counterparties knew who owed what to whom; poor risk management such that firms were not able to satisfy their contractual obligations with respect to collateral; and a generally fragmented and opaque market.
To reduce these risks, financial firms will now be subject to important record-keeping and transaction-documentation requirements. They will also be required to submit standardized contracts to central counterparties for clearing. In addition, the reforms include trading and transaction reporting requirements designed to make the derivatives markets more transparent. Finally, transaction information will be recorded in data repositories, which will allow regulators to monitor this market better.Â
The experiences with Lehman Brothers showed the potentially devastating consequences to financial stability of the disorderly bankruptcy of a significant financial firm. Thus, the statute provides for orderly resolution.
Finally, administering reforms to maintain financial stability is important not just for the U.S. financial system, but for the global financial community. There should be a level playing field for all firms, and regulatory coordination. We continue to work with our partners in the G-20 and the Financial Stability Board to ensure that the financial reform agenda is global in scope.
Cyrus Amir-Mokri is assistant secretary for financial institutions at the U.S. Department of the Treasury. This article is adapted and edited from a speech delivered at the 21st Annual Hyman P. Minsky Conference. The full text is available online.
