 | | Michael Burt
Associate Director
Industrial Economic Trends |
Nearly two years after the global financial crisis came to a head with the bankruptcy of Lehman Brothers, the U.S. has passed a regulatory reform package designed to prevent a crisis of this magnitude from ever happening again. The recently passed Dodd-Frank Act is an ambitious reform of U.S. financial regulation. It covers a wide array of topics, including establishing clear lines of responsibility for regulators, increased oversight and disclosure rules for a variety of financial products and firms including over-the-counter derivatives and hedge funds, and efforts to reduce conflicts of interest and increase transparency at credit ratings agencies. It also acknowledges the problem of systemic risk that accompanies organizations that are “too big to fail”.
Among the more than 2,000 pages in the Act are plans to create the Financial Stability Oversight Council. This council will be chaired by the Treasury Secretary and its members will consist of representatives from the different federal financial regulators, including the Federal Reserve Board and the Securities and Exchange Commission. Its purpose is to monitor, assess and mitigate systemic risk to the U.S. financial system.
In order to be able to achieve this objective the council has been given considerable powers. For example, limitations on the proprietary trading activity of banks and non-banks will be implemented. The council can also discourage excessive growth and complexity by implementing rules for capital requirements, leverage, liquidity and risk management that increase as companies grow in size. As a last resort, the council can even require a too large firm to divest some of its holdings if it is deemed to pose a “grave threat” to the financial stability of the United States.
The council has also been given the ability to extend the reach of regulators outside of the traditional banking sector. For example, if deemed to be a systemic risk, the council can apply the regulatory requirements of banks to non-bank financial firms such as insurance companies. As well, oversight of systemically important clearing, payments and settlements systems has been clearly identified as being under the purview of the Federal Reserve Board.
Finally, since failures may still occur despite this increase in regulation, large and complex companies will be required to periodically submit plans for their orderly shutdown and liquidation in the event of their failure. In essence, companies will be required to file and update a “living will”. It is expected that the requirement to produce a plan deemed credible by regulators will limit the interest of financial firms in products and services that cannot be easily unwound. There is also a provision in the Act that requires surviving financial firms to pay back any government funds that are used in the process of unwinding a failed company. It is expected that this provision will give leverage to regulators when organizing private rescues, which are generally preferable to liquidations.
In short, the Dodd-Frank Act encapsulates all three of the policy recommendations outlined in Lessons From the Recession Lesson 4 “Too Big to Fail” Means Too Big—living wills, increased regulatory oversight, and as a last resort, breaking up too large companies. One thing that it does not do is address the potential problem of non-financial firms that may be “too big to fail”. It is true that systemic risk is usually discussed in the context of the financial system due to its interconnectedness with every other part of the economy and the fact that confidence is critical to its proper functioning. However, the U.S. and Canadian governments did extend assistance to GM and Chrysler at the height of the recession under the rationale that they were “too big to fail”. If that is truly the case, then the objectives of the Financial Stability Oversight Council should be extended beyond the financial services sector.
It is also important to note that although these steps have been taken in the United States, there has been little impetus to assess or mitigate systemic risks in Canada. Because we did not experience a financial crisis here it has not been a major topic of discussion among policymakers. Although better regulation did limit the damage of the global financial crisis in Canada it does not mean that systemic risks cannot arise here. As such, it would be better to act to identify and control those risks now, before the next crisis occurs, than to react after the fact.