Abstract
This Selected Issues paper focuses on U.S. potential growth in the aftermath of the crisis. It discusses recent productivity developments in the nonfarm business sector. The paper uses back-of-the envelope calculations to gauge the effect of diminished financial sector activity on GDP growth in coming years. A simple production function framework is used to give a long view of key factors explaining potential GDP growth in the United States in the last 30 years and explore possible developments in the next few years.
III. Strategic Priorities for the Reform of U.S. Financial Regulation
Ashok Vir Bhatia, Andrea Maechler, and Paul Mills
A. Fundamental Challenges
1. Established in the Great Depression, the U.S. system of financial regulation now requires sweeping modernization. A primary cause of the crisis of 2007–09 was lax financial regulations in the United States. That, in turn, reflected a U.S. regulatory philosophy that focused on protecting retail depositors and depository institutions from the bank-based panics of the decades before the introduction of federal deposit insurance in 1933. The “runs” of this crisis have centered on institutional creditors, however, forcing an improvised but radical expansion of the safety net to a multitude of nonbanks, and prompting a renewed appreciation for the systemic risk arising from wholesale financial markets.
2. Although the widening of the federal financial safety net was a necessary and appropriate response to the turmoil, it has underscored the need for better regulation. Financial firms ranging from government-sponsored enterprises (GSEs) to broker-dealers to insurance holding companies have benefited, variously, from liquidity provision from the Federal Reserve (Fed), guarantees from the Federal Deposit Insurance Corporation (FDIC), and capital support from the U.S. Treasury, with an attendant dilution of market discipline. More fundamentally, even the most advanced risk management systems have proven unable to anticipate and prepare adequately for the collapse of market liquidity and jump in price correlations. Effective regulation and supervision, focused on systemic risk, have thus been shown essential to controlling the collective tendency toward booms and busts (Figure 1).
Net Income of U.S. Financial Sector and Total Private Sector Debt
Citation: IMF Staff Country Reports 2009, 229; 10.5089/9781451839746.002.A003
Sources: Board of Governors of the Federal Reserve System; Bureau of Economic Analysis; and Haver Analytics.B. Assessing the Administration’s Reform Proposals
3. Cognizant of the above, the U.S. Administration and Congress are committed to the timely passage of substantive regulatory reform. The Administration outlined its comprehensive package of proposals in mid-June (Box 1), including a raft of measures to better address systemic risk. The proposals are broadly in line with recent G-20 recommendations and past staff analysis (IMF, 2007). At the same time, they break new ground, nowhere more so than in the call to subject all systemic financial intermediaries—whether they own banks or not—to consolidated supervision focused on systemic risk, and to group-level prudential requirements linked to a bank-like prompt corrective action regime and resolution mechanism. The calls for more rigorous oversight of over-the-counter derivatives and centralized clearing of standardized contracts are similarly essential.
Key Elements of the U.S. Treasury’s Financial Regulatory Reform Proposals 1/
More robust supervision and regulation of financial institutions:
Creating a Financial Services Oversight Council (FSOC) of financial regulators, backed by force of law and chaired by the Treasury, to identify emerging risks and improve interagency cooperation. The FSOC would have authority to gather information from any financial firm and to recommend any such firm for designation as a “Tier 1 financial holding company” (FHC; see below).
Introducing a new category of financial firm, the Tier 1 FHC, under consolidated supervision and regulation by the Federal Reserve, with selection criteria based on, but not limited to, size, leverage, and interconnectedness per broad guidelines set in legislation.
Subjecting these systemically important Tier 1 FHCs to consolidated supervision with a macroprudential focus and stricter prudential standards, the latter linked to a prompt corrective action regime and special resolution mechanism at the holding company level.
Eliminating the federal thrift charter and the industrial loan company exception, such that holding companies of either (or both) will be reclassified as Fed-supervised bank holding companies (BHCs).
Merging the Office of Thrift Supervision and Office of the Comptroller of the Currency into a single National Bank Supervisor.
Reviewing the Fed’s governance structure and the supervision of all banks and BHCs, by end-September 2009; regulatory capital requirements for banks, BHCs, and Tier 1 FHCs, by end-2009; and the future of the housing GSEs, by the time of the President’s 2011 budget release.
Comprehensive regulation of financial markets:
Enhancing regulation of securitization markets, including through greater market transparency, more robust disclosure for credit rating agencies, and stronger incentives for securitizers to conduct due diligence on pooled assets and avoid excessive complexity.
Introducing comprehensive regulation for over-the-counter derivatives and encouraging centralized clearing of standard contracts.
Making money market mutual funds less vulnerable to liquidity pressures and credit losses through strengthened prudential requirements.
Requiring the registration with the Securities and Exchange Commission (SEC) of most advisors to hedge funds and other private pools of capital.
Mandating the Federal Reserve to oversee the payment, clearing, and settlement systems.
Consumer and investor protection from financial abuse:
Creating a new Consumer Financial Protection Agency to improve the transparency, fairness, and appropriateness of consumer financial products, services, and practices.
Promoting higher standards for providers of consumer financial products and services through greater reliance on standardized “plain vanilla” products.
Better crisis-management tools:
Creating a new resolution regime for any firm whose disorderly unwinding would risk serious adverse effects for the economy, as determined by the Secretary of the Treasury after consulting with the President and upon the written recommendation of the Federal Reserve Board and the FDIC Board (the latter replaced by the SEC Commissioners if the largest subsidiary in the group is a broker-dealer).
Requiring written approval from the Secretary of the Treasury for the Federal Reserve’s emergency lending powers under Section 13(3) of the Federal Reserve Act.
Higher international standards:
Encouraging a stronger capital and liquidity framework for all banks; more effective oversight of global financial markets; stronger cross-border supervision and coordination of resolution frameworks; and robust crisis-management arrangements internationally.
4. That said, many difficult issues will need to be tackled in the implementation phase. This chapter focuses on three key reform areas where the crisis and its aftermath have revealed major shortcomings, assessing them against the authorities’ reform objectives and proposals: first, internalizing the risk-taking of systemic financial intermediaries; second, designing a broader financial stability framework to control systemic risk; and third, closing key regulatory gaps.
Addressing the role of systemic financial intermediaries
5. At the heart of the challenge lies a select set of systemically critical financial conglomerates. These groups, straddling the boundary between the heavily regulated, bank-centric core and the more lightly regulated, nonbank periphery of the system, dominate key market segments ranging from private securitization and derivatives dealing to triparty repo and leveraged investor financing. Regulated by a multitude of agencies with narrow but at times overlapping jurisdictions, their complex webs of subsidiaries—bound together, ultimately, by a shared franchise—have made it difficult to assess group-wide resilience, let alone systemic risk. Without a means to resolve such groups while keeping them open, and lacking an official resolution mechanism for systemic nonbanks, “too big to liquidate” has become “too systemic to restructure,” eroding market discipline and exacerbating moral hazard. This calls for a two-pronged approach: controlling risk-taking while internalizing systemic risk, and strengthening crisis management and market discipline.
Controlling risk-taking while internalizing systemic risk
Issue: Pre-crisis, vulnerabilities were concentrated in the largest BHCs, investment banking groups, and GSEs, which also held the thinnest capital buffers (Figure 2). During the crisis, these firms required massive government support, necessary to mitigate systemic risk, but also leaving little ambiguity (if there was much at all) about which firms were (or are) “too big to fail” (Litan, 2009). As a result of crisis-related mergers, liquidations, and policies (e.g., the ramping up of GSE mortgage securitizations), they are emerging from the turmoil with even larger market shares, exacerbating the systemic risk associated with their size, leverage, and interconnectedness—even as the authorities’ ex post assumption of risk has cemented moral hazard. A major challenge will be to design a prudential regime that fully internalizes the potential for moral hazard.
Objective: The goal should be to give financial firms sufficient incentives to reduce their contributions to systemic risk by penalizing their systemically important status. This could be done through capital charges graduated to reflect contributions to systemic risk; rigorous application of competition limits (e.g., as with the current cap on an institution’s share of insured deposits); and greater use of risk- and size-sensitive insurance premia. Given the lack of evidence of efficiency benefits from scale once financial institutions reach a (reasonably low) size threshold, the policy objective should be for managers and shareholders to wish to avoid their firms being designated “systemic” due to the resulting additional costs imposed (Akhavein et al., 1997; and Berger et al., 1999).
Assessment of U.S. proposals: The Administration’s proposals contain many bold and innovative suggestions—e.g., for Tier 1 FHCs to prepare prepackaged resolution plans and purchase contingent capital—that should help to address moral hazard. In practice, it will be important that additional capital and liquidity requirements on Tier 1 FHCs fully internalize their contributions to systemic risk and, at the margin, disincentivize size, leverage, and interconnectedness. Otherwise, there could be a risk that, as with the pre-crisis regime for the housing GSEs, the regulatory structure would not address the problems associated with “too big to fail.”
Vulnerabilities in U.S. Banking Institutions
Citation: IMF Staff Country Reports 2009, 229; 10.5089/9781451839746.002.A003
Sources: SNL Financial; and Fund staff estimates.* TLGP stands for Temporary Liquidity Guarantee Program. Notes: At end-March 2009, the top-3 BHCs (Bank of America, JPMorgan Chase, Citigroup) accounted for 46.8 percent of total assets, the top-5 (including Wells Fargo and Goldman Sachs) for 63.4 percent, and the BHCs included in the U.S. Supervisory Capital Assistance Program (SCAP) for 85.9 percent. The remaining assets were held by BHCs with assets of $10-$100 billion (8.3 percent) and BHCs with assets of less than $10 billion (5.9 percent).Strengthening crisis management and market discipline
Issue: Rescues, expanded deposit insurance coverage, and liquidity support measures, while necessary to stabilize the system, have undermined market discipline and diluted market participants’ incentives to monitor risk-taking, especially by large institutions.
Objective: The goal should be to underpin market discipline through a resolution regime that ensures that senior managers, uninsured creditors, and equity holders each face a credible threat of consequences (including significant loss) in the event of failure. As the Administration has proposed, this expectation can be reinforced by requiring systemic financial firms to prepare and periodically update prepackaged wind-up plans. Also, a requirement to issue contingent capital (debt convertible to common equity in a crisis) for large firms would reinforce market discipline in benign times and protect taxpayers when capital is stressed (Rajan, 2009).
Assessment of U.S. proposals: The authorities’ decision to propose a comprehensive resolution mechanism for failing nonbank financial institutions and holding companies deemed systemically important is a significant step toward supporting market discipline and, in extremis, orderly crisis resolution. Given the groundbreaking nature of this framework, many issues are yet to be finalized, including which criteria would trigger the special resolution mechanism and for which firms, how to mitigate uncertainty regarding which insolvency regime will apply, and how to ensure that the special resolution mechanism does not reinforce the perception that creditors will be insulated from losses (as occurred when the two largest GSEs were put into conservatorship). Consequently, disincentivizing firms from being deemed systemic, including through a robust prompt corrective action framework built around consolidated capital requirements as proposed, would be a necessary complement for the special resolution regime to restore market discipline.
Addressing systemic risk
6. To address systemic risk, financial surveillance should be integrated into a broader financial stability framework. Individually sound institutions can, as a group, be conducive to risk accumulation. In stable conditions, market participants pursue profitable opportunities that are individually beneficial. But, if a sufficient mass of similarly motivated agents moves in lockstep, the result can be the formation of bubbles whose eventual bursting may impose unacceptable economic cost. A stability framework is thus needed that recognizes both the micro dimension of systemic risk, with regulations tailored to support a diversity of financially sound actors, and its macro dimension, with prudential tools deployed as a counterweight to procyclical behavior. This requires a surveillance framework that has an explicit mandate to mitigate financial vulnerabilities, wherever they emerge, and with a macroprudential orientation to account for the interlinkages among financial firms, financial markets, and developments in the broader economy.
The role of a systemic risk regulator
• Issue: The crisis has demonstrated the need for an agency to be charged with identifying and assessing the buildup of risk concentrations across the whole system and their feedback effects on the broader economy.
• Objective: The goal would be to designate an agency as systemic risk regulator (SRR), with a clear mandate for overall financial stability, and with the ability to work with other regulators to gather relevant information and potentially require them to address risk accumulations in particular firms or subsectors (Nier, 2009). Because of the potential fiscal implications, the SRR would need to work closely with the Treasury—the systemic insurer of last resort—while maintaining its independence. This could be achieved, for example, through a council of financial regulators, which could (say) be required to need a super-majority vote to overturn an SRR recommendation. Quantifying and addressing financial firms’ contributions to systemic risk would be a core mandate of the SRR. In turn, the SRR would publish regular financial stability reports flagging key vulnerabilities and risks.
• Assessment of U.S. proposals: The Treasury’s new financial stability framework is based on the Federal Reserve regulating and supervising all systemic institutions and the FSOC facilitating interagency discussion and identifying emerging risks. This two-pillar structure has many noteworthy features. It gives the central bank explicit responsibility for the prudential oversight of all financial firms that could pose a threat to financial stability—Tier 1 FHCs as well as all BHCs—which has advantages, given its mandates for payment systems stability and lender of last resort and its broader macro perspective. Critically, the envisaged categorization of Tier 1 FHCs should include any broker-dealer, hedge fund, or insurance company deemed to be systemic. This would be a major improvement over the past, when the Federal Reserve’s reach was limited to BHCs. Finally, the proposal strengthens substantially the Fed’s powers to conduct effective consolidated supervision, including over any regulated or unregulated subsidiaries, which will help address previous regulatory gaps. However, the proposals also leave a number of issues unaddressed for now:
The success of the proposed framework will depend on the Federal Reserve’s ability to interact effectively with other regulatory agencies to identify and control risk concentrations. This, in turn, will require a clear accountability mechanism for each of the relevant agencies, including the FSOC, effective information-sharing and coordination, and an explicit mandate for each agency to monitor and flag systemic risk within its regulatory perimeter. Under the Treasury proposals, the FSOC, rather than the Fed as SRR, would be responsible for reporting publicly on risks to financial stability.
It remains to be seen how the Federal Reserve, in consultation with the Treasury, will draw up rules to guide the identification of systemic firms to be brought under its purview, and how the FSOC will ensure that remaining intermediaries are monitored from a broader financial stability perspective. Although the criteria for Tier 1 FHC status appropriately include leverage and interconnectedness as well as size, identifying systemic institutions ex ante will remain a difficult task (cf., AIG).
In the proposed stability framework, the Fed’s still-constrained regulatory perimeter, extending to Tier 1 FHCs and BHCs, might not capture threats to financial stability arising out of the collective risk-taking of many smaller nonbank financial firms. A broader financial stability mandate that allows the Fed to monitor an institution’s (or group of institutions’) contribution to systemic risk without designating it ex ante as systemic would provide a more flexible surveillance tool.
Designing a macroprudential framework for financial stability
• Issue: A key challenge for policymakers—now widely seen as a priority—will be to adapt prudential regulations to limit the procyclical trends inherent in financial markets and encourage financial firms to build larger capital and liquidity buffers in “good times” that can be drawn down as strains materialize (e.g., Brunnermeier et al., 2009).
• Objective: The goal would be to introduce tools that help mitigate the procyclical tendencies of asset valuations and their distorting impact on risk perceptions. Potential tools to address these issues include policies that use a longer “through-the-cycle” horizon to measure risk, forward-looking loss provisioning, and capital or liquidity requirements linked to selected macroeconomic indicators, e.g., credit growth or asset prices (BIS, 2009; Borio and Drehmann, 2009; and Laeven and Valencia, 2008). Other commonly cited measures include maximum loan-to-value ratios to reduce the sensitivity of credit supply to collateral values; deposit insurance schemes funded more generously during benign times (currently permitted only within limits for the FDIC); and a leverage ratio that extends to off-balance sheet risk exposures. Dampening procyclicality would also require ensuring consistency in the macroeconomic policy mix and avoiding market distortions (e.g., short-sighted executive compensation schemes, subsidized risk-taking through the housing GSEs) that could further amplify the build-up of financial imbalances (Andritzky et al., 2009).
• Assessment of U.S. proposals: The Administration’s proposals contain many sensible suggestions to strengthen resilience—e.g., accounting reforms to permit forward-looking provisioning, policies, to reduce procyclicality (which would become a priority at the international level). However, it is unclear which actor in the system will be in charge of an overarching macroprudential financial stability framework that accounts for the effects and interactions of financial sector and macroeconomic policies. Such a role would seem to fall naturally to the Federal Reserve, given its mandate for both macroeconomic stability and the stability of systemic institutions. Key in this will be ensuring its ability to influence the supervision and regulation of institutions and markets not within its purview, to the extent these may pose systemic risks, perhaps through the offices of the FSOC.
Closing regulatory gaps and simplifying the regulatory structure
7. In one sense, the task is to catch up with three decades of financial innovation. Those parts of the system subject to limited prudential regulation expanded the fastest, reducing the retail deposit-taking core of the financial system to a diminishing fraction of the whole (Figure 3). Spurred in part by regulatory arbitrage, new institutions and markets took root—money funds in the 1970s, pass-through securitizations in the 1980s, hedge funds, structured finance, and credit derivatives in the 1990s—outside the perimeter of the safety net, often with limited or no safety-and-soundness requirements, and in key instances exempt from conduct-of-business rules. The demand for higher-yielding financial investments and safe and liquid collateral was met by a supply of complex instruments that would prove brittle under duress. Systemic risk built up largely unrecognized.
Total Assets of U.S. Financial Sector
(Excluding Hedge and Private Equity Funds)
Citation: IMF Staff Country Reports 2009, 229; 10.5089/9781451839746.002.A003
Sources: Board of Governors of the Federal Reserve System and Fund staff calculations.Note: U.S. “real money” investors include insurers, mutual funds, and pension funds. Asset-backed security pools include those of Government Sponsored Enterprises (GSEs) and private-label issuers. Other “shadow” banking system includes GSEs, money market mutual funds, finance companies, broker dealers, etc. Core banking system includes depositories and BHCs.Rationalizing U.S. financial regulatory structure
• Issue: While no one financial regulatory model has proven optimal in the global crisis, the overlapping multiplicity of federal and state regulators in the United States has resulted in regulatory arbitrage by firms and competition for assessment fees by regulators, a lack of coordination in addressing the build-up of vulnerabilities, unnecessarily complex interactions with foreign counterparts, and inconsistent crisis management. Key gaps in oversight highlighted by the crisis included state-licensed mortgage brokers and originators, institutions’ opaque exposures to special investment vehicles, and unregulated subsidiaries of holding companies (cf., AIG’s Financial Products unit). In addition, most hedge fund advisors do not currently need to register with the SEC.
• Objective: The U.S. financial regulatory structure should be rationalized to remove gaps and prevent firms from being able to “shop” for lighter regulation. Regulatory arbitrage can be moderated through the abolition of overlapping charters for similar activities. To minimize the risk of a monolithic view developing, the SRR will need well-informed and motivated counterweights among other regulators and at the Treasury, to test its assumptions.
• Assessment of U.S. proposals: The Administration’s proposals close some important regulatory “gaps, loopholes, or opportunities for arbitrage,” even if the final number of federal regulatory agencies would increase with the creation of two new agencies and some clear opportunities for consolidation (e.g., moving toward a single capital markets regulator) were not taken. The planned merger of the Office of the Comptroller of the Currency and the Office of Thrift Supervision would be welcome, as would the elimination of the federal thrift charter, the exemption of industrial loan holding companies from BHC-type consolidated supervision, and other “nonbank bank” categories. The Fed’s ability to designate any systemic institution as a Tier 1 FHC should ensure that unregulated entities that come to own significant financial firms (e.g., private equity partnerships) could be addressed. Conversely, the proposal to establish an Office of National Insurance does not seem to address the overlap and inefficiency that arise from 50 state regulators—although the Treasury’s declared support for strong risk standards and increased uniformity for insurers, and the likely inclusion of selected large insurance groups as Tier 1 FHCs, are positive.
Ensuring effective international coordination
• Issue: Improving international coordination will be key to avoid uneven competition, cross-border regulatory arbitrage, potentially destabilizing financial flows, and protectionism, while improving prospects for the orderly resolution of internationally active financial firms.
• Objective: Consistent regulations—including higher, countercyclical, and progressive capital requirements—will need to be established in all significant jurisdictions and are being considered in the Basel context. Similarly, international coordination and mutual recognition of bankruptcy and resolution frameworks—e.g., compatible treatment of collateral and preemption rights—are critical to achieving clarity and speed in the resolution of failing cross-border firms. Ongoing Fund-Financial Stability Board work, commissioned by the G-20, can provide background on how to set guidelines for assessing firms’ systemic importance, including as they relate to potential threats to international financial stability.
• Assessment of U.S. proposals: The U.S. authorities’ support for rapid progress on cross-border resolution and crisis management is welcome, not least for the recognition that the national ring-fencing of liquidity and collateral can have international spillover effects.
C. Conclusions and Policy Implications
8. The Administration’s regulatory reform proposals represent a major step forward. In particular, ensuring that systemic financial holding companies are subject to tougher prudential requirements should go some way toward mitigating systemic risk and moral hazard. Related key advances include calls to strengthen consolidated supervision of all systemic financial intermediaries, to establish an attendant framework for systemic risk, and to rationalize the bank supervisory structure.
9. The key now will lie in determined implementation of the proposals, ideally as a holistic package, with due attention to important details. Critical among these will be clarifying the respective roles of the Federal Reserve and the FSOC in identifying, managing, and communicating about systemic risks, calibrating the additional requirements for systemic institutions so as to incentivize the reduction in size and complexity, and ensuring that any gaps and inconsistencies in the still-complex regulatory structure can be bridged effectively. Measures will also be needed to mitigate procyclicality, with due international coordination. But overall, the proposals lay out a broad and appropriate agenda for addressing the issues thrown up by the crisis. These and other areas will be analyzed further in the context of U.S. participation in the Fund’s Financial Sector Assessment Program, scheduled to begin soon.
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