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Thursday, June 3, 2010

Financial Regulatory Reform: Systemic Risk and the Federal Reserve

Marc Labonte
Specialist in Macroeconomic Policy

The recent financial crisis contained a number of systemic risk episodes, or episodes that caused instability for large parts of the financial system. The lesson some policymakers have taken from this crisis is that a systemic risk or "macroprudential" regulator is needed to prevent similar episodes in the future. But what types of risk would this new regulator be tasked with preventing, and is it the case that those activities are currently unsupervised? 

Some of the major financial market phenomena that have been identified as posing systemic risk include liquidity problems; "too big to fail" or "systemically important" firms; the cycle of rising leverage followed by rapid deleverage; weaknesses in payment, settlement, and clearing systems; and asset bubbles. The Federal Reserve (Fed) already regulates bank holding companies and financial holding companies for capital and liquidity requirements, and it can advise their behavior in markets that it does not regulate. In addition, the Fed directly regulates or operates in some payment, settlement, and clearing systems. Many too big to fail firms are already regulated by the Fed because they are banks, although some may exist in what is referred to as the shadow banking system, which is largely free of federal regulation for safety and soundness. The Fed's monetary policy mandate is broad enough to allow it to use monetary policy to prick asset bubbles, although it has not chosen to do so in the past. Neither the Fed nor other existing regulators have the authority to identify and address gaps in existing regulation that they believe pose systemic risk. 

Opponents of a systemic risk regulator argue that regulators did not fail to prevent the crisis because they lacked the necessary authority, but because they used their authority poorly and failed to identify systemic risk until it was too late. They fear that greater government regulation of financial markets will lead to moral hazard problems that increase systemic risk. On the other hand, the current crisis has demonstrated that government intervention may become unavoidable, even when firms or markets are not explicitly regulated or protected by the government. 

If policymakers choose to create a systemic risk regulator, those duties could be given to the Fed or a new or existing regulator in the executive branch. The Fed's political independence has been used as an argument for and against giving it systemic risk regulatory responsibilities. Another consideration is that the Fed's existing responsibilities already have some overlap with systemic risk regulation. These responsibilities include a statutory mandate to maintain full employment and stable prices and the role of lender of last resort, as well as being the institution with the broadest existing financial regulatory powers. 

The Financial Stability Improvement Act of 2009 (H.R. 4173) passed the House on December 11, 2009. The Restoring American Financial Stability Act (S. 3217) passed the Senate on May 20, 2010. Provisions of these bills involving the Federal Reserve and systemic risk are discussed in this report, including the creation of a Financial Services (Stability) Oversight Council and the regulation of systemically significant firms by the Fed. Neither bill creates a "systemic risk regulator"; nonetheless, many of the potential duties that could be assigned to a systemic risk regulator discussed in this report are included in both bills. The bills spread these duties among multiple regulators, although many of the important ones are assigned to the Fed. Although this could be portrayed as an expansion of the Fed's powers, the bills also strip the Fed of certain powers and creates new checks on other powers.

Date of Report: May 26, 2010
Number of Pages: 28
Order Number: R40877
Price: $29.95

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