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Thursday, September 9, 2010

The Dodd-Frank Wall Street Reform and Consumer Protection Act: 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. At the time of the crisis, the Federal Reserve (Fed) already regulated bank holding companies and financial holding companies for capital and liquidity requirements, and it could influence their behavior in markets that it did not regulate. In addition, the Fed directly regulated or operated in some payment, settlement, and clearing systems. Many systemically significant firms are already regulated by the Fed because they are bank holding companies, although some may exist in what is referred to as the shadow banking system, which was largely free of federal regulation for safety and soundness. The Fed's monetary policy mandate was broad enough to allow it to prick asset bubbles, although it has not chosen to do so. Neither the Board of Governors of the Federal Reserve System (Fed) nor other existing regulators had the authority to address gaps in existing regulation that they believed pose systemic risk. 

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

The Dodd-Frank Wall Street Reform and Consumer Protection Act (H.R. 4173, P.L. 111-203) was signed into law on July 21, 2010. Provisions of this legislation involving the Federal Reserve and systemic risk are discussed in this report. The act creates a Financial Stability Oversight Council (Council) to identify (but not rectify) emerging threats and regulatory gaps. It authorizes the Fed to regulate systemically significant firms identified by the Council for safety and soundness. If the Secretary of the Treasury believes that a failure of a firm would threaten financial stability, the firm can be placed in receivership. It prohibits banks from engaging in proprietary trading, limits their ability to invest in hedge funds and private equity funds, and authorizes the Fed to regulate those activities at systemically significant firms. It also authorizes the Fed to regulate certain payment, clearing, or settlement systems identified as systemically significant by the Council. To prevent assistance to failing firms, it limits the Fed's authority to lend to non-banks in emergencies and requires more oversight and disclosure of Federal Reserve activities. It imposes minimum capital requirements on a greater array of institutions and calls for capital requirements to be made counter-cyclical. It attempts to move more derivatives into clearinghouses and exchanges. 

Although the act could be portrayed as an expansion of the Fed's powers, the legislation also strips the Fed of certain powers, such as consumer financial protection responsibilities, and creates new checks on other powers, such as requirements to obtain approval from the Council or the Treasury Secretary before undertaking certain decisions

Date of Report: August 27, 2010
Number of Pages: 29
Order Number: R41384
Price: $29.95

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