systemic risk in the modern financial era - francisco vasallo

Regulation of Systemic Risk in the Modern Financial Era

By: Francisco Vasallo

Submitted to: Professor David Glass

Banking Regulation: Fall 2010

New York Law School

December 23,2010

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Table of Contents

Introduction………………………………………………………………………………………………………………3

1. The Definition of Systemic Risk and How it can be Measured……………………………..…4

2. History Banking Leading to the Current Regime of Systemic Risk Regulation……….8

3. The Financial Stability Oversight Council…………………………………………………………….12

4. Implications of the Dodd-‐ Frank Approach to Systemic Risk Prevention…….....……16

Conclusion……………………………………………………………………………………………………….………20

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Introduction.

The world has recently suffered through the worst financial crisis since the 1930s, a

crisis that has precipitated a sharp downturn in the global economy. While the fundamental

causes of the crisis remain in dispute, issues concerning financial stability and the

prevention of future crises have come to the forefront of policy discussion. Policymakers

and regulators have already begun to implement broadly-‐conceived reforms to the existing

financial architecture that could help prevent a similar crisis from developing in the future.

It has become apparent that the current regime for regulating and supervising

financial firms suffers from gaps, weaknesses and jurisdictional overlaps. It is also based on

an outdated conception of financial risk – focusing on the safety and soundness of

individual institutions, but not on the interconnections among firms or the stability of the

system as a whole. “We must have a strategy that regulates the financial system as a whole,

in a holistic way, not just its individual components. In particular, strong and effective

regulation and supervision of banking institutions, although necessary for reducing

systemic risk, are not sufficient by themselves to achieve this aim.”1

The long tradition of regulating banks and financial markets in many countries has

greatly shaped our understanding of what systemic is and how it impacts the global

1 Ben Bernake, Financial reform to address systemic risk. Speech at Council of foreign relations (March 10 2009.) http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm

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financial system. The primary justification for bank regulation that is usually given is the

avoidance of systemic risk, or in other words, the avoidance of financial crises.2 “Systemic

risk” has become one of the most popular catchwords in the debate about banking

regulation, and the relationship between the banking industry and other financial markets

has also become increasingly important in over the years. This raises the vital question of

how the regulation of both banking and other financial markets needs to be changed to

focus more on systemic risk and whether a move away from a bank-‐based regulatory

framework towards a more market-‐based system is desirable in terms of crisis prevention.

Section 1 of this paper begins by presenting the various definitions of systemic risk

and the leading theory on how it can be measured. Section 2 provides context by laying out

the history of how the focus of central banks and bank regulation in the United States

became the prevention of systemic risk. Section 3 discusses the structure and objectives of

the Financial Stability Oversight Council, a new systemic risk authority created by the Dodd

Frank Wall Street Reform and Consumer Protection Act of 2010. Finally, section 4

considers the policy implications of the Financial Stability Oversight Council and the United

State’s chosen approach to systemic risk regulation.

1. The Definition of Systemic Risk and How it can be Measured

All financial market participants face systemic risk. Without it, financial

intermediation would not occur.3 However, there is no generally accepted definition of

2 Banking Regulation versus securities regulation, alle, Franklin 3 Financial intermediation is a productive activity in which an institutional unit incurs liabilities on its own account for the purpose of acquiring financial assets by engaging in financial transactions on the market; the role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them.

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systemic risk. At first glance the literature shows that systemic risk is used as a description

of many different phenomena.4 It is used to describe crises related to payment systems, to

bank runs and panics, to spillover effects between financial markets, and to a very broadly

understood notion of financially-‐driven macroeconomic crises.5 Systemic risk within the

financial system is often characterized as contagion, meaning that problems with certain

firms or parts of the system spill over to other firms and parts of the system.6 Furthermore,

the effectiveness and the economic consequences of various banking regulatory

instruments that are intended to attenuate systemic risk are still only partially understood

both theoretically and empirically, making systemic risk quite difficult to measure.

Experts in the field of banking regulation give individual definitions of systemic risk

that differ substantially:

§ “Systemic risk is the likelihood of a sudden, usually unexpected, event that disrupts information in financial markets, making them unable to effectively channel funds to those parties with the most productive investment opportunities.7

§ “Systemic risk may be defined as the risk of a sudden, unanticipated event that would damage the financial system to such an extent that economic activity in the wider economy would suffer” 8

§ “Systemic or contagion risk is the probability that cumulative losses will occur from an event that sets in motion a series of successive losses along a chain of institutions of markets comprising a system”9

§ Title I of the Dodd-‐Frank Wall street Reform and Consumer Protection Act of 2010 refers to systemic risk broadly as: “Risks to the financial stability of the United

4 De Brant, O., Hartmann, Ph., 2000, Systemic Risk, a survey, CEPR Discussion paper No. 2634. 5 Id. 6 See footnote 2 7 Frederic Mishkin (1995) suggests: 8 Allen, Franklin, Banking Regulation versus Securities Regulation, Wharton Financial Institutions Center, University of Pennsylvania. (July 11, 2001). 9 George Kaufmann writes:

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States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.” 10

A recent International Monetary Fund report points out that although the definition

is imprecise, systemic risk is often viewed as a phenomenon that is “there when we see it”,

reflecting a sense of broad-‐based breakdown in the functioning of the financial system,

which is normally realized ex-‐post, by a large number of financial institutional failures

(usually banks).11 Despite the lack of a precise definition, it seems that most authors have

in mind the problem of simultaneous failure of many institutions. Hence, for purposes of

this paper, it is sufficient to conceptualize the term systemic risk under this broad

definition.

In order to apply a specific set of prudential standards and guard against systemic

risk in any meaningful way, supervisors and regulators need to be able to identify the

extent to which firms are likely to be systemic. However, measuring a firm’s systemic

importance is far from an exact science. In general, a firm is systemic when its collapse

would impair the provision of credit and financial services to the market with significant

negative consequences for the real economy.12 The factors that make firms systemically

important fall into three main categories.

First, a firm can be systemic by size, otherwise known as “too big to fail”. This can

be in relation to a specific financial market or product in which a firm is particularly

10 H.R. 4173-‐19, Title I, §112(a)(1)(A) 11 International Monetary Fund, Global Financial Stability Report, April 2009, p. 113. 12 Financial Services Authority, A regulatory response to the global banking crisis: Systemically important banks and assessing the cumulative impact.

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dominant, or it can simply be a function of the firm’s absolute size.13 Secondly, a firm can

be systemic by inter-‐connectedness with other firms.14 Links and inter-‐connections can

include, among other things, inter-‐bank lending, cross holdings of bank capital

requirements, memberships of payment systems, and being a significant counterparty in a

crucial market. Excessive interbank exposure can lead to a domino effect where the

collapse of one firm leads to major losses at others, and in turn leads to their collapse, or

worse, the collapse of the whole economy. Finally, firms can be systemic as a heard.15 The

market can perceive a group of firms as a part of a common group, sharing common

exposure to the same sector or type of instrument.16 A single firm in this group may not be

systemic in its own right, but the group as a whole may be.

The fact that these general criteria are to a large extent intuitive and dependent on

wider market conditions makes it difficult, and in some cases impossible, to determine

ahead of time whether particular firms are of systemic importance. Nevertheless,

theoretically it is clear that obtaining information conveying the risk exposure of the

system as whole cannot be done through the supervision of single institutions without

knowing their mutual exposures.17 The difficulty lies in identifying the relevant

macroeconomic factors and painting a picture of the aggregate risk exposure of the

financial system as a whole, taking all correlations properly into account. This is an

13 Id. 14 Id. 15 Id. 16 Id. 17 Hellwig, M., (2000), Banks, Markets, and the Allocation of Risks in an Economy, Journal of Institutional and Theoretical Economics; 154(1), 328-‐45.

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ambitious, yet necessary, goal. In sum, the definition of systemic risk broad and imprecise,

and the agenda for measuring it is clear in principle, but unresolved in practice.

2. History Banking Leading to the Current Regime of Systemic Risk Regulation.

Because the U.S. banking system is perpetually influenced by rapid financial and

technological innovation, its regulatory regime is still evolving in many ways. U.S. Banking

regulation can best be understood by examining its evolution, its response to financial

crises, and the specific reasons why many of its features were originally adopted. It is

helpful to start by considering the way in which the focus of central banks and bank

regulation became the prevention of systemic risk.

The federal government first entered into bank regulation in 1791 when, at the

urging of Alexander Hamilton, Congress created the Bank of the United States under a

temporary charter.18 The Bank of the United States acted as a central bank by making loans

to state banks with temporary liquidity problems. Although the Bank of the United States

fulfilled its role, congressional and state bank opposition kept it from being rechartered in

1811.19 However, subsequent banking problems led to a congressional chartering of a

second Bank of the United States in 1816. This bank was organized much the same as the

first, but, being much larger, it played an even greater central banking role. Again, because

of political and state opposition, the second Bank of the United States met the same fate as

its predecessor, and its charter was not renewed in 1836. 20

18 Dionne, Georges, The Foundations of Risk Regulation for Banks: A review of the Literature, Journal of Political Economy 109 (2): 177-‐215 (2005) 19 Id. 20 Id.

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The United States has always been distrustful of centralized Power of any kind.

“Power for good is power for evil even in the hands of omnipotence.”21 From 1836 to 1914

the U.S. did not have a central bank, but it had many financial crises – on average about one

crisis every 10 years.22 These crises were usually followed by recessions.23 With a rapid

expansion of state banks after 1836 and an increase in bank note problems and bank

failures, proposals for a uniform and stable national currency began to attract public

interest. In 1864, the federal government passed the National Bank Act. The act provided

that a federal agency, the Office of the Comptroller of the Currency (OCC), would have the

power to charter banks.24 The National Bank Act also stipulated that newly chartered

banks had to buy federal debt and issue notes provided by the treasury.25 These provisions

for secured notes established the first uniform currency that circulated nationwide at par.

Both state and federal banking regulation increased between 1864 and the early

1900s, but financial panics and bank runs continued to occur. In 1907 there was a

particularly severe crisis that originated in the U.S. and spread to many other countries.

The severity of the 1907 crisis and the depth of the recession that followed it reignited the

debate over whether the U.S. should have a central bank. Finally, in 1913 Federal Reserve

Act was enacted.26

21 John Quincy Adams in a report on the Second Bank of the United States. Timberlake, R. The Origins of Central Banking in the United States, Cambridge: Harvard University Press. (1978). 22 Allen, Franklin, Banking Regulation versus Securities Regulation, Wharton Financial Institutions Center, University of Pennsylvania. (July 11, 2001). 23 Id. 24 The National Bank Act, 12 U.S.C. 38 (1864). 25 Id. 26 The Federal Reserve Act, 12 U.S.C. 226 (1913).

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The Federal Reserve Act established the Federal Reserve System (the Fed), to be

headed by a board of seven members.27 While it was a banking crisis that led to the

creation of the Fed, it was the concerns of bankers, businessmen, and others who feared

centralized control over the country’s banking and monetary system that resulted in the

Fed’s regional organizational structure and decentralized decision-‐making power.

Notwithstanding its primary objective, the Fed was unable to develop the ability to prevent

banking crises during the years after its creation. Bank failures accelerated after the great

stock market crash of 1929, which was followed by a major banking panic in 1933.

The effect of the banking crises in the 1930s was so detrimental that in addition to

reforming the Federal Reserve System the United States also imposed many types of

banking regulation to prevent systemic risk. Congress enacted the Glass-‐Steagall Act of

1933, which introduced the Federal Deposit Insurance Corporation (FDIC) and required

the separation of commercial and investment banking. 28 Two years later the Banking Act

of 1935 made the FDIC a permanent government agency and extended the powers of the

Fed, changing the way it operated.29 Subsequent regulations included capital adequacy

standards, asset restrictions, liquidity requirements, reserve requirements, interest rate

ceilings on deposits, and restrictions on services and product lines. In some instances the

government even intervened directly into the financial system to allocate resources and

usurped the role of market forces.

27 Id. 28 The Glass-‐ Steagall Act, 12 U.S.C. 93, ch. 89, 48 Stat. 162, (1933) 29 The Banking Act of 1935, 12 U.S.C 228, ch. 614, 49 Stat. 684 (1935).

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Under these reforms the occurrence of banking panics was effectively eliminated in

the United States for almost 70 years, during which time market participants gained

confidence that they had finally tamed the financial system. Over the years financial

markets became more globalized the banking environment became more competitive.

Financial innovation and sophisticated management practices allowed for persuasive

arguments in favor of doing away with several regulations. Despite the temporary trend of

deregulation, ensuring financial stability and preventing financial crises continues to be the

central purpose of federal banking regulation.

Today the Fed has supervisory and regulatory authority over a wide range of

financial institutions and activities. It works with other federal and state supervisory

authorities to ensure safety and soundness of financial institutions, stability in the financial

markets, and fair and equitable treatment of consumers in their financial transactions.30 As

the U.S central bank, the Fed also has extensive and well-‐established relationships with the

central banks and financial supervisors of other countries, which enables it to coordinate

its actions with those of other countries when managing international financial crises and

supervising institutions with a substantial international presence.31

Prior to enactment of the Dodd-‐Frank Act, the Fed lacked explicit authority to

intervene in financial markets and the Fed’s regulatory authority over holding companies

was dispersed among an array of regulators. 32 Virtually all of the Fed’s delegated authority

was specific in nature in the sense that it was targeted at individual problems in the

30 The Federal Reserve Board, The Structure of the Federal Reserve System. (2010). http://www.federalreserve.gov/pubs/fseries/frseri.htm 31 Id. 32 Gramm-‐Leach Bliley Act in 1999 P.L. 105-‐102, 113 Stat. 1339.

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financial system that could be addressed through narrowly tailored legislation. Therefore,

it can be said that during the recent financial crisis, there was no explicit statutory

delegation of broad authority for systemic risk regulation.

Even assuming that the Fed’s legal Mandate to “promote effectively the goals of

maximum employment, stable prices, stable prices, and moderate long term interest rates

provides it with systemic risk authority, the law seems not to have offered any clear-‐cut

mechanism to discipline the Fed for failure to prevent a systemic event,”33 Under the

Federal Reserve Act, Fed governors serve 14-‐year terms and can only be removed for

“cause”, not for policy disputes.34 The Fed is also self-‐financing. This means that without

changing the law, Congress could not adjust the Fed’s budget to influence its priorities.

Adding specific systemic risk authority to the Fed’s current wide-‐ranging mandate would

become the next major change in the evolution of the U.S. baking system.

3. The Financial Stability Oversight Council

The Dodd-‐Frank Wall Street Reform and Consumer Protection Act (The Dodd-‐Frank

Act) was signed into law on July 21, 2010.35 It is a broad-‐based reform package that

includes provisions affecting almost every part of the financial system. The Dodd-‐Frank Act,

for the first time, provides consolidated supervision and heightened prudential standards

for large, interconnected nonbank financial companies and large bank holding companies.

The overall goal of the act is to prevent another systemic risk episode and the new systemic

33 Section 2A of the Federal Reserve Act 12 USC 225a. 34 12 U.S.C. §§241-‐242 35 The Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub.L. 111-‐203, H.R. 4173 (2010).

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risk responsibilities created are mostly divided between the newly established Financial

Stability Oversight Council and the Federal Reserve Board.

Title I of the Dodd-‐Frank Act establishes the Financial Stability Oversight Council.

(The Council).36 The Secretary of the Treasury chairs the Council, and the voting members

consist of the Treasury Secretary himself, the heads of eight federal regulatory agencies37,

and one other member with insurance expertise that is appointed by the President. There

are also several nonvoting members that serve in an advisory capacity.38 The Council is

tasked with identifying risks to financial stability and responding to emerging systemic

risks, while minimizing moral hazard arising from expectations that firms or their

counterparties will be rescued in the future.39

The Council has the authority to designate systemically important nonbank financial

companies and large bank holding companies as “Tier 1 Financial Holding Companies”

(Tier1 FHCs).40 The Dodd Frank act defines “nonbank financial company” very broadly to

mean any company, other than a bank holding company, that is predominantly engaged in

financial services.41 Under this broad definition, the council may designate a wide variety of

financial market participants as Tier 1 FHCs, including national securities exchanges,

36 Id 37 Voting members of the FSOC also includes the Chairman of the Board of Governors of the Fed, Comptroller of the Currency, Director of the Bureau of Consumer Financial Protection, Chairman of the SEC, Chairperson of the FDIC, Chairperson of the CFTC, Director of the FHFA, Chairman of the National Credit union administrative Board, and 38 See footnote 35 39 Labonte, Marc. Systemic risk and the Federal Reserve, CRS report 7-‐5700 R41384 (August 27, 2010) 40 A Tier 1 FHC means a bank holding company with total consolidated assets of more than $50 billion or a nonbank financial company designated for supervision by the Fed, 41 see footnote 39

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clearing agencies, and any other entities engaging in payment and clearing, or settlement

activities that might pose systemic risk.

Before any systemically important firm can be subjected to supervision or

regulation as a Tier 1 FHC, there must be a vote of at least 2/3 of the voting Council

members then serving, including an affirmative vote by the Chairperson.42 In making its

determination, the Council is required by statute to consider 10 relevant factors, in

addition to any other risk-‐related factors that the Council deems appropriate. The factors

are worth listing, as they provide valuable insight as to how the Council attempts to

measure systemic risk in the financial system:43

1. The extent of the leverage of the company;

2. The extent and nature of the off-‐balance-‐sheet exposures of the company;

3. The extent and nature of the transactions and relationships of the company with other

significant nonbank financial companies and significant bank holding companies;

4. The importance of the company as a source of credit for households, businesses, and State

and local governments and as a source of liquidity for the United States financial system;

5. The importance of the company as a source of credit for low-‐income, minority, or

underserved communities, and the impact that the failure of such company would have on

the availability of credit in such communities;

6. The extent to which assets are managed rather than owned by the company, and the extent

to which ownership of assets under management is diffuse;

7. The nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of

the company;

8. The degree to which the company is already regulated by 1 or more primary financial

regulatory agencies;

9. The amount and nature of the financial assets of the company;

10. The amount and types of the liabilities of the company, including the degree of reliance on

42 The Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub.L. 111-‐203, H.R. 4173 (2010). 43 Id at §113

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short-‐term funding;

Once a systemically important firm is designated as a Tier 1 FHC by an affirmative

vote of the Council, that firm shall be supervised by the Fed and shall be subject to

prudential regulation. The Council has the duty of making recommendations to the Fed

concerning the establishment of heightened prudential standards for risk based capital,

leverage, liquidity, credit exposure reports and overall risk management of Tier 1 FHCs.44

However, the Fed is ultimately responsible for actually supervising these firms and only the

Fed has the authority to adopt specific prudential rules based on the recommendations it

receives from the Council.

In order to provide support for the Council in obtaining information, the Dodd-‐

Frank Act established a new Office of Financial Research (OFR). The OFR is tasked with the

responsibility of setting standards for data reported and collected. The OFR is also

responsible for collecting and publishing data and performing analysis on risks to the

financial system. Acting through the OFR, the Council may require firms designated as Tier

1 FHCs to submit certified reports in order to keep the council informed as to the financial

condition of the company and any threats the company may pose to the U.S. financial

system.

In addition to conducting market research and identifying systemically important

financial firms for supervision and regulation by the Fed, the council has a statutory duty to

facilitate information sharing and coordination among the member agencies regarding

domestic financial services policy development, rulemaking, examinations, reporting

44 Id.

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requirements, and enforcement actions.45 The Council provides an ideal forum for

discussion and analysis of emerging market developments, financial regulatory issues, and

for resolution of jurisdictional disputes among the members of the council. Through this

role, the Council will help eliminate gaps and weaknesses within the regulatory structure,

to promote a safer and more stable system.

4. Implications of the Dodd-‐ Frank Approach to Systemic Risk Prevention

Financial stability in the United States could undoubtedly be further enhanced by

incorporating an explicitly macroprudential approach to the current regulatory and

supervisory regime. Macroprudential policies focus on risks to the financial system as a

whole.46 Such risks may be crosscutting, affecting a number of firms and markets, or they

may be concentrated in a few key areas.47 A macroprudential approach would complement

and build on the current regulatory and supervisory structure, in which the primary focus

is the safety and soundness of individual institutions and markets.

When a systemically important institution does approach failure, government

policymakers must have an option other than a bailout or a disorderly, confidence-‐

shattering bankruptcy.48 Because of the size, diversity, and complexity of our financial

system, monitoring and addressing emerging risks to the system as a whole is a task that

exceeds the capacity of any individual agency. The Council, made up of the principal

financial regulators, is well suited to identify developments that may pose systemic risks,

45 Id at § 112(d)(3)(a) 46 Ben Bernake, Financial reform to address systemic risk. Speech at Council of foreign relations (March 10 2009.) http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm 47 Id. 48 Id.

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recommend approaches for dealing with them, and coordinate the responses of its member

agencies.

On the other hand, introducing a macroprudential approach to regulation also

presents a number of significant challenges. Most fundamentally, implementing a

comprehensive systemic risk program demands a great deal of supervisory authority in

terms of market and institutional knowledge, analytical sophistication, capacity to process

large amounts of disparate information, and supervisory expertise.49 Other challenges

include defining the range of powers that a systemic risk authority would need to fulfill its

mission and then integrating that authority into the currently decentralized system of

financial regulation in the United States.

It seems logical that a systemic risk authority should rely on the information,

assessments, and supervisory and regulatory programs of existing financial supervisors

and regulators whenever possible. This approach would reduce the cost to both the private

sector and the public sector and allow the systemic risk authority to leverage the expertise

and knowledge of other supervisors.50 Furthermore, the collaboration of multiple financial

regulators through their membership in the Council could resolve jurisdictional overlaps

and strengthen the regulatory framework.

However, because a primary objective of a systemic risk authority is to obtain a

broader view of the financial system, simply relying on existing structures would likely be

insufficient. The role of the OFR becomes central in this regard. Through the collection and 49 Ben Bernake, Fequently Asked Questions, speech At the Economic Club of Washington D.C., Washington D.C. (December 7, 2009). http://www.federalreserve.gov/newsevents/speech/bernanke20091207a.htm 50 Id.

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analysis of new data relating to systemic risk many spots in the financial system can be

removed and regulators will be more able to see the entire landscape. A clearer view of the

financial environment will make it easier to identify systemic risks as well as other

emerging threats.

The new supervisory authority over systemically important firms given to the Fed

by the Dodd-‐Frank Act effectively transforms the Fed into the systemic risk regulator for

the entire U.S. financial system. One important question is whether these new powers will

affect the Fed’s traditional role as the independent authority on monetary policy. Although

supervising and regulating systemically important financial institutions is a necessary task,

it is also a formidable one. A legitimate concern is that additional powers and

responsibilities will dilute the key mission of the Federal Reserve, which is to maintain

overall economic and price stability by controlling the growth of the money supply and

thereby influencing the overall level of interest rates.51 Institutions generally work best

when they focus on a limited set of understandable goals and are held accountable by the

public for achieving those goals. As the number of goals and the lack of clarity increase,

effectiveness and performance generally decline. By giving the Fed the responsibility for

supervising firms classified as Tier I FHCs and then giving it broad responsibility for their

stability and impact on the economy, the proposed plan would greatly expand the goals of

the Fed.

51 John B. Taylor. Monetary Policy and systemic Risk Regulation, testimony before the Subcommittee on Domestic Monetary Policy and Technology of the U.S. House of Representatives’ Committee on Financial Services on (July 9, 2009).

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Aside from the broad expansion of the Fed’s authority, subjecting the central bank to

the influence of the politically accountable financial regulators who make up the Council is

worrisome. There is a good rationale for an independent monetary authority; it provides a

shield from political interference and helps prevent giving too great a focus to the short run

at the expense of the long run.52 International comparisons have shown that independent

monetary authorities deliver better economic performance.53

Granted, limits on the authority of the Council prevent it from obligating the Fed to

implement the specific regulations the Council recommends. However, the Council does

have the statutory authority to designate Tier 1 FHC’s, which the Fed is required to

supervise. Although the Feds powers over monetary policy are separate and distinct from

its new powers as a systemic risk regulator, there are no formal barriers ensuring political

influence will not spread from the Fed’s new regulatory and supervisory function to its

traditional monetary function. Loss of the Fed’s independence regarding monetary policy is

a serious issue, especially in this time of rapidly increasing federal debt and a greatly

expanded Fed balance sheet.

As a practical matter, however, effectively identifying and addressing systemic risks

would seem to require the involvement of the Fed in some capacity, even if not in the lead

role. As the central bank of the United States, the Fed has long been a prominent figure in

the government's responses to financial crises. Indeed, the Federal Reserve was established

by the Congress in 1913 largely as a means of addressing the problem of recurring financial

panics. The Federal Reserve plays such a key role in part because it serves as liquidity

52 Id. 53 Id.

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provider of last resort, a power that has proved critical in financial crises throughout

history. In addition, the Federal Reserve has broad expertise derived from its wide range of

activities, including its role as umbrella supervisor for bank and financial holding

companies and its active monitoring of capital markets in support of its monetary policy

and financial stability objectives.54

Much discussion is still needed regarding what can reasonably be expected from a

macroprudential regime and how expectations, accountability, and authorities can best be

aligned. Important decisions must be made about how the systemic risk regulation function

should be structured and located within the government. Several existing agencies have

data and expertise relevant to this task, so there are a variety of organizational options. In

any structure, however, the scope of authorities and responsibilities must be clearly

specified to ensure accountability.

Conclusion.

The heart of the systemic risk discussion is basically a hypothesis about the inherent

fragility and instability of the financial system and about the possibility of simultaneous

default by many institutions.55 Like many theoretical concepts relating to finance, systemic

risk is not yet fully understood. Indeed, the term “Systemic Risk” itself lacks a precise

definition and the theories for measuring it are imprecise at best. Be that as it may,

mitigating the exposure of our financial system to systemic risk continues the central focus

of our banking system.

54 See footnote 36 55 This is termed “the financial fragility hypothesis” by De Brant and Hartman (2000). See footnote 2.

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Recent financial crises seem to indicate that a macroscopic view of the entire

financial system, accounting for the many interconnections among the largest and most

systemically important market participants, is necessary to effectively prevent future crises.

In an effort to stabilize the financial system and prevent another systemic risk episode, The

United States has created a new systemic risk authority, the Financial Stability Oversight

Council. The Council’s goal is to provide consolidated supervision and heightened

prudential standards for large, interconnected nonbank financial companies and large bank

holding companies. Under the new regulatory framework, the Federal Reserve Board will

play a role in the prevention of systemic risk.

Although the future of the financial system and its regulatory framework cannot be

seen with much certainty, further changes are undeniable. Much like the past few decades,

revolutionary advances seem almost certain to continue, and the U.S. regulatory system,

once again, will have to adapt to the changing environment. Financial crises will continue

to occur, as they have around the world for literally hundreds of years. Nonetheless, taking

adequate steps should help make crises less frequent and less virulent, and should

contribute to a better functioning national and global economy.

systemic risk in the modern financial era - francisco vasallo

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