We Need a New Organization to Handle Systemic Risk

"It was the best of times, it was the worst of times. It was the age of wisdom, it was the age of foolishness." - A Tale of Two Cities, Charles Dickens

This decade's credit bubble, nicely captured.

As policy makers seek to ensure that the financial system never again be exposed to the present level of systemic risk, the battle lines here and in Europe are being drawn as to who will fulfill the role of systemic risk regulator (SRR).

The American position is highly fragmented. The Obama plan perceives the Federal Reserve fulfilling that role, aided somewhat by a council of regulators, the Financial Services Oversight Council (FSOC), whose role would be to identify early the signs of systemic risk and refer their findings to the appropriate regulator for action.

This plan has been met with significant objection as to the role of the Federal Reserve, given that institution's previous inability to identify the enormous systemic risk that built within the financial system and its role in aiding and abetting the formation of a massive housing and credit bubble. Thus, Congressman Barney Frank has come forth with the statement that the FSOC should be the SRR, not the Federal Reserve.

Across the pond, the European Union apparently has begun to move in a different direction completely. Implicitly rejecting a SRR role for the European Central Bank, the EU has drafted plans, apparently reviewed by Reuters, that creates a new organization with powers to coordinate systemic risk identification and response amongst its members, but also to take action itself to curb systemic risk in the event that a local regulator fails to do so.

The weakness of the FSOC as proposed by the administration is that it is a council of regulators without sufficient power and authority of its own. This weakness was seized upon by Paul Volcker yesterday as he answered questions after a speech in Beverly Hills, California. He dismissed the proposed FSOC, saying, "I don't think that [financial institution oversight] can be fulfilled by a conclave of regulators. I do think we need an institution that has clear responsibility for overseeing the financial system." [source: Bloomberg]

It would appear that the EU has come to a similar conclusion, but elected to create and empower a new body for this crucial task. Should the U.S. follow suit in its creation of the FSOC, the question will be how it should be created to adequately track and identify incipient systemic risk and then to take quick and decisive action to prevent that risk from taking down the financial system or requiring trillions of taxpayer dollars as life support.

I tend to believe that a powerless FSOC would be worse than doing nothing at all. It would allow the financial services industry another lobbying source as it pursues aggressive profit-making strategies that ignore, intentionally or otherwise, mounting systemic risk. Moreover, a council of regulators would essentially be a conclave of turf protection, each regulator with its own agenda and reasons for protecting its institutional reputation.

Better would be to create an entirely new organization along the lines of the EU super-watchdog currently being planned. The critical aspects to this new FSOO (Financial Services Oversight Organization), should be:

1. The head of the organization should be an independent director, appointed and confirmed for a 10-year period, who reports to the Secretary of the Treasury, much as the FBI director reports to the Attorney General.
2. The FSOO needs an adequate budget to build a massive database (or what I've described earlier as the "mother of all databases"), run by qualified IT professionals to collect and analyze important financial risk data on as frequent of a basis as possible (e.g., daily data of cash flows as to the collateral underlying asset-backed securities and counterparty information as to financial contracts.
3. The FSOO also needs the power to compel the disclosure of the information it deems important to the monitoring of systemic risk. Without sufficient authority, the FSOO would be a paper tiger as it would be beholden to other regulators for financial information and we've already seen how deficient the current information flow to regulators has been.
4. Finally, the FSOO should be required to inform a special committee of Congress, made up of senior members of the appropriate House and Senate financial committees of any referrals made to regulators for action. This important check and balance should not be overlooked. Should the regulator to whom a referral is made regarding systemic risk not take appropriate action, the FSOO should be empowered to do so if it has previously informed the special committee of the referral.

As Congress works on the concept of a systemic risk regulator, it should review the EU plans in that regard and create a wholly new organization with significant information flow and authority to protect the country by identifying and eliminating early systemic risk.

Comments

[crutis:]

We need to eliminate systemic risk. Anyone with half a brain in the computing field knows that the most robust, resilient large-scale systems are distributed (think google's multiple data centers). Consolidating banking power inherently increases the damage done when the central authority makes a mistake (and boy, they've made some good ones so far). We need to unwind the Federal Reserve and create a truly free banking system. This localizes failures, prevents booms and busts, and most importantly makes the banking system far more immune to political pressure.

Sep 18 12:24 PM