Regulators in the Era of Systemic Risk — Potential Solution or Part of the Problem?

Since passage of the Dodd-Frank Act, Congress has generally looked to regulators to implement the myriad of regulations that purportedly will make the U.S financial system safer, sounder, and, thus, less susceptible to risk. But very little of the conversation has focused on what can reasonably be expected of regulators who must oversee an increasingly complex web of market interconnectedness and systemic-risk implications.

Not everyone is convinced that regulators are capable of reining in risk or devising systems to prevent the types of activities that contributed to the meltdown that started in 2007, particularly given their inadequate financial and staff resources. Moreover, some even question whether delegation of such authority to regulators provides a false sense of security to the markets and investing public that things are now “under control.”

At the recent CFA Institute Global Investment Risk Symposium, a panel of well-known experts — Brooksley Born, Richard Herring, and William Poole — discussed systemic risk and the current state of the industry and concluded that not all is well, yet. While several remaining sources of systemic vulnerabilities were discussed, one area in particular focused on the trust being placed in regulators to fashion and implement regulations that will shore up a U.S. financial marketplace. 

How Regulators Will Treat “Too Big to Fail” and Systemically Important Financial Institutions

Even with certain mandates under Dodd-Frank directives, the manner in which it considers how regulators react to future market developments still leave questions unanswered. One hotly debated topic in the industry is whether the Dodd-Frank Act effectively eliminates too big to fail and government bailouts, which led the symposium panel to question regulators’ abilities to walk away from rescuing certain institutions whose failure could severely affect the recovering economy.

The Dodd-Frank Act also is credited with reining in risk by imposing higher capital requirements and supervisory oversight responsibilities on those designated to be systemically important financial institutions (SIFIs). However, the SIFI designation may give people too much confidence that we’ve solved the problem and that “markets must think so,” given that the largest institutions pre-Dodd-Frank have grown even larger. One panelist even cautioned that the heightened supervision accompanying a SIFI designation is done by regulators that did a “dreadful” job in the past.

Pressures Endemic to the Regulatory System

And let’s not forget a regulatory system that is still fed by political appointments, special interest lobbying efforts, and a range of biases to the degree where it may be impossible to move impartially at all times. Discussions turned to the inevitability that over time regulatory procedures will be influenced heavily by the interplay of appointments, campaign contributions, and provisions that get “slipped into” financial legislation due to lobbying efforts. One panelist, who served on the independent Financial Crisis Inquiry Commission (FCIC), recounted how the FCIC provided the U.S. Department of Justice with a list of referrals relating to companies that had clearly violated the law, only to be met with deafening silence in terms of the number of Department of Justice actions brought as a result.

Moreover, the enormity of the task and the interconnectedness and complexity of the markets raises the question about whether it’s too much to ask regulators to bear responsibility for attesting to the soundness and safety of our markets.  During the last crisis, regulators often appeared to not know what was going on. For example, banking supervisors didn’t declare there was a problem in the bank holding companies until they were on the verge of collapse, and the then-chairman of the U.S. Securities and Exchange Commission (SEC) said that the capital of Bear Stearns was adequate right before it collapsed.

One may wonder who is keeping an eye on the regulators and the regulatory system as the U.S. financial marketplace tries to find a more stable and less risky way of doing business. Perhaps someone should question the undisputed faith many place in regulators that, because they are armed with new regulations, now will get it right.

The CFA Institute co-sponsored Systemic Risk Council (SRC, of which Ms. Born and Mr. Herring are members) can be viewed as one response. Created in part out of concern that the Financial Stability Oversight Council (FSOC) and Office of Financial Research (OFR) are not sufficiently active and doing their jobs to identify and mitigate risk, the SRC has served as a reasoned voice to bring additional attention to areas where regulators are trying to “get it right.” Through commentary, comment letters, conferences, and meetings, the SRC has weighed in on salient issues, including bank capital and liquidity requirements, money market fund reform, adequate funding for the U.S. Commodity Futures Trading Commission (CFTC) and SEC, whether the Dodd-Frank Act has adequately addressed too big to fail, and improving financial regulation.

Perhaps new regulations and increased regulatory oversight are significant steps toward a sounder and safer U.S. financial marketplace. But expecting regulators alone to patch a system this complex and challenging may be unrealistic and unfair. Instead, independent voices must continue to question the effectiveness of our regulatory approaches and the reasonableness of proposed regulations, while the investing public and marketplace look closely at market-based solutions and work together to realize realistic long-term goals.

Photo credit: iStockphoto/steinphoto