Systemic Risk: How Washington Intends to Address Regulatory Reform

With the nation’s attention squarely focused on financial markets reform, Congress has also focused their efforts on repairing a seemingly flawed system. Both the Chairman of the House Financial Services Committee, Rep. Barney Frank (D-MA), and the Chairman of the Senate Banking Committee, Sen. Chris Dodd (D-CT), have identified major regulatory reform as a key priority for their committees. Recently, Treasury Department Secretary Timothy Geithner sent legislative language to Capitol Hill that would allow the Federal Reserve Board (the Fed) to take the lead in determining which institutions pose a systemic risk while the Federal Deposit Insurance Corporation (FDIC) would handle resolution duties.

Acknowledging that the past 18 months has been tumultuous for our nation’s capital markets, the Secretary of the Treasury has attempted to craft a framework for major regulatory reform that provides new rules and focuses on containing systemic risk. This plan endeavors to provide stronger tools to prevent and manage future crises while simultaneously rebuilding confidence in the basic integrity of our financial system. The Treasury Department says that it wants to give "a single entity the ability to supervise, examine, and set prudential requirements for these critical parts of our financial system."

The new plan includes provisions to regulate hedge funds, create a central clearinghouse for derivatives transactions and add new oversight for money market mutual funds to reduce risk. Additionally, this new regulatory plan would require banks to set aside extra reserves during periods of economic boom to create a cushion for periods of economic slumps. Finally, Treasury’s program also includes the creation of a mechanism to seize and dismantle large institutions whose failure threatens the nation’s financial stability.

The four major components of this comprehensive regulatory reform are:

1. Addressing Systemic Risk: Consistent and conservative regulation of large interconnected firms and markets to avoid major crises.
2. Protecting Consumers and Investors: Providing more transparency and accountability to restore faith in the system.
3. Eliminating Gaps in Our Regulatory Structure: Creating a system where there is clear authority, resources and accountability so that regulation is balanced, effective and meets the needs of the American people.
4. Fostering International Coordination: Creating regulations that keep pace with ever changing global markets and ensuring that U.S. standards are consistent with international rules for financial regulation.

The first priority of the new Treasury financial stability plan is to adequately address systemic risk by creating a single independent regulator with responsibility over systemically important firms and critical payment and settlement systems. During his testimony before the House Financial Services Committee last week, Secretary Geithner attributed some of the current problems to inadequate internal risk management systems, ineffective rating agencies and slow responding regulators who did not address critical behaviors until such behavior had already resulted in catastrophic losses. To respond to this failure, Secretary Geithner is proposing that a new regulator:

• Define a systemically important firm
• Focus on what these institutions do and not the form they take
• Clarify regulatory authority over payment and settlement activities

In general, the first part of the financial stability plan seeks to strengthen prudential oversight for all financial firms regardless of whether they own a depository institution. Conservative and consistent general oversight will allow for more accurate account of the risk that distress of these institutions could impose on our current financial system and the overall economy. Additionally, the current plan not only calls for robust capital requirements for financial firms in order to avert a crisis of this magnitude in the future but, requires that the new systemic regulator impose liquidity, counterparty and credit risk management requirements that are more stringent than ever before. Along with these stricter standards, the financial stability plan allows for a prompt corrective action regime that would allow the regulator to force protective actions as regulatory capital levels decline, similar to the powers of the FDIC with respect to its covered institutions. .

Simultaneously, Secretary Geithner has suggested that all hedge funds and other private pools of capital, including private equity funds and venture capital funds, register with a federal financial regulator. In most instances, that regulator would be the SEC but the plan recognizes that some funds that trade commodity derivatives might fall under the Commodity Futures Trading Commission (CFTC). In addition to registration, the stability plan requires that all registered funds mandate investor and counterparty disclosure, provide information necessary to assess threats to financial stability and share reports with the systemic risk regulator. This is something of a non sequitor. Recent events with Ponzi scheme mastermind Bernard Madoff exposed wide gaps and significant weaknesses in the regulation and enforcement of broker- dealers, investment advisors and the funds they manage, these reforms are attempting to close those gaps.

The financial stability plan proposes a comprehensive framework of oversight, protections and disclosure for the Over-the-Counter (OTC) Derivatives Market. The current financial crisis has been amplified by excessive risk-taking and little transparency which threatened the stability of these products. To respond to need for greater oversight in this area, the recommendations under the plan are:

• To regulate all credit default swaps and OTC derivatives for the first time
• To institute a strong regulatory and supervisory regime
• To clear all contracts through designated central counterparties
• To require that all non-standardized derivatives be subject to robust standards
• To make aggregate data on trading volumes and positions available
• To apply robust eligibility requirements to all market participants

Along with the mandates for greater regulation and supervision also comes a mandate from Treasury for greater disclosure. Under the new plan, regulators will introduce disclosure and suitability requirements where all market participants will be required to meet recordkeeping and reporting requirements.

AFP Position

As the debate around regulatory reform continues to unfold, AFP will monitor the actions of the House and Senate and report back to our members on the specific reforms that directly impact corporate finance and treasury professionals. AFP continues to be a vocal advocate for clear and transparent practices in the regulatory process and we will continue to take that message to legislators as they consider the plans to fix our nation’s capital markets.

AFP fully supports effective regulation and oversight of our nation’s capital markets and we will advocate for disclosure requirements that are responsible and sensible. On behalf of our members, AFP will advocate that proposed regulations do not stymie the ability of businesses to do daily cash management and other necessary transactions.