Three Cheers for Treasury’s Plan for Regulating Systemic Risk

After a rocky start, Treasury Secretary Tim Geithner is getting his sea legs. Prime evidence for this is his release of the Administration’s six part plan for significantly reducing systemic risk in the financial system.

The plan has six key parts:

• The designation of a single independent “systemic risk” regulator
• Higher capital and risk management standards for systemically important financial institutions (SIFIs)
• Registration of all hedge funds above a certain size
• Comprehensive oversight, protection and disclosure for over-the-counter (OTC) derivatives markets
• Enhanced regulation of money market funds (MMFs)
• Prompt resolution authority for near-insolvent SIFIs

There are many lessons to be learned from the current financial and economic crisis, and certainly one of them is that the market alone will not adequately handle systemic risk, or the threat to the financial system posed by the near failure or outright of failure of multiple large, complex financial institutions at or near the same time. We definitely need new and better rules of the road for such institutions, including better ways of handling their financial difficulties than racing over a weekend to find suitable buyers or otherwise guaranteeing much or all of their liabilities. The six elements in the Treasury plan, if enacted into law, should significantly reduce the likelihood of single or multiple failures of SIFIs in the future, as well as the losses to taxpayers for protecting their creditors.

To be sure, there are and will be critics. Some will say we don’t need a single systemic risk regulator, that it is unrealistic to expect that such a regulator could prevent future crises, or that it would be unwise and could discourage innovation if we were to concentrate so much authority in a single regulator. To these lines of attacks there are several answers.

For one thing, even the critics are now likely to concede that special and most likely tougher rules need to be in place to ensure the solvency and liquidity of SIFIs, whose failures can have devastating economy-wide consequences. Once that concession is made, however, then the only question becomes: does it make more sense for a single regulator to set those rules, or to have the rules set by existing multiple regulators? Treasury chose a single regulator presumably because this would reduce the likelihood of inconsistent and possibly conflicting views about the nature of systemic risk and how to regulate it, compared to vesting regulatory authority in a collective body of multiple regulators or ignoring the systemic risk problem altogether. I believe that Treasury made the right call.

As for concentrating too much power in a single agency, the easy response to that is to recognize the enormous scope of the problem: financial institutions posing a systemic risk to the economy ought to be counterbalanced by a government authority with significant authority of its own. After all, we vest enormous authority in the hands of the President to deal with threats to our national security. Why should economic security – when threatened by large privately owned firms – be considered any different? In any event, if Congress fears that the systemic risk regulator will have too much power, then it should exercise its oversight responsibilities to ensure that this authority is being properly exercised.

Will a systemic risk regulator discourage socially useful innovation? Perhaps, but then let’s remember that large financial institutions played a central role in creating and marketing the complex mortgage-backed securities that triggered this most recent crisis. Strong regulatory oversight that cuts down on such socially destructive innovation, or that better cushions large financial institutions from the fallout of such innovation, would be a major improvement over the status quo. Furthermore, it is important to keep in mind that most radical innovations in our economy have been brought to market by start-ups or entrepreneurial firms, not well established large firms. A systemic risk regulator would have no oversight of such smaller, financial firms.

The Treasury plan reflects several additional sound political judgments. First, the plan offers sufficiently detailed objectives to inform the public and the Congress about the Administration’s idea of appropriate reform in this area without getting into the weeds of writing specific legislative language, which will be written by Congress in any event. In this respect, the Treasury’s systemic risk plan is more detailed than its much criticized initial bank rescue plan, which is a good thing. But it is also not so detailed that it locks the Administration into hard and fast positions on the multitude of more technical details – like which agency will be the systemic risk regulator (a topic I address in detail in an accompanying essay, “Regulating Systemic Risk, also released today), or which institutions will qualify for systemic risk regulation – which have to be hammered out through legislative negotiations and/or developed by the systemic risk regulator itself.

Second, Treasury made the wise decision of not rolling out a comprehensive reform plan to fix everything that is wrong in the financial system all at once. Treasury noted that its systemic risk proposals will be followed by proposals dealing with the protection of consumers and investors; eliminating gaps in the regulatory structure (possibly including the identification of Treasury’s preferred choice of systemic risk regulator); and how best to foster international coordination of financial regulation. Each of these subjects is complex in its own right and will require further thought and negotiation.

By offering the systemic risk proposals first, Treasury is putting its weight behind the highest priority right now, how best to keep something like the current disaster from recurring. This is not an issue for the long run, as one might think. Policy makers may soon have to deal with the failure of other large, complex financial institutions, and thus the sooner they have the additional authority to handle such failures in a more orderly fashion, the better. Congress is more likely to provide that authority, hopefully together with other initiatives to address systemic risk, if it has a smaller package of reforms to consider than if confronted with a much larger reform package at the outset. In addition, other countries are rightly most concerned about how to shore up financial regulation to prevent systemic risk, and Treasury’s systemic risk plan sends a strong signal to the rest of the world that the United States shares that view.

Finally, speaking of international coordination, the Treasury’s systemic risk proposals strike the right balance on the sensitive issue of global coordination. Reading between the lines of Treasury’s announcement, the Administration appears to be taking the position that the United States will fix systemic risk on its own, and not wait for some grand international negotiation to resolve the issue, let alone delegate the job to a not-yet-created global regulator. At the same time, however, Treasury is signaling that it will certainly listen to the views of other countries on this subject, and might be open to global deals on such issues as tax havens and money laundering, which clearly require international cooperation. Treasury’s approach should mollify critics from leaders of other countries who are justifiably upset about the fallout from the prior failures in U.S. policies that allowed the subprime lending crisis to mushroom into a financial conflagration.

To be sure, we have a long way to go before Treasury’s systemic risk proposals are enacted into law. But the Administration is certainly off to a good start, which augurs well for the other financial reform proposals to follow.