Will We See the Next Emerging Crisis in Time to Stop It?

June 21, 2010

A much-noted feature of the recent financial crisis is that none of the Federal regulatory agencies saw it coming. They could only respond to minimize the damage after it happened – at enormous cost.

One reason for the lack of prescience is that many of the large firms that over-exposed themselves and had to be rescued because they were “too big to fail” (henceforth TBTF) were not regulated by the agencies, and therefore were not on any early-warning radar screens. The agencies focused on firms under their legal jurisdiction; what happened outside their box was for someone else to worry about.


This is one problem addressed by the Senate’s Financial Stability Act of 2010, which is now in the hopper. The major purposes of the Bill are to end TBTF, to end taxpayer-financed bailouts, and to protect consumers from abusive financial practices. There are an enormous number of potential means to these ends, and the Bill includes enough of them to comprise a mammoth piece of legislation, weighing in at 1336 pages. At this writing it had yet to be reconciled with a House version that is similar but not identical.

One important provision of the Bill, which is the subject of this article, is a mechanism for identifying and fixing emerging systemic problems before they result in a crisis. It would do this by creating a Financial Stability Oversight Council that would be responsible for identifying TBTF firms that posed potential systemic risks, and imposing or augmenting regulatory restraints on such firms. The council consists of the heads of 8 Federal agencies plus an outsider with expertise in insurance – there is no Federal regulator of insurance

While all 8 members can vote, the Secretary of the Treasury and the Chairman of the Federal Reserve Board will have special powers. A new Office of Financial Research, designed as the intelligence arm of the council, is placed in the Treasury Department. The Fed is the designated regulator, which includes the power to examine any nonbank firm (including foreign firms) that the council deems to be a potential systemic risk, and to impose prudential standards such as capital requirements on such a firm.

The Council is not designed as a mechanism for dealing with an on-going financial crisis. Recent experience showed very clearly that to turn back a crisis that is underway, critically-important decisions have to be made within a few days, and sometime within a few hours,  which is possible only if there are very few decision-makers who have to agree. On this topic, I strongly recommend David Wessel’s book “In Fed We Trust”, which is a behind-the-scenes look at how decisions were made during the crisis.

In contrast, the proposed Council is a deliberative body which will not have the capacity to move fast. Any actions taken by the council must be passed by a 2/3 vote including an affirmative vote by the chairman, who is the Secretary of the Treasury. The process of identifying firms that are potential systemic risks and placing them under regulation is subject to time-consuming procedural rules, including the right of the designated firm to appeal. These rules are designed to protect the firm against arbitrary or hasty actions to place them under regulation, but this means that the process can take several months or more.

The upshot is that the council, to do its job, must identify emerging systemic risks, and take effective regulatory actions early enough to prevent systemic damage. There is nothing in the history of regulation that instills confidence that it will be successful.

Bank regulators often fail to identify and fix serious problems in banks under their legal jurisdiction, operating in an industry they are completely familiar with, and in possession of an array of regulatory tools. There is no reason we should expect that a committee of regulators will identify and fix serious problems in a firm that is in an industry they may not understand, and where they may have to justify imposing regulatory constraints in court.

I think the process would have a much greater chance of success if authority was centralized in the Federal Reserve. The committee approach is designed to avoid undue concentration of power in the Fed, following the substantial enlargement of its powers during the crisis. But the powers exercised by the Fed during the crisis were thrust on it by the urgent need for support that only the Fed could provide. The cost in bad PR was high and their independence from political meddling, which is highly prized, was jeopardized. The Fed does not want to have to do that again, and that is the best possible motivation for them to identify and sterilize systemic threats before they can develop into crises. A committee of regulators has no such motivation and may well get in the way.

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