How will regulators deal with firms deemed "too big to fail"?
FINANCIAL CRISIS
FED'S RESPONSE
ECONOMIC RECOVERY
REGULATORY REFORM
Identify and regulate systemically important institutions
The mission of the FSOC, a council of key regulators, is to identify
systemically important institutions. These are the largest and most
interconnected financial companies whose failure would threaten the health
of other firms, the financial system as a whole, or the broader economy.
Systemically important firms will be supervised by the Federal Reserve,
which has broad regulatory powers to guard against overly risky behavior. In
the past, the fragmented structure of regulation sometimes allowed problems
to grow unchecked. The goal is to prevent catastrophic failures and make
costly rescues unnecessary, such as that of insurance giant AIG, whose
connections with financial institutions around the world threatened
disastrous ripple effects.
References:
Brief Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act,
United States Senate Committee on Banking, Housing and Urban Affairs, July 1,
2010.
Regulating Systemic Risk, speech by Daniel K. Tarullo, Governor, Federal Reserve
Board of Governors, at the 2011 Credit Markets Symposium, Charlotte, North Carolina, March 31, 2011.
Limit destabilizing failures
To reduce the potential systemic threat to the financial system and broader
economy, the legislation requires larger and more interconnected firms to
hold more shareholder capital as a buffer against losses. The so-called
Volcker rule restricts the extent to which banks can use federally insured
funds for speculative trading and other risky investments. The new law also
shifts many complex financial instruments called derivatives onto open
exchanges rather than being privately negotiated between trading partners.
This makes such transactions more transparent to market participants and
regulators and provides greater assurance that contracts will be honored even
if a counterparty fails. Finally, the reform restricts the Federal Reserve's
ability to bail out individual institutions. This signals to financial companies
and their shareholders and creditors that they will bear the cost of risks that
lead to big losses.
References:
Brief Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act
, United States Senate Committee on Banking, Housing and Urban Affairs, July 1,
2010.
Financial Stability Oversight Council, speech by J. Nellie Liang, Director, Office of Financial Stability Policy and Research, before the Subcommittee
on Oversight and Investigations, Committee on Financial Services, U.S. House of Representatives, Washington, D.C., April 14, 2011.
Create an orderly resolution process
During the financial crisis, federal regulators lacked the tools to close large,
failing financial institutions that weren't banks or thrifts in ways that
protected the financial system. Regulators now have new authority to take
over and close failing nonbank financial institutions in the same way the
FDIC can take over failing banks. The reform act also requires that firms
create "living wills" or "funeral plans," which explain how they could be
shut down in a rapid and orderly way if they fail. If an institution cannot
come up with a credible plan, it will face financial penalties and constraints
on its activities. This new framework seeks to ensure that failure of a
nonbank financial institution doesn't ignite financial panic, and that
shareholders and creditors, not taxpayers, bear the costs.
References:
GAO, Financial Regulation: Recent Crisis Reaffirms the Need to Overhaul the U.S.
Regulatory System, GAO-09-1049T, Washington, D.C., September 29, 2009.
How Goes the Recovery? Challenges for the Nation, the Region and the Fed Speech
by Fed President Dudley of New York, speech by William C. Dudley, President,
Federal Reserve Bank of New York, remarks at the University at Buffalo, Buffalo, New York, October 27, 2010.
http://www.frbsf.org/econanswers/reform_q2more.htm
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