Halfway There on Regulating Systemic Risk

The Department of the Treasury today released five pieces of its proposed overhaul of financial regulations regulatory, including suggested rules for dealing with “large, interconnected financial firms.”

The proposed rules offer the Federal Reserve, which would be charged with limiting systemic risk, a broad array of tools. For example, the Fed could require the divestiture or liquidation of a subsidiary the Fed “determines … poses a significant risk to the Tier 1 financial holding company.” The Fed can even require the financial institution to “take any other action that the Board determines will be better” to limit significant risks. I’m sure that means the Fed can go well beyond eliminating peanuts from the financial institution’s commissary.

But the rules only go halfway to creating a lasting framework for containing systemic risk, and that is because all the powers and rights afforded the Fed are at least equally important to the final heightened reserve requirements that the Fed will assign to systemically risky companies. And the Fed — make that financial regulators worldwide — have absolutely no idea where to set those reserve requirements today.

During a conference call with reporters, I asked Michael Barr, the assistant secretary of the Treasury for financial institutions, about the reserve requirements, and he said the department was not going to build in the exact reserve requirements into the language of the proposed legislation. Instead, Congress would entrust the Fed to set those standards.

Barr also said that research was being done in the U.S. and around the world on what those requirements should be. He said officials who are part of the Basel II accords were continuing to work on the reserve conundrum, for example.

“Capital rules will take some time to develop,” he told me.

I’ll say. It’s going to take a very long time indeed, and the difference between getting those capital rules right and not is the difference between a successful framework for containing systemic risk and a framework that lacks teeth. I just hope they get that half of the equation right.

TREASURY’S PROPOSED LEGISLATION

* title I FSOC 7-22-2009 fnl.pdf
* title II Tier 1 FHCs 7-22-2009 fnl.pdf
* title IX subt E securitization 7-22-2009 fnl.pdf
* title VI BHCA amndts 07-22 fnl.pdf
* title XIII Fed Rsrv Act amndt 7-22-09 fnl.pdf