The Need for a Systemic Supervisor
Federal Reserve as Systemic Supervisor
Resolution Authority

Forum Policy on Reform and Modernized Financial Sector Supervision

Policymakers in Washington are undertaking an unprecedented examination of our financial supervisory framework. Discussions have begun in earnest about how best to create a 21st-century financial regulatory architecture that is structured to avoid financial crises and keep the U.S. financial system competitive and innovative in the global marketplace. At this time of economic uncertainty, it is more important than ever to ensure that the U.S. capital markets are fully functioning and stable.

The financial sector is the cardiovascular system of the U.S. economy, circulating the essential lifeblood — capital and money — to the businesses, workers, consumers, students, and homebuyers who need it to facilitate their investments. Many Americans rely on competitively priced capital and credit to start or expand a business, buy a home or a car, consume goods and services, or send a child to college.

But we can do better. The current U.S. apparatus of financial supervision is a Depression-era patchwork of legal entity- and product-focused regulatory fiefdoms with overlapping jurisdictions, varying statutory responsibilities and powers and, too often, inconsistent supervisory postures, priorities, and methodologies. These circumstances have led to needless duplication, confusion, regulatory arbitrage, structural imbalances, inefficiency, and waste. The balkanized nature of the current framework also undermines U.S. regulators' ability to ensure institutional and systemic safety and soundness, as amply demonstrated by the scale of the current financial crisis.

To retain its global leadership position, the United States needs a 21st century supervisory framework that ensures safety and soundness; meets the financial needs of American businesses, workers, and investors; ensures consumers and investors are treated fairly; and is efficient, flexible, and responsive to the activities, innovations, and risks of the world's most sophisticated and dynamic capital marketplace.

With these goals in mind, the Forum is of the view that a modern, world-class supervisory framework should be formulated to achieve objectives such as:

• comprehensive and consolidated supervision of financial institutions and of the financial system as a whole;
• significant rationalization, burden reduction, and cost savings by eliminating unnecessary supervisory overlap and duplication;
• the preservation of regulatory specialization and enhancement of consumer and investor protection, as well as the long acknowledged benefits of regulatory competition and innovation;
• improved supervisory cooperation, consistency, and effectiveness — both domestically and internationally;
• a more unified, coherent, and transparent rulemaking process across industry sectors; and,
• a meaningful shift toward principles-based supervision.

The Need for a Systemic Supervisor

Perhaps the most obvious and significant deficiency of our current supervisory framework is that it is highly balkanized, with agencies focused on specific industry sectors — commercial banking, securities firms, and insurance companies.

This stove-piped structure has led to at least two major problems that created the opportunity for, and exacerbated, the current crisis: 1) gaps in oversight naturally develop between the silos of sector-specific regulation; and, 2) no agency is currently charged with assessing risks to the financial system as a whole — the big picture.

A more seamless, consistent, and holistic approach to supervision is necessary to ensure systemic stability and the safety and soundness of all financial entities — and the cornerstone of such a modern framework is a systemic risk supervisor.

What is Systemic Risk?

"Systemic risk" refers to any threat to the stable and efficient functioning of the financial system. Such threats can stem from any number of sources:

• deterioration of a large, interconnected entity;
• problems effecting a collection of smaller institutions;
• rapidly increasing exposures to a particular asset class, like real estate;
• unexpected volatility in key markets;
• pervasive deficiencies in risk management methodologies; or,
• difficulties in the financial system’s clearing and settlement infrastructure.

Purpose of the Systemic Supervisor

A systemic supervisor should perform three essential tasks:

• First, looking out over the entire financial system, the supervisor would continuously monitor, assess, and, if necessary, address any risk that might threaten the stability of the system. Importantly, all three aspects of this role — monitoring, assessing, and addressing systemic risk — would require continuous interaction and cooperation with the functional regulators.

• Indeed, to avoid unnecessary supervisory duplication, and to avail itself of their sector-specific expertise, the systemic supervisor should rely on the functional regulators for examination reports and other relevant regulatory information. As a result, the systemic supervisor would perform a second critical task — helping to coordinate the functional regulators, close regulatory gaps, and promote more unified, consistent, and coherent supervision.

• Third, the systemic supervisor would lead crisis fighting efforts. Combating financial crisis and restoring systemic stability requires the capacity to act swiftly and decisively. For this reason, the systemic supervisor cannot be comprised of a council of regulatory authorities. Financial crises are wars, and wars are not won by committee. A single entity is required — with the authority, resources, and tools to effectively combat financial instability.

Federal Reserve is Best-Suited to Serve as Systemic Supervisor

The Federal Reserve is best suited to serve as the systemic supervisor. Indeed, Congress created the Fed in 1913 in response to another financial crisis – the Panic of 1907.

As the monetary authority and lender-of-last-resort, the Fed has unique tools and powers that enable it to reach into financial markets and alter fundamental conditions. And by way of its enormous balance sheet, the Fed can also, if necessary, become the buyer-of-last-resort for various classes of short-term debt instruments critical to the continued operation of businesses, such as commercial paper and asset-backed securities. No other agency has such tools.

As a result of these unique capabilities, the Fed is the agency most able to effectively combat financial crisis — the authority to which all financial entities and market participants naturally turn in time of crisis.

Moreover, by way of its role as the monetary authority — altering the supply of money by way of open market operations — the Fed has nearly 100 years of institutional experience in the capital markets. No other agency has capital markets experience.

The Fed also brings tremendous institutional experience to bear as the systemic supervisor. It has supervised bank holding companies since 1956, and the Gramm-Leach-Bliley Act of 1999 designated the Fed as the "umbrella supervisor" of financial conglomerates that include banking, securities, and insurance entities. And over the past 18 months, a number of major non-bank financial institutions — Goldman Sachs, Morgan Stanley, American Express, and even GMAC — have become bank holding companies and submitted to consolidated oversight by the Fed.

Finally, the Federal Reserve has unrivalled institutional experience in participating in and managing international harmonization and cooperation efforts, so critical to avoiding future crises and to successfully fighting them if necessary.

Resolution Authority

No institution should be too big to fail. Failure is an all-American concept because the discipline of potential failure is necessary to ensure truly fair and competitive markets.

To ensure that all financial institutions — regardless of size — can fail in an orderly way, Congress must act to provide the legal authority and procedural protocol for seizing and winding down even the largest, most interconnected and complex entities. No federal or state agency currently enjoys such authority.

Models for conglomerate wind-down do exist, including the process stipulated by the Federal Deposit Insurance Act for dealing with failing banks, as well as the framework established for Fannie Mae and Freddie Mac by the Housing and Economic Recovery Act of 2008. The Treasury Department recently released draft legislation that would empower the FDIC to appoint itself as the conservator or receiver of failing diverse financial groups.

Other related and important issues include necessary powers, how the new resolution powers will be coordinated with federal and state functional regulators, and the appropriate means of funding resolution-related activities and expenses. Nevertheless, it is critical that these issues be addressed in the context of providing an effective mechanism for fairly and expeditiously winding down troubled financial institutions posing systemic risk.