THE FED´S LEAD ROLE IN FINANCIAL REGULATION / THE FINANCIAL TIMES ( RECOMMENDED READING )

The Fed’s lead role in financial regulation

By Gerald Corrigan

Published: December 9 2009 16:09

In the US, as elsewhere, financial reform efforts are gaining momentum. These have many parts. But the most important initiative is the drive to cope with the related problems of “moral hazard” and “too big to fail.”

Achieving that will require a more rigorous framework of consolidated prudential supervision of large and complex financial institutions and the creation of a well designed system of enhanced resolution authority aimed at the orderly wind-down of troubled large and complex institutions.

A necessary condition in tackling “too big to fail” involves a move toward a more principles-based approach that provides greater room for case-by-case judgment. Consolidated supervisors of large institutions must also direct greater attention to the economic and financial environment these institutions are operating in. In short, although not easy, prudential supervision must focus more attention on potential sources of contagion and systemic risk.

The agenda for supervisory reform is now reasonably clear although the devil is in the details.

The main elements of that agenda include enhanced capital and liquidity standards; greater focus on corporate governance and risk management; more rigorous approaches to stress tests (including so-called reverse stress tests); greater emphasis on financial infrastructure (including practices in OTC derivatives markets); systematic and rigorous examination of extreme contingencies such as “living wills”; and strengthening the alignment between risk appetite, financial performance and compensation practices.

While these and other supervisory initiatives are necessary conditions for containing “too big to fail”, we need a flexible and effective framework for the resolution of seriously troubled large and complex institutions.

Reduced to its basics, the concept of enhanced resolution authority is one that contemplates a statutory and regulatory framework in which an authorised governmental body (or bodies) could take control of a large and complex financial institution that is experiencing serious problems to organise its orderly wind-down such that shareholders are likely to be wiped out, boards and senior managers dismissed and most classes of creditors at risk.

The practicalities of effective resolution are of staggering proportions. There is a risk – however small – that an ill-conceived or [ill]-executed approach to enhanced resolution could create instability. A list of “guiding principles” can help ensure that enhanced resolution authority achieves its objectives.

First, authorising legislation and regulations must not be so rigid as to tie the hands of the government bodies that will administer them.

Second, the responsibility of enhanced resolution authority should not be vested in any single government body.

Third, to the maximum extent possible, this authority should be administered using the open institution approach, which probably means the troubled institution should be placed into a some form of conservatorship allowing it to continue to perform and meet its contractual obligations.

Fourth, to the maximum extent possible, the rights of creditors and existing contractual rights and obligations need to be protected.

Fifth, the effectiveness of enhanced resolution authority pre-supposes that prompt corrective action by supervisory authorities is well established and is working effectively.

Finally, the orderly wind-down of any large institution is a highly complex endeavour that will take patience, skill and effective communication and collaboration with creditors, counterparties and other parties.

The simultaneous design and execution of enhanced prudential supervisory policies and practices and an effective approach to enhanced resolution authority represent a very large and highly complex undertaking.
That being the case, the prospect for success will be strengthened if the Federal Reserve is directly and substantially involved in both of these initiatives including acting as the consolidated prudential supervisor for all systemically important financial institutions.

The Fed – like other regulators – failed to anticipate the contagion and systemic force of the crisis. But the response of the Fed (and the Treasury) to the unfolding events of the crisis was, in my judgment, outstanding.

As the nation’s central bank and the only instrumentality of public policy that literally operates in the financial markets daily, the Fed is uniquely positioned to help reduce the probability of future financial shocks and better contain damage caused by such shocks. Those responsibilities are inherent to the central bank. The Fed, reflecting its heritage, and its broad and deep pool of economists, financial market experts, bank examiners and policy makers is too important and too valuable to be left on the sidelines in our quest for financial and economic stability.

Gerald Corrigan is a managing director at Goldman Sachs and a former president of the New York Federal Reserve

Copyright The Financial Times Limited 2009.