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Friday, August 1, 2014

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SRC Insights: Fourth Quarter 2008

Supervision Spotlight: Financial Crisis Spurs Extraordinary Response and Hastens Regulatory Reform

The turmoil that has rocked the U.S. financial system and set off global shockwaves has set the stage for a period of profound change that will transform the financial landscape in ways that were, until recently, unimaginable. Wall Street stalwarts that were seemingly unassailable have either vanished or been assimilated into other entities, the market's acceptance of the investment bank model is diminished, and we have seen government intervention in the financial markets on a scale unprecedented since the Great Depression.

Although we don't have a clear picture of what the financial landscape will ultimately look like, one thing is certain: the pendulum has swung decidedly in the direction of more regulation. This regulation will likely focus on making the financial system less vulnerable and increasing market transparency, especially with regard to the innovations—hedge funds, off-balance sheet entities, credit default swaps, etc.—that were lightly or unregulated and contributed heavily to the crisis of confidence that is reshaping our financial markets.

The deepening of the financial crisis over this past summer and early fall led to the passage of the Emergency Economic Stability Act, or EESA, which provided new tools to help stabilize the markets, rekindle lending, and restore confidence in the financial system. A key provision of EESA authorized the Troubled Asset Relief Plan, or TARP, which allows the Treasury to inject capital directly into the banking system by purchasing up to $250 billion in senior preferred shares of qualifying banks and thrifts. While there are no stipulated restrictions on how participating banks may use the funds, the ostensible goal of the program is to increase the amount of credit available to U.S. households and businesses. Participating banks must also agree to adopt the Treasury's standards on executive pay and corporate governance. A number of Third District institutions have expressed an interest in the program, which is open to institutions of all sizes.

The FDIC, meanwhile, is using its existing powers to complement the Treasury's capital relief efforts through a new program that will guarantee senior unsecured debt issued between October 14, 2008, and June 30, 2009, for a period of three years for all FDIC-insured institutions and their holding companies.

In addition to the tools provided under EESA and TARP, the Federal Reserve continues to implement other measures to ease pressures and promote market liquidity through its existing authority. Most recently, the Federal Reserve has introduced three temporary lending programs designed to enhance money fund and money market liquidity. These include the ABCP Money Market Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), and the Money Market Investor Funding Facility (MMIFF). The AMLF allows institutions to finance purchases of high quality, asset-backed commercial paper from money market mutual funds. Under the CPFF, the Federal Reserve Bank of New York will finance the purchase of unsecured and asset-backed commercial paper from eligible issuers through primary dealers. Under the MMIFF, the Federal Reserve Bank of New York will extend loans to five private sector special purpose vehicles to finance the purchase of eligible assets, such as large bank CDs, bank notes, and commercial paper, from eligible investors.

The dramatic events that have unfolded in recent months have underscored in the minds of many the need to revise and reform the U.S. financial regulatory structure for the 21st century. The existing regulatory structure is highly complex and reflects its evolution over the past seven decades in response to financial crises, industry practices, regulatory gaps, and various attempts to modernize the financial system. It has often been described as a regulatory patchwork that comprises numerous regulators at the federal and state level, some with overlapping responsibilities and some in direct competition with each other. Its ad hoc nature has created disparities in how different entities involved in similar activities are regulated, with some being heavily regulated, while others are either lightly regulated or not regulated at all.

Most observers agree that the U.S.'s current regulatory structure is suboptimal and has not kept pace with industry practices and marketplace innovations over the past several years. Some argue that it has not successfully accommodated the changes in financial markets resulting from the interconnectedness brought about by increased globalization and the rise of large financial services conglomerates involved in a broad range of financial services.1

Congressional leaders have recently declared their intention to overhaul the financial regulatory system in the coming year, and Treasury Secretary Paulson has urged Congress to move forward with implementing the Treasury's vision for a comprehensive, new regulatory system, "Blueprint for a Modernized Financial Regulatory Structure."2 The Treasury's blueprint would streamline the existing structure by creating three distinct regulatory bodies whose responsibilities are determined by the regulatory objectives of market stability, prudential regulation, and consumer protection.

While we don't know how much, if any, of the blueprint lawmakers may choose to use as a framework, some broad themes are emerging. The crisis has made evident that we face considerable challenges in predicting market conditions with a high degree of confidence. Any new regulatory framework should be agile enough to give regulators the flexibility they need to adapt to industry practices and respond effectively to market developments. The crisis has also made apparent that capital and liquidity rules need to be strengthened and consumer protections enhanced. New regulation may also attempt to level the playing field to ensure that entities engaged in similar activities will be regulated similarly.

Going forward, there will be more emphasis on sound corporate governance and risk management practices, especially with regard to the measurement and management of firmwide risks. Some have even suggested that the supervisory focus should shift from institutional health to systemic risk. That is, supervisors should assess the practices of institutions based on how practices affect the health of the financial system as a whole, rather than just the health of a specific institution.3 Other areas of focus may include accounting conventions that result in shifting off-balance sheet entities to on-balance sheet status, measures to better understand and manage complex financial instruments, and the formation of a clearinghouse for over-the-counter derivatives. Regulators and lawmakers will almost certainly continue the debate on how to incorporate much needed transparency into the financial system in a way that still allows for innovation and does not hinder competition.

Our nation's leaders have indicated that the road ahead is likely to be long and difficult, and much work remains. But history has shown that even in the most challenging periods, the financial system ultimately recovers and emerges stronger and more resilient than before.

For more information on EESA and TARP, including on how these programs will be administered, go to the U.S. Department of Treasury Exterior Link website. For more information on the Federal Reserve's money fund and money market lending facilities and other lending facilities, go to the Federal Reserve Bank of New York Exterior Link website.

  • 1   "The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace," Deloitte Exterior Link PDF Icon, October 6, 2008.
  • 2   Available online at the U.S. Treasury Exterior Link PDF Icon website.
  • 3   Summers, Lawrence, "Six Principles for a New Regulatory Order," Financial Times Exterior Link, June 1, 2008.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.