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Monday, November 24, 2014

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A Way Toward Real Reform

ColumnsFor better or worse, our financial markets will be shaped by the nature of financial regulatory reforms under consideration by lawmakers and policymakers around the world.

It is imperative that regulatory reform be the right reform — not a rash response to a crisis, but thoughtful, intelligent reform that will best serve our nation's financial system and the American people. Here are some key ideas that I believe will truly improve the strength and effectiveness of our nation's regulatory system.*

Create a bankruptcy code for large nonbank financial firms to solve the too-big-to-fail problem. In my view, regulatory reform must begin with the recognition that no firm is too big to fail. We must have in place a resolution mechanism for the orderly failure of large and interconnected financial institutions that will address systemic risk without requiring taxpayer support. I believe this can best be accomplished by amending our bankruptcy code rather than by expanding the bank resolution process under the FDIC Improvement Act (FDICIA) to nonbank financial firms. The goal must be a system that ensures that managers, owners, and creditors all know that a firm on the verge of failure will, in fact, be allowed to fail. In addition, to foster market discipline and reduce moral hazard, we must also limit regulatory discretion and the potential for political interference. In my view, an amended bankruptcy code could accomplish these goals.

Clarify the Federal Reserve's umbrella supervision role for financial holding companies. To reduce regulatory burdens, current law requires the Fed to rely on the functional regulator for information about holding company subsidiaries. I believe Congress should clarify that the Fed has umbrella supervisory powers and the responsibility to exercise them. Under the Gramm-Leach-Bliley Act, the Fed has authority to examine and take action against any financial holding company subsidiary that may pose a material risk to the financial safety and soundness of an insured depository affiliate or the payment system. Clarifying the Fed's umbrella supervisory role would encourage regulators to work together to examine systemic risks of consolidated financial organizations. This thorough review of each firm would help the Fed in its macro-prudential mission to help ensure financial stability and the integrity of the payment system.

Require a semi-annual Financial Stability Report for Congress and the public. Similar to the Fed's Monetary Policy Report to the Congress, which is required under the Federal Reserve Act, this report would improve the transparency and accountability of the Fed's financial oversight responsibilities, which would help ensure public trust and credibility.

Integrate market discipline into our regulatory structure. Rather than relying solely on more regulations, we need regulations that would strengthen market discipline. For instance, rather than simply raising capital requirements, regulators should require financial firms to hold contingent capital in the form of convertible debt that would convert into equity in periods of financial stress. Contingent capital would be less costly than simply raising capital requirements and would thus reduce incentives for financial firms to evade the regulation. Perhaps most important, it would also reduce the necessity of government rescues and bailouts. Moreover, the market price of such debt would provide regulators with a signal about the health of the firm and the market's perception of risk. These steps, which regulators could impose without legislation, would strengthen market discipline and improve financial stability.

These are a few of the ideas I have discussed in the past year. They would not require massive restructuring of our regulatory agencies or the creation of new bureaucracies. More important, they would truly reduce the probability of a future crisis.


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