The Financial Stability Oversight Council, a regulatory authority created by the Dodd-Frank Wall Street Reform and Consumer Protection Act, hopes to put itself into position to intervene when markets seem likely to become unstable.
It is a new force in the markets and the financial economy, and its mission is monitoring to identify systemic risk in the financial system and, where necessary, to intervene to ensure the stability of our nation's financial system.
The council will coordinate the activity of various federal financial and economic regulatory authorities — from the Securities and Exchange Commission to the Federal Reserve System to the Federal Deposit Insurance Corp. It is designed to strengthen the existing financial regulatory framework that “focused regulators narrowly on individual institutions and markets, which allowed supervisory gaps to grow and regulatory inconsistencies to emerge — in turn, allowing arbitrage and weakened standards,” according to a statement of the Department of the Treasury, whose secretary chairs the new authority.
The goal of making regulation more effective by eliminating regulatory arbitrage and filling supervisory gaps is a laudable one, but there are a number of dangers.
First, there is the danger that the FSOC has been handed too big a task — nothing less than identifying and preventing future financial crises — and that its rules, regulations and operations will choke innovation and efficiency in the U.S. financial markets. Another danger is that the existence of the FSOC might encourage complacency among institutions: They might relax their internal controls, assuming the council will keep systemic risks in check and provide warnings when danger threatens.
The FSOC's sweeping mandate has never been fulfilled in a market economy, and the government has had a mediocre track record in achieving ambitious systemic objectives.
For example, the Federal Reserve System, whose chairman is a member of the FSOC, failed to see the risks building in the system from a surge in mortgage lending and its own interest-rate policies that led to the financial market crisis.
And decades earlier, the Fed's mistaken policy of allowing the money supply to contract by 25% contributed to the Great Depression of the 1930s. In addition, the Fed has had trouble fulfilling its mission to use monetary policy to maintain full employment and stable prices, as shown by the double-digit inflation and interest rates of the 1970s and 1980s, and the current double-digit unemployment rate.
The SEC, whose chairman is also an FSOC member, has often failed in its mission to protect investors from investment management fraud. It failed to catch the Madoff Ponzi scheme, or investment consulting abuses. Its failures as an investor advocate are underscored by its need to create recently the Office of Investor Education and Advocacy.
Besides regulatory coordination, the FSOC has a duty to facilitate the sharing of data and information among the member agencies, and to collect any additional information that is needed.
While the FSOC will open its meetings to the public whenever possible, it plans to conduct much of its information collection and discussion in secret, in part because of the sensitivity of the proprietary information it expects to receive from hedge funds, other private investors, banks and other financial institutions. Revealing some of the information could be destabilizing.
However, the FSOC should make its activities and information — as well as models and other analytical tools — as transparent as possible. It should encourage better risk management practices and investment activities like financial arbitrage that bring equilibrium or balance to the financial system of competing interests.
The process of gathering this new information has begun. On Jan. 25, the SEC proposed a new extensive reporting requirement for hedge fund, private equity and other private fund mangers for new disclosures on a new form PF to assist the FSOC.
The FSOC analysis of emerging risks and its response to them apparently will be built on financial models. The details of those models should be made public, as well as how they describe the dynamics of the financial system and identify emerging risks. The transparency also should include the reasons some variables were included while others were excluded.
Institutional investors ought to have the opportunity to test the FSOC models and suggest modifications, and even incorporate them in their own risk management. Most fundamentally, the FSOC should reveal what benchmarks it will use.
Making information about the models and the inputs available to the institutions will encourage them to adopt similar models and likely will reduce the danger that they will relax their internal risk controls.