Treasury’s Outline for Systemic Risk Legislation

An interesting subject came up in a NY Times interview with CIT chief executive Jeffrey Peek last week. After discussing the lending firm’s collapse in detail, the author Joe Nocera wrote:

Perhaps Mr. Peek’s real failing was that he didn’t take enough foolish risks. Although Mr. Peek was a former top Merrill Lynch executive, he didn’t lead CIT into bundling mortgages into toxic derivatives, he didn’t get into credit-default swaps, he didn’t create a trading desk that swung for the fences and he didn’t build a company that was so big that it posed systemic risk. In other words, he acted a little too responsibly. So when CIT’s moment of crisis arrived, the F.D.I.C. looked it over and decided it wasn’t too big to fail. To Mr. Peek’s surprise, it turned out to be too small to save.

The White House’s new proposal for Tier 1 regulatory standards would essentially codify the too big to fail policy. Normally we would think of firms as wanting to avoid stricter regulations, but given a twisted incentive, it is interesting to think about firms trying to get themselves eligible for the higher regulatory standards of Tier 1 firms. CIT is an example.

Companies can design systems to work within regulations. They can figure out ways to pass off costs to consumers if necessary. And if it means bailout protection, why not go for it. Or some may be willing to have their profit margins diminished by the tight regulatory standards in order to get the peace of mind of being too big to fail. In this way the new tiered structure could wind up creating an incentive for some banks to take risks they otherwise wouldn’t to get to the too big to failed status. At the end of the day, CIT would have been better off taking on just a little bit more risk at the end of the day in order to get government protection. Just another in a slew of problems with the Obama Wall Street regulation plan.

Last Wednesday, the White House sent legislation to the Hill via Treasury regarding systemic risk. As expected, it was anchored in the President’s proposal for an alphabet soup-styled Financial Service Oversight Council. The FSOC, chaired by Treasury and consisting of the FED, CFTC, CFPA, FDIC, FHFA, NBS, and SEC, would become the overseer of all things risky in the market. Which is to say they will look at everything but Google’s stock.

The legislation also includes the other things the President outlined last month when he introduced the idea: the designation of certain firms as Tier 1 financial holding companies, who would have higher capital, liquidity, and risk management standards; a requirement that Tier 1 FHCs have a plan for rapid resolution in case the market gets harry again; and comprehensive regulation of securities, derivatives, and other products.

Bill sent to Congress did reveal new information, specifically how the government is planning to define a Tier 1, too interconnected to fail institution. Section 203 says,

“The term ‘Tier 1 financial holding company’ means a United States financial company or a Foreign financial company that is designated by the Board as a Tier 1 financial holding company in accordance with section 6.”

“Section 6” is outlined later on in the legislation and gives broad powers to the FSOC Board:

“The Board, on a non-delegable basis, may designate, by regulation or order, any United States financial company as a United States Tier 1 financial holding company, if it determines that material financial distress at the company could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress based on a consideration of the following criteria:

(i) the amount and nature of the company’s financial assets;
(ii) the amount and types of the company’s liabilities, including the degree of reliance on short-term funding;
(iii) the extent of the company’s off-balance sheet exposures;
(iv) the extent of the company’s transactions and relationships
with other major financial companies;
(v) the company’s importance as a source of credit for households, businesses and State and local governments and as a source of liquidity for the financial system;
(vi) the recommendation, if any, of the Financial Services Oversight Council; and
(vii) any other factors that the Board deems appropriate.

The next section in the legislation goes on to give the FSOC the same power to designate a foreign bank Tier 1 if they have enough operations in the US.

Again, I will continue to argue that this tiered structure, combined with the proposed resolution authority will essentially be codifying the bailout scheme and potentially lead to JP Morgan Mae and Citi Mac.