“Systemically important” firms – those whose failure may harm the U.S. financial system – are now being regulated by the Board of Governors of the Federal Reserve, overseen by the Financial Stability Oversight Council (FSOC). The FSOC can designate U.S. and foreign companies as systemically important and impose limits on their activities.
How will it define and measure "importance" and "risk"? What implications might its rulings have for competition in the financial industry?
Defining systemic importance. The law states that banks with $50 billion or more in assets are systemically important, but the FSOC can similarly designate nonbank financial firms – for example, a large insurance company like AIG. There are no bright-line tests that the FSOC can apply to determine importance. There are some company characteristics, however, that the law allows the FSOC to regulate, including the extent of a company’s relationships with other firms and the amount of leverage it has. Presumably, highly leveraged firms with lots of counterparty exposure would be deemed systemically important.
The new law could end up creating a two-tier financial system, with certain firms being more regulated than others.
Measuring risk. Economic growth requires risk taking; the new reform law, however, aims to prevent financial institutions from placing bets that could destabilize the financial system and impose costs on taxpayers. (The Volcker Rule, for instance, restricts proprietary trading by financial firms.) To determine the type and degree of restrictions necessary, the FSOC is likely to look closely at the structure of systemically important firms – for instance, imposing thresholds on size and complexity. In the course of rule making, the FSOC will also need to evaluate questions about safety (how much do we need, and how much are we willing to pay for it?) and competition.
Implications for competition. The FSOC must determine what sort of advantages new regulation creates for banks’ competitors. That means looking at foreign competitors as well as U.S. rivals that fall outside the oversight of the Federal Reserve and FSOC. Talks are under way about how best to regulate ”important” firms globally, but it is unclear whether an international framework can be applied consistently. A critical challenge for the FSOC is to strike a balance between curbing risk and encouraging innovation. Some economists have predicted that a two-tier financial system will emerge as a result of reform: The firms that are less subject to close regulation will have fewer restrictions on capital and leverage, and possibly on relationships and operations. They could become the focus of risk-taking and financial innovation in the sector while systemically important firms would become more ”utility-like.” ■
James Rosberg, Ph.D., a Vice President in our San Francisco office, advises clients on finance and health care economics.
Steven Saeger, Ph.D., CFA, a Vice President in our Denver office, specializes in banking and financial institutions, valuation, and tax litigation.
From Analysis Group Forum (Winter 2011)