Academic journal article Economic Perspectives

Implementing Dodd-Frank: Identifying and Mitigating Systemic Risk

Academic journal article Economic Perspectives

Implementing Dodd-Frank: Identifying and Mitigating Systemic Risk

Article excerpt

The 2008 financial crisis revealed some basic flaws in our financial system and in our financial regulatory framework. Specifically, the crisis demonstrated that the failure or the material financial distress of some of our largest, most complex firms could pose a threat to the financial stability of the United States.

The crisis also made manifest that the existing framework for government oversight of our major financial firms and our authority for resolving those firms when they get into trouble were suboptimal. Bankruptcy proceedings, which could be quite panic-inducing, and federal government assistance were the only available options for addressing the failures of some of these large, nonbank financial firms.

As a result of these infirmities in our regulatory framework and the imprudent risk-taking of many financial firms, unprecedented government assistance was necessary to support these firms and the broader financial system to prevent an economic catastrophe. Market participants before the crisis assumed there was a nonzero probability that our most colossal firms would receive government assistance if they became troubled. But the actions taken by the federal government during the crisis, although necessary, I think, to prevent the implosion of our financial system and significant damage to the real economy, have certainly solidified this market perception.

So taking on this moral hazard problem, this "too-big-to-fair" problem, and the threats to financial stability that are imposed by our most systemic financial firms are the central goals of the Dodd--Frank Wall Street Reform and Consumer Protection Act and of the Fed's implementation of the act. That will be the focus of my remarks today.

Addressing problems with "systemically important financial institutions" (SIFIs) is a necessary condition to protecting financial stability. However, it is not a sufficient condition. Systemic risk can certainly be generated and propagated outside of our largest financial firms. It can arise in systemic herds, that is, collections of firms that individually may not be systemic but collectively are systemic. Money market mutual funds would be a great example of that. It can arise in common funding patterns across broad financial sectors, and it can arise in collective underestimations of risk by the financial sector broadly during an irrationally exuberant credit boom. So efforts to tamp down on systemic risk need to address the SIFI problem at a minimum, but they also need to pitch themselves quite a bit more broadly.

In this article, I will outline some of the core efforts that the Federal Reserve has been taking to implement the Dodd--Frank Act and some related reforms to improve supervision and regulation of the most systemic firms and also to promote financial stability. I will also discuss some of the key challenges the Fed faces in implementing the act. I'll start by describing some of the work we have been doing as part of the Financial Stability Oversight Council (FSOC) and then rotate pretty quickly to talk about things that we are doing independently.

Work of the Financial Stability Oversight Council

The Dodd--Frank Act created the FSOC principally to help identify and mitigate threats to the financial stability of the United States. We have made some meaningful progress as we have established the organizational structure of the FSOC, and its committee structure was designed to help us get our duties done.

We have also completed a number of studies that were required by the act on some of the important provisions in Dodd--Frank, including the Volcker rule, financial sector concentration limits, risk retention, and the macroeconomic effects of systemic risk regulation. And we are working on additional studies, including one on contingent capital instruments and secured creditor haircuts.

A key task of the FSOC in the coming months will be to finalize its conceptual framework for identifying and designating nonbank financial firms that could pose a threat to financial stability. …

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