The Reduction of Systemic Risk in the United States Financial System
Scott, Hal S., Harvard Journal of Law & Public Policy
I. SYSTEMIC RISK REDUCTION: THE CENTRAL PROBLEM II. CAPITAL REQUIREMENTS A. CCMR Recommendations Aligned with the White Paper B. CCMR Recommendations That Differ from the White Paper and Pending Legislation: How Much and What Type of Capital 1. How Much Capital: Regulation and Markets 2. What Counts as Capital? III. CLEARINGHOUSES AND EXCHANGES FOR DERIVATIVES A. The Ability of the Clearinghouse to Reduce Counterparty Risk 1. Customized or Illiquid Contracts 2. Contracts Involving Nonparticipants in the Clearinghouse B. The Optimal Number and Scope of Clearinghouses C. Ownership of Clearinghouses D. Collection and Publication of Data E. Exchange Trading F. The International Dimension IV. RESOLUTION PROCEDURES A. The Importance of Resolution Procedures. B. What Institutions Should be Subject to Special Resolution Procedures? C. Imposition of Losses under Special Resolution Procedures D. Funding the Cost of New Procedures E. The International Dimension V. EMERGENCY FEDERAL RESERVE LENDING VI. REGULATORY REORGANIZATION A. Regulation of Systemic Risk B. Supervisory Authority C. International Developments CONCLUSION
This Article concentrates on the central problem for financial regulation that has emerged from the 2007-2009 financial crisis--the prevention of systemic risk. The discussion largely focuses on the relevant recommendations of the Committee on Capital Markets Regulation (CCMR) in its May 2009 report. (1) Where appropriate, the Article compares the CCMR recommendations to those of the United States Treasury in its June 2009 report (2) and its suggested implementing legislation, and also to pending congressional legislation. (3)
The CCMR is an independent, nonpartisan research organization founded in 2005 to improve the regulation of United States capital markets. (4) "Thirty leaders from the investor community, business, finance, law, accounting, and academia comprise the CCMR's membership." (5) Its "co-chairs are Glenn Hubbard, Dean of Columbia Business School, and John Thornton, Chairman of the Brookings Institution." (6) The Author of this Article is the Director.
I. SYSTEMIC RISK REDUCTION: THE CENTRAL PROBLEM
Going forward, the central problem for financial regulation (defined as the prescription of rules, as distinct from supervision or risk assessment) is to reduce systemic risk. Systemic risk is the risk that the failure of one significant financial institution can cause or significantly contribute to the failure of other significant financial institutions as a result of their linkages to each other. Systemic risk can also be defined to include the possibility that one exogenous shock may simultaneously cause or contribute to the failure of multiple significant financial institutions. This Article focuses on the former definition because proper regulation could have the greatest potential to reduce systemic risk in this area. (7)
There are four principal linkages that can result in a chain reaction of failures. First, there are interbank deposits, whether from loans or from correspondent accounts used to process payments. These accounts were the major concern when Continental Illinois Bank almost failed in the mid-1980s. (8) Continental held sizable deposits of other banks; in many cases, the amount of the deposits substantially exceeded the capital of the depositor banks. These banks generally held such sizable deposits because they cleared payments, such as checks or wire transfers, through Continental. If Continental had failed, those banks would have failed as well. Section 308 of the FDIC Improvement Act of 1991 gives the Federal Reserve Board powers to deal with this problem. (9) The Act permits the Board to limit the credit extended by an insured depository institution to another depository institution. …