Securities Industry Regulatory reform and the perils of “too big to fail”
A policy brief by The Regional Bond Dealers Association
The RBDA strongly supports comprehensive financial regulatory reform, including efforts to end the taxpayer bailout of financial institutions viewed as “too big to fail.” Meaningful regulatory reform must address the underlying causes of the financial crisis, such as the use of excessive leverage and inadequate disclosure of risk. An effective regulatory system also must establish barriers to firms ever becoming “too big to fail” and, thus, posing a risk to the financial system. For those firms that do pose such a risk, there must be additional costs of doing business. Regulators must have authority to significantly increase the cost associated with being too big to fail in order to negate the competitive advantage that label has provided firms in the past and to ensure that taxpayers are not held accountable for the risks such firms pose to the economy.
Importantly, regulatory reform must ensure that large institutions receive neither explicit nor implicit protection from the federal government. The financial system cannot operate efficiently if financial institutions and investors assume that the government will protect certain firms from the consequences of poor management. A regulatory structure that provides special treatment for specified large firms signals to the markets that the government will not let such firms fail and merely results in perpetuation of the too big to fail doctrine. Treating firms as too big to fail reduces market discipline and encourages excessive risk taking. It also provides an artificial incentive for firms to grow, in order to be perceived as too big to fail. Moreover, treating firms as too big to fail creates an uneven playing field with smaller firms, which do not have implicit government support.
II. Regulatory reform–ENDING TOO BIG TO FAIL
The lack of a clear policy regarding the treatment of large, systemic risk financial institutions lies at the center of the current financial crisis. The current regulatory framework permitted the explosive growth of large, highly leveraged financial firms over the past decade. The markets funded these firms at rates that implied they were simply too big to fail. That perception proved largely correct during the latest financial crisis as the federal government stepped in and provided funding to nearly all those firms viewed as posing a systemic risk in an effort to stave off the complete meltdown of the financial system.
As part of regulatory reform, Congress must address the gaps in the existing regulatory framework that allowed these firms to grow unchecked to the point where their failure jeopardized the health of the markets. In addition to improved oversight and transparency, Congress must create a system that provides incentives for sound management practices and imposes costs for engaging in the types of activities that contributed to the financial crisis. Specifically, Congress must establish a regulatory system that discourages firms from becoming too big to fail and imposes meaningful costs on those large firms that do pose a systemic risk to the economy.
Preventing Too Big To Fail Firms
An effective regulatory regime must not only address the dangers posed by existing systemic risk firms, it also must eliminate the regulatory gaps that allowed firms to become too big to fail in the first place. Thus, financial firms should be subject to progressively stricter oversight and regulation as they get larger or engage in riskier activities. Stricter regulation must include heightened capital requirements and increased transparency:
Increased Capital Requirements.
- As a firm grows larger and presents a heightened risk to the financial system, there should be a corresponding increase to the firm’s capital requirements. Subjecting firms to stricter capital requirements as they get larger would discourage firms from ever becoming too big to fail.
- In addition, leverage ratios and capital requirements also should be weighted according to the products a firm trades or the positions a firm takes. Thus, activities that involve heightened risk should be subject to enhanced capital requirements.
- Imposing more stringent capital rules and liquidity standards as a firm grows larger or engages in riskier activities or products would reduce the probability that financial firms experience financial distress, either through capital depletion or a run by creditors.
Increased reporting and disclosure requirements.
- The lack of transparency regarding positions in complex and risky products such as mortgage-backed securities and credit default swaps was a key source of uncertainty during the financial crisis since market participants could not easily tell which firms were burdened by toxic assets.
- Regulatory reform must provide for greater transparency that is based on the extent to which a firm’s products or positions present a risk to the financial system.
- For example, transparency would improve if firms were required to disclose the amount of mortgage-backed securities in their inventory, as well as the ratings of such securities.
- Similarly, requiring firms to list their top ten counterparties on swap transactions would reveal the extent to which a firm’s risk is interconnected with other firms in the market.
Eliminate the Advantage of Too Big To Fail Firms
While the focus of regulatory reform should be ensuring that firms do not become a risk to the system, there is no question that such firms already exist and other firms will undoubtedly present such a risk in the future, despite the best efforts of regulators. Thus, Congress must take this opportunity to articulate a clear policy against the too big to fail doctrine to ensure that large institutions receive neither explicit nor implicit protection from the federal government. Furthermore, Congress must provide regulators with the authority to impose significant costs on large, systemic risk firms that outweigh the benefits such firms have received in the past from the implicit government protection. Specifically, for any large firm that presents a systemic risk, the regulators must have authority:
- To require such firms to hold larger capital and liquidity buffers that mirror the heightened risk such firms pose to the financial system. The capital and liquidity requirements should be set at such a level that the firm has an incentive to shrink, simplify, and reduce its leverage or activities so that it is no longer treated as posing a systemic risk.
- To take necessary action to reduce the firm’s overall risk exposure.
Congress must take advantage of this opportunity to address the weaknesses in the existing regulatory system that contributed to the most significant financial crisis in decades. Congress’s top priority must be to articulate a clear policy against the taxpayer bailout of large financial institutions. Thus, financial reform legislation must impose meaningful costs of doing business for any large firm that pose a risk to the financial system so that such firms do not obtain a competitive advantage from an implicit federal guarantee. The financial system will only operate efficiently if large firms, rather than taxpayers, are held accountable for the consequences of poor management and risky behavior.