IMF Survey: U.S. Proposal to Extend Financial Regulation Breaks New Ground

IMF News, August 18, 2009

Source details

Canonical URL: IMF Survey: U.S. Proposal to Extend Financial Regulation Breaks New Ground

Publication date: August 18, 2009.
Core finding: The U.S. proposal to bring large, systemically important non-bank firms (such as insurance companies and other financial institutions that are not banks) under stronger supervision "breaks new ground," according to the IMF.
Context: The IMF discussed the proposal in a paper issued as part of the Fund’s annual review of the U.S. economy, known as an Article IV consultation, which covers the IMF’s 186 member countries.

Objective: Strengthen monitoring of risk across the financial system and address a critical regulatory gap revealed by the crisis that began with the U.S. subprime mortgage market in mid-2007.
IMF framing:
- “In one sense, the task is to catch up with three decades of financial innovation,” said the IMF on July 31 in the Article IV paper.
- Charles Kramer, chief of the IMF’s North American Division: “Systemic risk and the moral hazard it creates are economic spillovers, like pollution. Environmental policy addresses pollution by regulating it and financial policy should do the same with systemic risk.”
Key IMF emphasis: Force systemically critical firms to control risk taking and moral hazard, and strengthen crisis management.

Proposed change: Introduction of a new category called a Tier I Financial Holding Company (FHC) to be subject to group supervision by the Federal Reserve.
Designation criteria: Based on size, leverage, and interconnectedness in the financial system, to be set out in legislation.
Proposed requirements for designated firms:
- Higher capital and risk management standards.
- A special wind-down mechanism in case a firm fails.
- Preparation of resolution plans in advance.
- Purchase of contingent capital.
IMF assessment: The proposal “contains many bold and innovative suggestions,” and rules should discourage size, leverage, and interconnectedness to properly address moral hazard.

IMF concern: Lack of details in the U.S. administration’s plan on crisis management.
Specific unresolved issues cited by the IMF:
- Which criteria would trigger the special resolution mechanism and for which firms.
- How to mitigate uncertainty regarding which insolvency regime will apply.
- How to ensure that the special resolution mechanism does not reinforce the perception that creditors will be insulated from losses.
Integration: Financial surveillance should be integrated into the broader work of assessing risk across the financial system.
Coverage expansion: The U.S. proposal’s inclusion of broker-dealers, hedge funds, or insurance companies deemed systemic is viewed as a “major improvement over the past.”

Outstanding questions identified by the IMF:
- Risk posed by the collective risk taking of many smaller firms.
- How the Federal Reserve would work with other regulatory agencies to identify and control risk.
- The rules and governance for identifying who is systemically important.
Political and legislative uncertainty:
- Robert Litan (Brookings Institute): “This is the most controversial proposed function - the actual designation of systemically important institutions and who would supervise them. There is huge disagreement in Congress.”
- Likely legislative path (per observers): Congress may not pass a comprehensive bill by year’s end and may instead pass legislation on selected issues such as the regulation of derivatives, a new consumer protection agency, and rules on executive compensation.
Expert caution:
- Michael Mussa (Peterson Institute): “How do you go about internalizing risk? … That’s a tough nut to crack, and one of the things that makes it tougher is noted later in the paper, which is the problem of assuring that firms hold adequate capital in the good times so they don’t go under water in bad times.”

IMF workplan: The IMF expects to complete its first detailed analysis of the risks and weak points of the U.S. financial system, known as a Financial Sector Assessment Program (FSAP), in 2010.

IMF Survey: U.S. Proposal to Extend Financial Regulation Breaks New Ground