The problem with financial firms is that they are so interconnected.
The failure of one firm may unleash an unpredictable cascade of defaults at other firms, risking a market crash and economic downturn.
Even the possibility of failure is enough to freeze the capital markets, as investors brace for the next domino to fall and then the next after that. It is no surprise that regulators step in to bail out financial firms when they start to wobble. Costly and unpopular, yes, but bailouts are better than risking the collapse of the financial system under a wave of defaults, as we saw with the decision to let Lehman fail.
There is a better way. The Dodd-Frank financial overhaul law contains provisions to establish an interagency Financial Stability Oversight Council, which will be supported by a new Office of Financial Research in the Treasury Department, and it gives these entities significant budgetary resources and legal powers.
The mainstream media have not picked up on the revolutionary potential of these new agencies. In a nutshell, the reform law created a kind of air traffic controller for the financial system — a function that has been lacking.
Traditionally, regulators have supervised individual financial firms, making sure that each has adequate capital and follows prudent policies. In this way, they act much as the Federal Aviation Administration does, ensuring that aircraft are properly maintained and safe to operate.
However, the FAA also operates an air traffic control system, without which two perfectly safe aircraft might collide.
Similarly, two financial firms that had passed their regulatory exams could still get into trouble in a crisis, through their counterparty relationships.
Airplanes and financial firms have interconnections that must be monitored and managed.
Yet as strange as it may seem, there is no financial equivalent of the air traffic controller. No one in government systematically monitors interconnections. That is part of the reason that Federal Reserve Chairman Ben Bernanke and Henry Paulson, then the Treasury secretary, struggled during the 2008 crisis, bailing out some firms that were obviously systemically important (like AIG and Fannie Mae) but missing others (like Lehman).
The Financial Stability Oversight Council has a mandate to study and manage interconnections. To make this happen, the new law delegates significant responsibilities to the Office of Financial Research:
• It has a budget to develop information technology systems, which it could use to aggregate real-time data on counterparty exposures.
I imagine the systems would work like this: Whenever a regulated financial institution enters into a contract that exposes it to counterparty risk, it would log the transaction into the OFR's database, which would be electronically integrated into the firm's own risk management system.
The OFR would tabulate the information to determine which firms are sources of significant counterparty risk, identifying those likely to be systemically important if a crisis hits.
Given the large number of financial firms, the many interconnections between them and the speed with which they make transactions, regulators would never have a complete view. But any systematic collection of information would improve on the current situation.
• The OFR also would need to dispatch teams of experienced analysts to visit key financial institutions. These analysts would interview managements and review the books in order to sniff out new risks, which its information systems might miss if regulators are not on top of the latest innovations. Dodd-Frank gives the OFR significant legal power, including the right to subpoena information from recalcitrant firms; I think most firms would cooperate with its officials.
The goal of this two-pronged approach would be to identify firms that pose systemic risk because of their interconnections. Had the OFR been in place before the recent crisis, it might have identified AIG as posing systemic risk because several large investment banks depended on it for billions of dollars of insurance against subprime mortgage losses. Or it might have discovered that money market mutual funds held large amounts of Lehman's debt, or that many banks held preferred stock in Fannie Mae and Freddie Mac.
Firms with these levels of interconnections pose systemic risk because their failure can cause other firms to fail.
A consensus has emerged that regulators should make systemically risky firms hold capital not only for their own portfolios but for the risk they pose to the rest of the system.
An extra capital requirement would encourage systemically risky firms to shrink their portfolios or reposition their businesses so as to bring the interconnections under control. In the end, this would help make the financial system more robust in the face of the next crisis, whenever it may occur.