The continuing debate over whether the Dodd-Frank resolution structure for systemically important financial institutions is adequate has ignored the real-world interaction that will occur between the reform's "too big to fail" supervisory approach and the disclosure requirements of the federal securities laws.
If the Federal Reserve Board supervises U.S.-based SIFIs openly, the task of regulating large systemically important financial institutions will primarily become the role of the securities markets.
Most SIFIs located in the U.S. (and many global ones) are generally registered with the Securities and Exchange Commission via their top-level holding companies. As such, they are required to file quarterly and annual disclosures. Importantly, an SEC-registered SIFI is also affirmatively required to immediately disclose to the market significant adverse changes in its business that are material to investors and other stakeholders. (These disclosure obligations are well understood by SEC-reporting companies).
Following the completion of the TBTF supervisory regulations, the Fed must regularly monitor a SIFI's enterprise-wide business operations to determine whether it is creating systemic risk, (The Comprehensive Capital Analysis and Review stress testing is an example of the Fed's supervision process for this important task.)
In the event the Fed (or Financial Stability Oversight Council) concludes that systemic risk is present or imminent, the central bank may order the SIFI to eliminate the systemic risk by means of potentially onerous remedial measures, including increased capital, the cessation of specified business operations, replacement of management and similar measures.
The interaction between the Fed's ability to address identified systemic risk and the disclosure regime of the federal securities laws becomes pertinent. Should the Fed order the elimination of real or potential systemic risk, the issuance of such an order, formal or informal, requires a SIFI to disclose to the market that it must modify its business operations in a manner that would likely place it at a serious disadvantage to its competitors. Market reaction would be immediate and the securities of that SIFI would be adversely impacted.
Several observations are offered. The scenario described in this article assumes that the Fed will act decisively by ordering a SIFI to remediate identified systemic risk. Should the Fed act in that manner, it can employ market discipline as the primary enforcer of TBTF.
Managers of SIFIs will immediately begin to manage in a manner that avoids a determination of systemic risk. (It is not unreasonable to foresee management discussions in future SEC securities filings analyzing why their particular SIFI is not exhibiting systemic risk, including the use of appropriate risk management techniques to avoid that designation.)
Additionally, should the scenario suggested here prove to be correct (e.g., rapid market reaction to the identification of systemic risk by a SIFI), it calls into question the viability of the Fed's current proposal that SIFIs issue designated amounts of debt to be used to recapitalize a systemic failure. If the market were to determine that a failure of the SIFI is possible, that debt would likely lose value quickly. In the very least, the pricing of the proposed debt could become very problematic.
Finally, of course, this market-based enforcement approach is limited to systemic failures that are capable of being anticipated through regular examination oversight by the Fed. It does not address, for example, failures that might occur through sudden market disruptions such as fraudulent activity, non-reportable trading losses and similar sudden loss scenarios.
Notwithstanding the fact that the securities markets cannot address all TBTF situations, the prudent use of market discipline may prove to be one of the most effective means to eliminate TBTF.
Joseph Lynyak is a financial services regulatory partner at Pillsbury Winthrop Shaw Pittman in its Washington, D.C. and Los Angeles Offices.