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Our FSOC and Financial Early Warning System Is Broken

FSOC
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EDITOR NOTE: This may sound a bit simplistic but bear with me. An airplane has approximately 600,000 to 6 million parts, depending on the plane. If a particular plane keeps crashing, you can gather experts, enough to form several committees, to analyze what’s wrong with the plane. That’s actually a necessary step for the industry to take. As a passenger, however, if you can avoid taking a plane, then you can just drive or take the train. The article you’re about to read concerns one of these types of committees aiming to reduce financial risk. It’s a complex matter, no doubt. Apparently, many banks wouldn’t have survived the pandemic if it weren't for the aggressive monetary and fiscal policy. Problems in the money markets prompted the Financial Stability Board to advise funds to penalize investors for taking out money during an emergency--which is the point of holding money market funds versus plain cash (rainy day savings plus interest). If banks simply took every step to anticipate “tail risks” then perhaps when one does occur, they’ll be better prepared. It’s easier said than done, of course, because it may reduce a bank’s profit potential, among other things. But forming complex committees to analyze complex problems that may be solved by simpler means only adds more complexity (and hence risk) to the equation, doesn’t it?

The U.S. financial system emerged from the reforms that followed the 2008 global crisis stronger than it had been going in. But the onset of the pandemic in March 2020 demonstrated how much was left undone: Although banks weathered the storm well, financial disruptions elsewhere—in money market funds, in the Treasury market—necessitated extraordinary measures to prevent an even greater economic disaster.

A group that we co-chair, the Task Force on Financial Stability, has just released a report on how to make the system more resilient. Among other things, we see the need for a structural change: Overhaul the agencies tasked with identifying and addressing threats outside traditional banks.

The Dodd-Frank financial reform of 2010 created two new entities focused on systemic risk. The Financial Stability Oversight Council, which included the Treasury Secretary and the heads of all the major financial regulatory agencies, was supposed to foster collaboration in finding and fixing dangerous buildups, wherever they might arise. And the Office of Financial Research, formed within Treasury and equipped with subpoena power, was supposed to provide the FSOC with the data and analysis needed to do the job well.

This financial early warning system didn’t operate as intended. The FSOC’s efforts to impose special scrutiny on certain systemically important non-bank institutions, such as insurance companies, ran into legal and political headwinds. Its member agencies often proved reluctant to encroach on one another’s turf, and the FSOC lacked the power to compel action. The OFR never subpoenaed anything, for fear of making enemies. Ultimately, the Trump administration deemphasized and defunded the whole apparatus.

As a result, the U.S. was much less prepared for the shock of the pandemic than it could have been. A rush to cash triggered runs on certain money-market mutual funds, threatened the flow of credit to everyone from homebuyers to municipalities, and—in a troubling departure from the usual “flight to quality”—caused the prices of Treasury securities to fall sharply. The Treasury and the Federal Reserve had to go to extreme lengths and pledge trillions of dollars to restore stability.

Regulators’ objective should not be merely to put out fires once they see smoke, but to prevent the dangerous accumulation of combustible material. New threats will emerge in unexpected ways; solutions will prompt unanticipated responses. So regulation must be dynamic, requiring an ongoing assessment process, not just periodic changes. To meet that challenge, we urge a restructuring of the FSOC and the OFR.

• Congress should give each FSOC member agency an explicit financial stability mandate, and require each to establish a similarly focused office to inform its rule making. This would force agencies such as the Securities and Exchange Commission, the Commodities Futures Trading Commission, and the Consumer Financial Protection Bureau to consider systemic-risk issues that they can otherwise too often neglect.

• Only the Treasury Secretary should issue the FSOC’s annual report, avoiding the consensus-building process among member agencies that can weaken identification of risks and accountability for dealing with them. While each agency would write a separate appendix, the Secretary would bear ultimate responsibility. The report should include a look back at what risks were missed, why, and how they will be addressed. To ensure the subject gets adequate attention, a new under-secretary for financial stability should act as the secretary’s point person.

• The OFR should receive a clear new mandate to gather the data that policymakers need (and, today, often lack). To underscore its importance, it should be renamed the Comptroller for Data and Resilience—echoing the stature of the Comptroller of the Currency—and its head should have a voting seat at the FSOC, a level of authority that would help the government recruit talent and experience to the post.

As the pandemic begins to recede, concern over financial stability should not. We don’t know what major shock will next hit the economy and financial system. But a process to scan for risks and adapt to them should be front and center.

Original post from Financial Advisor

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