So far, the US financial system has survived the initial shock of the coronavirus crisis, thanks in large part to the Federal Reserve’s aggressive containment efforts. But another shock may well be coming, as millions of people and businesses fall behind on obligations such as mortgages and corporate loans. It’s a threat for which officials need to be much better prepared.
The experience of 2008 demonstrates how damaging a second shock can be when it hits an already weakened financial system. A year after the first signs of distress appeared, a series of disasters outside the traditional banking system – including the bankruptcy of Lehman Brothers and the near failure of giant insurer AIG – caused a simmering crisis to erupt. Regulators were caught off guard, lacking essential information such as the size and nature of counterparty exposures to Lehman. The repercussions overwhelmed poorly capitalised banks, requiring widespread government support and turning an already bad recession into the worst since the Great Depression.
In response to that episode, officials tried to safeguard the system. Lawmakers required banks to operate with more loss-absorbing capital, and created two entities – the Financial Stability Oversight Council and the Office of Financial Research — to identify and address emerging threats to financial stability wherever they might arise. The FSOC, headed by the Treasury secretary and including the leaders of all relevant agencies, could designate any nonbank financial company as posing a threat to systemic stability and hence subject to enhanced oversight by the Fed. The aim was to close the gap that allowed Lehman and AIG to escape federal oversight. The FSOC could also recommend that member agencies address systemic risks posed by firms or activities they regulate. The OFR was supposed to promote data standards to improve private and public oversight and gather the information needed to help the FSOC identify threats.
Neither the FSOC nor the OFR has lived up to its potential. Under the Trump administration, the FSOC has reversed or abandoned all its nonbank designations. The OFR has issued only one rule, has never used its broad authority to subpoena information, and has been strangely quiet during the pandemic. Both bodies have been allowed to atrophy, with the OFR’s staff shrinking by more than half.
It’s not too late for the FSOC and OFR to play a useful role in containing the Covid-19 crisis. The FSOC can, for example, meet more regularly and create groups to address specific issues, as it has for mortgage servicing. Potential hot spots flagged in the Fed’s Annual Financial Stability Report include large hedge funds and life insurance companies. Treasury Secretary Steven Mnuchin, as Chair of the FSOC, should be in close contact with all FSOC members to identify emerging fragilities. The OFR, for its part, should ramp up hiring, and make more use of its authority to bring in outside experts from academia, industry and other regulatory agencies to compensate for internal shortcomings.
Looking further ahead, the FSOC should recognise that it can’t properly oversee financial activities unless it has better information about what’s going on in the entities that conduct those activities. It must find a way –- through the nonbank designations or otherwise — to bring a broader set of institutions into the purview of federal regulators while accommodating their unique business models. The FSOC and OFR should also prioritise data standardisation. Requiring all entities that engage in financial transactions to have a Legal Entity Identifier, for example, would facilitate private risk management and make it easier for regulators to trace counterparty exposures and identify potential hazards.
Ultimately, Congress should revisit the structure of the FSOC and OFR. The OFR needs greater independence from Treasury, so it can use its powers more freely to gather data, identify trouble spots and take positions at odds with the administration. The FSOC’s member agencies should be encouraged to cooperate in addressing systemic risk – for example, by including resilience and financial stability in their mandates. And legislators should work with the administration to accelerate the political appointment process and fill vacancies.
Officials can’t head off a catastrophe unless they can see what’s going on and are paying attention. Although there’s no quick way to cultivate competent staff or fill vast information gaps, concerted efforts could reduce the probability that a second shock will send the financial system into a tailspin.
© 2020 Bloomberg