Time to bring in the “systemic regulator”?

The Congressional Oversight Panel monitoring the government’s financial bailout plan recommended a host of regulatory changes in a special report released Thursday that, if adopted, could have a major effect on how Wall Street does business for decades to come.

One of the more interesting parts of the hefty report by the panel, which is led by Elizabeth Warren, a Harvard professor, was for Congress to create a new regulatory body to oversee systemic risk.

According to the report — which came with an introductory YouTube video — one of the main problems with the current regulatory regime is that systemic risk, which is the risk that a failure of one institution could wreak havoc across the entire financial system, is often not identified or regulated until crisis is imminent.

“Systemic risk needs to be managed before moments of crisis, by regulators who have clear authority and the proper tools,” the report said. “Once a crisis has arisen, financial regulation has already failed.”

The report found that much of the current economic crisis could have been avoided if there had been a regulatory body overseeing big financial institutions that were deemed “too big to fail.”

“In 2008, Bear Stearns, Fannie Mae, Freddie Mac, A.I.G., and Citigroup all appear to have been deemed too big — or, more precisely, too deeply embedded in the financial system — to fail,” the report said. “The decisions to rescue these institutions were often made in an ad hoc fashion by regulators with no clear mandate to act nor the proper range of financial tools with which to act.”

The report, which was approved by the panel’s three Democratic appointees but opposed by its two Republicans, argued that systemic risk is caused by many institutions, like hedge funds, that are not currently covered, or inadequately covered, by the financial services regulatory system.

The new regulators proposed in the report would have sweeping powers that might include posing relatively stringent capital and liquidity requirements on large financial institutions that fall under the “too big to fail” category.

The report suggested that the new regulators could set an overall maximum leverage ratio (on the whole institution and potentially also on individual subsidiaries), which would curb the firms’ ability to bet on the market.

Other recommendations included setting well-defined limits on contingent liabilities and off-balance-sheet activity and setting caps on the proportion of short-term debt on an institution’s balance sheet.

Such changes to the way risk is managed could lower the profitability of the big financial firms significantly, but, if they work as intended, might also ensure that they stay afloat.

– Cyrus Sanati

Go to Video from the Congressional Oversight Panel »