Apr 9, 2009

New Regulations Proposed By The Treasury Department

(First read the post with the extract on Financial Regulation)

Every time there is a financial crisis new regulations and rules are implemented. The problem is that our hindsight is 20/20. Once a crisis has occurred the regulators realize that if certain rules had been set before hand this problem would never have happened (or at least have been unlikely).

First, what is a ‘Systemically Important Firm’?

Suppose the town has two big banks and a big insurance company and 4 small banks and a small insurance company. The big banks hold most of the money from the mine, farms and ranches. The big insurance company has insured all the big ranches and farms.
Most of the money in the town is in the big banks. If the small banks fall there will be a lot of capital loss. A lot of people will be unhappy. If the big banks and the big insurance company fall then most of the money of the town will cease to exist.

From the point of view of the town the loss of the small banks and insurance company will cause scandals and possibly a small recession. If the big banks fall then most of the capital in the entire town is lost. A serious recession/depression will result.

Look at it this way; The banks pass loans between each other, they have stocks in each other, they even are connected to the insurance company. i.e. all the big institutions are interconnected.

Each one of the big financial institutions of the town represent ‘systematic risk’ i.e. if one falls they can hurt the entire town financial system.

From the point of view of the town each one of the big banks and the big insurance company are ‘too big to fail’.

The following is from the Treasury Department's Press Release:

A Single Independent Regulator with responsibility over Systemically Important Firms and Critical Payment and Settlement Systems:

While we strengthen prudential oversight for all firms, we must also create higher standards for all systemically important financial firms – regardless of whether they own a depository institution – to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy. We will work with Congress to enact legislation that defines the characteristics of covered firms; sets objectives and principles for their oversight; and assigns responsibility for regulating these firms.

1) Defining a Systemically Important Firm:In identifying systemically important firms, we believe that the characteristics should include:

• The financial system's interdependence with the firm;
• The firm's size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding;
• The firm's importance as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.

This first point explains how they plan to determine if a firm is big enough to cause damage to the whole system if it collapses. i.e. they tend to find all the companies that are ‘too big to fail’ and regulate them from the beginning. If they do this properly then we will be able to avoid the global economic collapse the big financial institutions can cause with their failure. (i.e. they pose a risk to the local and global financial system)

2) Focusing On What Companies Do, Not the Form They Take:

These institutions would not be limited to banks or bank holding companies, but could include any financial institution that was deemed to be systemically important in accordance with legislative requirements. These provisions will focus on what companies do and their potential for systemic risk – and no longer on the form they take – to determine who will regulate them.

Past regulation has focused on controlling, say ‘Banks’. Yet a firm can be involved in transactions that affect banks and are like banks but they call themselves by some other name. Thus they don’t have to follow the already established laws for capital reserve requirements i.e. if the law says you should put 10% of the money you get aside for safety and NOT loan it out, by changing their definition some companies can avoid this law and loan it all out (and do other funny stuff such as over leveraging assets – giving out much more money than they have).

By looking for all ‘systemically important firms’ they are essentially looking for all the ‘too big to fail’ financial institutions. By identifying them they become easier to regulate.

II. Higher Standards on Capital and Risk Management for Systemically Important Firms:

1. Setting More Robust Capital Requirements:Capital requirements for these firms must be more conservative than for other institutions and be sufficiently robust to be effective in a wider range of deeply adverse economic scenarios than is typically required.

2. Imposing Stricter Liquidity, Counterparty and Credit Risk Management Requirements:Supervisors will also need to impose liquidity, counterparty, and credit risk management requirements that are more stringent than for other financial firms. For instance, supervisors should apply more demanding liquidity constraints; and require that these firms are able to aggregate counter-party risk exposures on an enterprise-wide basis within a matter of hours.

3. Creating Prompt-Corrective Action Regime: The regulator of these entities will also need a prompt-corrective action regime that would allow the regulator to force protective actions as regulatory capital levels decline, similar to the powers of the FDIC with respect to its covered agencies.

IN the banking basics post money put aside is the ‘capital reserve’. After identifying the biggest, most important financial institutions, they will be forced to have larger capital reserves. Thus they will be more liquid (i.e. they will have more money held in reserve).

If you go through the new proposed regulations of the financial system you will notice that they are pretty comprehensive. If properly implemented they should be able to prevent such a financial crisis in the future.

To read more about the financial regulation proposed by the US treasury department click here. According to the website more outlines on the new regulations is forthcoming.

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