When you hear the term "systemic risk," (1) what is the first thing that pops into your mind? Do you think about a "run on the bank"? The subprime mortgage crisis? The collapse of Bear Stearns or Lehman Brothers? Bernie Madoff? All of these are elements of systemic risk, and presently there is no governing body that has the ability to regulate these kinds of risks on a grand scale.
Attempts to define systemic risk have led to confusion and uncertainty. Alan Greenspan acknowledged this uncertainty as he remarked: "It is generally agreed that systemic risk represents a propensity for some sort of significant financial system disruption.... [O]ne observer might use the term 'market failure' to describe what another would deem to have been a market outcome that was natural and healthy, even if harsh." (2) Through this definition and his later statements, Greenspan has acknowledged that the very definition of systemic risk is "still somewhat unsettled." (3)
Even honest attempts to analyze all the available definitions of systemic risk may not lead to a concrete understanding of the subject. However, the various definitions (4) share at least one basic element--systemic risk involves a trigger event that leads to a chain reaction of negative effects. (5) The Chairman of the Securities and Exchange Commission ("SEC"), Mary L. Schapiro, provided information about systemic risk in a recent speech. Chairman Schapiro stated that "there are two different kinds of 'systemic risk': (1) the risk of sudden, near-term systemic seizures or cascading failures and (2) the longer-term risk that our system will unintentionally favor large systemically important institutions over smaller, more nimble competitors, reducing the system's ability to innovate and adapt to change." (6) With the various definitions for systemic risk, and the difficulty in truly understanding systemic risk, the regulation challenge is even more pronounced.
This Comment explores various agency proposals for establishing some kind of systemic risk regulation with a single entity regulator. According to Chairman Schapiro there are two different types of systemic risk regulation: "(1) the traditional oversight, regulation, market transparency and enforcement provided by primary regulators that helps keep systemic risk from developing in the first place and (2) the new 'macro-prudential' regulation designed to identify and minimize systemic risk if it does [develop]." (7) The agency reports discussed throughout this Comment will focus on systemic risk regulation most similar to the types described by Chairman Schapiro. Part I will provide a background picture of systemic risk and outline the need for this kind of regulation. Part II will examine and compare the four main proposals. Finally, Part III will suggest future steps the government can take to establish a systemic risk regulator that prevents future financial meltdowns.
Following the financial collapse of 2008, the relevant agencies' (8) main concern revolved around the means of protecting the financial systems from systemic risk. This same financial crisis also paved the way for the idea of a systemic risk regulator. (9) The gaps in the financial system presented themselves in full force when the crisis began, at which point the flaws in the system became apparent to financial reformers. (10) According to Federal Reserve Chairman Ben S. Bernanke, the present financial crisis is the worst since the Great Depression, and it has "precipitated a sharp downturn in the global economy." (11) In discussing potential causes of the crisis, Bernanke further stated that the downturn occurred, at least in part, due to the fact that "risk-management systems of the private sector and government oversight of the financial sector ... failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets." (12)
The idea behind a systemic risk regulator is to have a financial system in which one group has the big picture of the entire industry, instead of the less advantageous scheme of compartmentalized regulation by single groups that only see what is within their regulatory boundaries. (13) In the present financial system, there is not a single regulatory body with complete oversight. Instead, the system is broken down into regulators for "segregated functional lines of financial services." (14) Because of this segregated regulation there are many problems with the system, the most noteworthy being that "no single regulator possesses all of the information and authority necessary to monitor systemic risk, or the potential that events associated with financial institutions may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected." (15) The need for an overarching regulatory body is important so that the industry as a whole is properly managed and consumers are adequately protected. (16) Such a regulatory body could effectively gauge all risk and instill greater regulation on those institutions in which inherent risk is high and whose failure would be catastrophic. (17) Unfortunately, no institution in the present regulatory scheme allows for such an overarching view of the entire financial system.
The Need for Change
The need for change in the existing system arises because the present regulatory system is based on a seventy-year-old structure. (18) The system evolved in response to a series of financial crises ranging from the late 1800s to the mid-1900s. (19) The problem with the present regulatory framework is that maturing foreign markets have the ability to "alternate sources of capital and financial innovation in a more efficient and modern regulatory system," (20) thereby leaving the U.S. system struggling to find a way to continue to compete with the flexible and ever-changing global markets. With the continuous evolution of the financial markets, reform is inevitable if the U.S. wants to remain in competition with the rest of the world. (21) The growing inability to keep pace has not only stretched the system, but has also permitted the infiltration of financial crises into the system. (22)
The present regulatory structure focuses on a functional approach. A functional approach means that the regulatory structure of the U.S. financial system is separated according to regulatory function including securities, futures, insurance and banking, (23) preventing any single regulator from comprehensively monitoring systemic risk. (24) Furthermore, "the inability of any regulator to take coordinated action throughout the financial system makes it more difficult to address problems related to financial market stability." (25) Not only does the lack of a central regulatory figure hamper efforts to monitor the system and keep systemic risk at bay, but it also opens the door for jurisdictional disputes. (26) These disputes can hinder the introduction of new products and compel movement of financial products to offshore financial centers, while also slowing innovation. (27)
Yet another reason for reforming the regulatory system and moving toward one with a central regulatory figure comes from the fact that "many aspects of financial regulation and consumer protection regulation have common themes." (28) Providing financial strength and the ability to meet financial obligations are the most important functions of the regulatory framework. After all, "money makes the world go round." (29) Without financial integrity and strong financial regulations a nation simply cannot survive. (30) So even if the terms of the regulations differ, the underlying purpose remains the same.
This section will not only provide the main points of each agency report, but will also address the best anticipated solutions to protect against systemic risk. The present regulatory system faces many challenges, and several agency proposals have sought to address them. The sources include the following: (1) The Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure (31) ("Treasury Blueprint"); (2) the Group of Thirty's "Financial Reform: A Framework for Financial Stability" (32) ("Group 30 Framework"); (3) the Investment Company Institute's "Financial Services Regulatory Reform" (33) ("ICI Report"); and (4) The Department of the Treasury's "Financial Regulatory Reform: A New Foundation--Rebuilding Financial Supervision and Regulation" (34) ("New Foundation Report").
"[F]inancial institutions serve a vitally important function in the U.S. economy by allowing capital to seek out its most productive uses in an efficient matter." (35) The economic significance of the financial system led the Department of the Treasury to come up with the Treasury Blueprint. Of the four proposals, the Treasury Blueprint provides the most detailed information regarding several aspects of regulatory reform. First, the Treasury Blueprint focuses on the need for change in the existing system. (36) Second, it provides recommendations based on three different timeframes: (1) short term; (2) intermediate term; and (3) optimal regulatory structure. (37) Within the optimal regulatory structure, the Treasury Blueprint mentions two different regulatory structures similar to systemic risk regulators: (1) a market stability regulator; and (2) a prudential financial regulator. (38)
Recommendations for the Regulatory Framework
The Treasury Blueprint focuses on three different recommendations for the system. (39) First, in the short term, the Treasury Blueprint proposes making the President's Working Group on Financial Markets ("Working Group") an interim systemic risk regulator. (40) The Working Group was established in 1988 by Executive Order 12631 following the 1987...