Meaningful regulatory reform must ensure that large institutions receive neither explicit nor implicit protection from the federal government. The Regional Bond Dealers Association strongly supports comprehensive financial regulatory reform, especially the legislative efforts to end the taxpayer bailout of financial institutions deemed “too big to fail.”
The financial system cannot operate efficiently if financial institutions and investors assume that the government will protect certain firms from the consequences of poor management.
A regulatory structure that provides special treatment for specified large firms signals to the markets that the government will not let such firms fail and merely results in the perpetuation of the too big to fail doctrine.
The current practice of treating firms as too big to fail reduces market discipline and encourages excessive risk-taking. It also provides an artificial incentive for firms to grow, in order to be perceived as too big to fail. Moreover, treating firms as too big to fail creates an unlevel playing field for any firm without implicit government support.
The lack of clear policy regarding the treatment of large, systemic-risk financial firms was at the center of the financial crisis. The current regulatory framework permitted the explosive growth of global, highly leveraged financial firms over the past decade.
The markets funded these firms at rates that implied investors believed the institutions were simply too big to fail. That perception proved largely correct during the crisis as the federal government stepped in and provided funding to nearly all those firms viewed as posing a systemic risk in an effort to stave off the complete meltdown of the financial system.
As part of regulatory reform, Congress must address the gaps in the existing regulatory framework that allowed these firms to grow unchecked to the point where their failure jeopardized the health of the markets.
Congress must create a system that provides incentives for sound management practices and imposes costs for engaging in the types of activities that contributed to the financial crisis. Specifically, Congress must establish a regulatory system that prevents firms from becoming too big to fail and imposes meaningful costs on those large firms that could pose a systemic risk.
An effective regulatory regime must not only address the dangers posed by existing systemic risk firms, it also must eliminate the regulatory gaps that allowed firms to become too big to fail in the first place. Thus, financial firms should be subject to progressively stricter oversight and regulation as they get larger or engage in riskier activities. Stricter regulation must include both heightened capital requirements and increased public transparency.
As a firm grows larger and presents a heightened risk to the financial system, there should be a corresponding increase to its capital requirement. Subjecting firms to stricter capital requirements as they get larger would help prevent firms from ever becoming too big to fail. Leverage ratios and capital requirements also should be weighted according to the products a firm trades or the positions it takes.
For example, activities involving heightened risk, such as structuring and distributing exotic non-cash products, should be subject to enhanced capital requirements. Imposing more stringent capital rules and liquidity standards as a firm grows larger or engages in riskier activities would reduce the probability that such firms experience financial distress, either through capital depletion or a run by creditors.
Regulatory reform also must provide for greater public transparency. The lack of transparency regarding positions in complex and risky products such as mortgage-backed securities and credit default swaps was a key source of uncertainty during the financial crisis as market participants could not easily tell the extent to which large firms were burdened by toxic assets. This situation can be avoided in the future if disclosure requirements are based on the extent to which a firm’s products or positions present a risk to the financial system.
For example, transparency would improve if firms were required to disclose the amount of mortgage-backed securities in their inventories, as well as the credit ratings of such securities.
Similarly, requiring entities engaging in swaps to list their top 10 counterparties on such transactions would reveal the extent to which risk is interconnected with other firms in the market. Firms also could be required to disclose the percentage of their capital dedicated to certain riskier activities.
Congress must take advantage of this opportunity to address the weaknesses in the existing regulatory system that contributed to the most significant financial crisis in decades. Congress’ top priority must be to articulate a clear policy against the taxpayer bailout of large financial institutions.
Thus, reform legislation must impose meaningful costs of doing business on any firm that poses a risk to the financial system so that such firms do not obtain a competitive advantage from an implicit federal guarantee.
The financial system will only operate efficiently if all firms, rather than taxpayers, are held accountable for the consequences of poor management and risky behavior.
Mike Nicholas is chief executive officer of the Regional Bond Dealers Association