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Transparency Can Alleviate Systemic Risk

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In reforming regulation of the financial system, a key goal is to improve transparency.

A major flaw in recent years has been the way enormous risks affecting the entire financial system have been hidden from sight. The systemwide risks created by American International Group Inc. are the most vivid example—until the problems in its financial products surfaced, almost no one realized problems in the market for credit default swaps could threaten a global cascade of failures.

Treasury Secretary Timothy Geithner’s plan for regulation reform includes needed provisions to address systemwide failures, but the plan can be improved with increased transparency.

At the heart of Geithner’s plan is a proposal to have one agency, likely the Federal Reserve Board, become the systemic risk regulator. This regulator’s job would be to try to reduce the systemwide risk that comes from institutions that are "too big to fail."

Historically, these entities were the major banks, which played a unique role in facilitating payments and lending. To address this special risk, banks were subject to government examination and regulation. But today, as the AIG example shows, nonbanks, including insurers and investment banks, can also trigger systemwide problems.

The Geithner plan directly addresses some systemic risks caused by major nonbanks. The systemic regulator would ensure that all the regulated firms have enough capital on hand in the good times to withstand problems in the bad times. A regulated firm that got in trouble would be subject to the sort of prompt corrective action that banks are subject to already. Finally, the regulator would gain the power to put an insolvent nonbank into conservatorship or receivership.

These provisions are necessary steps in providing regulators the powers they lacked in the buildup to the current crisis. They would have subjected AIG to earlier intervention by a federal regulator. They also would have limited the investment bankers as they issued mountains of mortgage-backed securities, collateralized debt obligations and other instruments that used minuscule amounts of capital and excessive leverage.

However, these sorts of capital requirements and early-closure provisions will not provide the best available protection against future crises. Better protection would come if financial reform included new transparency measures that empower more than one agency to take action.

A useful addition to Geithner’s plan, therefore, would be to require the regulator to make a semi-annual report to Congress on systemic risk. The model here would be the monetary policy reports that the Fed has submitted twice a year since the Humphrey-Hawkins Act was passed in 1978. The new reports would be the subject of congressional hearings, and the systemic risk regulator would explain what it is doing to assess and respond to the various risks.

These reports would counteract any temptation on the regulator’s part for secrecy for reasons such as close relationships with the large firms or avoiding criticism for previous actions or inactions.

Currently, the threshold for action on systemic risk is too high—the risk is addressed when a problem is large enough to require regulators to close an institution or otherwise intervene directly.

By contrast, the threshold for action on the systemic risk reports would be much lower. The Fed or another regulator would simply show its analysis of the systemic risk from each source, such as hedge funds, swaps or any new sources that will arise in the future.

Regular reports to Congress would help all interested parties get better information sooner about systemic risk. The systemic risk regulator would have an earlier trigger before identifying and responding to new sources of risk. With better transparency, we would lower the risk of systemic risk.

Peter Swire is the C. William O’Neill Professor of Law at Ohio State University and a senior fellow at the Center for American Progress.

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