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Understand and articulate the ERM requirements of the various external stakeholder groups, the challenges involved in meeting those requirements, and the risks associated with not meeting them12 Feb 2014 draft
[Macroprudential Regulation.docx]
Systemic Risk and the Financial Crisis:
Protecting the Financial System as a ‘System’1
Steven L. Schwarcz2
I. INTRODUCTION …………………………………………………………………………………………….. 1
II. MICROPRUDENTIAL REGULATION …………………………………………………………….. 3
A. Correcting Market Failures Within the Financial System ……………………………………… 3
1. Information Failure …………………………………………………………………………………………… 3
2. Rationality Failure ……………………………………………………………………………………………. 6
3. Principal-Agent Failure ……………………………………………………………………………………… 8
4. Incentive Failure …………………………………………………………………………………………….. 10
B. The Inevitability and Consequences of Imperfectly Correcting Market Failures …….. 10
1. Could Market Failures Within the Financial System Have Systemic Consequences? . 10
2. How Exemplary Could Microprudential Regulation Become? ……………………………… 11
III. MACROPRUDENTIAL REGULATION ………………………………………………………… 12
A. Limiting the Triggers of Systemic Risk …………………………………………………………….. 12
B. Limiting the Transmission and Impact of Systemic Shocks …………………………………. 18
1. Ensuring Liquidity to Firms and Markets …………………………………………………………… 19
2. Requiring Firms to be More Robust ………………………………………………………………….. 20
3. Ring-Fencing………………………………………………………………………………………………….. 22
IV. CONCLUSIONS ………………………………………………………………………………………….. 25
I. INTRODUCTION
How should the law help to control systemic risk—the risk that the failure of
financial markets or firms harms the real economy by increasing the cost of capital or
1
Copyright © 2014 by Steven L. Schwarcz. This work is based in part on Controlling
Financial Chaos: The Power and Limits of Law, 2012 WISCONSIN LAW REVIEW 815, and
on Regulating Shadows: Financial Regulation and Responsibility Failure, 70
WASHINGTON AND LEE LAW REVIEW 1781 (2013). For helpful comments, I thank
participants in a University of Glasgow-sponsored conference at Chatham House,
London, on “Regulatory Coherence and the Future of Finance,” and . . . .
2
Stanley A. Star Professor of Law & Business, Duke University School of Law;
Founding Director, Duke Global Financial Markets Center. E-mail:
schwarcz@law.duke.edu.
Schwarcz_Paper
2
decreasing its availability.3 Many regulatory responses to systemic risk, like the DoddFrank Act in the United States, consist largely of politically motivated reactions to the
global financial crisis,4 often looking for wrongdoers (whether or not they exist).5 But
those responses are misguided if they don’t address the reality of systemic risk.
Systemic risk is a form of financial risk. The primary goal for regulating financial
risk is microprudential—maximizing economic efficiency by correcting market failures
within the financial system—and indeed certain of those market failures can be factors in
triggering systemic risk. Systemic risk regulation should therefore try to correct those
market failures. But systemic risk more directly represents risk to the financial system
itself. Any framework for regulating systemic risk should also include the larger
“macroprudential” goal of protecting the financial system as a “system.”
To establish that framework, Part II below first considers microprudential
regulation. Subpart A of that Part argues that at least four types of partly interrelated
market failures occur within the financial system, and that even exemplary
microprudential regulation is unlikely to completely prevent those market failures.
Subpart B then explains why those intra-financial-system failures could have systemic
consequences and why even the best microprudential regulation will be imperfect.
Thereafter, Part III adds to the regulatory framework by examining ways in which
macroprudential regulation could more directly protect the financial system, qua system.
To that end, subpart A of Part III analyzes how regulation could attempt to limit the
triggers of systemic risk. Finally, subpart B of Part III analyzes how regulation could
3
Cf. Steven L. Schwarcz, Systemic Risk, 97 GEORGETOWN LAW JOURNAL 193, 204
(2008) (defining systemic risk).
4
Another dimension of this problem is that politicians have short-term reelection goals
whereas good regulatory solutions are often long-term.
5
The Dodd-Frank Act delegates much of the regulatory details to administrative
rulemaking, in many cases after the relevant government agencies engage in further
study. Perhaps even more significantly, the Act creates a Financial Stability Oversight
Council, part of whose mission is to monitor and identify potential systemic threats in
order to find regulatory gaps. Dodd-Frank Act § 112. The Council is aided in this task by
a newly-created, nonpartisan, Office of Financial Research. Id. Regulators therefore will
have the ability to look beyond the Act’s confines.
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3
attempt to limit the transmission and impact of systemic shocks by ensuring liquidity to
financial firms and markets, by requiring financial firms to be more robust, and by ringfencing those firms.
II. MICROPRUDENTIAL REGULATION
At least four types of partly interrelated market failures occur within the financial
system: information failure, rationality failure, principal-agent failure, and incentive
failure. Consider each in turn.
A. Correcting Market Failures Within the Financial System
1. Information Failure. Complexity is the main cause of information failure.6
Financial markets and products are already incredibly complex, and that complexity is
certain to increase. Profit opportunities are inherent in complexity, due in part to investor
demand for securities that more precisely match their risk and reward preferences.
Regulatory arbitrage increases complexity as market participants take advantage of
inconsistent regulatory regimes both within and across national borders. And new
technologies continue to add complexity not only to financial products but also to
financial markets.7
Complexity is undermining disclosure, which has been the chief regulatory
response to financial information failure.8 The Dodd-Frank Act puts great stock in the
6
See generally Steven L. Schwarcz, Regulating Complexity in Financial Markets, 87
WASHINGTON UNIVERSITY LAW REVIEW 211 (2009/2010).
7
I have argued that there are two aspects to complexity: cognitive complexity, meaning
that things are too complicated and non-linear to understand; and temporal complexity,
meaning that systems work too quickly and interactively to control. Regulating
Complexity in Financial Markets, supra note 6, at 214-15. Engineers sometimes refer to
temporal complexity as tight coupling. Id.
8
See, e.g., Cynthia A. Williams, The Securities and Exchange Commission and
Corporate Social Transparency, 112 HARVARD LAW REVIEW 1197, 1209-35 (1999)
(discussing the general purpose of disclosure in the Exchange Act and the Securities Act).
Although most, if not all, of the risks on complex mortgage-backed securities were
Schwarcz_Paper
4
idea of improving disclosure,9 but its efficacy will be limited. Some financial structures
are getting so complex that they are effectively incomprehensible.10 Furthermore, it may
well be rational for an investor to invest in high-yielding complex securities without fully
understanding them.11
Moreover, even perfect disclosure would be insufficient to mitigate information
failures that cause systemic risk. Individual market participants who fully understand the
risk will be motivated to protect themselves but not necessarily the financial system as a
whole. A market participant may well decide to engage in a profitable transaction even
though doing so could increase systemic risk because, due at least in part to corporate
limited liability, much of the harm from a possible systemic collapse would be
disclosed prior to the global financial crisis, many institutional investors—including even
the largest, most sophisticated, firms—bought these securities without fully
understanding them. See Steven L. Schwarcz, Disclosure’s Failure in the Subprime
Mortgage Crisis, 2008 UTAH LAW REVIEW 1109, 1110 (2008). Cf. John D. Finnerty &
Kishlaya Pathak, A Review of Recent Derivatives Litigation, 16 FORDHAM JOURNAL OF
CORPORATE AND FINANCIAL LAW 73, 74 (2011) (observing that court records reveal
investors’ misunderstandings about the nature of derivative financial instruments).
9
See, e.g., Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No.
111-203 (2010), § 1103 (requiring additional disclosure); § 942(b) (requiring issuers of
asset-backed securities to disclose information on the assets backing each tranche of
security); § 945 (requiring the SEC to issue rules requiring issuers of asset-backed
securities to disclose the nature of the underlying assets); § 951 (requiring persons who
make solicitations for the sale of all or substantially all of a corporation’s assets to
disclose their compensation arrangements to shareholders).
10
See, e.g., Lee C. Buchheit, Did We Make Things Too Complicated?, 27
INTERNATIONAL FINANCIAL LAW REVIEW 24, 24 (2008) (U.K.); David Barboza, Complex
El Paso Partnerships Puzzle Analysts, N.Y. TIMES, July 23, 2002, at C1 (discussing that
“one industry giant, the El Paso Corporation, is growing ever more reliant on deals [using
off-balance sheet partnerships] so complex that securities experts call them
incomprehensible”). It appears hyperbolic to say that structures created by humans cannot
be understood by humans. The larger problem may be that relatively few people can
understand the structures and that many structures may not be able to be understood by
any single person.
11
For example, the investor simply may not have the staffing to evaluate the securities,
whereas failure in invest would appear to—and in fact could—competitively prejudice
the investor vis-à-vis others who invest. See Disclosure’s Failure in the Subprime
Mortgage Crisis, supra note 8, at 1113-15.
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externalized onto other market participants as well as onto ordinary citizens impacted by
an economic collapse.12
Complexity also makes it difficult for regulators to understand, and thus
effectively regulate, financial products and markets. There are at least three levels of
complexity in financial markets: complexities of the assets underlying investment
securities traded in financial markets and of the means of originating those assets;
complexities of those investment securities themselves; and complexities of those
financial markets, which operate as systems.13 An understanding of these levels of
complexity sometimes challenges experts at even the most sophisticated financial firms. 14
Regulators that lack that expertise will be even more challenged to understand these
levels of complexity.
The extraordinary income gap between financial industry employees and their
regulatory counterparts makes it likely that regulators will indeed lack that expertise. In
the United States, for example, financial industry employees earn at least twice as much
as their regulatory counterparts.15 This gap enables the financial industry to bid away the
smarter employees, thereby putting administrative agencies at a disadvantage.16 Reducing
12
See Systemic Risk, supra note 3, at 206 (explaining this concept and describing it as a
type of “tragedy of the commons”). It is a tragedy of the commons insofar as market
participants suffer from the actions of other market participants; it is a more standard
externality insofar as non-market participants suffer from the actions of market
participants.
13
Regulating Complexity in Financial Markets, supra note 6, at 216-36.
14
Cf. Disclosure’s Failure in the Subprime Mortgage Crisis, supra note 8, at 1113
(arguing that although the disclosure documents describing complex asset-backed
securities generally complied with federal securities law, investors did not fully
understand those securities or their risks); Regulating Complexity in Financial Markets,
supra note 6, at 243 (observing that even the most sophisticated investors lost money in
the recent financial crisis).
15
Intrinsic Imbalance: The Impact of Income Disparity on Financial Regulation, 78 LAW
AND CONTEMPORARY PROBLEMS issue no. 1 (forthcoming symposium issue on “The
Administrative Law of Financial Regulation”); available at
http://ssrn.com/abstract=2387020.
16
Id. (finding that the income gap between industry and regulators is much larger for
financial regulation than for non-financial regulation). Cf. The Boston Consulting Group,
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6
the income gap would be a politically challenging, if not impossible, task; even if
government could increase the incomes of financial regulators to private-sector levels, the
financial industry would be motivated to match and exceed any such increases that drew
away significant talent.17
There are, therefore, no complete solutions to the problem of financial
information failure.
2. Rationality Failure. Even in financial markets, humans have bounded
rationality—a type of information failure, but one distinct and important enough to merit
a separate category. In areas of complexity, for example, we tend to overrely on
heuristics—broadly defined as simplifications of reality that allow us to make decisions
in spite of our limited ability to process information.18 Sometimes these simplifications
are based on models.19 Other simplifications are more psychologically based.20 Reliance
U.S. Securities and Exchange Commission, Organizational Study and Reform 53-54
(Mar. 10, 2011), available at 2011 WL 830339 (observing that the SEC’s senior
management considers the SEC’s staff analytical capabilities to be only average or even
below, and attributing that to the SEC’s relatively flat budget and its resulting hiring
difficulties); Howell E. Jackson, Variation in the Intensity of Financial Regulation:
Preliminary Evidence and Potential Implications, 24 YALE JOURNAL ON REGULATION
253, 273 (2007) (finding that the regulatory budget per staff member indicates the staff
quality).
17
Intrinsic Imbalance, supra note 15. This article finds that other potential responses to
attempt to correct regulatory failures resulting from the income gap are even more
“second best.”
18
Steven L. Schwarcz, Protecting Financial Markets: Lessons from the Subprime
Mortgage Meltdown, 93 MINNESOTA LAW REVIEW 373, 379-83 & 404-05 (2008).
19
In operations research, for example, the term “heuristics” refers to “computationally
simple models that allow people to ‘ . . . quickly [find] good feasible solutions.’”
Konstantinos V. Katsikopoulos, Psychological Heuristics for Making Inferences:
Definition, Performance, and the Emerging Theory and Practice, 8 DECISION ANALYSIS
10, 11 (2011) (alterations in original) (quoting FREDERICK S. HILLIER & GERALD J.
LIEBERMAN, INTRODUCTION TO OPERATIONS RESEARCH 624 n.1 (7th ed. 2001)).
20
In psychology, the term “heuristic” refers to both informal and quantitative
psychological processes that “in general . . . are quite useful, but sometimes . . . lead to
severe and systematic errors.” Amos Tversky & Daniel Kahneman, Judgment Under
Uncertainty: Heuristics and Biases, 185 SCIENCE 1124, 1124 (1974). For a discussion of
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on a heuristic can become so routine and widespread within a community that it develops
into a custom—in its common meaning of “a usage or practice common to many or to a
particular place or class.”21
When a heuristic-based custom reasonably approximates reality, society should
benefit. Modern finance, for example, has become so complex that the financial
community routinely relies on heuristic-based customs, such as determining
creditworthiness of securities by relying on formalistic credit ratings and assessing risk
on financial products by relying on simplified mathematical models.22 Without this
reliance, financial markets could not operate.23
When a heuristic-based custom no longer reflects reality, however, reliance on the
custom can become harmful. In recent years, for example, financial markets and products
have innovated so rapidly that heuristic-based customs—and thus behavior based on
those customs—have lagged behind the changing reality. The resulting mismatch, in turn,
has led to massive financial failures, such as investors relying on credit ratings that no
many common psychologically based simplifications and errors, see generally DANIEL
KAHNEMAN, THINKING, FAST AND SLOW (2011).
21
MERRIAM-WEBSTER’S COLLEGIATE DICTIONARY 308.
22
Christopher L. Culp, Merton H. Miller & Andrea M.P. Neves, Value at Risk: Uses and
Abuses, 10 JOURNAL OF APPLIED CORPORATE FINANCE, Winter 1998, at 26, 27 (1998);
Steven L. Schwarcz, Private Ordering of Public Markets: The Rating Agency Paradox,
2002 UNIVERSITY OF ILLINOIS LAW REVIEW 1, 1–3.
23
See James P. Crutchfield, The Hidden Fragility of Complex Systems—Consequences of
Change, Changing Consequences, in CULTURES OF CHANGE: SOCIAL ATOMS AND
ELECTRONIC LIVES 98, 102–03 (Gennaro Ascione et al. eds., 2009) (noting the increasing
structural complexity and fragility of modern markets, including financial markets, as
part of “the world we built”); see also Manuel A. Utset, Complex Financial Institutions
and Systemic Risk, 45 GEORGIA LAW REVIEW 779, 799–803 (2011) (discussing the
complexity of financial markets and the bounded rationality of financial-community
members, as well as the need for heuristics to process and analyze financial information);
Markus K. Brunnermeier & Martin Oehmke, Complexity in Financial Markets 5–8
(Princeton Univ., Working Paper, 2009), available at
http://scholar.princeton.edu/markus/files/complexity.pdf (noting that because financialcommunity members have bounded rationality, they must simplify complex financial
markets by using, for example, models and summaries).
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8
longer are accurate and members of the financial community assessing risk using
simplified models that have become misleading.24
Overreliance on heuristics merely exemplifies rationality failure, which has a
wide range. Thus, market participants follow the herd in their investment choices and are
also prone to panic.25 Furthermore, due to availability bias, they are unrealistically
optimistic when thinking about extreme events with which they have no recent
experience, devaluing the likelihood and potential consequences of those events.26 There
are no complete solutions to the problem of rationality failure because human nature
cannot be easily changed.
3. Principal-Agent Failure. Scholars have long studied inefficiencies resulting
from conflicts of interest between managers and owners of firms.27 There is, however, a
much more insidious principal-agent failure: the intra-firm problem of secondarymanagement conflicts.28 The nub of the problem is that secondary managers are almost
always paid under short-term compensation schemes, misaligning their interests with the
long-term interests of the firm.
Complexity exacerbates this problem by increasing information asymmetry
between technically sophisticated secondary managers and the senior managers to whom
they report. For example, as the VaR, or value-at-risk, model for measuring investment24
See Steven L. Schwarcz & Lucy Chang, The Custom-to-Failure Cycle, 62 DUKE LAW
JOURNAL 767 (2012). Chang and I call this cycle—(i) reliance on heuristics that
reasonably approximate reality; (ii) the development of customs based on those
heuristics; (iii) changes that disconnect those customs from reality; and (iv) failures
resulting from continued reliance on those customs—the custom-to-failure cycle.
25
For a thoughtful analysis of how rationality failures help to explain the 2008 financial
crisis, see Geoffrey P. Miller & Gerald Rosenfeld, Intellectual Hazard: How Conceptual
Biases in Complex Organizations Contributed to the Crisis of 2008, 33 HARVARD
JOURNAL OF LAW & PUBLIC POLICY 807 (2010).
26
Iman Anabtawi & Steven L. Schwarcz, Regulating Systemic Risk: Towards an
Analytical Framework, 86 NOTRE DAME LAW REVIEW 1349, 1366-67 (2011).
27
[cite to representative examples]
28
See Steven L. Schwarcz, Conflicts and Financial Collapse: The Problem of SecondaryManagement Agency Costs, 26 YALE JOURNAL ON REGULATION 457 (2009).
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9
portfolio risk became more accepted, financial firms began compensating secondary
managers not only for generating profits but also for generating profits with low risks, as
measured by VaR.29 Secondary managers turned to investment products with low VaR
risk profile, like credit-defaults swaps that generate small gains but only rarely have
losses. They knew, but did not always explain to their superiors, that any losses that
might eventually occur would be huge.
In theory, firms can solve this principal-agent failure by paying managers,
including secondary managers, under longer-term compensation schemes—e.g.,
compensation subject to clawbacks or deferred compensation based on long-term
results.30 In practice, however, that solution would confront a collective action problem:
firms that offer their secondary managers longer-term compensation might not be able to
hire as competitively as firms that offer more immediate compensation.31 Because good
secondary managers can work in financial centers worldwide, international regulation
may be needed to help solve this collective action problem.32
29
See, e.g., PHILIPPE JORION, VALUE AT RISK: THE NEW BENCHMARK FOR MANAGING
FINANCIAL RISK 568 (3d ed. 2006).
30
It appears that at least two financial firms, Goldman Sachs and Morgan Stanley, are
beginning to implement this type of compensation policy. See Liz Moyer, On ‘Bleak’
Street, Bosses in Cross Hairs, WALL ST. J., Feb. 8, 2012 (reporting that these firms
“would seek to recover pay from any employee whose actions expose the firms to
substantial financial or legal repercussions”).
31
See, e.g., Kimberly D. Krawiec, The Return of the Rogue, 51 ARIZONA LAW REVIEW
127, 157-58 (2009) (arguing that financial firms have had trouble balancing the
discouragement of excessive risk-taking against the need to create profit-maximizing
incentives and preferences).
32
The Basel capital accords exemplify global rules intended to help avoid prejudicing the
competitiveness of firms—in this case, banks—in any given nation or region. See, e.g.,
Clyde Stoltenberg et al., The Past Decade of Regulatory Change in the U.S. and EU
Capital Market Regimes: An Evolution from National Interests toward International
Harmonization with Emerging G-20 Leadership, 29 BERKELEY JOURNAL OF
INTERNATIONAL LAW 577, 615-44 (2011) (examining U.S. and E.U. efforts to adopt
harmonized financial standards); Arie C. Eernisse, Banking on Cooperation: The Role of
the G-20 in Improving the International Financial Architecture, 22 DUKE JOURNAL OF
COMPARATIVE & INTERNATIONAL LAW 239, 254-56 (2012) (discussing the Basel III
capital and liquidity framework and its emphasis on consistent global standards).
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4. Incentive Failure. Risk dispersion can create benefits, such as investment
diversification and more efficient allocation of risk. But risk can be marginalized,
becoming so widely dispersed that rational market participants individually lack the
incentive to monitor it.33 Undermonitoring caused by this incentive failure appears to
have contributed, at least in part, to the global financial crisis.34
B. The Inevitability and Consequences of Imperfectly Correcting Market Failures
Even exemplary microprudential regulation is therefore unlikely to completely
prevent market failures within the financial system. That raises at least two issues: could
these failures have systemic consequences, and how exemplary could microprudential
regulation become?
1. Could Market Failures Within the Financial System Have Systemic
Consequences? Certain types of these market failures, even though they occur within the
financial system, could well have systemic consequences. Information failure is
classically seen, for example, as the source of bank runs.35 Information failure, principalagent failure, and incentive failure could, individually or in combination, cause one or
more large financial firms to overinvest, leading to bankruptcy; and the bankruptcy of a
large, interconnected financial firm could lead to a systemic collapse.
33
See Steven L. Schwarcz, Marginalizing Risk, 89 WASHINGTON UNIVERSITY LAW
REVIEW 487 (2012).
34
Cf. Jean-Claude Trichet, President of the European Central Bank, Speech before the
Fifth ECB Central Banking Conference (Nov. 13, 2008) (arguing that ‘the root cause of
the [financial] crisis was the overall and massive undervaluation of risk across markets,
financial institutions and countries’); Joe Nocera, Risk Mismanagement, N.Y. TIMES, Jan.
4, 2009, § 6 (Magazine).
35
Cf. Douglas W. Diamond & Philip H. Dybvig, Bank Runs, Deposit Insurance, and
Liquidity, 91 J. POL. ECON. 401, 404 (1983) (using the Diamond-Dybvig model to explain
bank runs as a form of undesirable equilibrium triggered by expectations based on
incomplete information, in which depositors (sometimes irrationally) expect the bank to
fail, thereby causing its failure). Information failures arguably are only part of the cause
of bank runs, however; even if an information failure initiates a run on a bank, depositors
with perfect information face the collective action problem that they may have to join the
run in order to avoid losing the grab race.
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Similarly, rationality failure could cause the prices of securities in a large
financial market to collapse. In 2008, for example, the realization that some investmentgrade-rated mortgage-backed securities (MBS) were defaulting or being downgraded
caused investors to panic. They lost faith in ratings and dumped all types of rated debt
securities, causing debt-market prices to plummet and (for a time) destroying those
markets as a source of corporate financing.36 Investor panics can occur in other contexts,
like investors in Greek sovereign bonds dumping not only those bonds but also the bonds
of many other Euro-zone countries.37
2. How Exemplary Could Microprudential Regulation Become? As discussed,
systemically consequential market failures are inevitable, notwithstanding exemplary
microprudential regulation. Unfortunately, real-world microprudential regulation will be
far from exemplary, making systemically consequential market failures even more likely.
For example, policymakers and thus regulators tend to focus on what historically
has gone wrong. Economist Barry Eichengreen calls this “the powerful role of historical
perception as a framing device.”38 Thus, the opinions of European policymakers
designing the European Union’s monetary union were “heavily informed by past risks,”
notably the possibility that excessive budget deficits could spark high inflation (such as
the German hyperinflation of the 1920s).39 As a result, EU policymakers ignored
emerging problems, like the fact that Euro-Area banks were even more highly leveraged
than U.S. banks.40
Real-world microprudential regulation will also be far from exemplary because
regulators respond to the media, which emphasizes what’s accessible to journalists. Even
36
[cite]
Barry Eichengreen, Euro Area Risk (Mis)management, in RECALIBRATING RISK:
CRISES, PERCEPTIONS, AND REGULATORY CHANGE (Edward Balleisen et al., eds., 2014).
38
Eichengreen, supra note 37, at [cite].
39
Id. at [cite].
40
Id. at [cite].
37
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12
sophisticated journalists are sometimes imprecise and biased.41 Yet another problem with
microprudential regulation is that, after a financial crisis, people naturally want to prevent
the next crisis. Regulators, who are themselves usually subject to political shorttermism,42 therefore respond by focusing on ex ante preventative regulation, or at least
regulation aimed at preventing the next financial meltdown. But that focus is insufficient
because it’s impossible to always predict the cause of the next financial crisis. Indeed,
although panics are often the triggers that commence a chain of systemic failures, it is
impossible even to identify all the causes of panics.
Effective regulation must therefore also be ex post ameliorative.43 Next consider
that in the larger context of macroprudential regulation.
III. MACROPRUDENTIAL REGULATION
There are at least two ways in which macroprudential regulation could protect the
financial system, qua system. First, it could attempt to limit the triggers of systemic risk.
Second, it could attempt to limit the transmission and impact of systemic shocks.
A. Limiting the Triggers of Systemic Risk
Ideal macroprudential regulation would act ex ante, eliminating the triggers of
systemic risk.44 For example, a classic trigger of systemic risk is a bank run, in which
some depositors panic and converge on a bank in a “grab race” to withdraw their monies
first. Because banks keep only a small fraction of their deposits on hand as cash reserves,
41
[cite]
See supra note 4.
43
See Iman Anabtawi & Steven L. Schwarcz, Regulating Ex Post: How Law Can
Address the Inevitability of Financial Failure, 92 TEXAS LAW REVIEW 75 (2013). Cf.
Eichengreen, supra note 37, at [cite] (observing that “Not all risks that materialize can be
anticipated, and not all risks that are anticipated can be avoided.”).
44
Cf. Steven L. Schwarcz, Keynote Address: Ex Ante Versus Ex Post Approaches to
Financial Regulation, 15 CHAPMAN LAW REVIEW 257, 258 (2011) (observing that
“[o]nce a failure occurs, there may already be economic damage, and it may be difficult
to stop the failure from spreading and becoming systemic”).
42
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13
other depositors may have to join the run in order to avoid losing the grab race.45 If there
is insufficient cash to pay all withdrawal-demands, the bank will default.46 That, in turn,
can cause other banks or their creditors to default.47 The standard regulatory solution is to
prevent a depositor panic by providing government deposit insurance.48
Realistically, however, we cannot eliminate all of the triggers of systemic risk.
For example, corporate finance is increasingly becoming disintermediated, bypassing
traditional bank intermediation (e.g., bank lending) between the sources of funds
(essentially the capital and other financial markets) and business firms that need funds to
operate. By bypassing banks, firms are able to avoid the profit mark-up that banks charge
on their loans. The system for generating disintermediated credit is often referred to as
“shadow banking.”49 The size of the shadow-banking system—which includes
securitization, money-market mutual funds, hedge funds, and repo financing—was
45
See, e.g., Jonathan R. Macey & Geoffrey P. Miller, Bank Failures, Risk Monitoring,
and the Market for Bank Control, 88 COLUMBIA LAW REVIEW 1153, 1156 (1988) (linking
bank runs and depositor collective action problems).
46
R.W. HAFER, THE FEDERAL RESERVE SYSTEM: AN ENCYCLOPEDIA 145 (2005)
(observing that a bank’s cash reserves are often less than five percent of its deposits).
47
See Chris Mundy, The Nature of Risk: The Nature of Systemic Risk—Trying to Achieve
a Definition, BALANCE SHEET, Jan. 2004, at 29 (referring to bank runs as the “classic
systemic risk”).
48
See, e.g., Douglas W. Diamond & Philip H. Dybvig, Banking Theory, Deposit
Insurance, and Bank Regulation, 59 J. BUS. 55, 63–64 (1986) (analyzing optimal
contracts that prevent bank runs and observing that government provision of deposit
insurance can produce superior contracts). It might be argued that the direct effect of
deposit insurance, protecting individual depositors, is somewhat misguided because
depositors are contracting creditors of the bank. The indirect effect, however, is to protect
the bank itself from a run.
49
See Steven L. Schwarcz, Regulating Shadow Banking, 31 REVIEW OF BANKING &
FINANCIAL LAW 619 (2012), also available at http://ssrn.com/abstract=1993185.
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estimated at $60 trillion worldwide in December 2011,50 and a more recent estimate
suggests an even higher number.51
Shadow banking can create the equivalent of a bank run to the extent it engages
in short-term funding of long-term projects.52 In the securitization context, for example,
asset-backed commercial paper (ABCP) conduits and structured investment vehicles
(SIVs) routinely issue short-term commercial paper to fund long-term loans or other
investments.53 Money-market mutual funds also provide short-term loans, essentially
50
See Philipp Halstrick, Tighter Bank Rules Give Fillip to Shadow Banks, REUTERS (Dec.
20, 2011, 4:17 AM), http://www.reuters.com/article/2011/12/20/ uk-regulation-shadowbanking-idUSLNE7BJ00T20111220 (last visited June 10, 2013) (indicating that shadow
banking is a $60 trillion industry).
51
See FIN. STABILITY BD., GLOBAL SHADOW BANKING MONITORING REPORT (2012),
http://www.financialstabilityboard.org/publications/r_121118c.pdf (estimating shadow
banking’s worldwide assets as $67 trillion in 2011).
52
See, e.g., Viral V. Acharya & S. Viswanathan, Leverage, Moral Hazard, and Liquidity,
66 JOURNAL OF FINANCE 99, 103 (2011) (observing that short-term funding of long-term
projects “played an important role in the financial crisis of 2007 to 2009 and the period
preceding it”); Kyle Glazier, Bernanke: Financial Crisis Was a Structural Failure, BOND
BUYER, Apr. 13, 2012, at 2, http://www.bond buyer.com/news/bernanke-speechfinancial-crisis-structural-failure-1038520-1. html?partner=sifma (last visited June 17,
2013) (quoting Federal Reserve Board Chairman Ben Bernanke as saying that “a key
vulnerability of the [disintermediated financial] system was the heavy reliance . . . on
various forms of short-term wholesale funding”); cf. Regulating Shadow Banking, supra
note 49, at 625 n.30 (arguing “that the instability of short-term ‘money-like’ securities is
the central problem for regulatory policy” in the disintermediated financial system);
Martin H. Wolfson, Minsky’s Theory of Financial Crisis in a Global Context, 36 J. ECON.
ISSUES 393, 394 (2002) (describing Minsky’s theory that market fragility grows as debt
levels rise and that the proportion of debt will increase as firms use short-term debt to
fund long-term financial assets). Economists sometimes refer to the short-term funding of
long-term projects as a form of maturity transformation or as an asset-liability mismatch.
See, e.g., Huberto M. Ennis & Todd Keister, Bank Runs and Institutions: The Perils of
Intervention, 99 AM. ECON. REV. 1588, 1590 (2009) (“Money market funds and other
arrangements perform maturity transformation by investing in long-term assets while
offering investors the ability to withdraw funds on demand.”).
53
The business model of ABCP conduits and SIVs is very similar to that of banks in that
they borrow short-term and lend long-term. See, e.g., Structured Investment Vehicle
Definition, MONEYTERMS.CO.UK, http://moneyterms.co.uk/siv/ (last visited Jan. 14, 2013)
(discussing the business model of SIVs).
Schwarcz_Paper
15
withdrawable on demand, to fund long-term projects.54 Additionally, repo lending by
securities lenders is almost always short term. The driving force behind much of the
short-term funding of long-term projects is the reality that the interest rate on short-term
debt is usually lower than that on long-term debt because, other things being equal, there
is less interest-rate risk and it is easier to assess an obligor’s ability to repay in the short
term than in the long term.
Short-term funding of long-term projects can be efficient so long as the firm
issuing the short-term debt will be able to “roll over” that debt (i.e., repay its maturing
short-term debt from the proceeds of newly borrowed short-term debt), if needed. Thus,
the traditional business of banking uses short-term deposits (loans from depositors) to
make long-term loans to bank customers. But if a short-term lender is unable to roll over
its debt, it could default, with potentially systemic consequences.55
The short-term funding of long-term projects is merely one mechanism by which
systemic risk could be triggered. As mentioned, systemic risk can also be triggered by
financial panics,56 yet it is impossible to identify all the causes of panics.57 Moreover, so
long as firms operate under a limited liability management regime, systemic risk can even
be triggered by rational management decisions. I have already observed that limited54
See Bryan J. Noeth, et al., Is Shadow Banking Really Banking?, 19 REGIONAL
ECONOMIST 8, 9 (2011) (describing the use of money market mutual funds to “provide
short term loans that are essentially withdrawable on demands”).
55
Federal Reserve Board economists thus argue that the inability of many ABCP
conduits to roll over their short-term commercial paper in the last five months of 2007
“played a central role in transforming concerns about the credit quality of mortgagerelated assets into a global financial crisis.” Daniel Covitz, Nellie Liang & Gustavo
Suarez, The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial
Paper Market 1 (Fed. Reserve Bd. Fin. and Discussion Series, Working Paper #2009‐36,
2009), http://www.federalreserve.gov/pubs/feds/2009/200936/200936pap.pdf. The
European Central Bank also has identified short-term funding of long-term projects as “a
major amplification mechanism in situations of stress,” which can particularly “foster
systemic risks . . . . if [it] takes place outside the regulated [financial] system.” KLARA
BAKK-SIMON ET AL., EUROPEAN CENT. BANK, OCCASIONAL PAPER NO. 133, SHADOW
BANKING IN THE EURO AREA: AN OVERVIEW, at 24 (Apr. 2012).
56
See supra notes 25 & 35-37 and accompanying text.
57
See supra note 43 and accompanying text.
Schwarcz_Paper
16
liability firms may well decide to engage in profitable transactions that increase systemic
risk, because much of the harm from a possible systemic collapse would be externalized
onto others.58
Policymakers considering macroprudential regulation should examine the
appropriate role of limited liability, especially for the small and decentralized firms (such
as hedge funds) that dominate the shadow-banking sector, where equity investors tend to
be active managers.59 Limited liability gives these investor-managers strong incentives to
take risks that could generate out-size personal profits, even if that greatly increases
systemic risk.60 The law does not effectively mitigate these systemic externalities.
Although tort law, for example, focuses on internalizing externalities by empowering
injured third parties to sue for harm, plaintiffs normally must show their harm to be a
causal and foreseeable consequence of the tortfeasor’s actions. Systemic harm, however,
is caused indirectly and affects a wide range of third parties in unpredictable ways.61 For
shadow-banking firms subject to this conflict, limited liability should be redesigned to
better align investor and societal interests.62
There may well be other reasons why we cannot eliminate all of the triggers of
systemic risk. Economists focus, for example, on monitoring; from that standpoint,
problems are inevitable because it is impossible to monitor everything in the financial
58
See supra note 12 and accompanying text.
Steven L. Schwarcz, The Governance Structure of Shadow Banking: Rethinking
Assumptions About Limited Liability, forthcoming [cite to LAW REVIEW].
60
Id.
61
Id.
62
Regardless of how limited liability is redesigned, however, it faces the dilemma that
investor-managers would have relatively little incentive to monitor and guard against
their firm’s potential to trigger systemic risk if tort law bars third parties injured by
systemic harm from recovering damages. Id. A possible solution to this dilemma would
be to couple the redesigned limited liability with a privatized systemic risk fund—which
would be used to mitigate systemic harm—into which systemically risky shadow-banking
firms would be required to contribute. If their firm has insufficient capital to make these
contributions, investor-managers would become personally liable for all or a portion of
the contribution, thereby motivating them to monitor and help control their firm’s
systemically risky behavior. Id.
59
Schwarcz_Paper
17
system.63 Another reason we cannot eliminate the triggers of systemic risk is that we
often lack empirical evidence on regulatory cause and effect. As a result, macroprudential
financial regulation—like microprudential regulation64—will sometimes be imperfect.
This imperfection can be illustrated by the special protections given to creditors in
derivatives transactions under bankruptcy and insolvency law. These protections, which
are claimed to be necessary to mitigate systemic risk,65 not only are arguably the most
important example of macroprudential regulation in the United States but also serve as
“an important precedent” for macroprudential regulation worldwide.66 At least in part,
however, these protections are a path-dependent outcome of decades of sustained
industry pressure on Congress to exempt the derivatives market from the reach of
bankruptcy law.67 Although the earliest such protection lacked any empirical evidence of
efficacy to mitigate systemic risk, once enacted as law it served as precedent for
subsequent broader protections.68 Recent research suggests, however, that these
protections can have unintended adverse consequences, possibly even increasing
systemic risk.69
63
Eugene N. White, Professor of Economics, Rutgers University (statement at Chatham
House conference, supra note 1) (Dec. 6, 2013).
64
Cf. supra notes 37-43 and accompanying text (explaining why microprudential
regulation will sometimes be imperfect).
65
See, e.g., Stephen D. Adams, “Derivative Exemptions in Bankruptcy and Dodd Frank:
A Structural Analysis,” Working Paper Draft (Dec. 2, 2013), at 10-13, available at
http://ssrn.com/abstract=2348828 (discussing that systemic risk has been central to
justifying these protections and noting both the unanimity and vagueness of the
discussions); Steven L. Schwarcz & Ori Sharon, The Bankruptcy-Law Safe Harbor for
Derivatives: A Path-Dependence Analysis, 71 WASHINGTON AND LEE LAW REVIEW issue
no. 3 (forthcoming 2014) (explaining the history of these protections).
66
Id.
67
Id.
68
Id. Overreliance on this precedent was almost certainly fostered by both the complexity
of derivatives and uncertainty over how systemic risk is created and transmitted. Being
concerned about systemic risk, members of Congress tended to see what they expected to
see, the expectation in this case being driven by powerful derivatives-industry lobbying
pressure. From a public choice standpoint, no powerful interest groups presented
Congress with opposing views. Id.
69
Id. See also DAVID SKEEL, THE NEW FINANCIAL DEAL: UNDERSTANDING THE DODDFRANK ACT AND ITS (UNINTENDED) CONSEQUENCES, 135 (2011); Mark J. Roe, The
Schwarcz_Paper
18
B. Limiting the Transmission and Impact of Systemic Shocks
It therefore is virtually certain that the financial system will face systemic shocks
from time to time. Any macroprudential regulatory framework should therefore be
designed to also act ex post, after a systemic shock is triggered, by breaking the
transmission of the shock and limiting its impact. This approach takes inspiration from
chaos theory, which holds that in complex engineering systems—and, I have argued, also
in complex financial systems—failures are almost inevitable.70
To break the transmission of systemic failures would require that the transmission
mechanisms all be identifiable. It is probably not feasible, however, to identify all those
mechanisms in advance.71 We therefore need to also find ways to limit the impact of
systemic shocks. This could be done by trying to stabilize systemically important firms
and financial markets impacted by the shocks.72 There are at least three ways that
regulation could accomplish that: by ensuring liquidity to those firms and markets, by
requiring those firms to be more robust, and by ring-fencing.
Derivatives Market’s Payment Priorities as Financial Crisis Accelerator, 63 STANFORD
LAW REVIEW 539, 561 (2010-2011); Stephen J. Lubben, Repeal The Safe Harbor, 18
AMERICAN BANKRUPTCY INSTITUTE LAW REVIEW 319, 331 (2010); Bryan G. Faubus,
Narrowing the Bankruptcy Safe Harbor for Derivatives to Combat Systemic Risk, 59
DUKE LAW JOURNAL 801, 828-29 (2009-2010); Stephen J. Lubben, Derivatives and
Bankruptcy: The Flawed Case for Special Treatment, 12 UNIVERSITY OF PENNSYLVANIA
JOURNAL OF BUSINESS LAW 61, 75 (2009); Franklin R. Edwards & Edward R. Morrison,
Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 YALE JOURNAL
ON REGULATION 91, 95 (2005).
70
See Regulating Complexity in Financial Markets, supra note 6, at 248-49. One aspect
of chaos theory is deterministic chaos in dynamic systems, which recognizes that the
more complex the system, the more likely it is that failures will occur. Thus, the most
successful (complex) systems are those in which the consequences of failures are limited.
In engineering design, for example, this can be done by decoupling systems through
modularity that helps to reduce a chance that a failure in one part of the system will
systemically trigger a failure in another part.
71
Anabtawi & Schwarcz, supra note 26, at [cite].
72
See Regulating Ex Post, supra note 43.
Schwarcz_Paper
19
1. Ensuring Liquidity to Firms and Markets. Liquidity has traditionally been
used, especially by government central banks, to help prevent financial firms from
defaulting. Ensuring liquidity to stabilize systemically important firms would follow this
pattern, except that the source of the liquidity could at least be partly privatized by taxing
those firms to create a systemic risk fund.
The precedents for requiring the private sector to contribute funds to help
internalize externalities include the U.S. Federal Deposit Insurance Corporation (FDIC),
which requires member banks to contribute to a Deposit Insurance Fund to ensure that
depositors of failed banks are repaid.73 Similarly, U.S. law requires each owner of a
nuclear reactor to contribute monies to a fund to compensate for possible reactor
accidents.74
In the systemic risk context, privatizing the source of liquidity would likewise
help to internalize externalities by addressing the dilemma that market participants are
economically motivated to create externalities that could have systemic consequences.75
Privatization would not only offset the cost to taxpayers of liquidity advances that are not
repaid but also, if structured appropriately,76 should reduce moral hazard by discouraging
fund contributors—including those that believe they are “too big to fail”—from engaging
in financially risky activities. The likelihood that systemically important firms will have
to make additional contributions to the fund to replenish bailout monies should also
motivate those firms to monitor each other and help control each other’s risky behavior.77
73
See infra note 76.
U.S. NUCLEAR REG. COMM’N, Fact Sheet on Nuclear Insurance and Disaster Relief
Funds, http://www.nrc.gov/reading-rm/doc-collections/fact-sheets/funds-fs.html (last
updated June 9, 2011).
75
Cf. Jeffrey N. Gordon & Christopher Muller, Confronting Financial Crisis: DoddFrank’s Dangers and the Case for a Systemic Emergency Insurance Fund, 28 YALE
JOURNAL ON REGULATION 151, 156 (2011) (calling for a systemic emergency insurance
fund that is funded by the financial industry).
76
For example, required contributions could be sized as a function, among other factors,
of the contributor’s financially risky activities.
77
The European Commission has been considering the idea of a systemic risk fund in
connection with its proposal to tax the financial sector. European Commission, Taxation
74
Schwarcz_Paper
20
It is not enough to try to stabilize systemically important firms. Financial
markets—which are now as much a part of the financial system as financial firms78—can
also be triggers and transmitters of systemic risk. Liquidity can be used to stabilize
systemically important financial markets.79 For example, in response to the post-Lehman
collapse of the commercial paper market, the U.S. Federal Reserve created the
Commercial Paper Funding Facility (“CPFF”) to act as a lender of last resort for that
market, with the goal of addressing “temporary liquidity distortions” by purchasing
commercial paper from highly rated issuers that could not otherwise sell their paper.80
The CPFF helped to stabilize the commercial paper market.81
2. Requiring Firms to be More Robust. Regulation could also help to stabilize
systemically important firms by requiring them to be more robust.82 This could be
accomplished in various ways.
of the Financial Sector, a Communication from the Commission to the European
Parliament, the Council, the European Economic and Social Committee and the
Committee of the Regions: (Brussels COM (2010) 549/5; SEC (2010) 1166). See also
European Draft Directive on a Common System of Financial Tax (Sept. 28, 2011),
available at
http://ec.europa.eu/taxation_customs/taxation/other_taxes/financial_sector/index_en.htm.
News reports indicate that an originally contemplated use was a systemic risk fund.
Commission Proposes a Bank Tax to Cover the Costs of Winding Down Banks that Go
Bust (May 26, 2010), available at http://ec.europa.eu/news/economy/100526_en.htm (last
visited Mar. 1, 2011). [Update-cite1]
78
See Systemic Risk, supra note 3, at [cite].
79
This was first proposed in Systemic Risk, supra note 3, at 225-30.
80
See Tobias Adrian, Karin Kimbrough, & Dina Marchioni, The Federal Reserve’s
Commercial Paper Funding Facility, FED. RESERVE BANK OF N.Y. STAFF REPORT NO.
423 (April 1, 2010).
81
Id. at 11 (concluding that “[t]he CPFF indeed had a stabilizing effect on the
commercial paper market”).
82
Although I refer to regulation requiring firms to become more robust as ex post (in the
sense that more robust firms can better withstand a systemic shock), such regulation
could also be viewed as ex ante in the sense that robust firms are less likely to fail and
thereby trigger a systemic shock.
Schwarcz_Paper
21
Regulation has long been focused on requiring traditional deposit-taking banks to
be robust, usually through capital and solvency requirements.83 Furthermore, to ensure
their liquidity, banks generally have had access to central bank liquidity, ensuring they
can pay their debts. Since the financial crisis, laws like the Dodd-Frank Act are beginning
to also require other “systemically important” financial firms to be subject to a range of
capital and similar requirements.84
The extent to which these types of approaches will work, and their potential
impact on efficiency, are open questions. Reducing a firm’s leverage, for example, can
certainly enable the firm to withstand economic shocks and reduce its chance of failure.
The Basel capital requirements, however, did not prevent the many bank failures
resulting from the global financial crisis. Setting regulatory limits on leverage could also
backfire because some leverage is good but there is no optimal across-the-board amount
of leverage that is right for every firm.
Another way that regulation could make systemically important firms more robust
is by requiring at least some portion of their debt to be in the form of so-called contingent
capital.85 Contingent capital debt would automatically convert to equity upon the
occurrence of pre-agreed events. Requiring contingent capital is therefore effectively like
requiring a pre-planned debt restructuring or workout. But it is unclear if regulatoryimposed contingent capital would be efficient.86 If contingent capital is a good idea,
83
See Systemic Risk, supra note 3, at 210 (“Historically, regulation of systemic risk has
focused largely on prevention of bank failure.”).
84
Dodd-Frank Act §§ 115(b) & 165(i). The Dodd-Frank Act directs the Federal Reserve,
for example, to set “prudential” capital standards for certain large financial firms,
including a maximum debt-to-equity ratio of 15:1. Id. § 165(j). [Also address potential
SIFI access to central bank liquidity under Dodd-Frank. cite1]
85
See, e.g., John C. Coffee, Jr., Systemic Risk After Dodd-Frank: Contingent Capital and
the Need for Regulatory Strategies Beyond Oversight, 111 COLUMBIA LAW REVIEW 795
(2011).
86
As of July 2011, the Basel Committee has determined that systemically important
financial firms will only be allowed to meet their additional loss absorbency requirement
with common equity Tier 1 capital, not contingent capital. The Basel Committee will,
however, “continue to review contingent capital, and support the use of contingent capital
to meet higher national loss absorbency requirements than the global requirement, as
Schwarcz_Paper
22
markets themselves should implement it; but there is no evidence of that implementation
(nor is there evidence of market failures impeding that implementation). Regulatoryimposed contingent capital might also have unforeseen consequences. For example,
automatic conversions of debt claims to equity interests might create counterparty risk by
reducing the value of firms holding those claims.
3. Ring-Fencing. Another way that regulation could help to limit the impact of
systemic shocks is through ring-fencing. When used as a form of financial regulation,
ring-fencing can best be understood as legally deconstructing a firm in order to more
optimally reallocate and reduce risk.87
The deconstruction could occur in various ways. For example, the firm could be
made more internally viable, such as by separating risky assets from the firm and
preventing the firm from engaging in risky activities or investing in risky assets.88 The
firm could also be protected from external risks, such as ensuring that the firm is able to
operate on a standalone basis even if its affiliates fail and insulating the firm from thirdparty claims, involuntary bankruptcy, and affiliate abuse.89
Although ring-fencing represents another way that regulation could help to limit
the impact of systemic shocks, ring-fencing can also help to limit the triggers and
transmission of systemic shocks.90 Thus, the so-called Volcker Rule, which imposes
limitations on proprietary trading in order to prevent systemically important financial
high-trigger contingent capital could help absorb losses on a going concern basis.” Bank
for Int’l Settlements, Consultative Document: Global Systemically Important Banks:
Assessment Methodology and the Additional Loss Absorbency Requirement, at 19-20
(July 2011), http://www.bis.org/publ/bcbs201.pdf.
87
Steven L. Schwarcz, Ring-Fencing, 87 SOUTHERN CALIFORNIA LAW REVIEW issue no.
1 (forthcoming 2014); available at http://ssrn.com/abstract=2228742.
88
Ring-Fencing, supra note 87, at [cite].
89
Id. at [cite].
90
Ring-fencing to make a firm more internally viable also overlaps with the earlier
discussion of requiring firms to be more robust. See supra notes 82-85 and accompanying
text.
Schwarcz_Paper
23
firms from investing in risky assets,91 is effectively a form of ring-fencing.92 Its primary
goal, however, is to prevent losses that could trigger the systemic collapse of those
firms.93
Ring-fencing’s reallocation of risk raises important normative questions about
when, and how, it should be used as an economic regulatory tool. For example, ringfencing is often considered to help protect publicly essential activities performed by
utility companies and sometimes considered to help protect publicly beneficial activities
performed by banks. The latter is exemplified by the ring-fencing used under the GlassSteagall Act94 and proposed in the final report of the U.K. Independent Commission on
Banking (often called the Vickers Report95). The Vickers Report recommends a limited
form of separation intended to protect the “basic banking services of safeguarding retail
deposits, operating secure payments systems, efficiently channelling savings to
productive investments [i.e., making loans], and managing financial risk.”96
From a cost-benefit standpoint, ring-fencing is highly likely to be appropriate to
help protect the publicly essential activities performed by utility companies, such as
providing power, clean water, and communications.97 Not only are those services
necessary but the utility company, normally being a monopoly, is the only entity able to
91
See Dodd-Frank Act sec. 619, § 13.
See text accompanying note 88, supra (observing that ring-fencing includes preventing
a firm “from engaging in risky activities or investing in risky assets”).
93
[cite]
94
In the United States, the Glass-Steagall Act (which has since been revoked) had created
a separation between commercial and investment banking—the former including deposit
taking and lending, the latter including securities underwriting and investing.
95
Although I provided input for this Report in a November 12, 2010 meeting at All Souls
College, University of Oxford, with Commission Chairman Sir John Vickers and other
members of the Commission’s Secretariat, I did not suggest the ring-fencing procedure
that the Report eventually adopted.
96
Vickers Report, at 7. Ring-fencing is more of a microprudential than macroprudential
approach to the extent its focus is more on protecting retail banking activities rather than
on preventing systemic collapse.
97
Ring-Fencing, supra note 87.
92
Schwarcz_Paper
24
provide the services. Ring-fencing utility companies against risk helps assure the
continuity of their services.
It is less certain, though, that ring-fencing should be used to help protect other
publicly beneficial activities. For example, even if the public services provided by banks
were as important as those provided by public utilities,98 the need to ring-fence banks
would not be as strong as the need to ring-fence public utilities. That’s because the
market for banking services is competitive. If some risky banks become unable to provide
services, other banks should be able to provide substitute services.99 It therefore is
uncertain whether the benefits of ring-fencing banks would exceed its costs.
Ring-fencing could also be used to help protect the financial system itself, by
mitigating systemic risk and the related too-big-to-fail problem of large banks and other
financial institutions.100 The competing costs and benefits of using ring-fencing for those
purposes, however, would be highly complex. Not only would they depend, among other
things, on the ways in which the ring-fencing is structured; they also would have to be
compared to the costs and benefits of other regulatory approaches to mitigating systemic
risk.101
98
I use this example solely as an illustration. I do not suggest that the public services
provided by banks are as important as those provided by public utilities.
99
Substitutability is one of three primary factors—the others being interconnectedness
and size—by which the Financial Stability Board assesses systemic risk. See FSB, [cite to
its systemic risk criteria] (2009). The more substitutable something is, the less
systemically risk would be its loss.
100
This is the purpose of ring-fencing proposed for systemically important financial
institutions under the Dodd-Frank Act.
101
There remains controversy, for example, over the desirability of implementing the
Volcker Rule, which paternalistically substitutes a blanket regulatory prescription for a
firm’s own business judgment. [cite to the current controversy] One should be generally
skeptical of any rule that attempts to protect a sophisticated financial firm from itself—
and indeed, Moody’s has warned that a leaked early draft of interagency rules
implementing the Volcker Rule would, if adopted, probably “diminish the flexibility and
profitability of banks’ valuable market-making operations and place them at a
competitive disadvantage to firms not constrained by the rule.” Edward Wyatt,
Regulators to Set Forth Volcker Rule, N.Y. TIMES, Oct. 10, 2011 (quoting Moody’s). On
the other hand, the fact that limited-liability firms may well rationally decide to engage in
Schwarcz_Paper
25
IV. CONCLUSIONS
An effective regulatory framework to help control systemic risk must look beyond
politics and blame. Because systemic risk is a form of financial risk, the framework
should start with “microprudential” regulation, designed to maximize economic
efficiency by correcting market failures within the financial system. This part of the
framework is additionally important because certain of those market failures can be
factors in triggering systemic risk.
Because systemic risk represents risk to the financial system itself, the regulatory
framework must also include the larger “macroprudential” goal of protecting the financial
system as a “system.” To that end, regulation should start by attempting to eliminate the
remaining triggers of systemic risk. For many reasons, however, regulation cannot
successfully accomplish that. Taking inspiration from chaos theory,102 the regulatory
framework must therefore also attempt to limit the transmission and impact of the
systemic shocks that inevitably will be triggered.
profitable transactions that increase systemic risk (see supra note 12 and accompanying
text) suggests that the Volcker Rule may not be completely misguided. The Volcker Rule
has not, however, been subjected to a rigorous cost-benefit analysis or compared to the
costs and benefits of other regulatory approaches to mitigating systemic risk. [cite]
102
Chaos theory holds that in complex systems, failures are almost inevitable. See supra
notes 70-72 and accompanying text.
Schwarcz_Paper
Understanding the New Financial
Reform Legislation: The Dodd-Frank
Wall Street Reform and Consumer
Protection Act
July 2010
THE DODD-FRANK WALL STREET REFORM AND CONSUMER
PROTECTION ACT
For more information about the matters raised in this Legal Update, please contact your regular Mayer
Brown contact or one of the following:
Scott A. Anenberg
+1 202 263 3303
sanenberg@mayerbrowm.com
Charles M. Horn
+1 202 263 3219
chorn@mayerbrown.com
Michael R. Butowsky
+1 212 506 2512
mbutowsky@mayerbrown.com
Jerome J. Roche
+1 202 263 3773
jroche@mayerbrown.com
Joshua Cohn
+1 212 506 2539
jcohn@mayerbrown.com
David R. Sahr
+1 212 506 2540
dsahr@mayerbrown.com
Thomas J. Delaney
+1 202 263 3216
tdelaney@mayerbrown.com
Jeffrey P. Taft
+1 202 263 3293
jtaft@mayerbrown.com
Table of Contents
Index of Acronyms / Abbreviations …………………………………………………………………………………….xv
The Dodd-Frank Wall Street Reform and Consumer Protection Act ………………………………………… 1
A.
Summary ……………………………………………………………………………………………………. 1
B.
A Very Brief History of the Legislation ……………………………………………………………. 1
C.
Overview of the Legislation ………………………………………………………………………….. 2
D.
1.
Framework for Financial Stability ……………………………………………………….. 2
2.
Orderly Liquidation Regimen ……………………………………………………………… 3
3.
Other Changes to the Bank Regulatory Structure …………………………………. 3
4.
Increasing Consumer Protection ………………………………………………………… 4
5.
Derivatives Regulation ………………………………………………………………………. 5
6.
Capital Markets and Investor Protection ……………………………………………… 5
7.
Registration of Advisers to Hedge Funds, Private Equity Funds, and
Others …………………………………………………………………………………………….. 6
8.
Insurance Oversight and Regulatory Reform………………………………………… 6
9.
Federal Reserve System Changes ……………………………………………………….. 6
10.
Other Provisions……………………………………………………………………………….. 6
Effective Dates and Implementation ……………………………………………………………… 7
TITLE I – FINANCIAL STABILITY ……………………………………………………………………………………………. 8
A.
Summary ……………………………………………………………………………………………………. 8
B.
Establishment of the Financial Stability Oversight Council ……………………………….. 8
1.
Organization / Structure ……………………………………………………………………. 8
2.
Purpose and Duties of the FSOC …………………………………………………………. 9
3.
Office of Financial Research ……………………………………………………………… 10
© 2010 Mayer Brown LLP
Understanding the New
Financial Reform Legislation
_______________________________________________________________________________
C.
D.
E.
F.
Registration of Nonbank Financial Companies with the FRB and
Identification of Systemic BHCs …………………………………………………………………… 11
1.
US Nonbank Financial Companies …………………………………………………….. 11
2.
Foreign Nonbank Financial Companies ……………………………………………… 13
3.
US Systemic BHCs……………………………………………………………………………. 15
4.
Foreign Systemic BHCs …………………………………………………………………….. 15
5.
Additional Considerations for Foreign Companies ………………………………. 15
Prudential Standards to be Developed for Systemically Significant
Institutions ……………………………………………………………………………………………….. 16
1.
Risk-Based Capital and Leverage Limits ……………………………………………… 17
2.
Liquidity Requirements ……………………………………………………………………. 22
3.
Overall Risk Management/Risk Committees ………………………………………. 22
4.
Resolution Plans ……………………………………………………………………………… 23
5.
Concentration Limits, Credit Exposure and Application of
Attribution Rule ……………………………………………………………………………… 24
6.
Enhanced Public Disclosures …………………………………………………………….. 25
7.
Short-Term Debt Limits ……………………………………………………………………. 25
Other Requirements Intended to Protect the Financial System ………………………. 25
1.
Heightened Requirements Applicable to Activities ……………………………… 25
2.
Mitigation of a Grave Threat to Financial Stability ………………………………. 25
3.
Stress Testing …………………………………………………………………………………. 26
4.
Limitations on Acquisitions ………………………………………………………………. 27
5.
Early Remediation Requirements ……………………………………………………… 27
6.
Depository Institutions Management Interlocks Act ……………………………. 28
7.
Ceasing to be a BHC ………………………………………………………………………… 28
Supervision and Reporting ………………………………………………………………………….. 28
1.
FRB Supervision of Systemic Nonbanks ……………………………………………… 28
2.
Expanded FDIC Supervisory Authority ……………………………………………….. 29
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G.
Efforts to Encourage Development of Similar Restrictions and
Requirements Outside of the United States ………………………………………………….. 30
1.
US Offices of Foreign Banks ……………………………………………………………… 30
2.
Broker-Dealer Registration ………………………………………………………………. 31
TITLE II – ORDERLY LIQUIDATION AUTHORITY ……………………………………………………………………. 32
A.
Summary ………………………………………………………………………………………………….. 32
B.
Covered Financial Companies ……………………………………………………………………… 32
C.
Excluded Entities ……………………………………………………………………………………….. 33
D.
Process for Determining That a Financial Company Is Subject to the New
Orderly Liquidation Regime ………………………………………………………………………… 33
E.
F.
1.
Written Recommendation to Appoint Receiver ………………………………….. 33
2.
Systemic Risk Determination by Treasury ………………………………………….. 34
3.
Judicial Review of Determination ……………………………………………………… 35
FDIC Appointment; Receivership Duties and Powers ……………………………………… 35
1.
Subsidiaries of a Covered Financial Company …………………………………….. 36
2.
Orderly Liquidation Modeled on FDIA ……………………………………………….. 36
3.
Differences from FDIA Provisions ……………………………………………………… 37
4.
Purposes of Orderly Liquidation ……………………………………………………….. 37
Orderly Liquidation of Covered Brokers and Dealers ……………………………………… 37
1.
FDIC Appointment of SIPC as Trustee ………………………………………………… 37
2.
FDIC Creation of Broker-Dealer Bridge Company ………………………………… 38
G.
Orderly Liquidation of Insurance Companies ………………………………………………… 38
H.
Orderly Liquidation and Repayment Plans ……………………………………………………. 38
1.
Orderly Liquidation Fund …………………………………………………………………. 38
2.
Repayment Plan ……………………………………………………………………………… 39
3.
Risk-Based Assessments to Recover Costs …………………………………………. 39
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I.
J.
Studies ……………………………………………………………………………………………………… 40
1.
Study on Secured Creditor Haircuts…………………………………………………… 40
2.
Study on Bankruptcy Processes for Financial and Nonbank
Financial Institutions ……………………………………………………………………….. 40
3.
Study on International Coordination Relating to Bankruptcy
Process for Nonbank Financial Institutions ………………………………………… 41
Effective Date ……………………………………………………………………………………………. 41
TITLE III – TRANSFER OF POWERS TO THE OCC, THE FDIC, AND THE FRB ……………………………….. 42
A.
Summary ………………………………………………………………………………………………….. 42
B.
Transfer of OTS Authority to the OCC, FDIC, and FRB …………………………………….. 42
C.
D.
1.
Transfer of OTS Federal Thrift and Rulemaking Authority to the
OCC……………………………………………………………………………………………….. 43
2.
Transfer of OTS Authority to the FDIC ……………………………………………….. 43
3.
Transfer of OTS Thrift Holding Company Authority to the FRB ……………… 43
4.
Transfer Date; Elimination of the OTS ……………………………………………….. 43
5.
Replacement of OTS Director on FDIC Board ……………………………………… 44
6.
Pending OTS Matters ………………………………………………………………………. 44
7.
Branching Powers of Thrifts That Convert to Bank Charters …………………. 44
Deposit Insurance Reforms …………………………………………………………………………. 44
1.
Permanent Increase of the Standard Maximum Deposit Insurance
Amount …………………………………………………………………………………………. 45
2.
Extension of Full Insurance Coverage for Noninterest-Bearing
Transaction Accounts ………………………………………………………………………. 45
3.
Revised Definition of Assessment Base ……………………………………………… 45
4.
Increase in the Minimum Reserve Ratio …………………………………………….. 46
5.
FDIC Authority to Suspend Payment of Rebates …………………………………. 46
Additional Measures ………………………………………………………………………………….. 47
1.
Agency Funding Authority ……………………………………………………………….. 47
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2.
Establishment of Offices of Minority and Women Inclusion …………………. 47
TITLE IV – REGULATION OF ADVISERS TO HEDGE FUNDS AND OTHERS …………………………………. 48
A.
Summary ………………………………………………………………………………………………….. 48
B.
Elimination of Private Adviser Exemption …………………………………………………….. 48
C.
Limited Exemptions from Registration …………………………………………………………. 49
D.
E.
1.
Advisers to Venture Capital Funds …………………………………………………….. 49
2.
Foreign Private Advisers ………………………………………………………………….. 49
3.
Advisers to Private Funds…………………………………………………………………. 50
4.
Advisers to Small Business Investment Companies ……………………………… 50
5.
“Commodity Trading Advisors” Who Advise Private Funds ………………….. 51
6.
Mid-Sized Investment Advisers…………………………………………………………. 51
Other Provisions………………………………………………………………………………………… 52
1.
Recordkeeping by Advisers to Private Funds………………………………………. 52
2.
Disclosure of Information; Confidentiality …………………………………………. 52
3.
Definition of “Client” for Anti-Fraud Purposes ……………………………………. 53
4.
Custody of Client Assets…………………………………………………………………… 53
5.
Net Worth Standard for “Accredited Investors” …………………………………. 53
6.
Qualified Client Test ………………………………………………………………………… 53
7.
Effect on the CEA ……………………………………………………………………………. 54
8.
Studies to be Undertaken ………………………………………………………………… 54
Effective Date ……………………………………………………………………………………………. 54
TITLE V – INSURANCE ………………………………………………………………………………………………………. 55
A.
Summary ………………………………………………………………………………………………….. 55
B.
Creation of the Federal Insurance Office ………………………………………………………. 56
1.
Monitoring …………………………………………………………………………………….. 56
2.
Advisory ………………………………………………………………………………………… 56
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C.
D.
3.
Administrative ………………………………………………………………………………… 56
4.
Reports ………………………………………………………………………………………….. 57
Information Collection ……………………………………………………………………………….. 58
1.
No Waiver of Privilege …………………………………………………………………….. 58
2.
Subpoena Power …………………………………………………………………………….. 58
Preservation of States’ Authority to Regulate Insurance ………………………………… 59
1.
E.
Authority of the FIO to Negotiate International Insurance Agreements …………… 60
1.
F.
G.
Preconditions for Implementing Preemption Authority ………………………. 59
Authority of the Secretary and USTR …………………………………………………. 60
Regulatory Reform Governing Non-Admitted Insurance Coverage ………………….. 60
1.
Treatment of Premium Tax Payments ……………………………………………….. 60
2.
Regulation of Non-Admitted Insurance by Home State of Insured
Party ……………………………………………………………………………………………… 60
3.
Streamlined Application for Commercial Purchasers …………………………… 61
4.
GAO Study of Non-Admitted Market …………………………………………………. 62
Regulatory Reform Governing Reinsurance and Reinsurance Agreements ……….. 62
1.
Regulation of Reinsurer Solvency ……………………………………………………… 63
TITLE VI – IMPROVEMENTS TO THE REGULATION OF BANK AND SAVINGS ASSOCIATION
HOLDING COMPANIES AND DEPOSITORY INSTITUTIONS ……………………………………………………… 64
A.
Summary ………………………………………………………………………………………………….. 64
B.
The Volcker Rule ……………………………………………………………………………………….. 65
1.
Ban on Proprietary Trading and Certain Relationships with Private
Funds …………………………………………………………………………………………….. 65
2.
Covered Entities ……………………………………………………………………………… 65
3.
Ban on Proprietary Trading ………………………………………………………………. 66
4.
Exemptions from the Ban on Proprietary Trading ……………………………….. 66
5.
Ban on Certain Relationships with Hedge Funds and Private Equity
Funds …………………………………………………………………………………………….. 68
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6.
Exemptions from the Ban on Certain Relationships with Covered
Funds …………………………………………………………………………………………….. 69
7.
Exemption Limits…………………………………………………………………………….. 71
8.
Volcker Rule Applicability to Nonbank Financial Companies
Supervised by the FRB …………………………………………………………………….. 72
9.
Implementation and Rulemaking ……………………………………………………… 72
C.
Conflicts of Interest Related to Securitizations ……………………………………………… 73
D.
Nonbank Bank Moratorium and Study …………………………………………………………. 74
E.
De Novo Interstate Branching ……………………………………………………………………… 74
F.
Authorization of Interest-Bearing Transaction Accounts ………………………………… 75
G.
Concentration Limits ………………………………………………………………………………….. 75
H.
1.
Ten Percent Consolidated Liabilities Cap ……………………………………………. 75
2.
Ten Percent Insured Deposit Cap ……………………………………………………… 76
Examination and Regulation of Bank and Thrift Holding Companies and
Subsidiaries ………………………………………………………………………………………………. 76
1.
Consideration of Risks to the US Financial System ………………………………. 76
2.
Enhanced FRB Regulation of Nonbank Subsidiaries …………………………….. 76
3.
Additional Restrictions on Financial Holding Companies ……………………… 77
4.
Enhanced Standards for Interstate Bank Acquisitions …………………………. 77
I.
Source of Strength …………………………………………………………………………………….. 77
J.
Lending Limits and Insider Transactions ……………………………………………………….. 78
1.
Exposure to Derivatives, Repos, Reverse Repos, and Securities
Lending ………………………………………………………………………………………….. 78
2.
Asset Purchases from Insiders and Asset Sales to Insiders …………………… 78
K.
Affiliate Transaction Restrictions …………………………………………………………………. 79
L.
Restrictions on Conversions of Troubled Institutions …………………………………….. 79
M.
Grandfathered Unitary Thrift Holding Companies …………………………………………. 80
N.
Supervision of Securities Holding Companies ……………………………………………….. 80
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O.
Miscellaneous …………………………………………………………………………………………… 81
1.
Study of Bank Investment Activities ………………………………………………….. 81
2.
Countercyclical Capital Requirements ……………………………………………….. 81
3.
Dividend Restrictions for Non-Qualified Thrift Lenders ……………………….. 81
TITLE VII – WALL STREET TRANSPARENCY AND ACCOUNTABILITY…………………………………………. 82
A.
Summary ………………………………………………………………………………………………….. 82
B.
Push Out of Swap Activities ………………………………………………………………………… 82
C.
Definition of “Swap” ………………………………………………………………………………….. 83
D.
Regulatory Coordination …………………………………………………………………………….. 84
E.
Regulation of Swap Markets ……………………………………………………………………….. 85
F.
1.
Clearing …………………………………………………………………………………………. 85
2.
Execution……………………………………………………………………………………….. 86
3.
Registration and Regulation of Swap Dealers and Major Swap
Participants ……………………………………………………………………………………. 87
4.
Capital and Margin Requirements …………………………………………………….. 89
5.
Position Limits ………………………………………………………………………………… 90
6.
Business Conduct Rules …………………………………………………………………… 91
7.
Regulation of Swap Execution Facilities, Clearinghouses, and
Repositories …………………………………………………………………………………… 92
8.
International Harmonization and Extraterritorial Issues ………………………. 94
Regulation of Security-Based Swap Markets …………………………………………………. 96
1.
Amendments to Federal Securities Laws ……………………………………………. 96
TITLE VIII – PAYMENT, CLEARING, AND SETTLEMENT SUPERVISION ……………………………………… 97
A.
Summary ………………………………………………………………………………………………….. 97
B.
Designation of Systemically-Important Financial Market Utilities and
Payment, Clearing, or Settlement Activities ………………………………………………….. 98
1.
Definition of an FMU……………………………………………………………………….. 98
2.
Financial Transactions Covered ………………………………………………………… 98
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3.
The Process for Designating an FMU or a Financial Activity as
Systemically Significant ……………………………………………………………………. 98
C.
Standards for Systemically-Important FMUs and Payment, Clearing, or
Settlement Activities ………………………………………………………………………………….. 99
D.
Operations of Designated FMUs ………………………………………………………………….. 99
1.
Access to Federal Reserve System Facilities ……………………………………….. 99
2.
Changes to Rules, Procedures, and Operations…………………………………. 100
E.
Examination of and Enforcement Actions Against Designated FMUs ……………… 100
F.
Examination of and Enforcement Actions Against Financial Institutions
Subject to Standards for Designated Activities ……………………………………………. 100
G.
Requests for Information and Other Coordination Matters ………………………….. 101
1.
Requests for and Access to Designated FMU and Financial
Institution Information ………………………………………………………………….. 101
2.
Coordination Activities…………………………………………………………………… 101
TITLE IX – INVESTOR PROTECTIONS AND IMPROVEMENTS TO THE REGULATION OF
SECURITIES …………………………………………………………………………………………………………………… 102
A.
Summary ………………………………………………………………………………………………… 102
B.
Investor Protection ………………………………………………………………………………….. 102
C.
D.
1.
Fiduciary Duty for Broker-Dealers …………………………………………………… 102
2.
Establishment of the Investor Advisory Committee …………………………… 103
3.
Management and Funding of the SEC ……………………………………………… 103
Enforcement of the Federal Securities Laws ……………………………………………….. 105
1.
Extraterritorial Application of Anti-fraud Provisions ………………………….. 106
2.
Securities Lending …………………………………………………………………………. 106
3.
Stoneridge Revisited ……………………………………………………………………… 107
Improvements to the Regulation of Credit Rating Agencies ………………………….. 107
1.
Rulemaking Required …………………………………………………………………….. 108
2.
Reports and Studies ………………………………………………………………………. 108
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E.
F.
Improvements to the Asset-Backed Securitization Process …………………………… 109
1.
Risk Retention ………………………………………………………………………………. 109
2.
Third-Party Due Diligence Reports ………………………………………………….. 110
3.
Studies and Additional Rulemaking …………………………………………………. 111
Corporate Governance …………………………………………………………………………….. 111
1.
Executive Compensation………………………………………………………………… 111
2.
Proxy Access …………………………………………………………………………………. 112
G.
Municipal Securities …………………………………………………………………………………. 112
H.
Public Company Accounting Oversight Board ……………………………………………… 113
TITLE X – BUREAU OF CONSUMER FINANCIAL PROTECTION ………………………………………………. 114
A.
Summary ………………………………………………………………………………………………… 114
B.
Bureau of Consumer Financial Protection …………………………………………………… 114
1.
Establishment……………………………………………………………………………….. 114
2.
Structure ……………………………………………………………………………………… 115
C.
Funding of the BCFP …………………………………………………………………………………. 115
D.
Covered Persons ……………………………………………………………………………………… 115
E.
Supervision, Examination and Enforcement Authority …………………………………. 116
1.
Nondepository Institutions …………………………………………………………….. 116
2.
Banks, Thrifts, and Credit Unions ……………………………………………………. 117
3.
Service Providers…………………………………………………………………………… 117
F.
Exempt Entities ……………………………………………………………………………………….. 117
G.
BCFP Rulemaking …………………………………………………………………………………….. 118
H.
1.
Enumerated Consumer Laws ………………………………………………………….. 119
2.
Unfair, Deceptive, or Abusive Acts or Practices ………………………………… 119
3.
Mortgage Lending …………………………………………………………………………. 120
BCFP Coordination with Other Agencies …………………………………………………….. 120
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I.
Federal Preemption …………………………………………………………………………………. 120
1.
National Bank and Federal Thrifts …………………………………………………… 121
2.
Procedural Restrictions ………………………………………………………………….. 121
3.
Operating Subsidiaries …………………………………………………………………… 122
4.
Exportation of Interest Rates and Fees ……………………………………………. 122
J.
Visitorial Powers ……………………………………………………………………………………… 123
K.
Enforcement Authority for Violations of CFP Act or BCFP Regulations …………… 123
L.
Debit Interchange Fees and Network Restrictions ……………………………………….. 123
M.
Miscellaneous Provisions ………………………………………………………………………….. 124
1.
Consumer Reports ………………………………………………………………………… 124
2.
Mandatory Pre-Dispute Arbitration…………………………………………………. 125
3.
Consumer Access to Information…………………………………………………….. 125
4.
Truth in Lending Act ………………………………………………………………………. 125
5.
Small Business Data Collection ……………………………………………………….. 125
6.
Remittance Transfers …………………………………………………………………….. 125
7.
Report on Private Education Loans and Private Educational
Lenders ………………………………………………………………………………………… 126
8.
Reforming the Housing Finance System …………………………………………… 126
N.
Financial Fraud ………………………………………………………………………………………… 126
O.
Transfer of Personnel, Authority, and Functions ………………………………………….. 126
P.
Designated Transfer Date; Effective Dates ………………………………………………….. 126
TITLE XI – FEDERAL RESERVE SYSTEM PROVISIONS ……………………………………………………………. 128
A.
Summary ………………………………………………………………………………………………… 128
B.
Changes to the FRB’s Emergency Lending Authority…………………………………….. 128
C.
FDIC Liquidity Programs ……………………………………………………………………………. 129
D.
Audits of Special Federal Reserve System Credit Facilities ……………………………. 130
E.
Changes to Federal Reserve Bank Governance and Supervision Policy …………… 132
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TITLE XII – IMPROVING ACCESS TO MAINSTREAM FINANCIAL INSTITUTIONS ……………………….. 133
A.
Summary ………………………………………………………………………………………………… 133
B.
Limited Treasury Assistance to Establish a Loan Loss Reserve Fund to
Defray the Costs of Operating Small-Dollar Loan Programs…………………………… 134
TITLE XIII – PAY IT BACK ACT …………………………………………………………………………………………… 135
A.
Summary ………………………………………………………………………………………………… 135
B.
Amendment to Reduce TARP Authorization ……………………………………………….. 135
C.
Deficit Reduction Provisions ……………………………………………………………………… 135
D.
Federal Housing Finance Agency Report …………………………………………………….. 136
TITLE XIV – MORTGAGE REFORM AND ANTI-PREDATORY LENDING ACT ……………………………… 137
A.
Summary ………………………………………………………………………………………………… 137
B.
Origination Standards for Mortgage Loans …………………………………………………. 137
C.
D.
1.
Duty of Care …………………………………………………………………………………. 137
2.
Prohibition on Steering and Certain Mortgage Originator
Compensation ………………………………………………………………………………. 138
3.
Rulemaking…………………………………………………………………………………… 138
4.
Rules of Construction …………………………………………………………………….. 139
Ability to Repay ……………………………………………………………………………………….. 139
1.
Nontraditional Mortgage Loans ………………………………………………………. 139
2.
Qualified Mortgages ……………………………………………………………………… 140
New TILA Liability and Enforcement Provisions …………………………………………… 140
1.
Creditors and Assignees …………………………………………………………………. 140
2.
Mortgage Originators ……………………………………………………………………. 141
3.
Statute of Limitations…………………………………………………………………….. 141
4.
State Attorney General Enforcement Authority ………………………………… 141
5.
Borrowers…………………………………………………………………………………….. 141
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E.
Additional Restrictions and Disclosures………………………………………………………. 141
F.
High-Cost Mortgage Loans ………………………………………………………………………… 142
1.
Coverage ……………………………………………………………………
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