Too Big To Fail, Part III: Heightened Regulation

I'm still reading through the House's new Financial Stability Improvement Act of 2009 proposal (.pdf). So far, I've looked at the Council and how it will identify firms. Next, I think it's important to look at what new requirements will be imposed on firms found systemically relevant.

The firms that pose a risk to the financial system must be identified because the House proposal seeks to expose them to a lot more regulation. Those rules will be imposed by the Fed. Here's some of what that would require:

- Risk-based capital requirements
- Leverage limits
- Liquidity requirements
- Concentration requirements
- Prompt corrective action requirements
- Resolution plan requirements
- Overall risk management requirements

The specifics will be set by the Fed.* And of course, the proposal makes clear that the Council can impose any other requirements the Fed wishes as well.

It should also be noted that the Fed can differentiate between financial firms. The rules will be specifically tailored to address risks at each firm separately. While this makes sense from a practical standpoint, it seems to give the Fed an awful lot of discretionary authority. Presumably, the Council will be aware of these rules, however. If so, it should question anything that looks fishy.

But here's a really interesting wrinkle. The Federal Reserve appears to have the power to break up firms it deems as too systemically risky:

If the (Federal Reserve) Board determines, after notice and an opportunity for hearing, that the size of an identified financial holding company or the scope or nature of activities directly or indirectly conducted by an identified financial holding company poses a threat to the safety and soundness of such company or to the financial stability of the United States, the Board may require the identified financial holding company to sell or otherwise transfer assets or off-balance sheet items to unaffiliated firms, to terminate one or more activities, or to impose conditions on the manner in which the identified financial holding company conducts one or more activities.

According to that, the Fed can also alter a firm's business strategy. For example, it might have said AIG can't sell credit default swaps. Again, that's a lot of power for the Fed. It's a little unclear that the Council would have a check on that power.

One final note about those concentration requirements. The proposal says no financial firm can have more than 25% of its capital stock and surplus exposed to the credit of an unaffiliated company. This seems reasonable and important from a systemic risk standpoint. If you have one firm going down, you wouldn't want more than 25% of another firm's capital exposed to that failure.

I would imagine that performing these concentration calculations will be a lofty endeavor, however. This exposure includes loans, deposits, lines of credit, repurchase agreements, securities borrowing, guarantees, acceptances, letters of credit, investment security purchases, derivative counterparty exposure and other miscellaneous credit exposure. That should provide auditors with plenty of billable hours.

Finally, these regulatory requirements will be in full effect after a three-year transition period, once the legislation is signed into law. That's quite a long time, but these rules appear to be so broad, that these firms would easily need that amount of time to ensure compliance.

* The proposal did mention a specific leverage range, however. Tangible equity must be: (1) not less than 2% of total assets, and (2) not more than 65% of the required minimum level of capital under the leverage limit.