7.23.2009 SEC Chairman Mary Schapiro testified before the Senate Banking Committee on Banking, Housing, and Urban Affairs concerning the regulation of systemic risk. The Chairman defined systemic risk as the risk of sudden, near-term systemic seizures or cascading failures and the longer-term risk that U.S. system will unintentionally favor large systemically important institutions over smaller, more nimble competitors, reducing the system’s ability to innovate and adapt to change. The Chairman stated that the best way to minimize both kinds of systemic risk was to achieve balance between two different kinds of systemic risk regulation - the traditional oversight, regulation, market transparency and enforcement provided by primary regulators that help keep systemic risk from developing in the first place and the new “macro-prudential” regulation designed to identify and minimize systemic risk if it does.

Before discussing how to address systemic risk and financial reform, the Chairman stated that the traditional “block and tackle” oversight is “vital to ensuring that systemic risks do not develop in the first place.” The Chairman then provided various ways that systemic risk can be addressed by regulatory reform:

  • Filing Regulatory Gaps: Ensure that the same rules apply to the same or similar products and participants.
  • Improving Market Transparency: Require better information about markets, products and participants to be given to regulators and investors.
  • Active Enforcement
  • Establishing a Regulatory Framework for Macro-Prudential Oversight: Adopt a hybrid approach consisting of a single systemic risk regulator and a powerful council.
    • The single systemic risk regulator should have access to information across the financial markets and, in addition to the individual functional regulators, serve as a second set of eyes upon those institutions whose failure might put the system at risk. The regulator should have ready access to information about institutions that might pose a risk to the system, including holding company liquidity and risk exposures; monitor whether institutions are maintaining capital levels required by a council; and have clear delegated authority to respond quickly in extraordinary circumstances. The regulator should also be required to report to a council on its supervisory programs and the risks and trends it identifies at the institutions it supervises.
    • There should be a financial stability oversight council with more strength than set forth in the Administration’s “White Paper.” This council should have the tools needed to identify emerging risks, be able to establish rules for leverage and risk-based capital for systemically important institutions; and be empowered to serve as a ready mechanism for identifying emerging risks and minimizing the regulatory arbitrage that can lead to a regulatory race to the bottom. The council should have authority to identify institutions, practices and markets that create potential systemic risks and set standards for liquidity, capital and other risk management practices at systemically important institutions. The regulator would then be responsible for implementing these standards. The council also should provide a forum for discussing and recommending regulatory standards across markets, helping to identify gaps in the regulatory framework before they morph into larger problems. The council also would monitor the development of financial institutions to prevent the creation of institutions that are either “too-big-to-fail” or “too-big-to-succeed.”
  • Controlled Unwinding of Systemic Risk: The Chairman stated that instead of providing government assistance to a failing institution, policy makers should consider a controlled unwinding of the institution over time. Structured correctly, such a regime could force market participants to realize the full costs of their decisions and help reduce the “too-big-to-fail” dilemma. Structured poorly, such a regime could strengthen market expectations of government support, as a result fueling “too-big-to-fail” risks.

Click http://www.sec.gov/news/testimony/2009/ts072309mls.htm to access Chairman Schapiro’s testimony.