[Economic Report of the President (2010)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 6

BUILDING A SAFER
FINANCIAL SYSTEM


From the ashes of the Great Depression, our leaders built a national
system of financial regulation. Before 1933, there was no national
regulator for stock and bond markets, no required disclosure by public
firms, no national oversight of mutual funds or investment advisors, no
insurance for bank depositors, and few restrictions on the activities
of banks or other financial institutions. By 1940, landmark legislation
had created the Securities and Exchange Commission, the Federal Deposit
Insurance Corporation, new and important powers for the Federal Reserve,
and disclosure requirements for virtually every major player in
financial markets. The pieces of this regulatory structure fit together
in a relatively cohesive whole, and the United States enjoyed a long
period of relative financial calm. In the 60 years before the Great
Depression, our Nation experienced seven episodes of financial panic,
in which many banks were forced to shut their windows and declined to
redeem deposit accounts. In the nearly 80 years since the Depression,
not a single financial crisis has risen to that level.

Although the system of regulation put together during the
Depression served us well for many years, warning signs appeared
periodically. The savings and loan crisis of the late 1980s and early
1990s showed how banking regulation itself can have unintended
consequences. At that time, deregulation coupled with generous deposit
insurance combined to create a dangerous pattern of risk-taking that
eventually led to a large Federal bailout of the financial system. In
1998, the collapse of Long-Term Capital Management highlighted gaps in
the regulatory structure and induced the Federal Reserve Bank of New
York to organize an unprecedented private rescue of an unregulated hedge
fund.  In 2001, the collapse of Enron laid bare the complexity of the financial operations at seemingly nonfinancial corporations and posed
new challenges for accountants, policymakers, and analysts. Regulatory
changes in the past 30 years responded to the specific weaknesses
demonstrated by these crises, but these changes were incremental and
lacked a strategic plan. Throughout this period, the architecture
created after the Great Depression was becoming increasingly
inadequate to handle ongoing financial innovation. It was in this
vacuum that financial innovation accelerated during the first
decade of the 21st century.

The weaknesses in our outdated regulatory system nearly drove
our economy into a second Great Depression. After the bankruptcy of
Lehman Brothers in September 2008, credit markets froze and the Federal
Government was forced to embark on increasingly aggressive intervention
in financial markets. But as bad as the situation was, it could have
been much worse. Courage and creativity during the depths of the crisis,
and forceful stewardship by the Administration in the aftermath, have
enabled our Nation to escape a second Great Depression. Chapter 2 of
this report discusses the major elements of the Administration's
recovery plan. This chapter focuses on the long-term changes necessary
to prevent future crises.

What Is Financial Intermediation?

Suppose that the world woke up tomorrow to find all the banks
gone, along with insurance companies, investment banks, mutual funds,
and all the other institutions where ordinary people put their savings.
What would happen? In the short run, people could keep their savings
in mattresses and piggy banks, and the only apparent losses would be
the forgone interest and dividends. But with no easy way to get the
savings from piggy banks into productive investment, the economy would
face bigger problems very quickly. Entrepreneurs with ideas would find
it difficult to get capital. Large companies in need of money to
restructure their operations would have no way to borrow against their
future earnings. Young families would have no way to buy a house until
they had personally saved enough to afford the whole thing. Our system
of financial intermediation makes possible all those activities, and
the infrastructure to perform that function is necessarily complex and
costly.

The Economics of Financial Intermediation

Figure 6-1 is a simplified diagram of the main function of
financial intermediation: transforming savings into investment. The
ultimate source of funds is shown on the left: individuals and
institutions that have the final claim on wealth and wish to save some
of it for the future. The ultimate use of funds is shown on the right:
the productive activities that need funds for investment. The middle of
the diagram can be classified as ``financial intermediation.''Financial
intermediation uses either markets (like the stock market) or
institutions (like a bank) to channel savings into investment.
In each of these cases, financial intermediaries provide three
important services: information production, liquidity transformation,
and diversification. The paragraphs that follow use a concrete
investment example to explain these services and define the terms used
in the figure.




Suppose that an entrepreneur has an idea for a new company
(right side of figure) to develop a new cancer treatment. The science
behind this business is specialized and complicated. He could directly
approach a wealthy individual with savings (left side of figure) and ask for an investment in his company. The potential investor would immediately
face two difficult problems. The first is that she does not know the
quality of the entrepreneur's idea. The entrepreneur is likely to know
much more about the science than does the potential investor. Maybe the
entrepreneur has already asked more than 100 potential investors and
been turned down by all of them. Maybe he knows that the idea has
little chance of commercial success but wants to try anyway for
humanitarian reasons. The investor knows none of these things and
cannot learn about them without putting in real effort. In this case,
there would be asymmetric information between the investor and the
entrepreneur at the time of the potential investment: economists call
this a problem of adverse selection.

The second problem faced by the investor is that, after she
makes the investment, she needs some way to monitor the entrepreneur
and make sure he is using the money in the most efficient way. Perhaps
the entrepreneur will decide to use the money for some other business
or research purpose. How will the investor know? Even worse, what is to prevent the entrepreneur from using the funds for his personal
benefit or taking the money without putting in any effort? In this
case, there would be additional asymmetric information introduced
after the investment was made: economists call this a problem of
moral hazard.

To solve these adverse selection and moral hazard problems, the
investor will need to expend some resources. She will need to study
the technology, evaluate its chances for scientific and commercial
success, and then carefully watch over the entrepreneur after the
investment is made. These activities are difficult and costly, and
there is no reason to believe that a typical source of funds (whose
main qualification is that she has money to invest) would also be the
best person to solve these problems. One important service of
financial intermediation is to efficiently solve the adverse
selection and moral hazard problems that come with the transformation
of savings into investment. This chapter refers to this service as
information production.

The second main service of financial intermediation is
liquidity transformation. Consider how long it takes to develop a
cancer treatment. In the United States, all new drug treatments must
pass through a complex regulatory review stretched over many years.
Even if a drug is eventually approved, the path to commercial success
can take many more years. Most investors do not want to wait that long
to see any return on their money. Individual investors have uncertain
liquidity needs-jobs can be lost, family members can get sick-and even
institutional investors are subject to performance evaluation over
short periods. Overall, investment projects tend to have long
production times, while investment sources prefer to have easy access
to their money. Somebody, somewhere, must be willing to absorb the
liquidity needs of the economy. In practice, these needs are provided
by liquidity transformation: financial institutions and markets
transform long-term (illiquid) investment projects into short-term
(liquid) claims.

Liquidity transformation is also important for another, more
worrisome, reason: it is the main source of the fragility that can
lead to a financial crisis. Because most intermediaries have illiquid
assets and liquid liabilities, any broad-based attempt by creditors to
call liabilities at the same time creates an impossible situation for
the intermediary. The classic example is a bank run, where holders of
deposits (liquid liabilities) all ``run'' at the same time to withdraw
their funds, leaving banks unable to sell the illiquid business loans
and mortgages quickly enough to meet these demands. The same process
can occur in a wide variety of nonbank institutions, as is discussed
at length later in this chapter.

The third main service of financial intermediation is
diversification. A single investment project can be very risky. In
the case of the drug company, no investor would want her entire net
worth riding on the success of just one technological project.
Individual investors can minimize their risk by purchasing a
diversified portfolio of investments. If, for example, an investor
could pay 1 percent of the costs for 100 different drug-development
projects, then her overall portfolio risk would be greatly reduced.
Further diversification is achieved by dedicating only a small share
of a portfolio to any given industry or country. Such diversification
is a main service of most financial institutions, which take funds
from many small sources and then invest across a wide variety of
projects.

Types of Financial Intermediaries

Figure 6-2 plots nominal gross domestic product (GDP) in the
United States against the total assets in the financial sector and a
long list of institutional types, including banks, securities firms,
mutual funds, money-market funds, mortgage pools, asset-backed-
securities (ABS) issuers, insurance companies, and pension funds.
Figure 6-3 plots the same set of intermediaries, this time as a
percentage of the total assets held by the entire financial



sector. All of these financial data are from the Federal Reserve's
Flow of Funds.

These figures show several important trends. First, assets in
the financial sector have grown much faster than GDP: from 1952 to
2009, nominal GDP grew by 4,000 percent and financial sector assets grew
by 16,000 percent. This trend is important to remember in considering
the regulation of finance. It would be helpful to know if the ratio of
financial assets to GDP is ``too big'' or ``too small,'' but no good
evidence permits such a conclusion. Furthermore, modern developments
in the financial system have allowed each dollar of underlying assets
to multiply many times across an increasing chain of financial
intermediation, so that any measurement of gross assets (as in
Figure 6-2) is misleading as a measure of the ``importance'' of the
financial sector. The concept of increasing intermediation chains is
discussed later for specific institutional types.

A second important trend is that the assets held by banks grew
at approximately the same rate as GDP. Nevertheless, because the
overall size of the financial sector has increased, the percentage of
financial sector assets held by banks has fallen over time. Third,
Figure 6-3 shows the rising share of assets held by mutual funds,
government sponsored enterprises (GSEs) and federally related mortgage
pools, and issuers of asset-backed securities. Some of this growth can
be attributed to the lengthening of the financial intermediation
chain, as pension funds delegate asset management to mutual funds,
banks sell mortgages to mortgage pools, and money-market
funds purchase securities from these pools.

Three long-standing institutional types are banks, securities
firms, and insurance companies. Banks, including commercial banks, bank
holding companies, savings institutions (thrifts), and credit unions,
are still the largest component of the financial sector, with $16.5
trillion in assets as of June 2009. Although bank assets represent
26.7 percent of the financial sector, their share has fallen
precipitously since 1952, when it was 53.2 percent. Securities firms,
also known as investment banks or broker-dealers, had $2.0 trillion in
assets, comprising 3.2 percent of the sector in June 2009. This
percentage was down considerably from an average of 5.1 percent in
2007, because most of the largest securities firms went bankrupt,
were acquired by banks, or formally converted to banks during the
crisis. Insurance companies have $5.9 trillion in assets,
comprising 9.5 percent of the sector as of June 2009.

Mutual funds and pension funds are a second layer of
intermediation, often standing in between investors and another
institution or market. Mutual funds had $9.7 trillion in assets,
comprising 15.7 percent of the sector, in June 2009, up from only 1.6
percent in 1952 and 3.1 percent in 1980. Mutual funds take money from
retail investors and invest in public securities. An important subgroup
of mutual funds are money-market funds (MMFs), which are broken out
separately in these figures and in the underlying Federal Reserve data.
In 1990, MMFs held less than $500 billion in assets; by June 2009,
their total assets were $3.6 trillion, comprising 5.8 percent of total
financial assets. MMFs invest only in relatively safe, short-term assets.
Pension funds are a large and growing share of the sector, with assets
of $8.3 trillion making up 13.5 percent of total financial assets in
June 2009.  Many pension assets are reinvested in mutual funds, so
they show up twice in the overall totals. Thus, some of the growth in
overall sector assets is driven by this extra step of intermediation.

The next category in Figure 6-2 is GSEs and federally related
mortgage pools, with $8.4 trillion in assets in June 2009. Beginning
in the 1930s, various nonbank sources emerged to buy mortgages on the
secondary market. By the end of the 1970s, federally related mortgage
pools-which include those established by GSEs known as Fannie Mae and
Freddie Mac-had almost $100 billion in assets. The growth of GSE
sadded an extra layer to the financial intermediation of mortgages.
Here, the bank provides a loan to a borrower but then resells this loan
to a GSE. The bank may hold debt securities issued by the GSE, and the
GSE creates a pool that holds the mortgage.

In addition to those created by GSEs, private mortgage pools,
focusing on ``subprime'' borrowers, have grown substantially in the past
10 years.  These private mortgage pools issue securities backed by the
mortgages; these securities, known as mortgage-backed securities
(MBSs), are purchased and held by mutual funds or other financial
intermediaries. They are one type of an asset-backed security managed
by an ABS issuer. ABS issuers do not confine themselves to mortgages;
they also pool and securitize auto loans, student loans, credit card
debt, and many other types of debt. Twenty years ago,few ABS issuers
existed, but by June 2009 they held $3.8 trillion in assets and
comprised 6.2 percent of total financial sector assets.

The remaining categories in Figures 6-2 and 6-3 are the
monetary authority (the Federal Reserve) and ``other.'' As discussed
in Chapter 2, the assets of the monetary authority increased rapidly
during the crisis, but the increase is expected to be reversed as the
Federal Reserve exits from its emergency programs and begins reducing
the large stock of long-term securities it had purchased. The ``other''
category includes special purpose vehicles created to manage the
emergency lending programs and various other minor groups of
intermediaries.

Hedge funds are an increasingly important financial
intermediary, but they are not included in Figures 6-2 and 6-3.
Because of a lack of data on domestic hedge funds, the Federal Reserve
classifies such funds as part of the household sector and computes the
assets of this sector as a residual after everything else is added
together and subtracted from total assets. The Federal Reserve is
unable to get a clean number for hedge funds because they are largely
unregulated private investment pools that are not required to report
their holdings to any official source. Unofficial sources estimate the
amount of assets held by hedge funds to have been $1.7 trillion in
2008, but in the absence of regulatory oversight, this estimate is less
reliable than the other totals shown in Figure 6-2 (Hedge Fund
Research 2009).


The Regulation of Financial Intermediation
in the United States

Private institutions and markets should clearly play the
central role in financial intermediation. But government also has a
role. Economists generally favor government regulation of markets that
exhibit a market failure of some kind. This chapter has already
discussed two types of market failure: adverse selection and moral
hazard. Both can be classified as special cases of asymmetric
information, where different parties to a contract do not have the
same information. The financial intermediation system alleviates
asymmetric-information problems betweens avers and investors,but
information can also be asymmetric between buyers and sellers of
financial services. Just as physicians almost always know more than
patients about medicine, and lawyers more than their clients about
law, banks and financial advisors should be expected to know more
than their investors about investment opportunities. For this reason,
there will always be a consumer protection basis for some government
regulation of financial services.

Consumer protection was an important motivation for several
important pieces of Depression-era legislation. The first two, the
Securities Act of 1933 and the Securities Exchange Act of 1934, set
forth a long list of requirements for issuing and trading public
securities. The list included many types of public disclosure that
persist to this day, including information about executive compensation,
stockholdings, balance sheets, and income statements. The 1934 Act
also created the Securities and Exchange Commission (SEC), the agency
responsible for enforcing the new rules. These securities laws were
the first Federal laws to regulate organized financial exchanges.

With regulated markets came the growth of intermediaries to
service them. These intermediaries gained Federal oversight with the
Investment Advisers Act of 1940 (for publicly available investment
advisory services) and the Investment Company Act of 1940 (for mutual
funds). In total, these four pieces of legislation enacted between
1933 and 1940 represented a huge changein the regulatory structure
of financial markets and in most cases can be considered attempts to
lessen adverse selection and moral hazard problems between investors,
intermediaries, and investments.

Depression-era laws also strengthened the national system of
bank regulation, adding new elements to a long pre-Depression history
of Federal regulation. Beginning with the National Bank Act of 1864,
federally chartered banks have been examined regularly for capital
adequacy. State-chartered banks received similar examinations from
both state and Federal banking agencies. Such examinations are a form
of microprudential regulation, with a focus on the safety and
soundness of individual institutions in isolation and with the aim of
reducing asymmetric-information problems. Few bank depositors have the
time or incentive to conduct detailed reviews of their banks. When
regulators conduct periodic reviews and publicize the results, they
create a public good of information about the safety and soundness of
individual banks. Furthermore, examinations and regulations can
constrain excessive risk-taking by federally insured institutions, a
moral hazard problem faced by the government, rather than by bank
depositors, in part because of deposit insurance.

The microprudential approach, however, is not well suited to
handle risks to the entire financial system. The next section of this
chapter discusses in detail the spread of crises. For now, it is
sufficient to think of a crisis as an occasion when there is a sudden
increase in the asymmetric-information problem in the financial system,
as can happen after a large economic shock or the failure of a major
bank. The microprudential system of bank examination can alleviate
asymmetric-information problems in normal times, but because the
government relies on careful periodic examinations, staggered across
banks, it does not have the capacity to examine all banks quickly
after a shock or to evaluate the risk that a single bank failure
will have on other institutions. Faced with a large economic
shock, bank customers can rationally fear for the safety of
their deposits. Since the upside of leaving one's money at a bank in
such a situation is relatively small, but the downside losing all one's
money-is large, it is individually rational for depositors to withdraw
their money when uncertainty increases. What is rational for
individual depositors, however, puts an impossible strain on the whole
banking system, since the liquidity transformation performed by banks
cannot be quickly reversed; the illiquid loans and mortgages held by
banks cannot immediately be returned to all depositors as cash.

One partial solution to the liquidity problem during banking
crises is to create a ``lender of last resort.'' This lender stands
ready to make cash loans to banks that are backed by illiquid
collateral: essentially, this lender serves as a new layer of liquidity
transformation above the banks. This form of macroprudential policy
was the traditional solution to banking crises in Europe in the 19th
century but did not come to the United States until the Federal
Reserve Act of 1913 created the first version of the Federal Reserve
System as a lender of last resort.

But a lender of last resort, by itself, is unable to prevent
bank runs across the entire system. Even illiquid collateral must be
given a value by the lender-by law the Federal Reserve can only make
secured loans-and if the entire system is failing at the same time,
there may be no way for a central bank to estimate reasonable valuations
quickly enough. A lender of last resort is designed to solve liquidity
problems, not solvency problems, but in a severe crisis, these two
problems can become inextricably tied together. (This problem arose
during the current crisis, when Lehman Brothers was unable to provide
enough collateral to qualify for sufficient Federal Reserve loans.)
During the Great Depression, some 9,000 bank failures occurred between
1930 and 1933, well above the number of failures in earlier panics.
Shortly after taking office in 1933, President Franklin Roosevelt gave
his first ``fireside chat'' and implied a government guarantee for all
bank deposits. The Banking Act of 1933 made the guarantee explicit by
creating deposit insurance through a new agency, the Federal Deposit
Insurance Corporation (FDIC). In the 75 years that followed, the
United States averaged fewer than 30 commercial bank failures a year.
The FDIC is a crucial piece of macro-prudential regulation in that it
provides a guarantee to all insured banks, regardless of the condition
of any specific bank. Within the account limits of FDIC insurance,
no depositor needs to worry about the soundness of her bank; thus,
the FDIC guarantee eliminates most asymmetric-information problems
that could lead to bank runs.

A constant tension in macroprudential regulation is that the
attempt to prevent bank runs can itself lead to new forms of moral
hazard. Because they have deposit insurance, small depositors no longer
need to monitor the safety of their banks; therefore, unless regulators
are watching carefully, the banks may take excessive risks with no fear
of losing deposits. This latent problem was exacerbated during the
1980s by deregulation in the thrift industry. Following this
deregulation, thrift institutions began aggressively seeking out
deposits by paying ever-higher interest rates and then intermediating
these deposits into speculative investments. This strategy allowed
thrifts to use FDIC insurance to gamble for solvency, and when the
investments failed, a wave of thrift failures swept through Texas, the
Midwest, and New England in the 1980s and early 1990s. This wave, now
known as the savings and loan crisis, represented the first significant
increase in bank failures since the Great Depression. The failures,
it should be noted, were not caused by bank runs-they were not driven
by a liquidity mismatch between deposits and loans. Deposit insurance
remained intact, and no insured deposit lost any money. Rather, the
bank failures were caused by the insolvency of the banks, as they
gambled and lost with (effectively) government money. Nevertheless,
even in the absence of bank runs, many economists believe that the
savings and loan crisis contributed to the ``credit crunch'' and
recession of 1990-91.

There has been no fundamental restructuring of the Nation's
financial regulatory system since the Great Depression. All changes
since that time have been piece meal responses to specific events,
added individually onto the original superstructure. That regulatory
stasis has led to four major gaps in the current system. First, many
of the newer financial institutions-hedge funds, mortgage pools,
asset-backed-securities issuers-have grown rapidly while being
subject to only minimal Federal regulation. These new institutions
suffer from many of the asymmetric-information problems that banks
faced before the Depression-era reforms. Second, overlapping
jurisdictions and mandates have led to regulatory competition between
agencies and regulatory ``shopping'' by institutions. Such competition
is yet another form of moral hazard-now centered on the regulators
themselves. Third, regulators operate separately in functional silos
of banking, insurance, and securities. Many of the largest institutions
perform all these activities at once but are not subject to robust
consolidated regulation and supervision. And finally, most of the
regulatory system is microprudential and focused on the safety and
soundness of specific institutions. No regulator is tasked with
taking a macroprudential approach, which attempts to monitor,
recognize, and alleviate risks to the financial system as a whole.
Such macroprudential regulation would require explicit rules for the
orderly resolution of all large financial institutions, not just the
banks currently resolved by the FDIC. In short, because of these four
gaps, the failure of one institution imposes negative externalities on
others, and there is no coherent system for fixing these externalities.

Of the four gaps, the last requires the most urgent reform and
the biggest change in regulatory thinking. The financial crisis made
clear how rapidly failures can spread across institutions and affect
the whole system. A primary challenge of macroprudential regulation is
to recognize such ``contagion'' and categorize and counteract all the
different ways it can manifest. The next section of the chapter turns
to this task.

Financial Crises:
The Collapse of Financial Intermediation

A financial crisis is a collapse of financial intermediation.
In a crisis, the ability of the financial system to move savings
into investment is severely impaired. In an extreme crisis, banks close
their doors, financial markets shut down, businesses are unable to
finance their operations, and households are challenged to find credit.
A financial crisis can be triggered by events that are completely
external to the financial system. If a large macroeconomic shock hits
all banks at the same time, regulators can do little to control the
damage. Some crises, however, are triggered or exacerbated by shocks to
a small group of institutions that then spread to others. This spread,
known as contagion, is a form of negative externality imposed by
distressed institutions. The recent financial crisis involved three
different types of contagion, referred to in this chapter as confidence
contagion, counterparty contagion, and coordination contagion. A macroprudential regulator must have the tools to handle all three.

Confidence Contagion

The classic example of a ``run on the bank'' is shown in
Figure 6-4. Banks are mostly financed by deposits, which are then lent
out as loans to businesses and mortgages for homeowners. A bank's
balance sheet has a maturity mismatch between assets (the loans) and
liabilities (the deposits): the loans are long term, with payments
coming over many years, while the deposits are short term and can be
withdrawn at any time. The liquidity transformation service of the
bank works in ordinary times but breaks down if all the depositors ask
for their money back at the same time.



Suppose, for example, a depositor in Bank A hears a rumor that
other depositors in Bank A are withdrawing their funds. He does not know
the explanation. It might be that Bank A has a problem with solvency,
that a fair accounting would show that its liabilities exceed its
assets. Typically, a depositor does not have the necessary information
to form an accurate judgment about solvency. So what does he do? The
safe thing, in the absence of deposit insurance, is to go to the bank
and take out his money. Perhaps these other depositors know something
that he does not. If he waits too long, the bank will be out of cash and
unable to redeem his account.

It is easy to see how the run at Bank A could lead to runs at
other banks. The public spectacle of long lines of depositors waiting
outside a bank is enough to make other banks' customers nervous-the
negative externality on confidence. Perhaps Bank A had many real
estate loans in some trouble area, and Bank B has an unknown number of
similar loans. The issue here is that bank depositors do not want to
take the risk of leaving their money in a failing bank. Unlike stock
market investors, who expect to take risks and face complicated
problems in forecasting the future path of company profits, bank
depositors want their money to be safe and do not want to spend an
enormous amount of time making sure that it is. The information
production service of banks cannot quickly be replaced if the bank is
in trouble. Banks, therefore, have historically been subject to runs,
and the runs have spread quickly across banks, a phenomenon called
confidence contagion.

Classic bank runs were commonplace in the United States before
(and during) the Great Depression. In the post-FDIC world, bank failure
has become a problem of insolvency, not illiquidity. FDIC insurance
works almost perfectly up to a current limit of $250,000 for each
account. What happens above this limit? What of the many corporations
and investors who want a safe place to put their million-dollar and
billion-dollar deposits? In the absence of insured accounts at this
level, they choose such alternatives as money-market funds,
collateralized short-term loans to financial institutions, and complex
derivative transactions. In each of these cases, the effort to find
safe, liquid investments can lead to situations that look identical
to a classic bank run, but with different players. When a single
investment bank (Bear Stearns in March 2008) or money-market fund
(the Reserve Fund in September 2008) gets into solvency trouble,
confidence can quickly erode at similar institutions.
Macroprudential regulation must stop this confidence contagion or,
at least, contain it to one segment of the financial system.

Counterparty Contagion

Counterparty contagion is illustrated in Figure 6-5. Here,
Bank A owes $1 billion to Bank B, which owes $1 billion to Bank C,
with this same debt going through the alphabet to Bank E. When Bank A
goes out of business owing money to BankB, then BankB can not pay
Bank C. To the extent that Bank C lacks the information or the ability
to insure against the failure of Bank A, that failure imposes an
externality. One failure could lead to defaults all the way to Bank E.
Such contagion seems particularly wasteful, because most of it could be
averted by getting rid of all the steps in the middle: the only banks
here with net exposure are Banks A and E; once the middle is eliminated,
all that is left is a $1 billion debt of A to E.

Derivatives are an important modern vehicle for counterparty
chains. A derivative is any security whose value is based completely
on the value of one or more reference assets, rates, or indexes.
For example, as imple derivative could be constructed as the promise
by Party B top pay $1 to Party A if and only if the stock price of
Company XYZ is above $200 a share on December 31, 2012. This contract
is a derivative because its payoff is completely ``derived'' from the
value of XYZ stock; the contract has no meaning that is independent of
XYZ stock. Things begin to grow more complicated when Party A and
Party B begin to make off setting trades with other parties, creating
counterparty exposures among the group of market participants. For
example, Party B, having taken on the risk that XYZ will climb above
$200 a share, may at some point decide to offset this risk by
purchasing a similar option from Party C. Eventually, Party C makes
the reverse trade with Party D, and soon the chain can extend across
the alphabet.



Coordination Contagion

Coordination contagion is illustrated in Figure 6-6. Here,
Bank A owns many assets of Type I and Type II; Bank B owns many assets
of Type II and Type III; and Bank C owns many assets of Type III and
Type IV. Suppose that a negative shock to the value of Type I assets
threatens the solvency of Bank A. In an effort to remain in business,
Bank A begins to liquidate its portfolio by selling Type I and Type II
assets. As is typical for banks, these underlying assets are relatively
illiquid, so it is difficult for Bank A to sell substantial quantities
without depressing the price of the assets. As the prices of Type II
assets fall, Bank B is in a quandary. The market value of its assets is
falling, and the regulators of Bank B may insist that it reduce its
leverage or raise more capital. Bank B may then sell Type II and
Type III assets to achieve this goal. Again, it is easy to see how this
process could flow through the alphabet. Here the process is called
coordination contagion because it is driven by the coordinated holdings
of the banks, rather than by confidence of investors (in any
particular bank) or the chains of contractual relationships (among
banks) that lead to counterparty contagion. The externality occurs
here only because the underlying assets are illiquid. With this
illiquidity, the transactions of each player can significantly affect
the price, and the forced sale by one bank harms all the others that
own these assets.

Coordination contagion is exacerbated if failing institutions are forced to liquidate their positions quickly. In the fall of 2008, many
large financial institutions had significant holdings of subprime
housing and other



structured instruments on their balance sheets. With capital scarce and
uncertainty about the value of these assets high, distressed
institutions faced pressure to sell these assets. If the most
desperate institutions sold first, then the depressed prices of these
sales would then place pressure on other institutions to mark down the
values of these assets on their balance sheets, further exacerbating
the problem. One partial solution to this coordination contagion
would be to allow the most distressed institutions to exit their
positions slowly, so as not to further destabilize the illiquid market
for these assets. Such slow exits can be enabled by taking failing
institutions into a form of receivership or conservatorship, an
enhanced ``resolution authority'' for nonbank financial institutions
that would be analogous to the FDIC process for failing depository
institutions.


Preventing Future Crises:
Regulatory Reform

The Financial Stability Plan and other policies to address the
current crisis described in Chapter 2 have had a positive short-run
effect on the financial system. To prevent future crises and achieve
long-term stability, however, it will be necessary to fill the gaps
in the current regulatory system. The Administration is working
closely with Congress to build a regulatory system for the 21st
century.1 The plan for regulatory reform has five key parts,
each covering a different aspect of the financial intermediation
system illustrated by Figure 6-1. The parts of the plan are discussed
below, with references back to the relevant sections of Figure 6-1.

Promote Robust Supervision and Regulation of Financial Firms

If the recent financial crisis has proven anything, it is that we
have outgrown our Depression-era financial regulatory system. Although
most of the largest, most interconnected, and most highly leveraged
financial firms were subject to some form of supervision and
regulation before the crisis, those forms of oversight proved
inadequate and inconsistent. The financial institutions at the top of
Figure 6-1 are a varied group that is no longer dominated by
traditional commercial banks. A modern regulatory system must account
for the entire group.

Three primary weaknesses inherent in the current system led to
the crisis. First, capital and liquidity requirements for institutions
were simply not high enough. Regulation failed because firms were not
required to hold sufficientcapitaltocovertradingassets,high-risk
loans,andoff-balance-sheet commitments, or to hold increased
capital during good times in preparation for bad times. Nor were firms
required to plan for liquidity shortages.

Second, various agencies shared responsibility for supervising
the consolidated operations of large financial firms. This
fragmentation of supervisory responsibility, in addition to loopholes
in the legal definition of a ï¿½bank,ï¿½ made it possible for owners of
banks and other insured depository institutions to shop for the most
lenient regulator.

Finally, other types of financial institutions were subject to
insufficient government oversight. Money-market funds were vulnerable
to runs, but unlike their banking cousins, they lacked both regulators
and insurers. Major investment banks were subject to a regulatory
regime through the SEC that is now moot, since large independent
investment banks no longer exist. Meanwhile, hedge funds and other
private pools of capital operated completely outside the existing
supervisory framework.

In combination, these three sets of weaknesses increased the
likelihood that some firms would fail and made it less likely that
problems at these firms would be detected early. This was a breakdown
in the supervision under current authority over individual
institutions. But glaring problems were also created by a lack of
focus on large, interconnected, and highly leveraged institutions
that could inflict harm both on the financial system and on the
1 This section is based heavily on the Administration's white paper on
financial reform (Department of the Treasury 2009). economy if they
failed. No regulators were tasked with responsibility for contagion,
whether from confidence, counterparties, or coordination.

To solve these problems and ensure the long-term health of the
financial system, the government must create a new foundation for the
regulation of financial institutions. To do that, the Administration
will promote more robust and consistent regulatory standards for all
financial institutions. Not only should similar financial institutions
face the same supervisory and regulatory standards, but the system can
contain no gaps, loopholes, or opportunities for arbitrage.

The Administration has also proposed creating a Financial
Services Oversight Council (FSOC). This body, chaired by the Secretary
of the Treasury, would facilitate coordination of policy and
resolution of disputes and identify emerging risks and gaps in
supervision in firms and market activities. The heads of the principal
Federal financial regulators would be members of the Council, which
would benefit from a permanent staff at the Department of the
Treasury.

Finally, the Federal Reserve's current supervisory authority for
bank holding companies must evolve along with the financial system.
Regardless of whether they own an insured depository institution, all
large, interconnected firms whose failure may threaten the stability
of the entire system should be subject to consolidated supervision by
the Federal Reserve. To that end, the Administration proposes creating
a single point of accountability for the consolidated supervision of
all companies that own a bank. These firms should not be allowed or
able to escape oversight of their risky activities by manipulating
their legal structures.

Taken together, these proposals will help reduce the weaknesses
in the financial regulatory system by more stringently regulating the
largest, most interconnected, and most highly leveraged institutions.
In effect, the Administration's proposals would operate on the simple
principle that firms that could pose higher risks should be subject to
higher standards. Furthermore, both the Federal Reserve and the FSOC
would operate through a macro prudential prism and be wary of contagion
in all its forms.

Establish Comprehensive Regulation of Financial Markets

The financial crisis followed a long and remarkable period of
growth and innovation in the Nation's financial markets. These new
financial markets, found in the bottom part of Figure 6-1, still
rely on regulation put together in response to the Great Depression,
when stocks and bonds were the main financial products for which
there were significant markets. But over time, new financial
instruments allowed credit risks to be spread widely, enabling
investors to diversify their portfolios in new ways and allowing
banks to shed exposures that once would have had to remain on their
balance sheets. As discussed earlier, securitization allowed mortgages
and other loans to be aggregated with similar loans, segmented, and
sold in tranches to a large and diverse pool of new investors with
varied risk preferences. Credit derivatives created a way for banks to
transfer much of their credit exposure to third parties without the
outright selling of the underlying assets. At the time, this
innovation in the distribution of risk was perceived to increase
financial stability, promote efficiency, and contribute to a better
allocation of resources.

Far from transparently distributing risk, however, the
innovations often resulted in opaque and complex risk concentrations.
Furthermore, the innovations arose too rapidly for the market's
infrastructure, which consists of payment, clearing, and settlement
systems, to accommodate them, and for the Nation's financial supervisors
to keep up with them. Furthermore, many individual financial
institutions' risk management systems failed to keep up. The result was
a disastrous buildup of risk in the over-the-counter (OTC) derivatives
markets. In the run-up to the crisis, many believed these markets
would distribute risk to those most able to bear it. Instead, these
markets became a major source of counterparty contagion during the
crisis.

In response to these problems, the Administration proposes
creating a more coherent and coordinated regulatory framework for the
markets for OTC derivatives and asset-backed securities. The
Administration's proposal, which aims to improve both transparency and
market discipline, would impose record-keeping and reporting
requirements on all OTC derivatives. The Administration further
proposes strengthening the prudential regulation of all dealers in
the OTC derivative markets and requiring all standardized OTC
derivative transactions to be executed in regulated and transparent
venues and cleared through regulated central counterparties. The
primary goal of these regulatory changes is to reduce the possibility
of the sort of counterparty contagion seen in the recent crisis.
Moving activity to a centralized clearinghouse can effectively break
the chain of failures by netting out middleman parties. A successful
clearinghouse can reduce the counterparty contagion illustrated in
Figure 6-5 to a single debt owned by Bank A to Bank E, thus sparing
Banks B, C, and D from the problems.

The Administration has also proposed enhancing the Federal
Reserve's authority over market infrastructure to reduce the potential
for contagion among financial firms and markets. After all, even a
clearinghouse can fail, and regulators must be alert to this danger.
Finally, the Administration proposes harmonizing the statutory and
regulatory regimes between the futures and securities markets.
Although important distinctions exist between the two, many differences
in regulation between them are no longer justifiable. In particular,
the growth and innovation in derivatives and derivatives markets
have highlighted the need to address gaps and inconsistencies in the
regulation of these products by the Commodity Futures Trading
Commission (CFTC) and the SEC. In October 2009, the SEC and the CFTC
issued a joint report identifying major areas necessary to reconcile
their regulatory approaches and outlining a series of regulatory and
statutory recommendations to narrow or where possible eliminate those
differences.

Provide the Government with the Tools It Needs to Manage Financial
Crises

During the recent crisis, the financial system was strained by
the failure or near-failure of some of the largest and most interconnected
financial firms. Thanks to lessons learned from past crises, the current
system already has strong procedures for handling bank failure. However,
when a bank holding company or other nonbank financial firm is in severe
distress, it has only two options: obtain outside capital or file for
bankruptcy. In a normal economic climate, these options would be suitable
and would pose no consequences for broader financial stability. However,
during a crisis, distressed institutions may be hard-pressed to raise
sufficient private capital. Thus, if a large, interconnected bank holding
company or other nonbank financial firm nears failure during a financial
crisis, its only two options are untenable: to obtain emergency funding
from the U.S. Government, as in the case of AIG; or to file for
bankruptcy, as in the case of Lehman Brothers. Neither option manages
the resolution of the firm in a manner that limits damage to the broader
economy at minimal cost to the taxpayer.

This situation is unacceptable. A way must be found to address
the potential failure of a bank holding company or other nonbank
financial firm when the stability of the financial system is at risk.
To solve this issue, the Administration proposes creating a new authority
modeled on the existing authority of the FDIC. The Administration has
also proposed that the Federal Reserve Board receive prior written
approval from the Secretary of the Treasury for emergency lending
under its ``unusual and exigent circumstances'' authority to improve
accountability in the use of other crisis tools. The goal of these
proposals is to allow for an orderly resolution of all large
institutions-not just banks-so that the coordination contagion
depicted in Figure 6-6 does not again threaten the entire financial
system. Taking nonbank financial institutions into receivership or
conservatorship would make it possible to sell assets slowly and with
minimal disruption to the values of similar assets at otherwise
healthy institutions.

Raise International Regulatory Standards and Improve International
Cooperation

The system in Figure 6-1 cannot be managed by one country alone,
because its interconnections are global. As the recent crisis has
illustrated, financial stress can spread quickly and easily across
borders. Yet regulation is still set largely in a national context and
has failed to effectively adapt. Without consistent supervision and
regulation, rational financial institutions will see opportunity in
this situation and move their activities to jurisdictions with looser
standards. This can create a ``race to the bottom'' situation.

The United States is addressing this issue by playing a strong
leadership role in efforts to coordinate international financial
policy through the Group of Twenty (G-20), the G-20's newly
established Financial Stability Board, and the Basel Committee on
Banking Supervision. The goal is to promote international initiatives
compatible with the domestic regulatory reforms described in this
report. These efforts have already borne fruit. In September, the G-20
met in Pittsburgh and agreed in principle to this goal. And while
those processes are ongoing, significant progress has been made in
agreements strengthening prudential requirements, including capital
and liquidity standards; expanding the scope of regulation to nonbank
financial institutions, hedge funds, and over-the-counter derivatives
markets; and reinforcing international cooperation on the supervision
of globally active firms.

Protect Consumers and Investors from Financial Abuse

Before the financial crisis, numerous Federal and state
regulations protected consumers against fraud and promoted understanding
of financial products like credit cards and mortgages. But as abusive
practices spread, particularly in the subprime and nontraditional
mortgage markets, the Nation's outdated regulatory framework proved
inadequate in crucial ways. Although multiple agencies now have
authority over consumer protection in financial products, the
supervisory framework for enforcing those regulations has significant
shortcomings rooted in history. State and Federal banking regulators
have a primary mission to promote safe and sound banking
practices-placing consumer protection in a subordinate position-while
other agencies have a clear mission but limited tools and
jurisdiction. In the run-up to the financial crisis, mortgage
companies and other firms outside of the purview of bank regulation
exploited the lack of clear accountability by selling subprime
mortgages that were overly complicated and unsuited to borrowers'
particular financial situations. Banks and thrifts eventually followed
suit, with disastrous results for consumers and the financial system
at large.

In 2009, Congress, the Administration, and numerous financial
regulators took significant measures to address some of the most
obvious inadequacies in the consumer protection framework. One notable
achievement was the Credit Card Accountability, Responsibility, and
Disclosure Act, signed into law by the President on May 22, 2009. This
Act outlaws some of the most unfair and deceptive practices in the
credit card industry. For example, it requires that payments be
applied to the balances with the highest interest rate first; bans
retroactive increases in interest rates for reasons having nothing to
do with the cardholder's record with the credit card; prohibits a
variety of gimmicks with due dates and ``double-cycle fees''; and
requires clearer disclosure and ensures consumer choice.

However, given the weaknesses that the recent financial crisis
highlighted, it is clear that the consumer protection system needs
comprehensive reform across all markets. For that reason the
Administration has proposed creating a single regulatory agency, a
Consumer Financial Protection Agency (CFPA), with the authority and
accountability to make sure that consumer protection regulations are
written fairly and enforced vigorously. The CFPA should reduce gaps in
Federal supervision and enforcement, improve coordination with the
states, set higher standards for financial intermediaries, and promote
consistent regulation of similar products.


Conclusion

Our Nation's system of financial intermediation is a powerful
engine for economic growth. Productive investment projects are risky,
complex to evaluate and monitor, and require long periods of waiting with
no returns and illiquid capital. Investors who provide the funds for
these projects would be far less willing to do so if they had to
absorb all these risks and costs. Bridging the gap between savings and
investment requires the efforts of millions of talented professionals
collectively performing the services of information production,
liquidity transformation, and diversification. In the recent financial
crisis this complex system broke down.

To prevent another such crisis from paralyzing our economy, the
Administration has embarked on an ambitious plan to modernize the
framework of financial regulation. The keystone of the new framework
is an emphasis on macroprudential regulation. The regulatory system's
past focus on individual institutions served the Nation well for many
decades but is now outdated. A modern system that can meet the needs
of the 21st century must have the tools to monitor and regulate the
interconnections that cause financial crises.