Federal Deposit Insurance Corp. (FDIC) chairwoman Sheila Bair today asked a Senate committee on banking to consider a government regulatory framework to monitor global, systemic financial institutions considered “too big to fail.” Bair argued the implementation of Basel II by financial institutions led to procyclicality (not an uncommon claim) and these firms should be subject to higher capital buffer requirements and stricter prompt corrective action under US law. She suggested the Federal Reserve could play an important role as systemic risk regulator to monitor and regulate the activities of systemically important institutions. US Treasury Department, Federal Reserve Board, FDIC and Securities and Exchange Commission could also join together in a system-wide regulatory monitoring effort, a systemic risk council “The creation of a comprehensive systemic risk regulatory regime will not be a panacea,” Bair said. “Once the government formally establishes a systemic risk regulatory regime…market participants may incorrectly discount the possibility of sector-wide disturbances and avoid expending private resources to safeguard their capital positions.” Even beyond the establishment of a risk regulatory regime, Bair called for the foundation of a legal mechanism for the orderly resolution of too-big-to-fail institutions, similar to the authority the FDIC imposes on insured banks. She recommended reducing risks associated with the derivatives market by imposing haircuts of up to 20% of the secured claim for companies with derivatives claims against the failed firm, if the taxpayer or a resolution fund is on the hook for losses. “This would ensure that market participants always have an interest in monitoring the financial health of their counterparties,” Bair said. The measures she called for today would lead to increased transparency of financial institutions’ liquidity pools. Firms would likely have to provide greater disclosure of the sources of capital as well as assets and liabilities on their books. It would make financial institutions more transparent than ever, but it would also mean heavy government regulation of a largely private industry. Critics of this kind of government interference argue that often good policy (increasing transparency to the public) makes for bad business (driving away clients who may not approve of where institutions get capital). Bair’s testimony skips over the fact that private institutions, such as hedge funds, are not required to implement Basel II and would fall outside of the perimeter of procyclicality. Read her testimony. Write to Diana Golobay.

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