Risk Council Should Clean Up SEC's Mess
To act or not to act?
That is the question facing the Financial Stability Oversight Council, which must decide whether to step in and fill the void created by the Securities and Exchange Commission's inability to tighten regulation of money-market mutual funds.
The FSOC, a council of regulators created by the Dodd-Frank law to prevent financial-system risk, has the power to do what the SEC won't. By designating a mutual fund company as a "systemically important financial institution," the government would subject a fund to tougher oversight and require it hold more cash, which has been at the crux of the debate.
The council, headed by Treasury Secretary Tim Geithner, has discussed whether to act but has held off, preferring to give SEC Chairman Mary Schapiro time to convince her four fellow commissioners to approve stricter money fund regulations. This week, Schapiro canceled a vote after failing to get the necessary support. Democratic commissioner Luis Aguilar -- who previously worked in the fund industry -- refused to commit to the reforms.
That creates a huge opportunity and risk for the FSOC. The group was created to avert the kind of risk (think subprime mortgages) that built up unchecked in the financial system until it exploded in 2008. But so far, the FSOC has proved a reluctant overseer, moving slowly and cautiously to address well-known trouble spots. For instance, for nearly two years the council has been debating which other non-bank financial companies -- such as insurers, hedge funds and private equity shops -- should be designated as SIFIs and subject to stricter oversight. They have yet to act, a delay I'm told has less to do with internal disagreement and more to do with fears of legal challenges by business groups.
FSOC officials say they need to proceed cautiously -- and transparently -- or risk a court undoing any efforts they undertake. There's logic to that argument: Business groups are increasingly challenging federal rules and courts have been siding against regulators. Cutting corners would inevitably delay any progress FSOC makes.
But money funds should jump to the front of the FSOC's agenda. They are a well-known threat to the financial system -- the FSOC itself has identified them as a market vulnerability -- and played a starring role in the 2008 financial crisis. When Lehman Brothers went bust, the Reserve Primary Fund was left holding $785 million in essentially worthless IOUs. In a classic bank run, Reserve investors demanded their money back but -- for the first time -- the fund couldn't pay back everyone's money and "broke the buck" by failing to maintain the traditional $1 share price. Funding in the commercial-paper market froze, leaving companies that rely on short-term financing out of luck and unable to finance inventories, payrolls and general operations. It took a guarantee by the Treasury and Federal Reserve to stop the panic.
That tool is now gone, thanks to Dodd-Frank, which prevents policymakers from using many of the efforts they employed in the last crisis. In other words, if it happens again, don't look to the U.S. to end the crisis. Schapiro had wanted to address this by giving funds the choice of switching to a floating share price that wasn't automatically pegged to $1 or requiring funds to hold more cash.
The SEC won't act but the risk remains: Money funds are exposed to Europe, which is far from stable at the moment and could potentially trigger a wave of redemptions if things deteriorate. Action by the SEC would have been preferable to the FSOC, since the council will have to designate firms individually -- it can't just declare an entire industry systemic. If recent history is any guide, that will be a long, laborious process as the council bends over backward to give companies a full window into what's happening.
With the approaching election and the uncertainty of who will be in the White House come January, they should get cracking. Otherwise it will throw into question whether the FSOC can actually serve its central role in thwarting risk.
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