Regulators Should Move Faster to Make Shadow Banks Safer

April 4 (Bloomberg) -- The U.S. is busy exiting its taxpayer-funded bailouts, most recently reducing its stake in American International Group Inc. And AIG is considering increasing its mortgage book by purchasing the loans it insures, a move that could be profitable for AIG, but could also heighten the insurer’s risks -- and taxpayers’ too.

Nearly four years after the financial crisis began, regulators on Tuesday finally agreed to the criteria they will use to decide which parts of the shadow banking system to regulate, but they still haven’t imposed tougher standards on a single insurer, hedge fund, private-equity shop or money-market mutual fund. Failure to do so exposes the U.S. economy to unnecessary dangers.

AIG is a prime example. The giant insurer required a $182 billion bailout in 2008. Its near-collapse helped propel the Dodd-Frank financial regulatory overhaul. Many lawmakers and policy makers agree that large, complex companies like AIG had fallen through the regulatory cracks.

The Dodd-Frank law addressed this by creating a special panel of top financial regulators, called the Financial Stability Oversight Council, to supervise large companies whose unraveling could threaten the economy. Those designated as “systemically important financial institutions” would be subject to stricter supervision and tougher capital and liquidity requirements.

Holes Remain

The stability council spent 18 months debating the criteria it would use to name so-called SIFIs. With that chore out of the way, the council should move quickly -- next month wouldn’t be too soon -- to begin naming the actual institutions.

The final criteria are an improvement over an earlier proposal, but holes remain. For one thing, many potentially risky companies probably won’t make the list. A Bloomberg Government analysis identified 15 that would meet or exceed the thresholds, and 10 more that might. Among the companies that probably will make the cut are AIG, General Electric Capital Corp. and 10 government-sponsored enterprises, including mortgage giants Fannie Mae and Freddie Mac.

Not a single hedge fund, private-equity shop or money-market mutual fund made the list.

Many of the criteria make sense, including a company’s debt relative to the capital it holds, reliance on short-term funding, importance as a source of credit and amount of derivatives outstanding. The U.S. will also consider existing regulatory scrutiny to ensure a company is not drowned by excessive oversight.

Yet the rule will mostly apply to firms with at least $50 billion in assets, the same threshold the Dodd-Frank law set for banks. It’s unclear whether any hedge funds or private-equity shops would meet that or the other tests. For example, just one U.S. hedge-fund manager, Bridgewater Associates LP, has more than $50 billion in assets, according to Bloomberg Markets.

The council said it lacks data on such firms and may have to adjust its criteria once it gathers more information. It also retained the right to designate any non-bank firm as systemic if “material financial distress” at the company could threaten the system. We hope the panel makes broad use of those powers -- and doesn’t let the $50 billion cutoff blind it to potential threats.

Hedge funds and private-equity firms have been lobbying regulators not to pull them into the dragnet. Many of these companies are closely held, and their financial data are not available to the public. The council should do whatever it takes to properly assess these firms’ risks.

Money-Market Funds

The panel also delayed a decision on whether to designate money-market mutual funds as systemically important. That’s surprising, given the tumult the Reserve Primary Fund caused in fall 2008 when it “broke the buck,” meaning its net asset value fell below the $1-a-share level that money-market funds are expected to maintain. The Securities and Exchange Commission is considering new rules for these funds, but if it fails to act, the council should.

BlackRock Inc., the giant money-management firm with more than $3.5 trillion in assets, is also worth a close look. The firm might not trigger any thresholds beyond size, but it’s hard to imagine why regulators wouldn’t want to closely supervise such a sprawling complex, regardless of how well it’s managed.

Large insurers, too, should get closer scrutiny, given that other financial institutions are highly exposed to them through derivatives and other instruments. It would be calamitous if an insurer with millions of policyholders and thousands of financial counterparties collapsed -- as the government feared would happen if AIG weren’t rescued.

If the council of regulators did all this, it would probably sweep up more firms than it expected to have to oversee. But erring on the side of tagging too many shadow banks as systemically risky, and making adjustments later, seems the wiser course. Anything less is asking for trouble.

Read more opinion online from Bloomberg View.

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