How to Fix Our Financial Early-Warning System

Is another one coming?

Six years after the 2008 crisis, U.S. financial markets are again displaying signs of excess. Stocks keep hitting new highs despite a lackluster economy. Investors are lending money on extremely easy terms to all kinds of risky borrowers, from highly leveraged companies to car buyers with questionable ability to pay.

It would be comforting to think that this time around, regulators are on it -- that they know where the risks are concentrated and are capable of acting to protect the broader economy. Sadly, that's not the case.

Back in 2010, Congress tried to set up a financial early-warning system. It created the Financial Stability Oversight Council to monitor systemic risk and coordinate the work of assorted regulators; it also formed the Office of Financial Research to supply information and analysis to the FSOC. The OFR was given subpoena power to collect the data it needed.

This system isn't working. Not wishing to make enemies, the OFR has hesitated to use its subpoena power. And the FSOC lacks an effective way to impose its will. It can call for closer supervision of companies it deems systemically important; beyond that, it has to rely on a fragmented group of other agencies (which don't necessarily share its goals) to carry out its recommendations.

Consider the case of leveraged lending, a sort of subprime finance typically used in corporate acquisitions. This business boomed in recent years as interest rates fell and investors looked for better returns. Total loans outstanding now amount to roughly $1.2 trillion. Most new loans lack basic investor protections -- such as covenants limiting companies' ability to take on added debt -- that were the norm as recently as 2010.

The Federal Reserve has repeatedly warned investors, to little avail. Most of the packaging, sale and trading of leveraged loans is done by institutions that the Fed doesn't oversee. This raises a systemic-risk issue: What if nonbank institutions -- such as hedge funds -- become heavily enough involved in the risky-lending boom to turn a series of defaults into a larger disaster?

To weigh that danger, the OFR would need detailed information on hedge funds' positions and their potential to infect other parts of the financial system. The ideal resource would be a global database containing information on all securities and derivative contracts, but that is years if not decades away. Meanwhile, the OFR has to deal with the hedge funds' regulator, the Securities and Exchange Commission -- an agency with no mandate to ensure financial stability and no strong incentive to cooperate.

Even if the OFR managed to get the data, the FSOC couldn't compel the SEC to act. Just recommending action would require the agreement of most of the nine agency heads on the FSOC's board, none of which wants the systemic-risk regulator to make a habit of treading on their turf. SEC officials have already clashed with the FSOC.

Too much is at stake for this dysfunction to continue. Four simple reforms -- suggested by former Fed Governor Donald Kohn -- would go a long way toward putting things right:

  1. Add financial stability to the mandate of all relevant regulatory agencies.
  2. Require them to collect and share any information that the FSOC deems necessary.
  3. Make the FSOC more independent -- with its own presidentially appointed chairman and direct authority over the OFR (currently part of the Treasury Department).
  4. Give agencies just two options when the FSOC recommends action: Draft the necessary rule within 30 days or explain why not.

Such changes will require new legislation -- so don't expect anything this side of the midterm elections. But action soon after would be good. It shouldn't take another financial crisis to drive home the need.

--Editors: Mark Whitehouse, Clive Crook.

To contact the editor on this story:
David Shipley at davidshipley@bloomberg.net