Federal Deposit Insurance Act:

Regulators' Use of Systemic Risk Exception Raises Moral Hazard Concerns and Opportunities Exist to Clarify the Provision

GAO-10-100: Published: Apr 15, 2010. Publicly Released: Apr 15, 2010.

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In 2008 and 2009, the Federal Deposit Insurance Corporation (FDIC) provided emergency assistance that required the Secretary of the Department of the Treasury (Treasury) to make a determination of systemic risk under the systemic risk exception of the Federal Deposit Insurance Act (FDI Act). The FDI Act requires GAO to review each determination made. For the three determinations made to date, this report examines (1) steps taken by FDIC, the Board of Governors of the Federal Reserve System (Federal Reserve), and Treasury to invoke the exception; (2) the basis of the determination and the purpose of resulting actions; and (3) the likely effects of the determination on the incentives and conduct of insured depository institutions and uninsured depositors. To do this work, GAO reviewed agency documentation, relevant laws, and academic studies; and interviewed regulators and market participants.

Treasury, FDIC, and the Federal Reserve collaborated before the announcement of five potential emergency actions that would require a systemic risk determination. In each case, FDIC and the Federal Reserve recommended such actions to Treasury, but Treasury made a determination on only three of the announced actions. Although two recommendations have not resulted in FDIC actions to date, their announcement alone could have created the intended effect of increasing confidence in institutions, while similarly generating negative effects such as moral hazard. However, because announcements without a determination do not trigger FDI Act requirements for documentation and communication, such as Treasury consultation with the President and notification to Congress, such de facto determinations heightened the risk that the decisions were made without the level of transparency and accountability intended by Congress. Further, uncertainties can arise because there is no requirement for Treasury to communicate that it will not be invoking a systemic risk determination for an announced action. Two of Treasury's systemic risk determinations--for Wachovia and Citigroup--were made to avert the failure of an institution that regulators determined could exacerbate liquidity strains in the banking system. A third determination was made to address disruptions to bank funding affecting all banks. Under this latter determination, FDIC established the Temporary Liquidity Guarantee Program (TLGP), which guaranteed certain debt issued through October 31, 2009, and certain uninsured deposits of participating institutions through December 31, 2010, to restore confidence and liquidity in the banking system. While there is some support for the agencies' position that the statute authorizes systemic risk assistance of some type under TLGP facts and that it permits assistance to the entities covered by the program, there are questions about these interpretations, under which FDIC created a broad-based program of direct assistance to institutions that had never before received such relief--"healthy" banks, bank holding companies, and other bank affiliates. Because these issues are matters of significant public interest and importance, the statutory requirements may require clarification. Regulators' use of the systemic risk exception may weaken market participants' incentives to properly manage risk if they come to expect similar emergency actions in the future. The financial crisis revealed limits in the current regulatory framework to restrict excessive risk taking by financial institutions whose market discipline is likely to have been weakened by the recent use of the systemic risk exception. Congress and regulators are considering reforms to the current regulatory structure. It is important that such reforms subject systemically important financial institutions to stricter regulatory oversight. Further, legislation has been proposed for an orderly resolution of financial institutions not currently covered by the FDI Act. A credible resolution regime could help impose greater market discipline by forcing participants to face significant costs from their decisions and preclude a too-big-to-fail dilemma.

Matters for Congressional Consideration

  1. Status: Closed - Implemented

    Comments: As a result of the recently-enacted Dodd-Frank Wall Street Reform and Consumer Protection Act, FDIC, the Federal Reserve, and Treasury are no longer authorized to make a systemic risk determination to implement emergency assistance to healthy banks. This change in authority eliminated the possibility for the lack of transparency and accountability that could be created by Treasury delaying or not making such a determination, as was the case during the recent financial crisis. Under the Act, FDIC only has authority to provide emergency assistance if FDIC's compliance with certain cost limitations with respect to a financial institution for which FDIC had been appointed receiver would cause systemic effects. If the determination is made by the Treasury Secretary, FDIC no longer has authority to provide assistance for the purpose of assisting healthy banks, bank holding companies, and other bank affiliates. Instead FDIC is authorized to provide assistance only for purposes of winding up the insured depository institution for which it has been appointed receiver.

    Matter: To help ensure transparency and accountability in situations where FDIC, the Federal Reserve, and Treasury publicly announce intended emergency actions but Treasury does not make a systemic risk determination required to implement them, Congress may wish to consider requiring Treasury to document and communicate to Congress the reasoning behind delaying or not making a determination.

  2. Status: Closed - Implemented

    Comments: In the recently-enacted Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress clarified the circumstances under which the systemic risk exception can be utilized and which institutions can be provided with assistance. FDIC no longer has authority to provide assistance based on the problems of the banking industry as a whole. Instead, FDIC has authority to provide emergency assistance only if the Treasury Secretary determines that FDIC?s compliance with certain cost limitations with respect to a financial institution for which FDIC had been appointed receiver would cause systemic effects. If the determination is made, FDIC no longer has authority to provide assistance for the purpose of assisting healthy banks, bank holding companies, and other bank affiliates. Instead FDIC is authorized to provide assistance only for purposes of winding up the insured depository institution for which it has been appointed receiver.

    Matter: Recent application of the systemic risk exception raises novel legal and policy issues, including whether the exception may be invoked based only on the problems of particular institutions or also based on problems of the banking industry as a whole, and whether and under what circumstances assistance can be provided to "healthy" institutions, bank holding companies, and other bank affiliates. Because these issues are of significant public interest and importance, as Congress debates the modernization and reform of the financial regulatory system, Congress may wish to consider enacting legislation clarifying the requirements and assistance authorized under the systemic risk exception. Enacting more explicit legislation would provide legal clarity to the banking industry and financial community at large, as well as helping to ensure ultimate accountability to taxpayers.

  3. Status: Closed - Implemented

    Comments: The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (P.L. 111-203) that was enacted on July 21, 2010, has several provisions to enhance the supervision of systemically importation institutions. Specifically, in Title I section 112(H)and (I)the Act "require(s) supervision by the Board of Governors for nonbank financial companies that may pose risks to the financial stability of the United States in the event of their material financial distress or failure, ... and make recommendations to the Board of Governors concerning the establishment of heightened prudential standards for risk-based capital, leverage, liquidity, contingent capital, resolution plans and credit exposure reports,concentration limits, enhanced public disclosures, and overall risk management for nonbank financial companies and large, interconnected bank holding companies supervised by the Board of Governors." In addition, Sec 115 states that the Systemic Risk Council "may make recommendations to the Board of Governors concerning the establishment and refinement of prudential standards and reporting and disclosure requirements applicable to nonbank financial companies supervised by the Board of Governors and large, interconnected bank holding companies, that are more stringent than those applicable to other nonbank financial companies and bank holding companies that do not present similar risks to the financial stability of the United States.The recommendations of the Council under subsection (a) may include? (A) risk-based capital requirements; (B) leverage limits; (C) liquidity requirements; (D) resolution plan and credit exposure report requirements; (E) concentration limits; (F) a contingent capital requirement; (G) enhanced public disclosures; (H) short-term debt limits; and (I) overall risk management requirements." The Dodd-Frank Act also granted additional authority to the Board of Governors of the Federal Reserve System for overseeing certain nonbank financial companies and bank holding companies.

    Matter: As Congress contemplates reforming the financial regulatory system, Congress may wish to conciser ensuring that systemically important institutions receive greater regulatory oversight. This could include such things as more consistent and enhanced supervision of systemically important institutions and other regulatory measures, such as higher capital requirements and stronger liquidity and risk management requirements and a resolution authority for systemically important institutions to mitigate risks to financial stability.

 

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