We Need a Watchdog for all the New Watchdogs

By Simon Johnson 

Two years after passage of the Dodd- Frank financial reform law, how are we doing putting in place crucial provisions, including a way to control systemic risk?
Not well, according to Sheila Bair, chairman of the Federal Deposit Insurance Corp. during the 2008-2009 economic disaster and author of some of the reforms in the act.

About Simon Johnson

Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, is a professor of entrepreneurship at the Massachusetts Institute of Technology's Sloan School of Management.
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Photographer: Brendan Smialowski/Bloomberg

Bair is still at it. On June 6 she established a private- sector systemic-risk council, an initiative funded by the Pew Charitable Trusts and the Chartered Financial Analysts Institute. (I’m a member of the council, but I am writing here in my personal capacity; we have agreed that only Bair will speak for the council.)
Her point is simple. The Dodd-Frank Act created the all- important Financial Stability Oversight Council (known as FSOC and pronounced F-Sock). It replaced the President’s Working Group on Financial Markets, a panel frequently mentioned in former Treasury Secretary Henry Paulson’s memoir of the financial crisis, “On the Brink.” That working group lacked authority to coordinate the alphabet soup of regulators overseeing the U.S. financial system.
The congressional intent behind this part of Dodd-Frank was clear: create a council to take charge of financial stability, put the Treasury secretary in the chair, and empower a new Office of Financial Research within Treasury to collect and analyze data on the financial system.

Slower, Cumbersome

None of this organizational structure has worked well in practice. The result is a much slower and more cumbersome rulemaking process than intended. “FSOC is M.I.A. OFR is barely functional. The Volcker Rule is mired in controversy. Securitization reform is stalled,” Bair told the New York Times. “The public is becoming cynical about whether the regulators can do anything right, which is undermining support for reforms.”
Why the stability council has been so ineffective is murky. Is it lack of enthusiasm on the part of Treasury, opposition from other regulators, or opposition by large banks? In any case, Bair is determined to turn up the heat on regulators and push them to do the job mandated by Congress.
The council is a bipartisan group, with former Democratic Senator Bill Bradley and former Republican Senators Chuck Hagel and Alan Simpson. It includes respected former regulators such as Brooksley Born, ex-Commodity Futures Trading Commission chairman. Paul Volcker, former chairman of the Federal Reserve, has agreed to be a senior adviser.
The private sector is also well represented, including Paul O’Neill, former chief executive officer of Alcoa and former U.S. Treasury secretary, and John S. Reed, the former Citicorp CEO.
The third group comprises people who, like me, are academics who have worked in various public policy and private sector capacities. Ira Millstein, chairman of Columbia Law School’s Center for Global Markets and Corporate Ownership, will be the risk council’s legal adviser. The full list of members can be found here.
As Bair puts it, “The great challenge is to devise a system to identify risks that threaten market stability before they become a danger to the general public.”

Persistent Pressure

Putting pressure on officials to implement Dodd-Frank is relatively straightforward. The council can use polite yet persistent pressure. This should prove particularly effective when the group can find a consensus, and my guess is that this will often be feasible. On bank capital, for example, an increasing number of well-informed people around the country insist that big banks need much more equity relative to debt -- that is, bigger buffers against losses. (To be clear, I don’t know what view the council will take on bank capital and other specific issues.)
The main obstacle to Dodd-Frank is the powerful bank lobby. The people who run these banks don’t want to be pushed to become safer; they like a payoff structure in which they get the upside when things go well and the downside risk is someone else’s problem. (Anat Admati of Stanford University and her colleagues continue to do the clearest work in this area; anyone who puzzles about these issues should look at her website.)
It surely helps sensible officials to have a well-informed, articulate group of outsiders pushing them from the other direction -- against the special interests.
A more difficult task is to measure and comprehend system risks before they become debilitating. That’s what the Office of Financial Research is supposed to do. It shouldn’t just report on current credit conditions in a generic fashion; it should coordinate the release of timely information from all parts of the financial system.
There may be alternatives to building up a strong and independent-minded OFR, but I don’t see them. I don’t see any chance that the Federal Reserve or other regulators will share the data needed to anticipate risks.
For example, how should we measure the current exposure of our financial system to the sovereign and banking crisis in Europe? What is the right way to think about the potential losses that could be incurred through the derivative positions of very large banks? How should we think about international counterparty risks when it is European sovereigns -- not just their banks -- that are under severe pressure?
Our ability to ensure financial stability is only as good as the available data. I’m concerned that, when the next financial crisis hits, the OFR will be the weakest official link. Thinking about how to strengthen that office is an important priority for anyone who cares about systemic risk. If you have specific ideas, send them along.