Introduction
The world economic landscape’s interconnectedness has created systemic risk within the US economy and globally. The interdependence of economic units has further amplified negative spillover effects during adverse economic environments. Regulations have been enacted to derisk and minimize negative exposures to the financial stability of the United States economy. Regulatory bodies tasked with overseeing the safety and soundness of the US economy are critical in ensuring risk-based supervision and examination of entities operating in the US economy.
The government agencies collaborate and work in harmony to assess and regulate the systemic stress of each business unit and its effect on the economy. The risk analysis aims to shrink or lessen systemic risk so that adverse effects are contained within the industry or sector without endangering the wider economy. In addition, resolutions of bank and non-bank companies are implemented as per set regulations to contain the spread of risk and to ensure continuity and stabilization of key operations in crisis scenarios.
There are many regulations and regulatory bodies in the United States of America with specific obligations and purposes.
The Dodd Frank Wall Street Reform and Consumer Protection Act was passed by parliament as a result of the 2007-2010 financial crisis. The United States economy is still saddled with legacy debts and is in deficit partly due to funding of the crisis. It is worth explaining the causes of the crisis.
Causes of the Financial Crisis
- Leverage
Banks and non-bank companies, including government-sponsored and private entities, acquired too much debt in comparison with their equity and the riskiness of their portfolio and operations. The equity capital levels were inadequate to withstand adverse economic conditions of the crisis. - Securitization
The traditional banking model of holding loans on the balance sheet until maturity was abandoned. Loans were bundled into securities and sold to investors to support home and mortgage purchases for low-income families. Investors, and almost the whole industry, did not understand the complex nature and risk of this new innovation. - Shadow banking
This emerged due to regulatory arbitrage as banks and non-bank institutions moved loans off their balance sheets to unregulated special purpose vehicles, with or without recourse. The result was excessive leverage, as movement of assets created room for more lending. - Rating Agencies
There was a conflict of interest as rating agencies were paid by the companies they rated. This contributed to governance and ethics failures. Moreover, the ratings were mostly rated excellent despite underlying and varying tranches of risk within the securitized debt. - Underwriting standards
Standards were relaxed to the extent that reckless lending became the norm. Loans were advanced to undeserving individuals who had no capacity, ability, or resources to repay. Adjustable-rate mortgages (ARM) were advanced at a premium to underserving clients; hence an increase in interest rates amplified the affordability crisis, which led to foreclosures in the real estate sector. - Government housing policy
The government passed regulations to increase housing affordability to low-income families despite inadequate capital reserves to cover losses during periods of stress in the real estate sector and wider economy. - Misuse of Derivatives
Misuse of derivatives created large notional exposures towards a few concentrated investment banks and insurance companies. Exposure to credit default swaps was too high relative to capital reserves required to cover unexpected losses, and the government rescued some of the failed institutions. - Too Big to Fail Syndrome
Moral hazard issues arose as some institutions knew in advance that government rescue would come when they failed. - Corporate governance and ethics failures
In the pursuit of profit and greed, internal procedures and ethical culture were disregarded, resulting in massive losses and poor customer outcomes.
Risk-Based Solutions to the Financial Crisis – Regulatory Changes
After risk assessment and evaluation of the causes of the financial crisis, the US government enacted the Dodd Frank Wall Street Reform and Consumer Protection Act.
- Too Big to Fail
The “too big to fail” syndrome was against the public good due to moral hazard issues, which weakened governance culture and ethics in the corporate space. This was addressed by requiring institutions to resolve themselves through internal resources or external private restructuring, depending on set conditions as per resolution regulations. - No Taxpayer Funds
No taxpayer funds are allowed to be used in resolving business failures unless there is a deficiency in internal and external private funding resources. The Secretary of the Treasury will approve the Orderly Liquidation Fund (OLF), and there will be a Mandatory Repayment Period (MRP) with recommendations from the Federal Deposit Insurance Corporation and other relevant agencies. - Basel capital requirements
New capital and liquidity measurement ratios were created to assist in the management of liquidity and funding during crisis scenarios.
They are:
Liquidity Coverage Ratio (LCR)
This requires banks to maintain a cushion of High-Quality Liquid Assets (HQLA) to cover total net cash outflows for a 30-day economic stress scenario. This allows continuity without the forced sale of assets.
Net Stable Funding Ratio
Banks are required to maintain a stable funding profile in comparison to their assets and off-balance sheet activities, ensuring available stable funding covers a one-year horizon. This helps to mitigate funding mismatches during stress periods. - Bail-in
Prioritise internal resources to resolve business stress and liquidation issues. - Central Counterparties
Over-the-counter derivatives are now required to be cleared through central counterparties, minimizing counterparty credit risk and settlement risk. - Resolution Title 1
This follows the normal US bankruptcy code. It is a pre-approved plan with pre-funded resources and specific triggers to adapt the plan according to the business model, size, and risk profile. The plan is tested to measure preparedness and capacity for timely implementation. - Resolution Title 11
The Federal Deposit Insurance Corporation (FDIC) and other agencies may recommend to the Secretary of the Treasury that Resolution Title 1 is inadequate and that Resolution Title 11 be implemented if financial stability is at risk.
Resolution Title 11 – Key Points
a) Single point of entry strategy
The parent holding company is placed into resolution. All subsidiaries are moved to a newly created Bridge Financial Company to ensure continuity of operations.
b) Holding company receivership
All unsecured debt is transferred to the holding company, and restructuring plans are implemented.
c) Treasury approval
The Secretary of the Treasury approves the restructuring plan, and the FDIC oversees implementation.
d) Post-resolution structure
After completion, the bridge company is terminated, and a new private entity takes over operations.
Risk practitioners should engage in continuous learning and development to expand their knowledge as regulations evolve. The emergence of new innovations, cybersecurity risks, and the interdependent nature of economic systems requires collaboration across disciplines to effectively manage systemic risk.
Conclusion
Regulatory changes have brought progress and certainty to resolution processes. Resolution implementation is now proactive and designed to minimise disruption to the economy, reducing systemic exposure and supporting financial stability.
References
[1] Overview of Resolution under Title 11 of the Dodd Frank Act, April 2024, Federal Deposit Insurance Corporation (FDIC)
