Reining In Risk: The Fed Tackles the Dodd-Frank Regulatory Mandates

Richard Heckinger is the Vice President and Senior Policy Advisor for the Financial Markets Group of the Federal Reserve Bank of Chicago. He oversees financial policy decisions in the 7th district—Iowa, Illinois, Indiana, Michigan and Wisconsin. He works closely on the regulation of Over the Counter (OTC) derivatives with regards to risk management, payments, clearing and settlements. This interview has been edited for clarity and length.

How are you trying to implement Fed’s new responsibility to monitor and regulate the exchange of various financial instruments (like credit default swap) as dictated by the Dodd-Frank legislation?

Let’s start with some background on how the initiative for further financial regulation came about as a result of the 2008 financial crisis. In 2009, countries of the G20 met in Pittsburgh to find agreement on the most efficient way to avert future, large-scale financial disasters. Developed nations in the G20 agreed to take steps and reform the financial markets by

1. Increasing transparency of financial products through an expansion in data reporting
2. Reducing systemic risk in the financial system
3. Standardization of OTC (over the counter) derivatives like credit default Swaps

As a result of this initiative, Congress then went on to pass the Dodd-Frank Bill. Titles II, VII, and VIII authorize the Fed regulatory capabilities over clearinghouses. They will act as a intermediary between two parties conducting a financial transaction like a credit default swap (previously conducted over the counter between parties). Like banking institutions, the Fed will be able to regulate the clearinghouse and set the reserve requirements the clearinghouse needs to have on a given day. And clearinghouses will be able to borrow from the Fed in a similar method that applies to most US Banks.

Some academic papers point to the fact that standardization of OTC’s can inadvertently reduce efficiency among firms in the financial markets. There has also been push back from the financial industry on regulation. In your view, is this criticism valid?

Well, standardization is not the only factor under discussion.  It is one of the aspects of how risk might be handled. For example, it is apparent that firms can get high payoffs by taking on risk by trading over the counter trades of derivatives with little or no collateral exchanged between the counterparties. On the other hand, we have to look at the effect of actions in the financial markets for the society as a whole and compare to see whether the policies make societies better. Standardization is expected to increase efficiency of trading and risk management, hopefully without reducing financial innovation.

If the clearinghouses only held credit default swaps, could we not see an AIG type of effect where the clearinghouse runs out of liquidity and cannot provide promised collateral due to a sharp decline in home prices and higher levels of mortgage defaults?

It is clear that whether OTC or through a clearinghouse, more collateral will be required to secure OTC deals.  In this respect, the Chicago Fed has created a collateral estimation tool that allows any user  to get an estimate of to get an estimate of the amount of collateral they may need to have on hand in an OTC.

Do you think the Fed has the capabilities to handle this oversight responsibility?

The Fed is not the sole regulator in the financial markets. In fact, as a result of the regulatory mandate in the bill, the Federal Reserve Bank and institutions like the SEC  and the CFTC  now work together on a much more frequent basis. For instance, there will be joint monitoring of the clearinghouses. Quite a bit of work in relation to the Dodd-Frank Act has been done to manage the distribution of responsibilities among the various regulatory institutions.

What is the current policy issue that regulators like you are dealing with in regards to global finance?

Most of the work is focused on harmonizing the financial market regulations across the developed countries and making an effort to avoid duplication. In particular, they are focused on the implementation and design of Basel III. Basically, it will strengthen capital requirements for banks and propose new requirements on bank leverage. If all countries implement the Basel III regulatory framework, it will first level the playing field and then reduce regulatory arbitrage.

Commentators have implied that systemic risk in the financial markets increased as a result of the size and scope of large multinational banks. Do you think that policy in the future could successfully allow large banks to reduce their size and coverage in the financial system?

I think the regulatory requirements within the Basel III regulation can reduce some of the moral hazard issues that led banks to take on extreme amounts of risk. Basel III is trying to reduce some of the bank leverage issues that lead to the financial crisis in 2008.

The Fed’s mandates are to keep inflation in check while trying to maintain full employment in the long term. After the financial crisis, the Dodd-Frank legislation gives more authority to the Fed to be a major regulator of the financial system and enact policies that mitigate systemic risk. In your opinion, do you think that the Fed will be as fervently dedicated to reducing systemic risk as they are to regulate inflation and unemployment without a formal mandate?

The Federal Reserve Act mandates the authority of the Federal Reserve , but importantly, its authority is not unlimited  The Dodd-Frank legislation has increased the regulatory awareness among financial market regulators. Overall, the legislation should be adequate in making regulatory agencies be aware of potential systemic risks in the financial system.

Feature photo:  cc/Josh Wellington

[This article has been updated since its initial publication — ed.]