January 06, 2012 at 09:45 AM EST
Dodd-Frank Act May Have Increased US Vulnerability To Systemic Risk
Despite passage of major regulatory reform in 2010, failure to provide adequate resolution authority in the Dodd-Frank legislation suggests that the US financial system remains vulnerable to the collapse of a large financial institution with major cross-border operations, according to Oxford Analytica: Perhaps the greatest concern is that Dodd-Frank explicitly bans [...]

Despite passage of major regulatory reform in 2010, failure to provide adequate resolution authority in the Dodd-Frank legislation suggests that the US financial system remains vulnerable to the collapse of a large financial institution with major cross-border operations, according to Oxford Analytica:

Perhaps the greatest concern is that Dodd-Frank explicitly bans some practices that regulators relied on to confront the 2008 financial crisis.

The Fed may still engage in traditional functions, such as lending money to banks using its discount window, and adding liquidity to the system through ‘open market operations.

However, Dodd-Frank precludes direct bailouts of individual firms using emergency lending authority. Instead, the Federal Deposit Insurance Corporation (FDIC) is empowered to supervise the liquidation of failed firms, putatively demonstrating that no bank is too-big-to-fail.

The FDIC is given broad power to resolve a firm’s existing operations quickly (within 24 hours) by settling transactions such as outstanding derivatives contracts. However, use of this authority could complicate proceedings, and may contravene or conflict with existing arrangements — such as the derivatives netting procedures set forth in standard International Swaps Dealers Association (ISDA) contract

Furthermore, Dodd-Frank requires waivers for financial firms that seek to expand beyond a threshold, limiting any firm to no more than 10% of the financial system’s outstanding liabilities; this could prevent the semi-forced mergers — Bear Stearns’ takeover by JP Morgan Chase, and Bank of America’s acquisition of Merrill Lynch — brokered during the 2008 crisis. The merged institutions would also need to satisfy bank capital requirements in place at the time of the transaction.

US policymakers would likely cobble together a fairly effective response to a major European crisis or sovereign default, but serious sources of systemic instability remain unaddressed or (at minimum) untested, despite regulatory reform. Moreover, by circumscribing regulators’ ability to pursue flexible policy responses during emergencies, vulnerability to systemic risk may actually have been increased.

For details see UNITED STATES: Contagion risk remains despite reform

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Technorati Tags: big banks, Dodd-Frank Act, financial-regulation, too-big-to-fail

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