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Overview: Secretary Geithner Outlines Framework for Systemic Risk Regulation; Potential Impact on Private Investment Funds

January 1, 0001

 

On March 26, 2009, Secretary of the United States Department of Treasury Timothy Geithner unveiled a plan to overhaul the regulation of systemically significant financial institutions. This proposal was prompted by the concern that certain large, interconnected firms and markets need to be under a more consistent and conservative regulatory regime intended to ensure not only the solvency of those firms, but also the stability of the entire economic system. Under the plan, any financial entity – regardless of type – that is determined to be systemically important would be subject to a single, independent regulator (most likely the Federal Reserve). These entities would be obliged to satisfy higher capital requirements, observe heightened risk management standards, and meet stricter liquidity and counterparty requirements.

Systemically Significant Entities Would Be Subjected to a New Systemic Risk Regulatory Regime

To identify which organizations are systemically significant, Secretary Geithner has identified three basic relevant factors: (1) the firm’s interdependence with the financial system; (2) the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding; and (3) the importance of the firm as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.

The funds determined to be systemically significant would be subject to more extensive prudential regulation, including potential examinations, mandated implementation of comprehensive internal controls and risk management measures, and compliance with directives by the regulator to limit borrowing or increase capital. The number of firms subject to this regime could be quite broad as Secretary Geithner refused during his testimony to quantify the number of institutions he expects to meet the criteria for inclusion.

Secretary Geithner’s plans remain fairly general in nature and many details remain to be determined, including which agency would act as systemic regulator. However, because Treasury has indicated that it does not expect to create a new systemic risk agency, many believe the Federal Reserve is the most likely candidate. Although some members of Congress have suggested that the FDIC should be the new regulator, such an outcome appears unlikely.

New Disclosure and Reporting Requirements for Private Investment Funds

Reflecting the perception that private pools of capital are potentially a source of systemic risk, Secretary Geithner’s plan imposes increased disclosure requirements for hedge funds and other private pools of capital. Under the plan, investment advisers of private pools of capital having assets under management exceeding certain (though not-yet-defined) thresholds must register as investment advisers with the Securities and Exchange Commission. These advisors would thus be subject to reporting obligations and inspections by SEC staff.

The private pools of capital covered by this plan would be subject to investor and counterparty disclosure requirements as well as regulatory reporting requirements that would require, inter alia, disclosure of information (on a confidential basis) necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability. While there may be pools of capital – such as structured investment vehicles – whose advisers less clearly fall within the scope of investment adviser registration, such issues may have to be worked out in legislation.

Other Features of Secretary Geithner’s Proposed Plan

These plans for private investment funds are part of the Treasury Department’s proposed comprehensive regulatory reform framework that has four primary goals: (1) limiting and managing systemic risk; (2) improving consumer and investor protection; (3) eliminating gaps in the U.S. regulatory structure; and (4) fostering improved international coordination. The imposition of more comprehensive supervision of systemically significant institutions is likely the least controversial of Treasury’s objectives. There have been other proposals – although none so comprehensive – for subjecting pooled vehicles to regulatory oversight. In January, Senators Chuck Grassley and Carl Levin introduced the Hedge Fund Transparency Act of 2009 which would have subjected a variety of private investment funds and similar vehicles to regulation by the SEC. While the specifics of Treasury’s proposal may be subject to further review, repeated statements from both the Obama administration and from Congressional members confirm that more intensive investment fund regulation in the United States is imminent.

Treasury’s proposals also contemplate that the Federal Deposit Insurance Corporation (FDIC) would be given resolution authority with respect to certain systemically significant entities (although not private capital pools), including authority to assist or potentially take over troubled institutions in cases where their failure threatens systemic soundness.

Other measures intended to address systemic risk include a new regulatory and supervisory regime to oversee credit default swaps and over-the-counter derivatives. This regime would include more robust eligibility requirements and a clearinghouse through which these transactions would be processed. Treasury also contemplates steps to constrain further the credit and liquidity profiles of money market mutual funds and would prevent and mitigate the risks associated with rapid withdrawals from those funds.

Finally, Treasury proposes that a single entity would be given the ability to supervise, examine, and set prudential requirements for systemically important payment and settlement systems and activities. This latter proposal arises from concerns that authority over payment and settlement systems is incomplete and fragmented and seeks to address weaknesses in over-night and short term lending markets that were evident in connection with the failure of Lehman and Bear Stearns.

Treasury’s reliance on existing agencies and unwillingness to engage in broader regulatory reform suggests that Treasury may have decided to defer comprehensive regulatory restructuring. Secretary Geithner clearly warned of the “turf wars” likely to emerge in connection with such an undertaking. At the same time, it is clear that working within the existing system will entail some significant compromises. This suggests that the Administration may have decided to concentrate on the most critical and least controversial proposals and to defer what are likely to be bruising fights over regulatory structure with Congress, the States and the advocates of different agencies.

Treasury’s plan has prompted some reservations in Congress, including concern that moral hazard will be exacerbated by identifying systemically significant financial institutions. No serious alternative to Treasury’s proposals has been offered, however, and it is difficult to imagine an effective mechanism for managing systemic risk that does not begin with an identification of those firms that are systemically significant.