Center for Financial Policy’s First Policy Chat, with Art Murton from FDIC

The Center for Financial Policy hosted Art Murton from the FDIC on Monday, November 08, 2010. Art is a veteran of the recent financial crisis as well as the earlier S&L crisis. As the Director of Insurance and Research, Art is directly involved in policy related issues faced by the FDIC. Currently, the FDIC is busy developing rules to implement the Dodd-Frank Wall Street Reform Act. Art took time out of his busy schedule to hold an hour-long conversation with faculty and Ph.D. students about the implications of the Dodd-Frank Act for the FDIC. He shared his views on four issues: (1) the Financial Stability Oversight Council (FSOC); (2) the FDIC’s new Orderly Liquidation Authority; (3) identification of systemically important non-bank financial institutions; and (4) how incentives-Based Compensation will be regulated under the Dodd-Frank Act.

Art gave a short history of the creation of the FSOC, and how it augments the existing President’s Working Group that many have blamed for allowing complex instruments like Credit Default Swaps to go unregulated. Unlike the three-person President’s Working Group, the FSOC is composed of ten voting and five nonvoting members who can give diverse opinions and thereby better identify potential problems before they have adverse effects on the markets. Additionally, the newly created Office of Financial Research will support the FSOC by providing new research and data on risks financial institutions are exposed to, as well as standardizing financial products to improve risk management. Admitting that “the state of stress-testing at banks is surprisingly bad,” Art expressed confidence that the OFR will play a strong role in improving regulatory tools such as stress-testing and the risk weighting of capital.

The conversation inevitably turned to the million-dollar question: “Is this the end of the era of bailouts?” While noting that bailouts will always be a politically tempting option for policymakers, Art said that the orderly liquidation authority outlined in the Dodd-Frank Act represents a new alternative to bankruptcy or bailouts. Together with the Federal Reserve, the FDIC is implementing regulations requiring banks to have resolution plans or “living wills” describing how to divest assets in case of insolvency. If the resolution plans are not sufficiently implemented by the stressed institution within two years , the FDIC has the power to require divestiture of assets not covered by the firm’s plan. Policymakers at the FDIC believe this plan will ensure an orderly liquidation when banks fail in the future, without requiring large government bailouts.

Under the Dodd-Frank Act, Art emphasized that a bailout of GM or GE would not happen. Only financial institutions can be assisted. Under the Dodd-Frank Act, financial activities have to be 85 percent or more of the total activities of the firm for it be considered a financial firm. Therefore, he noted, GM wouldn’t be rescued, but GMAC or GE Capital could be assisted during liquidity shortfalls by advance dividends (where the Fed would lend the firm up to 90 percent of the fair value of its assets), or resolved quickly and smoothly if the firm is insolvent. Murton cautioned the group in attendance that how the FDIC treats creditors may vary in some cases, for example by favoring utilities by making them whole in a resolution and letting them continue operations, and that this issue was still under much contention.

With regard to the last topic, Art mentioned that incentives-based compensation will be regulated directly and indirectly under newly proposed guidelines at the FDIC. Through the use of clawbacks and restrictions on executive pay, the FDIC hopes to limit risk-taking incentives of management. If that is insufficient, Art told the group that the FDIC is considering adding incentives-based compensation into its formula for computing risk-weighted assets used to calculate capital requirements. By implementing both types of regulation, Art hopes executive behavior will be managed to prevent systemic risk. However, he noted the challenges regulators are still facing when trying to implement these regulations, such as identifying who counts as an executive at a firm, and how much capital to require the financial institutions to set aside for potential clawbacks.

The policy chat generated several discussions of future research involving these topics, with particular attention on how to identify systemic risk and how to regulate capital structure. Several attendees discussed the unresolved problem of managing systemic risk caused by a potential state or foreign government default. Participants held a lively conversation about contingent capital and the terms and format needed to make contingent capital an effective check on the risk-taking incentives of shareholders, as well as what kind of contingent capital assets could be sold in the market. In particular a research agenda emerged based on studying the potential use of market forces and contingent capital to alter firm risk-taking behavior while forcing it to raise capital, and placing less of a monitoring burden on the regulatory system.

By Benjamin Munyan