Confronting Financial Crisis: Dodd-Frank's Dangers and the Case for a Systemic Emergency Insurance Fund

Abstract

The inherent tensions in the financial sector mean that episodes of extreme stress are inevitable, if unpredictable. This is so even if the regulatory and supervisory regimes are in many respects effective. The capacity of government to intervene may determine whether the distress is confined to the financial sector or breaks out into the real economy. Although adequate resolution authority to address a failing financial firm is a necessary objective of the current regulatory reform, a firm-by-firm approach will be unable to address a major systemic failure such as the Financial Crisis of 2007-08, which may require capital support of the financial sector to avoid severe economic harm. We therefore propose the creation of a Systemic Emergency Insurance Fund (the Fund) (SEIF), scaled appropriately to the size of the US economy, $1 trillion. The facility should be funded (and partially pre-funded) by risk-adjusted assessments on all large financial firms, including hedge funds, that benefit from systemic stability. The Department of the Treasury (Treasury) would administer the Fund, use of which would be triggered by a “triple key” concurrence among Treasury, the Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve (Fed). Unlike a taxpayer “bailout,” such a fund would mutualize systemic risk among financial firms through a facility overseen by the regulators. The funding mechanism will give financial firms new incentives to warn regulators of growing systemic risk. Such standby emergency authority avoids the need for high stakes legislative action mid-crisis, which can be destabilizing even if successful and catastrophic if not. Such an approach is superior to the financial sector nationalization strategy that is found in the newly enacted Dodd-Frank financial regulatory reform.