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Testing America’s financial stability

Far-reaching financial-reform legislation has just been enacted in the United States—a landmark response to the most devastating financial crisis in decades, and one that takes important and welcome steps toward addressing the many weaknesses in the US regulatory and financial system that the crisis revealed.

While the Obama administration and the US Congress were drawing lessons from the crisis and deliberating on reforms, the International Monetary Fund was also assessing the US financial system under the Financial Sector Assessment Program (FSAP). The FSAP was introduced in the wake of the Asia crisis in the mid-1990’s to enable objective assessment of the strengths and vulnerabilities of countries’ financial systems, including the extent to which they measure up to international standards. The latest global crisis prompted the G-20 to re-affirm the importance of these FSAP “check-ups” to efforts to promote global stability, and it has even committed its members to undergo them regularly.

So, with the US now having undertaken this exam, what insights does it provide about the health of the US financial system and recent regulatory reforms?

The review contains many positive conclusions. It commends the US authorities for their bold and decisive action to stem the risk of systemic collapse during a period of extreme market turmoil. Although the crisis has imposed devastating costs nationally and internationally, the mistakes that led to the Great Depression seem to have been avoided.

The US authorities also acted quickly to introduce reform legislation that addresses the weaknesses that led to the crisis. The passage of the Dodd-Frank Act by Congress represents a significant milestone in the reform of the US financial sector. Under the new act, a systemic risk regulator has been established, oversight of the shadow banking sector has been strengthened, and new mechanisms have been created to deal with the failure of systemically important non-banks.

These reforms provide a basis for a safer and sounder financial system. Nevertheless, the FSAP assessment emphasises that the job is not yet finished, and that there is critical work still to be done.

First, while broad financial stability has been restored, and bank capital has been boosted significantly as a result of last year’s “stress tests,” there are still important pockets of weakness. For, even if growth continues at its current pace, more capital will be needed, especially for small and mid-sized banks.

These needs seem manageable, but, as recent events in Europe and recent US data have reminded us, the recovery and confidence remain fragile, especially against the backdrop of high public debt. If the economy were to weaken, the need for additional bank capital could be significant.

Second, the Dodd-Frank Act represents a huge step forward in improving regulation of both individual financial institutions and the system as a whole. But it missed an important opportunity to streamline US supervisory agencies, leaving it unclear whether the longstanding gaps and conflicting mandates that contributed to the crisis have really been resolved. The legislation provides a skeleton for the new regulatory architecture, and it will be up to the new Financial Stability Oversight Council to put supervisory muscle on these bones: to improve interagency cooperation, tighten rules governing systemically important institutions, and respond quickly and forcefully to systemic risks.

Third, reducing systemic risks will require determined action to ensure that financial institutions are not too big to fail. The new legislation takes important steps in this direction, calling for additional capital and other charges on firms in proportion to their systemic risks, requiring systemically important firms to prepare “living wills” so that they can be easily wound up, and introducing a special resolution framework if they do fail. But these measures cannot be a substitute for strong and pre-emptive consolidated supervision; rules and regulations cannot be a substitute for the “will to act.”

Fourth, reform of US housing finance remains unfinished business. Public policies to subsidise US mortgage lending have been costly, inefficient, and have encouraged excessive risk-taking, which helped push the system toward crisis. Concrete proposals for addressing this situation are now being formulated, but the financial system cannot be said to be repaired without a decisive resolution of America’s [government-sponsored] mortgage agencies and significant cuts in US subsidies for mortgage borrowing.

In sum, the US authorities have done much to strengthen the financial sector. Their participation in the FSAP assessment—and their agreement to publish the results—speaks to their commitment to global efforts to ensure that the crisis of the last three years will not be repeated. The true test, however, will be how the recent reforms are implemented domestically, and how they will be coordinated internationally.

José Viñals is Financial Counselor and 
Director of the IMF’s Monetary and 
Capital Markets Department
© Project Syndicate