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

Abstract

Inherent tensions in the financial sector mean that episodes of extreme stress are inevitable, if unpredictable. This is true even when financial regulatory and supervisory regimes are effective in many respects. The government's capacity to intervene may determine whether 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 reforms, a firm-by-firm approach cannot address a major systemic failure. Major blows to the financial system, such as the financial crisis of 2007-2009, may require capital support of the financial sector to prevent severe economic harm. We therefore propose the creation of a Systemic Emergency Insurance Fund ("SEIF" or "Fund"), initially set at $1 trillion, but periodically rescaled to the size of the U.S. economy. SEIF 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, the use of which would be triggered by a "triple key" concurrence among the Treasury, the Federal Deposit Insurance Corporation ("FDIC"), and the Federal Reserve ("Fed"). Unlike taxpayer "bailouts, " such a fund would mutualize systemic risk among financial firms through a facility overseen by regulators. Moreover, its funding mechanism would give financial firms a greater incentive to warn regulators of growing systemic risk. And this standby emergency authority would avoid 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 embodied in the newly enacted Dodd-Frank financial reform bill.