9. “Dynamic Precaution” in Maintaining Financial Stability: The Importance of FSOC

Abstract

The Financial Crisis of 2007-09 has shown that financial stability is the ultimate public good: all benefit from it, it is costly to maintain, and its undersupply results in catastrophe. The threat to financial stability comes along four different avenues: first, the effort by institutions within the financial stability regime to find loopholes and other sorts of regulatory arbitrage to avoid the regime’s costs; second, the effort by institutions outside of the regime to produce financial intermediation services that are the functional equivalent of within-the-regime firms; third, “innovation,” which includes the unexpected consequence of existing rules in new application; and fourth, macroeconomic forces that magnify the threat of financial instability. The forces, separately and in combination, can reshape the financial system; these forces can move a formerly stable system into one that is systemically susceptible to either an internal or external shock. One very important lesson of the Financial Crisis is that the maintenance of financial stability is an on-going project that requires an approach of “Dynamic Precaution.” This requires an institution such as the Financial Stability Oversight Council to monitor the financial system as it evolves, to call attention to emerging risks to financial stability, and to catalyze the necessary regulatory intervention. In developing a case for Dynamic Precaution, this chapter explains first, why financial institutions need to remain as the focus of the FSOC regime even while observation and regulation aimed at activities is also important; second, how FSOC can serve Dynamic Precaution by using its designation authority to negotiate “off ramps” from enhanced oversight for firms whose instability or failure would otherwise have systemic implications; and third, if the maintenance of financial stability is the apex goal, why cost-benefit analysis can play only a limited role in financial regulation.