For some time, we have been reporting that the U.S. financial regulatory system has relied on a fragmented and complex arrangement of federal and state regulators to oversee its institutions.place over the last 150 years—has not kept pace with major developments in financial markets and products in recent decades. In particular, the current system was not designed to oversee today’s large and interconnected financial institutions, whose activities pose new risks This system—put into to the institutions themselves as well as to the broader financial system. This risk to the broader financial system, called systemic risk, refers to the possibility that a single event could broadly affect the entire financial system, causing widespread losses rather than just losses at one or a few institutions. Given these observations and concerns, we offered a framework for crafting and evaluating regulatory reform proposals that would have the characteristics that should be reflected in any new regulatory system. For example, we said that a regulatory system should minimize regulatory burden and promote accountability. We also designated reforming the financial regulatory system as a high-risk area in 2009. FSOC’s three primary purposes under the Dodd-Frank Act are to 1. identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies and nonbank financial companies, as well as risks that could arise outside the financial services marketplace; 2. promote market discipline by eliminating expectations on the part of shareholders, creditors, and counterparties of these large companies that the U.S. government will shield them from losses in the event of failure; and 3. respond to emerging threats to the stability of the U.S. financial system. To achieve these purposes, the Dodd-Frank Act gave FSOC a number of important authorities that allow it to collect information across the financial system so that regulators will be better prepared to address emerging threats; designate for supervision by the Federal Reserve those nonbank financial companies that pose risks to the financial system as defined by the act; designate as systemically important certain financial market utilities (FMU) and payment, clearing, or settlement activities, requiring them to meet prescribed risk management standards, and subjecting them to enhanced regulatory oversight; recommend stricter standards for the large, interconnected bank holding companies and nonbank financial companies designated for enhanced supervision; vote on determination by the Federal Reserve that action should be taken to break up institutions that pose a “grave threat” to U.S. financial stability; and facilitate information sharing and coordination among the member agencies to eliminate gaps in the regulatory structure. FSOC is chaired by the Secretary of the Treasury. As the chairperson of FSOC, the Secretary has certain powers and responsibilities related to FSOC’s meetings, rulemakings, recommendations, and reports and testimony to Congress. The Secretary, in consultation with the other FSOC members, is also responsible for regular consultation with the financial regulatory entities and other appropriate organizations of foreign governments or international organizations. As shown in figure 1, the Dodd-Frank Act provides that FSOC consists of 10 voting members and 5 nonvoting members. The 10 voting members provide a federal regulatory perspective and an independent insurance expert’s view. The 5 nonvoting members offer different insights as state-level representatives from bank, securities, and insurance regulators or as the directors of some new offices within Treasury—OFR and the Federal Insurance Office—that were established by the Dodd-Frank Act. The Dodd-Frank Act requires that the council meet at least once a quarter. The Dodd-Frank Act established OFR to serve FSOC and its member agencies by improving the quality, transparency, and accessibility of financial data and information, conducting and sponsoring research related to financial stability, and promoting best practices in risk management. The act requires OFR to set up a data center and a research and analysis center to, among other things, perform applied and essential long-term research; develop tools for risk measurement and monitoring; and make the results of its activities available to financial regulatory collect and provide data to FSOC and member agencies; standardize the types and formats of data reported and collected; agencies. FSOC and OFR do not receive appropriated funds. During the 2-year period following the enactment of the Dodd-Frank Act, the Federal Reserve provided OFR funds to cover the expenses of the office. Moving forward, OFR will be funded through assessments levied on bank holding companies with total consolidated assets of $50 billion or more and nonbank financial companies designated by FSOC for supervision by the Federal Reserve. Until FSOC finalizes its designations for nonbank financial companies, assessments will be levied only against large bank holding companies. The collected assessments will be deposited into the Financial Research Fund, which was established within Treasury to fund the expenses of OFR. FSOC’s expenses are considered expenses of OFR. The President’s fiscal year 2013 budget included estimates of about $123 million for the Financial Research Fund for fiscal year 2012 and about $158 million for fiscal year 2013. Most of these funds are to support OFR, but the estimates include about $8 million for FSOC operations in fiscal year 2012 and nearly $9 million in fiscal year 2013. Most of OFR’s funding is budgeted for contractual services—including reimbursable support from Treasury and administrative services from the Office of the Comptroller of the Currency (OCC) and the Bureau of Public Debt— employees and equipment. Key FSOC missions—to identify risks to U.S. financial stability and respond to emerging threats to stability—are inherently challenging. Risks to the stability of the U.S. financial system are difficult to identify because key indicators, such as market prices, often do not reflect these risks. Further, such threats do not develop in precisely the same way in successive crises, making them harder to identify. As FSOC’s chairperson acknowledged in FSOC’s 2011 Annual Report, the most significant threats to the stability of the financial system will often be the ones that are hardest to diagnose and preempt. Moreover, financial innovations that are not well understood further complicate the challenge. For example, prior to the 2007-2009 financial crisis, some experts viewed the risks associated with falling housing prices as a regional phenomenon. With the advent of mortgage-backed securities, these experts believed that the danger that falling house prices posed on the regional level had been mitigated, as they thought these securities had diversified and dispersed the risks. Although this dispersion of risk was expected to limit the impact of regional downturns, it helped to transmit the downturn in housing prices across the financial system and the nation. Experts have also noted that the task of effectively monitoring and mitigating systemic risk is both vast and procedurally complex. Additionally, actions to preemptively mitigate threats may appear unnecessary or too costly at the time they are proposed or taken. Although achieving FSOC’s key missions is inherently challenging, failure to achieve them will continue to leave the financial system vulnerable to large or multiple shocks that could result in the large losses in asset values, higher unemployment, and slower economic growth associated with previous financial crises. Although the Dodd-Frank Act created FSOC to provide for a more comprehensive view of threats to U.S. financial stability, it left most of the fragmented and complex arrangement of independent Federal and State regulators that existed prior to the Dodd-Frank Act in place and generally preserved their statutory responsibilities. As a result, FSOC’s effectiveness hinges to a large extent on collaboration among its many members, almost all of whom come from state and federal agencies with their own specific statutory missions. In testifying on the coordination of Dodd-Frank rulemakings assigned to specific FSOC members, before the U.S. House Financial Services Committee in October 2011, the chairperson of FSOC recognized this challenge. He noted that the coordination challenge in the rulemaking process was hard because the Dodd-Frank Act left in place a financial system with a complicated set of independent agencies with overlapping jurisdictions and different responsibilities. However, the Chairperson also noted that certain agencies were working much more closely together than they did before the creation of FSOC. In our prior work, the federal financial regulators also emphasized the importance of maintaining their independence while serving as members of FSOC. For example, several FSOC member agencies noted in our prior work on Dodd-Frank rulemakings that any effort to coordinate rulemakings assigned to specific agencies through FSOC would need to be balanced against the statutory requirements of the independent agencies involved. In addition, the Chairperson has similarly noted that he does not have the authority to force agencies to coordinate, and neither he, nor FSOC as a whole, can force agencies to adopt compatible policies and procedures. FSOC members’ staffs and staff at member agencies also noted that differences in policies and procedures are designed to address the differences in the entities they regulate. Regulators have also pointed to their differing statutory requirements to explain why they have differing views on policy issues. During the Basel II deliberations, for instance, U.S. bank regulators—the Federal Deposit Insurance Corporation (FDIC), Federal Reserve, and OCC—each had a different view of various aspects of those The regulators traced their differences back to their requirements.specific statutory responsibilities. Furthermore, although the United Kingdom (UK) and the European Union (EU) have established or are in the process of establishing councils to oversee systemic risk, in the UK and the EU the central bank has more members or more votes than other entities on these councils. In contrast, in the United States, the central bank—the Federal Reserve—has one member on FSOC and one vote among the 10 voting members. FSOC policy staff and staff at member agencies noted that the diverse perspectives of FSOC members enrich FSOC deliberations. OFR also faces the challenge of trying to build a world-class research organization from the ground up while meeting shorter term goals and responsibilities.