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FDIC Outlook

The Stroke of the Pen: A Unique Class of Risks to Insured Financial Institutions
Financial risk management, as practiced by depository institutions and many other classes of enterprises, tends to be based on a familiar taxonomy of risk classes. The three broadest and most commonly cited classes are credit, market, and operational risk.1 In addition to these categories, liquidity and solvency risks represent bottom-line measures of an institution’s vulnerability to adverse situations. Beyond this basic taxonomy, the recognized categories of risk tend to differ according to where they are applied. Reputational risk is generally of utmost importance to financial institutions because of the central role public confidence plays in their success. Regulatory risk assumes a prominent role for financial institutions because they tend to be heavily regulated.

This issue of FDIC Outlook is devoted to a special class of risks that may slip between the cracks of these standard taxonomies. What we will call stroke-of-the-pen risks share elements with regulatory risk, or the risk that a change in the rules governing the industry could impair an institution’s financial performance. However, our understanding of stroke-of-the-pen risks extends beyond changes in the regulatory rules governing banks and thrifts. After all, these rules are targeted to the concerns specific to the institutions themselves as well as their customers, regulators, and other major stakeholders. While changes in bank regulation usually have systematic effects on the banking industry, the outcomes are presumably deliberate and can be anticipated. By contrast, our conception of stroke-of-the-pen risks focuses on changes in policy, regulation, and accounting that address issues arising outside the financial services industry, but that can result in systematic risks to banks and thrifts. Such changes often arise in the political process, making them difficult to anticipate. A prime example (one that is addressed in the next article) is a change in the U.S. tax code. Tax reform has unique policy goals, related primarily to efficiency and fairness. Changes in the tax code may have implications for virtually any sector of the economy. But these implications are of particular interest to bank risk managers for two reasons: (1) they may have adverse effects that are difficult to minimize through geographic or product diversification, and (2) negative effects on banks or their borrowers may result from unintended or unanticipated consequences.

The very term “stroke of the pen” traditionally has referred to policy choices or significant actions made unilaterally—decrees that could carry profound positive as well as negative consequences for certain groups or constituencies. U.S. presidential executive orders sometimes are referred to as stroke-of-the-pen actions because they are directives made by one person that may carry momentous implications. What our definition emphasizes is that the risk arises not so much from the fact that the consequences of a policy change have not been evaluated by the person or group that initiated it, but that these consequences have not been evaluated primarily in terms of their effects on insured financial institutions.

In this vein, this issue examines policy changes—past and prospective—arising outside the realm of bank regulation that have led to (or may lead to) significant negative consequences for banks and thrifts. The first article is a historical look at the effects of three such changes: the 1979 change in Federal Reserve monetary policy targets, the 1986 Tax Reform Act, and the 1996 implementation of Financial Accounting Statement 125 by the Financial Accounting Standards Board. The second article considers the more recent and much-discussed effects of the 2002 Sarbanes-Oxley legislation on U.S. corporations and financial institutions. A final article looks prospectively at risks associated with possible changes in U.S. farm subsidies that could result from the ongoing World Trade Organization negotiations and the U.S. budget process. While it is difficult to predict the types of changes that may come about as a result of an ongoing policy process, it makes sense for policymakers—and bank managers—to consider in advance the implications such changes may have for the financial condition of FDIC-insured institutions.

1 For two examples of risk taxonomies as applied to depository institutions, see Cornett, Marcia, and Anthony Saunders. Fundamentals of Financial Institutions Management. New York: McGraw-Hill 1999, 180, and Cade, Eddie. Managing Banking Risks. Chicago: FitzroyDearborn Publishers, 1999, 16.

Last Updated 10/10/2005

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