In 2015 the Federal Reserve produced a new regulation to be adopted by financial investment firms titled, the “total loss-absorbing rule”. It effectively requires certain capital ratios (additional equity within risky institutions to help absorb the devaluation of assets) for particularly fragile financial institutions to adhere to. In order to explain this rule fully it is important to understand the concept of risk as it pertains to certain financial securities.

First consider the concept of risk weighting, with regards to the way in which an asset is configured. Based on which type of asset is being sold or lent out, this would determine the amount of risk assigned to the instrument. Therefore prescribing how much capital should be made available for that bank’s balance sheet in order to absorb the potential devaluation of that asset. Note, it was not until 1996 that banks were actually required to measure the risk of their assets. However, in November of 2001 financial regulators actually diminished capital requirements from 8% to 1.6% on mortgage-backed securities (MBS) as well as collateralized debt obligations (CDO). These are insurance securities that can be purchased and used as a means to hedge against potential mortgage loan default. These particular securities were assigned either a AAA- or AA- rating, these are almost risk free ratings. After this occurred investment firms began accumulating significantly larger quantities of CDOs and MBSs on their balance sheets. Later it came to light that these ratings were essentially inflated in order to attract investment.

In 2010, just after the 2007-2008 housing crisis the US legislature created the Dodd-Frank Act. The purpose of this bill was to make the Federal Reserve a lender of last resort only under dire circumstances. And only if that financial institution were a mega firm and was likely to incite a contagion among global banks. Dodd-Frank was also drafted in an effort to increase capital requirements, and restructure risk measurement models within investment firms. However, many economists and policy experts contend that special interests within the banking sector will minimize the impact of these new regulations through lobbying efforts. One can only wait to see how financial regulators react in a time of future crisis.