Regulators’ top risk cop assailed by reform-bent critics

Another longstanding target for critics is the Financial Stability Oversight Council. It took President Trump only two weeks in office before threatening an overhaul or dismantling of the FSOC, ultimately decreeing an end to the Council’s process for designating non-banks as “systemically important financial institutions (SIFIs).” Legislative efforts and regulator-led initiatives have come and gone with varying degrees of success.

The FSOC is comprised of the heads of federal regulatory agencies and an independent insurance expert appointed by the President. It is charged with identifying risks to the stability of the U.S. financial system. SIFIs are subject to “enhanced prudential standards” with higher capital requirements, the requirement to undergo annual stress testing, and enhanced reporting requirements including the creation of recovery and resolution plans or “living wills.” SIFIs must set aside more capital, significantly increase compliance staff, and increase technology and data capture processing.

The FSOC has broad authority statutorily when evaluating companies for SIFI designation. Banking companies with more than $50 billion in assets are automatically designated; non-banks are evaluated in terms of size, interconnectedness, leverage, liquidity risk, and existing regulatory scrutiny. The Council exercised its authority to designate AIG, MetLife, Prudential, and General Electric’s financing arm, GE Capital, as non-bank SIFIs. Over time, both annual reviews and (in the case of MetLife) successful lawsuits have stripped away their SIFI designations.

Over the years there have been numerous attempts to alter the FSOC’s designation process and assessment criteria. In November 2017, Treasury issued a report entitled, “Financial Stability Oversight Council Designations,” which provided recommendations to improve the FSOC’s designation process. One of those recommendations was for the FSOC to prioritize an activities-based approach to designation and work with relevant regulators to address any risks posed prior to considering designating a non-bank financial company. Another: only designate a non-bank financial company if the expected benefits to financial stability outweigh the costs of the designation; and provide a clear “off-ramp” for designated non-bank financial companies, including by identifying key risks that led to the designation and enhancing the transparency of the FSOC’s annual review process.

Rebuilding from within

The FSOC itself, now packed with officials appointed by President Trump, is looking to reconsider its own procedures.

On March 6, its members voted to replace current interpretive guidance on the non-bank designation process. Among the changes: prioritizing an activities-based approach to designation that would focus on identifying and addressing the underlying sources of risk and would only contemplate designating individual companies if a risk could not be addressed through an activities-based approach that evaluates risky practices; conducting a cost-benefit analysis prior to designating a non-bank; eliminating a six-category framework used to analyze individual companies; instituting procedural changes to improve engagement with companies and regulators; and clarifying “off ramp” opportunities for companies through risk mitigation efforts prior to or after designation.

“The U.S. regulatory system is riddled with gaps in areas like insurance, hedge funds, and FinTech. Because FSOC lacks authority to implement activities-based rules directly, this pervasive jurisdictional fragmentation would undermine efforts to enact and enforce uniform, consistent activities-based rules throughout the financial system.”

Jeremy Kress, Assistant Professor of Business Law, Ross School of Business

On the legislative front, Senate Bill 603, the “Financial Stability Oversight Council Improvement Act of 2019,” is bipartisan legislation that would require, before voting on a proposed designation, that the Council must consider whether the potential threat posed by a non-bank financial company could be mitigated through other means—a different action of the Council; action by the company’s primary regulator; or action by the company itself. If the Council determines that other means are impracticable or insufficient to mitigate the potential threat, only then may it proceed with a proposed designation.

That bill, and the continuing mix of praise and criticism the FSOC receives, was the subject of a hearing convened by the Senate Banking Committee last week.

“At the outset, the process for non-bank designation was immeasurable and unclear, which was not only contrary to the long-established principles of our regulatory framework, but also lead to legal uncertainty that undermined the very objective of FSOC,” said Sen. Mike Crapo (R-Idaho), chairman of the Committee. In 2013, he requested a study by the Government Accountability Office regarding the non-bank designation process. The report, issued the following year, concluded that the FSOC’s process lacked transparency and accountability, insufficiently tracks data, and does not have a consistent methodology for designations.

Sen. Sherrod Brown (D-Ohio) pushed back against what he perceived as efforts to weaken FSOC oversight of the financial markets. “Right now, the risks to the financial system have increased,” he said. “The biggest Wall Street banks have gotten even bigger and more interconnected. The shadow banking sector has grown and is taking on more risk. The business cycle is extended and growth is slowing. The global economy faces uncertainty from Brexit and growing debt levels in China.”

Many of these developments, Brown said, echo what led to the last financial crisis.

“FSOC has all but given up its role as the agency tasked with identifying and constraining excessive risk in the financial system, and Wall Street continues to push legislation that would further weaken it and make it impossible for future Administrations to designate non-bank financial firms,” he said.

Reforms afoot?

Douglas Holtz-Eakin, president of the American Action Forum, a think tank that promotes “center-right public policy,” testified at the March 14 hearing on what he sees as the need for “wholesale reform” regarding the FSOC.

“The non-bank designation process is arbitrary, inconsistent, and opaque,” he said. “FSOC must redefine its mission, which must involve a shift from entity-specific regulation to activities-based regulation or be disbanded as a regulator.”

For the FSOC to remain relevant, Holtz-Eakin said, “it must significantly overhaul its operating procedures, beginning with a philosophy of activities-based rather than entity-specific regulation.”

“The safety and soundness of the financial system is clearly a fundamental goal,” he said. “FSOC was however tasked with a difficult mandate in that the concept of ‘systemic risk’ has never been adequately defined and cannot be measured, let alone a ‘safe’ level of systemic risk. FSOC’s response to this challenge has been to create an environment where non-bank financial companies were laden with excessive regulation, and increased compliance costs, that were necessarily passed on to consumers.”

Among the common, ongoing complaints about the agency is that SIFI designations, particularly for non-banks, can be costly. AIG, for example, estimated that its de-designation saved the company $150 million a year in compliance costs. Research by the American Action Forum found that SIFI designation of asset managers or funds, should the Council pursue such efforts, would also be costly for investors. In some cases, investors could see their returns reduced by as much as 25 percent.

Beyond potential designations of asset managers and funds, Holtz-Eakin urged the FSOC to avoid assessing the riskiness of the insurance industry. “Insurers receive systemic risk—they do not drive it,” he said. “Liquidity is rarely an insurance concern, as assets are matched at long rather than short terms. Insurers do not lend to other insurers and are not as interrelated as banks. We will never see a run on an insurer. AIG failed because it had come to contain an unregulated hedge fund; risk did not stem from its insurance activities.”

Paul Schott Stevens, president and CEO of the Investment Company Institute, supports “improvements to the SIFI designation process to help avoid the risk of inappropriate designations—as would be the case if FSOC determined to proceed with the designation of a registered fund or fund manager.”

“Such designation is unwarranted, because registered funds and their managers do not pose the risks that SIFI designation seeks to address,” he said. “It would be harmful to fund investors, because it would result in the application of ill-suited measures—such as capital requirements—designed to moderate bank-like risks. These measures would increase costs and lower returns for fund investors.”

Despite some progress, he said, FSOC reforms are still needed in key areas: more engagement with a company being considered for possible designation; a greater role in the process for the company’s primary financial regulator; more rigorous analysis of the company and its potential to pose risk to the U.S. financial system stability; and greater transparency to the financial markets and market participants.

He added that Congress “should confirm in statute that SIFI designation is intended to be a regulatory tool of last resort.”

Despite numerous criticisms presented at the hearing, the FSOC was not without its supporters. Non-bank SIFI designations “are crucial for preventing catastrophic non-bank failures” like the collapses of Bear Stearns, Lehman Brothers, and AIG, testified Jeremy Kress, assistant professor of business law at the University of Michigan’s Ross School of Business. “Non-bank SIFI designations protect the financial system by deterring non-banks from becoming systemically important and by applying heightened safeguards to firms that nonetheless become excessively large, complex, or interconnected. By contrast, non-banks’ baseline regulatory regimes are generally not well-suited to accomplish these goals.”

“It is critical that FSOC retain non-bank SIFI designations as a viable regulatory tool,” he added. “Recent proposals to de-emphasize or eliminate non-bank SIFI designations—either formally or through onerous procedural requirements—ignore the unique ways in which SIFI designations can prevent catastrophic non-bank failures. Moreover, these proposals overlook the serious practical challenges that an activities-based approach would face in the United States’ fragmented regulatory framework.”

Kress called criticisms of non-bank SIFI designations “unpersuasive.”

“I am deeply concerned about recent initiatives to roll back non-bank systemic risk regulation. Efforts to marginalize the Council by diminishing its legal authority, politicizing its work, and reducing its budget collectively increase risks to the financial system and ultimately threaten the real economy,” he said. “Despite critics’ complaints, non-bank SIFI designations do not impose bank-centric rules on non-banks. To the contrary, the Federal Reserve has gone to great lengths to recognize the distinct regulatory issues associated with non-bank financial companies, and to tailor its approach accordingly. Moreover, to the extent that heightened regulations create an uneven playing field for designated non-bank SIFIs, this differential is a feature, not a bug. Enhanced safeguards for non-bank SIFIs ensure that companies have incentive to avoid becoming or remaining systemically important.”

Kress elaborated on his critique of proposals to replace non-bank SIFI designations with an activities-based approach. These plans are “deeply misguided,” he said.

“Activities-based regulation, on its own, will not prevent systemic collapses like those we experienced in 2008,” he explained. “It is unrealistic to expect that regulators will identify and appropriately regulate all such activities ex ante, especially given financial companies’ strong incentives to restructure or rename activities to avoid regulation. By contrast, policymakers are much more likely to consistently and accurately identify non-bank financial companies whose distress could threaten financial stability.”

A purely or predominantly activities-based approach to non-bank systemic risk will fail for yet another reason, Kress opined: The U.S. regulatory framework is not configured to implement effective activities-based regulation.

“The U.S. regulatory system is riddled with gaps in areas like insurance, hedge funds, and FinTech,” he said. “Because FSOC lacks authority to implement activities-based rules directly, this pervasive jurisdictional fragmentation would undermine efforts to enact and enforce uniform, consistent activities-based rules throughout the financial system. If configured appropriately, activities-based regulation could address some sources of non-bank systemic risk. As currently structured, however, the U.S. regulatory framework is simply not conducive to effective activities-based non-bank regulation.”