When the Dodd-Frank Act was working its way through Congress, few observers paid much attention to the powers that Congress was conferring on the Financial Stability Oversight Council (FSOC), an agency chaired by the Treasury secretary and composed of the principal federal financial regulators. The structure of the agency is also unique, roping into a single decision-making body such disparate organizations as the Federal Reserve, the SEC, FDIC, the Consumer Financial Protection Bureau, and an insurance expert appointed by the president.
Under Dodd-Frank, FSOC has the authority to designate any financial firm as a systemically important financial institution, or SIFI, if in its judgment the institution’s “financial distress” will cause “instability in the US financial system.” These terms are so vague that they amount to discretionary authority for the FSOC to determine its own jurisdiction. While the courts generally frown on this, it’s doubtful that this capacious power will ever be challenged; financial institutions, fearing retaliation, do not ordinarily take their regulators to court.
The troubling extent of the FSOC’s authority was revealed recently when it designated Prudential Financial, one of the nation’s largest insurers, as a SIFI. Every member of the FSOC that was expert in insurance (and was not itself an agency of the Treasury Department) dissented from the decision, arguing that the FSOC had not shown that Prudential’s financial distress could cause instability in the financial system. Almost all the other agencies, knowing nothing about insurance or insurance regulation, dutifully voted in favor of Prudential’s designation.
Indeed, the paper that the FSOC issued in support of its decision was noticeably devoid of data or evidence that Prudential’s distress would threaten other firms. This, together with the lack of support from insurance specialists on the FSOC, suggests that the decision was political—compelled by the Obama administration’s desire to use Dodd-Frank as a vehicle for further control of the financial system, rather than a reasoned decision on policy grounds.
FSOC’s action was also cast in a troubling light by two recent reports, requested by the agency, by the Office of Financial Research (OFR), another body created by the Dodd-Frank Act. These reports argued that the asset management industry—mutual funds, pension funds and other collective investments—could create systemic risk, and thus that largest funds or managers should be considered for designation as SIFIs. If so, they too would be subject to bank-like regulation by the Fed.
This would be a major extension of government power. Collective investment funds are completely different from the banks or investment banks that suffered losses in the financial crisis. When a bank or investment bank suffers a decline in the value of its assets—as occurred when mortgages and mortgage-backed securities were losing value in 2007 and 2008—it still has to repay the full amount of the debt obligations it incurred to acquire those assets. Its inability to do so can lead to bankruptcy. But if a collective investment fund suffers the same losses, these pass through immediately to the fund’s investors. The fund does not fail and thus cannot adversely affect other funds. OFR seems to have missed this vital point.
Following on the heels of the Prudential decision, it looks as though the FSOC is now preparing to declare that asset managers of all kinds should also be designated as SIFIs and regulated by the Fed.
This concern is made more pointed by the fact that—before the Fed acted on Prudential—the Financial Stability Board (FSB), a mostly European group of financial regulators of which the Fed is a member, designated nine large insurance firms (including AIG, Prudential and MetLife) as SIFIs. The FSB also proposed recently, just after the OFR reports, that asset managers with more than $100 billion under management should be subject to bank-like prudential regulation.
The similarity of the actions by the FSOC and the FSB raise the question whether the FSOC intends to follow the lead of the FSB, or at least that the organizations are coordinating their activities. If so, we are headed down a road that could be more problematic for the US financial industry than most observers have thought. The FSB recently announced that it is preparing “to extend the SIFI Framework to global systemically important non-bank and non-insurance financial institutions.” This category, said the FSB, “includes securities broker-dealers, finance companies, asset managers, and investment funds, including hedge funds.”
At a time when the ability of the president or the executive branch to act without the approval of Congress has become a serious political issue, the extraordinary authority of the FSOC, and its apparent willingness to follow the lead of the FSB, raises the question whether additional regulation of the financial system will occur without any congressional action.
More than that, unless the power of the FSOC is curbed by Congress, and soon, we may see many of the largest non-bank firms in the US financial system brought under the control of the FSOC and ultimately the Fed. Recalling the fact that the EU ruled in 2002 that US investment banks could not operate in the EU without a consolidated home country regulator, it may also mean that eventually the largest US financial firms will not be able to operate in Europe unless they have been designated as SIFIs by the FSOC and regulated by the Fed.
Wallison is the Arthur F. Burns Fellow at the American Enterprise Institute.