Update 308 — FSOC: Prudential off SIFI List;
Too Big to Fail “Solved” in Shadow Markets?
This Wednesday, the Financial Stability Oversight Council (FSOC) did what many have been expecting for a while and voted to de-designate Prudential, the last of the nonbank systemically important financial institutions (SIFIs). Its decision eliminated from this list all financial firms that don’t take customer deposits — from investment banks, to hedge funds, to private equity firms, to asset management firms, insurance companies, etc.
These subsectors, known as the shadow market, are a long list to exclude from the list. More on this below.
By the way, FSOC’s 66-page Notice and Explanation of the decision is littered with redactions and asterisks providing incomplete justifications for the decision to de-designate. I’ve never seen anything like it but it is fit subject for speculation for systemic sages over the weekend.
Have a good one,
Legislative Intent and Nonbank SIFIs
To understand the ramifications of FSOC’s decision, we have to understand the intent of Congress in mandating the designation of nonbank financial institutions as SIFI’s in the first place. The express statutory purpose of FSOC in designating nonbank institutions is codified under Section 113(a) of the Dodd-Frank Act (DFA) — bold added for emphasis:
The Council … may determine that a U.S. nonbank financial company shall be supervised by the Board of Governors and shall be subject to prudential standards … if the Council determines that material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.
It is clear in statute that Congress’s original intent in Dodd-Frank was to grant authority to FSOC to designate nonbanks that fit the description above. The decision by FSOC to remove the last remaining nonbank SIFI label seems questionable because:
- Prudential has arguably become more systemically risky since SIFI-designated
When it was designated in 2013, Prudential had more than $700 billion assets and around $3.5 trillion in life insurance policies under management. Today, the company has grown to around $830 billion in assets and has $3.7 trillion in life insurance policies under management. In fact, its notional derivatives exposures and repurchase agreements have grown by 30 percent since its designation.
Per Section 113(a), Prudential’s “size and scale” has in fact grown since its original designation. Under the current administration, size does not matter—too big to fail in the shadow markets has been solved. Last month, FSOC announced their intention to draft new plans for new “activities-based” regulation of nonbanks that would put the focus not on entities, but on the riskiness of business practices. This sounds reasonable in practice, but in reality this is likely more “tailoring” (read “deregulation”) talk we have heard from Quarles.
- FSOC itself concedes that Prudential’s failure would be DFA-level damaging
Prudential’s activities in securities lending and derivatives could cause big problems for counterparties, which could in turn have spillover effects. Additionally, while Prudential and other life insurers are not at risk of a run on the banks in the same way as banking financial institutions, they could experience early withdrawal, representing a considerable cash surrender value. If this action were to happen while the company was experiencing financial distress, this could further weaken the company’s position and, given its size, greatly affect market stability.
Congress, in Section 113(a) of Dodd-Frank, outlined two criteria for a company to to be subject to prudential standards: material financial stress and the nature, size, scope, etc. of the institution. It is clear that these two standards should be considered equally when it comes to assessing the overall risk to the financial system posed by a nonbank entity. If it is still the case that Prudential “could pose a threat to financial stability,” why is FSOC flouting the rules laid out in Dodd-Frank and shirking its regulatory duty?
This decision is significant, and it essentially puts an end to a key provision laid out in statute under DFA. There was a time when regulators thought about expanding the list and bringing other nonbank institutions into the fold, such as Sallie Mae, NY Life, Principal Financial Corp., et al, but that effort to focus on too big to fail nonbank entities seems to be at an end.
Prudential will no longer be subject to enhanced prudential standards, like stronger capital and liquidity requirements, stress testing, and living wills. The $800 billion company will now be regulated by the New Jersey Department of Banking and Insurance, a regulator that is severely understaffed and underprepared to oversee the operations of such a corporate behemoth. It is also unclear whether Prudential’s subsidiaries outside of New Jersey and overseas will continue to be regulated to the same degree. Not only will Prudential come under far less scrutiny than before but, if caught in the middle of a financial crisis, the firm would not have access to the same Federal Reserve liquidity facilities, nor will it be held to the same degree of capitalization standards a bank equivalent in size must follow.
Nonbank SIFI designation existed for those few large nonbanks, like Bear Stearns and Lehman Brothers, that proved to be too big not to regulate. Designation was a rare exception, not the rule. Formerly designated nonbank SIFIs like AIG and GE Capital drastically shrunk their operations and de-risked to shed their SIFI label. MetLife challenged its designation in court. Without changing its business model in any significant way, Prudential has been set free to return to the shadows.
On the Money
In 2017, the finance and insurance sectors combined represented 7.5 percent of U.S. gross domestic product. U.S. banks own over $17 trillion in assets and have a combined net income of over $165 billion. Earnings season is in full swing, and the “big four” U.S. banks posted healthy revenue growth and rising profitability, boosted by the tax cuts. This sector is large and, despite S. 2155, the too big to fail banks are still subject to enhanced prudential standards and oversight.
Like banks, nonbank institutions such as asset managers and insurers play an equally large part in the financial system: total U.S. retirement assets stand at over $28 trillion. If insurance assets and mutual funds are taken into account, this number rises to an eye-popping $50 trillion total assets under management. We now have a situation where there is a regulatory blind spot when it comes to the key players in this sub-sector. Nonbank too big to fail entities simply no longer exist in the eyes of federal regulators, no matter their potential risk exposures and interconnectedness in the overall financial system.
The Line Between Legislating and Regulating
Last November, the Trump Administration requested the revision and overhaul of the process by which FSOC designates financial institutions as systemically important. This call to action is part of a broader move to “tailor” the financial sector both within the margins of DFA legislation and by changing the legislation itself. As the economy continues to improve, rosy-eyed elected representatives and public servants alike are loosening the rules at both the macro- and microscopic ends, through legislation and regulation, respectively.
Interpreting Dodd-Frank: What’s Next?
The regulatory heads at FSOC and the Trump Administration are hiding under the cloak of statute interpretation to drive an agenda which has resulted in the disappearance of too big to fail in the nonbank sector. Now that Prudential has shed its SIFI label, the threshold for nonbank SIFI designation is so high that FSOC’s authority in this regard is essentially rendered moot. The advent of post-too big to fail in the shadow markets is a truly disturbing development and if history repeats itself, it’s a decision that could come back to haunt regulatory decision makers.
In the coming months, FSOC plans to publish more substance on the details of its proposed shift from targeting nonbank entities themselves, to an activities-based approach to nonbank supervision. Insiders at the Treasury have suggested these details might yet be released this fall, but with staffing constraints and their annual report due by the end of the year, this might be delayed until the start of 2019.