Red Herring from FSOC Gets Hearing at SBC (March 15)



Update 338 — “Activities-Based” Designation:

Red Herring from FSOC Gets Hearing at SBC

With April Fool’s Day coming up, one might believe a Trump Treasury proposal seeks greater regulatory focus on systemically risky financial activity, were one to read last week’s FSOC proposal (Authority To Require Supervision and Regulation of Certain Nonbank Financial Companies).  But the idea is a red herring intended to obscure rather than clarify accountability for systemic risk, as Democrats at yesterday’s hearing in Senate Banking made clear.

The FSOC proposal will probably never see the light of day as regulatory policy, this Congress at least, if only because the required enabling legislation would never make it through the House.  And here’s why it shouldn’t.

Good weekends all…

Best,

Dana

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Yesterday, Senate Banking held a hearing, “Financial Stability Oversight Council Nonbank Designation (FSOC),” to examine a recent rule change proposed by FSOC regarding the process by which it designates nonbanks as systemically risky.  

Nonbank institutions played a central role in the 2008 financial crisis, particularly in the underwriting of mortgage backed securities. The Dodd-Frank Act created FSOC and gave it authority to designate nonbank financial institutions as systemically important financial institutions (SIFIs). Four firms — MetLife, General Electric Capital, American International Group (AIG) and Prudential Financial — all received designations from FSOC in the years following the financial crisis. By October 2018, FSOC removed Prudential’s label as a SIFI, the last nonbank hold the designation.

The FSOC proposal released last week would reform its designation process, calling for a move from entity-based regulation to activities-based regulation. With this change, FSOC would identify risky activities in the nonbank financial system, rather than focus on individual companies, and give the primary regulator the deference to regulate the activities themselves.  FSOC would still have the option to designate entities, but only as a last resort, leaving problems to be dealt with as they occur instead of pre-empting them.

Senate Banking Hearing

During the hearing at Senate Banking yesterday, University of Michigan Assistant Professor of Business Law Jeremy Kress pointed out many of the flaws in the activities-based approach to designation proposed by FSOC:

  • FSOC lacks authority to implement: FSOC can only make a non-binding recommendation to the primary regulator of the activity, if there is one. Prof. Kress stated that Congress could strengthen FSOC’s activities-based approach to nonbank systemic risk by empowering FSOC to write activities-based rules directly, rather than simply make recommendations for the fragmented primary regulators.
  • Gaps in regulatory framework: Under the FSOC proposal, if the Council determined that nonbanks, such as insurance companies or hedge funds, were engaging in risky activities, the primary regulator may not have the authority to implement risk-reducing activities.
  • Proposal impedes FSOC mission: FSOC would have to look at “the likelihood of a firm’s failure” before designating. A firm would already have to show signs of distress before designation. Professor Kress warned against this approach because problems may not be apparent until too late — SIFI designations should be a prophylactic measure and are not meant to be an emergency response tool.
  • Activities-based designation a bad substitute: Only entity-based SIFI designation allows regulators to impose enterprise-wide consolidated and enhanced prudential requirements on capital, liquidity, and risk management. These requirements reduce the likelihood that a SIFI will damage the real economy.

Substitutes or Complements?

Entity-based regulation for nonbanks is meant to prevent and address the failure of large, interconnected companies, such as insurance giant AIG during the 2007-09 financial crisis.  This approach also aims to identify company-specific problems, like overleveraging or a lack of internal controls. Stress tests and living wills are examples of entity-based regulation.

FSOC’s move toward activities-based systemic risk regulation is in line with the Administration’s overall deregulation efforts. FSOC does not have the statutory authority to designate activities, it can only issue nonbinding recommendations — the equivalent of a strongly-worded statement to the primary regulator of the activity.

The proposal could introduce systemic risk into the insurance industry, specifically. Insurance regulation is done primarily by the states, and Section 2(12)(D) of DFA stipulates that FSOC can make recommendations to state insurance authorities. States often have limited authority to supervise (let alone regulate) top-tier insurance holding companies. If FSOC were to designate a risky activity engaged in by insurance agencies, state regulators would have limited capacity to address systemic risk issues.

DFA did implement some forms of activity-based regulation. The Commodity Futures Trading Commission was given new authority to oversee the $400 trillion derivatives market. Instead of substituting an institution-based regulation with an activity-based one, both regimes can work in tandem. Regulators could subject individual companies to prudential standards (capital requirements, living wills, stress tests), while also monitoring sector-wide trends and risky activities.

FSOC Improvement Act (S. 603)

Last month, Sen. Rounds introduced S. 603, a bill to require the Financial Stability Oversight Council to consider alternatives before determining that a US nonbank financial company should be designated a SIFI. According to Professor Kress, the bill would “lead us to an emergency situation and potentially make any future designation vulnerable to judicial review if a designated entity were to demonstrate any shortcomings in the process.” The bill has support from Sen. Tillis and Democratic Sens. Jones and Sinema. It would be dead on arrival in the House.

On its face, FSOC’s proposal is an insincere and disingenuous attempt to narrow its own authority under DFA. Proponents of activities-based regulation, including Treasury Secretary Mnuchin, have not proposed specific activities they’d like to regulate, let alone details on how to regulate them. Until proponents of activities-based regulation suggest specific ideas for what activities-based rules they want to implement, this whole effort looks like a smokescreen for deregulation, and ignorable for now as politically nonviable.  

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