Update 527 — Yellen Moves Markets
And Can Remove FSOC Roadblocks
The Federal Reserve surprised no one last Wednesday by continuing its near-zero interest rate policy and large-scale asset purchases. But markets tumbled Tuesday after Treasury Secretary Janet Yellen mentioned the possibility of raising rates, at some point, to prevent the economy from overheating.
In the long term, overheating may be a concern and the rates aren’t within her ambit. But Yellen and financial regulators share authority over systemic risk of another sort. As Treasury Secretary, Yellen chairs the Financial Stability Oversight Committee, where big picture and long-term issues like Too Big to Fail are paramount. Today, we have a look at how FSOC has been performing and its statutory responsibilities.
Also, 20/20 Vision is soliciting applications for an Economic Policy Analyst position with a target start date of June 1, 2021. Click here for a full description and information on how to apply.
FSOC’s Mandate and Recent Actions
FSOC was established in 2010 by the Dodd-Frank Act as a response to the inability of federal regulators to foresee and prevent the 2008 financial crisis. Eight federal agencies have regulatory authority over the financial services industry, but before 2008, no single agency was charged with overseeing systemic risk across the entire financial system. FSOC, which is chaired by the Treasury Secretary and consists of members from each of the financial regulatory agencies, is charged with improving coordination among the agencies and focusing on emerging threats to financial stability.
Dodd-Frank specifically gave FSOC the authority to designate certain nonbank financial firms as “systemically important financial institutions” (SIFIs), which subjects such firms to heightened regulatory scrutiny given their impact on financial stability. During the Obama administration, FSOC designated four nonbanks as SIFIs: AIG, General Electric Capital, Prudential Financial, and MetLife.
During the Trump administration, FSOC was alternately moribund and retrograde. Then-Treasury Secretary Mnuchin held fewer and shorter meetings, cut FSOC’s budget by 25 percent, and reduced its staff by almost 60 percent. Worse, he used FSOC to deregulate the financial services industry. The Trump FSOC de-designated AIG and Prudential as SIFIs and dropped the government’s appeal of MetLife’s court fight to fend off its SIFI status — resulting in zero nonbank institutions currently having SIFI designation. And in 2019, FSOC made it virtually impossible for future administrations to designate nonbanks as SIFIs, weakening regulators’ ability to identify and respond to potential threats to financial stability in the nonbank sector.
Recapping the First FSOC Meeting of 2021
On March 31, FSOC convened for the first time under the Biden administration. Treasury Secretary Janet Yellen, previously a member of the Council as Chair of the Federal Reserve, presided over the meeting. During the meeting, Yellen laid out a new agenda that will likely lead to a much more active role for the Council and a focus on issues — such as climate risk and the nonbank financial sector — that received scant attention during the Trump administration.
In her opening remarks, Yellen praised the federal government’s response to the initial market turmoil caused by the pandemic and noted that liquidity and capital requirements established by the Dodd-Frank Act after the 2008 financial crisis helped banks weather the crisis. However, she said that the fact that extraordinary measures were required to restore stability to the market last year demonstrates the need for further actions to address vulnerabilities.
Yellen laid out the following three areas of focus for FSOC moving forward:
- Nonbank Sector: In the executive session portion of the Council’s meeting, staff from the Office of Financial Research and SEC briefed the Council on recent developments related to hedge funds and open-end mutual funds. During the pandemic, money market mutual funds (MMMFs) in particular saw significant volatility as investors rushed for cash, requiring intervention from the Fed. Yellen praised efforts by regulators to find reforms for MMMFs. She also announced the reestablishment of the Council’s Hedge Fund Working Group to evaluate how hedge funds’ leverage can affect financial stability — key, given the recent implosion of Archegos.
- U.S. Treasury Market: The extreme demand for liquidity in March 2020 led to a period of disruption in the Treasuries market, a source of concern given that market’s critical role in the global financial system. Yellen called for an interagency effort to better understand the factors that led to the market instability.
- Climate-Related Risks: Yellen placed significant emphasis on the effect of climate change on financial stability, noting that of emerging risks to the financial system, “climate change is obviously the big one.” During the Council’s open session, several members from various regulatory agencies reported how they are incorporating climate risk into their policy frameworks. Federal Reserve Chair Powell said that one of his goals is to make climate change a regular part of the Fed’s financial stability framework.
Reinvigorating the Designation Process
Yellen’s first FSOC meeting rightfully placed an emphasis on evaluating risks posed by the nonbank financial sector and climate change. While understanding and monitoring these risks is critical, Trump-era changes to the designation authority threaten FSOC’s ability to fulfill its mission. This administration’s FSOC must focus on reinvigorating the designation process in the following ways:
- Repeal of 2019 SIFI Designation Guidance: The 2019 Guidance, created and finalized during the Trump administration, severely limited future administrations from using the designation process. This authority to designate nonbank financial companies as SIFIs is arguably FSOC’s most powerful statutory tool to mitigate and manage systemic risks to the financial system. Repealing this guidance must be a top priority for Biden’s FSOC to pursue designations where appropriate again.
- Shadow Bank Oversight and Designation: In March 2020, the shadow banking sector was on the edge of collapse. Without the Federal Reserve’s intervention in the nonbank financial sector, the fire sales and failures prevalent last year would have led to another full-blown financial crisis. Strengthening regulation and oversight of risky shadow banks such as hedge funds and asset managers must be a top priority for this administration. Thus far, FSOC has examined reforms to MMMFs and re-established the Council’s Hedge Fund Working Group, but regulators should be careful not to exclude certain types of shadow banks from designation.
- Climate Risk as Designation Factor: FSOC could issue guidance integrating climate-related risk as a factor in the SIFI designation process. This was proposed in Sen. Feinstein’s Addressing Climate Financial Risk Act of 2020. But FSOC is capable of independently integrating climate risks under one of its statutory standards, allowing FSOC to evaluate a firm’s contribution to climate-related financial risks.
Outside of designation, colleagues at the Center for American Progress, Public Citizen, and Americans for Financial Reform have published reports which include additional priorities for FSOC and Congress to consider.
Legislative Reforms Still Needed
The Dodd-Frank Act created FSOC as a deliberative body to monitor and regulate systemic risk in the financial system; however, FSOC has proven ineffective in regulating systemic risk due to the non-binding nature of its regulatory recommendations and politicization of designation. Legislative reform may be necessary to reinvigorate and protect FSOC’s regulatory authorities.
The Systemic Risk Mitigation Act reforms FSOC in a couple of important ways. It would strengthen FSOC by depoliticizing the designation and de-designation process, creating an “automatic” designation for nonbank financial companies of a certain size and riskiness as well as a de-designation process. The bill would also give FSOC rule-making authority to address systemic risk in the financial system. Providing FSOC with real regulatory power would ensure a more stable financial system and lessen concerns about asset bubbles and overheating in the economic recovery.