FSOC Designation: Is the Cart Outrunning the Horse?

Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act gave the Financial Stability Oversight Council the authority to assess whether a distressed nonbank financial firm could present a danger to the country's financial stability. Such determinations take into account the company's “scope, size, scale, concentration, interconnectedness, or mix of its activities.” If designated by the FSOC, a firm comes under the Federal Reserve Board's consolidated supervision and enhanced prudential standards. The FSOC designated American International Group Inc. and General Electric Capital Corporation Inc. in July 2013 and Prudential Financial Inc. in September of that year. It also designated MetLife Inc. in December of 2014. In a recent conversation with Bloomberg BNA's Richard Cowden, Thomas Vartanian, a partner at Dechert LLP, highlighted several issues related to FSOC designation, suggesting the need to consider whether the process sets into motion an irrational regulatory regime.

BNA: The Financial Stability Oversight Council (FSOC) is at a crossroads, having designated four companies as systemically significant in the face of congressional scrutiny, Government Accountability Office (GAO) concerns over process and transparency, dissenting members on FSOC, target company complaints of unfairness and now a formal challenge in court by MetLife to its designation. Given the background and purpose of the agency, what direction do you think the FSOC is likely to take next?

Vartanian: I think that they've shown their hand with respect to the world of asset management. And they are clearly evaluating the extent to which asset managers, and funds that are managed by asset managers, may have a systemic impact based upon all the channels and factors that they have identified. I think that they will look at other major financial companies in the country and try to figure out whether they too fit the mix in terms of what they are trying to do.

If I were a major financial nonbank at this point, I'd be looking pretty carefully at what FSOC has done and what they have said in these designations and see how that applies to me. There is a fundamental question that FSOC has to think about: Does the world of systemic risk get improved if they designate six companies or do they think they need 26 companies designated to make a difference? Clearly this is all about the kind of difference and the kind of improvements that FSOC can make in avoiding catastrophic systemic disruptions in the U.S. economy.

I don't consider FSOC a monolith. There are 10 voting members and another five nonvoting members, so it doesn't speak with one voice. I don't know if FSOC (or Treasury) has thought about the overall number of companies that need to be regulated by the Fed or whether they are just taking one company at a time based on how the staff is processing them. From a macro view, it does raise some interesting questions.

BNA: You've said the FSOC continues to designate companies to be regulated by the Federal Reserve to lower U.S. systemic risk and that the Fed must first explain how it will regulate such companies. What kinds of actions would you envision in this regard? Policy statements? Guidance or something else?

Vartanian: Let me go back to a fundamental issue here that we've focused on with FSOC and we've raised with them in various representations. When it comes to designating nonbanks as systemically significant, what does that mean? We know it means that those companies will be regulated by the Federal Reserve Board, which will apply a dozen different prudential requirements to them, ranging from leverage, liquidity, to stress testing. And more times than not, those companies have never seen those kinds of prudential regulation before.

Risk of Disruptions

Logically, there has to be some conclusion reached by the FSOC that designating such a nonbank financial company for enhanced regulation will lessen the systemic risks that are currently in the U.S. financial system. It seems to me there is no reason to designate anyone if you can't conclude as a government regulator that that designation will lower the risk of systemic disruptions.

If you start with the assumption—which I think is intuitively logical—that the FSOC is designating companies to reduce systemic risk in the marketplace, it is impossible for them to conclude that they are lessening a systemic risk at this point. That is because the Federal Reserve Board has not articulated how it will regulate those companies. What FSOC is effectively saying is that we can designate you because you create a threat, and we're hoping that the Federal Reserve Board will be able to lessen that threat. That's a pretty thin record on which to make a very critical decision that will affect the future of that company, the products it makes available to the public and the U.S. economy.

There ought to be some sort of regulatory standards laid down by the Federal Reserve Board as to what it is going to do with insurance companies, what it's going to do with finance companies, what it's going to do with asset managers, what it's going to do with funds, so when the FSOC designates a company to be regulated by the Federal Reserve Board, everybody understands what that means.

Said another way, there is a basic unfairness in the process when the FSOC can say, “We see risk,” and the company is unable to argue against that rationale when I'm representing a company subject to designation, I'd like to be able to know what the applicable regulations will and won't do.

The FSOC should be able to say how systemic risk is going to be reduced because of what the Fed will do. That's all absent from the record; there's nothing about that, so there is a certain cart-before-the-horse aspect to this process. It raises an issue when one tests it against administrative standards of reasonability and arbitrariness and capriciousness.

So I think FSOC ought to figure out how to get the cart back behind the horse so that it can fully evaluate the impact of designation, and the designated party can have a chance to fully and meaningfully argue against it and rebut it. Until that happens, I don't think you're going to have a fulsome record either for designation or to give a designated party a fair chance of rebutting designation.

Now, there is a related side issue. Since the economic impact of designation of one company will be so substantial on that company, and since the designation of a number of companies will probably have an impact on the economy, it would seem that as a part of a solid administrative record, FSOC would want to have a thorough cost/benefit analysis. Again, without having any idea of what the Fed is going to do to regulate the company, it seems to me it is impossible for them to do that kind of cost/benefit analysis or even just a simple economic environmental impact statement. Without that the process looks pretty arbitrary and capricious.

BNA: You've suggested that the FSOC has re-evaluated its processes, met with stakeholders and has taken steps that have led to changes. But you've also said that while helpful, those steps don't address the fundamental concerns with a process that can lead to a company being designated to be regulated by the Fed. What other measures should be taken that would give you more confidence in that process?

Vartanian: There are a number of things that we have addressed with the FSOC staff, who I give credit to just for asking the questions and listening to constructive criticism. I'll just give a few of them. Number one, we think the process benefits from more thorough attempt at communication between the staff and parties that are being looked at long before they get down to stage three (of designation). Those parties should have the opportunity, if they want, to go in and make a presentation.

Second, it seems to us to be extremely important that the principal regulatory agency, whether it be a federal regulatory agency or a state insurance regulator, or whoever it is, needs to have a meaningful role in the process if it is going to meaningfully be consulted, as the statute requires.

The statute affirmatively requires the FSOC to consult with the principal regulator. What does that mean? Well, you can consult in many different ways. At one end of the spectrum is sort of a “drive-by” consultation. You know, a phone call, what do you think, thanks a lot. At the other end is a sharing of information with the regulator, an ongoing dialogue, and a written record of how the consultation occurred, what the regulator relayed back to FSOC, and why FSOC either approved, disapproved, agreed or disagreed with what it got back.

Concurrence of the Primary Regulator?

I think you can take it one step further. It's unfortunate the statute does not require the concurrence of the primary regulator because the primary regulator arguably has to be the entity that knows the most about that company. To not give those views full and fair weight seems to be unfair to a number of the companies who have been in the cross-hairs of FSOC.

There is an offshoot of this issue, which we have discussed with FSOC, and that is the weight given to a voting member of FSOC who is a primary regulator. So if a primary regulator is actually someone who sits on FSOC, how much weight do you give that view or vote? And should FSOC not move forward unless it has gotten concurrence from the regulator?

In the cases of two insurance companies that have been designated, as examples, the only person on FSOC who is extremely experienced in insurance operation, insurance regulation and insurance laws is the only person who voted against both designations. The question is, if the person who has the most expertise about this industry doesn't think they create a systemic problem, how much weight should that be given? Why is that person on the FSOC?

It's unfortunate the statute does not require the concurrence of the primary regulator because the primary regulator arguably has to be the entity that knows the most about that company. To not give those views full and fair weight seems to be unfair to a number of the companies who have been in the cross-hairs of FSOC.

Another critical factor is how the record is constructed to support the designation. There are two problems with that. Number one, in the designations that have occurred, the designated party doesn't get to see the rationale of FSOC until it's too late, meaning they've already been preliminarily designated. And that's a problem because, assuming the process took one year, that means for one year the party may have been trying to rebut designation by guessing at what FSOC was thinking and doing. It was trying to file rebuttals to what it was speculating FSOC was concerned about.

And the second problem with the process is that, given the consequences of designation, FSOC should be held to a very high standard of proof and types of information in the record that should lead to a designation. Specifically, the process should take probabilities into account. The question is whether you require that the risk have a high likelihood of happening, a moderate likelihood of happening or just a possibility of happening.

For example, there is a possibility a meteor could hit the United States in the next 50 million years, but I don't know that there is anybody preparing to protect us against that. Similarly, the question here shouldn't be whether a company might create systemic risk, no matter how remote. The question has got to be, based on historical precedent and things that actually have happened, could this company either create, exacerbate or transmit systemic risk in a way that ought to be regulated by the Federal Reserve Board? And that's not a paramount consideration in the process that I've seen.

Also, when you start designating insurance companies based on the fear of a run on life insurance policies—and as far as I know, few insurance companies have created a meaningful systemic problem in the history of U.S. financial services—that is probably too speculative a risk to base a designation on. So there has got to be substantively a little more adherence to historical precedent and a little less reliance on what could happen in the worst of all worlds.

BNA: Does the financial services industry tend to believe that the FSOC itself was an overreaction by Congress to the recent financial crisis or is it a necessary component over an overall economic risk monitoring policy?

Vartanian: I think there are mixed views, quite frankly. I think a lot of the financial services business would say Dodd-Frank was an overreaction, period. On the other hand, many executives, scholars, lawyers and regulators would say it is hard to argue with a body that has the overall responsibility for the entire economy, as opposed to just a piece of it. I don't think that concept is as controversial as the way that FSOC was devised to operate and how it is operating. That's a little more controversial than the question of whether or not it should be there.

There were, at the time Dodd-Frank was being debated, questions about what FSOC should look like. Some had proposed that it shouldn't be the primary financial regulator, but an independent board that looks over these regulators. Why should we have regulators who are making day-to-day decisions step back once a month and decide whether the day-to-day decisions were correct? There can always be discussion about that. But I think the largest number of criticisms and concerns have been about the way the designation process has actually worked.

“Conversations” is a new feature in BNA's Banking Report that provides a periodic discussion with the publication's Advisory Board members on critical issues that impact financial institutions and their counsel.