By George W. Madison, Michael E. Borden, and David A. Miller
George W. Madison and Michael E. Borden are partners and David A. Miller is an associate of Sidley Austin LLP. During the financial crisis, Mr. Madison served as general counsel of the U.S. Treasury Department from 2009 to 2012, and Mr. Borden served as senior counsel to the U.S. House Financial Services Committee from 2007 to 2012.
This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.
Creating an inter-agency panel of financial regulators to monitor systemic risk was a hallmark achievement of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). The Financial Stability Oversight Council (FSOC), as Dodd-Frank coined it, was designed to correct perceived deficiencies in regulation – many different regulators oversaw different pieces of the financial system but none had visibility into the activities of entities they did not regulate. Under Dodd-Frank, the FSOC, chaired by the Secretary of the Treasury, would exist to promote cooperation among more than fifteen regulators and formalize coordination. Dodd-Frank did not end “too big to fail” by shrinking the largest financial institutions. Rather, it intended to better regulate large, complex financial institutions [Dodd-Frank’s revisions to the financial regulatory landscape extend far beyond large financial institutions to include, for example, material changes to the regulation of banks of all sizes, consumer protection, and derivatives.], including by empowering FSOC to designate certain nonbank entities as systemically important financial institutions (SIFIs), subjecting these SIFIs to enhanced prudential oversight by the Federal Reserve. This powerful regulatory tool has engendered significant controversy ever since.
Seven years after enactment, FSOC’s SIFI designation authority faces new scrutiny. On November 17, 2017, the U.S. Department of the Treasury (Treasury) issued a report (Treasury Report) in response to President Trump’s April 21, 2017 memorandum (Presidential Memorandum) directing Treasury to assess the efficacy of FSOC’s SIFI designation process and provide recommendations for reform. The Presidential Memorandum also instructed Treasury to report whether the SIFI designation process and FSOC’s designation activities are consistent with the “core principles” of financial regulation laid out in President Trump’s Executive Order 13772.
The recommendations in the Treasury Report would make significant, discretionary overhauls to the SIFI designation process and also provide the clearest indication yet for how the Trump administration believes FSOC may best achieve its ultimate mission. This article (i) briefly outlines the history of FSOC’s creation, its design and the problems it sought to address; and (ii) reviews certain Treasury Report recommendations in light of this context, noting particular recommendations whose implementation may raise concerns regarding the continued utility of SIFI designations.
When financial institutions such as Bear Stearns and Lehman Brothers, among others, first began to experience significant financial difficulties, policymakers feared that the failure of one or more of these firms could bankrupt creditors and counterparties, leading to cascading failures across the entire financial system. Trying to limit the potentially catastrophic effects of such failures and to stabilize the financial system, the federal government took extraordinary steps in 2008 and 2009 to bail out these companies and their creditors through the establishment of various emergency lending facilities and capital infusions authorized under the Troubled Asset Relief Program. Combined with the relatively contemporaneous bail-outs of Fannie Mae and Freddie Mac, these actions left little doubt that “too big to fail” had become the official policy of the U.S. government.
How to solve the “too big to fail” problem was not obvious. Richard Fisher, former president of the Dallas Federal Reserve Bank summed it up, “There appear to be three major ways to navigate proposed policy making toward big banks: (1) the regulate ’em camp, (2) the resolve ’em camp and (3) the shrink ’em camp.” The Dodd-Frank approach falls into the “regulate ’em” and “resolve ’em” camps.
Before Dodd-Frank, the President’s Working Group on Financial Markets (PWG), headed by the Treasury Secretary along with the Chairmen of the Federal Reserve, Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC) existed as an interagency mechanism to facilitate coordination and communication. SEC and CFTC involvement in systemic risk deliberations was particularly notable given neither had previously considered it a priority and their regulatory jurisdictions include nonbank entities.
But the PWG never acted like a systemic risk regulator. Authorized merely to collect information and make recommendations, the PWG was never granted the authority to implement or change regulations. Moreover, as a creature of executive prerogative rather than an agency established by Congress, the PWG never attained responsibility for ensuring the integrity of the financial system and therefore did not quell the inevitable turf wars between financial regulators.
The 2008 financial crisis showed that U.S. regulators lacked the proper tools to effectively oversee nonbank financial entities. The interconnectivity of the system proved impossible to address without regulatory cooperation and visibility into the effects of specific activities or entities beyond the silos of authority belonging to a given regulator.
A more robust mechanism to address systemic risk and ensure regulatory oversight of the whole system, inclusive of the growing “shadow banking” sector, was featured as a priority in the initial post-crisis reform proposals. Dodd-Frank did not streamline the fragmented regulatory ecosystem [Dodd-Frank did eliminate the Office of Thrift Supervision through a merger of its responsibilities into the Office of the Comptroller of the Currency (OCC), Federal Reserve, and Federal Deposit Insurance Corporation (FDIC). Additionally, consumer protection regulation was consolidated almost entirely in the newly formed Consumer Financial Protection Bureau (CFPB).]. Instead, Congress opted to create FSOC as a formalization of the formerly informal process of regulator coordination typified by the PWG. The critical distinction was that FSOC was provided actual power and given an explicit mandate in order to create accountability to allow for regulation of systemic risk.
Pursuant to Dodd-Frank, FSOC is tasked with the forward-looking responsibility to “identify risks to US financial stability that could arise” and “respond to emerging threats to the United States financial system.” To help achieve this, the SIFI designation authority is statutorily provided in order for FSOC to address risks that nonbank financial companies may pose to U.S. financial stability in the event of their material financial distress or failure, or because of their activities [12 U.S.C. §5322(a)(2)(H).]. FSOC may designate a nonbank financial entity as a SIFI to be supervised by the Federal Reserve and subjected to enhanced prudential standards if it determines the entity meets at least one of two alternative standards: (1) material financial distress at the nonbank financial entity could pose a threat to the financial stability of the United States; or (2) the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial entity could pose a threat to the financial stability of the United States.
The FSOC may designate a SIFI with a two-thirds vote of the voting members then serving, which must include the affirmative vote of the Treasury Secretary. The voting members of FSOC are the Treasury Secretary, the Chairman of the Federal Reserve, the Comptroller of the Currency, the Director of the CFPB, the Chairman of the SEC, the Chairperson of the FDIC, the Chairperson of the CFTC, the Director of the Federal Housing Finance Agency, the Chairman of the National Credit Union Administration Board, and an independent member with insurance expertise who is appointed by the President and confirmed by the Senate. FSOC also includes several non-voting representatives, including the Federal Insurance Office and state banking and insurance regulators.
At the outset it is important to note that numerous critics–including many members of Congress–have pushed for a wholesale repeal of the FSOC designation authority. In fact, the Financial CHOICE Act passed the House of Representatives in 2017 includes just such a provision (the Senate has not considered this bill). The Treasury Report recommends a fundamentally different approach, opting instead to offer discretionary changes FSOC could implement without Congressional action [Nearly the entirety of recommendations in the Treasury Report may be implemented on FSOC’s own volition using its existing rulemaking authority, issuing guidance, exercising its discretion with new approaches and priorities, etc. The lone exception is the recommendation that Congress amend section 113(e) of Dodd-Frank to increase from 30 to 60 days the statutory deadline for entities to request a hearing after FSOC proposes a designation and increase from 60 to 90 days the deadline for FSOC to make a final designation after any hearing. See 12 U.S.C. § 5323(e).] that together materially lessen the circumstances under which an entity would be designated a SIFI. Furthermore, the Treasury Report does not suggest structural changes to FSOC or the granting of any additional authorities in order to effectuate its recommendations. Treasury begins its reporting of specific recommendations by setting out five specific policy goals that the FSOC designation process should accomplish:
Prioritizing Activities-Based Designation. The Treasury Report reaffirms the need for FSOC to retain its designation authority in order to execute its core goal of identifying risks to the financial system as well as the important role FSOC serves as an interagency forum to monitor market developments and facilitate information sharing and regulatory coordination. However, Treasury recommends an entirely new approach to achieve its stated policy goals: shifting to prioritize an activities-based or industry-wide review of potential risks to financial stability rather than emphasizing SIFI designation. Citing FSOC’s broad authority to combat potential systemic threats, Treasury asserts that a focus on activities and products would allow FSOC to better identify the underlying sources of financial stability risk, prevent competitive disadvantages, and reduce unnecessarily burdensome regulatory requirements that in its view are the result of SIFI designations.
Specifically, Treasury recommends a three-step process. First, FSOC would identify particular financial activities or products that pose risks to financial stability with increased reliance on coordination with primary regulators. Second, FSOC would work with primary financial regulators to address identified risks industry-wide. Finally, only if entities still pose risks to financial stability after this consultation FSOC should then consider individual SIFI designations. Treasury cites FSOC’s experience addressing the structural vulnerabilities of money market mutual funds (MMFs) as a successful example of the collaborative, activities-based approach it envisions. The “historical case of Fannie Mae and Freddie Mac” is cited as the prototypical situation for SIFI designation, when it is “clear that individual institutions could pose a threat to financial stability, but a primary regulator has not taken or cannot take adequate steps to address the risk.”
Employing an activities-based approach makes sense for many reasons, including those cited by Treasury. Moreover, because systemic risk does not in fact depend on where risky activities and products are concentrated, relying on blunt instruments such as a firm’s size or legal form may merely move the risk throughout the financial system rather than alleviate it.
How FSOC would implement the new approach is ambiguous. The Treasury Report does not suggest replacing FSOC’s current emphasis on SIFI designation with designating particular activities or products as systemically important. The Treasury Report does not assert FSOC rely on the authority currently used for SIFI designations to designate classes of entities all as SIFIs by determining that a specific “mix of activities … could pose a threat to the financial stability of the United States” [12 U.S.C. § 5323(a)(1).]. Treasury also does not recommend use of the authority in Dodd-Frank Section 804 to designate “payment, clearing, or settlement activities” that “are, or are likely to become systemically important” [12 U.S.C. 5463(a)(1).]. Thus far FSOC has only invoked section 804 to designate financial market utilities as systemically important and the breadth of activities that fall under the scope of this provision is unclear.
Treasury instead relies on a combination of informal coordination with primary regulators and authority entirely separate from its designation powers in Section 120 of Dodd-Frank [12 U.S.C. 5330.]. Treasury stresses its desire to leverage primary regulator expertise and initially have primary regulators address identified risks through changes to existing regulations or otherwise “require firms to take additional risk-management steps.” In the event these informal collaborations are insufficient, FSOC should make formal recommendations under its Section 120 authority. Critically, however, Section 120 only allows for FSOC to recommend nonbinding heightened standards or safeguards subject to formal public notice-and-comment as opposed to increased prudential supervision. A primary regulator has 90 days to impose the recommendation or explain to FSOC its reasons for objection.
Treasury’s decision not to expressly invoke Dodd-Frank’s formal designation authorities suggests it has not settled how its recommended approach would work in practice. Longstanding commentators in favor of decreased FSOC power believe the new approach invoking “activities” authority will significantly expand FSOC designations by subjecting any firm engaged in an unapproved or prohibited activity to enhanced supervision by the Fed [See Peter J. Wallison, The Trump Treasury’s Disturbing Regulatory Turn, The Wall Street Journal (Dec. 6, 2017).].
Further, it remains to be seen whether difficulties will surface if the onus to confront systemic risk is ultimately shifted to primary regulators. Individual entities may face burdensome rules despite never posing a realistic threat to financial stability and certain financial innovations beneficial to companies, investors, or consumers may be stifled. Of particular concern also are the limitations of existing authorities to cover emerging activities or products, the threat of regulatory capture, and the fragmentation of regulations, all of which FSOC’s authorities and structure intend to guard against.
Additionally, placing such a high bar on when SIFI designation is used may present concerns to its utility and FSOC’s ability to effectively combat systemic risk before or during a crisis. The process to designate a SIFI currently takes approximately two years and the Treasury proposal would make this significantly more cumbersome by requiring attempted activities-based regulatory maneuvers to run their course before assessing individual entities for designation. This concern may be exacerbated in the lead up to a crisis where “emerging threats” to the financial system may not yet be observable on an industry-wide basis and particular entities may be singular in the systemic threat they pose.
Finally, using the activities-based approach at the expense of SIFI designations may preclude FSOC from maintaining the flexibility to address different industries with different approaches–a dynamism reflected in its statutory mandate and design. For example, the approach taken for MMFs or asset managers may not readily translate to the insurance industry where there is no primary federal regulator and thus national rules and standards may be difficult to obtain given jurisdictions’ desires to present a business-friendly regulatory climate.
Mandating Use of Cost-Benefit Determinations. In addition to generally pivoting away from emphasizing SIFI designations, Treasury also recommends requiring a cost-benefit analysis as part of the decision to designate any SIFI and to “only designate a company if the expected benefits to financial stability from Federal Reserve supervision and enhanced prudential standards outweigh the costs that designation would impose.”
This requirement addresses industry concerns as well as a federal district court ruling that rescinded FSOC’s designation of MetLife in part because it was found arbitrary and capricious on this ground [ See MetLife, Inc. v. Financial Stability Oversight Council, 177 F. Supp. 3d 219 (D.D.C. 2016). The MetLife decision rescinded FSOC’s designation based on two independent grounds. In addition to the failure to employ a cost-benefit analysis, FSOC’s designation process was also held “fatally flawed” for diverting from its own formally issued guidance in failing to assess MetLife’s vulnerability to financial distress and relying too heavily on assumption and speculation rather than clear, quantifiable standards in concluding MetLife’s failure posed a threat to financial stability. Each of the court’s concerns were also raised in the Presidential Memorandum and are addressed in the Treasury Report. FSOC appealed the MetLife decision and litigation remains ongoing.]. FSOC may ultimately be required to enact this recommendation in some form depending on the outcome of the MetLife litigation and Treasury is correct that FSOC may consider costs and benefits under its current authorities. However, the Treasury Report does not provide further guidance on how cost should be evaluated beyond the fact that FSOC may “consider the direct and indirect costs of designation.”
The Presidential Memorandum requested Treasury evaluate the “cost on the regulated entity,” but the Treasury Report is written generally in terms of enhancing financial stability while the Presidential Memorandum is not. Given FSOC’s mandate it is difficult to conceive of a cost analysis that did not factor in some way or another the social cost of designation, which would need definition and may differ markedly from the private cost to the SIFI. For example, under its Dodd-Frank section 120 authority FSOC must consider “costs to long-term economic growth” when formally recommending heightened standards or safeguards for primary regulators to implement [12 U.S.C. § 5330(b)(2)(A).].
This vague standard leaves open critical implementation details. Ensuring that the cost metric is tied directly to the potential benefit of designation will likely require more rigorous analytical standards in line with those proposed elsewhere in the Treasury Report to address aspects such as a potential SIFI’s actual vulnerability to financial distress. In any event, the difficulty in quantifying costs and benefits of SIFI designation will almost assuredly require extensive work to arrive at a conclusion and leave any such designation open to attack on the grounds that it is arbitrary and capricious. Therefore, there is a concern that cost-benefit analysis obtaining a central role in the designation process could compound earlier concerns regarding FSOC’s ability to designate a SIFI in a crisis.
Recommendations to improve transparency and fairness. The Treasury Report also directly addresses many of the most frequent criticisms of the designation process. First, Treasury recommends FSOC engage potential SIFIs earlier and more consistently during each phase of designation considerations. Unlike current practice, FSOC should explain the key risks it believes a potential SIFI poses at the moment it is selected for FSOC review to better allow the entity to take mitigating actions aimed at avoiding designation altogether. While the Treasury Report does not specify how FSOC would implement such early engagement in its industry-wide review phases, it is difficult to foresee how establishing more of a two-way information flow between FSOC and a potential SIFI aimed at addressing its particular risks could hamper rather than help FSOC’s ultimate goals.
Additionally, Treasury recommends developing more rigorous, targeted, specific, clear, and comprehensive frameworks for its designation analyses in relation to potential SIFIs and the public. Here too Treasury is responding to concerns from industry and litigation [ See MetLife, Inc. v. Financial Stability Oversight Council and discussion above.]. In line with the overall industry-wide approach, Treasury believes FSOC would promote certainty and decrease designation subjectivity by increasing the analytical rigor of designation analysis. Key to this effort is developing standards to be formalized in official guidance for aspects such as how FSOC will consider and weigh potential mitigating factors to a SIFIs counterparty risk exposure, identifying plausible asset liquidation risks, and evaluating the likelihood of financial distress as a threshold question.
Transparency in the process would also be improved through releasing to the public (to the extent possible) detailed bases for any SIFI designations or decisions to remove a designation. Acknowledging the clear risks to confidentiality of critical information and market integrity, Treasury believes FSOC will do more good by increasing information sharing in striking this balance.
Finally, in the interests of both fairness and transparency Treasury recommends providing a “clear off-ramp” for SIFIs to follow to remove a designation, including establishing such a process as part of its annual SIFI reevaluations. FSOC would provide SIFIs feedback on specific potential changes the entity could make and what to prioritize in order to address FSOC concerns. Furthering the policy goal of reducing regulatory burden, the off-ramp would also allow SIFIs to seek out FSOC post-designation to see if its own proposals would effectively address FSOC concerns.
The increasing size and complexity of the largest financial institutions also increased systemic risks across the entire U.S. financial system—risks which became apparent during the 2008 economic crisis. Rather than endorsing measures that would have shrunk the nation’s largest financial institutions, in 2010 Congress and the Administration chose to regulate them aggressively in the hopes of making them safer.
New leadership provides the opportunity to reconsider and evaluate crisis-response regulations and improve how FSOC wields its powerful designation authority, a key tool to mitigate systemic risk. As is often the case in financial regulation, the devil is in the details. It is hard to debate that the FSOC designation process needs to be fairer and more transparent. But effectively refocusing on industry-wide trends rather than individual SIFI designations as Treasury recommends will be the great challenge. How FSOC implements and executes these recommendations will go a long way in determining the long-term viability of FSOC to combat systemic risk.
Copyright © 2018 The Bureau of National Affairs, Inc. All Rights Reserved.
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