The Financial Stability Oversight Council (FSOC) was an innovation created by Dodd-Frank in response to several clear lessons learned in the 2008 crash. It was primarily to ensure that
(1) all financial regulators would meet jointly to address cross-jurisdictional financial matters; (2) systemic threats from nonbank would be analyzed and regulated similar to systemic banks to end
(a) the regulatory arbitrage that incentivized the dramatic growth of the shadow banking system and
(b) surprises and bailouts like the explosion of AIG;
(3) there would be a second check on all front-line financial regulators in the event that they failed to act or acted insufficiently within their area of jurisdiction; and (4) focus on emerging, “over the horizon” or “black swan” systemic threats regardless of where they originated or who had jurisdiction if and when such threats materialized.
While it may not have been ideal (and little is when massive legislation is enacted), its purpose and role is critically important in protecting taxpayers, the financial system and the economy. The motives and ideas behind FSOC had broad bipartisan and industry support. (For more in depth information and details, see the testimony of Better Markets’ President and CEO, Dennis Kelleher, before the Senate Banking Committee here.)
Unfortunately, FSOC has never lived up to its potential or purpose. The Obama administration’s FSOC was cautious to a fault, although it wasn’t entirely their fault. The hydra-headed structure, largely driven by political considerations, made it unwieldly under the best of circumstances and, no surprise, it was under constant assault from the industry seeking to prioritize its interests over the public interest. Nevertheless, they stood up FSOC from nothing and designated four systemically significant nonbanks and de-designated one that de-risked.
Rather than building on that foundation, however tepid, the Trump administration has been on a mission to kill FSOC from the beginning, which is what their industry allies wanted. Trump’s FSOC’s first moves, as discussed in detail here, were to de-designate the three systemically significant nonbanks Obama’s FSOC designated. But that was just the beginning.
Nonbanks in the shadow banking system like giant, global insurance companies and asset managers simply would not tolerate FSOC evaluating them as systemic risks. Therefore, in a move that can only be seen as an effort to intentionally blind itself to risks at systemically significant nonbank entities, Trump’s FSOC just moved to change its entire regulatory approach to stop evaluating specific nonbank entities as systemic threats and to only look at potentially systemic activities and products, a so-called activities-based approach.
While sounding reasonable, it is not. An activities-based approach to evaluating nonbank systemic risks is an untested, unproven and impractical way to determine or regulate systemic risks.
Moreover, making it more difficult to designate even nonbanks’ activities and products, the FSOC also needlessly added a quantitative cost-benefit analysis and a speculative assessment of how likely a company is to experience financial distress. These additional self-imposed, unnecessary hurdles that the FSOC has erected all but guarantees it will not be designating nonbank systemic threats.
These actions irresponsibly ignore the lessons of the 2008 crash, which was ignited in and spread by systemically significant nonbanks in the shadow banking system. Coming on top of its de-designation of the only three designated nonbanks, these actions put another nail in the coffin of FSOC, which is basically putting an “out of business” sign on its door.
Why do we say this? Because it is clear that if the FSOC’s new methods for evaluating systemically significant nonbank activities had been used in the years before the 2008 crash, it is extremely unlikely that any of the many nonbanks that collapsed and were saved by trillions of dollars in bailouts would have been identified or designated as systemically significant. Think AIG, Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, money market funds, and so many more. None would have met the criteria Trump’s FSOC has now established.
By caving to industry’s self-interested demands, the FSOC has subordinated the public interest to private profit maximization and the blind zeal not to be regulated no matter what. If that sounds like the reigning regulatory philosophy before the 2008 crash – which enabled that crash – it should: it’s the same. Designating nonbank entities or activities as systemically significant is not an either/or choice; it is both, depending on the facts and risks. It is irresponsible to prejudge a systemic risk analysis and raise the barriers to identifying systemic risks, which only increase the likelihood of future crashes and bailouts.