Good News for U.S. Capital Markets
Friday, August 8, 2014
The FSOC’s decision to back away from SIFI designations has major implications for the regulation of ‘shadow banking.’
After its last meeting at the end of July, the Financial Stability Oversight Council (FSOC) announced that it has “directed staff to undertake a more focused analysis of industry-wide products and activities” in the asset management industry. This has been interpreted as a step back from the FSOC's earlier position that the financial distress of large asset managers — or at least the funds they manage — could have systemic effects on the U.S. financial system and thus warrant designation as systemically important financial institutions, or SIFIs. The Wall Street Journal reported that the FSOC had “agreed to revamp their review of asset management firms to focus on potentially risky products and activities rather than individual firms.” If so, it’s good news for the U.S. capital markets.
If the FSOC’s new position is maintained, it has significant implications for the efforts of the Financial Stability Board (FSB), a largely European group of central bankers and bank regulators, to gain control of what it calls “shadow banks.” Both the Federal Reserve and Treasury are members of the FSB and have been strong supporters of the FSB’s efforts to subject shadow banks to bank-like supervision and regulation.
In 2009, in the wake of the financial crisis, the FSB was deputized by the G-20 leaders to reform the international financial system, and the agency has thus far used this baton to designate 39 banks and nine insurance firms as global SIFIs. The standards for global SIFIs are roughly the same as the standards for SIFI designation in the Dodd-Frank Act. The FSB has no enforcement power, but relies on its G-20 member organizations to carry out its mandates within their respective jurisdictions. In the United States, the FSOC has that role and has followed it diligently up to now. For example, after the FSB designated three U.S. insurance firms as global SIFIs — AIG, Prudential, and MetLife — the FSOC designated AIG and Prudential as SIFIs and has been investigating MetLife for this purpose.
“Shadow banks” have been a particular target of the FSB. In September 2013, the FSB defined a shadow bank as any financial intermediary that was not subject to bank-like regulation — about as broad a definition as could be imagined — and announced that it was “reviewing how to extend the SIFI framework to global systemically important nonbank noninsurance financial institutions.” This category of firms, said the FSB, “includes securities broker dealers, finance companies, asset managers, and investment funds, including hedge funds.” Given the breadth of the FSB’s definition of shadow banks, it also includes insurers.
The FSOC’s announcement may reflect a recognition that the FSOC isn’t ready to answer hard questions from Congress about asset managers and insurers.
Then, in January 2014, the FSB said that asset managers with more than $100 billion in funds under management should be considered for SIFI designation, and several European scholars and officials backed up this position by opining that large asset managers could create systemic risk. Shortly thereafter, the FSOC let it be known that BlackRock and Fidelity Investors, two of the largest asset managers in the United States, had been moved to the second stage of the three-stage process the FSOC uses to determine whether a nonbank financial firm should be designated as a SIFI. It seemed as though the FSB’s designation program was firmly in place.
But then Congress started to point out some major and troubling problems with what the FSOC is doing. On July 30, nine Republican members of the Senate Banking Committee, led by Senators Toomey, Crapo, and Shelby, sent a letter to Treasury Secretary Jack Lew, in his capacity as chair of the FSOC, strongly urging a suspension of SIFI designation until the Federal Reserve — which has the power to regulate and supervise the SIFIs that are designated by the FSOC — makes clear how insurers, asset managers, and others will be regulated. The senators argued, with some force, that it can’t be a responsible act to designate a firm as a SIFI without knowing how the Fed intends to regulate it; the Fed has given no indication how it will regulate Prudential and AIG, which have already been designated as SIFIs.
In addition, in appearances before Congress, Secretary Lew has been unable to explain how Prudential Financial received a fair or objective hearing on designation — or how MetLife could be getting one as it is investigated now — when the Treasury and the Fed have already approved their designation as global SIFIs by the FSB. In House hearings, witnesses have ridiculed the lack of data in the FSOC’s Prudential decision, suggesting that the agency really has no idea how to define systemic risk for an insurer.
Finally, the FSOC’s designation process has encountered sharp criticism in the House Financial Services Committee. Several weeks ago, the chairman, Jeb Hensarling, called on the FSOC to “cease and desist” its designations of nonbank SIFIs until Congress has had an opportunity to consider their economic effects. This was backed up by a one-year moratorium on SIFI designations adopted by the committee earlier in July, and the recent adoption of the same moratorium in an amendment to a House appropriations bill.
The FSOC’s announcement may reflect a recognition that the FSOC isn’t ready to answer hard questions from Congress about asset managers and insurers. If so, there is little it can do to assist the FSB in corralling and regulating shadow banks. The Dodd-Frank Act requires extensive reporting to the SEC and the FDIC by asset managers, but does not confer on the FSOC any authority to regulate fund managers or the funds themselves. The FSOC’s only role is to designate a nonbank firm as a SIFI, which automatically turns it over to the Fed for bank-like regulation and supervision.
‘Shadow banks’ have been a particular target of the FSB.
In the absence of a SIFI designation, the SEC is the primary regulator of asset managers, and while the FSOC under Dodd-Frank can make recommendations about activities that should be terminated or regulated more stringently, the SEC is not required to follow them. The SEC recently demonstrated its independence of the FSOC by adopting rules for money market mutual funds that were less stringent than the FSOC had recommended. The FSOC will have even less traction with insurers, which are regulated at the state level.
Accordingly, the FSOC’s decision to focus on products and activities — if it remains the agency’s policy — could be the end of the FSB’s effort to place securities firms, asset managers, insurers, or others that it considers shadow banks under FSB’s SIFI framework. Such institutions can’t be regulated or supervised like banks unless the FSOC is willing to designate them as SIFIs and — in light of the hostile congressional reaction it has received thus far — the FSOC may have decided that what the FSB wants to do won’t work now that Congress is asking difficult questions and threatening to legislate moratoriums.
The FSOC’s decision to pull back from the designation of asset managers as SIFIs may be temporary or it may end what was shaping up as a serious threat to the U.S. capital markets. Those in Congress who let the FSOC know of their objections deserve the thanks of everyone who understands the value of the free U.S. capital markets, but the threat isn’t over until the FSB gives up.
FURTHER READING: Wallison also writes “The G-7 Weighs in on SIFI Designations,” "Why the Volcker Rule Will Harm the U.S. Economy," “The FSOC Expands 'Too Big To Fail',” and “Get Ready for the Next Housing Bubble.” Alex J. Pollock offers “The Financial Stability Oversight Council’s Fatal Flaw” and “The Federal Reserve’s Second 100 Years.”
Image by Dianna Ingram/ Bergman Group