Financial Regulation Calls for 20/20 Vision

Antonio Weiss (Harvard Kennedy School) and Simon Johnson (PIIE)

June 1, 2017

One of the central pillars of financial reform, the Financial Stability Oversight Council (FSOC), is under political attack and at risk of coming undone.

In the past, the balkanized US financial regulatory system has consistently failed to address risks that took root in its jurisdictional gaps. The FSOC was created to solve that problem, bringing regulators together to make sure they have the tools to protect the economy from financial crises. It is already making an important difference.

Unfortunately, earlier this month the House Financial Services Committee passed the Financial Choice Act (CHOICE Act), which threatens to reverse that progress. It would, for example, all but eliminate the FSOC's ability to prevent the regrowth of an unsupervised shadow banking sector that might once again threaten our financial stability and economic resiliency. At the same time, the administration of President Donald Trump has signaled that it may use the council to pursue deregulation, rather than its core mandate of financial stability, and to reverse or limit its ability to designate systemically important non-banks for enhanced supervision. Meanwhile, MetLife Inc., the largest US life insurer, is fighting in court (unopposed by the Trump administration) to overturn its designation by the FSOC as a systemically important financial institution that should be subject to prudential oversight by the Federal Reserve.

In light of these actions in the executive, legislative and judicial branches, it's worth revisiting why the FSOC was created in the first place, and why its core mandate is so important.

Many of the vulnerabilities at the heart of the 2008 crisis can be traced to the growth of activities outside the core banking system, in the so-called "shadow banking" system. Regulators did not have sufficient legal authority to oversee shadow banking activities. As a result, risks metastasized outside their view.

The failures of Bear Stearns Cos. and Lehman Brothers, two such shadow banking firms, and the $182 billion bailout of American International Group Inc. (AIG), an insurance company, made clear that regulators needed better tools to address threats that such activities posed to financial stability.

In January 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created the FSOC to extend supervisory oversight to certain systemically important financial institutions, improve coordination across US regulators, increase awareness of emerging financial stability risks, and collectively mitigate those threats.

As part of this mandate, under Section 113 of Dodd-Frank, the council can designate a non-bank firm if the firm's failure could pose a threat to US financial stability. The Federal Reserve then subjects such firms to enhanced oversight that reflects the risks they pose, regardless of their particular business structures. FSOC has exercised this authority sparingly, designating just four of the largest, most highly leveraged and most interconnected companies: AIG, General Electric Capital Corporation (GE Capital) and Prudential Financial Inc. in 2013, and MetLife in early 2014. Following its designation, GE Capital—a non-bank financial company that nearly collapsed in the crisis due largely to its reliance on unstable, short-term funding—substantially restructured; since it no longer posed a risk to the financial system, its designation was rescinded.

The council is also responsible for scanning far and wide across the financial system to identify emerging risks. It serves as an important venue for regulators to convene, share information, establish a common baseline of facts, and develop coordinated solutions to potentially destabilizing financial activities. In order to keep pace with markets, products and institutions that are dynamic and constantly evolving, its mission is intentionally broad and forward-looking. In recent years, it has focused on risks as diverse as cybersecurity, central counterparties, and the growth of algorithmic trading in capital markets.

When the FSOC has identified specific risks, it has used its legal authority under Section 120 of Dodd-Frank and convening power to facilitate regulatory responses. For example, from its inception FSOC focused on the need to mitigate financial stability risks associated with money market mutual funds, which the government had to backstop in fall 2008 to stem investor runs. FSOC recommended that the SEC act to address those funds' structural vulnerabilities, as it ultimately did.

Similarly, when the FSOC identified potential risks related to asset management products, such as liquidity and redemption risks in open-ended mutual funds, it marshaled interagency expertise to devise a collective regulatory approach. That effort buttressed the SEC, as primary regulator, in its issuance of new rules to modernize and enhance the regulatory framework for asset management.

Despite the key role the FSOC plays in keeping our financial system safe, the CHOICE Act would roll back all of its substantive authorities. It would reduce the council to a regulatory book club that meets periodically and issues an annual report—without the ability to address threats to financial stability. Even more benign-sounding legislative proposals to add "transparency" to the council's process would render designations—which already take two years to complete—all but impossible.

As we have argued more fully in our policy brief for the Peterson Institute for International Economics, rescinding the FSOC's powers would open up major gaps between regulators. No single regulator would have sufficient information, expertise or authority to deal with systemic risks that developed in the space between banks and non-banks. This would risk a repeat of our experience with AIG and reopen many other core vulnerabilities that developed in the run-up to the global financial crisis and produced searing economic damage.

Members on both sides of the aisle should be able to agree on the importance of preventing the type of financial crisis that led to the worst recession since the Great Depression. Treasury Secretary Steven Mnuchin noted in his first meeting as chair "that he strongly valued the Council as a forum for its members to meet and share information." But the substantive agenda at FSOC meetings appears at risk of taking a deregulatory turn, and FSOC has become a target of political opponents of post-crisis reforms.

The FSOC must remain focused on its core mission and continue the hard work of analyzing and responding to risks. Any reforms should be designed to strengthen, not weaken, that ability—for instance, by making its recommendations under Section 120 binding in the absence of action by the primary regulator.

The council is the one entity that casts a clear eye on the entire financial system to identify new and evolving threats. Without it, the odds increase that taxpayers may again face the terrible choice between bailing out the financial sector or suffering the consequences of economic free-fall. No one can predict the precise nature or timing of the next crisis, but the FSOC is our best guardian against another systemic collapse.