FSOC Faces Challenging Year Ahead After Quiet 2015

WASHINGTON — The Financial Stability Oversight Council had a relatively quiet year in 2015, but a handful of critical tests coming up in 2016 could permanently shape the future of the interagency council.

It started the year on aggressive footing. At the final meeting of 2014, the council voted to designate the insurance giant MetLife as a systemically significant financial institution — making it only the fourth nonbank to be so designated. It was also the only nonbank to protest the ruling, suing the FSOC and setting up a legal battle with massive consequences for the financial system.

"The MetLife challenge brings us to an important juncture in the life of FSOC since it raises the fundamental question of whether the law permits an agency to speculate as to a risk scenario for which there is little or no precedent and the future likelihood of which is incalculable, so that it can regulate to that risk," said Thomas Vartanian, a partner with Dechert LLP and an attorney representing some clients who have filed an amicus brief in support of MetLife's suit. "That is the issue in this post-crisis regulatory era."

At the same time, the FSOC also announced that it was seeking comment on potential risks to financial security posed by the asset management industry, including hedge and mutual funds – a move that many observers saw as a potential first step toward tighter regulation of the so-called "shadow banking" industry.

Yet despite the aggressive start, the FSOC has been mostly quiet in 2015. Its most public action was to make changes to its nonbank SIFI designation processes in an effort to respond to Congressional criticism that the effort was too opaque.

There have been no new firms designated this year, nor are there any firms in the final "Stage 3" of the designation process, meaning that there will almost certainly be no new designations next year, either. During the final public meeting of the year, Treasury Secretary Jack Lew, who chairs the council, said that it will have an update on the asset management process next spring, but it appears to be waiting for a separate proposal on the issue by the Securities and Exchange Commission.

In its defense, the council appears to feel that there is simply less to do than before — Lew himself said in a speech in November that the FSOC was in no rush to designate companies or take actions just of their own sake.

"Some of these areas are more ripe for immediate action than others because it's clear what the issues are. Others require study, and we've been very careful in the Financial Stability Oversight Council to put an analytic process ahead of any decision that we make," Lew said. "So we don't jump to conclusions. We do the analysis, and if there's an issue, we address it. If not, we say we don't need to take action. I think that that's the right way."

Still, 2016 could shape up to be a very different year. Following is a guide to the issues facing the council in the new year — and how they may play out.

MetLife's Lawsuit

By far the biggest challenge facing the FSOC is MetLife's lawsuit over the council's authority. Most of 2015 was spent sorting through pretrial discovery, with MetLife accusing the FSOC of withholding certain documents related to its designation. The FSOC, meanwhile, has maintained that its entire record is available to the firm, though some materials amount to confidential business information that should remain under seal. Oral arguments in the case are slated to begin in February.

At the heart of MetLife's suit is the contention that the FSOC's designation of the insurance firm is based on the potential financial stability effects if MetLife were to fail. But MetLife argues that the scenario the FSOC uses to explain how the company could fail is far outside anything that has actually been observed in the markets, thus leaving MetLife in a position where it has to consider not only any plausible scenario that could threaten its stability but any conceivable scenario that could threaten its stability — a situation that it argues is beyond the scope of the authority Congress vested in the council.

Oliver Ireland, a partner at Morrison & Foerster, said that the MetLife suit — no matter what the result — is going to act as a turning point for the FSOC. If MetLife prevails, it will provide cover for the remaining nonbank SIFIs — insurance firms American International Group and Prudential — to challenge their own designations in court. A more sweeping ruling could throw out all of the council's designations or could make it much more difficult for the council to designate new firms in the future.

But if the FSOC wins, it could effectively mean that the council could designate anyone it wants for virtually any reason.

"It seems to me there are two bad results, and it's a question of which one you think is worse," Ireland said. "One is FSOC is going to get a whole lot of discretion and be able to pretty much be able to designate whoever it wants to designate. On the other hand, if FSOC can't designate the people it needs to designate, it can't perform its function. So how the MetLife case plays out I think is a big issue, and it is core to the whole concept of FSOC and systemically important institutions."

While MetLife is supported by many in the industry, consumer advocates argue it's an effort to gut the FSOC and take away its power, which they argue would have disastrous economic consequences.

"FSOC is the only entity that has the power and authority to designate a nonbank a systemically significant and directed for heightened regulation," Kelleher said. "If the MetLife lawsuit [prevails] or any of the bills in Congress become law, it has the potential to not just cripple the entity FSOC but eliminate the only means the U.S. has for regulating the shadow banking system."

The De-Designation Process

Another critical event coming up in 2016 is whether the council moves to de-designate GE Capital. The firm received billions in bailout money during the 2008 financial crash and was one of the first nonbanks to receive a designation in 2013.

But the company announced in April that it was going to spin off its financial arm — the basis of its SIFI designation — in order to shed its designated status. The Fed in July issued its final rule for how it would regulate GE, effectively treating it like any other bank holding company, including making it subject to stress testing and other requirements starting in 2017. That gives GE next year to shed its designation before the rules go into effect.

De-designation of a nonbank SIFI has been the source of a great deal of concern by lawmakers, who worry that the process is unclear and unproven. If GE is able to shed its designation quickly and easily, it will give the FSOC a valuable counterclaim to the accusation that SIFI designation is a one-way street. But if it proves complicated or fails, it could embolden the FSOC's critics further.

One reason the de-designation may not go as smoothly as both parties might hope is that one of GE's major financial properties — its $16 billion in online deposits, which Goldman Sachs applied to acquire in August — is being fought by a group of community activists who are seeking concessions from the Fed and Goldman over applicability of Community Reinvestment Act requirements in areas where depositors live. The Fed has not yet announced its decision on whether to hold public hearings on the acquisition.

But some in industry discount the extent to which a successful GE de-designation will be seen as a credit to the council or change anyone's mind in Congress. The circumstances of GE's business model is so unlike that of the remaining three nonbanks that it provides little in the way of meaningful example for how another SIFI might proceed, Ireland said.

"GE represents a particular fact pattern where GE has a lot of clearly commercial businesses and it has a financial arm to it," Ireland said. "What it's doing is it's saying, 'OK, we'll just get rid of the financial arm.' I don't think that represents a very complicated question. The more difficult question is, 'I'm a big insurance company. What about that insurance company creates this risk? What does it have to do to its business to become de-designated?' That is a much more complex question."

Vartanian said that GE represents a different, cautionary tale to the FSOC and other regulators, which is that it is possible to make a business so intolerable that the firm will choose to cease its line of business just to get out from those regulations. In that way, GE's de-designation could bring more heat on the FSOC rather than less.

"It speaks volumes about the impact of federal prudential regulation when a designated SIFI chooses to leave the business and that regulation behind," Vartanian said. "It's the canary in the coal mine that should make policymakers ask themselves whether the burden of regulation has crossed a line."

But Kelleher said the opposite, arguing that AIG and Prudential have borne the price of a designation without missing a beat, indicating that the cost is worth enduring.

"MetLife and Prudential and AIG aren't scratching their heads saying, 'I wonder why I'm systemically significant,' " Kelleher said. "They know exactly why they're systemically significant. If they want to dispose of the high-risk parts of their financial activities and then reapply … FSOC would conclude that, if they had de-risked, that it is no longer systemically significant. So to say that GE is not relevant or a not a good template for other companies is just false."

Congressional Action

The FSOC's tests will occur as Republicans continue to push ways to reform the council. GOP congressmen drafted a number of bills aimed at the council this past year, including one to subject it to the appropriations process and another to allow all members of an agency's board to attend.

The bills haven't gained much traction and the FSOC avoided seeing them added onto the omnibus spending bill passed two weeks ago. But those measures are likely to surface again next year.

The FSOC's longer-term future likely hinges on the outcome of the 2016 election. Democratic front-runner Hillary Clinton would likely steer a similar course to that of the Obama administration, though if her campaign CFO and former Commodity Futures Trading Commission Chairman Gary Gensler is named Treasury secretary — a post he has long sought — and consequently becomes chairman of the FSOC, he may be more aggressive than Lew.

By contrast, if virtually any Republican nominee wins the White House, Vartanian's expectation is that the FSOC would undergo something of a transformation from a council focused on the risks posed by U.S. companies to one focused on being an "early warning" system for economic instability, including risks posed by foreign countries.

"Tell me what's going to happen in November 2016, and I'll tell you where FSOC is likely to be pointed," Vartanian said. "If there is a Republican administration, it is likely to step back and be more focused on getting a reliable, sophisticated monitoring and early-warning system on systemic stability in place, rather designating a few individual companies."