Try as they might, Republicans can't stop FSOC's resurrection

FSOC 2022
The Financial Stability Oversight Council, or FSOC, on Friday issued a pair of proposals aimed at reinvigorating its ability to designate nonbank firms and activities as systemically risky. Those proposals will likely reignite simmering debates about the appropriate role of the council, but for the time being, Republicans are largely powerless to block the proposals from being adopted.
Bloomberg News

WASHINGTON — The Biden administration set the wheels in motion on Friday to deploy one of their strongest tools — designation authority — a move financial regulators can make almost unilaterally, despite political opposition. 

The Financial Oversight Stability Council, a body of financial regulators created in the aftermath of the 2008 financial crisis to spot and address emerging financial risks, unanimously approved a pair of proposals designed to streamline its ability to designate nonbank firms as systemically risky. 

That power was weakened during the Trump administration, and Republicans are expected to continue opposing FSOC's authority moving forward, particularly a provision that would lessen the need for FSOC to do a cost-benefit analysis of designating a nonbank firm. 

"The Financial Stability Oversight Council's proposed interpretive guidance on nonbank financial company designations raises serious questions about whether FSOC is taking the best approach to address systemic risk," said Rep. French Hill, R-Ark., the chair of the House Financial Services Committee's Subcommittee on Digital Assets and one of the lead Republican voices on financial services. "FSOC should reconsider its decision to eliminate the cost-benefit analysis prior to making entity designations, among the other proposed changes in the guidance."

But for their part, Republicans have little ability to limit FSOC's power while they hold only the House, said Ian Katz, managing director at Capital Alpha Partners. 

Katz said he expects House Financial Services Committee Chairman Patrick McHenry, R-N.C., and other lead Republicans to hold hearings and send letters as to how FSOC came up with the decision to revive its ability to designate nonbank firms, and to ask whether it has studied the economic costs of designation. 

"I don't think that would have a lot of impact," Katz said. "Maybe it would get the FSOC to go a bit slower as it responds to the criticism and does whatever it can to procedurally protect itself from lawsuits later, but Republicans can't stop it from happening." 

McHenry, whose office did not respond to a request for comment on FSOC's current move, has, in the past, spoken derisively of FSOC's designation ability. 

"You don't like something? Well let's just have FSOC label it as risky and regulate it away," McHenry said at a hearing on FSOC with Treasury Secretary Janet Yellen last year. "And before you know it, progressive policies will force lending decisions in favor of those customers who are activists and progressives support while law abiding business will be forced to close to appease the radical left."

FSOC's proposals will likely revive a now decade-long partisan squabble that pits Republican lawmakers and industry interests against the regulation-heavy approach championed by Democratic lawmakers. Those divisions were starting to reemerge in the wake of the Silicon Valley Bank and Signature Banks failures, but are likely to accelerate if and when FSOC becomes more active in bringing a wider swath of the nonbank financial landscape under the prudential regulatory umbrella. 

The FSOC proposals deal with nonbanks — not banks of a similar size to Silicon Valley Bank or Signature Banks — but the failure of the two banks throws into sharp clarity the idea that institutions previously thought to be insignificant with respect to financial stability can pose a greater hazard under the right circumstances. 

"This was clearly underway long before the failure of Silicon Valley Bank," said Kate Judge, a professor at Columbia Law School. "But the real benefit comes from the back-and-forth that we're now going into, because the ability of institutions to fight back and say we're not systemically significant and it's not appropriate to put these types of procedures in place has been cut down. 

"Part of the bigger lesson of recent events is just the need for incredible humility and appreciation of the range of different dynamics that can lead an institution to eventually cause ripple effects that are systemically significant," Judge said. "Their capacity to proceed in a timely and appropriate fashion has certainly been facilitated [with Friday's proposals]." 

Democratic lawmakers immediately applauded FSOC's proposed changes. Rep. Maxine Waters, D-Calif., ranking member of the House Financial Services Committee, urged financial regulators to use the power to designate nonbanks "whenever appropriate," particularly after the failures of Silicon Valley Bank and Signature Bank. 

"Last month's unexpected failure of SVB and Signature Bank and resulting bank crisis serve as a stark reminder that FSOC and our regulators must remain vigilant and seek to quickly address vulnerabilities in our financial system without delay," Waters said in a statement. "Trump's deregulatory agenda clearly contributed to these bank failures, so I repeat a recommendation I made several years ago: FSOC must not be shy in combating systemic risk and working to reverse the litany of deregulatory actions that left our system more vulnerable to a financial crisis." 

Sen. Elizabeth Warren, D-Mass., who questioned Treasury Yellen about FSOC's designation authority in a hearing last May, said that FSOC has taken "a powerfully important step," in reviving rules that would give them back that authority. 

"We saw in the 2008 crisis how financial institutions that aren't banks — including insurance companies, mortgage issuers, and hedge funds — can be big enough and risky enough to crash our whole economy," she said. "The Trump administration put us all in danger by significantly weakening financial regulators' oversight of these giant corporations, and now FSOC should follow through by using this tool to ensure the stability of our financial system." 

From the time FSOC was created until its designation authority was muted by the Trump-era guidance, the council only designated four firms, but all of them have since had their designations rescinded. 

While Republicans don't have a lot of tools to slow FSOC down right now, it's possible that, in the event of a turnover in Washington after the 2024 elections, they could begin dismantling the rules that Yellen and the Biden administration are now putting in place. That would, effectively, leave financial regulation back where it was at the onset of the Biden administration. 

"I wonder if we're just going to see a tit-for-tat, but that being said I don't know what the alternative for this FSOC is," said Todd Phillips, principal at Phillips Policy Consulting, LLC and fellow at the Roosevelt Institute. "Our legal system makes it a whole lot harder to affirmatively regulate than to deregulate." 

And although experts anticipate a relatively smooth process for FSOC to finalize its proposals, the real test for the effectiveness of this reinvigoration of the council's designation authority will come when it actually designates something as risky and develops regulatory standards for the designated entities and/or activities. 

"The feds have struggled with conceiving of appropriate regulation for nonbanks that were designated," said Aaron Klein, senior fellow at the Brookings Institution. "Could a future Republican administration roll these things back? Yeah, but the real test is going to be are there any designations under this new framework."  

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