Under Fire, FSOC Faces Tough Year in 2015

WASHINGTON — For the Financial Stability Oversight Council, 2014 is a year it may just as soon forget — and 2015 may not be much better.

The council will encounter several tests in the new year, including a potential formal contest from the life insurer MetLife over its recent designation as a systemically important financial institution. It also is trying to grapple with how or whether to regulate the multitrillion-dollar asset management industry, an effort that has already proved controversial. Both are happening as Republican lawmakers, long skeptical of the FSOC, will control both houses of Congress for the first time since the council's inception.

"They are going to be facing a very hostile audience in which the designation process, I think, is particularly challenged," said Karen Shaw Petrou, managing principal of Federal Financial Analytics. "I'm not sure what they could do, given the statutory requirements relating to designation and the rule they implemented" to gain momentum.

The council, formed in 2010 and tasked with identifying sources of systemic risk, took until last year to designate the first nonbanks as systemically important financial institutions. The most recent designee, MetLife, was named on Dec. 19 after the firm revealed it was the subject of an FSOC designation investigation in September. MetLife has until Jan. 16 to decide whether to challenge the designation.

The insurer hasn't said whether it will fight, but it doesn't sound pleased by the FSOC's decision, arguing it will hurt its competitiveness without reducing systemic risk.

Some said the council is vulnerable to a successful challenge because the Federal Reserve Board has not completed its rules laying out how it will institute capital requirements for SIFI insurance companies. Without those, it's both unclear how much a burden a designation is but also means the FSOC cannot reliable demonstrate that the designation has reduced systemic risk.

"How does a company rebut the conclusion that systemic risk will be lessened by its designation as a SIFI when it is not told what the Fed's prudential regulation will look like, or how it reduces systemic risk?" said Tom Vartanian, a partner with Dechert LLP. "It's the proverbial cart before the horse."

MetLife's designation comes as the FSOC is being heavily criticized for the opaqueness of its nonbank designations. Treasury Secretary Jack Lew, who also serves as chairman of the council, responded to that pushback by initiating a substantive review of the designation process to take comments on how it can be improved. But by then the damage had been done, according to several observers.

"They lost a lot of credibility on the transparency front that undermined the ability of the systemic designation process," Petrou said. "I don't think it was anything they did do as much as what they didn't do in 2014, combined with how much they had not done since 2010, that led to the cumulative credibility challenge."

Petrou said the council's decision to pursue the insurance industry — with the exception of AIG, which received a $182 billion bailout in 2008 — rather than more "low-hanging fruit," such as Fannie Mae and Freddie Mac, was a tactical error. The time it took to build cases against other insurers gave those companies and the broader industry time to organize itself against such designations.

"By the time they got there, [the insurance industry] knew it was coming and mobilized considerable defenses, and the same thing would be true for the asset managers as well," Petrou said.

The council has also been persistently criticized for its moves, however tentative, to identify and regulate risks posed by the U.S. asset management industry. The industry manages approximately $53 trillion in assets, according the Office of Financial Research, the FSOC's research arm.

The FSOC voted to solicit public comment through Feb. 23 on whether various aspects of the asset management industry — particularly liquidity, leverage, operational functions and resolution — might pose a systemic risk. The request also asked for comment on what the council or other regulators might do to curb those risks. Lew noted that "there are no predetermined outcomes" on how the council may move on asset managers, but said that "our work will not end there."

It was not the first time that the FSOC had targeted asset managers, however. In September 2013, the research office released a report outlining potential systemic risks posed by that industry, and the FSOC held a public conference on the same subject in May 2014. That public inquiry was met with criticism not only from the industry itself — which includes heavyweights such as BlackRock, Fidelity and Vanguard — but from members of both parties in Congress and the Securities and Exchange Commission, whose chair, Mary Jo White, sits on the council. The OFR report was blasted as being light on hard evidence that asset managers posed a systemic threat, and the council was accused of making up its mind on the issue without getting all the facts.

Tom Cooley, professor of economics at New York University's Leonard Stern School of Business, said the idea of investigating asset management is not necessarily wrong on its face. But he said the FSOC's approach opened it up to criticism and made the council look weak.

"That was just kind of wrongheaded in the way you think about asset managers," Cooley said. "They kind of got it wrong and kind of jumped the gun, and [it] got a lot of people who don't like Dodd-Frank to jump down their throats."

Even as the FSOC tries again on asset managers, the SEC, which holds primary jurisdiction over asset managers, appears to be trying to bolster its oversight of such firms. White announced in December that the SEC would begin work on a series of "regulatory enhancements" to address systemic risks in the industry. Those enhancements include reviewing data reporting rules to reflect changing markets; improving risk controls, particularly with respect to liquidity and the use of derivatives by mutual funds and exchange-traded funds; and greater stress testing and required transition plans for asset management firms.

Marcus Stanley, policy director for Americans for Financial Reform, said allowing the SEC take the lead on regulating asset managers may be the most viable approach available, and could yield the desired results.

"To the degree that you have... the primary lead agency working on a parallel track with FSOC, I think that's something that could end up working out well," Stanley said. The FSOC "got the SEC agreeing on what the important questions are and got the SEC to begin a work process to address those questions, and that's a good first step."

The FSOC did not respond to a number of requests for comment.

To grasp how the FSOC finds itself in a relative struggle to fulfill its mission — compared with, say, the Consumer Financial Protection Bureau, which was also created by the Dodd-Frank Act, or the Commodity Futures Trading Commission or the Federal Reserve, which gained broad new powers under the law — it is important to understand the council's mission and structure.

Of all the agencies to emerge from Dodd-Frank — indeed, of all federal agencies — the FSOC is unique. Rather than being an agency or department in its own right, it is a consortium made up of the heads of other financial regulatory agencies, with the Treasury secretary acting as permanent chair. There are 15 members on the council, 10 of whom are voting members (including one appointed voting member with insurance expertise appointed by the president).

The council is required to meet quarterly (though in practice it meets around six times per year). In those meetings, which may be open or closed to the public depending on the sensitivity of the subject matter, the council decides whether to designate a company or activity (other than banks, which are designated elsewhere) as a SIFI, thus subjecting it to Fed oversight and rules. Between meetings, each of the voting member agencies have staff dedicated to FSOC activities who communicate with one another, but there is no central office or dedicated staff.

That parliamentary structure, Petrou said, is "awkward at best" and makes it more difficult to make decisions quickly or unilaterally. In the end, the council has chosen to move more through its member agencies, particularly the Fed, than by using its own authority in the way it was intended. This has led to a lopsided regulatory atmosphere that weighs heaviest on SIFI banks, Petrou said.

"They viewed this committee structure as sufficiently dysfunctional that they were basically doing rules by individual agencies, working particularly with the Fed, which would account for why the Fed moved as fast as it did and FSOC seemed so mired," Petrou said.

Sheila Bair, former head of the Federal Deposit Insurance Corp., said she pushed for the council's authorities to be housed in a more traditional federal agency structure precisely because a council format is unwieldy.

"It's primarily a coordinating body," Bair said. "That's one of the reasons Dodd-Frank has been so delayed in implementation is because there's no process other than endless negotiation to report with interagency rules."

Bair added that if there is political will in Congress to amend Dodd-Frank and the FSOC's governing statute, it should be to make it "more politically independent and have more staff of its own to have simpler, more consistent rules across the board."

But that seems unlikely given the current makeup of Congress, which in 2015 will be under Republican control.

Several House lawmakers have pushed to reduce the FSOC's power. Rep. Scott Garrett, R-N.J., chairman of the Financial Services capital markets subcommittee, successfully included an amendment to a financial services appropriations bill in July barring the oversight council from designating any nonbank as a SIFI or finding that any nonbank activity could be viewed as systemically significant. The amendment was not enacted, but he and other lawmakers are likely to try again next year.

Some have suggested that the situation will improve when the Fed issues capital rules for nonbank SIFIs, particularly if those regulations are broadly acceptable. One of the final acts of Congress before it adjourned in December was to pass a bill amending Dodd-Frank to allow the Fed greater latitude in crafting nonbank capitalization rules for insurance companies. That could spur the central bank to act fast.

"They do want to right the ship," Cooley said. "I think they want to get it right, and it's part of the growing pains of having this kind of regulatory superstructure. They should be asking the question [of where systemic risk lies], but... you need simple approaches to making the financial system safer, and getting capital requirements right is all-important."

In the meantime, the oversight council is moving forward as best it can. Bair noted that, for all the criticism the council receives in Congress, "they're doing what Congress told them to do. People shouldn't take them to task for doing their job."

Vartanian agreed, but said the challenge and the mission of governance is to ensure that rules and related decisions are made fairly and deliberately. Given the level of scrutiny the FSOC has been under, it behooves the council to move carefully with each decision it makes, Vartanian said.

"I get the sense that agency people who are making the decisions are very focused on doing the best they can with a very difficult mandate and process," he said. "Just because it's challenging, however, doesn't mean that administrative procedures, due process and fairness should be shortchanged. Good government requires that the process be credible and fair, even before you get to the legal requirements."