FSOC needs to get people to care about nonbank regulation

Bloomberg News

WASHINGTON — Last Friday, the Financial Stability Oversight Council issued a pair of proposals that were conceptually straightforward but nevertheless surprising, if only for their timing.

The proposals effectively unshackled the interagency council's ability to designate nonbank firms and activities as systemically important — a designation that brings with it as-yet-unspecified prudential oversight from the Federal Reserve. What had been shackling that power was a 2019 guidance document that stipulated that the council could only designate a firm or activity if it had undergone a cost-benefit analysis that determined that the costs incurred by the company or companies being designated are outweighed by the public benefit of such a designation. 

Again, the substance of the proposals was not that surprising — the guidance in question was adopted after the Trump administration had un-designated the only two firms that still had the label, AIG and Prudential. The guidance was their way of blowing up the bridge to designation if and when a Democratic president was ever elected again. So here we are with a Democratic president, and it makes sense that his administration would reverse course.

But before this FSOC gets too far ahead of itself, its leaders would be wise to think about what they are actually trying to accomplish and how they might make those accomplishments durable. And to make nonbank designation more durable this time around, FSOC would be wise to consider what went wrong the last time so they don't make the same mistakes again.

Let's begin at the beginning. In 2008, the entire global economy was on fire, and it took an extraordinary effort to put that fire out. Once that had been done, lawmakers and regulators turned to the question of how to keep the economy from catching fire again, and the answer, in essence, was imposing higher capital and liquidity requirements (and many other things) than had been the norm before.

In the case of banks, imposing those new requirements involved some creative thinking, but the "how" was pretty straightforward — banks have been subject to regulatory and supervisory requirements for quite some time. Nonbanks — notably AIG — were not, and getting those firms and risky ones like it required some new authority from some new entity, and so we got FSOC.

In other words, public outrage was the impetus for Congress to create FSOC in the first place and the basis of its mandate to designate nonbank firms and activities as systemically risky. 

So what changed? One could argue that the four firms designated in the 2010s shed the label because they changed their business models to be less risky, thus making the designation process a success. But it would be more accurate to say that the reason at least some of those firms shed the label is because the designation process ran afoul of the courts on the one hand and the Trump administration didn't really believe in the process on the other. There wasn't much of an outcry when those last designations were shed, because people don't pay much attention to what the FSOC does and don't remember why they cared in the first place.

Politics and policy

FSOC isn't reining in nonbanks anytime soon

April 25, 2023 2:47 PM

FSOC and the Biden administration are correct to empower FSOC to designate nonbank firms — and, more importantly, nonbank activities — as systemically risky, and they don't even have to reach back to 2008 as justification. In 2020, banks showed robust balance sheets and capital ratios, while money markets, corporate debt and other nonbank markets needed to be rescued. Heck, just last month money market balances have blown up with what were once bank deposits and interest rates on corporate debt are surging. There's a case to be made that what has been good for the banking goose would also be good for the nonbank gander.

This administration should be making that case, and not just on C-SPAN. Nonbank regulation was recently described to me as the last unfinished business of the 2008 financial crisis, and instilling some prudential discipline on the wider financial system is probably something that President Biden could campaign on — he did it with "junk fees" after all. And he could enlist some powerful partners in that endeavor.

Part of the reason why building the public case is important is because of the timing of these proposals and the administrative lift that necessarily comes next. The FSOC proposals are out for public comment for 60 days — that means the earliest they could be finalized is perhaps this August. Then FSOC has to follow its own deliberate guidance to notify the firms and/or activities it has in mind for systemic designation. Then it has to designate those firms and/or activities. There will invariably be court cases and Congressional hearings. And after all that, the Fed would have to propose and finalize the actual prudential standards for those firms and/or activities to live by.

Maybe, just maybe, you could get all that done by the end of Biden's second term — if there is a second term. But even if there is and no mention of FSOC is ever made on the campaign trail, all of the council's efforts will be stymied every step of the way, and whatever is accomplished will be torn down entirely as soon as a Republican president takes office — unless there is a political price to pay for doing so.

Treasury Secretary Janet Yellen, in her remarks opening the FSOC hearing last Friday, made a pretty good first stab at making that case. 

"Last month's events show us that our work is not yet done," she said, referring to the failures of Silicon Valley Bank and Signature Bank. "The authority for emergency interventions is critical. But equally as important is a supervisory and regulatory regime that can help prevent financial disruptions from starting and spreading in the first place."

If that's what this administration intends to put in place, then it's going to need to make people want it first. If they don't, I guess I'll just write this column again in 2036.