Trump administration must rein in an overreaching FDIC

Bloomberg

If the new Trump administration resembles the old one in its approach to governing, the pace of issuing regulations and executive orders will eventually slow over the next four years. It remains unclear whether the president will have the political stamina to do away with some of the regulatory constraints imposed by the Biden White House, especially in its regulation of financial markets.

One important test case will be how the new administration deals with regulations that gave the FDIC a modicum of regulatory authority over large asset managers that passively invest in banks via popular index funds, like Vanguard, BlackRock and State Street.

The Federal Reserve currently regulates large asset managers. However, the law subjects any investor that acquires more than 10% of the outstanding shares of a bank to additional regulation via the FDIC.

This creates a potential conflict, as prominent index funds managed by companies such as Vanguard and BlackRock have grown so large that their shares in banks within the S&P 500 — the most common index for passively managed funds — approach that 10% threshold. Because index fund managers cannot use their holdings to exert pressure on management — as their decisions to buy and sell stock are determined solely by a company's relative market size — they have no levers to exert undue influence on bank management.

To ensure this remains the case, the investment management companies have agreements with the Federal Reserve that they will remain passive with respect to any bank investments.

However, some members of the Biden administration's FDIC board, most notably Rohit Chopra and Jonathan McKernan, saw no reason to cede any turf to its regulatory counterpart and pushed for the agency to assume the ability to regulate index funds with respect to bank investments.

In July, the FDIC adopted rule changes giving the agency more authority to interfere with the acquisition of equity positions in banks by asset managers. Armed with this additional regulatory ammunition, the FDIC forged an agreement with Vanguard prohibiting it from exercising control over any banks it has invested in, which the company had already committed not to do in a previous agreement with the Federal Reserve. If there's a better example of regulatory superfluity, I'd like to see it.

BlackRock had proposed an alternative arrangement with the FDIC that did not include the same level of oversight agreed to by Vanguard, but the FDIC did not respond until announcing its Vanguard settlement. After the agreement with Vanguard, the FDIC informed BlackRock on Jan. 2 that it had just one week to reach an agreement.

BlackRock objected, responding that it "was not aware of any imminent or ongoing issues that would warrant hastening the finalization of a completely new regulatory framework in a two-week period," ultimately forced the FDIC to back off of its harried, politically induced, artificial deadline.

Of course, there may have been "imminent issues" in the minds of Chopra and McKernan: They knew they would likely lose their jobs in a Trump administration. Newly sworn-in Treasury Secretary Scott Bessent dismissed Chopra on Feb. 1, and 10 days later McKernan announced that he would be departing as well.

The FDIC's rush to reach passivity agreements with major asset managers leaves many questions unanswered. Why are these duplicative regulations necessary? What impact will such regulations have on investments in banks through these asset managers? What is the regulatory gap that the FDIC board is trying to close?

These regulatory adventures can have far-reaching repercussions. A large number of American savers have a significant proportion of their investments in index funds, and passively managed funds recently overtook actively managed funds in total assets under management.

Government overregulation that hamstrings capital markets without cause impacts the retirement funds of millions of Americans. Power grabs by financial regulators should be unsettling for financial institutions, investors, taxpayers, and the economy, and appear to be so, judging by the public comments submitted when the FDIC proposed this rule. The commenters warned of the potential harm of redundant oversight, contradictory regulatory standards, increased compliance costs, and restricted investments in bank stocks. Travis Hill, acting chairman of the FDIC, noted these actions by the FDIC "might result in asset managers reducing their investments in banks."

Additional regulatory costs imposed by partisan regulators will increase banks' cost of financing and reduce returns to investors. Ultimately, this will leave less capital available for borrowers and result in lower returns to investors in banks, which includes everyone with money in an index fund.

Let's hope the Trump administration recognizes the superfluous nature of this FDIC rulemaking attempt and halts this unnecessary overreach from one financial regulator into the well-established realm of another.