On the Constitutionality of Systemic Risk Regulation

The near-meltdown of the US financial system in 2008-09 brought to light at least four critical truths that had gone insufficiently appreciated during that system’s rapid evolution over the late 1990s and early 2000s. The first is that many non-bank US financial institutions now have become bank-like in their vulnerability to ‘runs,’ thanks in part to multiple maturity mismatches between the asset and liability sides of their balance sheets. Hence today’s oft-heard references to ‘shadow banking,’ a term-of-art denoting non-bank financial institutions that are financially vulnerable in ways previously characteristic principally of banks.

The second truth is that many financial systems now have become more than the sums of their parts, thanks in part to multiple balance sheet interdependencies, direct and indirect, among financial institutions and other market actors. Accordingly, effective oversight of one institution now often requires simultaneous oversight of many other institutions and markets. Hence today’s oft-heard references to ‘systemic risk,’ ‘financial stability,’ and ‘macroprudential oversight,’ rather than just ‘institutional safety and soundness’ or ‘microprudential supervision,’ where finance and its regulation are concerned.

The third truth is that, owing in part to the inter-firm interlinkages and interdependencies just mentioned, it is effectively impossible now to predict with actuarial precision exactly when, or via which of a multitude of possible channels, a sudden systemic financial crisis might occur. Hence today’s oft-heard references to ‘black swans,’ ‘tail events,’ ‘Minsky moments,’ and the like. The proliferation of such terms indicates wide recognition, post-2008, that financial meltdowns are no longer a matter of calculable risk, but are instead subject to incalculable ‘Knightian uncertainty.’

Finally, the fourth truth is that the US’s ‘siloed’ system of financial regulation, shaped as it was by less and less tenable formal distinctions between ‘banks,’ ‘broker-dealers,’ ‘investment companies’ and ‘insurance companies,’ and focused as it was upon individual firms rather than systemic relations among firms, is no longer up to the task of addressing systemic vulnerabilities and thereby preventing financial and hence macroeconomic chaos. Regulators of non-bank institutions did not regulate them as banks even when they functioned as ‘shadow banks.’ Nor were these regulators, individually or collectively, authorised by the US Congress to oversee the financial system as a single, vulnerable whole. 

For these and related reasons, the US Congress established a new finance-regulatory council in the very first Title of its signature post-crisis finance-regulatory reform legislation, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (‘Dodd-Frank’). Chaired by the US Secretary of the Treasury and including among its voting members the Chairs of the Federal Reserve Board (‘Fed’), the Securities and Exchange Commission, the Commodity Futures Trading Commission, and all of the nation’s other top financial regulators, this new Financial Stability Oversight Council (‘FSOC’ or ‘Council’) was tasked specifically with identifying potential threats to the systemic financial stability of the US.

Pursuant to this function, the Council also was charged with identifying particular firms whose size, interconnectedness, balance sheet structure and other characteristics might render them themselves, in the event of financial distress, significant to the financial stability of the US. Firms thus identified would be subject to oversight and enhanced prudential regulation by the Fed with a view to (a) preventing their insolvency, (b) cabining the fallout effects of any such insolvency, or (c) both. Firms of this kind have since come to be popularly known as ‘systemically important financial institutions,’ or ‘SIFIs.’

During its first years of operation, after extensive data collection and evaluation, the Council identified four non-bank US SIFIs in need of enhanced oversight, explaining each designation decision with hundreds of pages of data and carefully elaborated analysis.  Three of the designated firms – AIG, MetLife, and Prudential – were and remain very large, complex insurance conglomerates whose balance sheets not only are broadly interconnected and bank-reminiscent in the maturity structures of many of their assets and liabilities, but also exceed the budgets of many US states, not to say many nation-states across the world. (MetLife alone holds nearly $1 trillion in consolidated assets.) Because the US lacks a system of federal insurance regulation, moreover, Fed supervision under the Dodd-Frank Act is the principal, if not sole, means of effectively preventing their financial distress from morphing into national and even international financial distress.  

Neither AIG nor Prudential challenged their SIFI designations. MetLife, however, did. It argued to the Council, and then in federal court, that FSOC was wrong on the merits in finding MetLife to be a systemically important financial institution in need of enhanced supervision, and that FSOC had violated MetLife’s constitutional due process rights in so finding. It claimed that FSOC was required to determine the actuarial probability of MetLife financial distress itself, and to calculate the costs MetLife would incur if designated as a SIFI, in reaching its final determination, and that it had not done so.

To the surprise of most commentators, the Federal District Court for the District of Columbia, per a judge best known for having entertained Republican Congressmen’s suits challenging the Obama Administrations signature health insurance reform legislation, found in favor of MetLife and against the considered judgment of the Treasury Secretary, the Chair of the Federal Reserve, and seven of the US’s top eight remaining financial regulators. The Court held that the Council had acted ‘arbitrarily and capriciously’ within the meaning of the Administrative Procedure Act, not by acting contrary to its enabling legislation or Congress’s substantive SIFI-designation criteria, but by putatively (a) failing to act in accordance with the Dodd-Frank-interpretive guidance that it had itself provided to prospective SIFIs for their convenience, and (b) failing to conduct a cost-benefit analysis of prospective MetLife SIFI designation – a form of analysis that Congress refrained from requiring and that is not possible in the context of SIFI designation in any event. 

In a forthcoming paper based upon written testimony delivered before the House Committee on Financial Services of the US Congress, I argue that both MetLife and the Federal District Court, whose decision is unlikely to withstand appeal, are as wrong as can be about FSOC and its decision to designate MetLife a SIFI. The basis of FSOC’s decision, which weighs-in at over 340 pages of exhaustive data presentation and analysis, proceeds precisely along the lines prescribed by Congress in Dodd-Frank. It also comports fully with FSOC’s own Interpretive Guidance, which the financially untutored Court clearly misunderstood. Finally, Congress deliberately refrained from requiring that cost-benefit analysis be employed in SIFI designation decisions, both because designation itself triggers heightened supervision whose details are developed only later, and because the expected disvalue of crises like that of 2008-09, and the likelihood of avoiding them via SIFI designations, is quite impossible to estimate given the current state of our knowledge.

The deadline for filing appellate briefs in FSOC’s appeal from the District Court’s ruling is tomorrow. Readers are advised to stay tuned!

Robert Hockett is Edward Cornell Professor of Law at Cornell Law School.