The current debate over the future of the Financial Stability Oversight Council (and specifically, its SIFI designation power) is missing an important point. The question should not be whether the FSOC stays or goes (in function or in form), but instead how to improve its design. In playing a zero-sum-type game, politicians may be missing an opportunity to serve the stability goals at the root of the FSOC’s existence, while also satisfying the industry’s efficiency-oriented concerns.
The FSOC has provoked the ire of politicians for several years now. In hearings before the US Congress in December 2015, one congressman described the FSOC as ‘one of the most powerful federal entities to ever exist’, and yet more secretive than most. Now, against the backdrop of President Trump’s de-regulatory agenda, the anti-FSOC camp is likely to be more focused than ever on reeling in the Council’s power—especially its ability to designate nonbank financial companies as ‘systemically important financial institutions’, or ‘SIFIs’.
The industry seems equally unhappy with the FSOC’s designation power. Two of the four nonbank companies that were designated as SIFIs have undertaken serious efforts to shed that label. GE persuaded the FSOC to de-designate it by shrinking its financial arm, and MetLife sued the FSOC in federal court, arguing that the designation process was unconstitutional and arbitrary and capricious under the Administrative Procedure Act. Meanwhile, the FSOC’s ongoing examination of the asset management industry appears to be on hold—notably, that industry strongly contested its putative SIFI status. In all likelihood, these institutions’ aversion to the SIFI label stems from the principal regulatory implication of a designation: the imposition of additional (expensive) capital requirements by the Federal Reserve.
But the FSOC need not be dismantled or substantially weakened to address these various concerns. In a forthcoming article, Regulating Nonbanks, I argue that much of the current resistance to the FSOC’s work may be owing to the binary quality of the designation power. That is, the current designation process allows only for a dichotomy—it treats the SIFI status as an on/off switch. And because the ensuing regulatory consequences of a designation are so stark—possibly, the full range of bank-like quantitative and supervisory requirements—firms’ incentives to avoid the designation are inordinately strong.
In the paper, I urge a more graduated and nuanced system that includes a SIFI ‘lite’ designation. Boiled down to its basics, the SIFI lite designation would apply to institutions that may be systemically concerning but, for a number of reasons, don’t fit the full SIFI bill. So, for example, SIFI lite might apply to companies engaged in potential but unknown systemic risks (like repo lending in FinTech firms) or to institutions engaged in some but not all systemically risky activities (like asset managers). In concept, SIFI lite thus offers the FSOC a more flexible tool for adjusting the regulatory perimeter.
It also prompts the Fed to take more surgical interventions in the nonbank space. Specifically, a SIFI lite designation would track an institution into a step-wise regime that begins first with supervision and resorts to capital only if and when needed. I suggest a way to design a supervisory stress test focused on an institution’s liquidity management tools, information security systems, and processes for collateral and counterparty selection (among other possible lines of inquiry). (Notably, this proposal could also plug key ‘information gaps’, as Professor Kate Judge calls them.) The paper explores ways to stress test these areas in order to address concerns relating to runs, cyber vulnerability, and securities lending, respectively.
Overall, a more carefully calibrated and less intrusive tool would arguably reduce the industry’s aversion to the nonbank SIFI regime. The end result: a macroprudential regulator (ie, the Fed) with informational oversight over a broader swath of systemically relevant activity than currently seems possible. This is how, the paper argues, a SIFI lite system could score wins for the stability and efficiency agendas alike.
In the current political environment, if the FSOC is to remain relevant, moderating its approach seems unavoidable. And finding ways to keep the FSOC relevant is a tremendously worthwhile project. As a relatively recent innovation in institutional architecture, the FSOC has a unique and untapped potential to contribute to financial stability. It is the place where regulators can see the forest through the trees and address systemic risk in a cross-sectoral way. The FSOC is, in short, one of the chief post-crisis advances toward a macroprudential approach to financial regulation. Discarding the FSOC now risks a retreat into pre-crisis, microprudential ways.
Ultimately, re-designing the FSOC is more likely to be a lasting solution, acceptable to industry and regulators alike. Indeed, some asset managers, like BlackRock, have already suggested their amenability to a supervisory scheme involving stress testing, implying that a SIFI lite designation could indeed present a politically viable middle ground between the FSOC’s proponents and its detractors.
Christina Skinner is an Assistant Professor at Brooklyn Law School and an Academic Visitor at the University of Oxford, Faculty of Law.