Opinion: The FSOC Quagmire

The following is an op-ed written by Douglas Holtz-Eakin, president of the American Action Forum.

This week, the Senate Banking Committee is holding hearings on accountability and transparency of the Financial Stability Oversight Council. In my opinion, the FSOC is a risky venture at best.

Created by the Dodd-Frank (D-F) financial reforms, it is the U.S. version of a “macroprudential regulator” devoted to controlling systemic risk. As a matter of principle, there is no single, simple way to measure systemic risk, so it will be a difficult task to evaluate its job performance.

Moreover, since the economic cost of eliminating systemic risk entirely is prohibitive, the goal will be to get the “right” amount of systemic risk. FSOC can’t measure progress and doesn’t know its target, two good reasons that the U.S. may wish it left macroprudential regulation in the land of academic theories.

The FSOC, in turn, employs the Federal Reserve as its chief regulator. As the FSOC moves from banks to designating non-bank entities as Systemically Important Financial Institutions (SIFIs), this means that the Fed has become a regulator of insurance companies, potentially the regulator of asset managers, and possibly the regulator of every financial entity. The Fed is a world-class monetary authority and quality bank regulator. As it takes on new regulatory duties, however, it will struggle to get the regulations right. In the process, the regulated entities will likely plead their case to Congress, which will in turn put greater scrutiny on the Fed’s activities. The bottom line is that the existence of the FSOC may endanger the independence of the U.S. monetary authority.

These are serious indictments of an FSOC that is doing its job well. The actual FSOC does not. Despite recent improvements, the FSOC process for designating a non-bank SIFI needs an improved analytic foundation, an infusion of quantitative analysis, a respect for other regulators, concern for upsetting the competitive balance in financial products, and a clear path to remove a SIFI designation.

The FSOC began with banks, moved to designating insurance companies (AIG, Prudential and MetLife) and was seemingly poised to march on the asset managers. This institution-by-institution approach missed the key issue: what specific activities or practices generate systemic risks? Activities-based regulation is more comprehensive as it will identify all of the market participants engaged in an activity that could pose a threat to stability. This is better than singling out one or a few large firms or funds for designation.

The good news is that the FSOC has directed its staff to turn its efforts on asset managers toward “a more focused analysis of industry-wide products and activities.” The bad news is that it did not stop the process on the insurance industry for the same reason and instead pursued its designation of MetLife. The inconsistency is transparent and damning.

FSOC also relies too much on hypothetical inquiries and improbable scenarios in its designation process. The focus instead should be shifted toward those risks that have transpired historically and should be informed by their historic size and frequency.

In addition, the FSOC process should be more respectful of the primary regulators of non-bank entities. Insurance industry designations proceeded with little respect for state regulators, and over the objections (in one instance) of the only insurance regulator on the FSOC. Indeed, there is a good case to be made that in addition to a greater role of the primary regulator in the designation process, that regulator should take on the enhanced supervisory role – not the Fed.

The FSOC process has generated instances in which participants in the same industry face very different regulatory requirements, inevitably upsetting the competitive balance that existed. Do the systemic stability gains merit the costs of unequal economic treatment? Under the FSOC process, the question is not even posed, much less answered.

Finally, a SIFI designation cannot be a mandatory, lifetime sentence with no chance for parole. The FSOC must create a process that would permit a firm to address risks to avoid designation. In addition, SIFIs should have a way to “de-risk” after designation, allowing an exit ramp from SIFI status.

In the end, it may be the case that macroprudential regulation is not ready for prime time and the FSOC cannot be saved. In the interim, at a minimum, it should conduct its business in a way that is analytically sounder, better grounded in the data and regulatory history, and providing a clear path away from SIFI designation for non-banks.