They would give regulators greater ability to reward their political allies and punish their enemies.
They would give regulators greater ability to reward their political allies and punish their enemies.
T he Financial Stability Oversight Council (FSOC) has proposed changes to the process by which it designates non-bank entities as systemically important financial institutions (SIFIs).
SIFIs are considered “too big to fail” since interruptions to their activities would result in severe disruptions to the financial system. In times of crisis, they are likely to receive bailouts and subsidies. But, as a matter of course, they are subject to heightened regulations or “enhanced supervision and prudential standards” intended to stop a crisis arising in the first place.
The FSOC proposal could politicize the designation process by giving regulators tremendous discretion over SIFIs. It could also push designated companies to take more risk than they otherwise would, creating a moral-hazard problem.
The SIFI-Designation Process
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created FSOC and charged it with the identification and regulation of non-bank SIFIs. It dictated a company’s risk would be judged on several factors, including its leverage, size, scale, interconnectedness, the nature and mix of its activities, and its importance as a source of credit for the financial system and broader economy.
FSOC revised the designation process in 2019 to be more transparent. Specifically, the revisions require the agency to conduct cost–benefit analysis and to focus on business activities that might pose a risk to the financial system.
In April of this year, FSOC proposed revisions to the SIFI-designation process that would undo many of the changes from 2019. The council recently met to discuss the proposal and reportedly aims to finalize it by the end of the year.
Cloudy Criteria
The FSOC proposal would make three key changes to the designation process, each of which will reduce transparency and increase regulatory discretion. Two of the key changes address the criteria for SIFI designation and could impede the fair and unbiased assessment of financial risk.
First, FSOC would employ a holistic assessment rather than the activities-based approach. It would no longer look at specific risks but would instead make more subjective, big-picture judgments. For example, a company that is highly interconnected in the financial system might be deemed a SIFI for strictly precautionary reasons, even if not engaged in risky business activities. Regulators, after all, have the incentive to be overly restrictive since they are blamed when things go wrong but are not rewarded when things go right.
Second, FSOC would not consider the probability that an entity could fail, only the potential consequences that might beset the financial system if it does. The process would no longer require that the economy “would” be adversely affected if the company were to fail, only that it “could,” in theory, pose a threat to financial stability.
These changes would tend to emphasize firm size rather than risk. They could result in asset managers like Fidelity Investments and BlackRock, Inc. being labeled as SIFIs despite posing little, if any, risk to the financial system.
At What Cost?
The third key change is that FSOC will no longer conduct cost–benefit analysis in identifying non-bank SIFIs or on the regulations applied to them. The proposal argues that cost–benefit analysis is unnecessary because it (mistakenly) assumes that regulations always reduce financial risk.
“For example,” the proposal states, “risk-based capital requirements . . . would reduce the risk the company poses to the financial system.” In fact, complex risk-based capital rules are known to increase financial risk and are an ideal example of why regulatory cost–benefit analysis is necessary.
In the same way that a complex tax code creates loopholes that can be used to avoid a high tax burden, complex regulations can be exploited by banks to increase risk while avoiding the burdens of regulation. This means complex regulations are worse, not better, at reducing financial risk. Researchers at the Bank of England, the International Monetary Fund, the World Bank, and even the Federal Reserve Bank of New York have all found that simple leverage ratios are better predictors of bank risk than complex risk-based capital rules.
In addition, complex capital rules can encourage companies to increase their risk exposure. The rules implicitly assume central banks know the riskiness of every asset in the financial system. But they don’t.
The perverse incentives of risk-based capital standards are viewed by many as a major cause of the 2007–09 financial crisis. Regulators wrongly believed mortgage-backed securities (MBSs) and asset-backed securities (ABSs) to be among the safest assets banks could own. Their complex rules encouraged banks to significantly increase their MBS and ABS holdings. We all know what happened next.
Proper cost–benefit analysis (better referred to as “regulatory-impact analysis”) could have helped minimize or avoid this financial catastrophe. By neglecting it, the FSOC process may increase systemic risk.
Regulatory Discretion
FSOC’s proposal would give regulators greater discretion to identify, regulate, and potentially break up non-bank SIFIs. This is especially concerning because regulators have misused such authority in the past: There are far too many examples of regulators using their discretionary powers to reward groups they like and punish those they dislike.
A decade ago, in Operation Choke Point, bank regulators pressured banks not to lend to politically unpopular industries like payday lenders, tobacco producers, and gun companies. Now, they are going after crypto companies and any business deemed to be at risk (directly or indirectly) from climate-change concerns. This process risks channeling financial resources based on political judgment rather than market demand. It harms the average American while benefiting regulators, politicians, and lobbyists.
Regulators exercised discretion this year in bailing out the uninsured depositors of failed Silicon Valley Bank (SVB). Those deposits were largely owned by tech start-ups and venture-capital funds. Though SVB clearly did not pose a systemic risk to the banking system, FSOC retroactively labeled it a SIFI in order to legally justify bailing out SVB’s uninsured depositors and passing the expense to FDIC-insured depositors, most of whom fall far below the $250,000 limit for insured deposits. Regulators used their powers to bail out Silicon Valley billionaires at the expense of ordinary depositors.
FSOC’s proposed changes to the SIFI-designation process would not make the financial system safer or bailouts less likely. They would give regulators greater ability to reward their political allies and punish their enemies. Perhaps that’s the point.