Dodd-Frank's Risk 'Council' Is Just an Unfocused Bureaucracy

Given that Congress has been unable to pass even modest changes to the Dodd-Frank Act, one may think lawmakers would be hesitant to consider revamping such a major creation of the 2010 law as the Financial Stability Oversight Council. But on the contrary, House Financial Services Chairman Jeb Hensarling has announced he will propose broad changes to Dodd-Frank this year, and since he, and many members of his committee, have expressed deep concerns with the FSOC, its reform will certainly be up for debate.

Let's look at just how we arrived at the current FSOC. Even before a systemic regulator was proposed by President Obama as part of this big reform package unveiled in June 2009, an FSOC-like concept was under discussion. Both Federal Reserve Board Chairman Ben Bernanke and Sheila Bair, then chair of the Federal Deposit Insurance Corp., had proposed systemic oversight powers ahead of Obama's plan, and the American Bankers Association supported the concept of a systemic regulator in March of that year. However, the ABA did not have in mind the type of entity that the FSOC ultimately became. Testifying before the House committee for ABA in July 2009, I supported a systemic oversight counsel, but I said it "should be focused and nimble." I said the council "should not be a large bureaucracy, but rather it should have a small staff" dedicated to the function of "searching for and identifying potential systemic problems."

While ABA and others were advocating a small council with a narrow focus, the original Obama plan went further. It proposed a "Financial Services Oversight Council" consisting of eight agency heads, with a mandate to "facilitate information sharing and coordination, identify emerging issues, [and] advise the Federal Reserve on the identification of firms whose failure could pose a threat to financial stability." Note that the administration plan had the Fed, not the FSOC, designating "Tier 1" institutions that would be subject to stronger regulation. Once the administration opened up the membership of the council to an unwieldy list of agencies and broadened its scope, it should come as no surprise that Congress, doing what it does best, increased the council's size to a ridiculous 14 members (including 10 voting members), gave it even more powers (including designating "systemically important financial institutions"), and created a large staff to crunch data in the new Office of Financial Research.

But since then, the council has demonstrated why that expansion was misguided. The FSOC should be downsized and focused on potential systemic problems, and not on other issues such as SIFI designations — in other words, restored to the original concept ABA and others supported.

The question which led to the FSOC's creation was basic: How could the government have failed to focus on and respond to the incredible growth of unsafe mortgages? The answer was there was no one focused on looking out across all sectors of the economy to see problems developing. Each agency, focused on its particular narrow part of the overall mortgage picture, missed the signs. The solution was, or should have been, to create a "focused and nimble agency" to identify such problems and advocate solutions.

The FSOC, as currently designed, will not accomplish this critical mission. Given its structure and authorities, over time it will lose the needed focus. Its reports will become routine and largely ignored. In fact, its reports already receive little public attention. And it will become bogged down in the bureaucratic infighting that has already started. This loss of focus is what happens in poorly designed bureaucracies (including in the private sector). This is why we have the Flint water crisis and the debacle in the Department of Veterans Affairs. A small, focused FSOC would be much more effective on the critical function of identifying and heading off potential systemic disasters.

What should a new FSOC look like? There are a number of options. For example, it could consist of the Treasury secretary, the heads of the Fed and Securities and Exchange Commission, and two public members. It should have a staff like the Office of Financial Research, but smaller and with a more focused mandate.

What about the FSOC's current function of coordinating deliberations among regulators on systemic risk issues? That can revert to the Treasury's coordination council that existed before Dodd-Frank, which could bring in participants depending on the particular issue at hand. No one who has attended an FSOC meeting can argue that it is an effective coordinating body.

And then the big question — what about designating SIFIs? During the debate on Dodd-Frank, I argued on behalf of ABA against the concept of designating firms as systemically important. As we had predicted, designation is read by some as meaning the firms are really too big to fail, by others as a bullseye for onerous one-size-fits-all regulation and government mandates. The reform law broadened that bullseye by saying all bank holding companies with at least $50 billion in assets are automatically subject to SIFI-like regulation, reinforcing Dodd-Frank's faulty message that all banks above a certain size are suspect.

Dodd-Frank's asset-size thresholds, which are part and parcel of the designation concept, are not surprisingly taking on a life beyond regulation, for example when Congress — to pay for highways — recently slashed the Federal Reserve dividend payments to banks above a minimum asset threshold. The designation and threshold concepts also have led to a lowest-common-denominator regulatory approach that fails to take into account great differences between institutions in their business models and riskiness. Incredibly, this approach actually penalizes less-risky institutions.

Eliminating an arbitrary designation process would not mean that systemically risky firms would be less regulated. It would just mean that the various components of regulation — extra capital and liquidity requirements, stress tests, etc. — would be applied to companies based on their individual risk profiles, rather than what prefabricated basket they are thrown into.

The FSOC, as currently structured, is highly likely to fail to identify and address the next crisis. In the meantime, Dodd-Frank's approach to systemic regulation is calcifying much of our banking industry.

Edward Yingling is senior counsel at Covington & Burling. Previously, he was president and CEO of the American Bankers Association.