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FSOC Lacks Credibility in Designating SIFIs

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As reported in American Banker on June 25, Treasury Secretary Jack Lew defended criticism of the Financial Stability Oversight Council when he told the House Financial Services Committee that “we have to be allowed to ask questions.” In this he is completely correct. There may be a need for a group of federal financial regulators who will get together regularly and ask questions about developments in the economy. A few smart questions by regulators about the build-up of subprime mortgages and mortgage-backed securities in the banking system between 2002 and 2007 might have prevented a lot of trouble in 2008.

But the complaints about FSOC – Rep. Jeb Hensarling, R-Texas, has called it the “nation’s least transparent federal entity” – did not stem from the fact that it is asking questions. They arise because this agency has the extraordinary power to designate financial firms as systemically important financial institutions, or SIFIs, and there is very little evidence available anywhere that it has the ability or desire to use that power other than arbitrarily. Indeed, all the evidence is to the contrary.

The Dodd-Frank Act authorizes FSOC to designate firms as SIFIs if their “material distress” could cause “instability” in the U.S. economy. Firms so designated are then turned over to the Federal Reserve for what appears to be bank-like regulation and supervision. In its three designations thus far—AIG, G.E. Capital, and Prudential Financial—FSOC has manifestly failed to demonstrate that it has any idea how to make these important judgments.

Let’s take the Prudential decision as an example, and look at what FSOC said about one of the key elements of “SIFIness”—the firm’s interconnections with others. The idea underlying the interconnectedness test is that the failure of a large interconnected firm would drag down others, creating a financial crisis. That’s why these firms are turned over to the Fed for special bank-like regulation—to prevent them from failing and, through their knock-on effects, dragging down others.

In dealing with interconnectedness in the Prudential case, FSOC had this to say: 

"Certain of Prudential's activities have a high degree of interconnectedness. The financial system is exposed to Prudential through the capital markets, including as derivatives, counterparties, creditors, debt and equity investors, and securities lending and repurchase agreement counterparties." 

That’s it -- a “high degree of interconnectedness.” Obviously, this statement in itself has no meaning, but nothing accompanied it to give it meaning. All financial firms are interconnected to some degree with others. That’s the way the system works. A “high degree of interconnectedness” is not a standard that will tell any other firm how it should conduct its business so as to avoid endangering others and thus deserving a SIFI designation.

Yet, on the basis of this meaningless statement, FSOC was able to designate Prudential as a SIFI and consign it to bank-like regulation and supervision by the Fed. The fact that no one knows—probably including the Fed—what that regulation and supervision will entail was not considered relevant by FSOC. The public document from which this language is taken is available on the FSOC’s website (www.fsoc.gov), and deserves to be read by everyone concerned about this issue. This 12-page paper is the only information available to MetLife and the asset managers that are now under threat of being designated as SIFIs. With all respect, this is a lot more than simply asking questions.

 It’s not as though it is impossible for FSOC to make its standards clear. Secretary Lew suggested that the information FSOC collected from Prudential was so competitively sensitive that it just could not be made public. OK, but it would be possible for the FSOC to have said; “Prudential’s debt securities are held by, say, five large firms and constitutes more than, say, 15% of their assets. If Prudential were to fail, these five firms would be in danger of failing, so in our judgment Prudential is dangerously interconnected.” 

This statement does not reveal anything about either Prudential or the five firms that anyone who can read a financial statement doesn’t already know. Of course, the fact that any large firm would hold so much debt of another firm is highly unlikely -- a $50 billion firm would have to hold $7.5 billion of Prudential debt in order to be in any danger if Prudential failed -- but it is hypotheticals of this kind that support the case for “interconnectedness.”

Indeed, the whole foundation of the interconnectedness idea — the very basis for Dodd-Frank’s concern about large firms dragging down others -- has been proven false. Lehman Brothers was one of the largest firms in the world. It failed at a time when all firms and investors were worried about the condition of their counterparties, but no other large financial firm failed because of Lehman’s bankruptcy. Even though it was interconnected in some sense, Lehman had no knock-on effects.  To be sure, the Reserve Primary Fund “broke the buck,” but it was not a large firm and the ultimate losses to its shareholders were less than 2%. Interconnectedness sounds plausible, until you think about it. 

Irrespective of the weakness of the interconnectedness idea, the unwillingness of FSOC to set any standards for interconnectedness or anything else is the source of the suspicion it has engendered in Congress. Either it does not want to set any standards for the judgments it will make—despite the fact that these judgments can have major impacts on firms, their shareholders and the economy generally—or the agency doesn’t have the ability to articulate standards for ideas like “material distress”, “instability” or “interconnectedness,”  in which case this emperor has no clothes. It was concerns like this that caused the House Financial Services Committee to vote out a one-year moratorium on SIFI designations.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.  

 

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Comments (2)
Putting the Treasury and Fed in charge of systemic regulation is like putting the fox in to guard the hen house!
Posted by kvillani | Monday, June 30 2014 at 5:47PM ET
What may be more appropriate to the interconnectedness issue and more egregious in turning over financial institutions to bank-like regulation is that of Financial Market Utilities (FMUs). The US's Dodd-Frank legislation defines FMUs as "...multilateral systems that provide the essential infrastructure for transferring, clearing, and settling payments, securities, and other financial transactions among financial institutions or between financial institutions and the system".

The Dodd-Frank Act authorizes the Financial Stability Oversight Council (FSOC) to designate a FMU as "systemically important" if the Council determines that the failure of or a disruption to the functioning of the FMU could create or increase the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the U.S. financial system.

In the US, the FSCOC has established nine (9) such entities as systemically important FMUs. They include:

The Clearing House Payments Company L.L.C.
CLS Bank International
Chicago Mercantile Exchange, Inc.
The Depository Trust Company
Fixed Income Clearing Corporation
ICE Clear Credit LLC
National Securities Clearing Corporation
The Options Clearing Corporation

The Financial Stability Board, jointly with IOSCO, published in January 2014 a consultative document on assessment methodologies for identifying non-bank non-insurer global systemically important financial institutions. The FSB's definition of SIFIs is "...institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity". In our response we emphasized that financial institutions, whether already designated SIFIs or not are globally connected through a vast array of networks and computers collectively referred to as the 'global financial system'. We suggested the interconnectedness criterion was better defined around systemic risk as in a computer and communications definition of systemic. See our public response at http://www.financialstabilityboard.org/publications/r_140423u.pdf.
Posted by Allan Grody | Tuesday, July 01 2014 at 1:21PM ET
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