SIFI Designations Aren't Meant to Last Forever

"We have to be allowed to ask questions," Treasury Secretary Jack Lew argued while defending the Financial Stability Oversight Council's ongoing designation process for systemically important financial institutions in June. Most people would agree with Secretary Lew. But after asking questions, the council should be required to give well-reasoned answers.

At Monday's FSOC meeting, council members said that they would review and work to improve the designation process. One key area for improvement is that the council must provide well-reasoned justifications as to why it chooses to designate a firm as systemically important. The FSOC has thus far demonstrated an inability to provide a convincing answer to this basic question.

The details of the FSOC's rationale for making a preliminary designation of MetLife in September are confidential; regulators have decreed that the information cannot be shared with the public. But informal discussions with insiders suggest to me that the arguments for MetLife's designation are business as usual — meaning that the decision was driven by hypothetical assumptions that cannot be objectively verified or disputed.

MetLife has announced plans to contest the council's designation, and the FSOC agreed to hear the appeal in Monday's meeting. But the administrative appeal process has little chance of success. While MetLife can present its case against designation in a private council session, Secretary Lew and the council have presumably already weighed the relevant points while MetLife was under consideration. And so the appeal amounts to little more than MetLife asking the council, "Are you really really sure you want to designate us?" Since the appeal proceedings are also confidential, the public will not learn anything more specific about why the council thinks that MetLife is systemically important, why MetLife disagrees, or what steps MetLife might take to remove the designation.

Therein lies the biggest problem with the council's designation process. According to my discussions with insiders at multiple designated institutions, the council has never outlined the steps that these institutions need to take to remove their designation.

Insiders say that the confidential justifications for council designation are very general and mostly involve speculation about how the designated firms' investors and policyholders would react in an imaginary crisis scenario. The assumptions about insurance policyholders' reactions are not based on historical evidence from the industry. Rather, the arguments seem to assume that insurance customers will react like bank depositors and withdraw all their resources, even though early policy redemption costs and state insurance safety nets make such behavior foolhardy in practice.

Two insurance companies — American International Group and Prudential Financial — have now been designated for more than a year. According to the provisions of the Dodd-Frank Act, designations should be reviewed annually. AIG's designation was renewed by the council over the summer and Prudential's designation is up for review this fall.

Secretary Lew and the FSOC should ask the Federal Reserve some hard questions before renewing Prudential's designation. After a year of detailed enhanced prudential scrutiny, surely the Fed can offer a more specific justification as to what features make Prudential systemically important. It is unclear whether the Fed has worked with Prudential on a plan that would remove its designation, or if the council and the Fed have even discussed with Prudential's management the steps it must take to remove itself from the systemically important list.

Moreover, Congress should ask Secretary Lew to share the specific requirements that the council has given to each designated institution about what changes would enable them to rid themselves of the SIFI label. The Dodd-Frank Act makes no presumption that council designation is permanent, yet the council and regulators do not appear to have provided a path to a cure.

In the available public record or in discussions with industry insiders, I am unaware of any evidence that the council or the Federal Reserve has been actively working with companies to reduce the size of the designated institutions list. I think even Secretary Lew would agree that Congress has a right to ask the council for this information. More importantly, I hope that the council appreciates the necessity of providing the Congress with a credible answer.

Paul H. Kupiec is a resident scholar at the American Enterprise Institute. He has also been a director of the Center for Financial Research at the Federal Deposit Insurance Corp. and chairman of the Research Task Force of the Basel Committee on Banking Supervision.