Does FSOC have a role to play in coronavirus response?
WASHINGTON — Following the last upheaval in the financial markets, policymakers created an interagency body to serve as an early-warning system to identify future threats before the next crisis.
Yet with the coronavirus now wreaking havoc on the economy, observers are questioning if the Financial Stability Oversight Council is up to the job.
The FSOC was established in essence as regulators' vehicle to address turmoil like that brought on by the pandemic. But the council has been largely silent as the Federal Reserve Board along with the bank regulatory agencies have played a more visible role in responding to the economic fallout from the virus.
“We have a highly fragmented financial regulatory architecture here in the United States and FSOC was designed to provide a place where all of these regulators could better coordinate with one another, manage a crisis response, and they haven't done that,” said Gregg Gelzinis, a senior policy analyst at the Center for American Progress.
Gelzinis and others say efforts earlier during the Trump administration to cut the FSOC's budget and staff, and shift the council's focus away from its most tangible job under the Dodd-Frank Act — subjecting systemically risky nonbanks to stricter supervision — have blunted its mission.
“In the middle of an economic crisis, it's hard to go from having really downplayed or ignored the importance of an agency to turning around on a dime,” said Michael Barr, a former Treasury official in the Obama administration and a law professor at the University of Michigan.
To be sure, many acknowledge that even a stronger FSOC would likely not have been able to alert policymakers about the financial market risks of the COVID-19 pandemic.
"Few predicted a global pandemic as the next threat to the safety and soundness of the economy,” said Thomas Wade, the director of financial services policy at the American Action Forum.
But with the pandemic sparking financial stability questions about the condition of corporate debt, liquidity in the mortgage servicing sector and the duration of a possible recession, the role of FSOC going forward is further under scrutiny.
Some observers wonder if the Trump administration has limited its own ability to react to the current economic turmoil caused by the coronavirus.
Since 2016, the FSOC — which is chaired by Treasury Secretary Steven Mnuchin and includes the heads of all the financial regulatory agencies — has removed the “systemically important financial institution” label from all nonbanks that had been designated under the Obama administration. The FSOC has also dramatically changed the process to designate nonbanks as SIFIs, and shifted its emphasis to identifying risky activities affecting whole sectors instead of individual companies.
Proponents of the activities-based approach say it will help to address underlying sources of risk to financial stability, but critics say the change in strategy makes it more difficult to designate nonbanks in the first place and enables them to operate with less oversight.
“All of these steps really increased risk in the financial system at a time when we should have been doing the opposite,” said Barr. “I'd say overall, the financial system is safer than it was in 2008, but not as safe as it should be — not safe enough. And the choices that the current administration made in the last three years contributed to that.”
FSOC held a public meeting last week in which each of the principals delivered a report on how their respective agencies were responding to economic concerns about the coronavirus.
“FSOC was established as a means of looking at systemic issues and coordinating across the agencies,” said Mnuchin at the meeting Thursday. “We have been using this in a very productive way, but now especially, this is a very important forum for us as we confront a unique situation.”
Mnuchin also said he had asked several FSOC members to form a task force on nonbank mortgage servicing in light of liquidity concerns.
“This is an excellent proactive step on behalf of the FSOC,” Wade said of the task force. He noted that mortgage servicing became a major flashpoint in the 2008 financial crisis.
Yet some question FSOC's ability to deal with stress in the servicing sector because that stress has likely already arrived.
Gelzinis said the council's authority to designate nonbanks and examine risks to the financial system are tools meant to be deployed before crises, not during them.
“If you look at all of the different tools that are then put in place once a firm's designated — the various safeguards, things like capital, liquidity, stress testing, risk management standards, living wills — all of those are prophylactic measures,” he said.
But with the FSOC moving away from designating specific firms for tougher supervision, Barr said that level of oversight is now absent.
“The point of designation as it was conceived in the Dodd-Frank Act was to do that in advance, to do that in good times so that you can supervise the firm and have them build up safeguards and include higher capital in advance,” he said. “That's the whole point that I think the administration didn't get.”
The Treasury Department declined to comment for this story.
Others countered that the activities-based supervision approach could result in similar safeguards but on a wider scale.
Stephanie Brooker, a partner at Gibson, Dunn & Crutcher LLP, said it is too soon to declare that approach ineffective since FSOC only voted to finalize the framework in December. She added that the process to confer a SIFI designation on a nonbank takes several months.
“Putting aside proponents of that approach and detractors to that approach, generally speaking, thinking about it in the context of where we are with the market reaction to the coronavirus, I think it would be premature to make a judgment about [FSOC’s designation activities],” she said.
Meanwhile, designating specific firms right now would be unwise since “you don't want crisis-type reaction to those very impactful decisions,” said Brooker.
Gelzinis agreed that designating nonbanks as SIFIs in this moment could actually put a company on shakier ground.
“If you were to designate a firm now because you think it's likely to experience material distress … then it's essentially a scarlet letter in that you can actually exacerbate the stress at a firm,” he said.
Wade said an activities-based approach is a more effective way for the FSOC to respond to financial stability threats on the ground.
“My view is that for the FSOC to actually have relevance in the coronavirus crisis it would need to ... cover activities, not just individuals, and the entire economy,” he said.
But many have raised questions about the effects of staff and budget cuts over the past three years, particularly at OFR.
“Part of the reason we needed to have [the financial research office] in place is that when things go wrong, new questions arise and we need to be able to ask timely questions and monitor what's happening,” said Kathryn Judge, a professor at Columbia Law School and a member of OFR’s financial research advisory committee.
As of September, OFR Director Dino Falaschetti reported that his office had about 100 employees, down from 220 in 2017. He added during a House Financial Services Committee hearing that he was looking to expand the office to 150 employees.
“I think not having the full capacity of OFR staff definitely hinders regulators' ability to sort of be as informed as possible in real time on what's going on and have the best analysis available to them from a body that's supposed to focus on financial stability, really exclusively across the financial system,” said Gelzinis.
But Judge said it is not too late for OFR and FSOC to do more to address strain in the financial system from the global pandemic.
“Personally, I would love to see the OFR just ramp up its operations in incredibly short order, because I think there's going to be a lot of important policy questions, or we're going to need really good information about where risks are but also the benefits to particular types of interventions,” she said.
Although individual agencies have put out statements and guidance to financial institutions on managing any difficulties due to the coronavirus, the council could also put out a statement itself, said Brooker.
“I think it could be very helpful for FSOC, particularly coming out of this meeting, to issue a formal statement that they believe the financial system can weather the storm [and] that they are committed to financial markets staying open,” she said. “I think that could be very useful, given the agency heads who sit on the FSOC, to have that type of unified statement.”
A group of Democratic members of the House Financial Services Committee, including Chair Maxine Waters, D-Calif., wrote a letter March 11 to Mnuchin urging FSOC to “coordinate an effective response to this urgent matter.”
“It is troubling that FSOC, under your leadership, has not been more responsive to this crisis,” they said.
Barr said he remains hopeful that FSOC can “figure out how to get it back into gear.”
“I hope that they are focused and I hope that they are looking out for risks throughout the financial system and thinking creatively about how to work with the Fed to backstop them, but I don't know,” he said.