Is Dodd-Frank council evolving, or throwing in the towel?

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WASHINGTON — When the Financial Stability Oversight Council proposed new guidance in March, the interagency body was signaling a clear change in approach to combating nonbank systemic risks: focus on activities, not individual firms.

The proposal would mean the FSOC spends less time targeting specific firms for new supervision. They would spend more time pinpointing risky behavior across the markets and directing prudential regulators to target that behavior in their oversight. At a meeting to unveil the proposal, Treasury Secretary and FSOC Chairman Steven Mnuchin said the new approach "would rely on the expertise of existing regulators to address potential risks.”

But critics say the proposal — and its emphasis on regulating activities instead of designating firms as "systemically important financial institutions" — would make the financial system riskier. The council's designation power under the Dodd-Frank Act filled a void, they say, and giving prudential regulators a greater role is a recipe for disaster.

"The prospect that regulators will accurately identify and appropriately regulate all such risky activities ex ante, I think, is pretty far-fetched,” said Jeremy Kress, a business law professor at the University of Michigan.

The council says it is not taking SIFI designations completely off the table. The new proposal would establish clearer guidelines for how it vets specific firms. "The proposal would enhance the council’s process for evaluating individual nonbanks companies for designation by increasing transparency and analytical rigor,” Mnuchin said.

But supporters of the SIFI designation powers say the change in direction undermines the FSOC's relevance.

“Today, FSOC appears to be closed for business,” Senate Banking Committee ranking member Sherrod Brown, D-Ohio, said during a hearing in March. “The FSOC has all but given up its role as the agency tasked with identifying and constraining excessive risk in the financial system.”

Kress said the chief problem is that the council’s statutory authority over activities is considerably weaker than its authority to designate whole firms. Dodd-Frank gives the FSOC the power to “recommend” that primary regulators issue rules for a nonbank activity. If those rules are not forthcoming, the council can refer the matter to Congress. Even in ideal circumstances, that assumes the regulators already have detailed knowledge of the nature of the impending systemic risk.

“By simply regulating activities you can't prevent AIG and Bear Stearns and Lehman Brothers from failing,” Kress said. “There are a lot of different activities that we know about — and others that we don't know about — that can create systemic risk."

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The other troubling aspect of the proposal, he added, is that it effectively makes it impossible for the council to designate a nonbank as a SIFI as a preventive measure. The proposed requirement that the council demonstrate that a company poses a risk of insolvency and produce a cost-benefit analysis are conditions that could only be met if a company were already in financial distress.

“FSOC effectively says we are going to take nonbank SIFI designations off the table,” Kress said. “Not only are we going to use activities-based regulation as our first option, but we are going to make it eminently harder for any future council to designate a nonbank SIFI. I think that's deeply misguided and that's what I'm most worried about here.”

Federal Reserve Chairman Jerome Powell addressed that concern during the March FSOC meeting, saying that although the nonbank designation power should be used “sparingly,” the proposal “preserves” that power, which will “remain an important tool for addressing financial stability risks.”

David Portilla, a partner at Debevoise & Plimpton who worked at Treasury when the FSOC was being established, said a shift toward activities-based regulation of nonbanks is the logical evolution of the council. The purpose of the designation authority was to spur changes in designated firms to make them less risky, and in many respects that approach has succeeded, he said.

“The FSOC isn't meant to be constantly searching for companies to designate and designating them,” Portilla said. “If that was the case, that would show not that the FSOC is doing its job, but that there's something wrong with the financial regulatory structure more broadly. Because there shouldn't be a multitude of companies that are unregulated that present risks to financial stability.”

The appropriate role for the council been debated ever since Dodd-Frank became law. Not only is it still unsettled whether the council should have a designation-first approach versus an activities-first approach, but some question whether its structure comprising the heads of the various regulatory agencies lends itself less to jurisdictional turf wars.

“In my judgment at the time" the FSOC was established was that "it was not well constructed,” said Alex Pollock, a senior fellow at the R Street Institute. “It's set up to be naturally a logrolling [operation] among bureaucratic agencies. It's a very hard kind of structure to get to work well, because everybody wants to defend his own territory from encroachment by somebody else.”

Gregg Gelzinis, a policy analyst at the Center for American Progress, said the most comprehensive way to improve regulators’ ability to foresee and prevent financial crises would be a more wholesale consolidation of the U.S. regulatory apparatus. But the FSOC is the next best thing given the political climate, he said. Dodd-Frank merged the former agency regulating federal thrifts into the Office of the Comptroller of the Currency, but more ambitious consolidation ideas were abandoned.

“I think in a perfect world, we would consolidate the banking system, and some other countries provide sort of a useful way to think about how to do that,” Gelzinis said. “But that's not going to happen. If after the worst financial collapse since the Great Depression we were only able to eliminate the Office of Thrift Supervision … then I highly doubt we'll be able to simplify and consolidate our regulatory architecture going forward.”

Gelzinis added that, given the structure of the FSOC, he hopes a more progressive future FSOC does not shy away from designating nonbanks as SIFIs, even if those designations might be challenged in court.

“I don't think the next progressive FSOC should see the designation process and the potential legal battles as a headache and not worthy of the time and resources, because it is,” Gelzinis said. “Subjecting a firm outside of the traditional banking system … to enhanced liquidity requirements, capital requirements, living wills, stress testing — all of that is extremely important and really can promote the stability and the resilience of the financial system.”

Pollock said the council’s ability to prevent crises should not be the sole criteria for judging the shift toward an activities-based approach, because the alternative of designating firms one by one might not succeed, either.

“I think it's worth a try. I think the whole thing is worth a try,” Pollock said. “This is hard to do. The world is full of tens of thousands of really smart people working at [financial stability questions] all the time. Well, how are you going to see this better than they do? Well, it's worth a try, and I think the activities-based [approach] is definitely worth a try.”

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