Curbing Bad Apples Won’t Erase Contagion Risk

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A federal court decision in March striking down the designation of MetLife as a "systemically important financial institution" has sparked a lively debate on the Financial Stability Oversight Council's ability to prevent future financial crises. But for all the attention paid to the court ruling, it does not directly address what the council must do to succeed.

In the Dodd-Frank Act, Congress wisely gave regulators greater authority to address systemic risk originating outside the banking sector by letting FSOC designate nonbank financial firms as SIFIs. The MetLife decision doesn't remove this powerful tool. Even if the government loses its appeal, FSOC could still take another crack at designating the insurer by addressing flaws in the council's SIFI designation process identified by the courts.

More important, independent of the legal battle, FSOC's designation authority as granted by Congress has several practical limitations.

For one thing, a designation is an either-or decision. FSOC can't designate every large nonbank financial firm, meaning the process is always going to be somewhat subjective.

Even though a firm designated as a SIFI faces prudential requirements that may make it less risky, it posed some amount of market risk before its designation, and will continue to if it sheds the SIFI label. Meanwhile, the system will also include firms with some amount of systemic exposure that do not face the same prudential standards as a SIFI. There is no magic threshold a firm can cross that suddenly makes it systemically risky. We just can't easily put market dangers into a box.

Designation also may simply shift risk rather than reduce it. If a firm restructures itself to attempt to escape its SIFI designation, which has already happened, it is not clear that the overall market will become less risky. As the firm makes divestments, closes units and unwinds certain operations, that risk may simply go somewhere else.

In addition, the designation process is cumbersome and lengthy. Since FSOC should be deliberate in these decisions, slow is not necessarily bad. But the process is not designed to allow FSOC to react quickly to emerging threats. That slowness may be one reason FSOC has justified its designations as necessary for companies that it believes could threaten financial stability if they were to fail, rather than focusing on particular characteristics and activities of companies that make them likely to threaten financial stability.

These shortcomings reveal how systemic threats are more related to the risky activities and products across a range of companies of different sizes and complexity, rather than to a specific set of individual companies deemed the riskiest. Financial crises are generally caused by activities and practices that inflate asset price bubbles that eventually burst.

For example, at its core, the 2007-8 crisis resulted from a housing price bubble inflated by activities like poor mortgage underwriting and excessive leverage at financial firms, and from products like credit default swaps for which risk was drastically mispriced. Speculative frenzies have driven bubble-and-collapse cycles for centuries, from Dutch tulips in the 1600s to dot-com stocks in the late 1990s and early 2000s. Not surprisingly, regulators focus on the riskiest activities and products at the firms they oversee.

Financial regulators may even agree that a focus on activities and products is the best approach. In April, FSOC released a public update on its ongoing review of activities and products provided by asset managers and hedge funds. FSOC could still designate one or more asset managers as SIFIs. However, the council is reviewing specific activities and characteristics that FSOC believes could threaten financial stability, and actions that firms and regulators may need to take to mitigate those risks.

If an activities-and-products approach is a better way to address systemic risk, why has FSOC focused on designation? A key reason is that designation is the only significant power the council has. FSOC can recommend stricter regulation on risky activities by a regulator — which has a seat on the council — but it cannot force a stubborn member agency to act on those recommendations.

The financial crisis showed why systemic oversight to identify and mitigate threats to financial stability is so important. Creating FSOC in Dodd-Frank was a good first step, but like any new agency—and particularly one made up of other agencies with their own mandates and perspectives—we should not expect FSOC to get everything right the first time. We should, however, expect it to keep getting better.

One way for Congress to improve FSOC is to give it additional options to address systemic threats. It is not that designation is never a good option, just that it is not always the ideal one and should not be the only tool in FSOC's toolbox. To the extent that it can, FSOC should try to address systemic threats using an activities-and-products-based approach. To the extent that it cannot, Congress should give FSOC a more diverse selection of tools to address emerging threats.

Justin Schardin is acting director of the Financial Regulatory Reform Initiative at the Bipartisan Policy Center.

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