BankThink

Lowering the bar on financial regulation is fraught with risk

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The Financial Stability Oversight Council’s recent proposals to retreat from supervising certain large nonbank financial companies would unnecessarily expose Americans to damaging instability in the financial system and economy.

Former Federal Reserve Chairs Janet Yellen and Ben Bernanke, and former Treasury Secretaries Timothy Geithner and Jacob Lew — all former FSOC members — recently expressed similar warnings.

The financial crisis showed how a piecemeal approach to regulation allows risks to slip between the cracks. So the Dodd-Frank Act established the FSOC to take a broad view of the entire financial system, to assess risks in both banks and nonbanks, and the activities in which they engage. Doing so requires examination and oversight of both.

However, the FSOC now proposes to raise the hurdle for enhanced supervision of large, systemically important nonbank financial companies, or NBFCs, far too high. As a result, it would focus almost exclusively on the financial activities that could threaten financial stability.

We applaud identifying and examining such activities. But risk assessment should begin, not end there. A focus on both activities and entities — not one or the other — is needed. By neutering its authority to designate nonbanks as systemically important institutions, the FSOC would eliminate an important deterrent to excessive risk-taking.

Indeed, were the failure of a large, complex and interconnected nonbank again to threaten widespread financial collapse, a future government would almost surely renege on today’s promise not to engage in bailouts. The appropriate oversight and supervision that would come with this designation is the FSOC and its members’ only means to make sure such risky financial entities self-insure, rather than depend on taxpayers in a pinch.

Critics of NBFC supervision see adverse consequences of the FSOC’s designation authority. They object to the Fed’s supervising of NBFCs. They argue that the Fed Board lacks the knowledge and expertise of the NBFCs’ primary regulators (e.g., the Securities and Exchange Commission or state insurance commissioners) to supervise broker-dealers or insurance companies. And the critics argue that the Fed will impose banklike regulatory measures that are inappropriate to mitigate risks in nonbank financial companies.

While the critics have legitimate points, sacrificing the designation authority is unwise. Instead, the FSOC should urge the Fed and other FSOC members to develop a framework for oversight and supervision that is effective, efficient and tailored for nonbanks. The existence of such a credible designation authority can deter firms from adopting risky business models or activities. And it will help the primary regulators of broker-dealers, insurance companies and other institutions to improve their monitoring of risky activities and of those firms that contribute most significantly to those risks. Ineffectiveness on either front could still lead to entity designation; credibility would require it.

Importantly, even strong critics of a nonbank systemically important financial institution, or SIFI, designation don’t object to designating Fannie Mae and Freddie Mac. The issue is not some doctrinal opposition to examining entity-based risks and vulnerabilities of nonbank institutions; it is about how high to set the hurdle. On that front, the financial crisis showed that there was then a small number of large, complex and interconnected nonbanks that belonged in the SIFI class. Without examination and oversight, one cannot know how many exist today.

Finally, asserting that the FSOC will focus on activities is one thing, but implementing this focus is another. The FSOC’s proposal offers no implementation plan. We urge the FSOC to swiftly articulate how it will identify and address activities that threaten financial stability. Market participants and the firms and markets in which they operate need to understand the governance and rules of the game for regulation. Otherwise, it will create either unneeded uncertainty or a cynical suspicion that officials are simply using an activities fig leaf to cover de facto deregulation.

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