Mnuchin's ill-advised plan on nonbank SIFIs
In March, the Senate passed the Economic Growth, Regulatory Relief, and Consumer Protection Act, which raises Dodd-Frank’s asset threshold — above which banks face enhanced regulatory standards — from $50 billion to $250 billion.
But the $50 billion threshold for banks is not the only one of its kind under threat.
Treasury Secretary Steven Mnuchin, who heads the Financial Stability Oversight Council, said at a January hearing that he intends to raise a lesser-known $50 billion threshold if the Senate legislation is enacted. This threshold is used by the FSOC to narrow the universe of companies considered in the first stage of the council’s multistage designation process for systemically important nonbank financial companies.
Increasing this threshold fivefold would allow massive asset managers, hedge funds and other nonbank financial companies to escape even a cursory look as to whether they pose financial stability risks. Mnuchin also included this recommendation in a November 2017 Treasury report — and the FSOC can make this change without legislative approval.
The FSOC was created by the Dodd-Frank Act to help identify and mitigate threats to financial stability — particularly those that emerge outside of the traditional banking sector. The collapse of nonbank financial companies like AIG, Lehman Brothers, Bear Stearns and Merrill Lynch during the 2007-08 financial crisis made it clear that these systemically important nonbanks were drastically under-regulated. Dodd-Frank gave the FSOC the authority to subject such nonbank financial companies to enhanced oversight by the Federal Reserve Board.
Unlike with systemically important banks, Dodd-Frank did not provide any statutory quantitative thresholds above which nonbank financial companies would be considered systemically important. The FSOC has the discretion to designate companies based on its analysis of whether material distress at the company — or the nature, scope, size, scale, concentration, interconnectedness or mix of the activities of the company — could threaten financial stability.
In implementing Dodd-Frank, the FSOC established a thorough, three-stage review process for designating nonbank financial companies as systemically important. In Stage 1, the FSOC applies a series of general quantitative thresholds to narrow the universe of companies that could merit further scrutiny; a company that triggers the quantitative thresholds in Stage 1 may be advanced to Stage 2. During Stages 2 and 3, the FSOC performs deeper analyses of the company and relies on increasingly detailed data and information — while coordinating with the company and the company’s regulators throughout the latter stages of review.
Secretary Mnuchin’s comments about raising the $50 billion asset threshold for nonbank financial companies were in reference to the Stage 1 quantitative thresholds. Under the current Stage 1 guidance, a company will trigger the quantitative thresholds if it has $50 billion or more in total consolidated assets and meets an additional quantitative metric pertaining to the company’s derivatives liabilities, debt outstanding, leverage, short-term debt ratio or credit default swaps outstanding that reference the company. If a company meets the asset threshold and one of the additional metrics, it may be advanced to Stage 2. So, these Stage 1 thresholds are simply used to determine which companies, in the vast universe of nonbank financial companies, warrant additional attention from the FSOC in the designation process.
By raising the $50 billion threshold to $250 billion, which the FSOC can do without legislative approval, a large swath of nonbank financial companies will fall off the council’s radar screen. A quick look at some of these companies makes it clear that raising the threshold would be a serious mistake.
Asset management firms have relatively small balance sheets compared to the total amount of assets they manage for clients. For example, BlackRock manages over $6 trillion in assets for its clients, but has a much smaller, $220 billion, balance sheet. If the Stage 1 asset threshold is increased to $250 billion, the largest asset management firm in the world may not even receive a first glance as to whether material distress at the company could threaten financial stability.
Under the Obama administration, the FSOC highlighted potential channels through which the asset management industry could disrupt financial stability — so not even taking a preliminary look at the largest asset managers would be an abdication of the FSOC’s mission.
At the same time, the council also pointed to the hedge fund industry as meriting a closer look. Yet Long Term Capital Management — a systemically important hedge fund that was bailed out in 1998 — had $125 billion in gross assets and would not trigger a $250 billion asset threshold.
It is troubling that the regulatory body tasked with identifying and mitigating risks to financial stability might not even consider subjecting an asset management firm or highly leveraged hedge fund to enhanced oversight. Reasonable minds can debate whether any current asset manager or hedge fund meets the designation criteria, but to not even look at these firms is inexcusable.
Unfortunately, this is simply one of the many ways Secretary Mnuchin is eroding — or proposing to erode — post-crisis financial stability safeguards for systemically important nonbank financial companies.