The Financial Stability Oversight Council and the Federal Reserve Board seem to think the Dodd-Frank Act opens the door to Fed supervision of any nonbank financial company designated by the FSOC as a systemically important financial institution. But a close read of the Dodd-Frank Act indicates this is not the case.

Dodd-Frank authorizes the Fed to supervise a nonbank SIFI only if the Fed imposes "more stringent" prudential standards on the company than would otherwise apply. The more stringent standards must include bank capital standards and be necessary "to prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions."

The intent is not for the Fed to duplicate the supervision of nonbank companies that already are well-regulated by another government agency. Absent more rigorous standards, the Fed has no authority under the Dodd-Frank Act to supervise a nonbank company as a SIFI and, correspondingly, the FSOC has no authority to designate it as a SIFI.

The Fed has yet to adopt stricter standards for nonbank SIFIs and therefore lacks any proper statutory basis to regulate them. The agency recently announced enhanced supervisory standards for large bank holding company SIFIs, but these standards do not apply to nonbank companies. The Fed sensibly recognized that nonbank SIFIs may have a diverse range of businesses, structures and activities and thus the enhanced prudential standards applicable to bank holding companies may not be appropriate for all nonbank SIFIs. Nevertheless, the Fed said that it intends to assess the business model, capital structure and risk profile of nonbank companies to determine how the proposed standards should apply — but only after the company has been designated as a SIFI by the FSOC.

The Fed's approach puts the cart before the horse and upends the SIFI designation process. No company should be designated a SIFI before the FSOC knows what "more stringent" prudential standards the Fed will apply to it. In order to make a defensible SIFI designation, the FSOC needs to analyze how the standards would mitigate risks to financial stability, weigh the necessity of those standards and determine whether the standards are in fact stricter than the rules to which the company is already subject. To date, such analysis has been absent from the FSOC's nonbank SIFI designations.

In the case of insurance companies and asset management firms such as mutual funds, it is difficult to envision what tighter standards the Fed could impose that are not already applicable — or could be made applicable by the primary regulator — under existing law. Even assuming the Fed has the technical expertise to supervise these types of companies — which are very different from banking organizations the Fed has traditionally supervised — the compliance and other costs of subjecting them to bank-like regulation could outweigh the intended public benefits.

The FSOC's authority to designate SIFIs is not a license to blindly assign nonbank companies to general Fed supervision. SIFI designation has the potential to adversely affect a designated company as well as its customers and the financial system as a whole. Moral hazard, competitive imbalances, and increased costs to consumers for financial services are possible outcomes. 

The capital markets tend to view a SIFI designation as a sign the company is "too-big-to-fail," a perception that may give the company funding advantages over its competitors and a more relaxed attitude to risk management. At the same time, heavy regulatory compliance burdens may make it uneconomical for a nonbank SIFI company to continue offering some financial products, lessening competition and the availability of cost-efficient financial services in the marketplace.

SIFI designation could even mean the demise of some business lines or models that have operated successfully for decades. It is unlikely, for example, that money market funds — which are safer than bank deposits for many investors — could survive SIFI designation and the imposition of mandatory capital rules, which are fundamentally incompatible with the way such funds operate. Bank capital rules also are highly problematic for asset managers and insurance companies, as the Fed lately has discovered.

The "shoot first, ask questions later" approach adopted by the FSOC and the Fed is fraught with these and other potential unintended consequences. The FSOC has authority to recommend that the primary regulatory agencies adopt specific regulations to address perceived financial stability problems at nonbank financial firms. It should use that authority to promote regulatory solutions through the existing framework rather than designate SIFIs for uncertain, open-ended supervision by the Fed with the possibility of doing more harm than good.

The Dodd-Frank Act had no intent of authorizing the FSOC to go on regulatory fishing expeditions or to single out well-regulated nonbank financial firms for disparate supervisory treatment, experimentation, or elimination. SIFI designations without an analysis of how the Fed's specific supervisory standards will mitigate risks to financial stability are open to legal challenge.

Melanie L. Fein is a former senior counsel to the Federal Reserve Board, now in private practice.