FSOC is too political to be taken seriously

Published in American Banker.

The Financial Stability Oversight Council is a political body masquerading as an analytical one. A dubious creation of the Dodd-Frank Act, it reflects that law’s urge to expand the power of bureaucrats, in turn reflecting the implausible credo that they can control “systemic risk” because they know the financial future better than other people. They don’t.

The expected result of a committee of heads of federal agencies chaired by the Treasury secretary is a politicized process. This was undoubtedly the case with the council’s attempt to designate MetLife as a “systemically important financial institution.” It should not be surprising that a U.S. District Court judge threw out the designation, ruling that it was “arbitrary and capricious,” and “hardly adhered to any standard when it came to assessing MetLife’s threat to financial stability.” In dissenting from the council’s action on MetLife, S. Roy Woodall — the FSOC’s statutorily required independent member with insurance expertise — said the designation relied on “implausible, contrived scenarios.”

Decisions concerning “systemic risk,” an unclear term in any case, cannot be purely analytical and objective. They involve generalized and debatable theories. They are, to a significant extent, inherently judgmental, subjective and political. The FSOC effectively sits as a miniature, unelected legislature. That is a bad idea.

The fundamental problem is the structure of the FSOC as designed by Dodd-Frank. To begin with, it is chaired by the Treasury secretary, a senior Cabinet member who always has major partisan interests at stake. No company can be considered for SIFI status without the Treasury secretary’s approval. This means that, by definition, the FSOC’s work is not a disinterested, analytical process. An administration is positioned to pick winners and losers. Under the Obama administration, MetLife was in the crosshairs, but Fannie Mae, Freddie Mac and Berkshire Hathaway were off-limits.

Meanwhile, most other FSOC members are heads of independent regulatory agencies, strongly motivated by bureaucratic self-interest to defend their jurisdictional turf from intrusions by the others, and to defend their regulatory records from criticism.

This conflicts with the ostensible purpose of the FSOC: to provide the combined substantive deliberation and development of insights into evolving risks from a diverse group of officials. The expectation that that purpose could be achieved was naive. When I asked one former senior FSOC official from the Obama administration if the meetings of the FSOC members had ever provided a new insight, he gave me a candid answer: No. One can hypothesize that the authors of Dodd-Frank were in fact not naive — that they welcomed another way to expand the reach of the administrative state.

The FSOC’s decision-making authority grants significant regulatory power to Treasury, as well as to members who help decide which firms are SIFIs and which are not. But that’s only the beginning, since the designation process also grants enormous power to the Federal Reserve. If an insurance company becomes designated by the FSOC, it falls under the Fed’s supervisory authority, even though the Fed has little or no experience in insurance regulation. Every head of the central bank who participates in FSOC designations is an interested and conflicted party in discussions that result in expanding the Fed’s authority. The politicization also leads the FSOC to ignore companies that more objectively deserve the SIFI label. The most egregious case of this, of course, is the council’s utter failure to address Fannie Mae and Freddie Mac, which are without question very systemically risky. On top of being huge, they are incarnations of these systemic risk factors: highly leveraged real estate and the moral hazard created by government guarantees.

Dodd-Frank assigns the FSOC the task of “eliminating expectations on the part of shareholders, creditors and counterparties that the Government will shield them from losses.” But Fannie and Freddie are pure cases of the government shielding creditors and counterparties from losses. But the staff of the FSOC was ordered not to study them—a bankruptcy of the FSOC’s intellectual credibility.

It appears that the FSOC has so much baggage that the best approach is simply to scrap it. If a truly independent, analytical systemic risk regulator is desired, it should be created outside of the Treasury’s political control.