The Biden administration is eager to loosen guidelines that would make it easier to subject asset management firms to elevated levels of regulation. The Financial Stability Oversight Council’s proposed guidance document and analytic framework roll back improvements made in 2019 under the Trump administration.
FSOC was created by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) as a response to financial instability emanating from the 2008 financial crisis. The Dodd-Frank Act allows FSOC to designate certain nonbank financial firms, such as asset managers, stablecoin issuers, hedge funds, mortgage companies, insurance companies, and private equity funds, as systemically important financial institutions (SIFIs) subject to prudential regulation and oversight by the Federal Reserve (Fed). This would allow the Fed to set capital and liquidity requirements, and leverage limits on these firms—restricting the return potential nonbanks can offer investors and retirees.
Designation of nonbanks by FSOC would be a gross expansion of the Fed’s regulatory authority over the financial sector. The Fed lacks accountability to Congress. It does not receive Congressional appropriations and members of the Board of Governors may only be removed “for cause” by the President if there is a reason to remove the board member, such as for “inefficiency, neglect of duty, or malfeasance in office.” Enhancing the Fed’s authority over new firms, many of which are already regulated by the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC), would bolster the executive branch’s control over nonbanks with little input from the elected officials in Congress.
The Dodd-Frank Act intended for FSOC to designate nonbanks as SIFIs if they have “material financial distress” or conduct activities that “pose a threat to the financial stability” of the U.S. New bank regulations as a result of the Dodd-Frank Act limited banks’ ability to engage in certain lending practices because of the enhanced capital requirements that accompanied the rules. The government wrongly clipped banks’ wings and a new organic source of lending sprouted from private credit funds.
The Fed’s recent review of financial stability found that although private credit funds have grown “rapidly” since the 2008 financial crisis, “the funds typically use little leverage, and investor redemption risks appear low.” Additionally, the instability of money market funds (MMF) is “highly misleading.” In fact, certain SEC regulations, such as allowing funds to impose liquidity fees or redemption gates, “may have contributed” to MMF runs during the COVID-19 pandemic.
Instead of subjecting these funds to the Fed’s regulatory purview, the SEC should remove regulations that created the self-fulfilling instability in the first place.
The most egregious change from FSOC’s 2019 guidance to the newly proposed guidance, is the removal of a cost-benefit analysis conducted prior to any nonbank SIFI designation. The proposed guidance contravenes MetLife, Inc. v. Financial Stability Oversight Council. The rulings of the case were incorporated into the 2019 guidance to mitigate governmental overreach and understand the benefits and costs of additional regulation on nonbanks.
The ruling in the MetLife case found that “FSOC failed to consider the costs associated with designating MetLife as a SIFI.” The court also cited Michigan v. Environmental Protection Agency, stating that FSOC needed to account for the cost of designating MetLife as a SIFI because “No regulation is ‘appropriate’ if it does significantly more harm than good.”
FSOC also issued an analytic framework that highlights key factors that may be assessed when evaluating nonbank designations. The risks outlined in the vague analytic framework are prospective and lack evidence to substantiate claims that some of the factors warrant prudential regulation. The framework even admits that “Empirical data may not be available regarding all potential risks.”
Congress should pass legislation to rein in FSOC’s authority. Rep. Andy Barr (R-Ky.) has a bill to force FSOC to be more transparent with Congress. The bill also gives Congress the option to overturn certain nonbank designations by establishing a process for voting on a joint resolution of disapproval. Congress should also consider codifying the cost-benefit analysis from FSOC’s 2019 guidance.
If the recent bank failures taught policymakers anything, it is that the Fed has already bitten off more than it can chew. Empowering the Fed’s unaccountability and inadequate supervision are a recipe for disaster that should be avoided at all costs.