Financial Stability Oversight Council Reform Or Abolition?

Richard Christopher Whalen

Kroll Bond Rating Agency; Villanova Finance Department Advisory Committee; Economic Advisory Committee of FINRA; Association of Private Enterprise Education (APEE); National Association of Business Economists (NABE)

April 4, 2016


FSOC Reform or Abolition: The Financial Stability Oversight Council was created by the 2010 Dodd-Frank law to focus a single agency of government on the issue of predicting the sources of financial instability, but it has become an agent for destroying investors value in the financial markets by virtue of its power to designate non-banks as being systemically significant. The existence of the FSOC has arguably not made markets any safer and, along with the other provisions of Dodd-Frank, the FSOC has in fact contributed to a reduction in credit creation and liquidity. The FSOC has led to several large non-bank firms (Metlife & GE) exiting important markets such as home mortgages and consumer credit. There is no practical reason for the FSOC to exist apart from the fact that residents of Washington still seem to believe that they can legislate economic outcomes. This paper argues that, in view of these shortcomings, eliminating the FSOC should be the first priority for the next administration of either party.

Financial Stability Oversight Council Reform Or Abolition? – Introduction

This paper asks a basic question about the 2010 Dodd-Frank law: Should the Financial Stability Oversight Council or “FSOC” be reformed or abolished? This paper argues first that abolition is the only reasonable course, both because of structural issues and also due to the problematic nature of the selection process for systemically important financial institutions or “SIFIs.” Second, assuming that Congress is unlikely to abandon the FSOC entirely, we discuss how the current process might be improved in some specific ways.

The FSOC was created by the 2010 Dodd-Frank Wall Street Reform legislation to oversee “systemic risk.” Risch (2013) notes that the FSOC is the largest agency comprised of ex officio members ever to be created by Congress. Chaired by the Secretary of the Treasury, the FSOC is comprised of ten voting members and five non-voting members, most of whom represent the heads of the federal financial regulators.

Under the Dodd-Frank Act, the primary responsibility of the Financial Stability Oversight Council is to identify non-bank financial firms that pose a risk to the stability of the United States and designate these firms as systemically risky financial institutions (“SIFIs”), including both banks and nonbanks. By statute, all bank holding companies with at least $50 billion in assets are automatically subject to additional regulation, reinforcing Dodd-Frank’s faulty logic that all banks above a certain size are “systemically” important or a potential source of instability.

The Dodd-Frank Act authorizes FSOC to designate nonbank firms as SIFIs if their “material distress” could cause “instability” in the U.S. economy. Firms so designated are then subject to bank-like prudential regulation and supervision by the Federal Reserve. The FSOC process is opaque and the Council is not required to defend its decisions publicly. Wallison (2014) argues that when it comes to selecting SIFIs, “[i]n its three designations thus far—AIG, G.E. Capital, and Prudential Financial—FSOC has manifestly failed to demonstrate that it has any idea how to make these important judgments.”

Skeel (2014) notes that while behavioralists might applaud the new FSOC, the structure of the FSOC itself, by contrast, is quite problematic due to its reliance upon the heads of existing regulatory agencies. Because the architecture of the FSOC depends upon the existing prudential regulators for its operations, and since these same regulatory agencies greatly contributed to the 2008 financial crisis, it seems reasonable to ask whether the Council has even the possibility of achieving its stated mission. The presence as chair and veto authority given to the Secretary of the Treasury, a throwback to federal financial legislation of a century ago, also raises the issue of political bias in the FSOCs considerations. Yet any bailout is by definition is a fiscal operation, thus the participation of the Secretary of the Treasury arguably is required.

Skeel notes:

“From a public choice perspective, the FSOC is problematic for different but related reasons. There is a significant risk it will be dominated by the Treasury Secretary, for instance, and thus subject to political pressures that compromise its independence. The decision to house the new Office of Financial Research in the Treasury, Dodd?Frank Act § 151 is another unfortunate structural decision that could undermine independence.”

Other federal regulatory agencies have taken issue with the Financial Stability Oversight Council process, as in the case of the Securities and Exchange Commission (SEC) and the possible SIFI designation of money market funds. The SEC has just one vote on the FSOC and cannot prevent the Council from acting. Under the financial reform law, designation of any nonbank financial firm requires a two-thirds majority vote by the council along with the approval of the Treasury secretary.

Chairman Mary Jo White has defended the primacy of her agency as the regulator of all funds from encroachment by the FSOC, but the other agencies represented on the FSOC have responded with a universal message that all nonbanks are bad. The experience during the financial crisis of money market funds requiring explicit support from the US Treasury has left many regulators as well as members of Congress reluctant to leave the regulation of these large entities up to the SEC and/or market forces. But, again, the FSOC and Congress conveniently ignore the fact that it was the toxic securities purchased by money market funds which caused investor distress, not the funds themselves.

Regarding the FSOC and its application for funds and other fiduciaries, Fein (2013) notes that:

“In adopting the shadow banking mythology, banking regulators deceived themselves as to the true nature of the forces that destabilized the financial system and misinformed policymakers in Congress. Now, having gained new powers to rid “systemic risk” anywhere in the financial system, they are seeking to uproot shadow banking competitors of banks that operate outside the regulated banking system. Chief among their targets is the money market fund industry, notwithstanding that money market funds are highly regulated and bear none of the key risk factors of shadow banks.”

Indeed, the application of the authority of the Financial Stability Oversight Council so far has been heavy handed and has generated a substantial effect on the nonbank financial sector, in theory advantaging the large universal banks. But in fact banks have problems of their own with other parts of the Dodd-Frank law, so that the net impact of the legislation on both banks and nonbanks can safely be described as negative for business volumes and profitability.

Financial Stability Oversight Council Reform Or Abolition?

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