In November, the Financial Stability Oversight Council — a group with voting members that include the secretary of the Treasury, the heads of all federal financial regulatory agencies and an independent insurance expert — revised its operating procedures. The change makes it easier for the FSOC to designate non-bank financial firms as “systemically important” and subject them to Federal Reserve regulation.
The FSOC, not Congress, decided on these changes.
The so-called “Basel III end-game” increase in bank capital requirements will encourage banking activities to migrate to non-bank financial institutions that are not regulated by FSOC members. In anticipation, the FSOC turbo-charged its designation power to facilitate the regulation of the non-bank financial firms that capture businesses once done by banks.
The FSOC has been ineffective in its duty to objectively identify financial stability risks and promote transparent improvements in financial safety and soundness supervision and regulation. Moreover, the FSOC’s reports and designations have been highly politicized.
As recently as last Spring, the FSOC failed to identify and ensure that its members take proactive actions to mitigate risks created by banks that ultimately caused financial instability.
The FSOC’s 2022 annual report highlighted the need for its members to closely monitor interlinkages between digital asset and traditional financial firms, and recommended that banking supervisors ”continue to ensure that banks maintain adequate capital and liquidity, sound interest rate risk management practices, and well-developed operational resiliency plans.“
But in a few short months, it was revealed that bank supervisors had not followed any of these recommendations. The FSOC and its bank regulatory members failed to identify and guard against the biggest financial stability risk — unrealized interest rate losses from maturity mismatches in the banking system.
These risks came home to roost as depositor runs and bank failures required a “systemic risk exception” and emergency federal guarantees to quell the crisis — an outcome antithetic to the FSOC’s congressionally-assigned responsibility to “[eliminate] expectations on the part of shareholders, creditors and counterparties of [financial firms] that the government will shield them from losses in the event of failure.”
When it comes to the regulation of non-bank financial firms, the FSOC has changed its designation standards and procedures every time the White House changes party.
Under the Obama administration, the FSOC aggressively fought to defend its designation of MetLife, Inc. MetLife litigated, and a district court overturned MetLife’s designation.
The court found the FSOC’s designation standards to be “arbitrary and capricious,” criticizing the FSOC’s failure to prove that MetLife was likely to become “materially financially distressed” as well as a failure to show that the benefits outweigh the cost of MetLife’s designation.
In 2019, President Trump’s FSOC revised its designation procedures in light of the shortcomings cited by the court. It shifted FSOC focus from designating firms to identifying marketwide products, activities and practices that may cause instability and working with state and federal regulators on crafting measures to mitigate these risks.
In 2023, President Biden’s FSOC lowered the threshold of what qualifies as “financial instability,” removed the requirement for a positive cost-benefit assessment and eliminated the FSOC’s duty to provide evidence that a designee might experience “material financial distress.”
Unless the FSOC is required to establish that a designee faces a heightened risk of financial distress, an FSOC designation is effectively punishment for a non-bank financial firm’s success.
Published guidance says FSOC designations will target the largest, most interconnected non-bank financial firms.
A designee gets new costly supervision by the Federal Reserve — a financial regulator that currently loses $2 billion per week and has $1.3 trillion in unrealized interest rate-related losses.
Historically, in order to escape an FSOC designation, non-bank entities have been forced to shrink their size and jettison many of the financial businesses that made them large and prosperous. For example, to escape designation, GE had to shrink to half its size and sell its depository institutions and virtually all of its financial businesses that were “interconnected” with large banking institutions.
Democratically-controlled FSOCs have never de-designated a non-bank financial firm unless it drastically shrank its financial footprint. In contrast, such draconian changes were not required once the lessons from MetLife’s litigation were reflected in FSOC votes taken in 2018 when it was controlled by a different political party.
Until 2021, no FSOC annual report mentioned climate change at all, let alone as a systemic risk threatening financial stability. Yet quashing climate-change systemic risk is the holy grail of this administration’s FSOC.
However, the council’s scheme to impose climate change regulations on banks and other financial institutions is not the result of objective FSOC analysis, but is instead the implementation of a political plan to discourage fossil fuel investments — a plan hatched well before the current administration was elected.
Common sense and a significant body of economic research suggest that regulatory uncertainty discourages private sector investment, and history demonstrates that FSOC polarization has been an important source of regulatory uncertainty.
This problem could be solved by changing FSOC voting rules. Congress could end the politicization of the FSOC activities by requiring that all of its reports and designations be approved by the ranking member of appropriate congressional committees in both the House and the Senate, where the congressional voting member is from a party not controlling the executive branch.
Paul Kupiec is a senior fellow at the American Enterprise Institute.