SIFI designation will change nature of competitive financial system

Reuters

U.S. Treasury Secretary Timothy Geithner (C) plays host to a meeting of the Financial Stability Oversight Council at the Treasury Department in Washington, March 17, 2011.

Article Highlights

  • Though few Americans have heard of it, the FSOC may be the most important agency established by #DoddFrank

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  • FSOC has authority to designate nonbank financial institutions as systemically important financial institutions (SIFIs).

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  • The FSOC hasn’t made any SIFI designations yet, but when it does the nature of our financial system will be changed.

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Although few Americans have heard of the Financial Stability Oversight Council (FSOC), it may be the most important agency established by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The FSOC is a council of federal financial regulators, chaired by the secretary of the Treasury, who have the authority to designate nonbank financial institutions – insurance companies, securities firms, hedge funds, finance companies and others – as systemically important financial institutions (SIFIs). These firms are considered “systemically important” because their failure might cause instability in the U.S. financial system. Once a firm is so designated it is turned over for “stringent” regulation by the Federal Reserve.

The FSOC was proposed by the Obama administration and adopted by a Congress sharply split along partisan lines. The underlying notion was that if large nonbank financial institutions fail they will cause another financial crisis like the one that followed the bankruptcy of Lehman Brothers in 2008.

There is little evidence to support this idea. To be sure, the bankruptcy of Lehman Brothers precipitated a financial crisis in which banks and others hoarded cash, but this was because the deflation of a massive housing bubble in 2007 and 2008 had produced a common shock that had weakened all financial institutions. When Lehman was allowed to fail, a full-scale panic ensued, the first such event in at least 80 years. No one knew which firms were healthy and which were in danger of failing. If the market had been stable at the time – if investors and other market participants had not been on the edge of panic – when Lehman declared bankruptcy, there wouldn’t have been a financial crisis.

The FSOC has not yet made any SIFI designations, but when it does the nature of our competitive financial system will be irrevocably changed. Creditors aren’t fools.

"The FSOC has not yet made any SIFI designations, but when it does the nature of our competitive financial system will be irrevocably changed. Creditors aren’t fools." -Peter J. WallisonBy designating a firm as a SIFI, the government will have declared that its failure could cause a financial crisis. Creditors will immediately know that their loans are going to be safer when made to SIFIs than when made to their smaller rivals. In other words, each of these SIFIs will be perceived as too-big-to-fail, and this perception will permit them to raise funds at lower rates than their competitors.

This has already happened in the banking industry. As many studies have shown, the largest banks – which are generally considered to be too-big-to-fail – have lower funding costs than their smaller competitors. Ironically, then, the Dodd-Frank Act – the law that was supposed to eliminate too-big-to-fail – will actually extend it beyond banking to other financial industries. When this occurs, these industries will consolidate, with the larger firms gobbling up the smaller. The intense competition that has always characterized financial services will be eliminated as a few large firms come to dominate each financial industry.

Why is this happening? Because the administration and Congress – intent on gaining greater government control over
the financial system – claimed that the financial crisis of 2008 was the result of insufficient regulation of the private financial sector.

In reality, however, the crisis was caused by government housing policies. In a misbegotten effort to increase home ownership, beginning in the early 1990s and extending through 2008, the government encouraged the degrading of mortgage underwriting standards.

By 2008, these policies had created a massive housing bubble – nine times larger than any previous bubble – and half of all mortgages in this bubble were 28 million subprime or otherwise weak and risky loans. Of these, 74 percent were on the books of government agencies like Fannie Mae, Freddie Mac, and the Federal Housing Administration, showing clearly where the demand for these mortgages came from. When the bubble deflated, these loans failed in unprecedented numbers, driving down housing prices, weakening the financial institutions that held them, and bringing on the financial crisis.

If we see the financial crisis in this light – not as a failure of regulation, but as a result of government housing policy – it makes no sense to designate large financial firms as SIFIs. This will only create a nonbank financial institutions that – like banks – will be perceived by creditors and other market participants as too-big-to-fail, doing irreparable damage to our competitive financial system.

Instead, we should repeal Dodd-Frank and concentrate on eliminating the government housing policies that were responsible for the financial crisis.

Peter J. Wallison, the Arthur F. Burns Fellow in financial policy studies at the American Enterprise Institute and a former general counsel of the Treasury Department, says the Dodd-Frank Act should be repealed and the focus shifted to eliminating government housing policies that were responsible for the financial crisis.

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