The Financial Stability Oversight Council and the Financial Stability Board: Issues in international regulation

Article Highlights

  • Congress should be wary of the FSOC’s extraordinary discretionary authority

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  • The FSB and the FSOC should open theirmeetings to observers so that the true reasons for their decisions become clear

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  • There is no indication that non-bank financial institutions had any major role in the financial crisis

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Chairman McHenry, Ranking Member Green, and members of the subcommittee:


Thank you for the opportunity to testify this afternoon on a number of issues in international financial regulation that I believe deserve serious attention by Congress. Financial services is one of the most important and successful industries in the United States. It includes banks, of course, as well as insurers, asset managers, securities firms, finance companies, private equity firms, and hedge funds. The services of these companies enable Americans to save for the future, buy and sell assets, and retire comfortably. As important, financial services firms provide the financing for business, which in turn creates jobs and—through growth in productivity—improves the standard of living for all of us.

Although some observers of the financial markets favor more regulation than others, it is not in dispute that financial regulation can have a major effect on the performance of financial institutions, and thus on economic growth. For this reason, Congress should have a major role in formulating the policies that underlie the decisions that affect the US financial industry. In the case of banking regulation, Congress has generally not intervened in the development of the bank capital regulations—Basel I, II and III—as these were developed, agreed internationally among bank regulators, and applied to the US banking industry. However, as discussed later in this testimony, there are reasons to believe that this abstention was not a good idea.

The Dodd-Frank Act, the FSOC, and the growth in the scope of regulation

In 2010, in the wake of the financial crisis, Congress adopted the Dodd-Frank Act, which created a special body known as the Financial Stability Oversight Council (FSOC). The FSOC  is composed of the heads of all the federal financial regulators—the Federal Reserve, FDIC, SEC, CFPB, etc.—and a person who is appointed by the President and confirmed by the Senate as an expert in  insurance, which is not regulated by the federal government. The secretary of the Treasury is the chairman of the FSOC and runs the meetings. The secretary also has an effective veto over the FSOC’s most important decisions, since his affirmative vote is necessary for approval. Because the act specifies that the members are the heads of the regulatory agencies—not the agencies themselves—virtually all the members are appointees of the administration in power. They are not required to represent their agencies and they don’t; they seem generally to follow the directions of the Treasury secretary.

Dodd-Frank enjoins the FSOC to “identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large interconnected bank holding companies or nonbank financial companies.” (Sec 112). To implement this idea, Section 113 authorizes the FSOC to designate a nonbank financial firm as a systemically important financial institution (SIFI) if “the Council determines that material financial distress at the US nonbank financial company…could pose a threat to the financial stability of the United States.” Firms so designated are then turned over to the Fed for regulation which the act requires to be more “stringent” than the regulation to which they are ordinarily subject. Other elements of the act suggest that this regulation be prudential and bank-like—that is, it should involve their capital and their risk-taking activities.

This is a sharp change in substantive US regulatory policies from those that prevailed in the past. The 2008 financial crisis was a disaster for the American people, but it was a huge gift for financial regulators in the US and abroad. After all major financial downturns, those who support government involvement in the economy claim that it wouldn’t have occurred if financial regulators had more power. Congress usually gives in to this argument, despite the evidence. The collapse of the S&Ls in the late 1980s brought forth the Financial Institutions Reform, Recovery and Enforcement Act of 1989 and the FDIC improvement Act of 1991. The Enron scandal produced the Sarbanes-Oxley Act. All these new laws promised to prevent the recurrence of the prior events. As we can see from the 2008 financial crisis, none of them succeeded.

The 2008 financial crisis was no different from earlier crises, except in two respects: it was much larger than any previous crisis and it involved the whole financial system and not just depository institutions. The narrative that grew out of the crisis was, once again, that it could have been prevented if the regulators had more power.  But there was a difference; before the crisis, the only theory for federal prudential regulation of financial institutions supported the regulation of banks; since banks were backed by the government, regulation was necessary to prevent moral hazard and to protect the taxpayers. But after the crisis, which involved many large financial institutions in addition to banks, the conventional Washington narrative became something far more expansive. In that narrative, the failure of any large financial institution could be a danger to the entire financial system. This spawned a wholly new and expansive theory for regulation—that the risk-taking and capital position of any financial institution should be subject to prudential bank-like regulation if there is even a minimal case that its failure could cause a financial crisis. That’s why the Dodd-Frank Act adopted the idea that any firm should be subject to this regime if its “financial distress” could cause “instability in the US financial system.” However, since it is impossible to know whether a particular institution’s “distress” would cause instability in the US financial system (whatever that is), the FSOC’s authority is in effect a blank check to consign to Fed control any large financial firm that the government wants to regulate.

The practical effect of this huge shift in regulatory policy was a large increase in the potential reach of bank-like prudential regulation and thus a large increase in regulatory power.  Now, all large financial institutions in the US—not just banks—can be made subject to bank-like prudential regulation unlike anything they have faced before. It seems reasonable that Congress should have a say, at the very least, about how this unprecedented change in the scope and range of regulation is being implemented, especially because the degree of regulation can have a substantial effect on economic growth and the well-being of all Americans.

Much of the rest of my testimony will discuss why congressional intervention is necessary as a matter of broad policy, but I’d like to mention one fact at this point that I think will be particularly salient with Congress. Recently, the FSOC has taken steps that indicate it is likely to designate large asset managers as SIFIs. When this became known, Barney Frank, the chief House sponsor of the Dodd-Frank Act and the authority of the FSOC, said that he had never intended that asset managers should be considered SIFIs.  Nevertheless, the breadth of the language in the congressional authority given to the FSOC would allow them to go this far. If Congress didn’t intend this, it should step in to make its intentions clearer to the FSOC.

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