(Bloomberg View) — One of the central pillars of financial reform, the Financial Stability Oversight Council, is under political attack and at risk of coming undone.
In the past, the balkanized U.S. financial regulatory system has consistently failed to address risks that took root in its jurisdictional gaps. The FSOC was created to solve that problem, bringing regulators together to make sure they have the tools to protect the economy from financial crises. It is already making an important difference.
Unfortunately, earlier this month the House Financial Services Committee passed the Financial Choice Act, or CHOICE Act, which threatens to reverse that progress. It would, for example, all but eliminate the FSOC's ability to prevent the regrowth of an unsupervised shadow banking sector that might once again threaten our financial stability and economic resiliency. At the same time, the administration of President Donald Trump has signaled that it may use the council to pursue deregulation, rather than its core mandate of financial stability, and to reverse or limit its ability to designate systemically important non-banks for enhanced supervision. Meanwhile, MetLife Inc., the largest U.S. life insurer, is fighting in court (unopposed by the Trump administration) to overturn its designation by the FSOC as a systemically important financial institution that should be subject to prudential oversight by the Federal Reserve.
In light of these actions in the executive, legislative and judicial branches, it's worth revisiting why the FSOC was created in the first place, and why its core mandate is so important.
Many of the vulnerabilities at the heart of the 2008 crisis can be traced to the growth of activities outside the core banking system, in the so-called "shadow banking" system. Regulators did not have sufficient legal authority to oversee shadow banking activities. As a result, risks metastasized outside their view.
The failures of Bear Stearns Cos. and Lehman Brothers, two such shadow banking firms, and the $182 billion bailout of American International Group Inc., an insurance company, made clear that regulators needed better tools to address threats that such activities posed to financial stability.
In January 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created the FSOC to extend supervisory oversight to certain systemically important financial institutions, improve coordination across U.S. regulators, increase awareness of emerging financial stability risks, and collectively mitigate those threats.
As part of this mandate, under Section 113 of Dodd-Frank, the council can designate a non-bank firm if the firm's failure could pose a threat to U.S. financial stability. The Federal Reserve then subjects such firms to enhanced oversight that reflects the risks they pose, regardless of their particular business structures. FSOC has exercised this authority sparingly, designating just four of the largest, most highly leveraged and most interconnected companies: AIG, General Electric Capital Corp. and Prudential Financial Inc. in 2013, and MetLife in early 2014. Following its designation, GE Capital — a non-bank financial company that nearly collapsed in the crisis due largely to its reliance on unstable, short-term funding — substantially restructured; since it no longer posed a risk to the financial system, its designation was rescinded.
The council is also responsible for scanning far and wide across the financial system to identify emerging risks. It serves as an important venue for regulators to convene, share information, establish a common baseline of facts, and develop coordinated solutions to potentially destabilizing financial activities. In order to keep pace with markets, products and institutions that are dynamic and constantly evolving, its mission is intentionally broad and forward-looking. In recent years, it has focused on risks as diverse as cybersecurity, central counterparties, and the growth of algorithmic trading in capital markets.
