September 25, 2013

The FSOC's Latest Careless Too Big to Fail Decision

Hester Peirce

Former Senior Research Fellow
Summary

Last week the Financial Stability Oversight Council designated Prudential Financial as a systemically important financial institution in need of regulation by the Federal Reserve. The FSOC's careless decision to slap a too-big-to-fail label on Prudential undermines-rather than secures-financial stability.

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Last week the Financial Stability Oversight Council designated Prudential Financial as a systemically important financial institution in need of regulation by the Federal Reserve. The FSOC's careless decision to slap a too-big-to-fail label on Prudential undermines-rather than secures-financial stability.

The FSOC's reasoning for selecting Prudential is far from compelling. It boils down to the fact that Prudential is really big. If Prudential hits a rough patch, its many policyholders and other customers might run, which could force Prudential to sell assets in harmful fire sales. Then there could be a widespread loss of confidence in the insurance industry and maybe even an industry-wide run. Even though no one company is overly exposed to Prudential and markets are sufficiently competitive to handle Prudential's disappearance, the firm would be tough to wind down. And, not surprisingly, the FSOC finds that a Prudential failure would be especially traumatic if the rest of the economy were in the dumps too. True, Prudential is heavily regulated, but, in the FSOC's view, there's no regulation like regulation by the Federal Reserve.

The FSOC's decision to designate Prudential was not unanimous. The SEC's Mary Jo White recused herself, two other FSOC members voted against the designation, and a nonvoting member dissented. Edward DeMarco, acting director of the Federal Housing Finance Agency, pointed out that the FSOC's analysis failed to give appropriate weight to Prudential's good characteristics, such as the high quality of its assets, the stability of its funding, the nature of its derivatives activities, or the ability of its contractual provisions to prevent runs. Some of the FSOC's reasons for selecting Prudential seemed to be broad concerns about the insurance industry. As detailed by the FSOC's independent insurance expert, Roy Woodall, the scenarios underlying these concerns "are antithetical to a fundamental and seasoned understanding of the business of insurance, the insurance regulatory environment and the state insurance company resolution and guaranty fund systems." Missouri Insurance Commissioner John Huff, who is a nonvoting participant of the FSOC, similarly objected to the Prudential designation on the grounds that it was supported by uninformed assumptions, rather than evidence-based analysis.

Applying the FSOC's approach, it is awfully hard to see how Prudential differs from any other large insurance company, or for that matter, any other large financial company. As Mr. Woodall observed, the FSOC's "line of reasoning would inevitably lead to a conclusion that any nonbank financial company above a certain size is a threat." FSOC designations were supposed to be based on nuanced analysis rather than simply considering whether or not a company is big.

Designating companies like Prudential only weakens the markets' intrinsic abilities to respond swiftly and effectively to the failure of large firms. The designation dangerously combines promises of hyped-up regulatory scrutiny and an expressed government unwillingness to let designated firms fail. The designation thus doubly dulls the market's incentive to contemplate, monitor, and prepare for potential failures.

In addition, the consolidation of large financial firms of all types-including banks, insurance companies, and asset managers-under Federal Reserve supervision can pose threats of its own. Given the large role that regulators play in deciding how firms are structured and the types of assets they can hold, companies that share a regulator are likely to end up looking similar to one another. For example, if the Fed constructs its insurance company regulatory program on a bank regulatory foundation, the resulting financial system will be more homogenous and thus more vulnerable to common shocks. The market, which will be composed of large look-alike institutions, will no longer be able to draw on a useful variety of strengths and structures to heal itself in crises.

If the FSOC persists in relying on uninformed, speculative analysis, there will be a flood of designations of insurance companies, asset managers, and other large firms. As a result, the Fed will be responsible for holding the whole financial edifice together with a special, super-strong set of rules. There's little reason to anticipate that, in crafting regulations for all these companies, the Fed will use more careful analysis than its chairman and his FSOC colleagues used to designate the entities to which the new rules will apply.