August 27, 2014

The Helicopter Parents At the FSOC Are Running With Scissors

Hester Peirce

Former Senior Research Fellow
Summary

The Financial Stability Oversight Council is rumored to be on the verge of designating MetLife as a systemically important financial institution. Through the FSOC's bureaucratic eyes, designating MetLife may appear to be a safer course than leaving it undesignated and facing questions later if the company runs into trouble.

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The Financial Stability Oversight Council is rumored to be on the verge of designating MetLife as a systemically important financial institution. Through the FSOC's bureaucratic eyes, designating MetLife may appear to be a safer course than leaving it undesignated and facing questions later if the company runs into trouble. But designation brings its own problems-problems that are likely to be ignored in the FSOC's broken designation process.

Thanks to Dodd-Frank, regulators are fully engaged in the business of picking out and propping up individual firms. Dodd-Frank gives the FSOC authority to require the Federal Reserve to supervise "nonbank financial companies that may pose risks to the financial stability of the United States in the event of their material financial distress or failure, or because of their activities." Once the Fed takes these firms on, for reputational reasons, it will not spare any expense or regulatory tricks to prop them up.

The trade-off, of course, is that the Fed will employ the same helicopter parenting style for these firms that it uses for the big banks it oversees. This overbearing parenting style is bad enough for banks. Sure, it is nice to know that Papa Fed will always be there to keep you safe, but banks chafe under micromanagement of supervisors whose demands do not match those of customers. Nonbanks are sure to find Fed micromanagement even more difficult to bear. The Fed is likely to make only minimal adjustments to its bank regulatory methods. And, as the CEO of MetLife explained, "no amount of ‘tailoring' will ever make bank capital standards fit a life insurer's balance sheet."

Designation proponents argue that financial firms are always arguing for a lighter touch approach to regulation, so their concerns should be ignored. Firms do care about regulatory costs, but designation matters to all of us. First, there is no reason to believe that complying with Fed mandates will pay off, since it is not clear that regulators at the Fed have the experience to run financial companies effectively. For example, Governor Tarullo, who is currently overseeing a lot of the Fed's regulatory work, is a former law professor and government official. Second, designation stultifies the financial landscape by creating a protected class of financial firms and thus inhibiting the dynamism of the financial services sector. Finally, some portion of regulatory costs is passed on to consumers in the form of higher prices and fewer options. For example, consumers use insurance companies to help manage their risks, but fewer will do so if regulatory costs force prices up.

The designation process is not designed to take such considerations into account. Although Dodd-Frank enumerated certain factors to be considered in the designation process, it also allowed consideration of "any other risk-related factors that the Council deems appropriate." The FSOC has not offered much insight into what these factors might be. Dodd-Frank's anti-evasion clause adds further ambiguity by implying that firms that take steps to make themselves less systemically important will be designated precisely because they take such steps. In effect, this provision discourages the FSOC from telling companies which aspects of their operations are risky, because then the firms might try to remake themselves to avoid designation.

To date, the FSOC largely has embraced Dodd-Frank's insular, nontransparent approach to designation. After some initial missteps, it did take a reluctant stab at making a public case for the designation of large asset managers. Loud criticism caused the FSOC to retreat from designating asset management firms and instead employ a "more focused analysis of industry-wide products and activities." However, even that promise leaves many questions about how the FSOC will conduct the analysis.

In approaching insurance company designations, FSOC has not troubled itself with much outside consultation. In the case of Prudential, the FSOC did not even listen to its own insurance expert. In his dissent from the designation, Roy Woodall attacked many aspects of the FSOC's justification for the designation for being inconsistent with the reality of the insurance industry and its existing regulatory scheme. Likewise, the FSOC's nonvoting state insurance commissioner representative, John Huff, faulted the FSOC for "inappropriately appl[ying] bank-like concepts to insurance products and their regulation, rendering the rationale for designation flawed, insufficient, and unsupportable."

Last week, a number of industry organizations filed a rulemaking petition with the FSOC. The petition requested an overhaul of the designation process. The recommended procedures would afford potential designated companies insight into, and timely opportunities to respond to, the FSOC's analysis. As the petition explained, a more interactive and transparent process would benefit the FSOC and the potential designee by allowing the company to respond directly to the FSOC's specific concerns, rather than inundating the regulator with documents not relevant to the analysis. The revised procedures also would allow for regulators of subsidiaries of potential designees to weigh in.

The FSOC faces tremendous temptation to designate with abandon. Doing so will impede the financial system's ability to provide consumers and companies with the financial services they need. The FSOC's current designation approach does not lend itself to careful consideration of these types of costs. Designation is flawed in principle, but improving the manner in which it is carried out would make it more likely that the downstream costs of designation are taken into account.