Depending on whom one asks, the Collyer decision to clip FSOC’s designation wings is either the spark that fires up the next financial crisis or an overdue blow against oppressive regulation. Neither of these conclusions is correct because a read of the actual decision forces a more nuanced understanding of its actual impact. What the District Court did in this case is demand that regulators say what they mean and consider the consequences of what they do. Neither mandate is in any way a stand-down order for post-crisis regulation as some have contended. Instead, as our Client Report this week laid out, the excruciating detail in the District Court ruling reiterates key provisions of administrative law that do and should bind all of the U.S. banking agencies, not just FSOC. The cost-benefit order is not the nickel-and-dime demand some have contended; instead, it says that regulators can’t cite just one side of a statistic to prove a point. Since more than a few other rules I can think of are far from perfect on either of the court’s counts, this case marks a watershed moment in which financial-services firms subject to the new regulatory rulebook will consider the strategic consequences of continued acquiescence or well-reasoned defiance.
Lost in much of the politicking that greeted the MetLife decision is a point Judge Collyer was at pains to emphasize throughout her opinion: nothing in it bars FSOC from designating SIFIs. In virtually every area in which MetLife challenged either this power or the facts on which FSOC designated the company, the court sided with FSOC. The devastating blows to FSOC came in the detailed review not of whether FSOC can designate, but rather how it did so for MetLife. Careful reading of the process and facts is far more troubling than I would have thought, making it yet another reason for FSOC to come out of its closet and subject itself to far more public scrutiny than it has been willing to endure in the six years since its creation.
Perhaps the most important aspect of the ruling assesses whether or not FSOC considered the likelihood of MetLife’s failure in addition to its systemic impact. In short, FSOC’s rule say it should, FSOC’s guidance says it can, and FSOC flip-flopped back and forth during the proceedings on whether or not it in fact reversed its rules and considered MetLife’s mortality risk. The judge does not opine on whether likelihood is an important criterion for effective SIFI designation, although anyone familiar with the PD and LGD framework of credit risk-based capital would argue it is. Instead, what she says is only that FSOC has to stick to the SIFI designation methodology it declares in public rulings and can’t reverse itself in private and nonetheless expect the courts to defer to its edicts from on high.
Due process requires either adherence by an agency to an agency’s stipulated processes or a change to the processes before a decision under new standards is made. Rule of law demands no less – without the protections of administrative procedure, any regulator could pick and choose among its subjects based not on fair rules of procedure, but momentary whim or even political ambition.
The cost-benefit provisions of the decision have also been mischaracterized as an instance in which the court inserted itself into a complex regulatory decision without right or reason. Nowhere in the Collyer decision did I see a requirement for FSOC to undertake the type of complex cost-benefit analyses required by law of other agencies that do indeed tie their hands in several key respects. Rather, the opinion goes through FSOC’s findings about what could happen if MetLife failed to poke very large holes in the underlying reasoning.
For example, the opinion argues – correctly in my view – that one cannot contemplate the systemic risk of securities-financing transactions solely by looking at the gross dollar totals of SFTs. Instead, the ruling states that collateral and other mitigating factors need also to be considered. FSOC countered – also rightly I think – that SFT risk isn’t simply a matter of netted positions – it’s far more a liquidity-risk situation than a credit-risk one. However, the court found that FSOC came up with that rationale only under pressure in the course of the litigation and thus sent the Council back to its drawing board. Going forward, if FSOC is thinking liquidity risk, it will have to be talking liquidity risk in the documents first provided to a possible designee and then to the public.
Another blow on cost came when Judge Collyer found that it was simply impossible in fact to consider it because the FRB has not advanced any of the rules that would govern MetLife as a SIFI. The law expressly mandates consideration of “risk-related” factors, leading to extensive back and forth discussion on whether this means “cost,” but the judge not-unreasonably believes that rules have a lot to do with risk and that, without rules, risk-related factors are unknowable.
Secure in its fortress, the FRB has been contemplating how it might come to construct regulatory-capital standards for insurance companies. Congress has tried to nudge the FRB to fish this critical piece of the post-crisis framework, leaving the Fed so far singularly unmoved. The court, though, struck at the heart of what the Fed cares about – systemic regulation. That FSOC foundered can in part be laid at the FRB’s slow-moving feet.
MetLife took on FSOC because all it could see was upside to its formidable, once seemingly-improbable challenge; banks have done little but agonize over similarly-strategic FRB rules because history and culture have quashed their fighting spirit. With this decision in hand, though, the biggest BHCs can and I think in some cases should force the FRB to be far more accountable and analytical as it picks winners and losers in the U.S. financial system. Banks might entertain this litigation to water down the FRB’s rules, but I think fear of failure will force the FRB to be far more careful in its thinking and public reasoning. This will make the rulebook a lot better and, over time, the financial system a good deal stronger.