In September 2014, the Financial Stability Oversight Council (FSOC), a sort of super-regulatory agency created by the 2010 Dodd–Frank Act, labeled MetLife as a systemically important financial institution (SIFI). It may sound like an honor, but what it really meant was that MetLife was officially designated for special regulation by the Federal Reserve.
Title I of Dodd-Frank gives the FSOC this designation authority on the premise that special regulations can prevent so-called SIFIs from causing a financial crisis.
In January 2015, MetLife announced they would fight the designation in federal court, and they’ve now won the first round of this fight. The U.S. District Court in D.C.rescinded the FSOC’s MetLife designation on March 30 and unsealed its decision on April 7.
Within days, U.S. Treasury Secretary Jack Lew (the Council’s Chair) announced the FSOC would appeal. (The appeal goes to the D.C. Circuit.) In a statement, Lew complained: “This decision leaves one of the largest and most highly interconnected financial companies in the world subject to even less oversight than before the financial crisis.”
That’s an interesting perspective since none of the new capital regulations had been imposed yet.
Regardless, the final resolution of this case has broad implications for other yet-to-be-singled-out financial firms. One major problem with the so-called SIFI designation process is that designated firms are extremely limited in their ability to challenge the FSOC in court.
Section 113(h) of Dodd-Frank limits legal challenges to “whether the final determination made under this section was arbitrary and capricious.” Since the FSOC developed a process for making these designations, winning such a legal challenge had been widely viewed as an uphill battle.
For the record, I thought that there was at least a 50-50 shot the FSOC would prevail in the MetLife case for this very reason. And my fear was that Dodd-Frank ensured the FSOC could set a very low bar for making these designations.
The Dodd-Frank bill authorizes these designations in the name of maintaining financial stability, but it doesn’t define financial stability. Nor does it direct the FSOC to do so.
Unsurprisingly, the FSOC’s final rule and guidance really didn’t define the term either.
Instead, the FSOC simply explained that they would consider a threat to financial stability to exist “if there would be an impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy.”
The guidance then explains three “channels” through which such problems could occur.
All of this amounts to little more than conjecture. The FSOC could claim, for example, that a financial firm’s distress could harm the broader economy if it had to sell its assets quickly at a loss.
The final rules were never really clear on how specific FSOC would be in this process, and that’s really no surprise. To carefully quantify these issues would require the FSOC to specify precisely what level of risk is acceptable, and then identify specific activities and assets that cause too much risk. It would also have to quantify how these risks impact specific counterparties.
It’s impossible to do this in a purely objective way. But even if it could be done objectively, the logical response for a designated firm would be to dump those assets, cease risky activities, and cut ties to specific counterparties.
Naturally, doing so would remove any real justification for the special designation, and that’s the last thing FSOC wants. There wouldn’t be any designations because everyone would avoid anything on the specific list.
Worse, the FSOC would be exposed as a failure if a financial crisis ever occurred because of an item they left off the list.
So an inherent conflict exists in the SIFI designation process because too little specificity could be viewed as arbitrary and capricious. It’s true that the courts tend to give regulatory agencies a great deal of leeway on these matters, but exactly how this would play out was always an open question.
Exactly how vague can the FSOC be to avoid making an arbitrary and capricious designation? We still don’t reallyknow, but the MetLife ruling gets us closer to finding an answer.
If the decision holds up on appeal, the FSOC will certainly have a higher hurdle to overcome when making future designations. But it’s still far from clear how much impact this ruling will ultimately have.
One key factor is that the FSOC can make these designations under either of two standards. The one they chose in this case designated MetLife on the premise that material financial distress at a company could pose a threat to U.S. financial stability.
The other standard lets the FSOC designate a firm when the very “nature, scope, size, scale, concentration, interconnectedness, or mix of the [company’s] activities” could pose a threat to U.S. financial stability.
While this ruling surely has implications for designations under either standard, the fact that the FSOC relied on only one standard sets the stage for future court battles. It’s also possible that the FSOC will issue new guidance on designations, thus mitigating some of the problems it ran into in the MetLife case.
Nonetheless, financial firms that find themselves in the FSOC’s crosshairs are in a better position now than they were prior to this ruling. Simply put, the FSOC will, under current rules, have to be more specific when it designates a firm.