(Thomson Reuters Regulatory Intelligence) – The U.S. Financial Stability Oversight Council’s recent review of the asset management industry seemed a rather routine piece of regulatory work. But the review released last week comes in a charged atmosphere for the council because of a court decision that rescinded its designation of insurer MetLife as a systemically important financial institution, or SIFI.
The federal court’s decision on March 30 marked the first successful challenge to the authority of the council in SIFI designations, and could lead to more skeptical inspection of its reports.
The asset management review was relatively noncontroversial. It reaffirmed the importance of three key risk areas that the Securities and Exchange Commission has been acting for a year: liquidity and redemption risk, leverage, and companies’ reliance on service providers for data collection and reporting. The council duly recommended more robust risk management practices, clearer guidelines on funds’ limits on liquidity, and possible stress tests and transition planning exercises.
The process for that review, which was already in the works for a year, could be the last taken at face value.
Precarious times for unclear analyses
The inter-governmental Financial Stability Oversight Council, or FSOC, has played a unique and vital role among regulators since its creation under the Dodd-Frank Act. Among its duties it is responsible for analyzing and detecting potential systemic risk areas in the nonbank sector (known as shadow banks) that could pose a threat to the rest of the U.S. financial system.
Through its authority, the council has designated a number of institutions as systemically risky, forcing them to abide by a more onerous set of regulatory requirements — such as higher capital thresholds and “living-will” resolution plans — broadly known as enhanced prudential standards.
On the face of it, the council relies on a methodology that draws upon six criteria used by the Basel Committee, the Financial Stability Board, and the International Association of Insurance Supervisors (IAIS). These are the nature, scope, size, scale, concentration, and interconnectedness in determining systemic risk levels. However, the similarity and clarity of methodology stops there.
Unlike these international regulatory bodies, the council does not apply transparent standards that limit its own discretion, and neither does it provide a roadmap for compliance by affected companies.
Furthermore, the council has not supported its decisions with detailed analyses specifying risk thresholds that warrant regulatory action (or SIFI designation). Nor has it identified specific type of activities or asset classes that may be riskier than others. Consequently, it has not been able to quantify the level of risk.
Furthermore, neither Dodd-Frank nor the council itself has ever clearly defined what constitutes financial distress or market instability. Nor have they designed any path for firms to shed their SIFI designation once they have it, should their risk profile drop due to restructuring.
The opacity that characterize council’s analyses has drawn criticism to the effect that its decisions can be subjective.
“I do not understand why the council does not share the qualitative and quantitative metrics it uses for its analyses,” said Mayra Rodriguez Valladares, managing principal at MRV Associates, over a phone interview with Thomson Reuters GRC.
FSOC’s authority challenged
Until the MetLife court decision, which is subject to a potential appeal, FSOC has enjoyed a significant leeway in its SIFI designation process. UNder Dodd-Frank its authority, methodology and the quality of its analyses in determining what institutions or activities are to be considered systemically risky could be challenged through a judicial review only if its final determination could be proven to be “arbitrary and capricious”.
Yet the court used these very words when it referred to the council’s process for reaching its designation decision, and stated that its decision process was fatally flawed, as it had “refused to undertake an adequate cost-benefit analysis.” Such analysis could also have included the cost of becoming a SIFI, as well as alert the firm about the likelihood that a financial shock could bring it down, and the potential risks the firm’s failure could pose to the broader economy.
The court, in an opinion released April 7, noted that “predictive judgment must be based on reasoned predictions; a summary of exposures and assets is not a prediction.” Indeed, theexposure channel analysis section in the council’s SIFI determination –one of the three transmission channels it identified, along with asset liquidation and critical function channels– amounted to little more than summing up gross potential market exposures, with little regard for mitigating factors like collateral or netting of positions.
The court decision also noted an inconsistency in FSOC’s guidance in reaching its determination on MetLife SIFI designation. FSOC asserted that it did not have to evaluate the possibility of material financial distress in a company. Instead, it based its decision on factors that increase that possibility (namely, leverage, liquidity risk, maturity mismatch among others).
Although imperceptible at the time, cracks in FSOC’s decision making process appeared earlier than the court’s ruling. The only independent member of FSOC with insurance expertise, Roy Woodall, dissented from MetLife’s (and Prudential’s) SIFI designations.
He stated that, “FSOC’s asset liquidation transmission channel analysis relied on implausible, contrived scenarios as well as failures to appreciate fundamental aspects of insurance and annuity products, and, importantly, State insurance regulation.” He voiced similar concern based on same reasoning for Prudential , when he found that the council’s “analysis utilizes scenarios that 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.”
Secretary of the Treasury Jack Lew defended FSOC’s methodology, most recently, in anopinion piece on Wall Street Journal , saying that it is “not making presumptions or jumping to any conclusions,” and stressed that “data and thorough analysis” guide the Council’s work. Referring to the court decision on MetLife, he added that, the ruling, if not overruled, “would leave one of the largest and most highly interconnected financial companies in the world subject to even less oversight before the financial crisis.”
The Secretary of Treasury officially chairs the 10 voting-member decision-making body of FSOC and holds a critical veto power in the designation process.
… but the King still has clothes
Legal entanglements aside, the SIFI designation still carries weight in encouraging large and potentially systemic institutions to lower their risk profile, even if the designation itself is no longer perceived as irrevocable as it once was.
Of the four non-bank SIFIs designated by the FSOC, three (General Electric, AIG, and MetLife) have made clearly laid down plans shortly after being designated to shed their SIFI stigma by divesting some of their businesses. General Electric has been spinning off quite a number of its units, including GE Capital, since early 2015, effectively removing itself from much of its banking business.
MetLife followed a similar path when it announced that it would divest its variable annuity and life insurance businesses in January 2016 — prior to being awarded the favorable court ruling– in order to avoid tougher capital regulations that come with the SIFI designation. And, AIG stated in January 2016 that it was reorganizing its core property-casualty operations into nine units with the intention to sell them, along with an advisor group and part of its United Guaranty Corp. subsidiary.
Prudential remains the only non-bank SIFI that has not embarked on a significant divestiture plan — it has a strong capital position – although it has discarded its commodities group and real estate brokerage. Despite initially suggesting potential legal action to challenge its SIFI designation, the firm has stopped short of doing so. It is possible, however, that should its rival MetLife win the legal battle, the firm may seek to follow a similar course.
GE petitioned to have its SIFI label removed in late March, but said the move was unrelated to the MetLife ruling.
The final outcome on MetLife may not shake the foundations of FSOC’s authority, nor challenge the reason of its very existence. It is likely that the council will still retain its power in identifying the spots in the financial system that can create systemic risk. Yet in this new brave world brought about in the aftermath of the MetLife court decision, it probably will have to become more transparent, revamping its designation process and its risk assessments by providing better guidance and clarity for the former and keener analysis for the latter.
(Bora Yagiz, FRM is a New York-based Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence, specializing in risk. He is a certified Financial Risk Manager. Mr. Yagiz has held positions as a bank examiner for the Federal Reserve Bank of New York, as senior consultant with Ernst & Young and vice president at Morgan Stanley. Follow Bora on Twitter @Bora_Yagiz. Email Bora at email@example.com)
(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Apr. 28. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)