Eakinomics: FSOC and the Courts
The Dodd-Frank Act created the Financial Stability Oversight Council (FSOC) and empowered it to designate non-bank financial entities as Systemically Important Financial Institutions (SIFIs). That is as it should be — Congress creates law. At the outset, FSOC followed an entity-based approach to designating SIFIs — for all practical purposes, a focus on the size of entities — and used this to designate the insurers MetLife, Prudential, and AIG as SIFIs. Again, that is how policy should be made — the Administration implements law.
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President Trump is focusing early on rolling back regulation, and on Friday he took another good step with directives to peel back Dodd-Frank and the Labor Department’s fiduciary rule. Democrats are predicting another financial crisis, but it’s possible to build a sturdy system that also allows for more risk-taking to serve economic growth.
Start by repealing rules that add costs without making the system safer, such as the fiduciary rule that Labor imposed last year under the guise of protecting savers. The rule requires brokers to act in the “best interest” of clients, though many investors will be harmed. The rule will make investment advice too expensive for many small investors as brokers eliminate commissions and instead charge fees. Plaintiff attorneys are circling, ready to slap brokers with class-action lawsuits if stock prices fall.
Small investors may also find themselves at the mercy of robo advisers that may have a hard time discerning their client’s best interest. Want to know whether to boost your investment in health stocks if ObamaCare is repealed? Ask Alexa. Robert Litan and Hal Singer have estimated that depriving small investors of human advice could cost clients $80 billion in a downturn. Mr. Trump ordered Labor to review and perhaps rewrite the rule that was scheduled to take effect in April.
The President also directed a review of the 2,300-page Dodd-Frank law that has turned banks into regulated utilities. Gary Cohn, who runs Mr. Trump’s National Economic Council, told the Journal that Dodd-Frank’s costs and complexity have restrained bank lending. Democrats wrote Dodd-Frank with enough ambiguity so the feds could regulate as they please. But this means a new government can ease those burdens without Congress.
Take the Financial Stability Oversight Council (FSOC), which has the power to designate “systemically important financial institutions.” SIFIs must comply with onerous regulations but carry an implicit taxpayer guarantee.
Big banks that accept taxpayer-insured deposits are obvious SIFI candidates, but the Obama FSOC also tagged AIG, MetLife and Prudential Financial as SIFIs. These insurers are burdened with bank-style regulations that don’t fit their business model. MetLife sued to rescind the arbitrary designation, and a federal judge has ruled in its favor. The Trump Administration could drop the government’s appeal and settle with MetLife in a way that exempts insurers from the SIFI label.
Also in need of review is the Volcker Rule, which had the sensible goal of barring high-risk trading at taxpayer-insured banks. But regulators needed four years to finalize the abstruse 950-page rule that includes 2,800 footnotes. One iron rule of government is that the more complex a regulation, the easier to find loopholes.
Dodd-Frank’s fatal flaw is assuming that regulators who failed to prevent the last crisis will foresee and prevent the next one. All they need are more rules and more power. But financial manias happen precisely because everyone assumes the good times will last forever.
The better way to prevent a panic is to have simple but firm rules along with high capital standards that make banks better able to endure losses in a downturn. That’s the philosophy behind House Financial Services Chairman Jeb Hensarling’s proposed financial reform, and it’s the direction the Trump Administration should take even without legislation.
But will it? The President signed his directives Friday after meeting with bank executives, and he didn’t help himself politically by praising the “great returns” BlackRock has earned. The point is to help the larger economy, not bank profits.
As a Goldman Sachs alum, Mr. Cohn has a particular burden not merely to relax regulations that are the bane of big banks while doing little to relieve the burden on their smaller competitors and tech start-ups. J.P. Morgan’s Jamie Dimon and Goldman Sachs’s Lloyd Blankfein have argued against a wholesale repeal of Dodd-Frank, which has given these large incumbents a competitive advantage.
Although Mr. Cohn said the U.S. has the highest bank capital standards in the world, they aren’t as high as they should be. The trade he could offer Wall Street is less burdensome regulation in return for higher capital standards. The banks would then be freer to lend money while taxpayers have more protection against the next bailout. This would have the added political benefit of blunting the inevitable Democratic attacks that Messrs. Cohn and Trump are trying to help Wall Street.
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Most people — at least regular Eakinomics readers — are now aware of the Financial Stability Oversight Council (FSOC), the creation of Dodd-Frank with the power to impose a stringent regulatory regime on banks and non-banks that it deems to be Systemically Important Financial Institutions (SIFIs). There are sound reasons to question whether the FSOC itself is a good idea — there is no consensus on what exactly constitutes a macro risk or how to manage it — but there are even more reasons to be skeptical of the procedure used to designate non-bank financial institutions as SIFIs. A bigger problem arose when FSOC itself failed to follow its procedures when designating MetLife as a non-bank SIFI. MetLife sued to remove its designation.
MetLife won its case against the FSOC arguing that, among other things, FSOC did not conduct a proper cost-benefit analysis when it designated MetLife a SIFI. Judge Collyer wrote that FSOC had acted “arbitrarily and capriciously” by failing to consider the costs of designating MetLife. She ruled that a thorough cost-benefit analysis was required not only by the text of Dodd-Frank and basic principles of administrative law, but also by the Supreme Court’s recent decision in Michigan v. EPA.
Therein lies the rub. FSOC appealed Judge Collyer’s decision, and a ruling on the appeal is expected any day. But there is a lot more at stake than simply the future of MetLife. If the D.C. Circuit Court rejects this aspect of Judge Collyer’s decision, the precedent would be that for any case in the District of Columbia Circuit court — where most suits regarding regulation will be heard — it will be exceedingly difficult to challenge a regulatory action for lack of a proper cost-benefit analysis. This would fundamentally undermine the current efforts to reform the regulatory state to be more cognizant of regulatory burdens and more accountable to the electorate.
Why run such a risk? It is obvious why the Obama Administration’s FSOC appealed the decision. But it is far from obvious why the new administration would not simply drop the appeal, provide MetLife with an exit from SIFI status and insulate the reform efforts from this threat.
President Donald Trump has been using executive orders to push his deregulation and financial reform agenda, but there are two alternative avenues available to him to achieve key wins in this arena. Over the course of his first month in office, Trump has targeted $181 billion-worth of Obama-era regulations with executive orders. One of Trump’s key campaign promises was to dismantle the “disaster,” or 2,300 page Dodd-Frank Act. While he has previously used orders to begin chipping away at Dodd-Frank, Trump could try working through the Treasury or the Oval Office to significantly scale back associated financial regulations.
Since 2010 when President Obama signed the Dodd-Frank Act into law, the Financial Stability Oversight Council (FSOC) has had the authority to designate non-banks such as insurance companies as systemically important financial institutions, or SIFIs. But as, Bob Dylan sings, “The times, they are a changin.”
A President Trump, along with Republican control of Congress, creates opportunities to bring rationality to the dramatic mis-regulation of the financial sector embodied in Dodd-Frank. The financial services sector does not need overregulation or under regulation. It needs right regulation. The stakes are high because a SIFI designation raises serious issues with a firm’s position in the marketplace and the types of requirements that would be imposed on it.
Overregulation, a worry expressed by Donald Trump in the presidential campaign, diminishes freedom and stymies the economy. President Barack Obama is its champ. A major victory of his, therefore, was the hurriedly, recklessly passed Dodd-Frank financial reform law meant to prevent another 2008-style fiscal crisis.
Its failure is too big to ignore.