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Systemically Important

Public Citizen lauds open eyes for financial risk

By Bartlett Naylor


Major bank failures in March stemmed from bad Trump financial policy reducing oversight of banks with as much as $250 billion in assets. Lest the nation suffer from more bad Trump policy, the Biden Treasury Department is reversing a rule regarding the supervision of other large financial institutions.

Among the most instructive, albeit painful, lessons that Congress and regulators learned from the 2008 financial crisis is that the failure of certain large financial institutions that are not regulated banks can lead to systemic repercussions in the economy. The largest failure of 2008 was that of insurance giant AIG. It wrote a type of bond insurance called credit default swaps. When the mortgage bonds against which AIG underwrote those swaps defaulted in droves, AIG was unable to make good on the claims. The government directed $165 billion in taxpayer dollars to make up the difference. One reason AIG was able to build up this portfolio of unsupportable swap contracts without detection was that, as an insurance company, it was not subject to federal oversight.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act repaired this supervisory oversight by establishing the Financial Stability Oversight Council (FSOC). Congress assigned FSOC to look for cracks in regulatory oversight. Congress further authorized FSOC to designate any institution as “systemically important,” where its failure would cause systemic repercussions. Statutorily, these are known as “systemically important financial institutions,” or “SIFIs.” Importantly, such designation is not triggered if the institution falters or fails; rather, they are designated if it is understood that their failure would cause system-wide problems. (The statute declares that a firm shall be designated a SIFI where material financial distress at a firm “could pose a threat” to US financial stability.)

The Obama Administration’s Treasury Department designated several firms as SIFIs. The Trump Administration’s Treasury Department abruptly dropped these designations. Worse, the Trump Treasury intentionally complicated the procedures by which SIFI designation takes place.

Comes now newly proposed guidance; essentially, the Biden Administration’s Treasury Department returns procedures to the precautionary status that Congress established with the Dodd-Frank statute.

The Proposed Guidance seeks to establish what the regulators call “a durable process” for FSOC to designate nonbank financial companies as SIFIs. FSOC adopted guidance in 2012, but this was before it had actually designated any institution. It now has experience, which informs this newly proposed guidance.

Additionally, because the 2019 Trump guidance muddied the waters and created inappropriate hurdles, this guidance from Biden Treasury eliminates a requirement to rely on federal and state regulators to address risks before FSOC is able to consider a SIFI designation. The 2019 Trump-era statement from Treasury ignored the AIG experience, where state regulators failed to identify the risk build up at the insurance giant. The new guidance also includes an analytic framework that includes risks that are either widespread or restricted to a single entity. The proposal also drops the 2019 cost-benefit analysis requirement. Dodd-Frank does not require cost-benefit analysis. Industry has long complained that FSOC should not designate a firm as systemically important if it’s not experiencing distress, which they identify as a cost. But the statute explicitly states that current distress is irrelevant. The point is to monitor firms whose failure could cause problems down the road. AIG showed excellent profits before the mortgage meltdown.

Since the 2008 financial crisis, industry has changed. Most mortgages now are issued by non-banks. And, private equity is much larger. Blackstone and Blackrock are giant financial institutions; BlackRock manages nearly $9 trillion in assets. The Citadel hedge fund controls more than $62 billion in assets. Clearly, failure of such firms would be traumatic. FSOC should be empowered to designate such firms.

Public Citizen enthusiastically supports this new guidance as a sober precaution. We should not be subject to the shock of a firm once considered stable that suddenly fails for lack of sound supervision.