Senate Banking Committee Hearing on FSOC Nonbank Designations
Senate Banking Committee
“Financial Stability Oversight Council Nonbank Designations”
Thursday, March 14, 2019
Key Topics & Takeaways
- Financial Stability Oversight Council (FSOC) Improvement Act: Stevens said the bill would enhance prudential supervision for fund managers, prevent fiduciary obligations for fund advisors from being broached by the Fed, and prevent bank regulations from overlapping prudential funding regulations. Stevens also said the bill would not change the FSOC timetable to control the designation process and will provide clarity for primary regulators to take steps to offramp. Holtz-Eakin said the bill would provide primary regulators a beneficial step in the process and create a chance for nonbanks to know their risks to remediate and offramp. Kress said for many nonbanks there is no appropriate regulator with authority to address the systemic risks.
- Nonbank SIFI Designation: Holtz-Eakin said the requirement to hold more capital would affect natural institution vitally and cost consumers more over time. Kress said nonbanks played a big part in the 2008 collapse and still contain many systemic risks unrelated to financial stability, consumer and investor protection, and that the designation is the only way to subject nonbanks to enterprise-wide safeguards like consolidated capital and risk management requirements to limit risks to the system.
- Activities-Based Approach: Holtz-Eakin stated that using a framework of identifying systematic dangers and burdens on primary regulators to insulate firms through activity-based approach is a good step forward. Kress said that when regulators are left with activities-based approaches, consistency and uniformity is lacking in the process.
Sen. Mike Crapo (R-Idaho), Chairman
In his opening statement, Crapo said the committee should continue to reform the Financial Stability Oversight Council (FSOC) to assist in identifying and addressing threats to financial stability. He noted the FSOC nonbank designation authority is an area for improvement, as the current process is unclear and immeasurable. Crapo said according to a Government Accountability Office (GAO) report, the FSOC process lacks transparency, accountability, sufficient data, and has no consistent methodology, which shows in its rescinding of four major nonbank designations. Crapo said this overall leads to higher costs being assumed by consumers and the economy. He said the process should be robust, clear and focused on addressing real risks, and should take in account how existing regulatory structures already address potential risks, before taking the “drastic” step of Systematically Important Financial Institution (SIFI) nonbank designations. Crapo recommended taking particular steps to reform the process, including using an activities-based approach, designating only if expected benefits to financial stability outweigh costs of the designation, and providing a clear offramp for nonbank companies by identifying key risks and enhancing transparency in the review process. Crapo said FSOC’s recent approval of a plan to make substantive changes prioritizing activity-based designations, conducting Cost Benefit Analysis (CBA) prior to designation, using the six-category framework, increasing procedural framework, and providing off ramp proposals, is the step in the right direction.
Sen. Sherrod Brown (D-Ohio), Ranking Member
In his opening statement, Brown said the FSOC nonbank designations matter due to risks Wall Street poses to America. He said the risks are costing jobs, retirement savings, leading to Americans falling behind. Brown said the FSOC, the administration, and Congress should evaluate risk, not profits. He said there is a lack of strong rules for oversight of nonbank risks, and the FSOC seems “to be closed for business.” Brown stated his priority to safeguard against systemic risks, and that the recent FSOC changes are making it more difficult for nonbank designations to safeguard against such risks. Brown said ignoring these risks and the rise of shadow banking led to the downturn in 2008, and it seems the Treasury is cutting staff and resources necessary for the FSOC to do its job. He said there is a need to overcome “collective amnesia” and give the FSOC more authority and resources.
Dr. Douglas Holtz-Eakin, President, American Action Forum
In his testimony, Holtz-Eakin said nonbank SIFI designations have a less than glorious track record, and there is a need for a system that measures risks to help regulate it. He said that under Dodd-Frank two criteria have been vague: the series of designations is not well thought out, and designations that did not occur would have profound impact to cost structures, ultimately passing the costs to consumers and leading to lowering return on investment (ROI) for their retirement savings. Holtz-Eakin said the FSOC authority is important and should move forward with three recommendations: an activities-based approach, disciplined CBA priorities to designation, and transparency and predictability for remediation and a path to offramp. He said the FSOC guidance plan is a good step but requires a permanent solution. Holtz-Eakin said a CBA would help assess likelihood for firms at risk, and would provide pre-designation risk in efforts to create an offramp, to reduce systematic risks.
Paul Schott Stevens, President and CEO, Investment Company Institute
In his testimony, Stevens said stability of financial markets is of the utmost concern to the Investment Company Institute (ICI) and major U.S. and global investors. Stevens said ICI supports sharing and coordinating information and activities between regulators and the FSOC and providing them convening authority. Stevens recommended using nonbank SIFI designation only under extraordinary circumstances, and the FSOC reducing risks though more effective and less burdensome methods. He said ICI supports the FSOC reviewing products and activities, as designations lead to bank-like regulations for investors, disrupting market stability and causing a reduction in consumer choice and market competition. Stevens also recommended greater engagement, a greater role for primary company regulators, more analytical rigor and attention, and greater transparency from the FSOC. He commended moving towards an activities-based approach that includes industry-wide designation of products and activities, de-risking company activities, and resorting to SIFI designation as a last resort. Stevens said S. 603, the Financial Stability Oversight Council Improvement Act, is a good bill and Congress should work to pass it.
Dr. Jeremy C. Kress, Assistant Professor of Business Law, University of Michigan
In his testimony, Kress said nonbank SIFI designations are very important, and recent efforts to de-emphasize or eliminate them would expose financial systems similar to 2008. He said these designations prevent catastrophic collapse like those of the Lehman Brothers, AIG, and Bear Stearns and safeguard from nonbank systematic risks. Kress said criticisms of these designations are not persuasive, and that the Federal Reserve has recognized distinct issues with nonbanks to tailor their approach to address risks. He said an activities-based approach is misguided and will not prevent collapses as financial companies often rename and restructure activities to avoid regulations, and that the U.S. framework is not configured to implement an activities-based approach. Kress said the FSOC lacks authority to directly implement activity-based rules, and this would undermine efforts to enact a uniform and consistent framework, leading to the FSOC facing more challenges to combat risks. He expressed concern about Treasury not currently using activities-based approaches, and their efforts to cut staff, funding, and authority for the FSOC.
Question & Answer
Financial Stability Oversight Council Improvement Act
Sens. Mike Rounds (R-S.D) and Doug Jones (D-Ala.) asked whether the Financial Stability Oversight Council Improvement Act improves efficiency for FSOC communication efforts and the designation process. Stevens said the bill would enhance prudential supervision for fund managers and prevent fund advisors from being broached by the Federal Reserve (Fed), and prevent bank regulations from overlapping prudential funding regulations. Stevens also said the bill would not change the FSOC timetable to control the designation process and will provide clarity for primary regulators to take steps to offramp. Holtz-Eakin said the bill would provide primary regulators a beneficial step in the process and create a chance for nonbanks to know their risks to remediate and offramp. Kress said for many nonbanks there is no appropriate regulator with authority to address the systemic risks. He said under the three-step interruptive guidance the FSOC increases coordination with companies to seek information before designation and that he is concerned with additional requirements beyond this plan leading to delays and any future designation being subject to judicial review if any shortcomings are presented in the FSOC process.
2008 Financial Crisis
Sens. John Kennedy (R-La.), Catherine Cortez Masto (D-Nev.) and Brown asked about mortgage credit swaps, what led to the 2008 crisis, and mitigating risk moving forward. Hotlz-Eakin stated credit default swaps were an important element in the crisis, but the collapse of AIG occurred due to poor internal management. Stevens said the idea of delivering a larger part of financial systems to Federal Reserve regulators is an imperfect model because they struggle to regulate the banking industry and the structure is not created to address other models. Kress stated that an activities-based approach would not have prevented the 2008 crisis, considering in 2004-2006 the President’s Working Group (PWG) on financial markets was the FSOC body, composed of various financial regulators, and they focused on hedge funds, mutual funds, and terrorist risk insurances unrelated to mortgage funds. He said the PWG eventually, in 2008, proposed enhanced rules for mortgage securities and derivatives, one week before Bear Stearns collapsed, and was an ineffective body.
Nonbank SIFI Designation
Sens. Crapo, Cortez Masto, and Brown asked about the costs and role of nonbank SIFI designations. Holtz-Eakin said the cost of these designations consist of shared compliance costs from stress tests, hiring of personnel, and reporting requirements that are costly to institutions and get passed on to consumers and shareholders. He said the requirement to hold more capital would affect natural institution vitally and cost consumers more over time. Kress said nonbanks played a big part in the 2008 collapse, and still contain many systemic risks unrelated to financial stability, consumer and investor protection, and designation is the only way to subject nonbanks to enterprise-wide safeguards like consolidated capital and risk management requirements to limit risks to the system. He said SIFI designation is not an emergency tool, it is supposed to be prophylactic to implement safeguards. Kress added that the Fed statutory mandate to tailor rules to nonbank designations is a beneficial tool under this authority.
Sens. Crapo and Cortez Masto asked about activity-based approaches. Stevens said the FSOC has vast members and expertise on the board and that writing regulation is impossible for them, but financial remediation and an activities-based approach is workable. Holtz-Eakin recommended using a framework of identifying systemic dangers and burdens on primary regulators to insulate firms through an activities-based approach is a good step forward. Kress said that when regulators are left with activities-based approaches, the process lacks consistency and uniformity.
Systemic Risks to Current Regulatory Systems
Sens. Elizabeth Warren (D-Mass.), Kennedy, Cortez Masto, and Crapo asked questions about current risks in the U.S., whether banks are too big to fail, capital requirements, and other approaches to remediate risks. Holtz-Eakin and Stevens said it is difficult to measure systemic risk with accuracy. Holtz-Eakin said that there is a difference between being too big to fail and the probability of failing. He said the failure of banks is quite low in demand-induced recessions in the U.S. Holtz-Eakin said there is also no substitute for equity requirements in the financial system as it is the greatest buffer for failure, but does come at a tradeoff of safety versus low costs for consumers. Kress said the FSOC is not tasked with measuring systemic risk, and that big banks are risky, highly leveraged, don’t have market discipline as non-financial institutions, and their size exasperates corporate governance, which pose risks that are difficult to manage.
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