A network Debate rages on how to protect the highly interconnected financial system from risky activity. (Image: Thinkstock)

While industry interests are supporting the Financial Stability Oversight Council’s new approach to evaluating markets’ financial systemic risk based on activities of players and institutions, some academic researchers remain wary.

FSOC has been talking about taking an “activities-based approach,” or focusing on what appear to be especially risky activities, such as some types of investment banking or speculative securities trading operations, rather than what appear to relatively stable businesses, such as selling life insurance policies designed with restrictions that keep panicked policyholders from rushing in to withdraw all of their cash value all at once.

Jeremy Kress, an assistant professor of business law at the University of Michigan Ross School of Business, told members of Congress Thursday that using activities-based rules to determine whether life insurers, asset managers or other “nonbank” companies are systemically important financial institutions (SIFIs) will fail, in part because FSOC lacks the authority it needs to set rules for companies that engage in many different types of activities.

Kress and others testified before the Senate Banking, Housing and Urban Affairs Committee on approaches to ensuring financial stability for nonbank financial institutions more than a decade after the financial crisis began.

FSOC last week voted to propose an activities-based approach to ferreting out risky activities. That’s a departure from the previously used institution-based or “entity-based” designation strategy.

That approach resulted in about 30 U.S. banks and four nonbanks — American International Group Inc. MetLife Inc., Prudential Financial Inc., and General Electric’s financing arm, GE Capital — getting SIFI designations from FSOC.

FSOC is a federal, multi-agency body that has the authority under the Dodd-Frank Act of 2010 to designate a company or an activity as systemically risky.

The four nonbank SIFIs have shed their too-big-to-fail labels.

(Related: Prudential Sheds ‘Too-Big-to-Fail’ Label, But…)

Kress says that at least one of the de-designations was illegal.

FSOC de-designated Prudential in October 2018. Prudential had $100 billion more in assets at that point than it had when FSOC classified it as a SIFI, Kress said.

FSOC “violated its formal procedures by second-guessing the council’s original assessment of Prudential’s systemic importance … and performed misleading quantitative analyses,” Kress alleged.

He said that FSOC had also dismissed evidence didn’t follow the statutes.

Under the new expected framework, it is “unrealistic” to expect that regulators are going to identify and then supervise all financial activities that might push financial markets into trouble, Kress testified. Moreover, market players will likely just restructure or rename activities to bypass any coming regulation, he warned.

Kress favors identifying the actual companies who could upend the financial system and repeatedly warned of multiple gaps in the oversight of insurers, hedge funds and fintech firms.

These holes will lead a mostly activities-based approach to fail, he argued, because the FSOC doesn’t have the authority to put rules in place over a fragmented system, at least not directly.

However, Paul Schott Stevens, president and CEO of the Investment Company Institute, testified that the new FSOC provisions, if implemented well, would reduce bad outcomes for the market.

He stated that Congress should pass legislation confirming that a company-specific designation should be a regulatory “tool of last resort,” pointing to bipartisan legislation introduced in the past by several committee members, including Sens. Thom Tillis, R-N.C., Doug Jones, D-Al., Kyrsten Sinema, D-Az. and Mike Rounds, R-S.D.

Douglas Holtz-Eakin, president of the American Action Forum, a center-right economic policy think tank, told lawmakers he welcomed the exit of the last of the institutions to be designated systemically risky with the FSOC’s vote last year to de-designate Prudential.

“For FSOC to remain relevant, it must significantly overhaul its operating procedures, beginning with a philosophy of activities-based rather than entity-specific regulation,” said the former director of the Congressional Budget Office under President George H.W. Bush.

He testified about the costs of company-specific designation, pointing out that AIG once estimated that shedding its risk label would save the company $150 million a year in compliance costs. FSOC is also proposing a cost-benefit analysis for designations in its new guidance.

AIG’s central role in the financial crisis and calibrating its financial riskiness in hindsight served as a late focal point during the hearing.

Sen. Catherine Cortez Masto, D-Nev., asked witnesses if credit default swaps on mortgage bonds were only systemic in hindsight.

Holtz-Eakin answered that he thinks they reflected the “bad internal management at AIG more than the product.” It’s not systemic, it’s the company, “and it’s bad,” he said.

Kress said it was difficult to foresee the credit default swap storm.

In response to lawmakers’ questions, witnesses agreed that it is challenging to measure systemic risk.

Any designation of asset managers or funds could cause their investors to experience returns reduced by as much as 25% over the long term, with additional costs passed on to consumers, Holtz-Eakin warned. FSOC declined to designate any asset managers as systemically risky in its era of entity designations.

He said he welcomed FSOC’s new tack with its proposed interpretative guidance, calling the previously employed nonbank designation process “arbitrary, inconsistent and opaque.”

“FSOC must redefine its mission, which must involve a shift from entity-specific regulation to activities-based regulation, or be disbanded as a regulator,” Holtz-Eakin said.

But, currently, FSOC only has the authority to issue recommendations, which are nonbinding, according to Gregg Gelzinis, a police analyst at the Center for American Progress, who was referenced in Kress’ written testimony and who was tweeting about the hearing.

FSOC does not have the authority to regulate the activities, Gelzinis noted, wondering whether Committee Chairman Sen. Mike Crapo, R-Idaho, would introduce anything that actually gave it that authority.

— Check out FSOC Proposes Changes to Nonbank SIFI Designation  on ThinkAdvisor.