Deregulation in financial stability oversight prompted lawmakers Wednesday to question if the system is strong enough to catch problems before they spread and cause contagion now that the systemically important financial institution designation has lost its teeth.
At a Wednesday hearing before the House Financial Services Subcommittee on Consumer Protection and Financial Institutions, lawmakers also expressed concern about the winnowing of staff at the Office of Financial Research, which, like the Financial Stability Oversight Council, is under the U.S. Treasury Department purview.
The 2010 Dodd-Frank Act, which created the multi-agency FSOC, paved the way for nonbanks like insurers and asset managers to be designated as SIFIs.
The three insurers and single finance company that FSOC named as nonbank SIFIs have all been set loose from their designations by the deregulatory approach of both the federal court system and the Trump administration.
FSOC is now pursuing an activities-based approach to systemic risk, OFR Director Dino Falaschetti testified.
Rep. Bill Posey, R-Fla., probed Falaschetti to explain how the current approach would have caught AIG before it wrought havoc on the financial system in 2008 during the financial crisis.
“How would they identify a derivative as being dangerous?” Posey pressed Falaschetti.
Falaschetti pointed to a list of proposed guidance that included looking at the complexity of a product.
OFR, which has served as a back bench for data research for FSOC and Treasury, has suffered a whopping 60% or more downsizing from more than 255 employees in earlier years to about 100 employees in the current administration, a source of concern for some lawmakers.
Falaschetti did respond that the office was “vigorously recruiting.”
However, Lael Brainard, a member of the Federal Reserve Board of Governors, let Posey know that the Fed, as the consolidated supervisor of any nonbank SIFIs, would have caught the problems at AIG under the now out-of-favor nonbank SIFI designation.
“For institutions with a lot of derivatives exposures that were not well risk-managed and that the company was not prepared to make good on in periods of stress, that kind of designation authority would have shown the full scope of activity to the supervisors and put in place resolution planning [and] liquidity requirements [and] capital buffers against the full scope of activities as opposed to the more narrow pieces that were under regulation,” Brainard testified.
Lawmakers continued to fret about the demise of the SIFI designation for nonbank companies and where it might lead in times of market stress.
“Is it appropriate that Prudential Financial, a company with over $800 billion in assets, has as its chief regulator, the New Jersey Department of Banking and Insurance?” asked Rep. Jesus “Chuy” Garcia, D-Ill., who raised the AIG bailout and the real pain felt by constituents pushed to peddle fruit and wares on the streets during the financial crisis.
“I’m worried that we failed to learn the lessons of 2008 and are making the same mistakes,” Garcia said.
Prudential is a former SIFI that shed its designation and thus its Fed oversight under Treasury Secretary Steven Mnuchin’s chairmanship of FSOC.
“I thought [SIFI designations of companies] was a very important authority,” Brainard told Garcia. “Nonbank activities were important and could be in the future sources of systemic risk,” she said.
Garcia pointed out that the FSOC’s financial stability report itself sounded a warning on leveraged loans to corporations, noting that the more risky tranches are primarily held by asset managers, insurance companies, hedge funds and structured credit funds.
In light of this, “do you really believe there is not a single insurance company, asset management firm, hedge fund, finance company or standalone investment bank whose failure could threaten financial stability today?” Garcia asked.
Brainard replied that although she was no longer close to FSOC matters, she believes “nonbank activities were important and could be in the future important sources of financial risk.”
“I certainly would feel more confident if we had greater lines of sights into where some of those nonbank, nonsupervised holdings are sitting,” she said.
The meeting also focused on some lawmaker concerns about collateralized loan obligations (CLOs), which spiked in 2018 but, according to the Fed, have slowed slightly.
Brainard testified that the Fed and bank regulators can monitor the direct exposures of the banking system in the form of loan portfolios and warehousing exposures. Yet, the Fed governor expressed concern about the indirect and more opaque exposures, underscoring in her testimony that “nonbank exposures are harder for us to track.”