Treasury FSOC Report’s Troubling Bailout Specter

On Friday, the Treasury Department released a report on Financial Stability Oversight Council (FSOC) designations. This report could have addressed the problem underlying FSOC’s designation authority: the fact that it makes explicit which financial institutions are “too big to fail,” paving the way for more bailouts of the kind we saw in 2008. Sadly, the report flew wide of the mark, focusing on the minutiae of the designation process and all but ignoring the glaring bailout problem.

A little background. FSOC is an entity created in 2010 by Dodd-Frank, the sweeping financial reform legislation passed in the wake of the 2008 crisis. It is comprised of the heads of various financial regulatory agencies, and is chaired by the Secretary of the Treasury. One of its purposes is to facilitate communication among regulators, helping to give them a complete picture of the financial sector beyond their own territories.

FSOC’s other purpose — and arguably its primary one — is to identify systemic risk and designate certain entities as “systemically important financial institutions” (SIFIs). These SIFIs are then subject to heightened oversight by the Federal Reserve. The idea is that increased oversight will reduce the chances of these companies running into trouble, and thereby obviate the need for bailouts.

But the government has not shown itself to be adept at identifying systemic risk. Not in 2008. Not in any of the last eight financial crises, in fact. Even if the coordination among regulators facilitated by FSOC improves the government’s ability to see trouble brewing, it will never have perfect foresight.

When one of these SIFIs stumbles — as one eventually will given a long enough timeline — how will the government avoid a bailout? In the past, large firms understood with a wink and a nod that Uncle Sam was backstopping their bets. But there was at least some ambiguity. And in the case of Lehman Brothers, the government did not ultimately provide a safe landing. Could the government have let Lehman fail if it had already branded it “systemically important”? I tend to think not.

Back to the new report. The report does a good job of identifying the problems that FSOC and SIFI designation present:

Designation by the Council…should not imply that the government will rescue the designated firm in the event of failure. A market expectation of such a rescue could cause inefficient investment decisions and increased risk-taking. Nor should government discipline be substituted for the market discipline of investors, counterparties, and clients as a result of the designation process.

I couldn’t have said it better myself. Later, the report states that “a company subject to a Council designation should not receive a financial advantage from any perception that the government may rescue the company in the event of its failure. Such a perception could give the company an unfair competitive advantage in funding markets.” Again, an excellent point.

Unfortunately, while the report accurately identifies and describes some of the chief problems with the SIFI designation, it completely fails to identify any corresponding solutions.

As to market advantage, the report does note off-hand that the market may adjust once the regulatory effects become more clear. But this explanation makes little sense. Yes, the market will incorporate the advantage by pricing in the government backstop a company is likely to enjoy as a SIFI.  That doesn’t mean the effect goes away. Instead, the company’s position in the market will reflect the costs and benefits of being designated as systemically important.

As for the SIFI designation potentially forcing the government’s hand if a bailout is needed, the report simply outlines the problem and then never mentions it again. The report does recommend using an activities-based approach to regulation, although it is not clear whether this is intended to address the specific problem of creating moral hazard by designating certain firms as SIFIs. In the past, while FSOC has been troublingly opaque about its designation process, it does seem that firm size has been the most salient concern. The report notes that focusing on activities may reduce the need to designate firms, principally because firms will likely avoid activities that might trigger designation. And yet, the report provides little detail about how FSOC will evaluate activities to determine their systemic risk or even what “risk” in this context means. Given the government’s poor track record in predicting crises, it would be helpful if the report had explained how FSOC’s analysis will be different going forward. Finally, the report suggests using designations sparingly.  But as long as any firm is designated as a SIFI, the specter of government bailouts remains.

It is worth noting that the report is written as a memorandum to President Trump, and comes in response to a request he sent to the Treasury Department earlier in the year. In that request, the president asks Treasury principally about the process for designating SIFIs — a process that has left much to be desired.

But the request also asks Treasury to assess whether FSOC and its SIFI designations align with the objectives laid out in the president’s February executive order establishing principles for financial regulation. Among those objectives is to “prevent taxpayer funded bailouts.” Addressing whether SIFI designation itself might lead to more bailouts was squarely within the four corners of the president’s request. And Treasury completely ignored it.

The report makes some worthwhile suggestions about the designation process. For example, it recommends that FSOC notify companies earlier in the process, so that they can take measures to address FSOC’s concerns and avoid SIFI designation entirely. Of course, to assume that addressing these issues is a good thing is to assume that FSOC has correctly identified problems in the first place. And that may be a big assumption.

The report also recommends that FSOC “should only designate a company if the expected benefits to financial stability from Federal Reserve supervision and enhanced prudential standards outweigh the costs that designation would impose.” This is a good recommendation but I’m fairly disheartened that it’s one that must be made. Should regulators need to be told that they should only act to make things better, not worse?

Then there’s the report’s recommendation that, before making a SIFI designation, FSOC should consider whether a company is actually likely to face financial trouble: “Material financial distress at a nonbank financial company does not pose a threat to U.S. financial stability if the company will not experience material financial distress.” Indeed: things that do not happen rarely cause distress. Again, I’m disappointed this must be explicitly stated.

It might be less distressing if the report had simply failed to mention the risk that SIFI designation could give rise to more bailouts. That would leave open the possibility that alerting Treasury staff to this danger would spur some action. Instead, the report’s authors, aware of the risk and explicitly stating the need to address it, offer no explanation of how that might be accomplished.

The bottom line is that there is probably no way for the government to designate firms as “systemically important” without simultaneously creating the guarantee of bailouts later on, should the need arise. As has been argued in several other places, the SIFI designation process not only fails in Dodd-Frank’s stated mission of ending “too big to fail,” but explicitly enshrines it in law.

The FSOC itself need not be disbanded, but if we’re serious about eliminating taxpayer-funded bailouts — and I hope we are — its power to name SIFIs should end.

[Cross-posted from Alt-M.org]