Financial Stability Oversight Council Research Articles

Publication Review: FSOC Report on Digital Asset Financial Stability Risks and Regulation

The Journal of FinTechOnline Ready Free AccessPublication Review: FSOC Report on Digital Asset Financial Stability Risks and RegulationJune DilevskyJune DilevskyE-mail Address: [email protected] Search for more papers by this author https://doi.org/10.1142/S2705109922800013Cited by:0 PreviousNext AboutSectionsPDF/EPUB ToolsAdd to favoritesDownload CitationsTrack CitationsRecommend to Library ShareShare onFacebookTwitterLinked InRedditEmail By Financial Stability Oversight Council 1500 Pennsylvania Avenue, NW, Washington, D.C., 2022, 120pp. To download the report: https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf FiguresReferencesRelatedDetails Recommended Online Ready Metrics History Published: 8 March 2023 PDF download

CDS Spreads, Systemic Risk and Global Systemically Important Insurers Designations

After the recent court case overturning the Financial Stability Oversight Council (FSOC)’s systemic importance designation of MetLife, the public raises awareness about the robustness of the identification methodology for global systemically important insurers (G-SIIs). As the G-SII identification framework proposed by the International Association of Insurance Supervisors (IAIS) lacks empirical support and relies heavily on historical accounting data, we examine how systemic risk measures constructed from credit default swaps (CDS) data, which are market-consistent and forward-looking, can supplement the IAIS’ identification framework. Using a dataset of insurers’ CDS spreads between 2011 and 2015, we construct three different kinds of systemic risk measures (i.e., MESCDS, networks of CDS spreads and absorption ratio) and assess the G-SII designation results announced by the Financial Stability Board (FSB). We find that: 1) the systemic risk of designated G-SIIs is, on average, higher than other insurers, suggesting that the IAIS’ G-SII identification methodology is, in general, sound and effective; 2) reinsurers should fall within the IAIS’ G-SII assessment exercise, as some of them generate more systemic risk than the designated G-SIIs; and 3) given the non-negligible litigation risk from the designated G-SIIs, the regulators should consider supplementing their G-SII identification methodology with CDS-based systemic risk measures to substantiate their designation decisions in court.

An FSOC for Continuous Public Investment: The National Reconstruction and Development Council

The crisis our nation presently faces does not stem from COVID-19 alone. That was the match. The kindling was that we have forgotten for decades that “national development” both (a) is perpetual, and (b) requires national action to guide it, facilitate it, and keep it inclusive. Hamilton and Gallatin, Wilson and Hoover and Roosevelt all understood this and built institutions to operationalize it. Although the institutions were imperfectly operated, they were soundly conceived and designed. Abandoning these truths and institutions these past fifty years has degenerated not only our public health but also our nation’s industrial and infrastructural muscle to a critical point. The same now increasingly holds for our social fabric. Full national regeneration—Reconstruction in both the post-Civil War and the mid-20th century senses of the word—has thus become a matter of urgent, even existential, necessity. Continuous national development, in the perpetual renewal sense of the phrase, must follow that Reconstruction. This is what “Building Back Better” must mean. Key to any such national project is how it is organized and then orchestrated. This paper proposes means of both organizing and orchestrating. These means are simultaneously incrementalist in their reliance upon existing institutions, while also regenerative in enabling new synergies among those same institutions—much as our Financial Stability Oversight Council (FSOC) is meant to enable our post-Lehman financial regulators to develop. An FSOC for national reconstruction and development will better use what we already have and augment it with a financing arm linked to the Federal Reserve and the Treasury. I call the resulting synthesis a National Reconstruction and Development Council (NRDC) and National Investment Council (NIC), which will both rebuild capacity now, and perpetually renew such capacity going forward, as knowledge and technology progress as they always do. Building Back Better means Building Back Now and Forever.

An FSOC for Continuous Public Investment: The National Reconstruction and Development Council

The crisis our nation now faces does not stem from Covid alone. That is the ‘match.’ The kindling is simply our having forgotten for decades that ‘national development’ both (a) is perpetual, and (b) requires national action to guide it, facilitate it, and keep it inclusive. Hamilton and Gallatin, Wilson and Hoover and Roosevelt, … all ‘got’ this. They built institutions to operationalize it – imperfectly operated, but soundly conceived and designed. Our having abandoned these truths and these institutions these past fifty years has enabled not only our public health, but also our nation’s industrial and infrastructural muscle, to degenerate to a critical point. The same now increasingly holds of our social fabric. Full national regeneration – ‘Reconstruction’ in both the post- Civil War and the mid-20th century senses of the word – has thus become a matter of urgent, even ‘existential,’ necessity. And continuous ‘National Development,’ in the ‘perpetual renewal’ sense of the phrase, must follow that Reconstruction. This is what ‘Building Back Better’ must mean.Key to any such national project is how it is organized and then orchestrated. This Paper proposes means of both organizing and orchestrating. These means are simultaneously ‘incrementalist’ in their reliance upon existing institutions, while also ‘regenerative’ in enabling new synergies among those same institutions – much as our Financial Stability Oversight Council is meant to enable our post-Lehman financial regulators to develop. An FSOC for national reconstruction and development will better use what we already have, and augment it with a financing arm linked to the Fed and the Treasury.I call the resulting synthesis a National Reconstruction and Development Council (NRDC) and National Investment Council (NIC), which will both rebuild capacity now, and perpetually renew such capacity going forward, as knowledge and technology progress as they always do. ‘Building Back Better’ means Building Back Now and Forever.

Do Nonbank Mortgage Companies Pose Systemic Risk to the US Economy?

This working paper reviews the work of the Financial Stability Oversight Council (FSOC) in terms of identifying potential systemic risk in the nonbank sector under authority from the Dodd-Frank Wall Street Reform Act of 2010. We discuss past efforts by the agencies represented within the FSOC to impose capital requirements on nonbank financial institutions such as insurers, mortgage lenders and servicers. The FSOC Annual Report issued in 2019 is then reviewed and assessed. Finally, recommendations are made to assist the FSOC in better understanding the systemic risks, if any, posed by nonbank companies engaged in lending and loan servicing.

Would Macroprudential Regulation Have Prevented the Last Crisis?

How well equipped are today’s macroprudential regimes to deal with a rerun of the factors that led to the global financial crisis? To address the factors that made the last crisis so severe, a macroprudential regulator would need to implement policies to tackle vulnerabilities from financial system leverage, fragile funding structures, and the build-up in household indebtedness. We specify and calibrate a package of policy interventions to address these vulnerabilities—policies that include implementing the countercyclical capital buffer, requiring that banks extend the maturity of their funding, and restricting mortgage lending at high loan-to-income multiples. We then assess how well placed are two prominent macroprudential regulators, set up since the crisis, to implement such a package. The US Financial Stability Oversight Council has not been designed to implement such measures and would therefore make little difference were we to experience a rerun of the factors that preceded the last crisis. A macroprudential regulator modeled on the UK’s Financial Policy Committee stands a better chance because it has many of the necessary powers. But it too would face challenges associated with spotting build-ups in risk with sufficient prescience, acting sufficiently aggressively, and maintaining political backing for its actions.

The Value of Systemic Unimportance: The Case of MetLife*

Abstract We use an event study approach to estimate the burden of the financial regulations associated with Systemically Important Financial Institution (SIFI) designation. On March 30, 2016, the US District Court determined that MetLife’s SIFI designation was arbitrary and capricious because the Financial Stability Oversight Council (FSOC) failed to weigh the economic cost of the financial regulation on MetLife against the benefits of increased financial stability. We find significant positive abnormal returns for MetLife and AIG on the date of the ruling. We estimate that the lifting of the SIFI designation created $1.4 billion in corporate wealth for MetLife, suggesting that MetLife would be 3.4% more profitable as a non-SIFI. These gains fall short of the $8 billion stipulated by MetLife in its complaint. We also find significant abnormal returns to SIFI institutions on the day following the US Presidential election.

Activities Are Not Enough!: Why Nonbank SIFI Designations Are Essential to Prevent Systemic Risk

Since the financial crisis, policymakers have developed two different approaches to systemic risk arising from nonbank financial firms such as insurance companies and investment banks. The first, dubbed an entity-based approach, empowers a public entity like the Financial Stability Oversight Council or Financial Stability Board to designate individual nonbank systemically important financial institutions for enhanced regulation and supervision. The second, known as an activities-based approach, seeks to regulate financial activities that can produce systemic risk. During the first several years after the crisis, governments and multi-national standard setters embraced both entity- and activities-based approaches to the problem of nonbank systemic risk. More recently, however, an emerging view has begun to dominate financial regulatory circles: that regulators should focus principally on an activities-based, rather than an entity-based, approach. This book chapter challenges this emerging consensus. It argues that, in the absence of entity-based designations, a purely activities-based approach will expose the financial system to the same risks that the world experienced in 2008. This chapter, which is substantially based on a more detailed law review article by the authors, focuses on the international dimensions of nonbank systemic risk regulation and the shift by multi-national standard-setters to an activities-based approach.

Would Macroprudential Regulation Have Prevented the Last Crisis?

How well equipped are today’s macroprudential regimes to deal with a re-run of the factors that led to the global financial crisis? We argue that a large proportion of the fall in US GDP associated with the crisis can be explained by two factors: the fragility of financial sector — represented by the increase in leverage and reliance on short-term funding at non-bank financial intermediaries — and the build-up in indebtedness in the household sector. We describe and calibrate the policy interventions a macroprudential regulator would wish to make to address these vulnerabilities. And we compare and contrast how well placed two prominent macroprudential regulators — the US Financial Stability Oversight Council and the UK’s Financial Policy Committee — are to implement these policy actions.

Unconventional Monetary Policy and Risk-Taking: Evidence from Agency Mortgage REITs

We study how the Federal Reserve's quantitative easing (QE) influenced the behavior of Agency mortgage real estate investment trusts (REITs)—a set of institutions identified by the Financial Stability Oversight Council as posing systemic risk. We document that Agency mortgage REITs: [i] equity prices reacted to QE announcements and in a manner consistent with their business prospects; [ii] grew markedly during QE2 and receded during QE3 in relation to the Federal Reserve's Agency MBS purchase activity; and [iii] increased their leverage during QE3. Our findings are consistent with unconventional monetary policy actions crowding out private investment and reaching for yield behavior by financial institutions.

Systemic Risk and Regulation: The Misguided Case of Insurance SIFIs

This paper provides an overview of research and debate over whether insurance poses systemic risk, with a focus on U.S. life insurance. It considers the Financial Stability Oversight Council (FSOC) process for designating nonbank financial institutions as systemically important and subject to enhanced supervision by the Federal Reserve under Section 113 of the Dodd-Frank Act, the FSOC’s rationales for designating AIG, Prudential, and MetLife, and MetLife’s challenge. The paper highlights the adverse consequences of designating individual insurance entities for enhanced supervision, which favor an alternative activities-based approach to addressing potential systemic risk. The principal conclusions are: (1) there is no compelling evidence that any life insurer poses a threat to the financial stability of the United States, (2) the Section 113 and FSOC regime of designating individual insurance organizations as subject to enhanced supervision is flawed in concept and execution, and (3) it would be preferable to move towards an activities-based approach to systemic risk monitoring and supervision.

Knightian Uncertainty, Systemic Risk Regulation, and the Limits of Judicial Review

In MetLife, Inc. v. Financial Stability Oversight Council, Civil Action No. 15-0045 (RMC) (D.D.C. March 30, 2016), the U.S. District Court for the District of Columbia overturned the designation of MetLife, Inc., as a systemically important financial institution regulated by the Federal Reserve Board. It reversed on two grounds. First, it held that the Financial Stability Oversight Council ignored its published guidance by not calculating the statistical probability of MetLife experiencing material financial distress or the magnitude of ensuing losses to MetLife’s counterparties. In addition, it determined that FSOC failed to but should have considered the costs of designation to MetLife. In doing so, the District Court ignored the fact that much of systemic risk oversight operates on the frontiers of what the economist Frank H. Knight termed the unknowable. It is impossible to quantify the likelihood of material financial distress (in its systemic sense) at any given nonbank financial services provider through multivariate statistical analysis. For that reason, in the Dodd-Frank Act, Congress permitted FSOC to evaluate systemic risk at nonbank firms based on qualitative factors and descriptive statistics without the need for multivariate statistical regressions or multivariate similar techniques. By requiring FSOC to make statistical projections that are impossible to make with confidence, the District Court not only vacated MetLife’s designation but undermined major aspects of the broader scheme for regulating systemic risk that Congress mandated in Dodd-Frank.

Comment on “Error and Regulatory Risk in Financial Institution Regulation”

Comment on “Error and Regulatory Risk in Financial Institution Regulation”

Kautilya on Foresight, Oversight, Regulations, Ethics and Systemic Risk

In the wake of the recent Great recession of 2008-9, prudential supervision and “too-big-to-fail” have become the focal topics of discussion and policy. Western countries have added prudential supervision to complement the traditional regulatory approach to prevent reoccurrence of financial crisis. Additionally, large financial institutions are subjected to repeated “stress tests” to diagnose the vulnerability of the financial system. Kautilya had argued a long time ago that moral failure was the primary source of the systemic risk. Keeping that in view, relevance of his three insights is presented. Firstly, regulations, prudential supervision and ethical grounding are needed for preventing future financial crisis. That is, current approach of relying only on regulations and supervision, most probably would not prevent future financial crisis. Secondly, if moral hazard resulting from moral failure is the primary source of systemic risk, undue focus on “too-big-to-fail” financial institutions is unwarranted. Thirdly, Financial Stability Oversight Council’s two objectives, promoting market discipline and prevention of another financial crisis, do not seem to be compatible with each other.

The Impact of the Dodd-Frank Act on Financial Stability and Economic Growth

This article assesses the benefits and costs of key provisions of the Dodd-Frank Act that strengthened regulation following the financial crisis. The provisions are placed into five groupings: clear wins, clear losses, costly tradeoffs, unfinished business, and too soon to tell. Clear wins include higher prudential standards, including for capital; the single-point-of-entry resolution authority; creation of the Consumer Financial Protection Bureau; and greater transparency and oversight of derivatives. Clear losses are restrictions on Federal Reserve emergency lending authority and forcing the Federal Deposit Insurance Corporation to obtain permission from Congress before providing temporary liquidity guarantees. Costly tradeoffs are the Volcker Rule and the Lincoln Amendment. Unfinished business includes regulatory consolidation and more independence for the Financial Stability Oversight Council and the Office of Financial Research. Too soon to tell are requirements and standards for leverage ratios, capital buffers, stress testing, and liquidity requirements.

Too Big for Administrative Law? FSOC Designations and the Fog of 'Systemic Risk'

The Dodd-Frank Act empowers the Financial Stability Oversight Council to designate nonbank financial companies as systemically important, and thus subject them to enhanced prudential supervision and regulation by the Federal Reserve, if the FSOC finds that the company “could” pose a “threat” to U.S. financial stability. Questions of systemic financial risk require profoundly difficult predictive judgments, based on hypothetical judgments and worst-case scenarios, as evidenced not just by the 2007–2008 financial crisis that precipitated the law, but also by the broader intellectual and philosophical questions raised by the specter of low-probability, high-impact events — or, as they’re often called, “Black Swans.” This paper traces the evolution of that statutory and regulatory framework, beginning with the 2007–2008 financial crisis and requiring the FSOC to push the limits of arbitrary-and- capricious agency action — and, most likely, to exceed these limits. This preliminary draft was prepared for discussion at a conference on current issues in financial regulation, hosted by the Center for Study of the Administrative State, at George Mason University's Antonin Scalia Law School on December 9, 2016.

Regulation by Threat: Dodd-Frank and the Non-Bank Problem

A central lesson of the global financial crisis is that banks are not the only types of financial firms that can pose dangers to the broader financial system. One of Dodd-Frank’s primary mechanisms for responding to this reality is to empower a council of financial regulators to designate individual non-bank financial institutions as systemically risky. Although the Financial Stability Oversight Council (FSOC) has only exercised this authority four times, it has occasioned considerable controversy in court, in Congress, and among commentators. This Article defends the FSOC designation scheme, arguing that most of its critics misunderstand the mechanisms by which it helps to reduce systemic risk outside of the banking sector. FSOC designation does not, and cannot, precisely distinguish between firms that could pose a systemic risk and those that could not. FSOC’s broad discretion to impose costly sanctions on designated firms instead advances two quite different goals. First, it deters non-bank firms from seeking out systemically risky strategies or activities. Second, it holds financial regulators to account by threatening to impose additional restrictions and supervision on the firms they regulate if they fail to address systemic risk on their own. We term this approach “regulation by threat,” and suggest that it is appropriate when risks are hard to identify, the perils of mistake are great, and the downsides of misdiagnosis extreme. Systemic risk outside of the banking sector meets this description to a tee. Moreover, we argue that the Council’s discretion is better cabined by its structure – which features diverse membership, voting, review, and political safeguards – than by insistence on particularly “hard look” judicial review, accompanied by the requirement of a cost benefit analysis for any individual designation decision. Similarly, the various reform proposals to limit FSOC’s discretion or impose additional procedural limits on its operations generally threaten to undermine the Council’s effectiveness by unnecessarily limiting its discretion, and thus its capacity to regulate by threat.

A Pilot Survey of Agent Securities Lending Activity

This paper reports aggregate statistics on securities lending activity based on a recently concluded pilot data collection by staff from the Office of Financial Research (OFR), the Federal Reserve System, and staff from the Securities and Exchange Commission (SEC). In its annual reports, the Financial Stability Oversight Council identified a lack of data about securities lending activity as a priority for the Council. This pilot data collection was a step toward addressing this critical data need. The voluntary pilot collection included end-of-day loan-level data for three non-consecutive business days from seven securities lending agents. Most but not all participating lending agents were subsidiaries of banks. The dataset of 75 reporting fields provides substantial new information about securities lending activity, including information concerning securities owners, securities borrowers, attributes of securities loans, collateral management, and cash reinvestment practices. However, the pilot data collection was limited in scope and duration. Comprehensive data are still lacking. To close this data gap, a permanent collection of data covering securities lending activity is recommended by the Council.

The symbolic politics of delegation: macroprudential policy and independent regulatory authorities

ABSTRACTThis paper investigates the motivations that led policy-makers to delegate macroprudential authorities to newly created independent systemic regulatory authorities (SRAs). Three case studies are examined: the US Financial Stability Oversight Council, the European Systemic Risk Board and the UK’s Financial Policy Committee. Policy-makers’ motivations are captured by examining the specific institutional features of the newly created SRAs and by tracing the legislative debates that surrounded their creation. The findings of this empirical analysis call into question several of the conventional claims that are used to justify delegation to technocratic agencies from the functionalist and ideational scholarship. Given the limitations of the explanations based on efficiency considerations and socialisation of welfare losses, this paper suggests that the delegation of powers to SRAs was ultimately motivated by what is referred to as the ‘logic of symbolic politics.’ It is argued that the main motivation that emerges from the legislative debates for delegating this important task is that the SRAs provided a quick institutional ‘fix’ to signal to the public that in the wake of the international crisis of 2007–2009, policy-makers were redressing regulatory mistakes made prior to and during the crisis that had caused a severe deterioration of public’s wealth.

Oversight of the Financial Stability Oversight Council: Due Process and Transparency in Non-Bank SIFI Designations

This is testimony given by the author before the House Committee on Financial Services on 19 November 2015 in connection with MetLife v. Financial Stability Oversight Council (FSOC). The author argues that the FSOC's SIFI-designation process represents a textbook case of a familiar finance-regulatory strategy, long upheld by our courts, aimed at dutifully discharging necessary Congressional delegation on the one hand while comporting with separation of powers and due process values on the other hand. He also argues that FSOC represents a quintessentially American, pragmatic solution to the long-festering 'silo' problem in American financial regulation, and that its designations of systemically important financial institutions (SIFIs), decided as they are by all of the nation's principal financial regulators, are entitled to great deference on grounds of (a) well-settled doctrine under Chevron, (b) the highly technical character of the problem with which FSOC deals, and (c) the exceptionally high stakes of failure adequately to monitor large, complex financial institutions.