Will the wriggling FSOC acquire relevance below Yellen?

WASHINGTON – Following the 2008 financial crisis, lawmakers established the Financial Stability Oversight Council, which acts as an early warning system to identify future threats before the next collapse. But since its inception, the group has faltered, with many wondering what the future of the body is in store for them.

The Dodd-Frank Act gave the FSOC the power to designate certain non-bank financial firms that are viewed as a threat to global markets, which in turn would subject them to bank-like oversight. However, in the past decade the council has named only four companies, all of which have now been delisted, and the budget and staffing have been cut.

Some are welcomed by Treasury Secretary Janet Yellen's Chairmanship of FSOC, who they hope will initiate a rethinking of the Interagency Council and the Office of Financial Research, which is located in the Treasury and supports the work of the Council.

"Very often when regulators are relatively young, early leaders create one imprimatur and others follow," said Kathryn Judge, professor at Columbia Law School. "I don't think FSOC has seen its brilliant moment yet, but I think it's possible it will be."

The judge is one of those closely watching whether Yellen will repeal the 2019 guidelines finalized by the FSOC under former Secretary Steven Mnuchin, which changed the process of designating "systemically important financial institutions" and highlighted regulatory activities in contrast to certain companies.

For some, Treasury Secretary Janet Yellen is already signaling a change in strategy as the Council pursues initiatives to study climate change risks and hedge funds.

Bloomberg News

Although Mnuchin said at the time that the so-called activity-based approach would provide clearer guidelines for the FSOC's review of certain companies, critics – including Yellen himself – expressed concern that the new process would undermine the council's purpose.

"It is against the legal obligations of the FSOC to unnecessarily restrict the tools Congress provides to pursue its mission," wrote Yellen, a former Federal Reserve chairman, in a letter to Mnuchin who spoke with former Fed Chairman Ben Bernanke and Ben Bernanke was signed to former Finance Ministers Tim Geithner and Jacob Lew. They added, "The Designation Authority is an essential complement to the prudential oversight of banks in a financial system where other financial firms are allowed to compete alongside banks without being subject to similar regulatory restrictions on leverage and funding."

For some, Yellen is already signaling a change in strategy as the council pursues initiatives to study climate change risks and hedge funds. A tougher stance comes as control increases over what led to the recent Archegos Capital collapse. Several banks posted significant losses in late March after the hedge fund was forced to sell $ 30 billion worth of stocks.

"The recent debacle with Archegos Capital also raises really important questions [which] … will only properly fall within the purview of the FSOC as they are issues that require the attention of both banking regulators and market regulators," said Judge.

Yellen's own opposition to council reforms in 2019 paved the way for her to overturn Trump-era guidelines, which ultimately made it harder to name companies, said Gregg Gelzinis, senior policy analyst at the Center for American Progress.

"We are assuming a place where the chairman of the FSOC has been shown to be strongly against these guidelines," he said. "I think then that it becomes very, very likely that these guidelines will either be repealed entirely or changed significantly."

But Yellen has signaled that the SIFI designation conceived in Dodd-Frank may not be entirely appropriate for certain companies either. In an exchange with Senator Elizabeth Warren, D-Mass., Last month, Yellen declined to label individual asset managers like BlackRock as systemically risky. Instead, she stated that she would advocate restrictions on asset management instead.

"I think that in terms of asset management, it is important to focus on such activity and review the appropriate constraints, rather than focus on naming companies," she said.

Such an approach could be more effective than naming specific companies, said Thomas Vartanian, founder and executive director of the Financial Regulation & Technology Institute at George Mason University's Law School.

“The question is not what institution can create a series of dominoes that fall across the economy. I think that's a good question, but it's not a critical question to deal with, ”he said. "I think the question is … what are the economic indicators across the economic and financial services system that we should be concerned about because of the risk they pose?"

Put another way, Yellen supports an activity-based approach but still intends to go in a different direction than the Trump administration, the judge said.

"It is not about activity-based regulation, but about using activities as a proxy to figure out how to set up a regulatory agenda," the judge said. "[Yellen] is likely to oppose activity-based regulation in the form adopted throughout the previous administration, which … was an excuse not to use the tools made available to the FSOC."

Still, Gelzinis says labels for specific companies should stay on the table, just without the extra steps that the 2019 guidelines added to the process of determining if a company is systemic. This included assessing the likelihood that a company is under financial strain and performing a cost-benefit analysis of bank-like oversight.

"I'm not trying to say that labels are the key to every problem, but they're a solution, and they're probably a solution to a lot of problems here," Gelzinis said.

At Yellen's first FSOC meeting last week as Chair, she announced that she would revitalize the council's hedge fund working group and said she intended to focus on brokering non-bank funding, the resilience of the U.S. financial market and focus on the emerging risks of climate change.

This could set the stage for new research, policy recommendations and coordination on these issues among the 10 regulators of the FSOC, aside from a possible review of the “activity-based approach”.

"The way our system is set up is kind of a silo," said Vartanian. "But when you have 10 different silos, they don't necessarily talk to each other or do things consistently. So there is no coordination when it comes to system stability and that is exactly what FSOC should be."

The hedge fund working group reviving Yellen could be a good start, Gelzinis said. The working group, originally convened in 2014, made five data recommendations to better understand the potential risks of highly indebted hedge funds before they expire in 2016.

"This Archegos incident has re-emphasized the importance and potential risks that hedge funds can pose to prime brokers and potential financial stability if the fund is large enough and has significant leverage," Gelzinis said.

This time around, the working group could collect more recent data related to hedge fund behavior at the start of the COVID-19 pandemic and give policy recommendations to FSOC regulators.

“I think the ultimate goal is the actual guidelines. You can identify a risk and talk about it until the cows get home. However, if you don't mitigate that risk, you haven't done much, ”Gelzinis said. "I think that's the ultimate goal for this working group."

Meanwhile, Bloomberg News reported that the Biden government plans to develop a strategy to assess climate-related risks for public and private financial assets. Under the plan, the Treasury Department would work with FSOC members to share climate-related financial risk data and produce a report within six months, the intelligence service reported.

However, in order to help the Council achieve its full potential, resources need to be strengthened in both the Board of Directors and the Research Office, the experts agree. Under the Trump administration, officials reduced the staffing of the FSOC by nearly 60% and reduced the budget for both the FSOC and the Office of Financial Research by more than 25%.

"I think from the perspective of FSOC it takes number one to get the most advanced forms of technology and artificial intelligence to work on its behalf," said Vartanian. "It has OFR to do that, but I don't think OFR has armed the OFR with the resources or the technology."

Rebuilding institutional capacity in the council should be one of Yellen's first priorities on the council, Gelzinis said.

"I don't think you can handle this moment and face all of these challenges without rebuilding the workforce that has been undermined at both FSOC and OFR," he said. "For me this is the first priority with which you can do everything else successfully."

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