By Peter J. Wallison.
Chairman McHenry, Ranking Member Green and members of the Committee:
My testimony today will focus on a different aspect of bank competition—the competition between banks and nonbank financial firms—what bank regulators call “shadow banking.” This needs more attention from Congress.
Under Dodd-Frank, Financial Stability Oversight Council (FSOC) has the authority to designate any financial firm as a systemically important financial institution, or SIFI, if the institution’s “financial distress” will cause “instability in the US financial system.” Non-bank financial firms designated as SIFIs are turned over to the Federal Reserve for what appears to be prudential bank-like regulation.
The troubling extent of the FSOC’s authority was revealed recently when it designated the large insurer, Prudential Financial, as a SIFI. Every member of the FSOC that was an expert in insurance (and was not an employee of the Treasury Department) dissented from the decision, arguing that the FSOC had not shown that Prudential’s financial distress could cause instability in the financial system. Virtually all the other members, knowing nothing about insurance or insurance regulation, dutifully voted in favor of Prudential’s designation.
Indeed, there was little in the document that the FSOC issued in support of its decision. The best word to describe the decision is perfunctory. There is a reason for this.
In effect, the decision on Prudential had already been made before the FSOC voted. The previous July, the Financial Stability Board, an international body of regulators empowered by the G-20 leaders to reform the international financial system, had already declared that Prudential was a SIFI. The FSOC’s action was simply the implementation in the US of a decision already made by the FSB. Since the Treasury and the Fed are members of the FSB, they had already approved its July action.
This raises a question whether the FSOC will be doing a thorough analysis of whether financial firms are SIFIs or simply implementing the decisions of the FSB. This is important because the FSB looks to be a very aggressive source of new regulation of nonbank financial firms.
In early September, it said that it was looking to apply the “SIFI Framework” to securities firms, finance companies, asset managers and investment funds, including hedge funds. These firms are the so-called shadow banks that the regulators want so badly to regulate. But it will be very difficult to show that these nonbank firms pose any threat to the financial system.
For example, designating large investment funds as SIFIs would be a major and unwarranted extension of government bank-like regulation. Collective investment funds are completely different from the banks or investment banks that suffered losses in the financial crisis.
When a bank suffers a decline in the value of its assets—as occurred when mortgage-backed securities were losing value in 2007 and 2008—it still has to repay the full amount of the debt it incurred to acquire those assets. Its inability to do so can lead to bankruptcy.
But if an investment fund suffers the same losses, these pass through immediately to the fund’s investors. The fund does not fail and thus cannot adversely affect other firms. Asset management, therefore, cannot create systemic risk.
Nevertheless, right after its Prudential decision, and following FSB’s lead, the FSOC now seems to be building a case that asset managers of all kinds should also be designated as SIFIs and regulated by the Fed. It recently requested a report from the Office of Financial Research, another Treasury body created by Dodd-Frank, on whether asset management might raise systemic risk. Not surprisingly, the OFR reported that it did.
Unless the power of the FSOC is curbed by Congress, and soon, we may see many of the largest non-bank firms in the US financial system brought under the control of the FSOC and ultimately the Fed.
As shown in my prepared testimony, these capital markets firms, and not the banks, are now the main funding sources for US business. Bringing them under bank-like regulation will have a disastrous effect on economic growth and jobs. And this outcome could be the result of decisions by the FSB, carried out by the FSOC.
This is an issue Congress should not ignore.
I look forward to your questions.
