Entity regulation

Same Function, Same Risks, Same Regulation

Technological progress always brings new challenges for financial regulators. While some innovations today seem revolutionary, in many cases they are not. What is new is the pace and breadth of innovation associated with fintech. Taking advantage of recent advances in information technology and communication, entrepreneurs and incumbent financial firms are creating a wide array of new intermediaries.

At a conceptual level, regulators’ approach to the risks created by these new entrants would seem to be straightforward: any provider of the same financial service, creating the same risks, should face the same regulation. Encourage innovation, but guard against any harm that it poses to the financial system.

How might we do this? Again, the answer is clear: focus on the financial activities, functions and services themselves (even though rule enforcement will almost surely proceed through the firms, entities or institutions that provide the services). Such activity-focused regulation requires an enormous shift of our approach. With our regulatory objectives in mind, we need to enumerate the financial activities and then create a framework that matches these two lists. In this post, we outline how regulators can begin to approach this task….

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Taking the **Sock** out of FSOC

In the aftermath of the financial crisis of 2007-2009, the U.S. Congress created the Financial Stability Oversight Council (FSOC – pronounced “F-Sock”)—a panel of the heads of the U.S. regulatory agencies—“to identify risks to the financial stability of the United States”; “to promote market discipline” by eliminating expectations of government bailouts; and “to respond to emerging threats” to financial stability.

Despite these complex and critical objectives, the law limited FSOC’s authority to the designation of: (1) specific nonbanks as systemically important financial intermediaries (SIFIs), and; (2) critical payments, clearance and settlement firms as financial market utilities (FMUs). Nonbank SIFIs are then supervised by the Federal Reserve, which imposes stricter scrutiny on them (as it does for large banks), while FMUs are jointly overseen by the Fed and the relevant market regulators.

At the peak of its activity in 2013-14, the FSOC designated four nonbanks as SIFIs: AIG, GE Capital, MetLife, and Prudential Insurance. Following the Council’s October 16 rescission of the Prudential designation, there are no longer any nonbank SIFIs. Not only that, but by making a future designation highly unlikely, Treasury and FSOC have undermined the deterrence effect of the FSOC’s SIFI authority. In short, by taking the sock out of FSOC, recent actions seriously weaken the post-crisis apparatus for securing U.S. (and global) financial stability. In the remainder of this post we review the Treasury’s revised approach to SIFI designation in the context of the Prudential rescission….

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