Thursday, March 2, 2017

Congressional Report Takes on FSOC "Too Big to Fail" Designations

"FSOC Designations of ‘Too Big to Fail’ Firms are Arbitrary and Inconsistent"

The House Financial Services Committee (“House Committee”) issued a report on February 28, 2017 calling into question the process by which the Financial Stability Oversight Council (FSOC) designates certain non-bank companies as "too big to fail.” Based on subpoenaed documents requested by the House Committee and the sworn testimony of Treasury Department officials, the report concludes that the FSOC is "inconsistent and arbitrary" in exercising its power to designate certain nonbank companies as systemically important. The report echoes criticisms made by government watchdogs and courts of the FSOC's transparency and its nonbank SIFI designation process.  


The Designation Process

The Dodd-Frank Act authorizes the FSOC to determine that a nonbank financial company’s material financial distress (or the nature, scope, size, scale, concentration, interconnectedness, or mix of its activities) could pose a threat to U.S. financial stability.[1] Termed “systemically important financial institutions” or SIFIs, companies so designated are subject to consolidated supervision by the Federal Reserve and enhanced prudential standards.[2] While Congress identified ten factors that the FSOC must consider when assessing whether material financial distress at a company could pose a threat to the national economy[3], the FSOC was free to create their own evaluation processes and methodologies and was allowed to consider additional factors, if necessary.[4]


The FSOC disclosed its process for SIFI designation in rules published on April 11, 2012, and supplemented on February 4, 2015 and June 8, 2015. The designation guidelines lay out a three-part process involving:

(1) narrowing potential nonbank SIFI candidates based on quantitative thresholds,

(2) evaluating potential nonbank SIFI candidates from step one based on the potential that candidates may pose a threat to financial stability, and

(3) application of additional quantitative and qualitative analyses of the overall risk of SIFI candidates to determine if consolidated supervision and additional prudential standards are warranted.  


Report Findings

Based on sworn testimony and records reviewed by the House Committee’s staff, however, the report concludes that the FSOC does not adhere to its own rules and guidelines. The report faults the FSOC for deviating from its published guidelines for SIFI determination by: 

  • considering non-systemic risks rather than merely systemic risks,
  • forgoing or assuming away analysis of whether SIFI candidates could reasonably pose both impairment and significant damage on the economy,
  • failing to evaluate all SIFI candidates consistently in the “context of a period of overall stress in the financial services industry and in a weak macroeconomic environment.”


The Committee’s review of FSOC data also led it to the conclusion that the FSOC’s analysis of companies has been "inconsistent and arbitrary.” The report cites what it says are instances in which the FSOC failed to apply the same standards between nonbank financial companies that were designated SIFIs and those that were not.  In particular, the report claims that the FSOC did not analyze each nonbank financial company’s vulnerability to financial distress in the same way, if at all. Also, the report asserts that use of collateral in certain financial transactions was applied as a mitigating factor against designation in some instances, but not all.  


Other Critics of the FSOC

The House Committee is not the only body to find fault with the FSOC’s designation processes. The report notes that the GAO had found similar faults in the FSOC's transparency and the SIFI designation process, citing deficiencies in:

  • the FSOC’s documentation of the process, 
  • transparency regarding the rationales for its determination decisions, and 
  • over-reliance on nonbanks’ likelihood for financial distress rather than its activities, potentially excluding as SIFI candidates companies that may pose a threat to U.S. financial stability.


In addition, in March of 2016, the U.S. District Court for the District of Columbia ruled in favor of MetLife’s challenge of its SIFI designation.[5] In its legal opinion, the court found that in making its SIFI determination the FSOC "made critical departures from two of the standards it adopted in its Guidance, never explaining such departures or even recognizing them as such.”  As a result, the court found the "FSOC’s determination process fatally flawed,” and that the designation of MetLife was "arbitrary and capricious under the latest Supreme Court precedent." 


The Future of the FSOC

Rep. Jeb Hensarling (R-TX) who chairs the House Committee that authored this report is an outspoken critic of the FSOC's power to designate SIFIs and its lack of transparency and accountability. In his opening statement before the House FSOC Oversight Hearings on December 8, 2015, Rep. Hensarling said:


“FSOC typifies not only the shadow regulatory system but also the unfair Washington system that Americans have come to fear and loathe:  powerful government administrators, secretive government meetings, arbitrary rules, and unchecked power to punish or reward. Thus, oversight and reform is paramount."


It is not surprising then that the Financial CHOICE Act, Hensarling's proposed replacement to Dodd-Frank, contains a provision that would revoke most of the FSOC’s powers, limiting it to reviewing financial stability and reporting to Congress its analysis. The congressman is expected to introduce a revised version of his Financial CHOICE bill sometime this year. Citing the House Committee’s February 28, 2017 report, the OMB’s report, and the FSOC’s legal setback as justification, the new CHOICE bill will likely deal just as harshly with the FSOC. 

NOTE: At the time of this writing, neither the FSOC nor the Treasury Department has responded to the House Committee’s report. 


The full text of the House Financial Services Committee’s February 28, 2017 report is available via:



[1] 12 U.S.C. § 5323(a)(1). Eligible companies may be designated by the FSOC for enhanced supervision under either of two determination standards: (1) when “material financial distress” at a company “could  pose a threat to the financial stability of the United States”; or (2) when the very “nature, scope, size, scale, concentration, interconnectedness, or mix of the [company’s] activities” could pose the same threat. 


[2] Under 12 U.S.C. § 5365(B)(1) these additional prudential standards include: (i) risk-based capital requirements and leverage limits, [subject to limited exception]; (ii) liquidity requirements; (iii) overall risk management requirements; (iv) resolution plan and credit exposure report requirements; and (v) concentration limits. The Federal Reserve may also establish “additional standards,” such as: (i) a contingent capital requirement; (ii) enhanced public disclosures; and (iii) short-term debt limits.   In addition, the Federal Reserve is authorized to establish “such other standards as [it] determines are appropriate.”


[3]  12 U.S.C. § 5323(a)(2).  In making nonbank SIFI determinations, the FSOC must consider the following factors: 

(1) the extent of the leverage of the company;

(2) the extent and nature of the off-balance-sheet exposures of the company;

(3) the extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;

(4) the importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;

(5) the importance of the company as a source of credit for low income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;

(6) the extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;

(7) the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;

(8) the degree to which the company is already regulated by 1 or more primary financial regulatory agencies;

(9) the amount and nature of the financial assets of the company;

(10) the amount and types of the liabilities of the company, including the degree of reliance on short-term funding.


 [4] Id. § 5323(a)(2)(K). In addition, FSOC “shall consider . . . any other risk-related factors that [it] deems appropriate.” 


[5] On December 18, 2014, MetLife was notified by the FSOC that it had been designated a non-bank SIFI. Dodd-Frank Section 113(h) provides that a designated company may seek judicial review, and MetLife sued to challenge the decision. On March 30, 2016 the U.S. District Court ruled in MetLife’s favor and rescinded FSOC’s designation of the company. The Department of Justice on behalf of FSOC has appealed that decision and the case is now under consideration by the U.S. Court of Appeals for the DC Circuit.