[Senate Hearing 114-103]
[From the U.S. Government Publishing Office]
S. Hrg. 114-103
THE ROLE OF THE FINANCIAL STABILITY BOARD IN THE U.S. REGULATORY
FRAMEWORK
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED FOURTEENTH CONGRESS
FIRST SESSION
ON
EXAMINING THE ROLE OF THE FINANCIAL STABILITY BOARD ON U.S. REGULATORS
INCLUDING WITH RESPECT TO ITS INFLUENCE ON THE FINANCIAL STABILITY
OVERSIGHT COUNCIL
__________
JULY 8, 2015
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
MIKE CRAPO, Idaho SHERROD BROWN, Ohio
BOB CORKER, Tennessee JACK REED, Rhode Island
DAVID VITTER, Louisiana CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois JON TESTER, Montana
DEAN HELLER, Nevada MARK R. WARNER, Virginia
TIM SCOTT, South Carolina JEFF MERKLEY, Oregon
BEN SASSE, Nebraska ELIZABETH WARREN, Massachusetts
TOM COTTON, Arkansas HEIDI HEITKAMP, North Dakota
MIKE ROUNDS, South Dakota JOE DONNELLY, Indiana
JERRY MORAN, Kansas
William D. Duhnke III, Staff Director and Counsel
Mark Powden, Democratic Staff Director
Jelena McWilliams, Chief Counsel
Elad Roisman, Senior Counsel
Laura Swanson, Democratic Deputy Staff Director
Graham Steele, Democratic Chief Counsel
Elisha Tuku, Democratic Senior Counsel
Dawn Ratliff, Chief Clerk
Troy Cornell, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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WEDNESDAY, JULY 8, 2015
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Brown................................................ 2
WITNESSES
Dirk Kempthorne, President and CEO, American Council of Life
Insurers....................................................... 4
Prepared statement........................................... 32
Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy
Studies, American Enterprise Institute......................... 6
Prepared statement........................................... 36
Paul Schott Stevens, President and CEO, Investment Company
Institute...................................................... 7
Prepared statement........................................... 47
Eugene Scalia, Partner, Gibson, Dunn & Crutcher LLP.............. 9
Prepared statement........................................... 72
Adam S. Posen, President, Peterson Institute for International
Economics...................................................... 10
Prepared statement........................................... 88
Additional Material Supplied for the Record
Prepared Statement of Michael S. Barr, The Roy F. and Jean
Humphrey Proffitt Professor of Law, University of Michigan Law
School......................................................... 93
Prepared statement of Chris Brummer, J.D., Ph.D., Professor of
Law, Georgetown University Law Center.......................... 95
Prepared statement of the National Association of Mutual
Insurance Companies............................................ 98
Prepared statement of the Property Casualty Insurers Association
of America..................................................... 103
(iii)
THE ROLE OF THE FINANCIAL STABILITY BOARD IN THE U.S. REGULATORY
FRAMEWORK
----------
WEDNESDAY, JULY 8, 2015
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:01 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Richard Shelby, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The hearing will come to order.
Today the Banking Committee will examine the role of the
Financial Stability Board, or what we call the ``FSB,'' in our
domestic regulatory framework.
The FSB is an international body that monitors and makes
recommendations about the global financial system. It was
established in April 2009 by the G-20.
Most of the members of the FSB are political appointees and
banking regulators. The three U.S. regulators who are members
of the FSB are the Treasury, the Federal Reserve, and the SEC.
As I mentioned at a Banking Committee hearing on the FSOC
in March, the FSB is not a U.S. regulator, and it is not
accountable to Congress or the American people.
At this same hearing, when asked about whether the FSB has
the power to designate U.S. firms as ``systemically risky,''
Secretary Lew acknowledged, and I will quote him, that ``the
FSB cannot designate a firm for us.'' And yet Secretary Lew
could not recall any particular instance in which the FSOC had
deviated from the FSB. Interesting.
Furthermore, two out of the three insurance companies that
the FSOC has designated were first designated by the FSB. The
question that appears is whether FSB designations have become a
substitute for the independent judgment of our regulators. And
if they have, what do we know about the FSB's designation
process?
The U.S. regulatory process should be open and transparent
and should encourage public participation in the rulemaking
process. Because the FSB process is opaque and devoid of public
participation, very little is known about the specifics of its
deliberations.
There remains much uncertainty regarding how a consensus is
reached and the degree to which U.S. regulators are involved in
FSB decisionmaking.
Ultimately, the FSB process should not allow U.S.
regulators to avoid our own rulemaking process or congressional
oversight.
In past hearings we have heard from the Treasury, the Fed,
and insurance experts, among others, about the interplay
between the FSB and the FSOC. Today the Committee here will
receive testimony from those affected by the FSB process as
well as experts who have studied and analyzed the FSB and its
impact on U.S. companies.
Senator Brown.
STATEMENT OF SENATOR SHERROD BROWN
Senator Brown. Thank you, Mr. Chairman. Welcome to the five
witnesses today. Thank you for joining us.
This month, as we know, marks the fifth anniversary of the
passage of Dodd-Frank and the Consumer Protection Act, over 7
years since the worst crisis since the Great Depression began
to spread through the global financial system.
As the months and years pass, we cannot forget that damage
that was done because we are still living with the after
effects. This Committee can never forget that in its
deliberations. We continue to see the damage done to Americans'
finances and their lives. We must make sure that financial
reform continues. That reform should not stop at the edge of
our shores.
The financial crisis showed us and showed the world how
interconnected our financial system had become, how fragile and
fragmented the regulatory system actually is.
In 2009, the leaders of the G-20 nations outlined an
agenda, agreed to an agenda to guide international financial
reforms and ``too big to fail.'' Improved capital standards
make markets more transparent and resilient.
The Financial Stability Board was formed, and international
reform initiatives were launched. We have heard over and over
in this room the importance of international cooperation and
the need for improved global standards.
In September 2009, SEC Commissioner Casey testified before
a Banking Subcommittee, ``International cooperation is critical
for the effectiveness of financial regulatory reform efforts.
The G-20 banking statement . . . '' she went on, `` . . .
correctly recognizes that, due to the mobility of capital in
today's world of interconnected financial markets, activities
can easily shift from one market to another.'' She continued:
``Only collective regulatory action can be effective in fully
addressing cross-border activity in our global system.''
In March 2012, Treasury Under Secretary Brainard appeared
before this Committee and said, ``We have secured agreement
internationally to strengthen liquidity standards and limit
leverage. We have identified the globally systemically
important banks. We have agreed to a capital surcharge for
these banks. We have developed a comprehensive set of enhanced
prudential measures to address risks from globally active
financial institutions.''
She continued: ``However, there is much work that needs to
be done. We must remain vigilant against attempts to soften the
national application of new capital and liquidity and leverage
rules.''
These statements, Mr. Chair, only begin to explain the need
for international coordination and financial regulation, not a
new concept. Basel dates back to the mid-1970s. The Financial
Stability Forum, the predecessor to FSB, was formed 16 years
ago. Cross-border cooperation is important because just in
recent memory we have seen several domestic and international
financial crises. From the savings and loan crisis in the 1980s
and 1990s, the bailout of Mexico in the mid-1990s, the Asian
financial crisis in 1997, which led to the failure and bailout
of the hedge fund Long-Term Capital Management, through to the
financial crisis, and the default and uncertainty facing Greece
right now, we know that another financial crisis can happen and
that it will happen. It will affect more than any single
nation.
It is the desire to prevent the next crisis that should
drive us to broad global efforts and higher regulatory
standards so that no market falls behind and allows unchecked
risk to accumulate. The world cannot afford another AIG or
Lehman. To make sure it does not have to, the United States has
led global reforms, passing comprehensive Wall Street reform
quickly in 2010, pushing for higher capital requirements,
improving derivatives regulation, building out resolution
mechanisms.
We can and need to do more. Risks do not just build up
overseas. They build up here in the shadows. Yesterday, IMF
released its 5-year financial sector assessment of the United
States. It identified several areas of so-called shadow banking
where we still have work to do. We need to address gaps in
regulation and oversight. We need to ensure that regulators
communicate globally. We need to expose areas where excessive
risk develops.
Given that all the systemic risk questions have not been
answered and regulations are still being considered and
implemented, it is clear our work is not done. I hope today's
witnesses will highlight the importance of international
coordination to a stable financial system. It would be a shame
if instead criticism of a nonbinding international coordinating
body were used to weaken or stop the kinds of safeguards needed
to prevent the next AIG.
Thank you, Mr. Chairman.
Chairman Shelby. Thank you. Thank you, Senator Brown.
Without objection, at this point I would like to enter into
the record statements from the following organizations:
Property Casualty Insurance Association of America and the
National Association of Mutual Insurance Companies. Without
objection, it is so ordered.
Senator Brown. Mr. Chairman, excuse me a second. If I
could, Mr. Chairman, I have two statements I would like entered
into the record: one from Michael Barr, University of Michigan
Law School, and one from Professor Christopher Brummer of
Georgetown Law School.
Chairman Shelby. Without objection, so ordered.
Senator Brown. Thank you, Mr. Chairman.
Chairman Shelby. They will be part of the record.
Our witnesses today--I think we have a distinguished panel
here--include the Honorable Dirk Kempthorne. He is no stranger
to a lot of us. He is President and the CEO now of the American
Council of Life Insurers. Governor Kempthorne has had a
distinguished public service career and has previously served
as Secretary of the Interior as well as mayor, U.S. Senator,
and Governor of Idaho. Dirk, thank you.
Peter Wallison is no stranger to this Committee either. He
is well known and distinguished in his own right. He is the
Arthur F. Burns Fellow in Financial Policy Studies at the
American Enterprise Institute. Mr. Wallison has held a number
of Government and private sector positions over his notable
career, and the Committee welcomes him again.
Mr. Paul Schott Stevens is President and CEO of the
Investment Company Institute. Mr. Stevens is a well-known
lawyer and previously served in senior Government positions at
the White House and the Defense Department.
Mr. Eugene Scalia is a Partner at Gibson, Dunn & Crutcher.
Mr. Scalia is a renowned administrative law scholar and
practitioner who previously served as U.S. Solicitor at Labor
and as a Special Assistant to the Attorney General of the
United States.
Dr. Adam Posen, the President of the Peterson Institute for
International Economics, will be our fifth witness. Dr. Posen
is a member of the Council on Foreign Relations. He previously
served as an external member of the Bank of England's rate-
setting Monetary Policy Committee.
All of your full written testimonies will be made part of
the hearing record, and, Dirk, we will start with you.
STATEMENT OF DIRK KEMPTHORNE, PRESIDENT AND CEO, AMERICAN
COUNCIL OF LIFE INSURERS
Mr. Kempthorne. Mr. Chairman, thank you so much. Chairman
Shelby, Ranking Member Brown, and all Members of the Committee,
thank you for this opportunity.
I would like to begin with a sincere thank you for
shepherding through Congress last year important legislation
that the Federal Reserve needed. Enactment of the Insurance
Capital Standards Clarification Act, a fix to the Collins
amendment, should enable the Federal Reserve to appropriately
account for the fundamental differences in business models
between banking and insurance. This was Congress at its best,
bipartisan work to enact essential legislation.
ACLI is the principal trade association for the U.S. life
insurance industry. Life insurers offer real solutions to help
millions of American families. We help people plan and save for
retirement. We help people cope when a loved one dies. We help
people who are disabled and need long-term care. Government
will face more problems without the solutions offered by life
insurers.
I offer three observations:
First, the Financial Stability Oversight Council should
utilize an activities-based approach to identifying systemic
risk rather than designate individual companies based merely on
size.
Second, the Federal Reserve should finalize their work on
capital standards in a way consistent with congressional
intent.
Third, common sense and good policy certainly should
require that the United States write its own insurance capital
standards before agreeing to any international standards.
Getting our standards completed at home and done right needs to
happen first. This will require Congress to continue proper
oversight of the work of Federal agencies who represent the
United States on the Financial Stability Board, the
International Association of Insurance Supervisors, and FSOC
should also be subject to congressional oversight.
I thank Chairman Shelby and Senators Heller and Tester for
including language in pending legislation to increase
opportunities for stakeholder input and congressional
oversight.
With respect to capital standards, ACLI is grateful that
the Federal Reserve will proceed with a methodical process that
will include a formal rulemaking and public comment period.
ACLI also commends the FSB and FSOC for considering an
activities-based approach for assessing the potential risks of
asset managers before systemic designations.
Yet with respect to insurers, I am troubled by the fact
that these two organizations have made no similar effort.
Instead, these organizations have chosen to designate
individual companies as SIFIs without providing insight into
the rationale for such designations or how the designations
could have been avoided.
The fact is that the FSB named institutions as ``globally
systemic important insurers,'' or G-SIIs, and the FSOC followed
suit. Designated companies were not accorded any ability to
engage directly with the FSB over its review or to challenge a
designation. The process is closed and opaque.
In a similar lack of transparency, FSOC also pursued the
designation of individual insurance companies and provided the
public with little, if any, rationale. FSOC's only independent
voting insurance expert, Roy Woodall, former commissioner in
Kentucky, raised serious concerns over the intersection between
the FSB's actions and FSOC's decisionmaking. To quote Mr.
Woodall, ``Although not binding on the Council's decision, the
declaration of Prudential as a G-SII by the FSB based on the
assessment by the U.S. and global insurance regulators,
supervisors, and others who are members of the IAIS has
overtaken the Council's own determination process.''
A relevant issue is how a company once designated a SIFI
can exit being a SIFI. In other words, what is the off ramp to
exit the SIFI highway? The answer to that question will help
companies understand how they became SIFIs in the first place.
Chairman Shelby, I thank you for working to provide the off-
ramp exit in pending legislation.
It is important for the Federal Reserve's capital standards
and the FSB's international capital standards to work in
harmony, not in conflict. Quite frankly, there should be no
rush in writing international capital standards for insurance
companies in a very short period of time. After all, consider:
It took 13 years to write Solvency II. It took 11 years to
write Basel II. Life insurers want international standard
setters to take the time to get it right, to avoid adverse or
unintended consequences. This will help preserve the ability of
insurers to provide financial and retirement security to
millions of families.
To quote Senator Tim Scott, ``the more successful the
insurance company industry is, the less Government will have to
do.'' We should embrace policies that enable Government to
focus on those who are truly needy.
Mr. Chairman, that is why the issues that you have
presented here today with the Committee are so vitally
important. Thank you for being vigilant in guarding against
unintended consequences of regulatory action wherever and
whenever they occur.
Thank you, Mr. Chairman.
Chairman Shelby. The Honorable Peter Wallison, welcome
again.
STATEMENT OF PETER J. WALLISON, ARTHUR F. BURNS FELLOW IN
FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE
Mr. Wallison. Thank you, Chairman Shelby, Ranking Member
Brown, and other Members of the Committee. Both the Financial
Stability Board and the Fed have made clear in public
statements that they want to impose prudential regulation on
what they call the ``shadow banking system.'' Both defined
``shadow banking'' as all financial intermediation outside the
regulated banking system. This means broker-dealers, asset
managers, mutual funds, insurance companies, hedge funds, and
any other firm that is not a regulated bank.
Prudential regulation is the regulation of risk taking.
This is normally the prerogative of a firm's managers. So what
the FSB and the Fed mean by placing shadow banking under
prudential regulation is they want to control the risk taking
of firms in the capital markets. This would be a major change
in the capital markets where firms are generally regulated for
conduct and not told by regulators what risks are permissible.
The free capital markets in the United States are the source of
our economic growth. Prudential regulation would end that
freedom.
The Treasury and the Fed are members of the FSB. Treasury
Secretary Lew has repeatedly denied that the United States is
bound by decisions made at the FSB. He told the House Financial
Services Committee, ``We work in the FSB to try to get the
kinds of standards that we think are appropriate in the United
States to be adopted around the world.'' This tells us two
things:
First, FSB is important because it provides a forum for
negotiating rules that will be globally effective. The Fed
cannot control shadow banking from the United States alone.
Second, Secretary Lew's statement makes sense only if the
FSB's decisions can be implemented in the United States. No
other country will abide by the FSB's decisions if the United
States does not. This raises the question where the Treasury
and the Fed think they have gotten the authority to implement
the FSB's decisions in the United States.
Unfortunately, it may be in the Dodd-Frank Act. Section 113
of Dodd-Frank says that the FSOC can designate a firm of any
size as a SIFI if its mix of activities could cause instability
in the U.S. financial system.
A year ago, Fed Governor Daniel Tarullo, who leads the
FSB's efforts on shadow banks, said it was necessary ``to
broaden the perimeter of prudential regulation both to certain
nonbank financial institutions and to certain activities of all
financial actors.'' The key word here is ``activities.''
In 2013, in outlining how it would regulate shadow banks,
the FSB stated that ``risk creation may take place at an entity
level''--what they mean is in a SIFI, a single institution--
``but it can also form part of a complex chain of
transactions''--still quoting here--``in which leverage and
maturity transformation occur in stages.''
This is a highly implausible idea, I think, but it is the
foundation of the FSB's efforts to impose prudential regulation
on the shadow banking system. The FSB would do it through
controlling ``complex chains of transactions.'' But this is how
business is done in the capital markets. Firms there buy, sell,
securitize, finance, and trade risks and assets through complex
chains of transactions.
Recently the Fed's Vice Chair, Stanley Fischer, adopted the
same idea, saying in a speech that, ``A complex chain of
activity can increase the likelihood or severity of systemic
stress.'' Thus, it appears that a global effort to control
shadow banking will probably be based on an FSB agreement to
regulate complex chains of transactions. But in the United
States, because of the Dodd-Frank language quoted earlier, it
will be based on regulating complex chains of activities.
Thus, the FSOC could threaten to designate nonbank firms as
SIFIs if they do not cease a certain class of activities--
unless the Fed approves the activity. That would, in effect,
give the Fed the authority to approve activities only if done
under the Fed's prudential rules.
If this Committee does not want to see prudential
regulation of the capital markets, it has to make clear to the
FSOC and the Fed that the term ``activities'' in Dodd-Frank
cannot be used for this purpose.
Thank you very much for the opportunity to testify this
morning.
Chairman Shelby. Mr. Stevens.
STATEMENT OF PAUL SCHOTT STEVENS, PRESIDENT AND CEO, INVESTMENT
COMPANY INSTITUTE
Mr. Stevens. Thank you, Chairman Shelby, Ranking Member
Brown, Members of the Committee. I am grateful for this
opportunity to discuss the FSB and the role it plays
internationally as well as here in the United States.
The Investment Company Institute is an association whose
members include mutual funds and other regulated funds in the
United States and in jurisdictions worldwide. ICI understands
the importance of sound, tailored regulation in maintaining
strong and resilient financial activities in a financial
system.
In recent years, we have made numerous submissions to the
FSB, including detailed responses to its successive
consultations on asset management. Our experience with these
consultations and with FSB more generally raises very serious
concerns.
FSB asserts a very broad mandate, no less than the
stability of the entire global financial system; but most of
its members and virtually all of its leadership consists of
central bankers or finance ministry officials. The FSB
describes its efforts in the asset management sector as a
review of ``shadow banking.'' This disparaging term reflects
the FSB's bias that all financial activity conducted outside of
banks is inadequately regulated and, therefore, is ``risky''
because it is not subject to bank standards and bank regulatory
supervision.
Compounding this predisposition are FSB's broad lack of
expertise on funds and capital markets as well as its
insufficient regard for empirical evidence on the regulated
fund industry, including our historical experience, structure
and practices, and existing form of regulation.
As a result, FSB's proposed methodology for G-SIFI
designation proceeds on the basis of flawed assumptions and
mere conjecture. Indeed, they appear almost reverse engineered
to result in possible designation of certain large U.S. asset
managers and the largest U.S. mutual funds.
Now, this is ironic. Unlike banks, the group of U.S. stock
and bond funds that FSB would single out for possible
designation demonstrated a high degree of stability during the
financial crisis. Why? As we have repeatedly explained to FSB,
mutual funds use little to no leverage. They do not ``fail''
like banks and do not require Government intervention. Their
structure and regulation limit risk as well as the transmission
of risk. And as history has repeatedly demonstrated, they do
not experience ``runs'' or ``fire sales'' during times of
stress.
In our view, FSB is not conducting its work with the same
degree of rigor required of regulators in this country, nor is
it operating with the same kind of transparency. We do not know
the positions that U.S. representatives have taken on the
methodologies proposed by FSB for possible G-SIFI designation.
We do know that the whole work stream in this area is being led
by the Fed.
It does seem plain that there are extensive links between
FSB and FSOC. It seems certain that any final FSB methodology
for possible G-SIFI designation of mutual funds and their
managers, no matter how deeply flawed it may be, will influence
FSOC's own review of asset management and financial stability.
In our judgment, a sector-wide appraisal of activities and
practices is the best way to evaluate any potential risks in
asset management. The Board of the International Organization
of Securities Commissions, a global group of securities
regulators with long experience in overseeing funds and asset
managers, has recommended that a review of asset management
activities ``take precedence'' over consideration of individual
funds or asset managers as systemically important.
Clearly, FSB's work would be far better informed and far
more effective if FSB were reconstituted to accord capital
markets regulators an equal place and an equal voice at the
table. It would appear that for both FSB and FSOC, however,
designation of mutual funds or their managers remains a live
policy option. Subjecting U.S. mutual funds or their managers
to bank-like regulation will harm millions of Americans saving
for long-term goals like retirement. The direct costs will be
substantial while the overlay of enhanced prudential
supervision will introduce a highly conflicted form of
regulation, clearly not in the best interests of fund
shareholders. So, in sum, ICI strongly commends this Committee
for its oversight of the role of U.S. regulators in the FSB.
Regarding FSOC's designation process, ICI believes that
before designating a company, FSOC should be required to
specifically identify any risks and communicate those risks to
the company and its primary regulator. It should provide a more
meaningful role for the primary regulator to address risks, and
it should provide companies under consideration with the
opportunity to ``de-risk'' prior to designation.
We, therefore, strongly support Chairman Shelby's efforts
to reform FSOC's designation process and are pleased that he
has included these common-sense reforms in Title III of S.
1484, the Financial Regulatory Improvement Act.
Mr. Chairman, thank you for the opportunity to present our
views. I look forward to your questions.
Chairman Shelby. Thank you.
Mr. Scalia.
STATEMENT OF EUGENE SCALIA, PARTNER, GIBSON, DUNN & CRUTCHER
LLP
Mr. Scalia. Chairman Shelby, Ranking Member Brown, and
Members of the Committee, thank you for the opportunity to
appear before you today. It is an honor.
I speak to you today not as an expert on financial
institutions, but as a lawyer who practices administrative law
and who has represented clients in connection with the
Financial Stability Board and designation as a systemically
important institution by FSOC. This includes representing
MetLife in connection with its designation as a SIFI, but today
I testify in my individual capacity and not on behalf of any
clients. The views I will express are my own.
I would like to touch on three legal points that I hope may
frame the Committee's consideration of the FSB.
First, it is a basic principle of administrative law that,
in the words of one court, an agency should not ``adjudge the
facts or law of a particular case in advance of hearing it.''
So in one case, the court found that there had not been due
process of law when an agency decisionmaker had made a speech
indicating that he had already reached a decision on a matter
that was currently pending in a case before him. The person who
had given the speeches was not the only decisionmaker involved
in those proceedings, but the court in the case said,
``Litigants are entitled to an impartial tribunal, whether it
consists of one person or 20.'' And it added that there was no
way of knowing what influence that one member had had.
There is no record of the role the U.S. members played in
the FSB's designation of the three U.S. insurance companies we
have heard about as systemically important. But to the extent
that one or all of the U.S. members joined in those
designations by FSB, it becomes a legitimate subject of inquiry
what effect that subsequently had in FSOC proceedings.
Second, and related, the designation process before FSOC
must not serve as a forum for implementing decisions
essentially already made before the FSB. Dodd-Frank sets forth
specific criteria for FSOC to apply. The FSB criteria are
different to the extent that they can be discerned at all. Most
important, Dodd-Frank establishes procedures for FSOC to reach
its decisions. Under law, those procedures must present
companies a real and genuine opportunity to make their case
before open-minded decisionmakers.
The statements you have heard by FSOC Member Woodall that
FSB's designations have ``overtaken'' FSOC's designation
process are troubling. By way of analogy, if the judge wrote in
dissent that her colleagues had based their decision on
considerations other than applicable law, the facts in the
record, and the explanations set forth in their majority
opinion, we would regard that as a matter warranting further
inquiry.
The third point I'll make is that weaknesses in FSOC's SIFI
designation decisions to date give further reason to question
whether the rationale in those decisions is a full account of
what drove FSOC's decisionmaking. One such weakness is FSOC's
insistence on a company-specific designation process for
insurance companies even as it considers an activities-based
approach for other entities.
In explaining in its MetLife decision why it was not taking
an activities-based approach, FSOC used circular reasoning. It
said that Dodd-Frank required it to consider specific statutory
criteria when making a company-based designation and ``an
activities-based analysis is not one of the statutory
considerations.''
In other words, FSOC said that it was not considering an
activities-based approach because it had not considered taking
an activities-based approach. One is left to wonder again about
the degree to which FSOC's designation of three specific
companies designated by FSB resulted from that prior FSB
action.
Mr. Chairman, the legislation you have introduced would
address some of the concerns that I have raised today. Section
403 would provide visibility into FSB-type processes, including
the positions taken by U.S. regulators on policies they may be
called upon to address back home.
Section 302 addresses the uncertainty companies face about
how to avoid being considered systemic. Under the bill, a
company could submit a plan to FSOC for changing its corporate
structure and operations so the company would not be deemed
systemically important. If FSOC believed that plan was
insufficient, it would have to explain why and what actions the
company could take to avoid SIFI regulation. That change, like
Section 403, would increase transparency, fairness, and thereby
the quality of Government decisionmaking.
Thank you for this opportunity, and I look forward to any
questions that you may have.
Chairman Shelby. Thank you.
Dr. Posen.
STATEMENT OF ADAM S. POSEN, PRESIDENT, PETERSON INSTITUTE FOR
INTERNATIONAL ECONOMICS
Mr. Posen. Thank you, Mr. Chairman and Ranking Member
Brown, for this opportunity.
Let us begin sort of as Senator Brown did, to remember that
international coordination and regulation remains in the U.S.
interest. It remains in the U.S. interest because the rest of
the world's banks and financial entities exist whether or not
we want them to or not. And the spillovers of them screwing up
are much bigger and much faster today than they have ever been.
There is no simple defense against that. I realize no Members
of the Committee are challenging that, but let us start there
because that is where the FSB comes from.
It is also worth remembering that the FSB, like every other
international financial institution since the war, is largely
the child of success of American administrations, Democrat and
Republican. When we think of the Financial Stability Forum,
that was founded 16 years ago through U.S. efforts. The
graduation of it to the FSB was, again, through U.S. efforts,
through the U.S. Government, and it remains the fact that the
United States is the dominant voice in this effort.
This is, in fact, because of our technological experience,
our technical expertise, the depth of our markets, the fact
that we still remain a model, and we have overweight influence
in the FSB. Most of the complaints about the FSB abroad are
because the United States is seen as having too much power, not
too little. I think it is important to have that baseline as we
go forward. We cannot simply live with the institutions and the
misbehaviors of other countries' financial institutions.
So, therefore, what is it we want and what is it we get out
of international regulation? We want to raise minimum
standards, we want to increase cross-border transparency, and,
most importantly, we want to prevent regulatory arbitrage. We
want to prevent, whether it is U.S.-based entities or foreign
entities, getting around the legislated regulations from
Congress and from Congress' appointees by going to other
jurisdictions and inflicting damage on the United States. The
FSB is actually making a major contribution to diminishing
this--not getting rid of it, but certainly diminishing it.
There are instances where the FSB is messing up, and I will
indicate that I actually share some views with some of the
other witnesses on the insurance industry where I think the FSB
does have it wrong. But these are instances of where they are
getting a specific decision wrong, not something inherent to
the process or inherent to the relationship between the FSB and
the FSOC or the U.S. Government.
Now, why is the FSB useful? There has been a lot of talk
about the fact that it is opaque, it is not accountable.
However, I think it is important to recognize several
attributes that are positive. The first is it involves all of
the major countries that have major financial centers and all
of the minor countries that have major financial centers, which
is a body that we need if we are going to plug these holes.
It also, for that matter, is small enough that it can make
decisions, which is a key attribute. As we know from, say, the
IMF or the WTO, when every member gets a vote, it deadlocks,
you get nothing.
It is cutting across regulatory and turf barriers, perhaps
not always in a way the other witnesses would like, but it
importantly gets us out of this cognitive capture that both
United States and other regulators can get when they are only
in their own silo.
It is coordinated directly with the G-20 economic leaders'
meetings and processes, which means there have to be
transparent progress reports, there have to be public
accountings, and things that reach the G-20 level can be
brought to the public for buy-in.
By including central banks and finance officials, you are
not only getting the right experts in the room; you are getting
it past the narrow bank supervisors, which is an important
quality.
And, finally, I would argue that, in addition to the
bipartisan U.S. legacy, it has rightly a soft-law legacy. They
are not legislating for us. They are setting standards that we
and others might adhere to, and if they are good standards,
there will be market and peer pressure and public pressure to
adhere to them by others. All the FSB can do is name and shame.
It cannot enforce anything.
Now, I think we can get some specific areas where the FSB
has done great work. People who believe in resolution as a key
cause of the financial crisis can see huge progress there,
certainly bank capital standards, certainly liquidity
standards. These are important aspects.
I do believe the FSB is wrong about insurance companies
because of a general problem in the FSB, but also a general
problem in the FSOC. We do not have a coherent U.S.
representative of expertise on insurance companies at that
level. Therefore, the European Commission, which has a pre-
made, pre-baked Solvency II, gets to shove that through, and
their companies who are going to be stuck with it want to be
sure that their competing foreign companies also get stuck with
it. That is not a good reason for a law, and if the U.S.
representatives of the insurance companies were better equipped
and had better arguments at FSB, we could prevent Solvency II
from causing harm. Solvency II harm is not because it engages
in prudential risk regulations, as Mr. Wallison said; it is
because they interfere with long-term capital in ways that are
not efficient for insurance companies by making them act like
banks. That is a mistake. But it is an intellectual mistake of
the FSB that the FSOC and U.S. representatives have the power
to correct. It is not an inherent problem of the FSB.
Thank you for this opportunity.
Chairman Shelby. Thank you, Dr. Posen.
A lot of concerns have been raised in testimony today and
at previous hearings we have held here about the role of the
FSB and its regulatory influence in the United States. As I
have mentioned, the FSB is neither a U.S. regulatory body nor
is it accountable to Congress and the American people.
Could each of you succinctly elaborate, if you can do that,
on your top concerns with the work, the transparency, and
accountability of the flexibility and what Congress can do to
address some of these concerns? Governor, we will start with
you.
Mr. Kempthorne. Mr. Chairman, thank you very much. In
visiting with different members of the FSB, in one instance
where it was a central bank president of another country, but
he made the point--he said one of the things that we should do
is give much greater exposure to the insurance industry because
we do not know much about it. We have had other members of FSB
say it is interesting at times to see what the International
Association of Insurance Supervisors say they must do in the
name of FSB, and that somebody should press them on that. There
are a variety of things.
And then, Mr. Chairman, as mentioned earlier, the close
connection between FSB actions and FSOC actions, where within
days AIG is named as a G-SII, the three that are now designated
as SIFIs were all named as G-SIIs first by the FSB. Why did
they not coordinate? Why did they not say to those that have
the expertise in this country, ``Where do you think there may
be a problem?'' And that is why, again, Mr. Chairman, we ask
that the activities-based approach should be taken. That has
not occurred. There is no transparency. The FSB does not
communicate to the companies why they made the decision they
did. We would like greater transparency.
Chairman Shelby. Mr. Wallison, succinctly.
Mr. Wallison. I will try.
Chairman Shelby. I know, I know. Thank you.
Mr. Wallison. My concern, as I expressed in my oral
testimony, is that the FSB is intending to regulate shadow
banks and the shadow banking system. I think that would be a
major mistake, and if that idea is brought into the United
States, it would substantially weaken our financial system.
I would like to see a lot more transparency and
accountability at the FSB so that we understand why they are
trying to regulate shadow banks, other than the fact that
banking regulators in general are trying to get control of
everything that is not a bank. But, of course, we are not
getting that. To the extent we can, that would be helpful. But
the most important thing I think we have to worry about is the
idea that our capital markets will ultimately be put under
prudential regulation by an organization like the Fed.
Chairman Shelby. Mr. Stevens.
Mr. Stevens. Mr. Chairman, there are any number of issues.
One, for example, is that the full record of comments that the
FSB receives is not made public, so you do not really have an
idea of who or what may be influencing its decisions.
Second, it does not appear that the FSB feels obliged as a
U.S. regulatory agency would actually to take into
consideration and respond to the commentary it receives. This
pack of papers in front of me represents just what the ICI has
put in front of the FSB. Much of it has been, frankly,
disregarded. We have no idea what the positions are that the
U.S. representatives are taking, but when recommendations
emanate from the FSB, it is clear they have been front-run in
terms of the FSOC process, and certain decisions have already
been made, which are then revisited here in Washington. It is
sort of like being both the pitcher and the umpire in a
baseball game.
Chairman Shelby. Mr. Scalia.
Mr. Scalia. Transparency certainly, you have heard.
Transparency also into the influence that might exist, FSB upon
the FSOC, which has not been provided and should be avoided in
the future.
Second, a balance. Dr. Posen's point about insurance
representation is a very important one, I think.
And, third, FSB should hesitate and think long and hard
before making company-specific decisions. That implicates
principles of due process, the opportunity to be heard and the
like, that really change the nature of what it is doing.
Chairman Shelby. Dr. Posen.
Mr. Posen. Thank you. I am much more concerned about the
substance than the process. I think the substance has gotten
too bank-captured, too bank-controlled, too much bank
supervisor mind-set, as my colleagues and I have discussed. I
think they remain a little too timid on surveillance, and they
need to extend what needs to get the Chinese banks, which, of
course, are in the news right now, which are becoming major
systemic actors. We need to be willing to open up the
governance enough because we need to get them in and get them
observed.
And I sort of echo Mr. Scalia's point. I think there has
been too much time wasted and too much distraction on
individual designations, and that is a fight we cannot have.
But at the same time, if the FSOC and the FSB come up with
completely different designations, that is a recipe for
regulatory arbitrage because national champions will cheat
around our rules.
Chairman Shelby. Thank you.
Governor Kempthorne, could you briefly describe the key
differences between the U.S. and European regulation of
insurance? And given those differences, is it appropriate for
the FSB to influence insurance regulations in the United
States?
Mr. Kempthorne. Mr. Chairman, it is a totally different
system that is used in the European Union than in the United
States. I have stated in international forums that the idea of
Solvency II, it may work for Europe. It will never, ever work
here in the United States. We are State-regulated, and as
Secretary Geithner said after the 2008 crisis, the insurance
industry came through it ``quite well.'' So we have a program
that has worked for decades.
Chairman Shelby. Even AIG did not get in trouble on
insurance. They got in trouble doing something that they
probably wish they had never known about.
Mr. Kempthorne. Mr. Chairman, you are absolutely correct.
It had nothing to do with their insurance element within AIG.
Chairman Shelby. Thank you.
Dr. Posen, in your testimony you highlighted several
troubling FSB outcomes. For example, you noted that calling all
nonbank financial companies ``shadow banks'' and regulating
them as banks endangers the very financial diversity that
enabled the United States to recover from the financial crisis
better and more quickly than our global counterparts.
You also noted, and I will quote you, ``We do not want any
global regulatory process to interfere with this diversity in
U.S. finance.''
What are your concerns with the FSB potentially interfering
with the U.S. financial system's strength and diversity?
Mr. Posen. My concerns are more theoretical, to be honest,
than practical at the moment. I do not think the FSB is a
direct threat. I do think that it is important that the U.S.
regulators and your representatives make it clear that it is a
good thing to have capital markets as well as banks. It is a
good thing to have lively risk taking as well as lending. It is
a good thing to have nonconcentrated banking systems. And it is
entirely possible and consistent with part of the FSB process
to make that the agenda.
I do not think there is a need for absolute convergence.
The example I chose to give of the insurance companies is the
one place where I do feel there is a costly effort being under
way from the FSB. I do not think this is motivated so much
because the leadership of the FSB wants convergence, although
some people do. I think it is motivated by an excessive--some
people have mentioned rush to judgment. The FSB is trying very
hard to wrap up what it considers its post-crisis duties very
quickly, and I think it is trying to force everything with off-
the-shelf solutions because it is rushing too much.
Chairman Shelby. The last question will be directed to Mr.
Scalia. As an administrative law practitioner, among others,
you are familiar with our domestic rulemaking process. For
example, the Administrative Procedures Act governs the way, as
I understand it, in which Federal and administrative agencies
may propose and establish regulations in the United States. But
none of those processes apply to the FSB. In fact, according to
the FSB, ``The organization operates by moral suasion and peer
pressure to set international standards.''
Mr. Scalia, in your opinion, would FSB's reactions and
decisions pass legal muster in the United States? And what are
your main concerns with the role and impact of the FSB on our
regulatory process?
Mr. Scalia. Mr. Chairman, no, the FSB processes would not
pass legal muster in the United States. One principle that is
absent is that of notice, of providing notice to the public in
advance of what might be coming down the pike.
Now, that furthers interests of fairness, but I think more
importantly it leads to better decisionmaking, because when the
public has notice, it has an opportunity to weigh in, provide
guidance, and regulators benefit from those insights. So I
think that is one important difference.
A second I will mention is the opportunity to be heard and
appear and defend your rights and interests. And I think when
FSB finds itself making company-specific designations, the
absence of that is striking as a matter of the perspective of
U.S. law, or really I think any perspective.
A third difference that I will mention--and then I will
stop in the interest of time, although I could go on--is an
opportunity to appeal. You know, in the United States, when
there is regulatory----
Chairman Shelby. Basic due process.
Mr. Scalia. Basic due process, being able to go to court
and say, respectfully, we believe this was a mistake, you
erred. And that also is absent from the FSB process.
Chairman Shelby. Thank you.
Senator Brown, you have been very patient. Thank you.
Senator Brown. Thank you, Mr. Chairman, as you always are,
so thank you for that.
These hearings are especially important, and I am
appreciative that we have them so that we do not forget the
cost of the financial crisis. I live in a Zip code in
Cleveland, Ohio, 44105, which had more foreclosures in 2007
than any Zip code in America. I still see the cost in that
neighborhood, and neighborhoods all over my State, as I think
is true in so many places. I think these hearings force us to
remember, and should, what Dodd-Frank and what the consumer
protections did for our financial system and for consumers and
for people that work and use the financial system. And I think
it helps--these hearings help us recognize how much more we
still have to do.
Let me start with you, Dr. Posen. You mentioned cognitive
capture today. I remember some maybe 3 years ago, I was on a
panel with Governor Huntsman and at that point just former head
of the FDIC, Sheila Bair, and I believe you were moderating it,
and you used that term at the Peterson Institute 1 day of
``cognitive capture,'' where regulators begin to hold the same
world view as the companies which they oversee.
It seems that one of the benefits of a single body with
broad international membership and different agencies is that
you can avoid a single nation or regulator protecting one of
its companies or industries by avoiding regulation.
My question is this: Dr. Posen, we know inconsistent
regulatory standards create the potential for substantial risk.
Would you discuss the importance of coordinating standards to
address regulatory arbitrage and other systemic risks, please?
Mr. Posen. Thank you very much, Senator Brown. You have
already hit the issue in your question, so let me try to
document the issues you raise.
What I think has to be looked at when we look back at the
financial crisis in the United States and the other major
Western economies in recent years was that everyone was pulling
in the same direction. Banks, their lobbyists, Congress people,
Fed officials, Treasury officials, both parties--they were all
largely on the same line that less regulation, infinitely less
regulation was better, self-regulation was better. And as a
result, when we look for a cause of the crisis, there is a
clear failure of behavior, of regulation, of supervision, but
it is so dispersed. It was not one person's decision, nor was
it one person's bribe. It was, as I put it, cognitive capture,
that everyone bought into this being the way of the world.
And the FSB has been successful in breaking that down, not
just because it has a mandate to look at regulations, a mandate
to improve regulations, but because it is, as you say, cross-
border.
We had a world in which AIG financial products, as
mentioned, got away with doing something that an insurance
company or, for that matter, no one ever should have done,
because it took place in London instead of New York and because
it took place in a subsidiary that was supposedly not part of
the insurance, and so, therefore, it had a loophole to get to.
And we all know the repercussions of that.
We had bad lending on mortgages, be it in Spain, be it in
the United Kingdom, and certainly here in the United States.
And that was not because of Fannie and Freddie. As former Fed
Governor Randall Kroszner has pointed out, it was because of
bad standards in the banking system, bad enforcement of
standards in the banking system. And that allowed other
countries to get their mortgages paid for, distributed, and the
standards to be lower throughout the world.
So how do we stop this? We make our best efforts. We make
our best efforts to come up with best practice; we make our
best efforts to challenge assumptions; we make our best efforts
particularly to assure that no one country, be it France, be it
Japan, or even the United States, gets to say, ``The interests
of my banking system, as companies not as a public interest,
trump the need for decent regulation.'' And the FSB has been
pursuing that goal at least.
We have had various aspects where in the past, as created
the euro crisis, French banks and German banks were bailed out
at the public's expense, leaving Greece with the bill. This is
the kind of thing that the FSB is meant to avoid by breaking
down these barriers and subjecting these kinds of bad behaviors
to global scrutiny and raising these bad behaviors. I agree,
activity-based not so much institution-based, up to the G-20
level where they can be properly addressed as well.
I will finally say that the--this is where I differ on the
due process point. I think it is important that international
regulations be done by sovereign nations agreeing and creating
standards that are soft power, that when countries or companies
do not comply, it is up to the market and the public to punish
them; it is not some supranational agency to do it. And I think
the FSB is making huge strides and getting more plugging of
holes of the AIG financial products kind because it involves
this voluntary shaming and voluntary invoking of the market
rather than legislating.
Senator Brown. Dr. Posen, speak to the designation process
in terms of interconnectedness related to securities lending
and derivatives, the risk of runs, the potential for fire
sales, if you will.
Mr. Posen. Yes. Obviously, the question of how to handle
the asset management industry is a crucial factor here, mutual
funds and other asset managers. So much of our private savings,
so much of our people's pensions and long-term savings are
there, for understandable reasons.
But as we saw with the money market mutual funds during the
crisis, they were able to act as though they had an implicit
Government guarantee and then eventually an explicit Government
guarantee, because no one wanted to see them break the buck,
and because it was so politically unpopular to see them not
have deposit insurance like the banking system, even though
inherently they are much more short term than the banking
system.
Paul Volcker, who is hardly a radical, has bemoaned this
fact at great length before this Committee, I believe.
This is just one example of how it is correct and right for
the ICI and others to go out there and say you cannot treat
mutual funds and asset managers like banks. They are not the
same as banks. You have to judge the regulation appropriately.
But it is not an argument that there should be no regulation or
that we have sufficient regulation at this point.
We have seen repeatedly that asset managers may not
themselves cause leverage, which is a good thing and should get
them some points. But we have also seen that fire sales can and
do occur. We saw this with the European crisis in the past in
which we have seen the sell-off of European bonds, which then
led to losses in the U.S. system, which also exacerbated the
European financial crisis in 2010-11.
Fire sales, we may not have the right answer. Circuit
breakers are not necessarily a perfect thing, as we have seen
with the U.S. stock market. We have to think hard about how to
do it, and we do not need to rush to regulate it in the next 5
minutes. There clearly is a gap in regulation in this area.
Mr. Stevens. Senator, since this is now touching on----
Senator Brown. Thirty seconds, because my time has run out,
and I want to ask Mr. Kempthorne--but, Mr. Stevens?
Mr. Stevens. The ICI has insisted all along that there be
an evidence-based analysis of things like fire sales. The
documentation we have in front of the FSB is very clear. In the
75-year history of U.S. stock and bond funds, there has never
been the kind of fire sale or panicky sell-off that Dr. Posen
is describing. It is hypothetical. It is a matter of
conjecture. It is not a matter of historical experience or
empirically demonstrated. And the money market fund example,
which central bankers go back to all the time, has already been
addressed in two successive rulemakings by the SEC. It is
important to note the FSB's focus here is not money market
funds; it is ordinary stock and bond funds. And so the issue
is, I think, a false scent to raise the experience of money
market funds in the crisis, because FSB's focus is elsewhere.
Senator Brown. Governor Kempthorne, let me shift to
something else. A number of my colleagues and I worked to pass
and sign into law clarifications of insurance capital
standards. You mentioned that a moment ago. Would you update us
on your talks with the Fed to implement them?
Mr. Kempthorne. Yes. Senator Brown, thanks very much. It
was critical for the solution that Congress came up with. The
Fed acknowledged that. They said, ``Absent that, we were not
able to differentiate the business models between banks and
insurance.''
Since then, we have a group of companies that are under the
banner of ACLI that leadership has met with Fed officials. They
now have put in place what will be a series of just working
sessions. We appreciate the fact that the Fed is saying while
we have been for decades dealing with banks, this is a new area
for us, and so they have asked the industry to please have the
dialogue so that they can understand some of the nuances and
some of the elements with regard to the insurance industry.
We certainly as an industry cannot predict the outcome of
what the Fed would recommend, but at least we appreciate this
dialogue that is taking place.
Senator Brown. Thank you.
Thanks, Mr. Chairman.
Chairman Shelby. Senator Heller.
Senator Heller. Mr. Chairman, thank you, and thanks to the
witnesses for being here today. It is a good group, and I
appreciate your knowledge on these issues.
I want to echo what has been said. It is no doubt that
regulators are looking at risks associated with activities--
should be looking at risks associated with activities and not
just the size of an institution. One of the frustrations is,
instead of working to decrease systemic risk, it seems
regulators just want to make more SIFI designations. I think
most of the panel would agree with that.
I think some of the best solutions, Mr. Chairman, is what
you put together in your bill and what this Committee passed
recently. I think the legislation does a great job in the
nonbank SIFI designation process, and I would like to hear from
the Governor and Mr. Stevens their thoughts on the Chairman's
bill, specifically Title III and the reforms of FSOC's
designation process.
Mr. Kempthorne. Yes, Senator Heller, thank you very much,
Mr. Chairman. We greatly appreciate the efforts of the Chairman
and Members of the Committee. Specifically, one of the elements
that we think is absolutely critical is the off ramp for a
SIFI, because I do not think any of the companies can tell you
what were the elements that put them into a SIFI designation.
So perhaps by having an off ramp, it will give us those
elements now so that a company knows how it can get off. It may
help other companies from ever getting on.
Also, I would just note that with regard to a lawsuit that
has been referenced in this hearing, again, we think that will
bring additional light to what were the elements that were
utilized in actually putting a company in that situation.
It can put an adverse competitive problem to those that may
be designated SIFIs. One element may be additional capital
requirements, different regulations that may put them at a
disadvantage in a competitive marketplace. We need to have a
highly competitive marketplace and not disadvantaged some of
those elements.
I would also say, Senator Heller, as I indicated in my
opening comments, to you and Senator Tester, we greatly
appreciate language, which you have included, that would help
bring about much greater transparency, the idea that it would
require that those entities in the United States, which have
been termed ``Team USA,'' would on an annual basis have to
submit a report to this Committee and would have to come to a
hearing so that the Members of the Committee can ask them,
``What is taking place at FSB, at FSOC?'' I think that is a
tremendous benefit, and I compliment you.
Senator Heller. Is this your view or ACLI's view?
Mr. Kempthorne. I will tell you, Senator, that this is a
view that I have heard repeatedly by industry. We need much
greater transparency, and this would help accomplish that.
Senator Heller. Mr. Stevens?
Mr. Stevens. Senator, thank you for your question. The
purpose of addressing potential systemic risk is not simply to
identify it and admire it. Presumably it is to deal with it.
And so common-sense provisions like those that are in the
Chairman's bill that would, prior to designation, allow either
a primary regulator or a firm to address and mitigate or
eliminate the risks seems to me to be an improvement on the
mechanisms in Dodd-Frank, and a sensible one as well.
I think that it would require the FSOC to be specific about
what risks it thinks exist, but if the FSOC cannot be specific
and cannot articulate what they are, they probably should not
be designating in the first place.
So it seems to me that the provisions in Title III of the
bill in that respect make eminently good sense and are
consistent with the broad objectives of the statute.
Senator Heller. Let me ask you a follow-up question. If
some of these asset managers are labeled SIFI designations, who
bears the cost of these increased regulations?
Mr. Stevens. Well, you have to be mindful of what that
entails under Dodd-Frank. There is a mandatory 8 percent
capital requirement. There are various fees and assessments.
There would be putting the fund into a bailout pool for large
banks or other SIFIs that may fail in order to make sure the
taxpayer is not on the hook. It is just another way of putting
some of our taxpayers on the hook.
And then, finally, it would subject them to enhanced
prudential supervision, which essentially is the Fed coming in
and telling the portfolio manager potentially how to run the
fund. I think that a fund so designated is not going to be too
big to fail. It is going to be too burdened to succeed because
there are lots of alternative funds in the competitive
marketplace for mutual funds in the United States, and many
investors, being sensitive to costs, will simply say, ``Well, I
will not invest in that fund. I will take my money somewhere
else where I am not paying these kinds of penalties.''
Senator Heller. So what you are saying is ultimately there
will be cuts in their returns on their investments.
Mr. Stevens. It will be paid by millions of Americans who
are seeking to save for retirement.
Senator Heller. OK. Mr. Chairman, thank you.
Chairman Shelby. Senator Menendez.
Senator Menendez. Well, thank you, Mr. Chairman.
International coordination to address systemic risk is not
easy, but as we learned during the financial crisis, I think it
is critically important. As we saw with companies such as
Lehman Brothers and AIG, systemic risk can easily cross
national borders, and a company large enough to create systemic
risk will most certainly have activities affecting or occurring
in multiple countries.
We also saw the need for harmonization; otherwise, risk can
just flow to the darkest and least regulated corner of the
system, where it can build unchecked beyond the reach of
countries whose citizens could bear significant costs if things
go wrong.
Now, the Wall Street Reform Act made important reforms to
address systemic risk here at home, and internationally, the
United States and other countries have established forums such
as the Financial Stability Board to improve coordination and
close gaps across jurisdictional lines.
Now, I understand that some companies have legitimate
concerns about whether and how particular measures might be
applied to them. And it is important that we distinguish these
substantive concerns from procedural ones so that we are able
to make appropriate improvements on both fronts. But if you are
concerned about a SIFI designation, it would be overkill to
destroy the entire process for designating anyone else as
systemically important, too.
So as always, from my perspective, in the 23 years that I
have spent in the Congress, it is about getting the balance
right at the end of the day.
So I think individual cases may be able to illuminate ways
that both the domestic and international processes can be
improved, as we have already seen in some of the changes the
Financial Stability Oversight Council has made to strengthen
its review process. So with that focus in mind, I have a few
questions for our witnesses.
Dr. Posen, many have raised concerns about the sequencing
of actions by U.S. authorities and international bodies such as
the FSB, and this really gets at the heart of the challenges we
face in terms of coordination with other major markets. So to
me, it is important that concerns about sequencing be dealt
with, but not be used as an excuse for inaction or obstruction.
There are real questions about how to keep the domestic and
international tracks moving together at the same pace.
So why do you think international bodies such as the FSB
have chosen to move ahead of individual countries' authorities
in certain areas, whether SIFI designation or articulating a
framework or principles for something like capital standards?
What are the benefits of doing that?
Mr. Posen. Thank you, Senator, and as you rightly said in
your remarks, it is a question of balancing risks. The idea is
that the United States has to be engaged with the international
process not so much because of defending the United States from
overregulation, but defending us from underregulation and poor
performance abroad. And there has to be some willingness to
tradeoff not the U.S. sovereignty and not the U.S. oversight,
but occasionally officials want to be able to say I am much
more at risk of something terrible going wrong, as you say, in
the dark corner of some country that is eluding the safety net,
eluding the regulators, than I am about the X pennies cost of
slight overregulation in the United States. And that is a
legitimate kind of tradeoff to make.
And so in the real world, just as the case in Congress, as
we saw with the TPA vote last week, the Senate and the House
are not always perfectly sequenced. What matters is that in the
end they come to an agreement. Nothing terrible is going to
happen with them being out of sequence for a short while. What
matters is the debate and the eventual convergence and
compromise.
Similarly, the FSB in part because it is more closed, in
part, however, because, as I said to Senator Brown, they are
also less subject to any individual country or interest group's
lobbying, is able to make decisions faster. It does not mean
they are right. It does not mean they should always do them at
maximum speed. But in the case of the SIFI designations, for
example, I think it was an important decision that was made
about the balance of risks, that leaving the uncertainty about
who was going to be a SIFI, at least as far as the FSB was
concerned, had unfair costs to those private sector entities
and had costs to the regulatory process. And so, therefore, it
made sense for them to go forward, and if it turns out that the
FSOC or other national regulators were to push back, those are,
as you said, individual cases that could be corrected.
The process, the fact that this appearance of timing is not
the subject of a conspiracy or even of undue pressure on the
FSOC, it is just we are iterating to the right goal.
Senator Menendez. Thank you. One last question. I think the
sequencing in the Congress would go better if the House of
Representatives would understand the enlightened process of the
Senate. But, Mr. Stevens, let me ask you, how do you feel the
feedback you have given at the domestic level, in terms of how
different metrics might apply differently in the asset
management context than they would to other kinds of financial
market participants, is carrying through the international
level? And to the extent that you have the concerns you have
expressed about whether actions at the international level
might reduce opportunities for a full and well-informed process
here in the United States, what are some of the top
recommendations that you would make to improve the process
without effectively killing it overall?
Mr. Stevens. Thank you, Senator. As I elaborate in my
written statement, I do think there is a cognitive capture at
FSB, and it is because virtually all of its members and all of
its leadership consists of central banks. If its mandate is to
look at the financial system in its totality, it needs to be
reconstituted, in our judgment. It should not simply be bankers
with their point of view trying to impose bank-type regulatory
models on everyone. The capital markets regulators and
securities regulators ought to sit as co-equals at the table
when you are talking about areas like asset management.
Insurance regulators ought to be there as co-equals at the
table when you are talking about insurance. That would be a
meaningful form of international collaboration and
international exchange, and I think it would solve many of the
problems.
We have an example now of IOSCO basically saying that it
thinks that the FSB is headed in a completely wrong direction
with respect to asset management, putting the cart before the
horse, trying to find what the solution is before it has even
identified the problem. And so IOSCO has said let us look at
activities and products straight across the asset management
sector instead of, as the FSB's process essentially is doing,
picking a handful of large U.S. mutual funds and U.S. advisers
and recommending them for designation as SIFIs.
So I think the fundamental reform of the FSB is to
reconstitute it in a significant way and break up the club of
central bankers who have only one view of the world.
Senator Menendez. Thank you, Mr. Chairman.
Chairman Shelby. Senator Kirk.
Senator Kirk. For Mr. Scalia, I would ask you a question
about--what would you think of applying notice and comment
provisions of the U.S. Administrative Procedures Act to the FSB
deliberative process so that U.S. insurers could have notice
and time to comment on potential actions? I have been very
worried over time that the process of providing insurance to
millions of Americans is different than banking in
international circles, that if we provide the wrong standards,
we could make insurance products much more expensive and less
available to Americans.
Mr. Scalia. Thank you, Senator. I think it would be a
valuable improvement for there to be advanced notice and
opportunity for public comment, and also consultation, which
are some features that I believe the Chairman's bill would
achieve before the FSB takes action.
As I mentioned, notice is in part simply about fairness,
giving people a heads up and a chance to speak up, assert their
rights and interests. But it is also about reaching better
decisions through information, consultation and the like. So
those benefits would certainly exist.
Dr. Posen has drawn the analogy to the House and Senate,
and I am sure all of us could identify respects in which we
think the House and Senate could do their jobs even better than
they do. But one very important thing they do have going for
them is the openness of the debate that occurs and the like,
and we do not have that in connection with the FSB.
Dr. Posen also referred to the House and Senate coming to
agreement, which is what they do. It is also what the FSB does.
And, yes, it purports to act through moral suasion, but there
certainly appears to have been an influence exerted on the FSOC
process as a result of the FSB designations. At least it is
something worth examining as the Committee is seeking to do
today.
Finally, with respect to your comments, Senator Kirk, about
insurance and the FSB, there seems to be perhaps consensus
among members of the panel that the FSB would benefit from
representation of a broader set of expertises and that one area
of expertise that is underrepresented currently is insurance,
and it may well be that had that insurance expertise been
present in 2013, the designation decisions that were made might
have been approached differently.
Senator Kirk. Thank you. Mr. Chairman, I will be
considering legislation to provide notice and comment
provisions with regard to insurance matters in the FSB. I think
that would--as one commentator said, the FSB was as clear as
mud. To provide the notice and comment provisions, to provide
much more transparency, would calm people's irrational fears.
Chairman Shelby. Thank you, Senator Kirk.
Senator Warren.
Senator Warren. Thank you, Mr. Chairman. It is good to be
sitting beside you.
Because our financial institutions can transfer assets
around the globe in the blink of an eye, they can effectively
choose which country regulates many of their riskiest
transactions. That means that regulators around the world must
be vigilant and must coordinate their efforts in overseeing the
world's largest financial institutions. The Financial Stability
Board is the main forum for that kind of coordination, which
makes its work critical in preventing another financial crisis.
Now, while the FSB is not legally binding on the United
States, its decisions are not, those decisions can certainly
influence our domestic policies, and that is why it is
important that the FSB have the same kind of transparent, data-
driven decisionmaking that we ask of our own regulators.
For example, here in the United States, a company may be
designated by FSOC as systemically important, but the
designation can be reversed if the company restructures its
operations so that it creates less risk. That means there are
now two ways to manage risks posed by a big bank--the bank can
change its business model to produce less risk or it can face
the stricter regulations and greater oversight. The bank
decides which is less costly, and the result we get is what we
want, and that is, less risk.
Now, Governor Kempthorne, as you have noted, many of your
members have been designated systemically important by the
international FSB. Are you aware of any process that the FSB
has for allowing those companies to reverse their designation
by changing their business activities?
Mr. Kempthorne. Senator Warren, thanks for the question. I
am not aware of any FSB off ramp to get the G-SIIs out of
there. It would have been extremely helpful if they would have
announced what were the elements that caused them to be name G-
SIIs in the first place, and also, was there an opportunity to
correct that, as you are alluding to, before they were
designated?
Senator Warren. OK. So let me just break this down. So the
answer to the question--Was there any process for reversing the
designation?--you are not aware of any process for reversing
it. I do want to talk about whether or not companies were
informed about what the criteria would be. Does the FSB provide
designated companies with the information they need to
understand why they were designate and how they could
potentially change their business activities to pose less risk?
Mr. Kempthorne. Senator Warren, based on the input I have
received from those companies, the answer is no.
Senator Warren. All right. Would you support changing the
FSB process so that designated companies would have a chance to
change their operations and possibly reverse their designation?
Mr. Kempthorne. Senator, yes, because we must have greater
transparency; we must have greater communication. And, again,
before a designation, why not identify what is the risk and
then a company may determine it could take its own actions to
remove the risk, or it could change its operation, or you could
ask the primary regulators: Would you please deal with this
issue?
Senator Warren. Mr. Stevens, would you agree with that?
Would you support such a proposal?
Mr. Stevens. I am trying to puzzle out, Senator, how it
would actually work in the methodologies that have been
proposed with respect to mutual funds. The methodology
basically is based solely on size. What the FSB has proposed is
if you are a mutual fund with $100 billion in assets under
management, you will be automatically within a materiality
threshold recommended for consideration.
So to change the business model, I suppose, you would
either have to split the fund in half--and now the manager has
got two $50 billion mutual funds. Maybe that makes it less
risky. I think what it does is says that the original
materiality threshold is nonsensical.
Senator Warren. So I take it, though, Mr. Stevens, what you
are concerned about is you believe--although I am not sure if
it is posted, but you believe that in an area--there is an area
where FSB says size is all that is ever going to matter to us,
we do not care what your practices are? But I take it there are
also many that are pulled into designation because of their
specific business practices, some combination of the risks they
present, because of size, and because of the activities they
engage in. This is what I understand Governor Kempthorne to be
talking about, that there is no information right now about
what it is that causes this designation and no off ramp for the
companies that are willing to adjust.
So my question is: Does it make sense to at least ask the
FSB for more clarity around what it is that causes someone to
be so designated and to provide off ramps if there are multiple
factors that are involved?
Mr. Stevens. I certainly would never argue against more
clarity. In fact----
Senator Warren. Good.
Mr. Stevens.----we have even asked for them to justify the
materiality thresholds that they have put into their
methodologies, and, Senator, they are nothing more than just
numbers picked out of the air.
Senator Warren. Mr. Scalia.
Mr. Scalia. Thank you, Senator. I think it is a very
important question you have asked. One other point that I would
make is that if FSB were to make that change, it is not clear
at this time what difference that would make for companies that
have already been designated by FSOC, because it is FSOC that
has designated them and the Fed that will regulate them.
What we are told is that FSOC is not influenced by FSB
decisions. But an FSB un-designation would only matter to an
FSOC-designated company if, lo and behold, FSOC were influenced
by FSB.
So I think it is a very important question, but it is only
getting at one part of the problem the companies face.
Senator Warren. I appreciate that point, although at least
we have within FSOC--we have had the testimony here that there
are off ramps, there are possibilities for coming out from
underneath an FSOC designation. And so what we are looking for
is can we get the same kind of thing over at FSB. And I take it
you would support that sort of change in the approach that FSB
uses.
Mr. Scalia. Yes. I think it would be a valuable step
forward if FSB considered the sort of changes that the
Chairman's bill would make in the FSOC process.
Senator Warren. Well, so this is--Governor Kempthorne, I
think you wanted--I am sorry, Mr. Chairman. I think we are
running over.
Mr. Kempthorne. Senator Warren, thanks very much for the
line of questioning, and just a clarification. There currently
is not an FSOC off ramp from designation. There is language
that is proposed in Senator Shelby's bill that would provide
that off ramp.
Senator Warren. I think we have had testimony, though, from
those on the FSOC saying that adjustment is possible so that if
risk is reduced, then FSOC designation changes, which sounds to
me an awful lot like an off ramp.
Mr. Kempthorne. Again, Senator Warren, based on the input I
have received from the member companies that have been so
designated, I do not believe they know what would be elements
necessary to be de-designated.
Senator Warren. All right. Fair enough on the transparency
point, and one we have certainly had this conversation, I think
with those who have testified before us. But they have
indicated there are ways to change FSOC designation and that it
is important to review how much risk is posed.
You know, I just want to make the point, as I see it--and
we have heard the testimony repeatedly in front of this
Committee that once a company is designated as systemically
important here in the United States, the company should have a
chance to reverse that designation if it can show that it no
longer poses a systemic risk.
The United States, according to those who have testified in
front of us, say that we now permit this, and I believe the FSB
should do so as well. It seems to me that is fully consistent
with the FSB's important mission of making global financial
markets safer.
Thank you, Mr. Chairman. Sorry to run over.
Chairman Shelby. Senator Warren, I believe Mr. Wallison has
a comment.
Senator Warren. Yes.
Mr. Wallison. I just have a small point here, but the
problem is that we do not understand the metrics that either
the FSOC or the FSB uses to designate a company as a SIFI. And
we could avoid a lot of problems, including the need for an off
ramp, if it were clear to companies before they were designated
what they could do to keep from being designated. That is not
available to anyone, but it is in the Chairman's bill and makes
a certain amount of sense. We reduce a lot of the legal costs
and other problems that companies have if they are condemned to
be SIFIs and regulated by the Fed.
Senator Warren. Well, as I said earlier, I think it is
important that there be transparency about what it is that
causes an FSOC designation and that it is important that the
company have the alternative of choosing to reduce its own risk
so that it has an exit ramp from FSOC designation.
Thank you very much, Mr. Chairman.
Chairman Shelby. Thank you, Senator Warren. Thank you for
raising the question.
Senator Merkley.
Senator Merkley. Thank you very much, Mr. Chairman, and
thank you all for your testimony.
As a strong supporter of our State-based insurance
regulatory system, I share the concern of many of my colleagues
and some of the witnesses that an international body would set
standards for U.S. financial institutions. During the trade
debate that we just had, I supported Senator Warren's amendment
to the Trade Promotion Authority Act that would limit the
inclusion of financial services in future agreements.
Unfortunately, we did not pass that amendment. I wish
otherwise. But I am concerned about international organizations
setting structures that might diminish our regulation of risk
within our own American economy. So U.S. officials at the very
least should have a say in efforts to change or influence our
financial regulatory system.
The conversation about the FSB, we are represented right
now by the Federal Reserve Board, the Treasury Department, the
Securities and Exchange Commission. Governor Kempthorne, as a
representative of the life insurers, do you see this as
sufficient or the appropriate representation or specific
recommendations for how that might be changed?
Mr. Kempthorne. Senator Merkley, thanks for the question.
Without question, with regard to Treasury, they need to have
developed the additional expertise on the insurance industry.
There is a step forward in the designation by Dodd-Frank of the
Federal Insurance Office. Director Mike McRaith is doing a
commendable job in that position. But I think some of the
reports that perhaps have not come out in the timeframe first
suggested may suggest that the vetting of those reports is more
difficult because there is not the insurance expertise at this
point within Treasury, with
regard to the Federal Reserve; and, again, we appreciate
Governor Tarullo's approach where he is now having
opportunities of working groups to just discuss the elements of
the industry. With regard to the Fed, they have added Tom
Sullivan, a former State insurance commissioner, who is doing a
fine job at the Fed.
But I would add, Senator Merkley, when we had post crisis
and the Fed decided to put in a low interest rate environment,
we sent teams of two to four insurance industry CEOs to every
regional Fed President, and I will tell you that the comments
were such as: ``We did not even have anecdotal evidence about
your industry.'' ``We did not realize that you were the number
one U.S. investor in corporate bonds.'' ``We did not realize
that, on average, you hold your investments for 17 years, quite
different than banks.'' ``We did not realize what a capital
source you could be for infrastructure.''
So I think through those comments, Senator, you realize
that those who are now given responsibility with regard to the
well-being and the regulation of the industry have a learning
curve. They are on the curve. We appreciate their efforts. But
there is still a tremendous amount that needs to be done.
I would add that is true of the FSB as well, which is
populated in a great deal by banks.
Senator Merkley. Well, your points are well taken. Thank
you. And if I could just summarize it, it is not so much who is
there as how they proceed to educate themselves on the issues,
the huge range of issues that are important, and in your cases
specifically the life insurance industry.
I just would like to ask the parallel question, if anyone
else wants to chip in, about ways that U.S. representation
could be improved on the FSB. Mr. Stevens?
Mr. Stevens. Senator, I think it is a substantive issue,
not just a process issue. But you have to look closely at the
FSB as an organization and ask yourself who its members are. By
and large, the members are central bankers and finance ministry
officials. They do have some capital markets regulators, like
the Securities and Exchange Commission. Virtually the entire
leadership--that is to say, the head of the FSB, the head of
its important working committees, and things of that sort--are
all central bankers. I think the IOSCO statement makes it very
clear that having now experienced over a couple of years an
effort collaboratively within the FSB to work, that they have
said this is not going to be satisfactory, we have got to take
a different approach.
And so what we take from all of that is the need to
reconstitute some international body and to give capital
markets regulators, and insurance regulators for that matter, a
co-equal place at the table. Because if the mandate is to look
at the entire global financial system, that is much more than
banking, and you need to bring the right expertise and
background and experience to bear. The FSB simply cannot do
that as it is currently constituted.
Senator Merkley. Thank you. Yes?
Mr. Posen. Senator Merkley, just very rapidly, as I said in
my written testimony, like others here, I support filling the
particular gap that we have in insurance knowledge where I
think the European regulators are going amok. But that said, I
think it is very important that we pick up on something Senator
Brown and I
exchanged upon earlier, which is that the FSB by its
international nature also provides a certain amount of
insulation against industry lobby groups and against national
champions of various companies. And I think it is important
that we do not make this into a body that, for all our desire
for admin law, not oppressing any individual company that does
not--that gets captured in the way that various specific
regulators got captured in the past. And we always have to be
suspicious when you can say central bankers have limitations. I
am one of that breed, and I certainly have mine. But the fact
remains that we know that there are particular industry-
designated regulators who become captured either in corrupt
terms or intellectual terms by those industries, and we do not
want this to become that again.
Senator Merkley. And so if I can capture your comment,
while expertise is essential in order for the FSB to have
insight on key industries in various countries, you are raising
the concern that the regulators, the FSB, not be intellectually
captured by those industries.
Yes, Mr. Wallison?
Mr. Wallison. I would like to add one thing here, and that
is, we have to understand that the FSB as well as the FSOC,
whatever decision they come to, is an agreement among
regulators. Regulators have an interest in having more power
and more opportunity to control the direction of their
respective economies. So although it is a good idea to have
regulators talk to one another, discuss ways that they can
address things, I think we have to recognize that regulation
can be imposed because regulators want it to be imposed, and
from the standpoint of the United States, where we have very
free capital markets which have kept us ahead of almost the
rest--actually created the economy that we have in the United
States today, which is the best in the world, we have to be
concerned that someone is speaking from the standpoint of the
United States. And when we look at what the Fed wants to do,
which is to get control of shadow banks, which is basically our
entire capital market system, we have to be worried about that
and be sure that whatever the FSB does, or even the FSOC, it is
consistent with what Congress wanted when it created the Dodd-
Frank Act. And I am afraid that we are not exactly clear on
that right now.
Senator Merkley. Thank you very much, and my time has
expired. Thank you, Mr. Chairman.
Chairman Shelby. Mr. Stevens, I would like to ask you a
question about mutual funds and the model. It is totally
different from banking, as we know. We know insurance is
different. We know that you are dealing with financial products
and so forth. And you brought it up earlier. If you are a $100
billion mutual fund, you have that under management. Now, if
you are 25, that does not change the risk, does it? If you are
big, you might be so well run and so forth. But explain
basically the difference in the model of a bank and a managed
fund, just for the record.
Mr. Stevens. Well, in the case of United States mutual
funds, Mr. Chairman, irrespective of their size, there are
still certain principles that apply.
Chairman Shelby. Absolutely.
Mr. Stevens. They use little to no leverage, which
dramatically distinguishes them from banks. They act as agents,
not principals, so that the adviser is not retaining risk at
the adviser's level. Whatever the----
Chairman Shelby. They are spreading the risk, aren't they?
Mr. Stevens. That is correct, and----
Chairman Shelby. They are spreading the risk. If I buy
mutual funds, I am taking a risk in a sense. I am hoping it
goes up, but it could go down. Right?
Mr. Stevens. And it does both over a cycle.
Chairman Shelby. Sure.
Mr. Stevens. But all those investment risks are then
experienced by the underlying shareholders in their millions.
They are also highly transparent, Mr. Chairman. The amount of
information you can get about how a mutual fund and its
portfolio and the like are managed is really quite dramatic.
There is also extensive regulation that is calculated to
control risks, and, frankly, that is why even these largest
funds exhibited a remarkable degree of stability in the
financial crisis. Now, this is the second worst financial
crisis since the early 19th century. Some of our stock and bond
fund investors lost very substantial portions. Equity funds
went down 40, 45 percent--even more. There was no panicky sell-
off----
Chairman Shelby. The same thing with 401(k), our pension
funds, everything up and down. That is the market.
Mr. Stevens. That is exactly right.
The other thing, Senator, is that our industry in the
United States is largely a retail industry. Upwards of 90
percent of our investors are individual investors who are
saving for very long-term purposes. So they do not look at
mutual funds as a short-term trading proposition. They look at
it as something that they are going to stick with--and they did
stick with them during the crisis--for the very longest term
and most important financial goals that they may have.
Chairman Shelby. Let me ask you this. Let us say I could
buy through a mutual fund part of an index fund, right?
Mr. Stevens. Yes.
Chairman Shelby. How are you going to regulate the index
fund which is based, say, on the S&P 500 or some other model
like that? Basically you are tracking the market, aren't you?
Mr. Stevens. That is exactly right, Senator, and in the
FSB's methodologies, there are a number of very large index
funds that would be captured, because they tend to grow above
$100 billion as they are sponsored by some firms in the United
States.
So you ask yourself then, that recommendation comes to the
FSOC, and were the FSOC to say, yes, you know, you are right,
FSB, we need to designate that fund, how then would the
provisions of Title I of Dodd-Frank apply in that case? They
are actually nonsensical as you think of them in the context of
a mutual fund, and to me that is the very best evidence that
when Congress put Dodd-Frank together, it never intended the
result that Title I of Dodd-Frank would be brought to bear
against our largest mutual funds unless that title is looked at
as a roving commission by the Federal Reserve simply to get
more and more and more of the U.S. financial system under its
jurisdiction. I think Congress did not intend that at all.
Chairman Shelby. I agree. But, Mr. Wallison, let me ask you
a question, and then any comment you want to follow up on that.
The ramp in the legislation, some of it I proposed, if you are
designated--and Senator Warren got into this, which I think was
an excellent topic. If you are designated, that is not an easy
thing. That is tough. Most people have a way through process to
get un-designated or get off the hook, so to speak, probation
or whatever you want to call it. I do not believe that they
have, although they alluded to it here, that there is a way to
get off, because it is not explicit, it is not transparent.
There is no mechanism that I understand to do it. Once you are
designated, you know, a lot of people say you are damned in a
way. Do you want to comment on that?
Mr. Wallison. Well, I think it is absolutely true, Mr.
Chairman, that once you are designated, unless there is a clear
way for you to exercise an off ramp in some way, you are
damned. But look at it this way: If you do not know why you
have been designated----
Chairman Shelby. That is exactly right.
Mr. Wallison. And that is where we are today.
Chairman Shelby. Well, that is what Senator Warren got
into----
Mr. Wallison. Right, and she is completely right. If you do
not know why you have been designated, there is no way that you
can exercise the off ramp unless the regulating agency, like
the FSOC, is willing to say to you, well, you were designated
for this particular reason or these four particular reasons,
and if you eliminate all of those things, well, then, we will
un-designate you. But apparently we have no indication that the
FSOC at least is willing to do that, and certainly not the FSB.
If I may follow up, Mr. Chairman, on one issue----
Chairman Shelby. Go ahead. Go ahead.
Mr. Wallison.----you were talking about with Mr. Stevens,
and that is, mutual funds, the key issue here is what is called
``maturity transformation.'' Mutual funds and other investment
organizations do not involve maturity transformation. That
happens to be the riskiest thing that banks do. They borrow
money short term and lend it out long term. That is maturity
transformation, and it is very risky because the funds you lent
out could be withdrawn by depositors when you are a bank.
Mutual funds do not have that problem and should not----
Chairman Shelby. And neither do insurance companies.
Mr. Wallison. And insurance companies, too. Mutual funds
and insurance companies and other capital markets operators
generally do not have that problem at all. Yet the FSB says, as
I said in my oral statement, the FSB says that complex chains
of transactions can create maturity transformation
collectively. That raises the question of whether all of these
small firms operating in the capital markets, engaged in these
complex chains of transactions, could be designated by the
FSOC. Certainly that is what the FSB is after. And whether the
FSOC has the power to do that is the problem.
Chairman Shelby. Mr. Scalia, do you want--I know you want
to answer that, too--to get into due process? It seems like
there is lack of due process here, but go ahead.
Mr. Scalia. Thank you, Mr. Chairman. In a sense, that is
what I wanted to comment on. This exit ramp idea is a very
important one. It would be a significant contribution of your
bill, and it would be good if agencies, FSOC in this case,
disclosed to companies what FSOC needed to be done in order for
that company not to be systemic.
But I think we would want to avoid a circumstance where a
company's fate depended on FSOC's opinion or FSOC's whim, FSOC
saying, ``We have decided you do this, that, or the other
thing, and then you will be OK.''
Obviously what we need as well is discernible,
ascertainable legal and empirical standards that the public can
look to and judge for themselves what they need to do, and if
FSOC, for example, declines to de-designate, that those
entities can have the confidence that they could go to court
and say, ``Look at all we did, but FSOC is not letting us out
of the pen.''
Mr. Stevens mentioned the importance of evidence-based
approaches, and that has been lacking as well in FSOC's
decisionmaking. So I think in addition to providing the off
ramp, it will be very important in the future for FSOC to base
its decisions more on a closer empirical and evidentiary
approach toward its task.
Chairman Shelby. Governor?
Mr. Kempthorne. Mr. Chairman and, again, Senator Warren, I
think this answers a bit to what we were discussing and that is
with regard to the off ramp that may exist. In the Dodd-Frank
Act, it does call for an annual review of a designated company
by FSOC. However, as Mr. Wallison pointed out, they do not know
what was the criteria, the metrics that made them designated in
the first place.
If there was an existing off ramp, I think a major company
would not have felt that they needed to go through a legal
process. Currently there is no appeal process with regard to
designation of a SIFI, and that is why we do commend and
support the concept of an off ramp of a designation so you can
de-designate knowing what it was that put you there in the
first place.
Chairman Shelby. Thank you.
Senator Warren, do you have any comments?
Senator Warren. No. I am good. Thank you, Mr. Chairman.
Chairman Shelby. I thank all of you for the hearing. This
is very important, and we appreciate your contributions here
today. Thank you very much.
Mr. Kempthorne. Thank you.
[Whereupon, at 11:40 a.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF DIRK KEMPTHORNE
President and CEO, American Council of Life Insurers
July 8, 2015
Chairman Shelby, Ranking Member Brown, and Members of the
Committee, I am Dirk Kempthorne, President and CEO of the American
Council of Life Insurers (ACLI). ACLI is the principal trade
association for U.S. life insurance companies with approximately 300
member companies operating in the United States and abroad. ACLI
advocates in Federal, State, and international forums for public policy
that supports the insurance marketplace and the 75 million American
families that rely on life insurers' products for financial and
retirement security. ACLI member companies offer life insurance,
annuities, reinsurance, long-term care and disability income insurance,
and represent more than 90 percent of industry assets and premiums.
ACLI appreciates the opportunity to address the impact of the
Financial Stability Board (FSB) on the U.S. regulatory framework. ACLI
recognizes the important role of the FSB in enhancing international
cooperation and coordination among financial supervisory organizations.
The FSB was formed in 2009 by the G20 to promote financial stability
through reform of the international financial regulatory structure. Its
membership includes financial regulators from 25 major nations,
including the European Union; international financial institutions,
such as the IMF and World Bank; and standard-setting bodies, including
the International Association of Insurance Supervisors (IAIS) and the
International Organization of Securities Commissions (IOSCO). The U.S.
representatives to the FSB are the Department of the Treasury, the
Federal Reserve, and the Securities and Exchange Commission.
My testimony focuses on two standard-setting actions by the FSB and
its member organizations that intersect with the powers and authorities
of the Financial Stability Oversight Council (FSOC) and the Federal
Reserve Board. Those standard-setting actions are the designation of
``globally systemically significant'' insurers and the establishment of
an international capital standard for insurers. More specifically, ACLI
is concerned that----
FSB's designations of G-SIIs have prejudged FSOC's
designations and placed designated insurers at a competitive
disadvantage in the marketplace;
The FSB and FSOC have not applied consistent standards to
the designation of nonbank financial companies; and
There is a potential for conflict between insurer capital
standards being developed by the Federal Reserve Board and
those under development by the IAIS. These new standards may
also unnecessarily deviate from the existing, proven insurance
risk-based capital regime U.S. State insurance regulators use
today.
To address these concerns, ACLI is recommending that----
The designation process for insurers should be replaced
with ``activities-based'' regulation that avoids the negative
consequences of designating individual companies merely because
of size.
The Federal Reserve Board should finalize the capital
standards mandated by Congress last year in a manner that is
consistent with the Insurance Capital Standards Clarification
Act before agreeing to capital standards developed by the IAIS;
and
This Committee should exercise vigorous oversight of the
capital standard-setting process by the Federal Reserve Board
and the IAIS to ensure that the intent of Congress and the
competitiveness of the U.S. insurance industry is preserved.
Before I address those issues, however, I would like to commend
Chairman Shelby and the Committee for The Financial Regulatory
Improvement Act of 2015.
Financial Regulatory Improvement Act
The Financial Regulatory Improvement Act reflects many of the
principles of transparency, accountability, and due process that are
supported by ACLI and its member companies. In particular the bill:
(1) Proposes important, meaningful reforms that would strengthen
Financial Stability Oversight Council procedures and ultimately
facilitate a reduction in systemic risk;
(2) Increases opportunities for stakeholder input and Congressional
oversight of the International Association of Insurance
Supervisors regarding the development of international capital
standards. ACLI commends Senators Dean Heller (R-Nev.) and Jon
Tester (D-Mont.) for their strong leadership on this issue;
(3) Requires the Federal Reserve Board to plan for the different
kinds of nonbank financial companies, including insurance
companies that it supervises; and
(4) Includes language from the Policyholder Protection Act of 2015,
which would afford insurance policyholders in the context of a
savings and loan holding company structure the same protections
as those currently provided under the Bank Holding Company Act.
ACLI urges the Committee to move this important legislation to the full
Senate for consideration.
FSB's Designations of Globally Systemically Important Insurers (GSIIs)
Seems to Have Prejudiced FSOC's Designations and Placed
Designated Companies at a Competitive Disadvantage
Both FSB and FSOC have designated three U.S. insurers as
``systemically important.'' In July 2013, the FSB, in consultation with
the IAIS, designated nine insurers as G-SIIs, including three U.S.
insurers: AIG, Prudential and MetLife.\1\ These designations were based
upon a methodology developed by the IAIS.\2\ The FSB envisioned that
designated companies would be subject to certain policy measures, which
would be developed by the FSB and IAIS and implemented by member
countries. Those policy measures include recovery and resolution
planning requirements, enhanced group supervision, and higher loss
absorbency requirements for nontraditional activities.
---------------------------------------------------------------------------
\1\ Global Systemically Important Insurers (G-SIIs) and the Policy
Measures That Will Apply to Them, Financial Stability Board, July 18,
2013.
\2\ Global Systemically Important Insurers: Initial Assessment
Methodology, International Association of Insurance Supervisors, July
2013.
---------------------------------------------------------------------------
FSOC also has designated AIG, Prudential and MetLife as
systemically important, subjecting them to supervision and regulation
by the Federal Reserve Board. FSOC's designation of AIG occurred on
July 8, 2013, just days before the FSB initial designations.\3\
Prudential was designated by FSOC in September 2013,\4\ and MetLife was
designated in December 2014.\5\ The regulation of these companies by
the Federal Reserve Board includes heightened capital standards,
resolution planning requirements, liquidity requirements, and risk
management standards.
---------------------------------------------------------------------------
\3\ Basis of the Financial Stability Oversight Council's Final
Determination Regarding American International Group, Inc., Financial
Stability Oversight Council, July 8, 2013.
\4\ Basis for the Financial Stability Oversight Council's Final
Determination Regarding Prudential Financial, Inc., Financial Stability
Oversight Council, September 19, 2013.
\5\ Basis for the Financial Stability Oversight Council's Final
Determination Regarding MetLife, Inc., Financial Stability Oversight
Council, December 18, 2014.
---------------------------------------------------------------------------
FSOC's independent member having insurance expertise, Roy Woodall,
has raised serious concerns about the timing of these designations. In
his dissents to both the Prudential and MetLife designations, Mr.
Woodall noted that the FSB's designations were taken in consultation
with members of FSOC, and that these discussions appear to have pre-
judged FSOC's independent designation process:
Although not binding on the Council's decision, the declaration
of Prudential as a G-SII by the FSB based on the assessment by
the United States and global insurance regulators, supervisors,
and others who are members of the IAIS has overtaken the
Council's own determination process.\6\
---------------------------------------------------------------------------
\6\ http://www.treasury.gov/initiatives/fsoc/council-meetings/
Documents/September%2019%
202013%20Notational%20Vote.pdf.
It is clear to me that the consent and agreement by some of the
Council's members at the FSB to identify MetLife a G-SIFI,
along with their commitment to use their best efforts to
regulate said companies accordingly, sent a strong signal early
on of a predisposition as to the status of MetLife in the
United States--ahead of the Council's own decision by all of
its members.\7\
---------------------------------------------------------------------------
\7\ http://www.treasury.gov/initiatives/fsoc/designations/
Documents/Dissenting%20and%20
Minority%20Views.pdf.
ACLI shares Mr. Woodall's concern. FSOC has a mandate to designate
nonbank financial companies for supervision by the Federal Reserve
Board based upon criteria established by Congress, and FSOC's
designation decisions should not be pre-determined by the actions of
the FSB.
A lack of transparency and due process compounds this concern.
While the FSB has stated that it follows a designation methodology
developed by the IAIS, the FSB designations are not accompanied by any
explanation or rationale. Nor are designated companies accorded any
ability to engage directly with the FSB or challenge a designation.
Moreover, there is no transparency surrounding the FSB's actual
directions to the IAIS, other than what the IAIS or FSB chooses to
announce after the fact.
The immediate and potential negative consequences of designation
are significant. The insurance industry is highly competitive, and the
additional regulation imposed upon a designated company can place that
company at a significant competitive disadvantage relative to its
nondesignated competitors. Capital standards are the most obvious
example. If capital requirements on designated insurers are materially
different from those imposed by the states, designated insurers may
find it difficult to compete against nondesignated competitors,
resulting in a loss of business or an altered product mix. Less
competition or less product availability is not in keeping with a
healthy market that best serves insurance consumers. Even before any
additional regulation is implemented, the prospect of such regulation
has an immediate impact as it forces designated companies to manage
their operations taking into account looming but unspecified regulatory
requirements.
FSB and FSOC Should Pursue ``Activities-Based'' Regulation of Insurers
Rather than Designating Individual Companies
FSB and FSOC have taken markedly different approaches in their
treatment of different categories of nonbank financial companies. While
FSB and FSOC have designated three U.S. insurers for heightened
supervision and regulation, they are pursuing an ``activities-based''
approach for asset managers rather than the imposition of heightened
regulation on individual companies merely because of size.
Recent public statements by Federal Reserve Board Governor Daniel
Tarullo and by Greg Medcraft, the Chairman of IOSCO, have acknowledged
this different treatment accorded asset managers over insurers.\8\
---------------------------------------------------------------------------
\8\ See, Conversation with Governor Tarullo, Institute for
International Finance, North American Summit, June 4, 2015; https://
www.youtube.com/watch?v=dV1tJMX-z2c&feature=
player_embedded; and Remarks of Greg Medcraft, Chairman, International
Organization of Securities Commissions, to the National Press Club,
Washington, DC, on ``IOCSO and the International Reform Agenda for
Financial Markets,'' June 22, 2015.
---------------------------------------------------------------------------
The difference in treatment also is evident in the manner in which
FSOC has approached the evaluation of insurers and asset managers.
Instead of designating asset managers, FSOC has directed its staff to
``undertake a more focused analysis of industry-wide products and
activities to assess potential risks associated with the asset
management industry.''\9\ This request followed the release of a study
by the Office of Financial Research on asset management and financial
stability, which FSOC had requested ``to better inform its analysis of
whether--and how--to consider such firms for enhanced prudential
standards and supervision.''\10\ This request also followed a
conference on the asset management industry by FSOC ``to hear directly
from the [asset management] industry and other stakeholders, including
academics and public interest groups, on [the asset management industry
and its activities].''\11\ At that conference, FSOC members heard from
representatives of the Securities and Exchange Commission, the Bank of
England, New York University, Columbia Business School, and the Wharton
School, as well as several asset management companies. No such public
hearing was conducted to engage insurers and other stakeholders about
the insurance industry.
---------------------------------------------------------------------------
\9\ Press Release, U.S. Treasury Department, Financial Stability
Oversight Council Meeting, July 31, 2014.
\10\ Office of Financial Research, Asset Management and Financial
Stability, Sept. 2013. 11 Press Release, U.S. Treasury Department,
Financial Stability Oversight Council (FSOC) to Host Public Asset
Management Conference, March 28, 2014.
\11\ Press Release, U.S. Treasury Department, Financial Stability
Oversight Council (FSOC) to Host Public Asset Management Conference,
March 28, 2014.
---------------------------------------------------------------------------
In sum, the FSOC's actions with regard to the asset management
industry stand in sharp contrast to FSOC's treatment of the insurers.
FSOC has pursued the designation of individual insurance companies and
provided the public with little, if any, insight into the rationale for
those designations or how designations could have been avoided.
Moreover, FSOC has pursued this approach despite the fact that one
of the principal authors of the Dodd-Frank Act has stated publicly that
he sees no difference between the asset management industry and the
insurance industry when it comes to systemic risk. In a hearing before
the House Financial Services Committee last year, former Congressman
Barney Frank told the Committee that ``I don't think asset managers or
insurance companies that just sell insurance as it's traditionally
defined are systemically defined . . . Their failure isn't going to
have that systemic reverbatory [sic] effect.''\12\
---------------------------------------------------------------------------
\12\ Assessing the Impact of the Dodd-Frank Act Four Years Later
Before the H. Comm. On Fin. Serv., 113th Cong., Statement of the
Honorable Barney Frank during question and answer session, unofficial
transcript.
---------------------------------------------------------------------------
ACLI finds this disparate treatment of insurers inexplicable and
distressing. Why has FSOC undertaken a thoughtful analysis of one
category of nonbank companies, but not another? Why has FSOC concluded
that an ``activities-based'' approach to regulation is appropriate to
asset managers, but not insurers?
The Dodd-Frank Act gives FSOC two principal powers to address
systemic risk. One power is the authority to designate nonbank
financial companies for supervision by the Federal Reserve Board. The
other power is an ``activities-based'' authority to recommend more
stringent regulation of specific financial activities and practices
that could pose systemic risks.
FSOC's power to recommend more stringent regulation of specific
activities and practices has distinct public policy advantages over its
power to designate individual companies for supervision by the Federal
Reserve Board. FSOC's power to recommend primary regulator action
brings real focus to the specific activities that may involve potential
systemic risk and avoids the competitive harm that an individual
company may face following designation. As I have noted above, in
certain markets designated companies can be placed at a competitive
disadvantage to nondesignated companies because of different regulatory
requirements. Finally, the power to recommend avoids the ``too-big-to-
fail'' stigma that some have associated with the designation of
individual companies.
FSOC's recommendations for more stringent regulation of certain
activities and practices must be made to ``primary financial regulatory
agencies.'' These agencies are defined in the Dodd-Frank Act to include
the SEC for securities firms, the CFTC for commodity firms, and State
insurance commissioners for insurance companies. A recommendation made
by FSOC is not binding on such agencies, but the Dodd-Frank Act
includes a ``name and shame'' provision that encourages the adoption of
a recommendation. That provision requires an agency to notify FSOC
within 90 days if it does not intend to follow the recommendation, and
FSOC is required to report to Congress on the status of each
recommendation.
ACLI believes that FSOC and FSB should both pursue an ``activities-
based'' approach to insurers through their processes and not rely on
designations, in the same manner that they are pursuing such an
approach to asset managers. Failure to do so raises a fundamental
question of fairness and casts doubt on the legitimacy of the policies
and practices of FSOC and the FSB.
The Federal Reserve Board Should Finalize the Capital Standards
Mandated by the International Capital Standards Clarification
Act Before Agreeing to IAIS Standards
Both the Federal Reserve Board and the IAIS are developing
insurance capital standards that are likely to have significant impacts
on life insurance companies. Considered together, these two initiatives
directly affect approximately 60 percent of the direct premiums of ACLI
member companies. If these standards are bank-centric or inconsistent
with capital standards developed by State insurance supervisors, they
will disrupt the marketplace and undermine the ability of life insurers
to provide long-term, guaranteed retirement products to savers and
retirees.
To ensure the best possible outcome for policyholders, the Federal
Reserve Board should adhere to the intent of Congress as reflected in
the Insurance Capital Standards Clarification Act, which was
unanimously approved by Congress last year, and develop an insurance
capital standard that is appropriate for U.S. insurers and the
insurance business model. We are encouraged by the fact that the Board
has indicated its intent to undertake a methodical, thoughtful approach
to the development of these standards. Moreover, the Federal Reserve
Board should partner with the other U.S. representatives to the IAIS
(FIO and State insurance supervisors) to ensure that any international
insurance standards reflect the unique strengths of the U.S. system of
insurance supervision.
It is essential that policymakers correctly address insurance
capital standards here in the United States first, so that our
representatives to the IAIS, ``Team U.S.A.,'' have a stronger, unified
position in any international discussions. Common sense suggests that
the United States should conduct its own process for the development of
an insurance capital standard before agreeing to any international
standards. The ACLI believes that it is in the best interests of the
United States to focus on domestic rulemaking first and ensure that the
domestic process is as thoughtful, informed, and transparent as
possible.
The Federal Reserve Board's capital setting process should include
formal rulemaking with notice and public comment, and ACLI is grateful
that the Federal Reserve Board has indicated it will proceed in this
way. Any insurance capital standard must reflect the long-term nature
of life insurers' investments and the need to match investments with
the long-term duration of insurance liabilities. Bank standards that
favor short-term assets simply do not work for the insurance company
business model, in which commitments to provide benefits to insurance
policyholders and annuity contract holders often last many decades.
The ACLI has been actively engaged with the Federal Reserve Board
on a proposed capital regime for insurance companies. The IAIS timeline
must accommodate the Federal Reserve Board's implementation of the
Insurance Capital Standards Clarification Act. These processes should
not be abbreviated or confused by a rushed IAIS timeline. Just last
month, the IAIS released a proposal for higher loss absorbency capital
standards and reiterated plans to finalize these standards by the end
of this year. The Federal Reserve Board's rulemaking process should
proceed normally and allow ample time for notice and public comment.
The three U.S. representatives to the IAIS should not agree to anything
at the IAIS that would interfere with a robust and thoughtful
rulemaking process here in the United States. In fact, the IAIS process
would benefit from the work being conducted by the Federal Reserve
Board and should adjust its timeline accordingly.
ACLI is encouraged by the recent IAIS announcement to develop
international insurance capital standards, particularly the ICS,
through a staged and incremental process that will be more respectful
of and informed by jurisdictional developments.\13\ This is a clear
example of Team U.S.A. working on all cylinders to achieve a positive
outcome for U.S. insurers and insurance markets. However, much work
remains to be done, including further and deeper consideration and
analysis of what types of activities actually create systemic risk in
the insurance model. Getting our standards completed at home needs to
happen first.
---------------------------------------------------------------------------
\13\ ``The IAIS Risk based Global Insurance Capital Standard (ICS):
Ultimate and Interim Goals, Principles for Development and Delivery
Process'' June 25, 2015.
---------------------------------------------------------------------------
ACLI commends the three U.S. representatives to the IAIS for the
important partnership that they have established in the Team U.S.A.
approach. Only by working together, meeting regularly, coordinating
their efforts, and agreeing to common objectives, the Federal Reserve
Board, FIO, and State insurance supervisors are best positioned to
represent the United States and secure the best outcome for U.S.
consumers and insurers. The Team U.S.A. concept constitutes an effort
to speak with a strong, unified voice as part of any IAIS discussions
and ACLI fully agrees with the wisdom of this approach.
ACLI urges this Committee to exercise vigorous oversight of the
capital standard-setting process by the Federal Reserve Board and the
IAIS to ensure that the intent of Congress and the competitiveness of
the U.S. insurance industry are preserved. Congressional oversight of
the development of a workable domestic capital standard for U.S.
insurers will help support the goal of a well-capitalized and
competitive insurance industry that continues to serve the needs of
U.S. consumers.
______
PREPARED STATEMENT OF PETER J. WALLISON *
---------------------------------------------------------------------------
* The views expressed in this testimony are those of the author
alone and do not necessarily represent those of the American Enterprise
Institute.
---------------------------------------------------------------------------
Arthur F. Burns Fellow in Financial Policy Studies, American
Enterprise Institute
July 8, 2015
Chairman Shelby, Ranking Member Brown and Members of the Senate
Banking Committee:
Thank you for the opportunity to testify in this important hearing.
My name is Peter J. Wallison. I am the Arthur F. Burns Fellow in
Financial Policy Studies at the American Enterprise Institute. The
opinions expressed below are mine alone and not necessarily those of
the American Enterprise Institute.
This testimony will discuss the relationship among the Federal
Reserve, the Financial Stability Oversight Council (FSOC) established
by the Dodd-Frank Act, and the Financial Stability Board (FSB). As this
Committee is aware, the FSB is a largely European group of financial
regulators and central banks which was deputized by the G-20 leaders in
2009--after the financial crisis--to reform the international financial
system.\1\ The Treasury, the Federal Reserve and the SEC are members of
the FSB.
---------------------------------------------------------------------------
\1\ Financial Stability Board, ``Overview of Progress in
Implementation of the G20 Recommendations for Strengthening Financial
Stability'' Report of the Financial Stability Board to G20 Leaders,
September 5, 2013, p3.
---------------------------------------------------------------------------
Summary of this testimony
This testimony makes the following points:
Both the FSB and the Fed have determined to impose
prudential regulation--i.e., regulation of risk-taking--on what
they call the ``shadow banking system.'' They define the shadow
banking system as all financial intermediation outside the
regulated banking system.
Shadow banks, then, are essentially all the nonbank firms
that operate in in today's U.S. capital markets-broker dealers,
asset managers, hedge funds, mutual funds, insurance companies
and many others.
The FSB and the Fed believe that ``complex chains of
transactions'' among these firms can create risks to financial
stability that are similar to the failure of a large financial
firm.
On this basis, the FSB could decide that all member
countries should impose prudential regulation on firms active
in the capital markets-that is, shadow banks.
The question is whether an agreement at the FSB to impose
prudential regulation on complex chains of transactions can be
enforced in the United States under the Dodd-Frank Act.
Section 113 of the Dodd-Frank Act provides the FSOC (and
thus the Fed) with authority to designate firms as SIFIs
because of their ``mix of activities.'' These activities could
be deemed to include participating in ``complex chains of
transactions.''
Although this would be a major extension of the language in
the Dodd-Frank Act, it is possible that the courts would defer
to the FSOC's interpretation.
If the Committee does not want prudential regulation
imposed on the capital markets, it must act to prevent this
outcome, through amending Dodd-Frank or through aggressive
oversight of the Fed, FSOC and Treasury.
Introduction
In recent years, both the FSB and the Fed have both expressed a
determination to impose ``prudential regulation'' on what they call the
``shadow banking system.'' Prudential regulation generally refers to a
regulator's ability to supervise or control the risk-taking of
regulated firms, and the shadow banking system--as defined by the FSB--
includes all financial intermediation that is not subject to bank-like
prudential regulation.\2\ The Fed also accepts this definition. Stanley
Fischer, vice chair of the Fed, refers to ``nonbank financial
intermediation'' as including ``insurance companies, finance companies,
Government-sponsored enterprises, hedge funds, security brokers and
dealers, issuers of asset-backed securities, mutual funds and money
market funds.''\3\ These are most of the major participants in the U.S.
capital markets, and thus the prudential regulation of shadow banks is
the same thing as prudential regulation of the U.S. capital markets.
---------------------------------------------------------------------------
\2\ See, for example, FSB, ``Consultative Document/Strengthening
Oversight and Regulation of Shadow Banking/An Integrated Overview of
Policy Recommendations,'' November 18, 2012, p1.
\3\ Stanley Fischer, speech at a Bundesbank conference on March 27,
2015, p2.
---------------------------------------------------------------------------
In general, although capital market firms like broker-dealers,
finance companies, hedge funds and other types of funds and fund
managers are subject to regulations of various kinds, these are mainly
conduct regulations. Some, such as insurers and broker dealers, have
capital requirements, but they are all generally free to take the risks
that their managements consider prudent. Under prudential regulation,
as bank supervisors see it, they are entitled to examine and criticize
management risk-taking decisions. For example, the Fed has recently
been telling banks that it does not want them to make leveraged loans,
which the Fed considers excessively risky.
The Fed has clearly decided that bringing ``shadow banking'' under
prudential regulation should be a priority of the agency, and in this
effort the Fed and the FSB are working together. The Fed's position was
made clear by Governor Daniel Tarullo a year ago:
The turmoil that attended the collapse of several large nonbank
financial institutions, and the extraordinary Government
measures necessary to contain the turmoil, had quickly changed
into a consensus--previously a
minority view--that prudential regulation should be broadened
to better safeguard the financial system as a whole.\4\
---------------------------------------------------------------------------
\4\ Daniel Tarullo, Speech at the Federal Reserve Bank of Chicago,
May 8, 2104, p2, http://www.federalreserve.gov/newsevents/speech/
tarullo20140508a.htm.
The Fed is devoting a great deal of attention to this FSB project--
and for good reason. Governor Tarullo, is leading the FSB's work in
this area. The close collaboration between the Federal Reserve and the
FSB is happening because controlling ``shadow banking'' is not
something the Fed can do alone; it is too easy for financial activities
to be conducted outside the Fed's U.S. jurisdiction. The Fed cannot
control shadow banking if they focus solely on the United States;
pressure on the shadow banking system in the United States will only
stimulate the development of shadow banking activity in other developed
markets. The FSB, therefore, is the ideal venue for an international
agreement to impose coordinated prudential regulation on shadow
banking, which in effect means prudential regulation of the
international capital markets. In one of its first statements on the
need to regulate shadow banking, the FSB pointed this out: ``It is also
important to note that different parts of the [shadow banking] chain
are frequently located in different jurisdictions, underscoring the
need for a global approach to monitoring and policy responses.''\5\
---------------------------------------------------------------------------
\5\ FSB, Shadow Banking: ``Scoping the Issues: A Background Note of
the Financial Stability Board,'' April 12, 2011, p5.
---------------------------------------------------------------------------
The FSB is the successor to something called the Financial
Stability Forum, an organization of the same developed countries that
was formed in 1999 as a discussion group to promote financial
stability. In April 2008, the group delivered a series of
recommendations to the G-7 for increased prudential regulation. After
the financial crisis, in 2009, the group was deputized by the G-20
leaders to reform the international financial system, and changed its
name to the Financial Stability Board. Since then, it used its mandate
to broaden its reach and elevate its profile. Its statements regularly
refer to the fact that the G-20 leaders have approved or authorized its
activities. In 2011, according to the FSB, the G-20 leaders agreed to
``strengthen the oversight and regulation of the shadow banking
system,''\6\ and remarkably they did this before the FSB had actually
defined what shadow banking was. Nevertheless, the FSB has no
enforcement powers and--at least in the United States--no authority by
virtue its G-20 mandate. The FSB says that it is relying on its members
to enforce its decisions within their own jurisdictions, if they have
the authority to do so.
---------------------------------------------------------------------------
\6\ FSB, ``Strengthening the Oversight and Regulation of Shadow
Banking,'' April 16, 2012, p 1.
---------------------------------------------------------------------------
An apt analogy might be the agreements that are reached among bank
regulators from many nations under the auspices of the Basel Committee
on Bank Supervision. The decisions reached there are applied in each of
the countries that are participants. This might even be seen by the
U.S. regulators as a precedent for the enforceability of any agreement
reached at the FSB, but this would be incorrect. The U.S. bank
regulators already have the statutory authority to impose the capital
requirements that are agreed in Basel. Congress has not (to my
knowledge) ever questioned that authority.
This raises the question whether the Dodd-Frank Act or any other
U.S. law has given U.S. regulators the authority to impose on U.S.
firms the decisions that originate in an agreement at the FSB. It is
not true, as some may believe, that Dodd-Frank does not provide
authority that can be used for this purpose. Unfortunately, as I will
discuss below, the excessively broad language of the Dodd-Frank Act may
permit the FSOC and the Fed to impose substantially the same
regulations in the United States as the FSB will prescribe for its
other members. Moreover, U.S. officials seem to believe that if the FSB
adopts prudential regulation for the capital markets--that is, the
shadow banking system--U.S. regulators will be able to impose it in the
United States. If this effort succeeds, it will be a disaster for
robust economic growth in the United States. Accordingly, this
testimony will also explore the authorities that the FSOC and Fed might
use, at the behest of the FSB, to control shadow banking in the United
States.
In March, 2015, the FSB issued what it called its Second
Consultative Document on Methodologies for Identifying NonBank Non-
Insurer Global Systemically Important Financial Institutions (the
Second Consultative Document).\7\ This is similar to a U.S. regulatory
agency taking a second set of comments on a proposed regulation under
the Administrative Procedure Act. The Second Consultative Document is
basically a roadmap for FSB members to follow if they wish to subject
nonbank firms within their jurisdictions to prudential regulation.
There is little question that under the Dodd-Frank Act the FSOC could
designate any financial firm as a systemically important financial
institution (SIFI), and in fact after the FSB designated three U.S.
insurers as global SIFIs, the FSOC did the same.
---------------------------------------------------------------------------
\7\ FSB, ``Consultative Document (2nd)/Assessment Methodologies for
Identifying Non-Bank Non-Insurer Global Systemically Important
Financial Institutions/Proposed High-Level Framework and Specific
Methodologies,'' March 4, 2015.
---------------------------------------------------------------------------
Many of the comments submitted by U.S. firms on the Second
Consultative Document reflected concern that the FSB will designate
large U.S. firms--especially large investment funds and asset
managers--as global SIFIs. That concern arose, presumably, because of
fear that an FSB designation would provide a foundation for the FSOC to
do the same. To forestall this possibility, the FSB was urged instead
to consider regulating ``activities'' rather than designating SIFIs.
This approach, as discussed below, is not without risk. Limiting the
FSB and the FSOC to regulating activities, instead of designating
SIFIs, may not prevent the FSOC and the Fed from imposing prudential
regulation on virtually all firms that operate in the capital markets,
including asset managers, regardless of size.
In a recent speech, Governor Tarullo said that he favors
``activities-based regulation'' for asset managers,\8\ and with
Tarullo's support it is likely that the FSB will oblige. But as I will
show several provisions of Dodd-Frank, if interpreted broadly by the
FSOC and the Fed, could enable the Fed to place many transactions that
are routine activities in the U.S. capital markets under what is
essentially prudential control.
---------------------------------------------------------------------------
\8\ John Heltman, ``Fed's Tarullo Favors Activities-Based
Regulation for Asset Managers,'' American Banker, June 4, 2015.
---------------------------------------------------------------------------
The need to cover these activities was outlined by Governor Tarullo
a year ago: ``Prudential regulation,'' he said, ``must deal with
threats to financial stability whether or not those threats emanate
from traditional banking organizations. Hence the need to broaden the
perimeter of prudential regulation, both to certain nonbank financial
institutions and to certain activities by all financial actors.''\9\
[emphasis supplied] This is a statement of determination; if the Dodd-
Frank Act provides the necessary authority, we may see an effort by the
FSOC and the Fed to impose prudential regulation on activities--that
is, what they see as excessive risk-taking--in the capital markets.
---------------------------------------------------------------------------
\9\ Daniel Tarullo, Speech at the Federal Reserve Bank of Chicago,
note 4 above, p1.
---------------------------------------------------------------------------
If this is not acceptable to this Committee it should act to modify
these provisions before the FSB, the FSOC and the Fed act to impose
prudential restrictions on the entire U.S. financial system.
Efforts by the FSB and the Fed To regulate shadow banking
The widespread concern among bank regulators about ``shadow
banking'' is best understood in the context of the competitive
challenges facing the heavily regulated banking business. Since the
mid-1980s, the capital markets have outcompeted banking in the
financing of corporate and business borrowers. The chart below shows
the growing gap between banks and capital markets financing. The
existence of this gap was recently confirmed by Stanley Fischer, the
vice chair of the Fed, when he told a banking audience: ``In recent
years, about two-thirds of nonfinancial credit market debt has been
held by nonbanks, which includes market-based funding by securitization
vehicles and mutual funds as well as by institutions such as insurance
companies and finance companies.''\10\
---------------------------------------------------------------------------
\10\ Stanley Fischer, ``Nonbank Financial Intermediation, Financial
Stability, and the Road Forward,'' March 30, 2015, p.1. http://
www.federalreserve.gov/newsevents/speech/fischer20150330a.htm.
Source: Federal Reserve Flow of Funds
To a significant degree, this gap is the result of the relative
efficiency of obtaining credit through the capital markets rather than
banking, and left to itself this gap is probably irreversible. However,
nonbank competition for banks restricts bank regulators' freedom in
regulating banks. Tightening bank regulation simply makes banks even
less competitive with the capital markets. A partial solution, then, is
to gain some kind of regulatory control over the capital markets--the
shadow banking system--so that some regulatory burden can also be on
shadow banking. The financial crisis was a disaster for the American
people, but it has provided a unique opportunity for bank regulators to
seek greater authority over the whole financial system, despite their
failure to prevent the failure or near-failure of the largest banks
(and hundreds of smaller banks) in the financial crisis.
Whatever the motive, the FSB's analysis of the dangers of shadow
banking rests heavily on the risks associated with ``maturity
transformation,'' an inherent risk of traditional banking. When banks
take deposits withdrawable on demand and use those funds to make long-
term loans they are engaged in what is called maturity transformation.
By its nature, this is a risky activity because the supporting deposits
can be withdrawn while the loan is still outstanding, threatening the
bank's liquidity position. Banks are subject to prudential regulation
and have access to the Fed's discount window in part because of this
inherent risk.
The FSB has argued that the shadow banking system is also subject
to this risk. For example, in a paper outlining its effort to gain some
control of shadow banking, the FSB stated:
[E]xperience from the crisis demonstrates the capacity for some
nonbank entities and transactions to operate on a large scale
in ways that create bank-like risks to financial stability
(longer-term credit extension based on short-term funding and
leverage). Such risk creation may take place at an entity level
but it can also form part of a complex chain of transactions,
in which leverage and maturity transformation occur in stages,
and in ways that create multiple forms of feedback into the
regulated banking system.\11\ [emphasis added]
---------------------------------------------------------------------------
\11\ FSB, ``Strengthening Oversight and Regulation of Shadow
Banking,'' August 23, 2013, pii.
As the FSB sees it, then, many entities in the shadow banking world
work together to produce the maturity transformation that is the risky
element of traditional banking. This might seem somewhat dubious as an
idea, but former Fed chair Ben Bernanke--a strong and persistent backer
of regulating shadow banks--tried to provide an example of a ``complex
---------------------------------------------------------------------------
chain of transactions'' in a 2012 speech:
As an illustration of shadow banking at work, consider how an
automobile loan can be made and funded outside of the banking
system. The loan could be originated by a finance company that
pools it with other loans in a securitization vehicle. An
investment bank might sell tranches of the securitization to
investors. The lower-risk tranches could be purchased by an
asset-backed commercial paper (ABCP) conduit that, in turn,
funds itself by issuing commercial paper that is purchased by
money market funds.\12\
---------------------------------------------------------------------------
\12\ Ben Bernanke, ``Fostering Financial Stability,'' Speech at
2012 Federal Bank of Atlanta Financial Markets Conference, p2.
The problem with this, Bernanke went on, is that ``Although the
shadow banking system taken as a whole performs traditional banking
functions, including credit intermediation and maturity transformation,
unlike banks, it cannot rely on the protections afforded by deposit
insurance and access to the Federal Reserve's discount window to help
insure its stability.''
Thus, to the extent that Bernanke's views reflect the underlying
ideas circulating in the FSB--a good bet given the importance of the
Fed in the world's financial system--the effort to control shadow
banking is based on the idea that while it can create risky maturity
transformation it does not have the necessary access to either deposit
insurance or the Fed's discount window, both of which supposedly would
protect shadow banks against runs or other instability. It follows that
the risks taken by unregulated participants in the capital markets can
only be mitigated by access to a bank-like Government safety net--and
absent these protections must be modulated by strict prudential
regulation. Of course, access to a bank-like safety net, as the
President of the New York Federal Reserve Bank has noted, ``would
entail substantial prudential regulation of entities--such as broker-
dealers--that might gain access . . . [since this would be] required to
mitigate moral hazard problems.''\13\ Thus, more regulation begets more
risks for the taxpayers, and more regulation after that to protect the
taxpayers from the risks the regulators failed to foresee the first
time.
---------------------------------------------------------------------------
\13\ William C. Dudley, ``Fixing Wholesale Funding to Build a More
Stable Financial System,'' February 1, 2013.
---------------------------------------------------------------------------
Pursuing this idea, the FSB is developing a theory that would allow
regulators in member countries to impose prudential regulations on
capital markets firms. The basis for this regulation is the claim that
``complex chains of transactions'' can create risks to market stability
that are similar to the risks created by maturity transformation.
The Fed's pursuit of shadow banking
There is no doubt that the Fed is an active partner of the FSB,
maybe even the driving force in the effort to gain some control of
shadow banking.
In remarks at a meeting in New York on December 2, 2014, Stanley
Fischer, the Fed's vice chair who also heads an internal systemic risk
committee at the agency, described the Fed's then-current effort to
control shadow banking. To the extent that the Fed itself does not have
the authority to exert this control, he said that the Fed intends to
use the authorities of the FSOC for this purpose.
At the meeting, Fischer was interviewed by Larry Fink, chairman of
BlackRock, one of the largest asset-management firms in the world.
According to a transcript of the interview, Fischer was asked by a
member of the audience: ``Stan, can you talk a little bit more about
the shadow banking system and what, if anything, you think should be
done at a policy level to ensure that there is the financial stability
over this 80 percent that you don't--you have less control over?''
Fischer responded:
FISCHER: Well, the--you know, there are real institutions--in
the shadow banking system. There are hedge funds. There are
insurance funds.
FINK: Even asset managers.
(LAUGHTER)
FISCHER: Even asset managers, I've been reliably informed.
(LAUGHTER)
And other financial institutions, some of those have
regulators. The insurance companies, for instance, have
regulation. Others do not have--have regulation. And what is
being done right now is mapping out this system. One of the
most complicated maps you've ever seen was produced in the New
York Fed showing the shadow banking system and the interactions
between it and, you know, everybody is talking to everybody
else, doing business with everybody else, it's to understand
that [sic] that system is as a system, how it interacts with
the banking system, and who has any authority that will enable
them to take action--undertake actions to deal with a firm,
which is if it's large enough or interconnected enough, would
create a big problem if it failed.
That's what we're doing now. And then, if it's--if we the Fed
have the authority to regulate it. Then on the basis of that
analysis, we would then go ahead, if we have the authority--for
instance, we have control over margin requirements--and if we
don't, then it goes to the FSOC and is discussed there.\14\
---------------------------------------------------------------------------
\14\ Bloomberg transcript.
The identity between the work of the FSB and the work of the
Fed on shadow banking is nowhere better exemplified than in a
statement by Mr. Fischer to a banking audience at a conference
---------------------------------------------------------------------------
sponsored by the Federal Reserve Bank of Atlanta in March 2015:
[N]onbank intermediation often involves complex chains of
activity encompassing many entities and markets. Such chains
tend to increase the web of interconnections in the financial
system that, in some circumstances, can increase the likelihood
or severity of systemic stress . . . It is often said that
stronger regulation of the banking sector will cause activity
to move outside the perimeter of regulation. The evolution also
could lead to greater complexity, such as longer chains of
interconnection, which make it more difficult for market
participants to understand the risks arising from their
exposures. Examples of migration that have already occurred
include the movement of many loans made to large corporations
from banks to collateralized loan obligations, the
securitization of many credit card receivables, and the
securitization of mortgages.\15\ [emphasis supplied]
---------------------------------------------------------------------------
\15\ Stanley Fischer, ``Nonbank Financial Intermediation, Financial
Stability, and the Road Forward,'' Remarks at Central Banking in the
Shadows: Monetary Policy and Financial Stability Postcrisis, Federal
Reserve Bank of Atlanta, March 30, 2015. [emphasis supplied]
Although the FSB's ``complex chains of transactions''--a way of
describing the shadow banking system--became ``complex chains of
activity'' in Mr. Fischer's telling, the concept is the same. The use
of the term ``activity,'' as we will see, ties it more closely to the
relevant Dodd-Frank language. In both cases, these unregulated complex
chains are seen as increasing risks in the markets, and the migration
of lending from banks to nonbank financial intermediation--``regulatory
arbitrage'' to bank regulators, but in fact the inevitable outcome of
greater efficiency--is an example of the problem the Fed and the other
bank regulators are facing.
The FSB's influence on SIFI designations
The way the FSOC has exercised its designation authority suggests
that it is also cooperating with, if not leading, the FSB's efforts. In
any event, the FSOC has been implementing the FSB's decisions in the
United States. When Congress authorized the FSOC to designate large
nonbank financial firms as SIFIs, it assumed that the FSOC would follow
a fair, objective, and fact-based process in exercising that authority.
Although officials have asserted that the FSOC's designation decisions
have been the result of such a process, that is not supported by the
facts.
The Treasury and the Federal Reserve Board are unquestionably the
most important and influential members of the FSOC--the Treasury
because the secretary of the Treasury is the chair of the FSOC and the
Fed because it is by far the most powerful and well-resourced U.S.
financial regulator, especially after the extraordinary authorities it
received in Dodd-Frank. Both the Treasury and the Fed are also members
of the FSB, and it is reasonable to assume, given the importance of the
U.S. financial system, that the Treasury and the Fed are the most
important and influential members of the FSB.
After receiving this mandate from the G-20 in 2009, the FSB
determined to proceed by designating certain firms as ``global SIFIs,''
and on July 18, 2013, it designated nine large international insurers--
including three large U.S. insurers, AIG, Prudential and MetLife--as
global systemically important insurers, or G-SIIs.\16\ The FSOC had
designated AIG as a SIFI before the FSB had made its designations, but
Prudential was not designated as a SIFI until September 2013 and
MetLife not until December 2014.\17\
---------------------------------------------------------------------------
\16\ FSB, ``Global systemically important insurers (G-SIIs) and the
policy measures that will apply to them'' July 18, 2013, http://
www.financialstabilityboard.org/wp-content/uploads/
r_130718.pdf?page_moved=1.
\17\ FSOC, U.S. Department of the Treasury, Designations, Feb. 4,
2015, http://www.treasury.gov/initiatives/fsoc/designations/Pages/
default.aspx.
---------------------------------------------------------------------------
The designation of SIFIs by the FSOC is what is called a quasi-
judicial proceeding, where evidence is weighed against a statutory
standard of some kind, and an administrative agency applies the
standard to a single party, as a court--based on evidence--would apply
the law to a single defendant. Quasi-judicial proceedings are usually
expected to meet certain standards of fairness and objectivity. This
fairness and objectivity was missing in the FSOC's treatment of at
least two of the U.S. insurers designated as G-SIIs by the FSB.
In March testimony before the House Financial Services Committee,
Treasury Secretary Lew stated that the FSB ``acts by consensus.''\18\ A
consensus literally means an agreement; synonyms of consensus in most
dictionaries are concurrence, harmony, accord, unity and unanimity. So
when these three firms were designated by the FSB as G-SIIs the
Treasury and the Fed necessarily concurred in the decision.
---------------------------------------------------------------------------
\18\ See transcript of Hensarling/Lew exchange, March 25, 2015.
http://www.aei.org/publication/exchange-between-rep-jeb-hensarling-and-
treasury-secretary-jacob-lew/?utm_source=para
mount&utm_medium=email&utm_campaign=wallison-kupiec-newsletter.
---------------------------------------------------------------------------
This means that months before the FSOC designated Prudential or
MetLife as SIFIs the Treasury, the Fed and the chair of the SEC--the
three most important members of the FSOC and perhaps the FSB as well--
had already determined as members of the FSB to designate Prudential
and MetLife as G-SIIs. Obviously, if a firm is a G-SII on a global
scale, it is going to be a SIFI in its home country. Thus, whatever
process the FSOC might have followed in the designation of Prudential
and MetLife, it could not be considered fair, objective and evidence-
based if the chairman of the FSOC, the Fed and the SEC--as members of
the FSB--had already decided the issue months before.
Moreover, the FSB has not explained the basis for its designations
of Prudential and MetLife, except to say that they were made in
conformity with a methodology of the International Association of
Insurance Supervisors. Although the methodology was made public, the
FSB has never explained how the methodology applied to any of the
insurers, including the three U.S. insurers. So the need for an
objective evidence-based decisionmaking process could not be cured in
any way by whatever process the FSB may have followed in making its
designations.
Clearly, then, the FSOC's tainted designations of Prudential and
MetLife cannot be considered the kind of deliberative process that was
sanctioned by Congress when it authorized the FSOC to make SIFI
designations.
Finally, there is now reason to believe that the FSOC's designation
of MetLife was not the result of an objective study of evidence. In
2015, as part of its legal challenge to the FSOC's designation, MetLife
filed a brief that, for the first time, made publicly available the
evidence that FSOC had produced to support its position. The brief
showed that FSOC does not have any significant evidence that MetLife's
financial distress or failure would cause financial instability in the
United States.
In the regulations it adopted to implement the designation process,
the FSOC outlined two principal ways that the distress or failure of a
firm could cause instability in the financial system as a whole: by
causing losses to others financially exposed to the failing firm
(called the Exposure Channel) or through a ``fire sale'' liquidation of
assets that drives down asset prices and thus weakens other firms
holding the same assets (the Liquidation Channel).
MetLife's brief demolishes the factual underpinnings of both ideas.
In addressing Exposure Channel, MetLife submitted evidence that
showed other major firms had very small exposures to MetLife. For
example, in the unlikely event that the largest U.S. banks were to lose
100 percent of their exposure to MetLife, that loss would not exceed 2
percent of their capital. In a point that would be funny if weren't so
serious, MetLife showed that the fines recently levied on the largest
U.S. banks by the Justice Department were four times larger than the
biggest loss that any large bank would suffer in a total MetLife
collapse, yet these fines had no observable effect on the health of the
banks involved.\19\
---------------------------------------------------------------------------
\19\ MetLife Brief, p46-7; https://www.metlife.com/sifiupdate/
important-updates/index.html
?WT.ac=GN_sifiupdate_important-updates.
---------------------------------------------------------------------------
With respect to the Liquidation Channel, a study done for MetLife
by Oliver Wyman showed that even in the implausible event that all
policyholders were to surrender their policies and ask for return of
their cash values--and all other MetLife liabilities that could
accelerate would immediately become due--the firm could still liquidate
enough assets to cover its liabilities ``without causing price impacts
that would substantially disrupt financial markets.''\20\ According to
the brief, the FSOC produced no data to contradict this evidence, but
summarily asserted that these assets sales ``could'' have an adverse
effect on the broader economy.
---------------------------------------------------------------------------
\20\ MetLife Brief, p52.
---------------------------------------------------------------------------
These facts raise the question of why FSOC chose to designate
MetLife. Although the actions of the FSOC have consistently mirrored
the decisions of the FSB, including the designation of the same three
insurers, the FSOC has always denied that these decisions were in any
way related to or compelled by similar decisions of the FSB. However,
the designation of MetLife with so little evidence of its systemic
importance adds weight to the idea that the FSOC is simply following
the directives of the FSB.
There is also evidence that the FSB, as well as the Treasury and
the Fed, believe they, as members of the FSB, are bound by FSB
decisions. In early February, 2015, Mark Carney, the chairman of the
FSB, sent a memorandum to FSB members, notifying them that the FSB
considered them to be bound by its decisions. Because of the importance
of the United States as a member of the FSB, it is highly unlikely that
the FSB chairman would have sent this memorandum without the prior
agreement of the Treasury and the Fed.
The memorandum noted peremptorily that the FSB expects ``full,
consistent and prompt implementation of [its] agreed reforms.''\21\
This sounds like the FSB's decisions are binding, but when questioned
about this by Chairman Jeb Hensarling at the HFSC's March hearing,
Treasury Secretary Lew denied that the United States was bound by these
``agreed reforms.'' Hensarling pointed out that the FSB had recently
``exempted'' three Chinese banks from the reforms and asked ``if these
are preliminary suggestions and not rules [by the FSB] why is it that
the FSB found it necessary to grant exemptions, specifically to the
Chinese?'' Secretary Lew had no answer to this question at the
hearing.\22\
---------------------------------------------------------------------------
\21\ Mark Carney, Memorandum to G20 Finance Ministers and Central
Bank Governors, February 4, 2015, http://
www.financialstabilityboard.org/wp-content/uploads/FSB-Chair-letter-to-
G20-February-2015.pdf.
\22\ See transcript, note 15 above. See also, Peter J. Wallison and
Daniel M. Gallagher, ``How Foreigners Became America's Financial
Regulators,'' The Wall Street Journal, March 19, 2015.
---------------------------------------------------------------------------
If in fact the FSOC, the Treasury and the Fed are committed to the
idea that FSB members are bound by FSB decisions, there is a further
reason for seeing the FSOC's designation of Prudential and MetLife as
illegitimate. The designation decision was in effect made by the FSB
and not the FSOC.
In a June 2014 letter to Congressman Scott Garrett, chair of a HFSC
subcommittee, the Treasury secretary and the chairs of the Fed and the
SEC denied that FSB designation decisions are binding on the United
States: ``The identification of a firm as a G-SIFI does not have legal
effect in the United States or any other country; rather, any action to
implement heightened supervision of an identified G-SIFI within a
particular country would need to be taken by that country pursuant to
its own laws.''\23\
---------------------------------------------------------------------------
\23\ Letter dated June 20, 2014, to Scott Garrett, chair of the
HFSC subcommittee on Capital Markets and Government-Sponsored
Enterprises, p2.
---------------------------------------------------------------------------
However, the notion that United States is not obliged to follow FSB
decisions is questionable in light of Treasury Secretary Lew's
description--in the same March 25 HFSC hearing--of the purpose of the
United States involvement in the work of the FSB. When asked by
Chairman Hensarling whether FSB decisions were binding on the United
States, the secretary replied: ``We work in the FSB to try to get the
kinds of standards that we think are appropriate in the United States
to be adopted around the world so that the whole world will have high
standards.'' Clearly, if that is the Obama administration's purpose, it
must itself accept and be bound by the FSB's decisions; if the United
States isn't bound, the effort to get others to comply will never be
successful. So Secretary Lew, at least, seems to be operating under the
assumption that the FSB's decisions will eventually be imported into
and adopted by the United States.
In this connection, it is important to recall that the FSB's
authority ultimately derives from the G-20 leaders. As S. Roy Woodall,
the Independent Member Having Insurance Expertise on the FSOC noted in
testimony before this Committee in April 2015: ``[I]nternational
agreements and commitments made by the U.S. members of the FSB . . .
are commitments made under the auspices of the G-20. As such, they
carry considerable weight. Although it is true that they are not
legally binding, such commitments are expected to be implemented as
part of the G-20's regulatory reform agenda.''\24\ President Obama was
a member of the G-20 when it directed the FSB to regulate shadow banks,
and all the voting members of the FSOC are political appointees of
President Obama. It is a small step in logic for the members of the
FSOC--all of whom are appointees of President Obama--to believe that in
following the directions of the FSB they believe they are carrying out
the President's own policies.
---------------------------------------------------------------------------
\24\ S. Roy Woodall, Testimony Before the Senate Banking Committee,
April 28, 2015, p5.
---------------------------------------------------------------------------
Thus, while the FSB's decisions have no direct legal effect in the
United States, it seems that the U.S. members of the FSB believe that
they have sufficient authority to agree to the FSB's decisions and
impose them in the United States. Whether they actually have that
authority is covered in the next section.
Do the FSOC and other U.S. agencies have authority to implement FSB
directives?
If, as Secretary Lew avers, the Obama administration is using the
FSB as a mechanism for raising ``global standards'' to a level that
``we think are appropriate in the United States,'' this must mean that
the Treasury and the Fed believe they have the authority to do in the
United States what they are attempting to get the FSB to prescribe for
all other FSB members.
Where is this authority?
Although the Dodd-Frank Act clearly provides authority for
regulating entities that are deemed to be systemically important, the
authority for regulating ``complex chains of transactions'' is not as
clear. Yet, by concurring with--if not actually sponsoring--the FSB's
idea that ``complex chains of transactions'' should be regulated in
order to control the dangers of shadow banking, it is apparent that the
Treasury and the Fed believe that they would have the power to regulate
those transactions when the directive from the FSB instructs them to do
so.
Indeed, a concept similar to ``complex chains of transactions'' has
already been articulated by the FSOC, while using a slightly different
form of words. In its December 18, 2014, Notice on Asset Management
Products and Activities, the FSOC stated: ``risks to financial
stability might not flow from the actions of any one entity, but could
arise collectively across market participants.''\25\ [emphasis
supplied]
---------------------------------------------------------------------------
\25\ FSOC, ``Notice on Asset Management Products and Activities,''
December 18, 2014, p4.
---------------------------------------------------------------------------
Most of the attention to the FSOC's designation of SIFIs has
focused on the agency's efforts to designate large financial
institutions which, if they become financially distressed, could cause
instability in the U.S. financial system. The underlying idea here is
that, because of its interconnections with other firms, the financial
distress or failure of a nonbank firm could drag down others, causing
the financial instability that the Act is intended to prevent.\26\
---------------------------------------------------------------------------
\26\ The historical record does not support these claims. When
Lehman Brothers failed--from the market's perspective suddenly and
without a Government rescue in September 2008--it did not drag down any
other significant financial firm, even though Lehman was one of the
largest nonbank financial institutions in the United States. There was
certainly chaos after Lehman's bankruptcy, but that was because the
Government suddenly reversed the policy of rescuing large financial
firms that it appeared to have established 6 month earlier with the
rescue of Bear Stearns. This reversal completely upended the
expectations of market participants, creating a panic in which
institutions and investors sought and hoarded cash. The draining of
liquidity from the financial system after the Lehman bankruptcy is what
we now know as the financial crisis.
---------------------------------------------------------------------------
However, the FSOC's authority is not limited to designating SIFIs
because their financial distress could cause instability in the U.S.
financial system. It also has authority to designate as SIFIs--and
consign to regulation by the Fed--many firms that are not large and
whose failure alone would not cause financial instability. For example,
Sec 113(a) of Dodd-Frank states:
The Council . . . may determine that a U.S. nonbank financial
company shall be supervised by the Board of Governors and shall
be subject to prudential standards . . . if the Council
determines that material financial distress at the U.S. nonbank
financial company, or the nature, scope, size, scale,
concentration, interconnectedness, or mix of activities of the
U.S. nonbank financial company, could pose a threat to the
financial stability of the United States. [emphasis supplied]
In addition, Sec. 112(a)(2)(H) describes the duties of the FSOC as
follows:
[R]equire supervision by the Board of Governors for nonbank
financial companies that may pose risks to the financial
stability of the United States in the event of their material
financial distress or failure, or because of their activities
pursuant to section 113; [emphasis supplied]
Finally, Sec. 120 provides that
The Council may provide for more stringent regulation of a
financial activity by issuing recommendations to the primary
financial regulatory agencies to apply new or heightened
standards and safeguards, including standards enumerated in
section 115, for a financial activity or practice conducted by
bank holding companies or nonbank financial companies under
their respective jurisdictions, if the Council determines that
the conduct, scope, nature, size, scale, concentration, or
interconnectedness of such activity or practice could create or
increase the risk of significant liquidity, credit, or other
problems spreading among bank holding companies and nonbank
financial companies, financial markets of the United States, or
low-income, minority, or underserved communities.
Finally, under Title VIII of Dodd-Frank, the Fed, with the approval
of the FSOC, has authority to impose ``risk management standards''--
these are undefined--on any financial firm engaged in payment,
clearance and settlement (PCS) activities. These provisions are
sometimes seen as applicable only to clearinghouses and other financial
market utilities, but in fact they are also applicable for financial
firms that engage in payment, clearing and settlement activities. PCS
are very broadly defined in Title VIII and could provide another avenue
through which the FSOC and the Fed could gain prudential controls over
the firms that make up the capital markets.\27\
---------------------------------------------------------------------------
\27\ Peter J. Wallison, ``The Regulators' War on Shadow Banking,''
AEI Research, January 22, 2015. http://www.aei.org/publication/
regulators-war-shadow-banking/.
---------------------------------------------------------------------------
All of these provisions are important because the FSB and the Fed
are both focusing on a ``complex chain of transactions''--or as the Fed
describes it, a ``complex chains of activity''--as a way to describe
how the shadow banking system operates. The term ``activities'' could
be interpreted to refer to a ``complex chain of transactions'' and thus
provide the Fed and the FSOC with the authority to impose prudential
standards on ordinary transactions in the capital markets.
Thus, there is a plausible argument based on this language that the
FSOC could designate as SIFIs all firms that engage in certain defined
transactions--say, buying the commercial paper of asset-backed trusts--
or participate in those transactions to an extent that exceeds some
dollar amount. The danger of being designated for these suspect
transactions would be enough to give the Fed the ability to approve or
disapprove transactions of that kind on a case-by-case basis--a
plausible substitute for prudential regulation.
The FSOC and the Fed would defend their position by arguing that it
was transactions like those they are banning that caused the financial
crisis. In addition, if the FSOC determines that a firm's activities
should be regulated by the Fed under Section 112 or 113, the Fed is
arguably then the firm's primary financial regulator for purposes of
Section 120.
We don't know, of course, how the courts will respond to
interpretations like these. It is a distortion of the statutory
language, but the courts often accord deference to agencies'
interpretation of the scope of their statutory authority, especially if
they believe that the agency is attempting to address a serious problem
that is within the ``spirit'' of the legislation. The FSOC and the Fed,
in carrying out a mandate of the FSB, could claim that they have
authority to take these steps because they are attempting to prevent
another financial crisis, and no one might be willing--or have the
standing--to challenge them. Cases like this suggest the Supreme
Court--as suggested recently by Justice Thomas, should revisit
Chevron.\28\
---------------------------------------------------------------------------
\28\ Michigan v. EPA, 576 U.S._(2015) (slip op., at 4-5) (Thomas,
J., concurring).
---------------------------------------------------------------------------
If the FSOC and the Fed are successful in controlling what the FSB
has now defined as shadow banking--that is asset managers, securities
firms, investment funds, finance companies and hedge funds, among
others--they will succeed in stifling the continued growth of the
securities and capital markets in the United States, which have been
far and away the main sources of financing for U.S. business.
What to Do
If this Committee believes that applying prudential regulation to
capital markets activities should be unacceptable, it should act to
prevent this from happening. The FSB is not the problem; as noted
earlier, it has no legal authority in the United States; nor would a G-
20 statement or an agreement by U.S. regulators at the FSB by itself
confer this authority.
The problem is that there is language in the Dodd-Frank Act that
could be interpreted to confer the authority on the FSOC and the Fed to
control the so-called shadow banking system by imposing prudential
regulation on ordinary activities in the capital markets. Section 113
of Dodd-Frank refers to ``mix of activities'' as a basis for
designation of a SIFI, but it does not refer to the control of chains
of transactions or an entity's participation in chains of transactions
or chains of activities. In any event, the list of items in Section 113
for which firms can be designated (``nature, scope, size, scale,
concentration, interconnectedness, or mix of activities'') is far too
broad and contains no inherent limit. Did Congress really intend to
give the FSOC authority to designate a firm as a SIFI because of its
``nature?'' If the doctrine of unconstitutional delegation of
legislative authority were still alive, this would be a perfect
candidate. Congress should repeal this list. Alternatively, Congress
could make clear that the term ``activities'' was not intended to
include specific chains of transactions, but the best solution would be
to remove the term ``activities'' from the Act.
Conclusion
Complacency about what the FSB, the FSOC and the Fed are doing to
control shadow banking is not only unwarranted, it is a grave danger to
U.S. economic growth. ``Shadow banks,'' as these agencies conceive it,
are the firms active in the capital markets in the United States. The
freedom of these firms to take the risks their managements find
acceptable is the foundation of the innovative and efficient financial
system that has made the U.S. economy the world's unquestioned leader.
The financial crisis may have given bank regulators new powers that
they can use to impose prudential controls on capital market firms.
Indeed, several provisions of the Dodd-Frank Act could be creatively
interpreted to provide the legal authority to do so. If this Committee
agrees that bank--like prudential controls over the capital markets
would be harmful to economic growth, it should take steps today to
cutoff the legal authorities on which these agencies are likely to
rely.
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
PREPARED STATEMENT OF ADAM S. POSEN
President, Peterson Institute for International Economics\1\
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\1\ I am grateful to the Alfred P. Sloan Foundation for its support
of my research on global financial stability, and to my colleagues
Morris Goldstein, Simon Johnson, Avinash Persaud, Edwin Truman, and
Nicolas Veron for their suggestions for this specific submission of
testimony. I remain solely responsible for the views and any errors in
this statement, and thus it does not necessarily represent the views of
the Peterson Institute, the Sloan Foundation, or any member of their
staff or boards. Disclosure of the Institute's funders and transparency
policy are available at http://www.piie.com/content/?ID=138.
---------------------------------------------------------------------------
July 8, 2015
1. The rationale for international financial regulatory
coordination at this time--Generally, the U.S. Government has the lead
in international economic negotiations--as the largest and most
developed economy, as the incumbent creator of the rules and
institutions started after World War II, often as having the most
technical expertise on a given subject, and usually as having the model
of a property-rights respecting rule of law in its commercial affairs
that other economies wish to emulate or import. But even where the U.S.
Government is not entirely dominant in international policy agenda
setting, there is room for the U.S. economy and citizens to benefit
from international coordination. The rest of the world economy exists,
whether or not the U.S. Government chooses to engage with other
governments in discussion of the rules by which it is partially
governed. Economic activities abroad can have significant negative
spillovers on U.S. well-being, as well as present opportunities for
(mutual) gain to be unlocked. Mostly, though not always, international
economic coordination ends up raising standards abroad while
constraining harmful behaviors in the United States that we would wish
to limit anyway--and in fact, our own Government's legislated intent is
often more effectively applied by making it harder for U.S. entities to
skirt domestic regulations by moving abroad.
The benefits to the U.S. economy and public from international
financial regulatory cooperation are particularly high for a simple
reason: unnecessary financial volatility and misbehavior abroad is
transmitted to the U.S. economy directly, rapidly, and strongly. As
other economies inevitably grow in size and financial depth relative to
the U.S. economy, the impacts of their problems on the United States
grow. We can see this in the comparison between the real but limited
impact of the Latin and Asian financial crises of the 1990s on the
United States and the far greater harms felt from the European crisis
of recent years and the swings in capital flows and commodity prices
driven by Chinese financial instability. This can do us great harm,
despite the size, depth, diversity, and general robustness of U.S.
financial markets and lending activities making us less vulnerable than
other economies to any given shock.
We cannot simply live with the misbehaviors and even unintended
weaknesses of other economies' financial systems. We need changes in
those other countries to defend ourselves, as well as to help them.
Furthermore, the usual concern in international economic governance
about a race to the bottom of low standards winning out takes on a
particular form in the financial sector: cross-border regulatory
arbitrage. Given the mobility of capital and the availability of
information technology and connectivity, jurisdictions where
regulations are much weaker can become places where activities
prohibited in the United States and elsewhere thrive. These activities
can produce globally dangerous buildups of financial risk very quickly
and easily. While international regulatory coordination cannot rule
these out completely, it can make it both much more difficult for such
legal loopholes to arise, to be defended, to grow in size and
riskiness, and to hide from at least supervisory awareness.
International regulatory coordination, in the manner in which it is
currently led by U.S. Government and Federal Reserve representatives,
is reducing these risks to U.S. economic and financial stability.
Please note that I said reducing, not removing, these risks--please
note, also though, that I said reducing not raising. This reduction of
foreign financial risks to the United States (including from U.S.
entities moving dangerous activities abroad to elude supervision) is
happening along four channels at present:
Raising minimum standards for the soundness of major banks
and banking systems, including by setting minimums for bank
capital, improving risk assessment (e.g., stress testing),
creating liquidity/leverage limits, identifying systemically
important institutions, making cross-border resolution more
feasible, and so on.
Increasing cross-border transparency of financial systems'
organization, institutions, financial flows, and buildups of
risk.
Reducing the possibilities of regulatory arbitrage across
major financial centers, both in terms of getting agreement on
activities to be restricted and monitored, and of providing a
means for `naming and shaming' noncompliant regimes.
Promoting largely U.S.-based versions of best practice for
regulators, supervisors, bankers, and nonbank financial
institutions in other countries.
I would be remiss in my duty to this Committee, however, if I did
not point out that other countries can legitimately expect better U.S.
behavior and practice to emerge from international regulatory
coordination as well. Our regulators, supervisors, banks, and other
financial institutions did not cover themselves in glory with their
practices in the run-up to the financial crisis of 2008-10. At a
minimum, having the U.S. financial regulators and supervisors be
confronted with international questions and standards should reduce the
cognitive capture of that community by a set of blinders, as I have
argued played a critical role in causing the U.S. financial crisis.
There are other views which will claim that the current
international financial regulatory process is either eroding desirable
U.S. regulations by having other countries force compromise on the
United States through the process, or is imposing unnecessary
additional regulations upon the United States to erode our competitive
advantages, or both. I readily acknowledge that there are a few
instances of this sort--I believe that the attempt by European Union
[EU] regulators to impose Solvency II, their set of insurance
requirements, on insurers in the United States and elsewhere is a
particularly costly example, as I will explain--but I view that as
indeed instances of bad regulation, not the overall international
process being inherently harmful. Any regulatory process, domestic or
foreign, will have debates and make some mistakes. Arguably, the
domestic Financial Stability Oversight Council [FSOC] within the United
States is if anything primed to be more biased toward lowest common
denominator or group think leaving gaps in the U.S. financial
regulatory framework than the international Financial Stability Board
[FSB]. So, the FSB is a useful check and occasional corrective to the
U.S. FSOC process.
Whether it is discussions of Trade Promotion Authority (which I
commend the Senate for recently passing), of responses to climate
change, of efforts to balance healthy global tax competition with the
prevention of tax avoidance by multinational corporations and wealthy
individuals, or of the need to prevent cross-border regulatory
arbitrage by financial institutions, the U.S. Government has to
confront the fact that behaviors and policies abroad affect us here at
home. There is sometimes a paranoid tendency by some American
politicians and pundits to assume that all international economic deals
are about putting one over on the United States, eroding our high
standards through subversion of domestic regulation, or eroding our
market-based competitiveness by imposing undue additional regulation.
This is a profound misunderstanding on both the right and the left of
our public debate. The United States advances the economic welfare of
its people through constructive international engagement, usually gets
its way in such efforts and extends the rules it wants to others, and
sometimes even benefits from having constraints imposed from outside
pressure that domestic special interests would be able to prevent
absent that. Yes, sometimes other governments do pursue narrow
interests of their national champions, whether State-owned or simply
influential private businesses, through these processes. But American
economic negotiators are grown-ups, they can handle it, just as they
would when having business negotiations in the private sector. The fact
that somebody tries something self-interested does not mean you cannot
work with them, you simply call them on that attempt.
2. The demonstrated utility of the Financial Stability Board--
Turning from the general issue of international coordination on
financial regulation to the current process for pursuing it, what about
the FSB? Does it serve U.S. and global interests as currently
constituted and operating? I believe that it clearly does, though with
some inherent limitations, as well as some areas for improvement that
can be fixed. I resolutely dispute any claims that the FSB is run amok,
is undermining U.S. domestic financial regulation, or is trying to, let
alone succeeding in, forcing our diverse and unique private-sector
financial system to converge on others' models. This is not because I
am part of some technocratic self-appointed elite, or more crassly
simply buddies with the people involved in the FSB process--I have been
rather critical on the record of some of the FSB's decisions for lack
of ambition and for too much clubbiness in its agenda setting.\2\ But I
do believe that the FSB as an organization for international
coordination is a reasonably good institutional response to the need
for effective, legitimate, and well-motivated global financial
regulation.\3\ Among the positive attributes of the FSB are:
---------------------------------------------------------------------------
\2\ See, among others, Adam S. Posen, ``Confronting the Reality of
Structurally Unprofitable Safe Banking,'' in Too Big to Fail III:
Structural Reform Proposals: Should We Break Up the Banks?, Andreas
Dombret and Patrick Kenadjian, eds., Boston/Munich: De Gruyter, 2015.
http://tinyurl.com/oxc7wk2.
\3\ For an earlier assessment of the FSB, many of whose
recommendations have largely since been adopted, see Edwin M. Truman
and Gary Schinasi, ``Reform of the Global Financial Architecture,''
PIIE Working Paper 10-14, October 2010, http://www.piie.com/
publications/interstitial.cfm?ResearchID=1674.
Its national membership covers all of the world's major
financial centers but is still limited enough in number to be
---------------------------------------------------------------------------
able to make decisions.
It usefully cuts across national and regulatory turf
barriers in a way that is needed to confront regulatory
arbitrage and address globally connected financial networks.
It is coordinated with the G20 economic leaders' meetings
and processes, which means major agenda items from the FSB get
on to the G20 agenda for buy-in.\4\
---------------------------------------------------------------------------
\4\ I am grateful to Morris Goldstein for this insight regarding
the G20 link.
This also creates scrutiny and oversight for the G20
decisions, and a structure for issuing public progress reports
---------------------------------------------------------------------------
for assessment.
By including central bankers and financial officials, as
well as bank supervisors narrowly defined, it avoids some of
the narrow thinking and silo mentality that caused cognitive
capture in the earlier Basel banking processes and in U.S.
supervisory decisions pre-crisis.
It is a soft-law organization, meaning that agreements it
reaches are only binding on member governments to the degree
that not complying involves naming and shaming
When a regulation issued becomes recognized as worthy,
popular and market pressure to adopt a good standard are the
main source of compliance, with the FSB simply providing public
benchmarks and monitoring.
This to me is a virtue in a world of sovereign nation
states and the need to change regulations over time.
It has grown out of leadership efforts by both Democratic
and Republican administrations, including the creation of its
direct predecessor the Financial Stability Forum, and as such
is at its core a U.S.-instigated nonpartisan institution.
The proof is in the pudding, even though it has had little time to
cook. The FSB process has produced some useful achievements that are
being applied globally as a result of these structural attributes.
Banking transparency, standards, and particularly capital requirements
have been raised in the major financial institutions of a wide range of
countries, including in some critical emerging markets and some
financial centers outside of the United States and European Union.
Agreement on a set of G-SIFIs, globally systemically important
financial institutions, and on capital surcharges for them as partial
insurance for the public, has been mutual including all FSB member
countries, and done on largely sound replicable criteria. Progress has
been made on procedures and compelling conditional funding for safer
expedited resolution of such important institutions when they run into
trouble.\5\
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\5\ Which matters if you believe that resolution threats are
credible to large/important institutions, and that inability to resolve
Lehman Brothers and others was a cause of the financial crisis. I have
my doubts this is going to help much in preventing the next crisis. For
this hearing, however, the point is that the majority of U.S. officials
do believe this is important, and the FSB has delivered in response to
their belief some global adoption of measures desired in this regard.
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Having widespread divergence on what different governments believe
is adequate bank capital or what banks are systemically important would
be a recipe for precisely the kind of race to the bottom that would
imperil U.S. financial stability--every country would get looser
regulations for its preferred client banks, and some would compete to
be the place the world's banks could engage in activities that should
not be allowed. This will become increasingly important with large
Chinese financial institutions, as we are seeing in today's news. Given
China's membership in the FSB and G20, we have a means to bring those
potential dangers into the regulatory system beyond Chinese government
bailouts and own soft-touch regulation (following the United States and
United Kingdom mistakes of the 2000s, sadly).
3. Where and why bad regulation is emerging from the FSB process
regarding nonbanks--As I mentioned earlier, the FSB can be a good
process, producing some good international standards as a result, thus
serving U.S. economic interests, and still get some things wrong. This
is inevitable, as getting things right is difficult, both because there
are governments pushing compromises and proposals for the wrong reasons
on any given issue, and because some issues are more difficult to
tackle than others. Where the FSB at present is getting things wrong,
in my opinion, largely has to do with its approaches to coordinating
regulation of the nonbank parts of the financial system. Regulating
nonbanks is more difficult because some well-organized interest groups
that were less weakened or tainted by the financial crisis have some
sway, because intellectually the manner and extent of nonbank
regulation is less obvious and certainly less well precedented, and
because the kinds of national regulators and supervisors involved are
much more diverse. I also believe that the FSB has demonstrated a
tendency to treat nonbanks as banks because it is something its
technocratic members are more familiar with, it allows claims of
neutrality across the financial sector, it utilizes off-the-shelf
remedies, and it speeds the conclusion of the post-crisis agenda. In
other words, treating banks and nonbanks largely the same is the easy
way out.
Diversity in financial systems is, however, a virtue. As I have
argued for some time, a major reason that the United States and Germany
recovered from the financial crisis more rapidly and strongly than
other advanced economies was that they had more diversified financial
systems, and thus were more robust in continuing to provide financing
to nonfinancial business and households.\6\ This financial diversity so
helpful to the United States comes along at least two dimensions:
first, that we have a relatively unconcentrated banking system, despite
the existence of megabanks, which includes community banks and various
regional lenders; second, that we have a variety of nonbank means of
providing finance for investment, including corporate and junk bonds
and commercial paper, venture capital and private equity, pension funds
and insurance firms, as well as newly emerging forms of direct lending.
This makes the U.S. economy far more resilient to financial shocks,
even the worst ones we have seen. We do not want any global regulatory
process to interfere with this diversity in U.S. finance.
---------------------------------------------------------------------------
\6\ See Adam S. Posen, ``Why is Their Recovery Better than Ours?,''
speech at the National Institute for Economic and Social Research,
London, 27 March 2012, available at http://www.bankofengland.co.uk/
publications/Documents/speeches/2012/speech560.pdf.
---------------------------------------------------------------------------
That is not the same, though, as saying any international
regulation of nonbanks is a bad thing. If one remembers all the
different kinds of financial firms engaged in bad lending and
investment decisions, fraudulent behavior, speculation with other
people's money, and reliance on implicit government bailout guarantees,
during the 2000s in the United States, there is a prima facie case
which I support for more entities coming under regulation than fewer.
What the FSB needs to do, and the U.S. representatives there need to
encourage, is serious discussion of which parts of the nonbank
financial sector need further regulation, and which do not, and what
form that regulation should take. Simply amping up capital
requirements, for holding ``safe assets,'' and calling everything a
``shadow bank'' that provides funding and is not a bank, misses the
point and potentially does harm.
Right now, the biggest mistake the FSB is making in this regard is
in the attempt to extend Solvency II, the European Commission's
regulation for insurance firms, to global application. This is a bad
idea for European insurers on its own lack of merits--as argued by my
colleague Avinash Persaud, long-term investors like life insurers with
clear payout obligations need a very different approach to their
portfolios than do asset managers or banks, and what constitutes safe
investment for them is different than for banks.\7\ Insurers certainly
need regulation and supervision, including clear capitalization to meet
their policyholders' expected payouts. But almost every jurisdiction,
and certainly the U.S. states, already provides such pure protective
supervision. Solvency II tries to add on capital holding requirements
of Government bonds and short-term assets akin to what is (rightly)
required for banks. This is not only ill-suited for insurers, it is
likely to result in a short-fall of private funds for long-term
investment like infrastructure in the jurisdictions that adopt this set
of requirements--where those investment funds for the long-term are
desperately needed.
---------------------------------------------------------------------------
\7\ Avinash D. Persaud, How Not to Regulate Insurance Markets: The
Risks and Dangers of Solvency II, PIIE Policy Brief 15-5, April 2015,
http://www.piie.com/publications/interstitial.cfm?ResearchID=2777.
---------------------------------------------------------------------------
This bad outcome from the FSB illustrates what happens when the
United States goes into international processes with its own house not
in order. We have 54 State and other local insurance commissioners, and
despite the addition of a Federal oversight, no real one representative
to strongly present in the FSB. Meanwhile, the
European Union has a coherent Commission point of view on this, which
has huge bureaucratic momentum after years of preparation centrally.
The insurers in Europe for the most part rightly hate it, but since it
seems inevitable to be imposed on them, they have given up fighting
Solvency II, and instead back using the FSB to impose it on the United
States, Japanese, and other competing insurers. They figure if they
will be limited, they want to be sure their global competitors are as
well. The United States needs to stand up against this in the FSB. This
is the exception that proves the general rule that the FSB process
serves U.S. interests, but it reflects an instance of bad regulation,
not an overall assault on U.S. financial
diversity. And it should be responded to as such within the FSB
process.
Additional Material Supplied for the Record
PREPARED STATEMENT OF MICHAEL S. BARR
The Roy F. and Jean Humphrey Proffitt Professor of Law
University of Michigan Law School
July 8, 2015
In 2008, the United States plunged into a severe financial crisis
that shuttered American businesses, and cost millions of households
their jobs, their homes and their livelihoods. The crisis was rooted in
years of unconstrained excesses and prolonged complacency in major
financial capitals around the globe. The crisis demanded a strong
regulatory response in the United States and globally as well as
fundamental changes in financial institution management and oversight
worldwide. The United States has led these reforms, both domestically
and internationally.
In the United States, the Dodd-Frank Act created the authority to
regulate Wall Street firms that pose a threat to financial stability,
without regard to their corporate form, and to bring shadow banking
into the daylight; to wind down major firms in the event of a crisis,
without feeding a panic or putting taxpayers on the hook; to attack
regulatory arbitrage, restrict risky activities through the Volcker
Rule and other measures, regulate repo and other short-term funding
markets, and beef up banking supervision and increase capital; to
require central clearing and exchange trading of standardized
derivatives, and capital, margin and transparency throughout the
derivatives market; to regulate payments, settlement, clearance and
other systemic activities; to improve investor protections; and to
establish a new Consumer Financial Protection Bureau to look out for
the interests of American households.
The Act established the Financial Stability Oversight Council with
authority to designate systemically important firms and financial
market utilities for heightened prudential oversight by the Federal
Reserve; to recommend that member agencies put in place higher
prudential standards when warranted; and to look out for and respond to
risks across the financial system. The Council is aided in these tasks
by its own staff, the staff of member agencies, and the independent
Office of Financial Research, which has a duty to standardize and
collect data and to examine risks across the financial system.
One of the major problems in the lead up to the financial crisis
was that there was not a single, uniform system of supervision and
capital rules for major financial institutions. The Federal financial
regulatory system that existed prior to the
Dodd-Frank Act developed in the context of the banking system of the
1930s. Major financial firms were regulated according to their formal
labels--as banks, thrifts, investment banks, insurance companies, and
the like--rather than according to what they actually did. An entity
that called itself a ``bank,'' for example, faced tougher regulation,
more stringent capital requirements, and more robust supervision than
one that called itself an ``investment bank.'' Risk migrated to the
less well-regulated parts of the system, and leverage grew to dangerous
levels.
The designation of systemically important nonbank financial
institutions is a cornerstone of the Dodd-Frank Act. A key goal of
reform was to create a system of supervision that ensured that if an
institution posed a risk to the financial system, it would be
regulated, supervised, and have capital requirements that reflected its
risk, regardless of its corporate form. To do this, the Dodd-Frank Act
established a process through which the largest, riskiest, and most
interconnected financial firms could be designated as systemically
important financial institutions and then supervised regulated by the
Federal Reserve. The Council has developed detailed
interpretive guidance and a hearing process that goes beyond the
procedural requirements of the Act, including extensive engagement with
the affected firms, to implement the designation process outlined in
Dodd-Frank. The approach provides for a sound deliberative process;
protection of confidential and proprietary information; and meaningful
and timely participation by affected firms. The Council has
already designated a number of firms under this authority.
Critics of designation contend that it fosters ``too big to fail,''
but the opposite is true. Regulating systemically important firms
reduces the risk that failure of such a firm could destabilize the
financial system and harm the real economy. It provides for robust
supervision and capital requirements, to reduce the risks of failure,
and it provides for a mechanism to wind down such a firm in the event
of crisis, without exposing taxpayers or the real economy to the risks
of their failure. The FDIC is developing a ``single point of entry''
model for resolution that would allow it to wind down a complex
financial conglomerate through its holding company with
``resolution-ready'' debt and equity, while permitting solvent
subsidiaries to continue to operate. Similar approaches are being
developed globally.
Other critics argue that the FSOC should be more beholden to the
regulatory agencies that are its members, but again, the opposite is
true: Congress wisely provided for its voting members, all of whom are
confirmed by the Senate, to participate based on their individual
assessments of risks in the financial system, not based on the position
of their individual agencies, however comprised.
Members must also individually attest to their assessments in the
FSOC's annual reports. The FSOC, moreover, has the duty to call on
member agencies to raise their prudential standards when appropriate,
and member agencies must respond publicly and report to Congress if
they fail to act. If anything, the FSOC's powers should be
strengthened, so that fragmentation in the financial regulatory system
does not expose the United States to enormous risk, as it did in the
past.
Some critics contend that certain types of firms in certain
industries or over certain sizes should be categorically walled off
from heightened prudential supervision, but such steps will expose the
United States to the very risks we faced in the lead up to the last
devastating crisis. The failure of firms of diverse types and diverse
sizes at many points in even very recent memory--from Lehman and AIG to
Long-Term Capital Management--suggest that blindspots in the system
should at the very least not be intentionally chosen in advance by the
Congress. The way to deal with the diversity of sizes and types of
institutions that might be subject to supervision by the Federal
Reserve is to develop regulation, oversight and capital requirements
that are graduated and tailored to the types of risks that such firms
might pose to the financial system, as the agencies have been doing.
FSOC and member agencies also have other regulatory tools available
with respect to risks in the system for firms not designated for Fed
supervision, including increased data collection and transparency,
collateral and margin rules for transactions, operational and client
safeguards, risk management standards, capital requirements, or other
measures.
Some critics complain that the FSOC's work is too tied to global
reforms by bodies such as the Financial Stability Board (FSB). But
global coordination is essential to making the financial system safe
for the United States, as well as the global economy. The United States
has led the way on global reforms, including robust capital rules,
regulation of derivatives, and effective resolution authorities. These
global efforts, including designations by the FSB, are not binding on
the United States. Rather, the FSOC, and U.S. regulators, make
independent regulatory judgments about domestic implementation based on
U.S. law. And U.S. regulators follow the normal notice and comment
process when developing financial regulations. The FSB itself has
become more transparent over time, adopting notice and comment
procedures, for example, but it could do more to put in the place the
kind of protections that the FSOC has established domestically.\1\
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\1\ See Michael S. Barr, Who's in Charge of Global Finance?,
Georgetown Journal of International Affairs.
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As with designation, global coordination--and independent
regulatory judgment--is essential to capital rules. Strong capital
rules are one key to a safer system. There's already double the amount
of capital in the major U.S. firms than there was in the lead up to the
financial crisis. Globally, regulators are developing more stringent
risk-based standards and leverage caps for all financial institutions,
and tougher rules for the biggest players. In the United States,
regulators have proposed even stronger leverage and capital
requirements for the largest U.S. firms, and other countries are
putting in place stricter approaches when warranted by their local
circumstances.
In my judgment, the local variation based on a strong minimum
standard is healthy for the system, taking into account the different
relative size of financial sectors and differing local economic
circumstances. There's been progress on the quality of capital--
focusing on common equity--and on better and more comparable measures
of the riskiness of assets, but more could be done to improve
transparency of capital requirements across different countries and to
make them stronger buffers against both asset implosions and liquidity
runs. We need to continue to insist that European capital standards and
derivatives regulations are strong--and enforced even-handedly across
the board.
The United States has taken a strong lead in pursuing global
reforms, galvanizing the G-20, pushing for the creation of the global
Financial Stability Board, and pursuing strong global reforms on
capital, derivatives, resolution, and other matters.
The G-20 has been driving financial reforms at a global level; the
Financial Stability Board pursues agreement among regulators; and
technical teams at the Basel Committee on Banking Supervision, the
International Organization of Securities Commission, and the
International Association of Insurance Supervisors hash out industry-
relevant reforms. While the process of reaching global agreement has at
times been quite messy, divisive, and incomplete, the last thing we
need is to hamstring global cooperation or U.S. regulation. These
mechanisms should be strengthened and improved, not ignored or
weakened.
Strong U.S. financial rules are good for the U.S. economy, American
households and businesses, and we also need a stronger, harder push to
reach global agreement on core reforms. In fact, such an approach is
essential in order to reduce the chances of another devastating global
financial crisis that crushes the U.S. economy.
The task of financial reform is not over. We need to keep pushing
forward if we are to have a financial system that is safer, fairer, and
better serves our economy.
______
PREPARED STATEMENT OF CHRIS BRUMMER, J.D., Ph.D. *
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* Chris Brummer is Professor of Law at Georgetown University Law
Center and Faculty Director of the law school's Institute of
International Economic Law. He is also Project Director for the
Transatlantic Finance Initiative and C. Boyden Gray Fellow at the
Atlantic Council, as well as senior fellow at the Milken Institute's
Center for Financial Markets.
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Professor of Law, Georgetown University Law Center
July 8, 2015
What's in it for the United States?: On the Constitutionality and
Legitimacy of the FSB (and International Financial Regulation)
The fact that legislators discuss and grapple with FSB policies is
in itself a testament to just how far ``soft law''--nonbinding,
international accords between regulators--has come. When discussing
policies, international policymakers routinely reference FSB principles
and best practices, and even domestically, in the United States,
administrative agencies from the Federal Reserve to the Securities and
Exchange Commission grapple with and publicly acknowledge notions of
international regulatory ``commitments'' and ``obligations.''
That U.S. agencies take the FSB and other international standard
setters seriously does not, however, a constitutional crisis make. By
definition, international soft law standards do not create any formal
obligations. They are not treaties under the Vienna Convention on the
Law of Treaties or under Article II of the U.S.
Constitution. Instead, both the FSB's original charter and its revision
(as well as virtually all other international standards) explicitly
state: ``This Charter is not intended to create any legal rights or
obligations.''\1\
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\1\ See Article 16, FSB Charter, http://
www.financialstabilityboard.org/wp-content/uploads/
r_090925d.pdf?page_moved=1; see also Article 23, http://
www.financialstabilityboard.org/wp-content/uploads/FSB-Charter-with-
revised-Annex-FINAL.pdf (amended).
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As informal organizations, the FSB, Basel Committee, IOSCO and
other regulatory bodies instead rely on their members to participate in
discussions, and after participating, to voluntarily implement those
standards at home by crafting them to their local conditions. In the
United States, this implementation is done in accordance with the
Administrative Procedure Act and other internal agency policies, as
well as in keeping with the mission and mandate of the specific
regulator involved. A bilateral or multilateral memorandum of
understanding on enforcement coordination, for example, is justified
and operationalized on the basis of the SEC's core mission of investor
protection (which necessarily requires cross-border cooperation in
today's globalized financial markets); similarly, articulations on
interest rate benchmarks speak to concerns regarding capital allocation
in global markets (and again require cross-border cooperation). Even
the more recent but controversial rule on asset managers speaks to core
concerns among regulatory agencies on the impact of shadow banking on
financial and price stability, and capital allocation.
Furthermore, as a tool for achieving the mission of regulatory
agencies, international standard setting bodies like the FSB enjoy both
functionality and usefulness--and even as informal instruments can
exhibit considerable ``compliance pull.'' Markets, for one, often take
direction from best practices in an assumption that they provide an
indication or roadmap of future regulatory rulemaking. Meanwhile,
regulators recognize that in order to influence other countries, they
can't lead from behind. Instead, they have to lead by example.
Fortunately for the United States, its ability to impact global
standard setting bodies is in many ways unmatched:
The United States was a founding member of every major
international regulatory forum--distinguishing it from China,
Russia, Brazil India and even
Germany and (depending on how one dates the founding of IOSCO)
the United Kingdom;
In most agencies, consensus expectations for decisionmaking
give the United States a de facto veto authority on most
international initiatives;
The United States hosts the world's largest and most liquid
capital markets giving it unparalleled capabilities to impact a
number of fields including securities, accounting and auditing;
Emerging markets have been noticeably subdued on Basel
Committee and even FSB, leaving comparatively like-minded
countries of the G10 (under U.S. leadership) to dominate
discussions on core banking and financial stability matters;
Although Europe technically has more countries sitting on
some bodies (since individual member states can participate),
they are often constrained by a necessity to act in unison and
EU-level policymaking capabilities are in many sectors still in
early stages; and
The United States boasts the largest (though not best-paid)
workforce and thus has a home regulatory ``back office''
allowing the United States to process and present data and
reforms with unparalleled sophistication.
With all this in mind, however, let me be clear: the FSB (and
indeed global standard-setting more generally) is no panacea. A number
of issues can and do confound the process. In part because of their
informality, mandates and missions of international standard setting
bodies can (and at times do) overlap. This causes intermittent turf
wars (most notably between the FSB and IOSCO--two relatively young
standard-setting bodies seeking to establish credibility) that do not
always speak well of international diplomacy or financial regulation.
Furthermore, even though the FSB and other standard-setting bodies
may be constitutional, they do not always boast the kind of popular or
policy legitimacy some U.S. stakeholders would prefer. This lies in
part from the turf wars described above. Dissension between
international standard setting bodies, which can be an expression of
honest disagreement or the political posturing of competing
bureaucracies, by definition leads outsiders to conclude that one party
is ``wrong,'' undermining the sense that the substantive output,
perhaps of both agencies is of the highest quality. Furthermore,
legitimacy can be undermined because of the complicated institutional
arrangement supporting the rulemaking, and the at times opaque nature
of decisionmaking. Indeed, some standard setting bodies do not always
practice notice and comment procedures allowing for the same levels of
nongovernmental and stakeholder participation that one expects here in
the United States.
In my opinion, however, these challenges, do not merit a wholesale
unwinding the work of cross-border standard setting, or the FSB in
particular. For one, the turf wars played out internationally also have
domestic drivers. The SEC, for example, does not participate in G20
meetings like the Federal Reserve and Treasury do, and is overshadowed
by both in the FSB. Thus its best opportunity to articulate and advance
its vision internationally is through IOSCO, which it dominates and
where neither the Federal Reserve or Treasury have a seat. That policy
discord can subsequently arise at the international level, given the
varying priorities of prudential and market supervisors, should thus
not be surprising.
Second, jettisoning or (erroneously) maligning the international
architecture as unconstitutional would undermine, as already spelled
out above, an important strategic advantage the United States currently
enjoys--the ability (to resuscitate the objectives of the TPP) to
``write the rules of the 21st century,'' with if not an American pen,
at least with a good dose of U.S. ink.
Third--and this is a point opponents to international financial
regulation often miss--the FSB, and international standard setting
bodies more generally, do not only write rules, but they also serve as
the basis of more streamlined cross-border financial services. To the
extent to which, for example, the FSB is able to articulate shared
paths on issues like capital, margin, interest rate policy, and
reducing credit rating agency reliance, it is facilitating the
interoperable and harmonized provision of cross-border services.
Moreover, regulators use the logic and principles embedded in the
standards to justify the recognition of market participants (including
those in the United States) as equivalent. And when this is done, it is
done via the mechanism of soft law (and often explicitly referencing
FSB, IOSCO or Basel Committee reforms). From this standpoint, some
intellectual consistency is required: if international standard setting
bodies are to be applauded for establishing the conditions for more
efficient cross-border finance, and effectively lower regulatory
burdens, they can't be condemned as illegitimate when they raise them
in order to safeguard markets.
Again, I do not wish to downplay the considerable challenges of
international regulatory policymaking. Even with the overwhelming
influence practiced by the United States, we still have to negotiate
with our partners, and occasionally make compromises. And compromise is
slow, and won't always get to the best results for the United States.
So we have to be agile and tailor our domestic practice in ways that
speak to international commitments credibly while also achieving our
own prudential and market objectives. Furthermore, turf wars can
compromise the effectiveness of international financial regulation, and
even undermine the robustness of global reforms. That said, these are
procedural and institutional challenges--indeed, challenges that the
United States is in an enviable position to address with the right
political (and regulatory) will. The ideal Congressional oversight
would elevate these concerns to the top of the regulatory agenda, and
not promote strategically maladroit initiatives targeting our very
tools of economic statecraft.
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