One of the tough lessons learned the hard way from the financial crisis was that a nonbank financial company could pose enormous risk to the financial system at large.
The havoc wreaked by AIG's Financial Products division laid bare a gaping hole in systemic risk regulation that the Dodd-Frank Act's "systemically important financial institution" designation process for nonbanks is intended to address. As important as this new process is to forestalling future systemic risk events, the zeal to implement something as expansive and unprecedented as the non-bank SIFI designation rules may be like opening Pandora's Box.
The Financial Stability Oversight Council approved the final release of rules for the designation process which the council says could affect as many as 50 firms. While that number may seem small, consider that this potentially includes insurance companies, money market mutual funds, hedge funds, broker dealers, asset management and nonbank finance companies. Firms meeting the criteria set out in a three-stage assessment process would be subjected to heightened supervision by the Federal Reserve on capital adequacy, leverage, and additional oversight.
Initially there was some concern voiced among candidates for the nonbank SIFI designation that the evaluation process applied a far too bank-centric approach to firms that were fundamentally different. Although the Federal Reserve has indicated that a one-size-fits-all approach will not apply to the designation process, the stakes are incredibly high for getting the designations right.
Some well-known nonbank firms have already begun restructuring their business as a means of reducing their chances of being ensnared in the designation process. Market participants are naturally reactive creatures to regulatory burden and will follow a path of least resistance where possible to pursue. Such behavior can lead to a host of unanticipated market outcomes in the form of higher costs and restricted product availability for consumers as well as competitive challenges for designated firms. And in some cases firms may abandon otherwise prudent risk management practices such as hedging using derivatives if it helps them avoid the SIFI designation.
Why is it then that no equivalent to an environmental impact statement is required of the designation process? In theory such analysis should be performed for any major regulation. Before a power plant or gas pipeline can be built, detailed studies of the potential effects such projects would have on the environment are required by EPA and other relevant regulatory bodies. The implications for the financial landscape are no less important than for the physical environment and similarly come with a great amount of uncertainty in terms of possible negative consequences.
Although the Federal Reserve has an impressive staff, its comparative advantage and focus has been and will continue to be on supervising banking institutions and holding companies. Embarking on a radically new regulatory focus that includes a divergent group of complex organizations with highly specialized and unique business models requires a level of expertise well beyond that of traditional banking. The criteria that pose risk to insurance companies are likely to differ from those of asset management companies, for example.
Translating Congressional intent into an actionable and semi-repeatable process requires a structure that can be applied on a consistent basis across firms. This type of process may emphasize certain attributes and thresholds at the expense of others that may be far more important to that particular type of firm.
For example, why is a single threshold of $3.5 billion in derivative liabilities the right number to apply in the first stage of the nonbank SIFI designation process? It may very well be that the criteria and thresholds would differ considerably across firm types. Granted, a firm meeting a screening criterion would not necessarily wind up designated as a SIFI, but this test highlights the somewhat subjective nature of the process. While the Fed has significant latitude to adjust its evaluation of nonbanks, so far it isn't clear how the Federal Reserve is staffing up or modifying the process to meet this challenge.
The nonbank SIFI designation process is fraught with precedent-setting outcomes that will reverberate across financial markets for years to come. The long-term impacts for markets and consumers are hard to imagine given the complexity and scope of business operations of nonbank firms with potential to be designated as SIFIs. As a result, the old mantra of first, do no harm comes to mind.
Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.