The FSOC Experiment
Treasury Secretary Jack Lew is testifying before Congress on Tuesday and Wednesday on the Financial Stability Oversight Council (FSOC). The FSOC is charged with identifying “systemically important financial institutions” (SIFIs) that could under certain circumstances pose potential threats to the financial system, and taking appropriate action to reduce that threat. Clearly, in the aftermath of the financial crisis something like the FSOC was necessary and appropriate.
Yet the FSOC should be viewed as a regulatory experiment. No one knows how it will work in practice, or whether it even will. Moreover, an essential principle of pro-growth progressivism is that regulation, while essential, needs to be targeted appropriately in order to reduce unanticipated costs to consumers and businesses.
For example, the Sarbanes-Oxley Act of 2002 was conceived as a way of preventing corporate and accounting abuses at large companies such as Enron. But Sarbanes-Oxley turned out to impose relatively large costs on small start-up companies that were ready to go public by forcing them to set up overly complicated accounting systems, while doing nothing to prevent the financial crisis that started unrolling in 2007.
Today, the issue is how broadly the FSOC should construe its mandate. With excess debt at the heart of the financial crisis, the FSOC clearly needs to target the large highly-leveraged global banks.
But should large asset managers such as Vanguard or Fidelity be subject to the same intensified regulatory regime? There is one argument in favor of FSOC designating large asset managers as SIFIs, and two arguments against.
The argument in favor of SIFI designation of asset managers: Since regulators don’t know where the next financial crisis is going to come from, better to get all the big financial institutions under tighter control now. This might be called the “precautionary principle” of regulation—asset managers are not potential threats now, but they conceivably might be in the future, so let’s round them up now.
The two arguments against SIFI designation of asset managers: First, asset managers are a very small source of leverage and debt in the economy. To the degree that financial crises have historically been caused by excess debt, the fuel for the next crisis is unlikely to come from asset managers. Indeed, if we were to tick off potential sources of the next crisis, our list would start with trouble spots such as student debt and state and local pension shortfalls (which represent an excess of liabilities over assets).
Perhaps more important, designating large asset managers as SIFIs may have the perverse effect of reducing both stability and growth. Regulators will be stretched further, so less regulatory resources will be available to monitor the activities of the large global banks, the undeniable nexus of the most recent financial crisis. At the same time, because the asset managers will be forced to follow an extra set of rules, their ability to direct capital to the areas of highest return will be impaired, lowering overall growth.
Wise regulation in the 21st century requires focusing on the most important problems. To regulate out of fear is to give up on the growth that we need.