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The FSOC Expands 'Too Big To Fail'

Thursday, July 18, 2013

The FSOC’s decision to expand the too-big-to-fail designation to nonbank firms will be seen as the most damaging action taken under Dodd-Frank.

It was no surprise that the Financial Stability Oversight Council (FSOC) decided last week to cite a number of nonbank firms as systemically significant, placing them in line for greater regulatory scrutiny by the Federal Reserve. What was a surprise is that — in the midst of a huge outcry in Congress about banks that are too big to fail (TBTF) — neither Congress nor the administration asked the FSOC to stop the designation process until the too-big-to-fail issue had been fully thought through. After all, by designating some nonbanks firms as TBTF — GE Capital, AIG, and Prudential Insurance are in the group — the FSOC has created a whole new set of institutions that will now be considered TBTF.

This is more than peculiar. The legitimate concern of Congress comes from the belief that firms deemed TBTF have funding advantages over their competitors. There is logic and some evidence for this view, but whether it is so serious a problem as to require the breakup of the large banks — as some legislators and regulators have argued — is in question. Nevertheless, the idea that in the midst of this debate the government itself would proceed to make the TBTF problem materially worse, and extend it to other sectors of the financial system, seems particularly senseless.

Underlying the debate about banks that are TBTF is the recognition that Title II of Dodd-Frank has failed. That title sets up a resolution system, called the orderly liquidation authority (OLA), for large financial institutions. The framers of Dodd-Frank believed that the source of TBTF was regulators’ fear that allowing a large financial institution to fail would create serious instability in the U.S. financial system. Regulators, they thought, would always choose to bail out these large firms rather than risk the disruption that would follow their bankruptcy.

The OLA was supposed to end these fears by providing an orderly system for winding down large financial firms, allowing the government to seize and liquidate them without concern for adverse consequences in the financial system.

The fact that there is still a belief in the markets and in the political class that TBTF still exists is a demonstration that the OLA is not a credible solution and should be repealed.

By designating some nonbanks firms as TBTF — GE Capital, AIG, and Prudential Insurance are in the group — the FSOC has created a whole new set of institutions that will now be considered TBTF.

Under these circumstances, it was particularly obtuse for the FSOC to move forward with designating certain nonbank firms as systemically important. What it has now done is taken the first major step to extend the TBTF problem to sectors of the financial system beyond banks. GE Capital is a diversified finance company, AIG is an insurance holding company, and Prudential is a diversified insurer. These firms operate in many sectors of the economy, and their designation, in effect, as TBTF will upset competitive conditions elsewhere in the economy in the same way that TBTF banks are said to have upset competitive conditions in banking.

If indeed the large banks receive funding benefits because market participants believe that they will not be allowed to fail, then these three firms will now also receive that advantage. Indeed, Robert Benmosche, the president and CEO of AIG, has already recognized this, noting in an interview recently that he is looking forward to the FSOC’s designation because “when we go out and say we’re strong, we’ll have [the FSOC] as a voice of the good housekeeping seal that says they are strong.”

Pity the firms that will have to compete with this. Smaller insurance firms may find that GE Capital and AIG are spreading the word that they are considered special by the government. Not only are they regulated by the Federal Reserve, but they have also been designated as systemically important and are thus too big to fail. The implication is that the Fed’s regulation will keep them financially strong, but if in the future they should become weak for any reason, their customers and their creditors can have some confidence that the government will step up to be sure that they meet their financial obligations.  

What the FSOC has done will be seen in the future as the most damaging action taken under the authority of Dodd-Frank. It has the potential to turn what are today competitive industries into financial sectors dominated by large, government-backed firms, exhibiting all the indicia of crony capitalism. The fact that it was done in the shadow of our disastrous experience with Fannie Mae and Freddie Mac, and while Congress was concerned about firms that are too big to fail, only demonstrates how mindless it really was.

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Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

FURTHER READING: Wallison also writes “Dodd-Frank: The Economic Case for Repeal,” “SIFI Designation Will Change Nature of Competitive Financial System,” “A Bill to Prevent the Expansion of ‘Too Big To Fail’” and “Crony Capitalism, Dodd-Frank Style.” Arthur C. Brooks agrees, writing “Dodd-Frank Is the Poster Child For Crony Capitalism.” James Pethokoukis explains “Another Way ‘Too Big To Fail’ Skews Market Forces.” Alex J. Pollock looks at “The Financial Stability Oversight Council’s Fatal Flaw” and Arnold Kling analyzes “The ‘Two Drunks’ Model of Financial Crises.”

Image by Dianna Ingram/Bergman Group

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