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March 2014 o o

What the FSOC’s Prudential Decision Tells Us about l t SIFI Designation u By Peter J. Wallison O

Key points in this Outlook : s • In September 2013, the Financial Stability Oversight Council (FSOC) designated Prudential Financial as a systemically important financial institution (SIFI); its rationale was perfunctory and data-free, suggesting e

that the FSOC sees no need to justify its designation decisions. c i • Thus far, the FSOC has been following—and is likely expected to implement in the US—the decisions and

policy positions of the Financial Stability Board, a group of mostly European central banks and regulators v

that has been designating US firms as global SIFIs. r

• If this pattern continues, large sectors of the financial system beyond banking—particularly the securities e and capital markets—will be swept into bank-like regulation by the Fed, and firms considered too big to fail may come to dominate currently competitive financial industries. Congress must step in, and quickly. S

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In September 2013, the Financial Stability Over - appointed by the presidential administration in i sight Council (FSOC) determined that Prudential power and are likely to follow the lead of the Trea - Financial Inc., one of the country’s largest insurers, sury secretary on policy simply because he is the c

was a systemically important financial institution highest-level political official at the table. n (SIFI). Under the Dodd-Frank Act, accordingly, is regulated at the state level in the Prudential was turned over to the Federal Reserve , so no federal agency has expertise in a

for what the act calls “stringent” regulation. In the insurance. For this reason, the Dodd-Frank Act n

context of the act, this appears to mean bank-like authorizes the president to appoint (with the con - i regulation and supervisory control of risk taking. sent of the Senate) one voting member of the FSOC The FSOC is a creation of the Dodd-Frank Act who is called the “independent member with insur - F and is a uniquely powerful body within the executive ance expertise.” branch of the US government. It consists of 15 The Prudential decision was the second FSOC members, of which 9 are the chairs of other federal decision involving an insurance-related firm. In July financial regulatory agencies. Five are nonvoting 2013, the agency designated American International members. 1 The secretary of the Treasury is the chair - Group (AIG) as a SIFI. That decision was expected, man and has an effective veto over any major FSOC perhaps even politically compelled; AIG had action because the act requires his affirmative vote. famously been bailed out by the Treasury and the In addition, because the members are the chairs of Federal Reserve during the financial crisis. If the SIFI various regulatory agencies, they have all been idea has any validity, it would have to apply to AIG. Peter J. Wallison ([email protected]) is the Arthur F. Burns The Prudential decision, however, was the first to Fellow in Financial Policy Studies at AEI. designate a nonbank financial institution as a SIFI

1150 Seventee nth Street, N. W., Wa s hi ngt on, D.C. 20036 20 2.862.5800 www.aei.org - 2- when that firm had not suffered any significant financial dis - under the control of the Fed by the time the Supreme tress during the financial crisis. Court hands down its ruling. Dodd-Frank enjoins the FSOC to “identify risks to the In its Prudential decision, the FSOC makes full use financial stability of the United States that could arise from of its discretionary authority; it failed to develop or imple - the material financial distress or failure, or ment any intelligible standard for deter - ongoing activities, of large interconnected In its Prudential mining whether a particular financial firm bank holding companies or non-bank is a SIFI. The same was true of its prior des - decision, the FSOC financial companies” (Section 112). The ignations of AIG and GE Capital, which decision to designate Prudential as a SIFI makes full use of its are both equally devoid of any coherent or was made under Section 113, which autho - rational standards. The most descriptive discretionary authority; rizes the FSOC to designate a nonbank word for all these decisions is “perfunctory.” financial firm as a SIFI if “the Council it failed to develop If it can continue to get away with this, the determines that material financial distress at agency will be free to implement in the or implement any the US nonbank financial company . . . United States the designations and other could pose a threat to the financial stability intelligible standard decisions of the FSB. In September 2013, of the United States.” the FSB announced that it plans to extend for determining whether The first thing to be said about this lan - what it calls the “SIFI framework” to secu - guage is that it is a remarkable grant of a particular financial rities firms, asset managers, mutual funds, authority and essentially permits the hedge funds, and others that operate in the firm is a SIFI. FSOC to determine the scope of its own capital markets. jurisdiction. Although the courts frown on Unless Congress intervenes, and soon, to this when it is called to their attention, it is possible tell the FSOC that it wants to have a say in how SIFIs are that this grant of authority will never be challenged; regu - designated, large portions of the US financial system will be lated firms, fearing retaliation, are very reluctant to brought under bank-like regulation by the Fed. This will not challenge the legal authority of their regulators. In addi - only slow the growth of the American economy but also tion, because the key terms the FSOC must apply to take almost certainly create a too-big-to-fail problem in indus - jurisdiction over any particular firm—“financial distress” tries that have previously been competitive. and “market instability”—have no clear meaning, and because both involve making predictions about the future, The Prudential Decision they amount to a grant of discretionary authority to the FSOC that may be an unconstitutional delegation of leg - Dodd-Frank sets out the standards that the FSOC is islative power. required to use in determining whether a nonbank financial Although the doctrine of unconstitutional delegation institution threatens the stability of the US financial system. has not been used since the 1930s, the two cases to which About a dozen factors can be taken into account, but the it was applied by the Supreme Court have not been key ones are overruled. If ever there were a candidate for a holding of unconstitutional delegation in the modern era, the • Leverage; grant of authority to the FSOC would be it. 2 As I will dis - • Off-balance-sheet exposures; cuss, the fact that the FSOC was unable to develop any • The nature, scope, size, scale concentration, intelligible principle on which to designate Prudential interconnectedness, and mix of activities; and as a SIFI strongly suggests that Congress delegated the • Reliance on short-term funding. vast discretionary authority that, constitutionally, it alone can exercise. Still, if a firm should in the future Whether any or all of these applied to Prudential challenge its SIFI designation as an unconstitutional can only be guessed at by reading the document the delegation or on any other ground, the case is likely to FSOC published in support of its decision. In that move slowly up to the Supreme Court. During that time, paper, entitled Basis for the Financial Stability Oversight the Financial Stability Board (FSB) and the FSOC may Council’s Final Determination Regarding Prudential Finan - continue to designate SIFIs, ultimately creating a fait cial, Inc. (the Basis), the FSOC summarizes its decision accompli in which many firms are already functioning as follows: - 3- Prudential is a significant participant in financial Asset Liquidation Channel. In its asset liquidation channel markets and the U.S. economy and is significantly argument, the FSOC argued that if policyholders choose to interconnected to insurance companies and other terminate their relationships with Prudential in sufficient financial firms through its products and capital numbers, or to seek the cash surrender value of their poli - markets activities. Because of Prudential’s inter- cies, this could cause Prudential to “liquidate a substantial connectedness, size, certain charac - portion of its general account assets to meet teristics of its liabilities and products . It is impossible to redemption and withdrawal requests.” 5 This . . material financial distress at Pru - in turn “could cause significant disruptions determine what the dential could lead to an impairment in key markets.” 6 However, the FSOC of financial intermediation or of mar - FSOC considered never explained what a “substantial por - ket functioning that would be suffi - tion” of Prudential’s assets was, how many significant or sufficient ciently severe to inflict significant policyholders would have to withdraw their damage on the broader economy. 3 to cause financial funds, or what actual effect that might have on markets. instability in the market Although this statement is only a sum - The FSOC’s liquidation channel argu - mary, we will see that the agency never as a whole. ment would be plausible only if there were adduced any specific evidence to back its some likelihood that it might occur. On assertions. That explains why the two members of the this question, Woodall again dissented: FSOC who had insurance expertise (and were not employ - ees of the Treasury Department) dissented from the FSOC’s While there have in fact been liquidity runs on life decision. On the other hand, the banking regulators—who insurance companies, no historical, quantitative or have no experience or knowledge in this area—all voted qualitative evidence exists in the record which for it, following the Treasury’s lead. supports a run of the scale and speed posited, or to The dissent by Roy Woodall, the presidentially support a rapidly spreading sector-wide run. The appointed independent member with insurance expertise, asset liquidation analysis appears to assume a con - was particularly stinging: temporaneous run against the general and separate accounts by millions of policyholders In making its Final Determination, the Council has and a significant number of annuity and other adopted the analysis contained in the Basis. Key contract holders of products with cash surrender aspects of said analysis are not supported by the value—a scale for which there is no precedent, and record or actual experience; and, therefore, are not for which the likelihood is believed by most experts persuasive. The underlying analysis utilizes scenar - to be extraordinarily low. 7 ios that are antithetical to a fundamental and sea - soned understanding of the business of insurance, Nevertheless, the FSOC could have made an argument the insurance regulatory environment, and the for its liquidation channel scenario if it had data to show state insurance company resolution and guaranty that Prudential substantially relied on leverage and short- fund systems. As presented, therefore, the analysis term funding. In that case, a sharp change in the availabil - makes it impossible for me to concur because the ity of short-term credit in the market could cause a lack of grounds for the Final Determination are simply not confidence in Prudential that might lead to fund with - reasonable or defensible, and provide no basis for drawals. me to concur. 4 But the FSOC apparently did not have such data or did not bother to present it. In fact, its decision paper did not The FSOC’s discussion of how Prudential might discuss leverage and noted that Prudential did not use cause financial instability in the US market was organized short-term funding. Without either unusual leverage or under two key subjects, called the asset liquidation chan - major short-term funding, it is highly unlikely that policy - nel and the exposure channel. A third channel, critical holders would run in the event of a financial downturn, functions or services, did not add anything to the even a severe one. discussion in the other two and will not be covered in Insurance firms, unlike banks, match their assets with this Outlook . their long-term liabilities. The claims of policyholders are - 4- the long-term liabilities of insurers and are generally In any event, the interconnectedness idea is invalid as a supported by long-term assets like corporate bonds or basis for designating a firm as a SIFI. 9 It posits that when a mortgages. A collapse in the short-term funding market, large financial institution fails, its interconnections with as occurred in 2008, would not put policyholders in others will have knock-on effects, causing others to weaken any danger. or fail. The notion that interconnectedness among large financial institutions is a source of danger to the financial The Exposure Channel and Interconnectedness. The system is at the heart of the Dodd-Frank Act. The reason question addressed in the exposure channel was whether for designating certain bank and nonbank financial firms as Prudential’s failure would harm the rest of the market SIFIs and subjecting them to bank-like and other stringent because of the firm’s interconnections. As regulation by the Fed was to prevent them in its discussion of the liquidation channel, The entire Prudential from failing and then, supposedly, causing a the FSOC simply says that Prudential’s decision process was financial crisis by dragging down others. interconnections are “significant” but does But we know from the Lehman Brothers not define what that means for either Pru - a kind of show trial; bankruptcy that interconnectedness was dential or its counterparties. Without that the issue had already not a factor in the financial crisis. 10 clarification, it is impossible to determine Lehman’s failure, to be sure, caused chaos in what the FSOC considered significant or been decided. the financial markets, but no major (or even sufficient to cause financial instability in minor) financial institution failed as a the market as a whole. The FSOC said: result. This was true, even though Lehman, with over $600 billion in assets, was one of the largest financial firms in the The financial system is exposed to Prudential world and was active in such inherently “interconnected” through the capital markets, including as derivatives activities as the credit default swap market—and even counterparties, creditors, debt and equity investors, though the financial markets were in the midst of an and securities lending and repurchase agreement unprecedented panic so great that banks were refusing to counterparties. . . . Prudential also uses derivatives to lend to one another, even overnight. hedge various exposures related to its assets and lia - The only serious knock-on effect of the Lehman bank - bilities. Prudential’s derivatives counterparties ruptcy was the inability of one money market , include several large financial firms, which are signif - the Reserve Primary Fund, to maintain the value of its icant participants in the global debt and derivatives shares at $1 per share. The fund had continued to hold markets. . . . Prudential’s off-balance sheet exposures Lehman commercial paper (probably expecting that could serve as a mechanism by which material finan - Lehman, like Bear Stearns, would be bailed out by the gov - cial distress at Prudential could be transmitted to ernment), and its potential losses in the bankruptcy were banks and to financial markets more broadly. For great enough to reduce its net asset value to less than $1 if example, Prudential’s total off-balance sheet expo - the Lehman paper was uncollectible. This is known as sure due to derivatives counterparty and credit facil - “breaking the buck.” ities commitments with large global banks is In the midst of a panicky market and a general flight to significant .8 [emphasis added] quality, this produced what has been called a “run” on the fund, but in the end the losses to the Reserve Fund share - The word “significant” is used 47 times in the 12-page holders were minimal, about 1 or 2 percent. Whatever FSOC document—mostly to describe the effect that a Pru - might be said about the Reserve Fund’s “breaking the dential failure might have on the markets and on counter - buck,” it was not akin to a firm’s being dragged into bank - parties—but the FSOC made no effort to support its ruptcy by the failure of a counterparty; it was simply a firm characterizations with the kind of numerical data that encountering an unexpected 1–2 percent loss. would give the word some meaning. Again, the same is true Some also occasionally argue that AIG’s bailout follow - of the designation decisions on GE Capital and AIG, with ing the Lehman failure is an example of the dangers of inter - the word “significant” used 42 times in the 14 page AIG connectedness, but this idea also fails under any serious decision and 32 times in the 14 page GE Capital decision. examination. First, AIG had virtually no exposure to Indeed, in all these decisions, the only useful numbers are Lehman. In addition, despite a lot of speculation in the page numbers. media about the Fed’s reasons for rescuing AIG two days - 5- after Lehman was allowed to fail, the officials involved at aggressive in designating large banks and insurers as SIFIs, the Treasury and Fed have never said anything other than and it is beginning a program for doing the same in the that they stepped in to rescue AIG because it was so large securities and capital markets industry, which is what the that its bankruptcy—in the midst of the post-Lehman FSB and US regulators call “shadow banking.” 12 Both the panic—would have caused a complete meltdown of the Treasury and the Fed are members of the FSB—and proba - financial system. It is not then a case of bly its most influential members. It is incon - interconnectedness, but of the Treasury and The financial crisis has ceivable that the designations of three US Fed’s view of market psychology at a time of in many ways changed insurers would have gotten through the FSB particular turmoil. without the express approval of the Fed and Although interconnectedness had no the rules that formerly the Treasury. role in the financial crisis, the idea is catnip confined financial Thus, the principal players in the for regulators because it provides a basis for FSOC—the Treasury and the Fed—had regulators to a limited more comprehensive regulation of financial already approved designating Prudential as institutions—something they arguably range of powers. a SIFI before the FSOC took any action. In know how to do. The old adage comes to other words, the entire Prudential decision mind: if all you have is a hammer, everything looks like a process was a kind of show trial; the issue had already been nail. Thus, the Dodd-Frank Act assumes that stringent reg - decided. A sham proceeding, in turn, was necessary because ulation can keep large financial institutions such as Pru - the Dodd-Frank Act seems to require the FSOC to do an dential from failing and bringing down other firms with analysis of some kind before it determines that a particular which they are “interconnected.” financial institution is a SIFI, but the Treasury and the Fed The FSOC’s use of the interconnectedness idea in its had already decided the issue through their membership in Prudential decision could have been barely persuasive—at the FSB and their participation in the FSB’s earlier desig - least in theory—if the FSOC had shown that Prudential’s nation of Prudential as a global SIFI. Obviously, the Trea - counterparties and creditors had unusually large exposures sury and the Fed cannot continue to both participate in to Prudential. But as in the AIG and GE Capital decisions, decisions of the FSB that designate US firms as SIFIs and the FSOC did not even attempt to demonstrate this. then turn around and act as though the same decision by The failure of the FSOC to justify its Prudential or ear - the FSOC is a case of first impression. lier decisions in any intelligible or coherent way suggests In the FSOC’s defense, it might be possible to argue the two possibilities. First, the agency did not want to articulate FSB did the kind of analysis about the three US insurers that any standard because this would restrict its discretion in the the FSOC should have done, and therefore that the FSOC’s future. Or second—perhaps more troubling—is the likeli - failure to create any intelligible standard about the “SIFI - hood that there is in fact no intelligible standard for deter - ness” of Prudential can be excused. The FSB’s test for SIFIs mining whether a firm is a SIFI. In this extremely is whether they are “institutions of such size, market impor - important area with major implications for the US econ - tance, and global interconnectedness that their distress or omy, the FSOC is making what can only be called a polit - failure would cause significant dislocation in the global ical or ideological decision—choosing to designate firms as financial system and adverse economic consequences across SIFIs for no other reason than that it wants to increase the a range of countries.” 13 This language stresses international government’s regulatory control of the financial system. effects, but if an insurer is considered to create systemic risk The same question arises when we get to a discussion of the globally, it will certainly have a systemic effect in its home Financial Stability Board. country. Accordingly, the FSB standard is not materially dif - ferent from Dodd-Frank’s reference to “instability in the US The Role of the Financial Stability Board financial system,” and thus FSB designations could involve roughly the same judgments about what factors will consti - As noted earlier, the FSB is an international group of cen - tute a SIFI as the Dodd-Frank and FSOC standard. tral banks, government ministers, and financial regulators. However, it appears that FSB did no such analysis. In November 2008, shortly after the financial crisis, the The FSB purported to base its decision on a methodology G-20 leaders met in Washington and directed the FSB to developed by the International Association of Insurance reform the international financial system so that a financial Supervisors (IAIS) for determining whether an insurer is a crisis would not recur. 11 Since then, the FSB has been SIFI. 14 The methodology was reasonably thorough, - 6- showing that if the FSOC had actually been interested Thus far, it appears that the FSOC is simply implement - in doing a serious analysis of whether Prudential was a ing the earlier FSB policy and designation decisions. For SIFI it could have done so by adopting and publishing a example, the FSB has recommended that if money market similar methodology. mutual funds do not adopt a floating net asset value, they But in the end the FSB did no more than what the should be subject to capital requirements like banks. 16 The FSOC had done; in fact, it did less. It designated nine FSOC then pressured the US Securities and Exchange large insurers as SIFIs—including AIG, Prudential, and Commission to adopt similar rules for money market funds. MetLife—but gave no indication of how, or even whether, The FSB indicated that all asset managers with assets of the IAIS methodology had been applied to each of more than $100 billion may be subject to prudential regula - them. Moreover, the IAIS methodology differs substan - tion. 17 Then, the Office of Financial Research, another tially from the “channels” structure the FSOC uses, so Treasury agency created by Dodd-Frank, produced two the FSOC clearly did not implicitly adopt the IAIS reports at the request of the FSOC to support the idea that methodology. For example, the IAIS methodology assigned large asset managers should be designated as SIFIs. The weights to specific activities of insurers, assigning 45 per - FSB has designated three US insurance firms as SIFIs— cent weight to engaging in bank-like activities and only AIG, Prudential, and MetLife—and the FSOC has already 5 percent to size. None of this shows up in the FSOC designated AIG and Prudential as SIFIs and is currently decision paper. investigating MetLife for a possible SIFI designation. Since the FSB is completely opaque and does not allow These parallel policy pronouncements and decisions again independent observers or the media at its meetings, it is suggest that, unless Congress asserts its interests, the SIFI impossible to know for certain if the IAIS methodology was designation process—despite the requirements of the APA used. However, given that none of the nine insurers that and Dodd-Frank—will devolve into the implementation of were designated as SIFIs made any public statement accept - policies and decisions of the FSB. ing the FSB’s decision or disputing the facts it used, it seems likely that none of the insurers had any idea what facts, if An Unprecedented Opportunity for any, the FSB used to designate them as SIFIs or how the Increasing Regulatory Power methodology was applied. 15 The nontransparent, indeed secretive, role of the FSB The financial crisis has in many ways changed the rules raises a question about what effect the FSB’s SIFI designa - that formerly confined financial regulators to a limited tions are expected to have in the US. Thus far, the FSB has range of powers. Bank-like regulation—which includes been acting as though it is another Basel Committee on supervisory control of risk taking and minimum capital Bank Supervision. Since at least the mid-1980s, the Basel requirements—was previously approved for federal regula - Committee has functioned as a supranational decision- tors only where government support, such as deposit insur - making body on bank capital regulation; the committee ance, threatened to create moral hazard. However, the agrees on capital regulations for banks and expects all mem - narrative that came out of the 2008 financial crisis was that bers of the organization to implement these decisions any large financial institution could cause another financial within their respective jurisdictions. Congress has generally crisis if it failed. This provided the authority for the FSOC not interfered with bank capital regulation, but it is not and the FSB to adopt prudential bank-like standards for the clear how and when US regulators were authorized to par - largest financial institutions—not just banks—because any ticipate in what is essentially the development of rules that one of them could, under the prevailing theory, cause a may not meet the requirements for rule making under the financial crisis if it failed. Administrative Procedure Act (APA) or have never been For this reason, the FSOC (empowered by the Dodd- specifically authorized by Congress. Frank Act) and the FSB (empowered by the G-20) were The issue becomes more acute when the Treasury and given what seems to be quasi-judicial authority to make the Fed participate in the FSB’s SIFI decisions, if these deci - decisions about specific institutions and not just general sions are ultimately to apply in the United States. On its rules. The FSB, as mentioned earlier, has already outlined face, this seems inconsistent with both the APA and the an aggressive program that could eventually result in the Dodd-Frank Act, especially because the outcome of these designation of SIFIs in many other financial fields, report - decisions may be far more consequential for the US econ - ing in September 2013 that it is “reviewing how to extend omy than bank capital regulations. the SIFI Framework to global systemically important - 7- non-bank non-insurance (NBNI) financial institutions” multibillion-dollar business ought to be turned over to (emphasis added). This category of firms, the FSB contin - bank-like regulation by the Fed. Yet that is where we seem ued, “includes securities broker-dealers, finance companies, to be heading with the designation of SIFIs by both the FSB asset managers and investment funds, including hedge and the FSOC. funds.” 18 When those designations occur, it seems the If this happens, the consequences for the US economy firms so designated will be required by the Dodd-Frank could be dire. The designation of SIFIs is a statement by the Act to have bank-like capital requirements, as well face government that the designated firms are too big to fail. We stress tests and liquidity coverage ratios that regulators can see the effects of ignoring this danger in the condition have prescribed for banks under the Basel standards. of the banking industry today. We have no way of knowing All of the participants in this process—the G-20 whether the gigantic banks we have created are dangerous leaders who authorized the FSB, the FSB itself, the FSOC, because of their size or what size they ought to be to elimi - and the Fed—are government or regulatory organizations. nate the danger. What we do know is that in other indus - For this reason, the FSB and the FSOC have an interest in tries, particularly insurance, there has never been a sense increasing regulation of the largest financial institutions— that any firm is too big to fail or would be treated as such by not just because the conventional narrative holds that any the government if it exhibited financial distress. With the of these institutions could cause the next financial crisis— designation of SIFIs among insurers, we are paving the way but more importantly because regulators always want for these large firms to claim that they are safer investments more power. This is not a new idea; one of the funda- and safer sources of insurance protection than their smaller mental elements of what is known as public choice competitors because the government has determined that theory is that it models the actions of government officials they cannot be allowed to fail. as self-interested. 19 The narrative about the financial It is worth noting that the chairman of AIG, Robert crisis has given the regulators an unprecedented oppor- Benmosche, welcomed AIG’s SIFI designation because tunity to extend their power, and they are not likely to he believed that it implied that the government had waste it. endorsed the safety and soundness of his firm—what he This is a key point that those representing institutions called a government “seal of approval.” 20 This raises the under threat of SIFI designation must bear in mind. The possibility—never fully explored by Congress—that SIFI lack of a factual basis or clear standards behind FSB’s deci - designations may extend the spread of too-big-to-fail firms sion on nine large insurers and the FSOC’s Prudential and beyond the banking industry. Accordingly, although other decisions demonstrate that their discretion is essen - expanding these designations may be in the interests of tially unbounded. Decisions of this kind—especially when regulators, it decidedly does not serve the interests of the they serve the interests of regulators rather than the pub - US economy. lic—are too important for Congress to ignore. If the FSB Moreover, it is not a mitigating factor that a firm and FSOC intend to follow the precedents set by the Basel designated as a SIFI then becomes eligible for the “orderly Committee on Bank Supervision, they will expect that the liquidation” process set up by Title II of Dodd-Frank. Under international agreement of regulators on what firms are the act, the secretary of the Treasury has the power to SIFIs would be supported in the United States through seize any financial firm—whether or not the firm is a decisions of the FSOC. SIFI—and turn it over to the Federal Deposit Insurance Given the incentives of regulators and the prospect for Corporation (FDIC) for liquidation if he believes that its vastly enlarging regulatory control, it is very doubtful that financial distress will cause “instability in the US financial either the FSB or the FSOC will be responsive to factual system.” Thus, any firm, whether or not designated as a presentations in the future. The benign interpretation of SIFI, can be placed in the orderly liquidation process of the the Prudential decision is that the FSOC does not want to FDIC through a decision of the Treasury secretary that limit its discretion in designating SIFIs by articulating any involves discretionary power at least as unbounded as the standards. The more troubling interpretation is that the SIFI designation itself. FSOC has no idea how to determine whether a particular firm is a SIFI. The famous remark about pornography by Conclusion former Supreme Court Justice Potter Stewart, “I know it when I see it,” should not be acceptable in a process as A close study of the FSOC’s Prudential decision tells us sev - important to the US economy as determining whether a eral important things. - 8-

Agency; the chair of the National Credit Union Administration 1. Either the FSOC does not take seriously its Board; and an independent member with insurance expertise. The responsibility to designate SIFIs or it is unable nonvoting members are the director of the Office of Financial to develop a coherent or intelligible set of stan - Research, the director of the Federal Insurance Office, a state insur - dards for performing this function. In either ance commissioner, a state banking supervisor, and a state securities case, the agency should not be permitted to commissioner. proceed with these designations without fur - 2. Although many think that the doctrine of unconstitutional del - ther review by Congress. egation of authority is no longer viable, as recently as Mistretta v. United States [488 U.S. 361 (1989)], Justice Antonin Scalia referred to 2. The participation of the Treasury and the Fed it as “a question of degree,” implying that it still had a core of validity. in the FSB’s opaque process for designating 3. Financial Stability Oversight Council, Basis for the Financial SIFIs is inconsistent with the idea that the Stability Oversight Council’s Final Determination Regarding Prudential FSOC will do a full and fair analysis before des - Financial, Inc. , September 19, 2013, 2, www.treasury.gov/initiatives ignating a firm as a SIFI. /fsoc/designations/Documents/Prudential%20Financial%20Inc.pdf. 4. Roy Woodall, “Views of the Council’s Independent Member 3. The new powers to designate SIFIs offer an Having Insurance Expertise,” 1, www.treasury.gov/initiatives/fsoc/ unprecedented opportunity for regulators, both council-meetings/Documents/September%2019%202013%20 at the FSB and the FSOC, to enhance their Notational%20Vote.pdf. control over the financial system. With this 5. FSOC, Basis for the Financial Stability Oversight Council’s Final incentive, it is highly unlikely that they will Determination , 4. stop the SIFI designation process before all large 6. Ibid., 3. financial firms—in all financial industries— 7. Woodall, “Views of the Council’s Independent Member have been designated. Having Insurance Expertise,” 3. 8. FSOC, Basis for the Financial Stability Oversight Council’s Final 4. The designation of SIFIs is likely to spread the Determination , 8. dangers of too big to fail beyond the banking 9. For further discussion of this issue and the effect of the Lehman industry to industries such as insurance, securi - bankruptcy, see Peter J. Wallison, “Magical Thinking: The Latest ties, and capital markets. Regulation from the Financial Stability Oversight Council, AEI Outlook (October-November 2011), www.aei.org/ The only way to slow or stop this train will be through outlook/economics/financial-services/magical-thinking-the-latest- some action by Congress. That does not necessarily regulation-from-the-financial-stability-oversight-council/. mean that Dodd-Frank must be amended at this point, 10. Comprehensive work on this subject has been done by Hal S. but only that the FSOC, Treasury and Fed should be Scott of Harvard Law School. See Hal S. Scott, Interconnectedness advised by members of Congress that SIFI designations are and Contagion , November 20, 2012, www.aei.org/files/2013/01/08/- not just another version of the Basel Committee process. A interconnectedness-and-contagion-by-hal-scott_153927406281.pdf. resolution in the House or a joint letter by a large number 11. Financial Stability Board, Overview of Progress in Implementa - of influential lawmakers in the House and Senate might be tion of the G20 Recommendations for Strengthening Financial Stability , enough to stop or significantly slow the movement cur - report of the Financial Stability Board to G20 Leaders, September 5, rently underway. 2013, 3, www.financialstabilityboard.org/publications/r_130905c .htm. 12. See, among many others, Tom Polansek, “Fed’s Bernanke Notes Warns Shadow Banking Risks Persist,” Reuters, May 10, 2013, www.reuters.com/article/2013/05/10/us-usa-fed-bernanke-idUS - 1. The voting members are the secretary of the Treasury, who is BRE9490J820130510. also the chair of the FSOC; the chairman of the Board of Governors 13. Financial Stability Board, Progress and Next Steps Towards End - of the Federal Reserve; the comptroller of the currency; the director of ing “Too-Big-To-Fail” (TBTF) , report of the Financial Stability Board the Consumer Financial Protection Bureau; the chairman of the to the G-20, September 2, 2013, 8, www.financialstabilityboard.org Securities and Exchange Commission; the chair of the Federal /publications/r_130902.pdf. Deposit Insurance Corporation; the chair of the Commodity Futures 14. International Association of Insurance Supervisors, Trading Commission; the director of the Federal Housing Financial Global Systemically Important Insurers: Initial Assessment Methodology , - 9-

July 18, 2013, www.iaisweb.org/view/element_href.cfm?src=1/ 18. FSB, Progress and Next Steps Towards Ending “Too-Big-to-Fail ,” 19151.pdf. 17. 15. Stuart Collins, Enhanced Regulation of Nine Named GSIIs 19. See, for example, Pierre Lemieux, “The Public Choice Receives Cool Reception , Geneva Association, July 26, 2013, Revolution,” Regulation (Fall 2004): 27, http://pierrelemieux.org www.genevaassociation.org/media/624404/26072013_commercial - /artpublicchoice.pdf. riskeurope_gsifis.pdf. 20. Leslie Scism, “AIG’s Benmosche and Miller on Villains, 16. FSB, Overview of Progress in the Implementation of the G20 Turnarounds and Those Bonuses,” Wall Street Journal MoneyBeat Recommendations for Strengthening Financial Stability , 24. blog, September 23, 2013, http://blogs.wsj.com/moneybeat/2013/ 17. Financial Stability Board, Assessment Methodologies for Identify - 09/23/aigs-benmosche-and-miller-on-villains-turnarounds-and- ing Non-Bank Non-Insurer Global Systemically Important Financial Insti - those-bonuses. tutions: Proposed High-Level Framework and Specific Methodologies , consultative document, January 8, 2014, www.financialstabilityboard .org/publications/r_140108.pdf.