The 2010 Dodd–Frank Act greatly expanded the federal government’s reach into financial markets. In particular, the creation of the Financial Stability Oversight Council (FSOC) leaves the Federal Reserve poised to regulate nonbank sectors of financial markets more extensively than ever before. The FSOC is supposed to increase U.S. financial stability, but in practice it will lower competition, increase concentration risks, and cost consumers money.
These regulations also increase the likelihood of future taxpayer bailouts for even more nonbanking financial firms. The FSOC’s existence has enshrined and expanded—not eliminated—the too-big-to-fail doctrine. The FSOC has already targeted insurance companies, and it now appears ready to single out asset management firms for special regulations under the Federal Reserve.
Asset Management Firms: Money Movers
An asset management firm is essentially any company that manages investments for people. Mutual fund companies, for example, pool investors’ money to buy stocks, bonds, and various other investments. Companies such as Fidelity are dedicated asset management firms, while insurance companies and banks also operate asset management divisions. The key commonality, though, is that all asset management firms act on their clients’ behalf and do not bear their clients’ losses.
This arrangement is in stark contrast to the relationship between a bank and its depositors. Typically, a bank owes its customers their deposits on demand at all times even though it uses those funds to make commercial loans. This relationship is one of the main justifications for requiring capital standards and imposing regulations on banks. It does not apply to asset managers.
Nonetheless, certain features of Dodd–Frank are set to impose new regulations and fees on asset management firms thus increasing costs on both small and large investors. In certain cases, these new regulations would extend the too-big-to-fail stigma to yet another sector of the economy.
FSOC Expands Too Big to Fail
One of the main ways that Dodd–Frank worsens the too-big-to-fail problem is through the FSOC. The FSOC is tasked with identifying risks to the financial stability of the United States. Under this broad, ill-defined mandate, the FSOC designates certain financial companies for special regulations under the Federal Reserve, but its authority goes well beyond these designations. Ultimately, the FSOC can require new regulations for any financial company for virtually any stability-related reason.
In addition to singling out firms for special supervision, Section 112 of Dodd–Frank even authorizes the FSOC to identify specific financial activities that justify heightened regulations. The FSOC has not yet identified specific activities that pose a systemic threat, but it has designated three nonbank financial firms—the American International Group, General Electric Capital Corporation, and Prudential Financial—for heightened regulation under the Fed. The insurance company Met Life is in the final stages of the FSOC’s determination process. It now appears that asset management firms are one of the FSOC’s next targets.
FSOC’s Controversial Report
In September 2013, the FSOC’s official research agency, the Office of Financial Research, released a report titled “Asset Management and Financial Stability.” The stated goal of this study was to assist the FSOC in deciding whether—and how—to apply heightened regulations and supervision to asset management firms under the Fed. Strangely, the report fails to identify specific risks that these companies actually pose to the U.S. economy. The report also neglects to describe how heightened regulations under Section 113 of Dodd–Frank might reduce systemic risk caused by the asset management industry.
The report was so vague and controversial that the Securities and Exchange Commission (SEC)—whose chairman sits on the FSOC—publicly criticized it and separately (from the FSOC) requested public comments on the study. Further, a group of five U.S. Senators—three of whom sit on the Banking Committee—pointedly criticized the report, stating that it “mischaracterizes the asset management industry and the risk asset managers pose, makes speculative assertions with little or no empirical evidence, and in some places, predicates claims on misused or faulty information.”
In the House, more than 40 Representatives signed a letter urging the FSOC to provide more specifics before designating any asset managers for heightened regulations. Regardless of its stated purpose, the report does not justify imposing new regulations on the asset management industry. Moreover, the Federal Reserve should not be in charge of regulating the asset management industry.
Fed’s Authority Should Be Limited
Traditional lending by banks has accounted for an increasingly smaller share of commercial financing since the 1970s, thus reducing the Fed’s customary role. Rather than allowing nonbank financing to evolve unencumbered, Dodd–Frank has extended the Fed’s reach into this sector of financial markets. This expansion is the wrong approach because it increases the likelihood of future bailouts and makes it more likely that monetary policy will become entangled with fiscal policies.
What Congress Can Do
Congress should fix the most glaring weaknesses in the process the FSOC uses to designate firms for heightened supervision under the Fed. In particular, Congress should force the FSOC to be more transparent and should lift Dodd–Frank’s restrictions on legal challenges to the FSOC’s designations. However, Congress should be wary of improvements that might lead to the impression that Title I of Dodd–Frank should remain in the U.S. code.
The mere existence of the FSOC is wholly incompatible with the functioning of a dynamic private capital market. Going forward, Congress’s best course of action remains repealing the Dodd–Frank Act. Until a full repeal is politically possible, Congress should focus on repealing Title I and Title II of Dodd–Frank or, at the very least, eliminating the FSOC. Any other reforms to Titles I and II should be viewed as temporary fixes.
—Norbert J. Michel, PhD, is a Research Fellow in Financial Regulations in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.