Financial oversight board’s review process cloaked in mystery

Since Babylonian times and King Hammurabi’s code of laws, two basic legal principles have guided lawmakers: (1) when you read a law, you should know what is required to obey the law; and, (2) a citizen accused of a crime should have the opportunity to prove his or her innocence. 

These principles were completely ignored by the authors of the Dodd-Frank Act when they created the Financial Stability Oversight Council (FSOC) and gave it the power to designate nonbank financial firms as “systemically important institutions” (SIFIs), a designation that imposes additional regulation by the Federal Reserve Board.

{mosads}A recent report by the House Financial Services Subcommittee on Oversight and Investigations on “The Arbitrary and Inconsistent FSOC Nonbank Designation Process,” followed by a subsequent discussion of the findings at a hearing on March 28, perfectly demonstrates what happens with an out-of-control government institution. It is also an excellent reminder of the wisdom of King Hammurabi’s principles.

Because a technical discussion of the troubled FSOC designation issue hides the legal difficulties in a haze of financial jargon, I will illustrate the problem using a simple analogy.

When pulled over for speeding, most people instinctively check their speedometer against the posted speed limit. The innocent will rely on the legal process to prove his or her innocence by establishing the miss-calibration of police measurement equipment, or the absence of a clearly posted speed limit. Now think about applying these legal standards to an FSOC designation. 

Imagine that you are the CEO of a large, successful, nonbank financial firm, and you receive an FSOC notice that your institution has been selected for a stage-three designation review. Stage-three review, you ask? Who knew that the FSOC had already concluded two reviews, let alone completed its findings from these two exercises?

Imagine your institution to be profitable, well-capitalized and growing. Your state regulators — and you have regulators in every state where you do business — have given your institution a clean bill of health. No one on your staff can imagine what the institution has done to trigger the FSOC’s ire.

Back to the analogy. Now ask yourself: Is there a speed limit for the institution? How fast is the firm going? How fast does the FSOC think the firm is going? Where can the institution find out answers to these questions? The subcommittee report shows there are no definite answers to any of these questions.

The FSOC has the power to set individual speed limits for each and every nonbank financial institution under its designation jurisdiction. The FSOC does not have to disclose an institution’s speed limit — even if the firm pays a white-shoe law firm to make a formal request.

Worse yet, the FSOC is the only agency that has the authority to measure a non-financial firm’s speed, and it does this using a confidential process without any impartial witnesses present.

When the FSOC makes a designation, it posts a public document with an outline of its reasoning for the designation. FSOC stage-two examinations, completed without a recommendation for a stage-three examination, are totally opaque to outside eyes.

The public is unaware which firms the FSOC has examined under its stage-two procedures and the reasons why the FSOC concluded that these firms were not SIFIs. 

The lack of documentation and information regarding the FSOC’s stage-two decisions in which it refrains from designating a firm as a SIFI is critical for any institution wanting to challenge its FSOC designation.

Since there is no posted speed limit, a designated firm needs historical legal cases to establish the processes that the FSOC used in prior instances to determine the “safe operating speed” for similar institutions. To be fair, the process used by FSOC in determining whether a nonbank financial institution is, or is not, a SIFI should be transparent and available to all concerned. 

The subcommittee report finds that the lack of public disclosure regarding the FSOC stage-two reviews allowed the FSOC to treat comparable firms differently in its designation decisions. Apparently, under FSOC rules, not all similar firms need to be treated similarly.

The upshot is that one can read the law that empowers the FSOC to make SIFI designations, but still have no idea what is required to obey the law and avoid being designated as a SIFI. Moreover, the government withholds the information you need to prove your innocence if you are designated as one.

I myself doubt the need for nonbank SIFI designations, and would repeal the FSOC’s power. But even if you disagree with me about that, you must admit there are serious flaws in an opaque designation process. These disastrous defects require major legislative reform. Hammurabi would be horrified.

Paul Kupiec is a resident scholar at the American Enterprise Institute. He has also been director of the Center for Financial Research at the Federal Deposit Insurance Corporation and chairman of the Research Task Force of the Basel Committee on Banking Supervision.

The views expressed by contributors are their own and not the views of The Hill.