On September 29, the Financial Stability Oversight Council (FSOC) removed AIG’s designation as a systemically important financial institution (SIFI), relieving it of significant regulatory burdens, such as stress testing by the Fed and high capital requirements. FSOC is the chief regulator of systemic risk put in place by the Dodd-Frank Act. In its own words, one of FSOC’s purposes is “to identify risks to financial stability that could arise from the material financial distress or failure, or ongoing activities, of nonbank financial companies.” What does FSOC’s action portend for regulating “too big to fail” firms under the Dodd-Frank Act? After all, AIG was the poster child of “too big to fail,” paying $165 million in bonuses after the Fed provided it with an $85 billion bailout loan? In view of that, it was inevitable that FSOC would designate AIG as a SIFI, one of the first to receive the label. The only nonbank financial institution still with the SIFI label is Prudential Financial, Inc.
But the FSOC designation process is far from ideal in tackling the “too big to fail” issue. FSOC’s designation criteria involve broad discretion to determine (or remove) SIFI status that can make the process nontransparent. Criteria include, among others, size, interconnectedness, liquidity, and lack of available substitutes for a firm’s function in the financial markets. The voting process is unwieldly. A supermajority of two-thirds of the ten voting members (the heads of the financial agencies) must vote in the affirmative, and the requirement that the FSOC Chair, the Treasury Secretary, who is a member of the President’s cabinet , vote yes politicizes the process.
The removal of AIG from FSOC’s SIFI list does necessarily mean that the sudden lifting of regulations governing large, complex financial institutions is near at hand. True, the Administration has a powerful lever over financial institution regulation through its appointment process, which may have played a role in the FSOC vote. But Dodd-Frank has several other highly effective means of reducing the systemic risk of large, complex financial institutions that would require amending the Dodd-Frank Act, a significant hurdle for this Congress. These include living wills (or resolution plans), stress testing, a resolution process outside of bankruptcy, and higher capital charges for the large banks. The two remaining large investment banking firms, Goldman Sachs and Morgan Stanley, are bank holding companies and, due to their size ($50 billion in assets is certainly an objective standard), will remain regulated SIFIs without Congressional action. As discussed in a previous blog, the June report of the Treasury Department took a relatively moderate approach to these other tools available to tackle systemic risk. FSOC’s action last week is no reason to rush to judgment.