Regulation by Threat: Dodd-Frank and the Non-Bank Problem

Abstract

A central lesson of the global financial crisis is that banks are not the only types of financial firms that can pose dangers to the broader financial system. One of Dodd-Frank’s primary mechanisms for responding to this reality is to empower a council of financial regulators to designate individual non-bank financial institutions as systemically risky. Although the Financial Stability Oversight Council (FSOC) has only exercised this authority four times, it has occasioned considerable controversy in court, in Congress, and among commentators. This Article defends the FSOC designation scheme, arguing that most of its critics misunderstand the mechanisms by which it helps to reduce systemic risk outside of the banking sector. FSOC designation does not, and cannot, precisely distinguish between firms that could pose a systemic risk and those that could not. FSOC’s broad discretion to impose costly sanctions on designated firms instead advances two quite different goals. First, it deters non-bank firms from seeking out systemically risky strategies or activities. Second, it holds financial regulators to account by threatening to impose additional restrictions and supervision on the firms they regulate if they fail to address systemic risk on their own. We term this approach “regulation by threat,” and suggest that it is appropriate when risks are hard to identify, the perils of mistake are great, and the downsides of misdiagnosis extreme. Systemic risk outside of the banking sector meets this description to a tee. Moreover, we argue that the Council’s discretion is better cabined by its structure – which features diverse membership, voting, review, and political safeguards – than by insistence on particularly “hard look” judicial review, accompanied by the requirement of a cost benefit analysis for any individual designation decision. Similarly, the various reform proposals to limit FSOC’s discretion or impose additional procedural limits on its operations generally threaten to undermine the Council’s effectiveness by unnecessarily limiting its discretion, and thus its capacity to regulate by threat.

Keywords: FSOC, Dodd-Frank, SIFI, Designation, Systemic Risk