Regulating Entities and Activities: Complementary Approaches to Nonbank Systemic Risk
70 Pages Posted: 3 Sep 2018 Last revised: 17 Sep 2018
Date Written: August 24, 2018
The recent financial crisis demonstrated that, contrary to longstanding regulatory assumptions, nonbank financial firms — such as investment banks and insurance companies — can propagate systemic risk throughout the financial system. After the crisis, policymakers in the United States and abroad developed two different strategies for dealing with nonbank systemic risk. The first strategy seeks to regulate individual nonbank entities that officials designate as being potentially systemically important. The second approach targets financial activities that could create systemic risk, irrespective of the types of firms that engage in those transactions. In the last several years, domestic and international policymakers have come to view these two strategies as substitutes, largely abandoning entity-based designations in favor of an activities-based approach. This Article argues that this trend is deeply misguided because entity- and activities-based approaches are complementary tools that are each essential for effectively regulating nonbank systemic risk. Eliminating an entity-based approach to nonbank systemic risk — either formally or through onerous procedural requirements — would expose the financial system to the same risks that it experienced in 2008 as a result of distress at nonbanks like AIG, Bear Stearns, Lehman Brothers, and Fannie Mae. This conclusion is especially salient in the United States, where jurisdictional fragmentation undermines the capacity of financial regulators to implement an effective activities-based approach. Significant reforms to the U.S. regulatory framework are necessary, therefore, before an activities-based approach can meaningfully complement domestic entity-based systemic risk regulation.
Keywords: Systemic Risk, Financial Stability, Financial Stability Oversight Council, Nonbank Financial Companies, Entity-Based Regulation, Activities-Based Regulation
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