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The Financial Stability Oversight Council – Risk Manager or Debating Society?

Journal 33: Technical Finance

Jerry W. Markham

The financial crisis in 2008 was unequaled in severity since the Great Depression of the 1930s. Its economic effects were widespread and are ongoing. At the time, Treasury Secretary Henry Paulson, Federal Reserve Board chairman Ben Bernanke, and New York Fed Bank president Timothy Geithner led governmental efforts to contain that crisis. They sometimes clashed with other regulators and were roundly criticized for their largely successful efforts to contain the crisis. Critics also believed that those regulators had wrongly led Congress to pass the TARP legislation, which was used to bail out many large institutions with taxpayer funds.

Congress reacted to that criticism with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which seeks to prevent such bailouts in the future. As a part of that effort, Dodd-Frank created a Financial Stability Oversight Council (FSOC) and designated a host of regulators to comprise its members. FSOC is tasked with overseeing large financial institutions that pose systemic risk to the financial system. Once identified, those institutions may be the subject of special regulation. Such identification and regulation, it is claimed, will allow those institutions to be “resolved” by an orderly liquidation like other banks, if they fail, avoiding the need for a federal bailout. This article describes the history behind concerns over the systemic risks posed by large financial institutions and the “too big to fail” dilemma they present to the financial system. It then addresses the role of FSOC in resolving those concerns and the likelihood of its success in the next financial crisis.

The bailout of several large financial service firms during the financial crisis in 2008 led to the passage of the massive (2,300 page) Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). A key thrust of that legislation was the special regulation it imposed on large institutions that might pose systemic risk to the financial system. Among other things, Dodd-Frank created a new Financial Stability Oversight Council (FSOC) that was broadly tasked with identifying systemic risks presented by large interconnected bank holding companies, nonbank financial institutions, and even those that “could arise outside the financial services marketplace.” Once identified as systemically important, nonbank financial service firms will be subject to special regulation by the Federal Reserve Board. That regulation will be designed to alleviate systemic risks that any one firm, or group, might pose to the financial system. FSOC was also charged with eliminating any belief on the part of shareholders, creditors, and counterparties that the federal government will bail out a large financial services firm that is about to fail. Rather, those institutions are required to have “living wills” that will provide a guideline for their orderly “resolution” in the event they fail.

This article will describe the long-held and deeply seated populist sentiments in America, which has given rise to a deep distrust of large financial institutions. It will describe how prior efforts to contain systemic risks through bailouts only served to further public distrust of financial institutions, eventually leading to the passage of Dodd-Frank. It will then address the role of FSOC and explain why its composition will make it an ineffective decision-maker. The author concludes that the defense of bureaucratic turf by FSOC members, and their conflicting regulatory agendas, will likely prevent FSOC from operating effectively during the next financial crisis.

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