A central lesson of the global financial crisis is that banks are not the only financial firms that can endanger the broader financial system. The Dodd-Frank Act responded to this reality by empowering a council of financial regulators to designate individual nonbank financial institutions as systemically risky. Although the Financial Stability Oversight Council (FSOC) has exercised this authority only four times, it has occasioned controversy in court, in Congress, and among commentators. And with Donald Trump’s 2016 presidential victory, FSOC’s designation authority is now in danger of being radically altered or terminated completely. This Article defends the FSOC designation scheme, arguing that its critics misunderstand the mechanisms by which it helps to reduce systemic risk outside the banking sector. FSOC designation does not, and cannot, precisely identify firms that could pose a systemic risk to the financial system. FSOC’s broad discretion to impose costly sanctions on designated firms instead advances two quite different goals. First, it deters nonbank firms from seeking out systemically risky strategies or activities. Second, it holds financial regulators to account by threatening to intrude on their regulatory turf 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. 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 “hard look” judicial review or a cost-benefit requirement for individual designation decisions. The council offers a useful alternative mechanism to standard approaches to regulation.

Introduction

The global financial crisis was much more than a disaster for banks. In fact, some of the worst parts of the crisis—the surprising collapse of the country’s largest insurance company on the same day that one of its oldest money market funds collapsed, and one day after two of its largest investment banks fell, for example—did not involve banks at all.1

The government responded to this nonbank problem by creating the Financial Stability Oversight Council (FSOC, or the “council”)—a panel of the nation’s most prominent financial regulators with the power to designate particular financial firms as systemically significant. Designated firms are subject to various specific anti-insolvency rules—including minimum capital and liquidity requirements—and supervision by the Federal Reserve (the “Fed”).2

This power of the council, although it has been utilized only four times, has occasioned considerable controversy in court, in Congress, and among commentators.3 The chair of the Senate Banking Committee has wondered whether the council’s designation decisions are “sufficiently open, objective, data driven, and free from the influence of outside organizations.”4 The Republican Party’s presidential platforms in both 2012 and 2016 have committed the party to revoking the council’s powers.5 One court has reversed the council’s designation of the country’s largest life insurer as an arbitrary and capricious exercise of its authority.6 And many commentators speculate that President Donald Trump may formally or informally terminate or radically alter FSOC’s designation process.7 Indeed, an executive order has already been promulgated that changes the focus of the council,8 and the first comprehensive postelection reform proposal to the Dodd-Frank Act9—the Financial CHOICE Act—would completely eliminate FSOC’s designation power.10

These critics typically assume that the core purpose of FSOC designation is to accurately and consistently identify nonbank financial firms whose collapse would threaten the financial system.11 They often imply that FSOC can accomplish this only by developing a detailed and analytically complete account of what factors render a nonbank financial firm systemically suspect, complete with a quantified and comprehensive cost-benefit analysis conducted in the course of any particular designation.12

The council’s designation decisions look less like the critics’ preferred sort of precise determination and more like an inference, based on a range of factors and evidence, that material financial distress at targeted firms “could” contribute to broader financial instability. This approach, they suggest, could plausibly permit “any nonbank financial company [to] meet the standard of a threat.”13 FSOC applies its broad-ranging and flexibly defined authority, critics conclude, to arbitrarily and inconsistently designate a subset of disfavored firms.14

We defend the way the council regulates in this Article. The council was created not to adjudicate between safe and risky businesses as a court might, or to create a mathematical formula that firms can apply to their balance sheets to see if they are risky. Instead, it was created to encourage all financial firms to avoid taking excessive risks.15 It has chosen to do this by taking action against some, and in so doing, warning the rest. The threat of FSOC designation—and the regime of enhanced regulatory requirements and supervision by the Fed that comes along with it—is meant to deter nonbank financial firms from seeking out risk. It is also designed to hold nonbanks’ primary financial regulators to account. When firms that they oversee face insufficient systemic risk regulation, FSOC threatens to intrude on their regulatory turf.

We call this scheme “regulation by threat.” Regulation by threat requires that a regulator will have the broad discretion to impose costly sanctions on those they regulate; done well, it will be a power the regulator wields rarely. The use of regulatory threats can, in the right circumstances and with the right constraints, induce caution in an industry inclined to risky behavior that is difficult to police.

The council’s regulatory powers fit this scheme well. It is capable of making effective threats that have a real deterrent effect precisely because of the discretion that it enjoys in applying a malleable standard to identify systemically important financial institutions (SIFIs). Nonbank financial firms facing a risk of being deemed systemically significant by FSOC will tend to avoid embracing strategies that could create systemic risks because designation comes along with costly regulatory restrictions and supervision. By contrast, nonbanks that know that the council will not designate them if they abide by pre-specified rules might take on risk to increase their odds of outsized gains, with, potentially, the promise of a bailout if things go wrong and the attendant low cost of capital that accompanies this prospect.

Regulation by threat works only if designation is costly.16 The evidence so far suggests that the council’s threats are working: both industry and regulators have changed their conduct to avoid costly council oversight. FSOC recently rescinded its designation of GE Capital as systemically significant after the firm sold off its operations related to short-term debt markets, which were a focus of FSOC’s initial designation decision.17 And investors or management in two of the three other designated firms—American International Group (AIG) and MetLife—have urged their firms to pursue a similar strategy, an invitation that AIG accepted.18 After, among other things, exiting business in ways that made that company less interconnected with the rest of the financial system and reducing “the amounts of its total debt outstanding, short-term debt, derivatives, securities lending, repurchase agreements, and total assets, in some cases significantly,” as FSOC put it, it also won de-designation.19 Indeed, the entire insurance industry has taken steps to lessen the prospect of designation by the council, a process that already appears to be bearing fruit with AIG.20 Moreover, regulators have worried about losing turf to the Fed—the threat they face if they fail to properly supervise risky nonbanks. Here too, recent evidence—including a series of Securities and Exchange Commission (SEC) rulemakings geared toward financial stability in the money markets and emerging reforms in state insurance regulation—is illustrative.21

All of this can be characterized as standards-based regulation, in which the requirements for designation of nonbanks are kept broad and subject to interpretation.22 But FSOC’s regime of regulation by threat is not just an example of regulation by standard. It is, as a matter of law, unique. We do not ordinarily associate the broad discretion to administer intensive oversight, sometimes on recipients surprised to be subjected to the treatment, with good government. As a first approximation, that power to surprise and penalize sounds like arbitrariness. Moreover, scholars have grumbled that permitting regulators to use threats of enforcement reduces their incentives to regulate through notice-and-comment rulemaking, which in turn permits them to evade judicial review.23 This risk has led even scholars willing to live with threat-based regulation, such as Professor Tim Wu, to conclude that it is only “under certain circumstances[ ] a superior means of regulatory oversight.”24

We conclude that the judicious deployment of regulation by threat is both appropriate and necessary in the context of regulating systemic risk outside of the banking sector.25 Threats, deterrence, and the strict supervision of some are appropriate when the risks are hard to identify, the perils of mistake are great, and the downsides of misdiagnosis are extreme. These are characteristics of a mission to prevent financial crises outside of the banking sector, and they exist regardless of the technological ferment.26 The use of enforcement threats also can be an efficient use of regulatory resources. The council has quite rigorously overseen a substantial segment of the financial system by selecting four firms for particular attention.27

More generally, regulation by threat might be one effective way to regulate when a precautionary principle is appropriate, the threat of regulation can deter risky behavior, and precisely defining risky behavior ex ante is impossible.28 As Professor Cass Sunstein has explained, two tests for evaluating when regulators should take a “better safe than sorry” approach are (1) when “regulators lack information about the likelihood and magnitude of a risk,” and so “buy an ‘option’ to protect against irreversible harm until future knowledge emerges”; and (2) when “risks have extremely bad worst-case scenarios.”29 These criteria do not just apply to nonbank systemic risk regulation. Many scholars have called for more oversight of enforcement decisions at agencies ranging from the Department of Justice to the SEC.30 They worry that regulators choose enforcement because they do not have to justify any particular prosecution through the hurdles of Administrative Procedure Act31 (APA) rulemaking procedure.32 Regulators can and should act through notice and comment when doing so is likely to effectively defuse the underlying risks.33 But when it is difficult to tell in advance what conduct will create risks, regulators must be permitted to regulate through enforcement and example-making; it is a form of regulation that has a venerable pedigree in, for example, policing tax evasion and antitrust violations.34 In financial regulation itself, the designation of financial institutions as complicit in the financing of terrorism or the activities of enemy states involves a similar designation process and a similar sort of example-making.35

The broader implications of regulation by threat, however, do not distract us from a second aspect of the central question this Article answers—whether the council’s designation process is legal. That aspect requires a consideration of the checks on the council’s power, given that some of the conventional constraints of administrative law—reducing discretion through ex ante rulemaking and requiring a cost-benefit analysis—are inappropriate for the council’s mission.

We argue that the council’s discretion is better cabined by its structure than by insistence on particularly “hard look” judicial review or cost-benefit analysis for any individual designation decision.36 Although the council’s procedures look like a rather unorthodox form of administrative law, they feature voting, review, and political safeguards, all of which support the case for the legitimacy of the way the council does designations.37

First, and perhaps most importantly, FSOC is a council, not an agency, and designation requires a series of affirmative votes by supermajorities of the council’s membership. This membership incorporates a number of diverse viewpoints and, unlike other interagency committees, uniquely includes voices of state regulators in its mix. As a council with no independent regulatory turf of its own, it is immune from the regulatory temptation to grow its own programs.38

Second, although FSOC’s substantive standard for designating nonbanks as systemically important is indeed flexible, it was itself adopted through a process of notice-and-comment rulemaking and, partially as a result, includes a number of guideposts and safe harbors that limit FSOC’s discretion. For instance, FSOC’s final rule on designation both identifies the factors on which the council will focus in making designation determinations and presumptively excludes from designation firms with less than $50 billion in total consolidated assets. These standards limit or eliminate the threat of designation for the vast majority of nonbanks.

Third, the parallel processes of SIFI designation by international organizations like the Financial Stability Board (FSB) provide an underappreciated check on FSOC’s exercise of its power.39 Increasingly, financial regulators have made themselves, with congressional approval and the president’s support, part of an international web of regulation, meant to respond to the fact that capital easily crosses borders, and that these days financial institutions do as well.40 FSOC is not the only institution in this global environment that designates financial institution as systemically risky; this also limits its discretion.41

Our analysis not only offers the benefit of making sense of the unorthodox regulatory remit of a powerful, new federal entity. It also answers many of the specific challenges to designation leveled by FSOC’s critics and helps resolve policy questions that have arisen as FSOC has done its business. For instance, it suggests that FSOC should retain its relatively unfettered hand to designate nonbank financial institutions if it is to fulfill its purpose. This requires rejecting calls from critics to require FSOC to engage in more detailed cost-benefit analysis, a requirement that risks imposing an impossible burden on the council and thus neutering its capacity to deter the aggregation of systemic risk.

None of this is to suggest that FSOC’s designation process is beyond reproach, and we could see it usefully being reformed in ways that would remove a degree of potential politicization among its decision-makers and expand the diversity of viewpoints available to it.42 But these improvements would affect the structure of the council; its processes, we think, are entitled to respect. More generally, regulation by threat is not held up here as some sort of regulatory perfection. Instead, such regulation is the best of the alternatives, when less supervision would lead to industry risk-taking and more precise regulation would likely be misguided.

In what follows, Part I outlines the persistent, but difficult-to-detect and ever-changing, tendency of nonbank financial firms to take on systemic risk. In Part II, we describe FSOC’s designation process and the inherent difficulties associated with any judgments about which firms could and could not prove systemically significant in the midst of a future crisis. In Part III, we explain how FSOC’s designation process operates as a dual threat against individual nonbank firms that might seek out systemic risk and their primary regulators who might allow this to occur on their watch. Finally, Part IV suggests that regulation by threat is a legitimate approach to regulating systemic risk more generally, as well as in the council’s case.

  • 1. On September 15, 2008, two investment banks were closed—Merrill Lynch was sold at a cut-rate price, and Lehman Brothers went bankrupt. See generally Andrew Ross Sorkin, Lehman Files for Bankruptcy; Merrill Is Sold (NY Times, Sept 14, 2008), archived at http://perma.cc/7HUB-4UYA. One day later, the insurance giant AIG accepted an $85 billion bailout that gave the federal government a 79.9 percent stake in the company, and the Reserve Primary Fund, a large and trendsetting money market fund, “broke[ ] the buck.” See In re The Reserve Fund Securities and Derivative Litigation, 673 F Supp 2d 182, 198 (SDNY 2009). For a discussion, see generally Jill E. Fisch, The Broken Buck Stops Here: Embracing Sponsor Support in Money Market Fund Reform, 93 NC L Rev 935 (2015). At the close of the second day, the Dow Jones Industrial Average had fallen 800 points since the start of the week. Brenna Maloney and Todd Lindeman, Five Days That Transformed Wall Street: Sept. 15–19, 2008 (Wash Post, Sept 20, 2008), archived at http://perma.cc/E3UJ-GQUZ. See also Jerome L. Stein, Stochastic Optimal Control and the U.S. Financial Debt Crisis 111 (Springer 2012) (suggesting that the government’s decision to rescue the insurance company, AIG, was driven in part by the collapse of the money market fund, Reserve Primary).
  • 2. 12 USC § 5323(a)(1) (providing that FSOC “may determine that a US nonbank financial company shall be supervised by the Board of Governors and shall be subject to prudential standards”).
  • 3. See, for example, Peter J. Wallison, The Latest Twist in a Regulatory Sham (Wall St J, Sept 10, 2014), online at http://www.wsj.com/articles/peter-j-wallison-the-latest
    -twist-in-a-regulatory-sham-1410389724 (visited May 17, 2017) (Perma archive unavailable) (“Jeb Hensarling (R., Texas) has also called on FSOC to ‘cease and desist’ further designations . . . . The House backed Mr. Hensarling in July by passing an appropriations-bill amendment that imposed a one-year moratorium on SIFI designations.”).
  • 4. Senate Committee on Banking, Housing, and Urban Affairs, Shelby Statement at Hearing on FSOC Accountability (Mar 25, 2015), archived at http://perma.cc/KX4W-N6QH.
  • 5. See Republican Platform: Restoring the American Dream (GOP, 2016), archived at http://perma.cc/GE6E-6U49 (calling for the repeal of the “regulatory nightmare” of the Dodd-Frank Wall Street Reform Act and replacement with “legislation to ensure that the problems of any financial institution can be resolved through the Bankruptcy Code”); 2012 Republican Party Platform: We Believe in America (American Presidency Project, Aug 27, 2012), archived at http://perma.cc/2YTB-TJMX (“A Republican Congress and President will repeal the [Dodd-Frank Act] . . . .”).
  • 6. See Metlife, Inc v Financial Stability Oversight Council, 177 F Supp 3d 219, 241 (DDC 2016) (applying a controversial cost-benefit requirement to reverse the designation), citing Michigan v Environmental Protection Agency, 135 S Ct 2699, 2707 (2015).
  • 7. See, for example, Ryan Tracy, How a Financial Council Republicans Loathe Could Work in Their Favor (Wall St J, Jan 17, 2017), online at http://www.wsj.com/articles/how-a-financial-council-republicans-loath-could-work-in-their-favor-1484581368 (visited Aug 21, 2017) (Perma archive unavailable) (discussing how to “maintain FSOC’s authority—and use it for different aims”).
  • 8. See Executive Order 13772 § 2 (2017), 82 Fed Reg 9965, 9965 (“The Secretary of the Treasury shall consult with the heads of the member agencies of the Financial Stability Oversight Council and shall report to the President” on a broad array of policy goals, including “advanc[ing] American interests in international financial regulatory negotiations and meetings” and “foster[ing] economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry.”).
  • 9. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub L No 111-203, 124 Stat 1376 (2010).
  • 10. See generally House Financial Services Committee, The Financial CHOICE Act: Executive Summary (Feb 28, 2017), archived at http://perma.cc/8QGA-KLY4.
  • 11. See, for example, Republican Staff of the House Financial Services Committee, The Arbitrary and Inconsistent FSOC Nonbank Designation Process *4 (2017), archived at http://perma.cc/S8PN-KNZE.
  • 12. See Metlife, 177 F Supp 3d at 239–40 (requiring the council to conduct a quantified cost-benefit analysis of designation before designating any particular firm).
  • 13. FSOC Nonbank Designation Process at *5 (cited in note 11).
  • 14. Id at *3.
  • 15. See Financial Stability Oversight Council (FSOC), archived at http://perma.cc/V4VE-T2GK (“The Council is charged with identifying risks to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the United States’ financial system.”).
  • 16. See Louis Kaplow and Steven Shavell, Fairness versus Welfare, 114 Harv L Rev 961, 1226 (2001) (observing that law enforcement often pursues “the reduction in the commission of harmful acts through the threat of sanctions”).
  • 17. See Financial Stability Oversight Council, Basis for the Financial Stability Oversight Council’s Rescission of Its Determination regarding GE Capital Global Holdings, LLC *9–10 (June 28, 2016), archived at http://perma.cc/NWD8-3MYK.
  • 18. See text accompanying notes 210, 217.
  • 19. See Financial Stability Oversight Council, Notice and Explanation of the Basis for the Financial Stability Oversight Council’s Rescission of Its Determination regarding American International Group, Inc. (AIG) *6 (Sept 29, 2017), archived at http://perma.cc/F6F2-SCXH.
  • 20. See Part III.A.
  • 21. See note 246 and accompanying text.
  • 22. The dynamics of standards-based regulation have produced a voluminous literature across the firmament of legal disciplines. See, for example, Thomas W. Merrill, The Mead Doctrine: Rules and Standards, Meta-Rules and Meta-Standards, 54 Admin L Rev 807, 819–26 (2002) (looking at rules- and standards-based approaches to judicial review of agency action); Gideon Parchomovsky and Alex Stein, Catalogs, 115 Colum L Rev 165, 208–09 (2015) (outlining the rules-and-standards debate and highlighting some of the leading scholarly participants in it).
  • 23. See, for example, Jerry Brito, “Agency Threats” and the Rule of Law: An Offer You Can’t Refuse, 37 Harv J L & Pub Pol 553, 562 n 47, 564–65 (2014); Philip Hamburger, Is Administrative Law Unlawful? 260–61 (Chicago 2014) (worrying about the breadth of agency enforcement powers). See also Appalachian Power Co v Environmental Protection Agency, 208 F3d 1015, 1020 (DC Cir 2000) (describing how agencies evade judicial review by refusing to issue narrowing regulations and thereby retaining discretion to act as they choose in particular cases).
  • 24. Tim Wu, Agency Threats, 60 Duke L J 1841, 1848 (2011). “Threat regimes . . . are best justified when the industry is undergoing rapid change—under conditions of high uncertainty.” Id at 1842.
  • 25. We also tie the threat to final agency action, reviewable by a court—the designation of a nonbank financial institution as systemically significant—unlike Wu, who would apply it to “warning letters, official speeches, interpretations, and private meetings with regulated parties.” Id at 1844.
  • 26. See, for example, Steven L. Schwarcz, Regulating Complexity in Financial Markets, 87 Wash U L Rev 211, 223–27 (2009) (noting the immense downside of financial crises); Hilary J. Allen, A New Philosophy for Financial Stability Regulation, 45 Loyola U Chi L J 173, 195–97 (2013) (arguing for the use of the precautionary principle in financial regulation).
  • 27. Designations (FSOC, Jan 31, 2017), archived at http://perma.cc/2FFB-UV9F (noting the designation of AIG, General Electric Capital Cooperation, Prudential Financial, and MetLife as firms for particular attention).
  • 28. See Cass R. Sunstein, Laws of Fear: Beyond the Precautionary Principle 109–28 (Cambridge 2005). The precautionary principle originated in continental legal systems and appears in the Treaty of the European Communities (EC) in Article 174. Jan Bohanes, Risk Regulation in WTO Law: A Procedure-Based Approach to the Precautionary Principle, 40 Colum J Transnatl L 323, 331 n 24 (2002).
  • 29. Cass R. Sunstein, Irreversible and Catastrophic, 91 Cornell L Rev 841, 845–46 (2006).
  • 30. Some scholars have worried that the breadth of enforcement discretion in administrative law is worryingly uncabined. See, for example, Rachel E. Barkow, Overseeing Agency Enforcement, 84 Geo Wash L Rev 1129, 1137 (2016) (“Throughout the federal system, agencies often use enforcement and adjudication (as opposed to rulemaking) to set norms, and there is reason to worry that agencies may misuse their discretion.”). Others have argued that aspects of agencies like the SEC in civil enforcement actions also ought to be subject to more procedural constraints. See, for example, David Zaring, Enforcement Discretion at the SEC, 94 Tex L Rev 1155, 1158–59 (2016) (listing critics and observing that “agencies have always enjoyed unfettered discretion to choose their enforcement targets”).
  • 31. 60 Stat 237 (1946), codified as amended in various sections of Title 5.
  • 32. See Barkow, 84 Geo Wash L Rev at 1160 (cited in note 30).
  • 33. See National Petroleum Refiners Association v Federal Trade Commission, 482 F2d 672, 681 (DC Cir 1973) (“[C]ourts are recognizing that use of rule-making to make innovations in agency policy may actually be fairer to regulated parties than total reliance on case-by-case adjudication.”).
  • 34. See notes 267–68 and accompanying text.
  • 35. See David Zaring and Elena Baylis, Sending the Bureaucracy to War, 92 Iowa L Rev 1359, 1397–99 (2007) (describing the Treasury Department’s Office of Foreign Assets Control designation process).
  • 36. But see Metlife, 177 F Supp 3d at 241 (reversing the council’s designation of MetLife on “hard look” review and requiring the council to conduct a cost-benefit analysis). Obviously, we disagree with the court’s analysis.
  • 37. About FSOC (FSOC, Feb 27, 2017), archived at http://perma.cc/VY37-X2HU.
  • 38. See, for example, Jonathan R. Macey and Geoffrey P. Miller, Reflections on Professional Responsibility in a Regulatory State, 63 Geo Wash L Rev 1105, 1119 (1993) (describing the turf-building problem).
  • 39. See David Zaring, Finding Legal Principle in Global Financial Regulation, 52 Va J Intl L 683, 700–01 (2012) (describing how the FSB makes decisions).
  • 40. See Jean Galbraith and David Zaring, Soft Law as Foreign Relations Law, 99 Cornell L Rev 735, 746 (2014) (describing this evolution).
  • 41. See, for example, id at 746, 761–62 (detailing the existence of the International Organization of Securities Commissions and the FSB in this regulatory space).
  • 42. See Part IV.