Hedge funds, private-equity firms, insurance companies and other nonbanks are sending a clear message to the interagency council tasked with identifying systemically important institutions: don't look at us.
In dozens of comment letters to the Financial Stability Oversight Council, a parade of nonbank companies and their representatives warned that designating companies as systemically important could do more harm than good, damaging individual business models and the entire financial system.
"Designation of nonbanks should be the option of last resort because of all the options, it is the most likely to exacerbate systemic risk, rather than mitigate it," wrote Scott Goebel, senior vice president and general counsel for Fidelity Investments.
Some commenters said there are inherent flaws in the council's still-developing system for designating systemically vital firms, and called its criteria too broad and subjective. Others wanted the council to keep the system flexible but to avoid toggling companies in and out of the definition or automatically designating those that receive some type of government assistance.
Many said the process must be completely transparent, even suggesting a real-time watch list of companies likely to be designated as systemically risky to eliminate potentially harmful effects of guesswork by the market.
"Making an individual determination of systemic risk based on subjective and uncertain criteria will increase moral hazard and create uncertainties in the marketplace and among investors. Inevitably, therefore, the markets will be impacted adversely," wrote Hal Scott, director of the Committee on Capital Markets Regulation. "The designation of a firm based on a set of vague standards will inevitably lead to a legal challenge based on the criteria the Council used. The cry will be why me and not them or why them and not me."
The letters speak to the pervasive underlying uncertainty in the market and by industry about how the council will proceed. What will it mean if an institution is deemed systemically significant? Will the structure of its operations change?
The unanswered questions help explain many institutions' inclination to try to ensure they are not designated as systemically risky.
For example, companies including General Motors Financial Co. Inc., Seimens Financial Services, Boeing Co. and Caterpillar Financial Services Corp., joined by six others, sought to make the case to regulators that nondepository captive finance companies should not be subjected to stricter standards and oversight by the Federal Reserve Board.
Their rationale is that companies that engage in financing activities with end users of financial services are not interconnected, and therefore pose no risk to the system at large.
"The lack of interconnectedness among these entities and the less complex and unconcentrated nature of the activities of such companies strongly suggest that such companies should not be deemed a threat to the financial stability of the United States," the 10 executives wrote. "We believe a financial distress at such a consumer or commercial finance company is extremely unlikely to have a systemic effect."
IBM Corp.'s Global Financing argued that captive finance activities, which are used for lease financing or lines of credit to cover the costs of a product or service, by their nature pose considerably less risk to U.S. financial stability. Any change to its regulation should be avoided.
"Captives are an area of the economy where overregulation — or the prospect of overregulation — could have a direct impact on U.S. production and jobs, and unnecessarily set back the economic recovery now under way," Robert Zapfel, general manager of IBM Global Financing wrote along with two of his colleagues.
In its letter, Vanguard argued that mutual funds should also be kept out of the Fed's purview. The company pointed out that the Securities and Exchange Commission already limits the amount of leverage mutual funds can use; and it said that the marketwide illiquidity that occurred in the recent financial crisis did not result from money market fund activity, but rather from banks' unwillingness to accept one another's credit.
"Efforts to identify any entity that could impose any degree of systemic risk will be overwhelming and fruitless, and could cause the council to miss the next systemically risky actor that threatens the markets," wrote Gus Sauter, managing director and chief investment officer at Vanguard, and John Hollyer, principal and head of risk management and strategy analysis at Vanguard.
John D. Hawke Jr., a partner at Arnold & Porter LLP and former comptroller of the currency, agreed that money funds should be exempted. "Care should be taken not to impose excessive regulatory burdens on money funds that would effectively force them out of business," Hawke wrote.
If money funds were to disappear, banks would likely pick up the balances in money market deposit accounts. The $2.8 trillion currently invested in money funds would require a significant amount of new equity capital at banks to offset the added leverage of the new deposits, Hawke said. That would also greatly increase the size of the federal safety net to cover the new Federal Deposit Insurance Corp.-insured deposits.
"One of the fundamental purposes of the Dodd-Frank Act was to scale back the size of the federal safety net and the amount that taxpayers are on the hook for in the future," Hawke wrote. "Forcing investors out of money funds and into bank deposits will have the perverse effect of increasing the size of the federal safety net."
To many, it's clear regulators have their work cut out for them and designation of systemic risk will not be a strict science.
That's one reason some regulators, such as FDIC Chairman Sheila Bair, favor a gradated process that first identifies a small group of companies clearly subject to the Dodd-Frank Act, and then working through to identify the more nuanced cases.
"Discerning the potential systemic importance of a particular nonbank financial company is likely to be an art, not a science, and will require keen judgment and careful balancing of policy objectives," wrote Mark Zingale, senior vice president and associate general counsel at the Clearing House Association LLC. "It is also among the most challenging of the Council's statutory mandates, as there are neither one-size-fits-all definitions of systemic importance nor objective standards that can be applied in all cases."
In its advance notice of proposed rulemaking, the council said it will use 11 criteria in making its determinations, including size, concentration, interconnectedness, and mix of activities. But it is unclear how those factors will be assessed or weighted.
"There is no precise way to identify nonbank financial companies as potential threats to financial stability," wrote Kenneth Bensten, executive vice president of public policy and advocacy for the Securities Industry and Financial Markets Association, whose members includes securities firms, banks and asset managers. "The assessment of systemic significance is not purely a 'by the numbers' activity, but one that requires experience and judgment."
Other company executives concurred, arguing that the number of factors that will be considered "does not lend itself easily to a formulaic approach."
"It appears that the determination will necessarily be based on all facts and circumstances in each case and will involve a subjective element," said the letter signed by the 10 company executives. "Furthermore, the number of questions and issues raised in the advance notice of proposed rulemaking demonstrate the complexity of the required assessment and the difficulty the Council will have in ensuring that the process is fair and consistent."
Richard Trumka, president of the AFL-CIO, wrote: "The questions posed in the advance notice of proposed rulemaking … raise concerns that the FSOC is moving in the direction of creating an overly complex, unwieldy system for designating nonbank financial companies for supervision and regulation."
Some said the council would do best to abandon the process altogether.
"There is simply no principled way to single out particular firms — we really cannot tell which firms are systemically important a priori," Scott wrote. "The best course of action for the Council would be to avoid making any such designations at all."
To be sure, some in the banking system were cheering the council on.
In a letter from the Independent Community Bankers of America, Christopher Cole, the group's senior regulatory counsel, said that the "shadow banking industry should be subject to enhanced supervision and regulation.
"During the financial crisis, larger broker-dealer holding companies faced serious losses and funding problems creating severe instability at Bear Stearns and Lehman Brothers," he wrote. "AIG's insurance operations were supervised and regulated by various state and international insurance regulators, but somehow the division which housed the derivative activities and that caused most of its major losses was completely overlooked."
For that reason, Cole argued, the council's process of determining which nonbank financial institutions are systemically risky should be a "broad enough inquiry to include as many large or interconnected nonbank financial firms that pose systemic risk to the financial system and the economy as possible."
They should include: large investment banks, insurance companies, hedge funds, private-equity funds, venture capital firms, mutual funds, industrial loan companies, special-purpose vehicles and nonbank mortgage origination companies, the ICBA said.
This story has been reprinted with permission from American Banker.
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Corrected November 12, 2010 at 10:32AM: yes