On Friday, the Biden Administration’s FSOC proved yet again that it deserved Rohit Chopra’s dismissive description as a “book report club.” As far as we can tell, all it has done for all of the last four years is issue some nice papers about digital assets and the payment system about which nothing was ever done and put forth dutiful annual reports along with two new systemic-designation standards with which it has since done absolutely nothing. We’ll take our usual look at this year’s annual report, but it will be even less relevant than usual because FSOC is likely to do at least as little in Trump 2.0 as it did with its own recommendations during Trump 1.0. Given this sorry record, should the Department of Government Efficiency eviscerate the Council?
Sure, why not if all FSOC plans to do is as meaningless as all is town over the past eight years. Still, Congress wasn’t wrong when it created a Council designed to force communication across super-siloed regulators and to look hard at nonbanks outside their reach. Indeed, as nonbanks increasingly dominate core intermediation and infrastructure functions, a forward-looking, effective FSOC would be a vital safeguard against market success derived principally from regulatory arbitrage.
Effective system-wide governance is not impossible. Late last month, the Bank of England showed what can and should be done to address systemic risk. Using the Bank’s authority to govern across the financial industry, it released a “System-Wide Exploratory Scenario” (SWES), essentially a financial-system wide stress test based on an acute geopolitical risk scenario run by fifty banks, insurers, hedge funds, CCPs, and asset managers. The results showed that NBFIs had voluntarily improved resilience since 2022, but many firms still expected counterparties to behave in ways counterparties declined to do when confronted with the stress scenario. This was especially true when it came to continuing bank intermediation, with banks understandably generally saving themselves, not even longstanding customers in the repo market. Central-bank facilities built only for banks were also found to be hazardous because banks did not need them and were reluctant to absorb the costs and possible stigma of draw-downs to save their counterparties.
The Bank of England has a signal advantage over FSOC: actual authority to mandate action by nonbanks as well as banks, but FSOC could have followed up on all of the alarm bells it rang and member agencies have significant direct and, if need be, indirect safety-and-soundness reach. The Bank of England’s ability to backstop NBFIs is also clear, unlike that of the Federal Reserve.
But these added powers fade in the face of a force which the Bank of England has that FSOC and other agencies could emulate: the courage to talk straight and take action. In the SWES, it wasn’t afraid to ask hard questions about financial stability and disclose even the most worrisome result. This stands in sharp contrast to FSOC’s academic analyses and the Fed’s say-no-evil systemic-risk reports. The only entities subject to stringent stress testing in the U.S. are big banks and, as in the U.K., banks do just fine under even extra-acute stress because they are now generally soundly capitalized, sufficiently liquid, and ready for trouble. The Fed bestirred itself this year to do an exploratory stress test related to hedge-fund exposures, but what if the reason banks passed is because they can quickly pull back as leveraged hedge funds hemorrhage? As in the SWES, banks will be fine; everyone else, not so much.
Over time, even if banks are still better able to save themselves than they are now, a financial system with asymmetric safety-and-soundness rules is one in which regulated companies consolidate into a few behemoths and the occasional community banks along with specialized, concentrated nonbank financial intermediaries with unchecked market power and ever-more certain taxpayer bailouts. Congress saw this risk coming and created FSOC to prevent it. Oh well…