Although attention focused on FRB Chairman Powell’s truly viral comments over this week’s hearing marathon, a lot of quieter news was overlooked.  Our client reports thus highlighted key developments in areas such as central-bank digital currency, repo-driven regulatory reforms, and the Quarles supervision rewrite.  However, one exchange – about ESG finance – warrants special attention in light of its critical importance not just as annual meetings get under way, but also on the campaign trail.  Here, I look at Mr. Powell’s promise to submit ESG policy to FSOC and what might then become of all the corporate initiatives meant to make us greener, better, and less prone to take up arms.

During the House Financial Services Committees hearing, Rep. Andy Barr (R-KY) asked a question critical to his coal-country constituency:  would divesting fossil-fuel finance or other criticized instruments on social-welfare grounds have systemic consequence?  Mr. Powell declined to take a stand on yet another of the third rails he is regularly asked to hug, but he acceded to Rep. Barr’s request for FSOC review.  Mr. Powell did so not only because he doesn’t much care for mandatory investment edicts and wanted to placate many Republicans otherwise inclined to side with President Trump, but also because of the political imperative increasingly forcing FSOC’s hand.  Why not agree to an FSOC review if one is already under way?

As I recently noted, calls are growing for President Trump to issue an Executive Order barring financial institutions from allocating credit or investment based on anything but financial rationales.  Reflecting this, Comptroller Otting indicated that he may well issue such an edict to the national banks under his sway.  I’ve said before that the Federal Reserve will be reluctant to join Mr. Otting in his unconventional interpretation of the Community Reinvestment Act, but what about kicking the problem upstairs?  Especially if Treasury Secretary Mnuchin shares Mr. Otting’s opprobrium for ESG mandates – and he does – then the FSOC is the perfect place to take a stand with no real market impact but considerable political appeal.

In its new systemic policy, FSOC eschews SIFI designations in favor of activity-and-practice declarations.  Were FSOC to decide that financial stability is threatened when essential sectors are denied financial lifelines, one of these activity-or-practice designations could be deployed to order banks to lend to all creditworthy comers and demand that money managers look only at money.  What then?

An FSOC systemic declaration must be implemented by federal regulators who take months to act under applicable administrative procedures.  Thus, real action will be slow in coming, if it comes at all.  But, even if the regulators determine that they have the authority under federal law to order companies to offer finance to all deserving customers, this is not just a tricky legal ground, but also one full of moral sand traps.

The only way to avoid governmental edicts based on subjective judgment is to assert that which is subjectively bad is also objectively risky.  In its new green policy, the Bank for International Settlements wrapped itself around one after another financial conundrum trying to assert that green finance, for all its social-welfare benefits, is also lower-risk finance.  FSOC would find itself in the same precarious spot were it to assert the opposite and insist that brown finance is as deserving as green on the basis of financial risk.

But, no matter who’s good or bad to whom, ordering financial institutions to do the government’s bidding is at least as risky as each financial institution’s decision to concede to policy or political demands.  Brown enterprise may well be disadvantaged as finance greens up, but there is in practice no safe, sound, or equitable way to force companies to do business with ventures they don’t like unless, at least under U.S. law, the denial is attributable to discrimination.  This may often be based on color, but preferring green over brown is not yet in the rulebook nor is an edict for brown over green any better founded.

As a result, an FSOC declaration of ESG’s systemic risk will have little market impact beyond giving companies a federal skirt to hide behind if they choose to do business with fossil-fuel companies, firearms manufacturers, or similarly tarnished companies.  However, its political impact could be lasting and dangerous.  Once one side says lend, another side upon taking power will in turn demand on similarly ambiguous systemic grounds that banks no longer lend.  This year’s Administration goes for brown; next year’s goes for green and bank political risk goes from bad to worse.  Those demanding FSOC intervention now believe that they are reinforcing free-market capitalism, but they are in fact exerting as much market control as the socialists they decry.  Ordering banks to lend is, after all, only the flipside of telling them not to.