Treasury Department's Regulatory Overreach Expands


The Treasury Department’s Financial Stability Oversight Council (FSOC), having cast its regulatory shadow over the insurance industry, is now turning its sights on investment advisors.

At a time when we are trying to avoid creating the perception that certain large financial organizations are underwritten by the U.S. taxpayer, it seems foolhardy to label even more firms “systemic,” a euphemism for “too big to fail” (TBTF). Especially when there is no evidence that they operate in industries that are even remotely likely to create widespread problems for the financial system.

First, it is helpful to outline what makes banks “systemic,” and why other types of financial companies are different. In other words, why are banks prone to creating problems in the real economy if they fail en masse? The answer is: Banks borrow short and lend long, making them vulnerable to liquidity problems. Even a solvent bank can run into trouble if its depositors or other short-term creditors panic. This phenomenon is true of both traditional commercial and investment banks.

Commercial banks are largely deposit-funded and therefore prone to runs by retail depositors. Similarly, investment banks -- which in the U.S. are not eligible to take or use insured deposits -- fund themselves, using short-term sources such as overnight commercial paper or repurchase agreements.

Banks are the mechanism by which money flows through the economy, meaning that the failure of a large number of banks is likely to result in a sudden contraction in the money supply. Indeed, the problems in 2008 manifested initially through a run on the short-term funding used by investment banks and some commercial banks.

For this reason, banks are subject to special treatment by regulators. While it is not clear that this treatment has yielded better results, there is at least some logic to it.

But there is no logic in applying this regulatory attention to industries and firms that do not operate with a “maturity mismatch,” that is, borrowing short and lending long. Indeed, one of the most worrisome aspects of the Dodd-Frank Act has been the extension of bank-like supervision to other types of financial institutions.

As noted, Dodd-Frank gave the FSOC, an arm of the Treasury, the power to label nonbank financial companies -- any company predominantly involved in finance -- as “systemic.” But determining what makes a company a “systemically important financial institution” has turned out to be rather difficult.

Dodd-Frank defines it as a company whose “failure would threaten the financial stability of the United States.” That description is deliberately terror-inducing, and also highly subjective. As we saw in 2008, one person’s systemic event is another’s market correction.