The FSOC's Extreme Hubris Nearly Ensures Its Failure

A new Congress is arriving, and it is time to reform FSOC, the "Financial Stability Oversight Council." FSOC is part of the efflorescence of regulatory bureaucracy created by the notorious Dodd-Frank Act of 2010-- a typical political over-reaction, as happens in every cycle.

FSOC is a committee of regulators assigned the high-sounding job of identifying and preventing the threat of "systemic risk." This is probably not possible. The utter failure of central banks, notably including the Federal Reserve, regulators and economists in general to diagnose the great 21st century bubbles in the U.S. and in Europe, or to anticipate their disastrous consequences, as well as their failure in all previous crises, suggests that it is not. This unlikelihood of success is accentuated by the nature of the committee as a combination of turf-protecting bureaucratic fiefdoms.

But politicians in the wake of a financial crisis have an imperative to be seen to be doing something. Setting up a committee is something which can always be done.

A committee of jealous fiefdoms is unlikely to recognize systemic risk when it does occur. In the first place, the real problem is not risk, but uncertainty: the impossibility of knowing the future, and the impossibility of knowing even the odds of future outcomes. That is, systemic risk is created by what we do not know, and therefore cannot "see" intellectually.

Even worse, systemic risk is caused by what we think we know, when really we don't. For example, regulators and central bankers, as well as other financial actors, thought they knew, but didn't, that:

-U.S. house prices could not go down on a national average basis-this was plausible, until it wasn't.

-Central banks had achieved the "Great Moderation"-- actually it was the great leveraging.

-Government debt was risk free-with the government defaults which litter financial history, this one was particularly silly.

Did the government bureaucracies which are now represented on FSOC see in advance that this "knowledge" was false, any better than anybody else? Nope. Looking at the historic busts of the 1970s, 1980s, and 1990s, did they do any better? Nope. Are they exempt from the cognitive herding which is a fundamental characteristic of human minds? Nope. Will they have superior insight into the false beliefs and fads of the next crisis? That is most improbable.

A fatal flaw of a government committee like FSOC is that governments themselves are major creators of systemic risk, including of course the U.S. government, with its huge financial activities. This is especially true of central bank money printing blunders, like those which set off the enormously destructive Great Inflation of the 1970s, or which stoked the U.S. housing boom as it turned into a bubble in the 2000s. Indeed the Federal Reserve, the central bank to the world, is itself the greatest creator of systemic risk of them all.

But a committee of government employees is constitutionally incapable of criticizing the government, no matter how much risk it is generating. The Federal Reserve and the Treasury, whose bonds the Fed has so generously been monetizing, are the most senior members of FSOC. Is FSOC going to attack the actions of the Fed, however culpable it may be, for creating systemic risk? Nope. Likewise, is FSOC going to criticize the Department of Housing, let alone the Congress, for promoting poor quality mortgage loans or the Department of Education for pushing extreme levels of student debt with no credit underwriting? Nope.

But in the meantime, FSOC has been granted an unprecedented and unwise power. It can expand its own jurisdiction, escaping democratic checks and balances, by meeting in secret to designate companies as "systemically important financial institutions" or SIFIs, thus subjecting them to intrusive additional regulatory controls. A sensible Congress would not allow an unelected committee to expand its own jurisdiction in this fashion, but the Dodd-Frank Act throughout displays a naïve faith in the knowledge and virtue, rather than the driving will to power, of government agencies.

As a prime example of the shortcomings of FSOC, consider how it has failed to deal with Fannie Mae and Freddie Mac. Fannie and Freddie were principal inflators of the housing bubble, made boodles of bad loans, bought billions in subprime mortgage-backed securities, and collapsed into government ownership and control. They have combined assets of over $5 trillion and over half the mortgage credit risk of the country, combined with zero capital. If they are not SIFIs, no one is a SIFI.

But does FSOC designate them as SIFIs? Nope. Why not? Because a government committee is unable to deal with risks created by the government. The egregious failure to address Fannie and Freddie, all by itself, deflates FSOC's intellectual credibility.

Among its fixes to the excesses of Dodd-Frank, the new Congress should make a number of key reforms to the governance of FSOC.

First, only Congress should have power over the jurisdiction of government agencies. Congress should simply remove FSOC's designation power.

Then Congress should designate Fannie and Freddie as the SIFIs they so obviously are.

FSOC should not be directed by a political officer. The Treasury Secretary should be removed as Chairman of FSOC, and replaced by a rotation of the regulatory agency representatives. The systemic risk research organization, the Office of Financial Research, likewise should not be controlled by or be part of the Treasury. It should be removed from the Treasury and made into an independent, instead of politically dependent, research body.

FSOC's membership gives an unbalanced weight to the heads of the banking regulators, for the irrelevant reason that there are more banking agencies. But the capital markets, represented by the SEC, are far larger than the banking system. Publicly held equities and debt total over $70 trillion, compared to $15 trillion of total banking assets. The SEC therefore should have FSOC voting power at least equal to, if not greater, than the combined banking regulators. Also, the insurance sector should not get less voting power than banking.

Any FSOC member whose agency itself has a board, should be required to have its FSOC representative's positions and votes at FSOC subject to approval by that agency's board. To have it otherwise, as it is now, subverts the statutory governance of the agency.

These governance reforms are consistent with FSOC's fundamental knowledge problem, its inherent conflict of interest with respect to government risk creation, and with the checks and balances required of all democratic government.