Criticism of the Financial Stability Oversight Council (FSOC) has been quietly building inside the financial industry.  Most of the criticism has centered on the FSOC’s lack of transparency and clear standards with respect to designating large financial firms as systemically important financial institutions, the so-called SIFIs.

AEI’s Peter Wallison has just given a terrific recap of these issues and Treasury’s feeble defense of FSOC, but many outsiders still aren’t familiar with the FSOC.  That’s most unfortunate because it’s one of the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act’s worst creations.  Given the calamity that is Dodd-Frank, such a distinction can’t be given out too lightly.  

President Barack Obama meets with Rep. Barney Frank, (D-Mass), Sen. Dick Durbin, (D-Ill), and Sen. Chris Dodd, (D-Conn), in the Green Room of the White House prior to a financial regulatory reform announcement June 17, 2009. (Photo credit: Wikipedia)

Think of the Dodd–Frank Act as a giant squid.  Both creatures use about a dozen appendages to trap their victims.  The much publicized Consumer Financial Protection Bureau has a slightly longer reach than Dodd-Frank’s other tentacles, but it is by no means the beast’s most dangerous feature.

That distinction belongs to the Financial Stability Oversight Council—the beak with which Dodd-Frank dismembers its prey.  FSOC is typically thought of as the outfit in charge of identifying so-called systemically important financial institutions, or SIFIs.  But this council of regulatory agencies has responsibilities that go far beyond that.

FSOC has an ill-defined mandate to stamp out risks to U.S. financial stability.

How vague is this directive?  To begin, the term “financial stability” is impossible to define objectively.  And it is not defined at all in Dodd-Frank or anywhere else in the U.S. code.  Further, the articulated mission requires the FSOC to identify financial stability risks that arise outside of the U.S., as well as to respond to emerging threats.

It’s not just the supposed SIFIs that have to be worried.  Dodd-Frank specifically gave the council the authority to require new heightened regulations for any financial company it determines poses a threat to “financial markets of the United States, or low-income, minority, or underserved communities.”  How in the world can anyone successfully argue in court that they’re not an emerging threat to a concept that is so broad and ill-defined?

The FSOC is not really in charge of financial market regulations, and that’s good.  But, at its own discretion, it can require new regulations on companies that already have a main regulator.  In other words, agencies that have their own priorities and responsibilities will have to bow to the FSOC, but exactly how that process will play out is far from certain.  This sort of regulatory jumble didn’t bother Dodd-Frank’s authors because they constructed the bill based on the notion that more regulation is always good.

The economy will suffer, though, because the council – much like Dodd-Frank itself – was built on more faulty logic than the flat earth movement.  For starters, the notion that—without an FSOC—federal regulators will tend to hone in on problems at individual firms rather than concern themselves with “macro” stability is absurd.

The Federal Reserve was not created to save one or two banks, it was started to stop bank panics from crippling the broader economy.  And bank regulations have always been justified on the premise of protecting the general public.

Yet, the council’s new rules are supposed to mitigate crises because now the Fed will finally shift to a macro-oriented view of regulation.  Aside from the Fed, Congress and the U.S. Treasury have openly had roles in stemming economy-wide systemic risk and promoting financial stability for decades.  The U.S. House of Representatives’ actually had a Subcommittee on Economic Stabilization before the Basel I accords were accepted in 1988.

This entire Financial Stability Oversight Council enterprise is really just more of the same.  Much, much more.  The council’s role of identifying large financial companies for special regulatory supervision is just one new facet.  This special designation identifies exactly who the Fed will help out in the next crisis, a process which perpetuates the too-big-to-fail problem.

The Fed itself will be regulating these companies so allowing them to fail would be an admission the Fed can’t save us.  Not likely to see that one.

More broadly, we can expect the council to evolve and ultimately do much more damage to financial markets.  Financial companies of all sizes now operate under the constant threat of having new, company specific, regulations thrust upon them for virtually any reason the FSOC can come up with.  That’s not the type of regulatory environment that helps companies grow.

The best way to ensure firms don’t take undue risk is to credibly state that owners and creditors – not taxpayers – will be responsible for financial losses.  Nobody will believe such a statement until the many pieces of Dodd-Frank are chopped off, and the first one to go should be the Financial Stability Oversight Council.

 - Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.