August 16, 2016
“It was really a moment of levity in a rough day, rather than a display of humility,” said Treasury Secretary Hank Paulson in 2008 as he dropped on one knee before Nancy Pelosi, the House speaker, imploring her not to blow up the $700 billion bank bailout deal by withdrawing Democratic support. “I didn’t know you were a Catholic,” replied Ms. Pelosi, herself of impeccable Italian Catholic ancestry.
This was the prelude for the Dodd-Frank Act to authorize the Financial Stability Oversight Council (FSOC), the FDIC, and the Federal Reserve to determine that a financial institution’s material financial distress could pose a threat to U.S. financial stability. Such companies, designated as “Systematically Important Financial Institution,” or SIFI, will be subject to consolidated supervision by the Federal Reserve and enhanced prudential standards.
Currently in the United States, there are 33 large global money-center banks, seven insurance companies, and most recently, four nonbank companies (GE Capital, MetLife, AIG, and Prudential) designated as SIFI, or “Too Big To Fail.”
The intent of any financial regulation is to limit excessive risk at the expense of forgone growth and profit. By limiting SIFI’s ability to increase debt, taking on risky acquisitions, paying out dividends, and stock buybacks, other than stabilizing the SIFI risk impact, it is also set to prevent moral hazards, i.e., transferring wealth from debt holders to stock holders.
That being said, being designated as a SIFI also signals to the market your business is risky. So, the real question is whether being labeled as a SIFI is a good thing for a company?
When MetLife was declared a SIFI in September 2014 by FSOC, the insurance company sued the US government, taking the stance that the designation will drive up the compliance cost with the regulations. In March 2015, U.S. District Court Judge Rosemary Collyer ruled that the SIFI designation imposed on MetLife was determined through a flawed process with hypothetical assumptions. While the ruling on rescinding MetLife’s “too big to fail” label remains in the Court of Appeals, MetLife’s stock has dropped more than 25%, or 40% below the market, since the day of the SIFI designation.
In contrast, having sold off more than $200 billion risky assets, GE Capital was the first and only company exiting (“GExit”) its 2013’s SIFI designation on June 28, 2016. Amid the news of the rescindment, the stock of GE, the parent company, jumped 5%.
Though, how soon do we forget! It is again the rough-and-tumble presidential election year politics “trumpling” over the usual campaign issues. This time, Democratic presidential candidate Hillary Clinton has picked on big banks,
“The reason we passed Dodd-Frank was to make it clear no bank is too big to fail, no executive too powerful to jail. And we’ve got to keep face with the American people. I’m sorry that you’ve made bad decisions, but we’re going to have to unwind you and yes, break you up.”
We can only hope that as the debate between regulation and deregulation is like any other campaign pivoting, let rhetoric stay rhetoric.
For the intended target of the SIFI designation, 33 too-big-to-fail banks, they have been triply monitored by the “Living Wills” and “Stress Tests” imposed by the FDIC and Federal Reserve concurrently. Not until just two months ago, most banks were finally cleared, after multiple “makeup” tests on both accounts. Not surprisingly, all bank stocks rallied 5% to 8% on the day of the clearance, followed by the simultaneous banks’ announcements of increasing stock dividends and stock buybacks. While the dust of SIFI is not yet settled, most banks have underperformed the market by 40% since the FSOC release of the first 29 SIFI list in November 2011.
There you go! Being labeled as a SIFI has cost a financial firm, at a minimum, 30% of its market value.
The cost of regulation is that the number of compliance officers at large institutions is more than the total number of employees at regional banks. The cost of regulation is that the regulators’ punch-list mentality can distract examiners from the intent of determining safety and soundness. The cost of regulation is that the efforts to prevent a financial crisis often, and almost always, reduces to respond to a financial crisis.
On good days, risk managers or compliance officers in a financial institution are no more than “the flower vase in the bathroom.”
In bad days, they are the first ones to go. Regulation is always reactionary. Regulation is often redundant. Regulation is politically motivated. Regulation is always hard to enforce. Regulation, when it is bad, destabilizes the financial system more than no regulation at all.
On the other hand, it is six years after Dodd-Frank and nine years after the financial crisis. All big banks, albeit bigger, are under much tighter scrutiny. We still have, on average, one bank closed every day just like the last 60 years. Any surviving banks need to be big enough to get access to the public capital market in time of confidence crisis, so taxpayers’ bailout like 2008 won’t happen again.
After GE’s exit, MetLife’s contested designation, and most banks being cleared by the banking regulators, only AIG and Prudential remain under FSOC’s watch. One might expect that the FSOC should seriously re-examine the justification for its existence. In late 2012, the FSOC has proposed new designations of an initial set of eight financial firms, “Financial Market Utilities” (FMUs) as systematically important.
Looks like the regulation of large banks eventually becomes the regulation of all financial intermediaries, including asset managers, hedge funds, and financial technology firms.