The Financial Stability Oversight Council is the only regulatory body in the United States with an express mandate to “identify risks to the financial stability of the United States” and to “respond to emerging threats to the stability of the United States financial system.” But the FSOC is not a stand-alone agency; rather it is a council of regulators, lacking sufficient staff or resources to operate on its own. To function, the FSOC must leverage the expertise of its component agencies – including the Securities and Exchange Commission.
There have been several subtle (and not-so-subtle) tugs-of-war between the FSOC and the SEC in recent years, however. In 2012, for example, the FSOC recommended that the SEC adopt money market mutual fund reforms that were designed to mitigate the systemic risks posed by such products. The SEC responded by adopting reforms that were more limited than the FSOC had recommended. In 2014, the FSOC publicly noted that the SEC’s regulatory reform work on the asset management industry was not focusing on financial stability issues, and in response, then-Chair Mary Jo White suggested that the systemic risk posed by investment companies was outside of the SEC’s regulatory scope. When the FSOC made recommendations for addressing systemic risks posed by mutual funds in 2016, White issued a public statement that the FSOC’s recommendations “should not be read as an indication of the direction that the SEC’s final asset management rules may take.”[1] Former SEC Commissioner Daniel Gallagher and current acting SEC Chair Michael Piwowar have been particularly vociferous critics of the FSOC’s attempts to involve the SEC in prudential regulation. Gallagher, for example, stated that “the move to impose prudential regulation on our capital markets, in particular by applying a one-size-fits-all approach to capital requirements, is nothing short of an existential threat to those markets — and to the SEC itself”,[2] and Piwowar has pledged “to defend our jurisdiction from the prudential regulators’ [FSOC]-enabled turf war.”[3]
While the foregoing suggests opposition within the SEC to promoting financial stability through prudential regulation (a stance that is unlikely to change as new commissioners are appointed by the Trump administration), financial stability regulation encompasses more than just prudential regulation. Since the financial crisis, it has been recognized that financial stability regulation requires oversight not only of individual financial institutions, but also of the markets and other interconnections that link those institutions. As IOSCO has noted, securities regulators (rather than prudential regulators) have significant experience in regulating to maintain the integrity of the securities markets, ensuring the stable and continuing provision of the market liquidity that is essential to a well-functioning financial system.[4]
I have previously argued that the SEC has the necessary legal authority to act as a financial stability regulator. This authority derives from a number of legislative sources. First, Section 2 of the Securities Exchange Act explains that the securities laws were designed to promote stable financial markets, in order to promote broader economic well-being – the promotion of financial stability by the SEC is consistent with this Section 2 (as well as the SEC’s self-described mission to maintain orderly markets). Second, financial stability can be conceptualized as an indirect way for the SEC to discharge its investor protection mandate.[5] Because investors with diversified stock portfolios are – collectively – harmed more by crises that cause equity market failures than they are by individual instances of fraud and misconduct, the SEC can best serve investors by seeking to prevent such market failures. Finally, the Dodd-Frank legislation enacted after the financial crisis provides implicit directions to the SEC to consider financial stability issues in a number of contexts in order to facilitate the SEC chair’s participation in FSOC deliberations.[6] Notwithstanding these legislative provisions, however, there is no unambiguous statutory mandate for the SEC to promote financial stability. As such, the SEC could choose to ignore financial stability and instead focus exclusively on its investor protection and capital formation mandates.
The ascendance of high frequency trading serves as just one example of why it would be dangerous for the SEC to ignore systemic risks arising in the equity markets it oversees. While many seem to assume that the impact of future “flash crashes” in the equity markets will be short-lived and contained within those markets, it is short-sighted to dismiss the shocks that high frequency traders can generate or transmit (perhaps both) to the broader financial system. High frequency trading firms prize speed above all else, and so the trading algorithms they develop tend not to include code that responds to unlikely but high-impact tail events (such code would waste processing time). Instead, most high frequency trading algorithms are designed to simply withdraw from trading when unexpected events occur. Given that high frequency traders are estimated to account for more than half of all equity market trading in the U.S., withdrawal of high frequency traders from the equity markets will have a significant impact on the availability of market liquidity. The prices of mutual funds and derivatives (amongst other instruments) are tied to the prices of equity stocks, and so if liquidity disappears from the equity markets in a way that compromises the trading and thus pricing of stocks, the impact of such disruption will be felt far beyond the equity markets.
Over the last seven years, SEC commissioners and staff have made speeches, issued press releases, and given testimony suggesting that the SEC is amenable to implementing equity market structure rules designed to promote the stability of those markets and the continuing provision of market liquidity – in other words, to act as a financial stability regulator, albeit in a non-prudential sense. But there will always be pressure for the SEC to focus on its more visible investor protection and capital formation mandates. If the SEC were to choose not to consider financial stability matters as it pursues equity market structure reform, this would leave a gaping hole in the FSOC’s understanding and oversight of systemic risks posed and propagated by the equity markets.
To avoid alienating the SEC, the prudential regulators, acting through the FSOC, may need to stop pushing the SEC to engage in prudential regulation.[7] To be clear, restricting the SEC’s systemic focus to the markets it oversees is not a perfect solution. The SEC remains the primary regulator of institutions (like mutual funds) that perhaps deserve more prudential attention. As I have previously argued, regulatory gaps like this would ideally be addressed by the creation of a well-resourced financial stability regulator with a clear mandate to oversee the buildup of risk across the entire financial system, irrespective of the institutions and markets involved. However, there is no political will for the creation of such a regulatory body, and so we must make the best of the regulatory system we have. As such, the other members of FSOC should encourage the SEC to make its contribution to promoting financial stability in a way that accords with its own identity and expertise: by regulating the securities markets with a view to reducing the risk that such markets will generate or transmit a shock to the rest of the financial system.
ENDNOTES
[1] Mary Jo White, Statement on Financial Stability Oversight Council’s Review of Asset Management Products and Activities (Apr. 18, 2016) (available at https://www.sec.gov/news/statement/white-statement-041816.html).
[2] Daniel M. Gallagher, The Importance of the SEC’s Rulemaking Agenda — You Are What You Prioritize: Remarks at the 47th Annual Securities Regulation Seminar of the Los Angeles County Bar Association (Oct. 24, 2014) (available at https://www.sec.gov/News/Speech/Detail/Speech/1370543283858)
[3] Michael S. Piwowar, Remarks at AEI Conference on Financial Stability (Jul. 15, 2014) (available at https://www.sec.gov/News/Speech/Detail/Speech/1370542309109).
[4] Technical Committee of the International Organization of Securities Commissions, MITIGATING SYSTEMIC RISK: A ROLE FOR SECURITIES REGULATORS (Feb. 2011).
[5] The SEC is directed to consider the protection of investors by Section 2(b) of the Securities Act of 1933 and Section 3(f) of the Securities Exchange Act of 1934.
[6] See Sections 112(b), 113, 120 and 804 of Dodd-Frank.
[7] It is worth noting that even if the SEC were willing, it might not be a particularly effective prudential regulator – the SEC’s pre-Crisis Consolidated Supervised Entity program serves as something of a cautionary tale here.
This post comes to us from Professor Hilary Allen of Suffolk University Law School. It is based on her recent essay, “Financial Stability Regulation as Indirect Investor/Consumer Protection Regulation: Implications for Regulatory Mandates and Structure,” available here, and on research for a forthcoming article about the role that the SEC can play as a financial stability regulator.