An October 2017 Treasury Department report on the asset management and insurance industries includes an important—and fundamentally flawed—recommendation that could change the way U.S. regulators monitor risk in the financial system.  The Treasury report recommends that regulators focus on identifying and overseeing potentially risky financial activities rather than systemic firms like AIG, Lehman Brothers, and Bear Stearns.

This proposal, long favored by the insurance sector, would represent a sharp departure from U.S. and global regulators’ approach to systemic risk since the financial crisis.  When Congress created the Financial Stability Oversight Council as part of the Dodd-Frank Act, it gave the FSOC two tools to control systemic risk.  First, Congress authorized FSOC to designate a non-bank firm for enhanced regulation by the Federal Reserve if the firm’s distress would pose a threat to financial stability (the entity-based approach).  Second, Congress empowered FSOC to recommend enhanced regulations for any financial activity that could increase systemic risks (the activity-based approach).  To date, the FSOC has exclusively used the entity-based approach, designating AIG, GE Capital, MetLife, and Prudential for Federal Reserve oversight.

While opponents of the entity-based approach argue that FSOC designation subjected these firms to unjustified compliance costs, the FSOC’s entity-based designations have undoubtedly helped reduce systemic risk.  AIG and GE Capital substantially shrank their balance sheets and curtailed some risky activities before convincing FSOC to lift their designations.  While MetLife successfully challenged its designation in court, it also has shrunk, spinning off its retail segment in part to avoid the possibility of re-designation.

Despite the success of the entity-based approach, Treasury’s proposal to shift to an activity-based approach has some important advantages.  It would, for example, allow FSOC to target risky products like credit derivatives and investment guarantees issued by many firms rather than just a handful of companies deemed systemically important.  In addition, adopting the activity-based approach would alleviate criticism that the Federal Reserve inappropriately applies bank-centric regulations to non-bank firms under the entity-based approach.

The activity-based approach, however, has several critical drawbacks.  For one, how will FSOC know in advance which activities are systemic?  It seems unlikely, given prevailing market conditions, that regulators would have identified credit default swaps and mortgage-backed securities as systemically important while the housing bubble inflated in the mid-2000s.  In light of the size and interconnectedness of many financial conglomerates, I am more confident that regulators will accurately identify, ex ante, systemic firms than systemic activities.

Most important, the U.S. regulatory system is simply not equipped to execute an activity-based approach.  Under Dodd-Frank, the FSOC may develop enhanced regulations for systemically important activities.  Because the FSOC has no direct regulatory power, however, Dodd-Frank directs the “primary financial regulatory agencies” to implement FSOC’s recommendations.  Here’s the rub: There is no “primary financial regulatory agency” to regulate the activities of most large insurance companies—including AIG and MetLife.

Due in part to Civil War-era legal precedent, U.S. insurance companies have traditionally been regulated by the states, with little federal involvement.  As a result, large insurance companies typically establish subsidiaries in each state in which they operate, and state insurance commissioners supervise the subsidiaries located in their jurisdictions.  In general, there is no consolidated regulator for a top-tier insurance holding company.  Nor is there a regulator for an insurance company’s non-insurance subsidiaries, such as AIG Financial Products, AIG’s little-known subsidiary that issued $2.7 trillion in credit default swaps, necessitating a federal government bailout.

Before the financial crisis, many insurance companies were at least nominally regulated on a consolidated basis by the federal Office of Thrift Supervision, because they owned bank-like savings and loan subsidiaries.  (The OTS was a notoriously weak regulator and, as a result, the Dodd-Frank Act abolished it and transferred its holding company authority to the Federal Reserve.)  Since the crisis, however, most large insurance companies have gotten rid of their depository subsidiaries and, therefore, have escaped federal regulation.  AIG and MetLife, for example, both disposed of their depository subsidiaries, and neither is currently regulated on a consolidated basis.  If FSOC lifts Prudential’s entity-based designation—as many observers suspect it soon will—Prudential will likewise lack consolidated supervision.

In sum, the fatal flaw of the activity-based approach is that there is no regulator to oversee insurance companies’ risky activities conducted outside of their regulated insurance subsidiaries.  Credit derivatives, guaranteed investment contracts, securities lending transactions, and other potentially-systemic products may therefore escape regulatory scrutiny.

Several potential reforms could mitigate shortcomings in the activity-based approach.  For one, the Federal Insurance Office could supervise insurance companies on a consolidated basis and implement FSOC’s regulatory recommendations.  But FIO currently lacks regulatory authority, and the insurance sector and its allies in Congress have opposed expanding FIO’s powers.  Alternatively, other regulators may be able to limit risky transactions by applying enhanced standards to insurance companies’ regulated counterparties.  But this strategy still provides an incomplete picture of financial markets.

The activity-based approach, therefore, is insufficient on its own to protect the financial system.  Critically, however, the activity-based and entity-based approaches are not mutually exclusive.  FSOC can—and should—continue designating systemically risky financial companies for enhanced regulation while also incorporating an activity-based approach targeting risky activities market-wide.  This belt-and-suspenders strategy would be appropriate given the high stakes involved in systemic risk regulation.

Treasury is due to issue its long-awaited report on FSOC designations in the coming days.  That report is widely expected to lay out a road map for FSOC to ditch the entity-based approach and transition to the activity-based approach.  For the sake of the financial system, Treasury should reconsider its faith in activity-based regulation.

This post comes to us from Jeremy C. Kress, a senior research fellow at the University of Michigan Center on Finance, Law & Policy and lecturer in business law at the University of Michigan Ross School of Business.  Kress was previously an attorney in the Banking Regulation & Policy Group of the Federal Reserve Board’s Legal Division.