On October 18, federal regulators released the largest U.S. insurance group, Prudential Financial, Inc., from enhanced government oversight.  Prudential had been the last remaining systemically important financial institution (SIFI)—a designation Congress created in the Dodd-Frank Act for nonbank financial companies that could threaten U.S. financial stability.  Prudential’s deregulation fulfills a years-long effort by Dodd-Frank critics to weaken a crucial post-crisis regulatory reform.

In my new essay, “The Last SIFI: The Unwise and Illegal Deregulation of Prudential Financial, Inc.,” I contend that overturning Prudential’s “systemically important” status was not only misguided, it was also against the law.  By illegally deregulating Prudential, policymakers have opened the financial system to the same risks it experienced in the lead-up to the financial crisis.

After the crisis, Congress created the Financial Stability Oversight Council (FSOC) to safeguard the financial system against investment banks like Lehman Brothers and insurance companies like AIG.  Congress directed FSOC to designate a nonbank financial company as a SIFI if the council determines that the firm’s material financial distress could threaten U.S. financial stability.  Any firm that FSOC designates as a SIFI becomes subject to enhanced supervision and regulation by the Federal Reserve.

At least initially, the FSOC embraced its mission to identify nonbank SIFIs.  The council designated Prudential, AIG, MetLife, and GE Capital as systemically important.  The four designees, unsurprisingly, resisted the nonbank SIFI label and accompanying Federal Reserve oversight.  The firms complained of increased burdens associated with this added layer of regulation.

One by one, the designated firms began to sell off parts and shift to less risky activities in an effort to escape the SIFI label.  GE Capital, for example, shrank by more than half and substantially reduced its heavy reliance on risky short-term funding.  AIG likewise contracted by roughly 10 percent relative to when it was designated.  Even MetLife, which successfully challenged its SIFI status in court, spun off its retail insurance segment, shrinking by nearly 20 percent in the process.  One by one, therefore, FSOC de-designated these firms in recognition of their reduced systemic footprints.  FSOC removed GE Capital’s SIFI label in 2016, and it did the same for AIG the following year.  Thus, just seven years after Dodd-Frank, nearly all of the nonbank SIFIs were free from federal oversight.

All, that is, except Prudential.  In contrast to its former SIFI peers, Prudential neither shrank nor simplified itself.  To the contrary, Prudential actually expanded its systemic footprint after becoming a SIFI.  Prudential apparently calculated that it could escape its SIFI label simply by waiting until deregulatory policymakers controlled FSOC.

Prudential’s gamble paid off when Donald Trump won the presidency, earning the right to appoint new members to the council.  Trump selected nominees drawn from the financial sector, which had long criticized nonbank SIFI designations as burdensome and inequitable.  Thus, on October 18, 2018, FSOC formally de-designated Prudential.  And with that, the last remaining nonbank SIFI escaped federal oversight, and nonbank SIFI designations—a key post-crisis regulatory tool—fell into complete disuse.

My essay contends that the council’s decision to rescind Prudential’s SIFI status was arbitrary and capricious.  Three separate errors substantially undermine FSOC’s conclusions.

First, FSOC violated its established procedures by second-guessing its original assessment of Prudential’s systemic importance.  FSOC does not deny that Prudential has done little to shrink or simply itself since being designated as a SIFI.  To the contrary, FSOC admits that Prudential’s systemic footprint has grown substantially, as evidenced by its increased asset size and risky activities.  FSOC insists, however, that the council erred when it originally designated Prudential in 2013.  Indeed, the entire basis for FSOC’s decision—to the extent one can be discerned—boils down to its belief that the Obama Administration FSOC made a mistake in designating Prudential.

The council, however, is not supposed to second guess itself in this way.  Indeed, FSOC has committed that it will rescind a SIFI designation only if the company’s systemic footprint has materially decreased.  In its formal procedures for SIFI designations and de-designations—promulgated through notice-and-comment rulemaking—the council stated that its reevaluation of a nonbank SIFI’s status “will focus on any material changes with respect to the nonbank financial company or the markets in which it operates since the Council’s previous review.”  FSOC’s reevaluation of Prudential does not focus on these factors.  Rather, FSOC simply disagrees with the previous council as to Prudential’s systemic importance.  By second-guessing the Obama Administration’s determination, the council illegally violated its binding procedures rules.

Second, FSOC arbitrarily disregarded a well-respected indicator of Prudential’s systemic importance.  Prudential ranks third among all U.S. financial companies in SRISK, one of the most commonly cited measures of a firm’s systemic footprint.  SRISK measures a firm’s expected capital shortfall given a severe market decline, based on its size, leverage, and risk.  Prudential’s SRISK is roughly comparable to Morgan Stanley’s, and it ranks behind only Citigroup’s and Goldman Sachs’.

FSOC, however, inappropriately dismisses Prudential’s exceptionally high SRISK.  FSOC insists that SRISK “does not fit the long-term nature of the insurance business model.”  But FSOC’s dismissal of Prudential’s elevated SRISK is disingenuous—indeed, it is arbitrary and capricious—because FSOC cited SRISK favorably last year in its evaluation of AIG, another insurance company.  The council emphasized that AIG’s SRISK had been equivalent to those of systemically important banks before the crisis, but its SRISK had fallen to zero by 2013.  Having cited AIG’s negligible SRISK as a justification for its de-designation, the council cannot arbitrarily disregard Prudential’s exceptionally high SRISK just a year later.

Finally, Prudential’s de-designation was improper because FSOC completely ignored one of the factors Congress required the council to consider when assessing a nonbank’s systemic importance.  Dodd-Frank enumerates several statutory factors that the council must weigh when evaluating a nonbank, including the firm’s asset size, leverage, and “the degree to which the company is already regulated by 1 or more primary financial regulatory agencies.”  In this case, however, FSOC ignored its statutory mandate to consider Prudential’s existing regulatory scrutiny.

Prudential’s insurance subsidiaries, like all U.S. insurance companies, are regulated primarily by the states.  Traditionally, however, U.S. insurance conglomerates like Prudential have not been regulated on a consolidated basis at the holding company level.  In 2014, though, Prudential’s home state of New Jersey enacted a new law authorizing its Department of Banking and Insurance (DOBI) to supervise New Jersey-based insurance conglomerates on a consolidated, group-wide basis.  In its de-designation of Prudential, FSOC emphasizes that the DOBI can now collect data on and monitor Prudential’s worldwide operations pursuant to this new authority, unlike when Prudential was originally designated.

FSOC, however, fundamentally misconstrues its statutory mandate.  FSOC focuses on the extent to which the DOBI supervises Prudential, but Congress instructed it to consider the degree to which other agencies regulate the firm.  Supervision and regulation are very different.  Supervision refers to the oversight of an institution’s financial condition and compliance with relevant laws.  Regulation, by contrast, refers to the setting of rules and guidelines applicable the firm.  FSOC does not even attempt to address Prudential’s baseline regulatory regime.  That is a serious problem because DOBI’s statutory authority to regulate Prudential’s top-tier holding company is ambiguous, at best.  The New Jersey agency lacks clear authority to address the company’s weaknesses through regulation.  The council’s de-designation of Prudential was therefore arbitrary because it inappropriately conflates state-level supervision with regulation.

Vigilant congressional oversight is the most promising pathway to hold FSOC accountable for improperly de-designating Prudential.  Although the council’s action could in theory be subject to judicial review, individual citizens probably lack standing to challenge the de-designation in court, and Prudential’s competitors likely do not have sufficient incentive to bring a suit.  It is therefore imperative that the relevant congressional committees hold hearings to evaluate the legitimacy of Prudential’s de-designation. 

In sum, FSOC’s de-designation of Prudential was both unwise and illegal.  The council violated its established procedures, used misleading quantitative analyses, and ignored a crucial statutory factor—all in an effort to reach its preordained conclusion that Prudential should be removed from enhanced federal regulation.  In doing so, the council opened the financial system to the same risks that the country experienced in 2008.  Congress should not tolerate this renewed threat to U.S. financial stability.

This post comes to us from Jeremy C. Kress, assistant professor of business law at the University of Michigan Ross School of Business.  It is based on his recent essay, “The Last SIFI: The Unwise and Illegal Deregulation of Prudential Financial, Inc.,” available here and forthcoming in the Stanford Law Review Online.