Regulate Non-Banks by Focusing on Products and Activities

The Treasury Department is currently reviewing the process for designating non-banks as systemically important financial institutions and is expected to issue a report soon. In our view, the Treasury should recommend the Financial Stability Oversight Council (FSOC) be given more authority to address risky activities and products and not focus on designating individual firms.

Non-banks are financial institutions that are not regulated like banks but engage in bank-like activity, such as borrowing short-term to make loans and investments. This dichotomy has led to a two-tiered regulatory system for banks and non-banks, which can encourage the migration of risky financial activities and products towards less regulated parts of the financial system.

Designating individual firms likely will result in risky activities and products migrating towards non-designated firms.

The non-bank sector played a central role in the 2008 Financial Crisis. Many money market mutual funds, investment banks, and insurance companies engaged in risky activities that caused major stress to the financial system that helped fuel the crisis. These firms did not have access to federal deposit insurance and a lender of last resort, which were designed to protect the financial system from panic in the banking sector. To stabilize non-banks, policymakers took ad hoc, emergency actions that put taxpayer money at risk.

The crisis rightfully outraged the public. In response, policymakers tried to find ways to better regulate non-banks and created FSOC, a committee consisting of top financial regulators chaired by the treasury secretary, with the power to designate non-banks for stricter regulatory scrutiny.

Stricter regulation of the non-bank sector is a good idea and should be encouraged. However, the process of designating individual firms for stricter regulation has several weaknesses.

First, the designation process can be slow and cumbersome. Regulators should be deliberate and methodical about regulating systemic risks, but they also must be able to react quickly to emerging threats.

Second, the designation process results in an either-or decision, which is not ideal. The varied levels of systemic risk posed by different non-banks requires better tailored and varied levels of regulation, rather than a binary system. Otherwise, designated firms with lower risk profiles will face the same enhanced regulation as designated firms with the highest risk profiles, putting them at a competitive disadvantage.

Third, designating individual firms likely will result in risky activities and products migrating towards non-designated firms. This shifts risk rather than reduces it.

For instance, the Great Depression did not involve large systemically important firms but led to a financial crisis. This suggests that simply designating financial firms as systemically risky is not the best way to prevent a financial crisis.Given these weaknesses, public policy would be better served by moving away from the designation process for non-banks toward a process focused on regulating products and activities instead. Risky products and activities are generally what cause financial crises and not systemically important firms.

While the 2008 financial crisis involved systemically important firms, it was largely the result of a bursting housing bubble that was inflated by risky activities like excessive borrowing by financial firms, poor mortgage underwriting, and the imprudent use of derivatives.

There are serious concerns about the systemic risks posed by the non-bank sector and these concerns should be addressed through proper regulation. However, the designation of individual non-banks for enhanced regulation is not the best approach because it would likely shift rather than reduce threats to the financial system. A focus on risky products and activities can mitigate this risk-shifting. Treasury should call on FSOC to move away from designating individual non-banks and to be given more authority to focus on regulating risky products and activities instead.