The U.S. Risks Blinding Itself to the Next Financial Crisis

(Bloomberg Opinion) -- After the 2008 financial crisis, Congress created a new federal entity with an important mission: to ensure that regulators would never again be caught off-guard. The Financial Stability Oversight Council brought together different agencies to watch for threats within the banking system and beyond.

The Trump administration is now undermining those efforts — at the very point in the economic cycle where the FSOC is needed most.

The crisis made clear just how much had fallen through the cracks. The nonbank mortgage companies that issued many of the worst subprime loans operated with little supervision or incentive to act responsibly. Much of the risk was hidden in off-balance-sheet entities and derivatives — or in overseas operations (like the London-based unit of AIG) that were beyond the purview of domestic regulators.

To put this right, Congress gave the FSOC two powers. First, if the council deemed any financial firm so large or interconnected that its failure could destabilize the system, it could designate that firm as systemically important and subject it to special oversight from the Federal Reserve. Second, if it found any financial activity to be a systemic threat, it could recommend that the relevant regulator take action. To widen its range of vision, Congress also created the Office of Financial Research, and gave it subpoena power to demand information.

Granted, the council’s record is mixed. Its designation authority — by far its most most important power — was weakened in 2016, when a court ruled in a case brought by insurer MetLife that the FSOC had to show not only that a company was systemically important but also that it was likely to experience distress. This defeated the mechanism’s purpose: to prevent such companies from becoming vulnerable in the first place.

Elsewhere, the FSOC can boast only partial success. It pressured the Securities and Exchange Commission to prevent certain money-market mutual funds from pegging their share price to a dollar — a practice that proved fragile during the 2008 crisis. But the SEC’s measures fell short. The council’s members have also been reluctant to tread on each other’s turf. They can’t compel agencies to act. And the OFR’s early-warning system isn’t yet up to the job.

No question, then, the FSOC needs reform. Congress should make it an independent agency with its own director, clarify its designation power and give it broad authority to make rules across markets. To align incentives, financial stability should be added to the mandates of all agencies. And the OFR, currently part of the Treasury Department, should report directly to the FSOC.

Rather than undertaking these changes and strengthening a body that’s essential for financial safety, the Trump administration is doing just the opposite. Under the chairmanship of Treasury Secretary Steven Mnuchin, the council has reversed all its designations of systemically important non-bank companies. Worse, rather than appealing the ill-advised MetLife decision, Treasury wants to adopt it as policy by making the likelihood of distress a prerequisite for designation. This would all but guarantee that no companies — most notably insurance companies — would face oversight until it was too late.

Treasury says it wants the FSOC to shift its primary focus from individual firms to activities and products that pose risk more widely. In principle, this could work — if it were combined with scrutiny of systemically important companies and if the FSOC were equipped to carry it through. That’s not the case, and Treasury has shown little interest making it happen. On the contrary, it has sharply cut funding for the OFR, just as an abundance of potentially troubling activities — from subprime corporate lending to the resurgence of non-bank mortgage lenders — requires attention.

It’s to be hoped that Treasury has second thoughts, or that Congress steps in. The FSOC’s other members can help by speaking up. If nothing is done, the U.S. could find itself as poorly prepared for the next crisis as it was for the last.

Editorials are written by the Bloomberg Opinion editorial board.

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