The most important policy stance in the Report is Treasury’s rebuke of FSOC’s entity-based focus to designate asset managers and insurers as “systemically important.” The Treasury Report finds that “entity-based systemic risk evaluations” of nonbanks are “generally not the best approach for mitigating risks arising from [these industries].” This is a sound observation. As Manley Johnson, a former Federal Reserve Board (“Fed”) Vice Chair, and I recently pointed out in American Banker, “designations purport to protect the U.S. economy through ensuring the proper oversight of very large nonbank financial firms,” but instead, “have caused serious economic harm through the anti-competitive too-big-to-fail status that designations implicitly confer.”
In its forthcoming FSOC-specific report, Treasury should take a stronger position against economically destructive and unconstrained FSOC designation powers, which bring about bank-like Fed regulations for nonbanks. The Treasury Report’s recommendation related to firm-specific designations implies that in some circumstances FSOC may appropriately designate nonbanks as “systemically important.” Likewise, some elements of the Report raise questions as to whether Treasury’s forthcoming FSOC report will indeed call for FSOC’s sweeping regulatory powers – and the costly Fed rules that stem from designation – to be reined in.
For example, the recently released Treasury Report argues that FSOC should maintain “primary responsibility” not just for “identifying” and “evaluating” systemic financial system risks, but also “addressing” those risks. As bad as Dodd-Frank is, the statute clearly leaves the primary regulatory responsibility in agencies’ hands. Similarly, in its discussion of the Fed’s proposed liquidity regulation for “systemically important” insurance companies, the Report calls for the Fed, along with state regulators and the National Association of Insurance Commissioners (“NAIC”), to “continue their work on addressing potential liquidity risk in the insurance sector.” The Report also notes that the Secretary “will direct [the Federal Insurance Office] … to encourage state insurance regulators, the NAIC, and the Federal Reserve to continue to make progress on domestic liquidity risk initiatives.” Taken together, these and other policy positions set forth in the Treasury Report suggest that Treasury envisions that FSOC will maintain authority to subject nonbank areas of finance to bank-like regulation by the Fed, and the Fed would continue some role in the regulation of nonbanks.
Adding further confusion as to where Treasury stands on FSOC’s designation powers, the Treasury Report calls for the U.S. to work with the Financial Stability Board (“FSB”) – an international council of central banks and financial regulators – to “revise the … framework” by which the FSB designates nonbank firms as “systemically important.” The FSB has no legal authority and is merely a Kaffeeklatsch of various G-20 regulators. Notably, in its three past designations of nonbank insurers, FSOC seemingly took marching orders from the FSB, as American Enterprise Institute’s Peter Wallison observed in 2014. That year, FSOC’s independent insurance expert also expressed concern that FSB’s designation decisions were driving those of FSOC.
Treasury’s recommendations are also disappointing in that they do little to push back against the FSB. For example, Treasury could have called for U.S. representatives to the FSB to end firm-specific designation by this global star council. Treasury nevertheless should be complimented for calling out the FSB for its use of the pejorative term “shadow banking” to refer to mutual funds and their advisers.
Besides those recommendations related to FSOC and designation powers, the Treasury Report also sets forth a number of recommendations related to other aspects of asset management and insurance industry regulations. An assessment of several policy stances related to asset managers endorsed by Treasury is provided below.
- Stress testing. Treasury is right to support legislative action to eliminate Dodd-Frank’s stress testing requirement for investment advisers and investment companies. Such action also would eliminate issues presented by applying bank-like stress testing requirements on nonbanks. These issues include difficulty in determining how funds and advisers should be stress tested and issues with establishing appropriate consequences for funds that perform poorly.
- Liquidity risk management. Treasury rightly supports the Securities and Exchange Commission’s (“SEC”) adopting a principles-based liquidity risk management rulemaking approach for open-end funds. The Treasury Report also “rejects any highly prescriptive regulatory approach to liquidity risk management,” such as Rule 22e-4, which requires, among other things, most open-end funds to classify each of their portfolio investments into one of four so-called “liquidity categories.” Because of the fluctuating and often subjective nature of liquidity, an overly-prescriptive approach can result in misguided measures of liquidity risk, as explained in the Report. Treasury appropriately notes that when measuring liquidity risk, funds should be allowed “a certain amount of flexibility to account for market and issuer-specific dynamics.” Treasury’s position aligns with the majority of the more than seventy commenters who, as the SEC reported in 2016, wrote to the agency regarding the current rules asking for a “risk oriented and principles based” approach. Commenters appropriately criticized the liquidity classification requirement, noting that the classification scheme supports a “one-size-fits-all” approach over a risk-based approach to liquidity management.
- Dual CFTC and SEC registration. Since 2012, due to a change in Commodity Futures Trading Commission (“CFTC”) rules, certain investment companies and their advisers engaging in commodity transactions have been required to register with both the CFTC and the SEC. Treasury calls for this dual registration to end and appropriately makes three recommendations aimed at regulatory streamlining, always a worthy goal: (i) that the CFTC and SEC “cooperate to share information provided by their respective regulated entities” so that each agency can more effectively monitor securities and derivatives markets; (ii) that the CFTC amend its rules to exempt private funds and their advisers from registering with the CFTC if the advisers are subject to regulatory oversight by the SEC; and (iii) that either the CFTC or the SEC take sole regulatory responsibility for “de facto commodity pools.” Improved coordination between the CFTC and SEC will undoubtedly provide relief to investment companies and advisers by reducing unnecessary compliance burdens arising from duplicative disclosure requirements. As several former SEC officials and I have argued, there is no evidence that the CFTC’s 2012 rule change requiring dual registration benefited investors. Rather, its “significant” costs are “inevitably be passed along to shareholders,” as duplicative registration reduces the ability of mutual funds to “implement the most efficient and beneficial investment strategies” for investors.
- Modernizing delivery of fund disclosures. Treasury should be highly commended for recommending that the SEC finalize its proposed rule to modernize its mutual fund shareholder report disclosure requirements and permit the use of implied consent for electronic disclosures (via websites). The same can be said for Treasury’s recommendation that the SEC explore other areas for which electronic delivery of information to investors using implied consent would be appropriate. By allowing the default disclosure mechanism to be electronic delivery, the SEC would save investors millions of dollars. The current outdated system, which mandates paper disclosure, imposes costs directly on fund shareholders that amount to an estimated $340 million per annum. The benefits, on the other hand, are enjoyed largely by a few companies that benefit from the printing and distribution of paper disclosures. This situation of diffused costs and concentrated benefits has led inevitably to cronyist behavior, including a virtual monopoly over distribution, which has to date successfully hampered prior SEC efforts to modernize fund disclosures.
- Asset management reporting and disclosure requirements. Treasury appropriately recommends that the SEC, the CFTC, and other regulators work together to rationalize and harmonize the various reporting regimes, including, where possible, eliminating duplicative forms and unnecessary data collection. This recommendation goes straight to the President’s Core Principle of improving the efficiency of the regulatory process. One of the most efficient ways to satisfy that principle would be to streamline the reporting requirements for funds and their advisers. This would be achieved by combining duplicative forms, and remediating and eliminating unnecessary or inconsistent data collection.
- Volcker Rule. The misguided Volcker Rule created by Dodd-Frank places restrictions on proprietary trading by banking entities and certain types of funds associated with banking entities. The rule is complicated, costly to follow and enforce, shaky in its foundation, harmful to market liquidity, and worthy of being scrapped. It is good to see, therefore, that Treasury recommends that for the time being regulators forbear from enforcing the Volcker Rule against some funds. It is disappointing that Treasury does not recommend that Congress repeal the Volcker Rule. The Treasury Report merely recommends that the rule’s scope be amended to apply to fewer types of banking entities. Because the costs imposed by the 1080-page rule affect the American financial sector as a whole, fixes to address the rule must take into consideration the sector in its entirety. The Volker Rule’s restrictions on trading activities have harmed the U.S. economy by reducing liquidity in the corporate bond market and other financial markets, impeding the competitiveness of American banks compared to foreign competitors, and increasing the cost of borrowing for companies and consumers.
- Economic growth and informed choices. Kudos to Treasury for recommending that the Department of Labor (“DOL”): (i) “delay full implementation of the Fiduciary Rule until the relevant issues, including the costs of the rule and exemptions, are evaluated”; and (ii) include the SEC and other regulators in any renewed assessment of the Fiduciary Rule. As I discussed in an op-ed in The Hill earlier this year, the Obama DOL’s rulemaking process leading to the Fiduciary Rule was terribly flawed. The DOL aggressively thwarted the SEC’s participation in the rule’s design, allowing the DOL to roll out a cost-benefit analysis containing obvious errors of both understated costs and overstated benefits.