As we mentioned in our "Link of the Day" Friday, U.S. S.E.C. Commissioner Daniel Gallagher recently issued a "Comment Letter on the OFR Asset Management and Financial Stability Report" ahead of Monday's "FSOC Public Conference on Asset Management." Today, we excerpt more extensively from Gallagher's letter. He says in his comment letter (available at http://www.sec.gov/comments/am-1/am1-52.pdf), "It is my hope that my comments will prove useful to the discussion at the conference on the asset management industry and its activities to be held by the Financial Stability Oversight Council on May 19, 2014... To be clear, like FSOC, despite its broad remit encompassing by its own terms the entire field of "financial sector policies," the FSB and its agenda are dominated by banking regulators and appear to be guided by the principle that regulations designed for banks should be applied as widely as possible. What's good for the goose is good for the gander, they believe -- but the gander has had enough of this power grab, and is calling for an honest debate on these issues."
Gallagher continues, "The FSOC and FSB initiatives are pure-and dangerous-folly. Applying bank regulatory principles to capital markets regulation is a fatally misguided approach, the regulatory equivalent of trying to jam a square peg into a round hole. Bank regulators should resist their apparently innate urge to regulate asset managers -- and, for that matter, all other non-bank entities -- like banks. Forcibly imposing bank-like regulation on these capital market participants will negatively impact the U.S. economy and work to the detriment of the investing public while doing nothing at all to protect taxpayers or investors."
He tells us, "I appreciate the concept of an entity tasked with playing a coordinating and information sharing role. FSOC, however, emerged from the final legislation with unprecedented and extraordinary regulatory powers, in particular the authority to subject non-bank financial institutions to prudential regulation by the Federal Reserve if such institutions are deemed to pose a threat to the financial stability of the U.S. economy, and to make a "recommendation" that an independent agency engage in a particular rulemaking. FSOC soon showed it had no hesitation to exercise this power, as the SEC learned with respect to the regulation of money market mutual funds. In November 2012, the members of FSOC voted unanimously to propose for public comment "Proposed Recommendations Regarding Money Market Mutual Fund Reform," a proposal that, if adopted, would allow FSOC to issue a formal "recommendation" to the SEC."
Gallagher comments, "The example of money market mutual funds, the subject of FSOC's proposed "recommendation" to the SEC, provides a useful illustration. These funds were created in the early 1970s as a response to the prohibition on paying interest on demand deposit accounts at U.S. banks and have been regulated by the SEC ever since. Over time, these funds grew to the point where they represented a significant alternative to banking products -- and a constant thorn in the side of the bank regulators unable to extend their jurisdiction to include this so-called "shadow banking" alternative. Having proven its ability and willingness to take steps to impose its "recommendations" upon purportedly independent agencies, last year FSOC commenced a review of the activities of asset management firms to determine whether such firms should be designated as SIFIs and therefore subject to enhanced prudential standards and supervision. In connection with this review, FSOC asked the Treasury-based OFR to perform an analysis of the asset management industry, including its vulnerability to financial shocks and the potential risks it poses to the financial markets."
He continues, "In September 2013, OFR released its findings in the OFR Report, a document riddled with fundamentally flawed conclusions that were the inevitable result of the deeply unsound process followed by OFR in its performing its analysis. Not only does the OFR Report inaccurately define and describe the activities and participants in the asset management business, it makes matters worse by analyzing the purported risks posed by asset managers in a vacuum instead of in the context of the broader financial markets. It offers up speculative conclusions of systemic risk without any reference to the data used to support them -- unsurprising, given that clearly, little if any data was actually considered -- and without any reasoned policy arguments about how to address them. The end product was a botched analysis that grossly overstates indeed, in many cases simply invents without supporting data -- the potential risks to the stability of our financial markets posed by asset management firms."
Gallagher adds, "Exponentially compounding the mistakes of fact and poor substantive analysis contained in the OFR Report was OFR's brazen refusal to consider the comments and input of experts from the SEC, the very agency charged by Congress with regulating asset managers. The Commission has had regulatory authority for over seventy years to oversee the asset management industry, yet the comments of SEC staff -- many of which were meant to correct or clarify plainly inaccurate statements and non-sequiturs -- fell on deaf ears. As members of Congress aptly noted in a recent letter to Treasury Secretary Lew, thanks to the cavalier attitude of the OFR Report's authors, the SEC staff "left little more than fingerprints, while their attempts to substantively improve the final product were summarily rejected.""
He writes, "In a letter sent to Congress on May 14, 2014, the Treasury Department argued that OFR had, indeed, consulted extensively with the SEC on its report, and cited numerous emails and staff meetings to support the claim. Being an outsider to all things FSOC, and certainly never having received any of the cited emails or participated in any of the referenced meetings, I will not wade into this suddenly lively factual dispute. I am compelled, however, to point out one fact that I found astonishing. Apparently, even the Treasury Department, the Secretary of which is the Chairman of FSOC, does not understand the membership structure of FSOC. The letter repeatedly cites to "member agencies," of which there are none. Anyone who has paid any attention to the flawed construct of FSOC knows that its membership consists only of the chairpersons, directors, and secretaries of selected federal entities. With respect to the independent agencies, the "agencies" are not members, and therefore non-chairperson presidential appointees to those entities such as myself and my fellow Commissioners at the SEC do not belong to the club. This is not just semantics -- as FSOC painfully learned in the context of money market funds, an "agency" isn't really involved in a matter unless all of the presidential appointees are. A chairperson and selected staffers do not an agency make."
Gallagher continues, "Having been warned that my comments would not be considered, as well as having experienced FSOC's blatant and complete disregard for any input whatsoever from the primary regulator during the money market mutual funds debate, I declined to grasp at straws in the unrealistic hope of leaving even my "fingerprints" on the OFR Report. That the presidentially appointed Commissioners of the agency responsible for regulating the asset management industry were not afforded a meaningful opportunity to comment on the report is strong evidence that, as the same members of Congress observed in their letter to Secretary Lew, "OFR produced the report as simply a pretext for further action to designate asset managers as systemically important, and not as an unbiased and objective review of the industry.""
He adds, "In short, the OFR Report completely failed to provide a legitimate rationale for systemic risk designation. I am sure that its myriad inaccuracies and unsupported conclusions would make excellent fodder for the litigation that would be sure to follow any decision to designate asset managers as SIFIs. Nevertheless, it appears that FSOC is intent on marching forward with its analysis. While I appreciate the efforts of FSOC to provide at least a veneer of willingness to consider outside input by holding a public conference on May 19th, it is nonetheless clear to me that the bank regulators riding herd over FSOC have decided that neither the professional staff nor any non-Chair Commissioners of the SEC will be invited to the party. We can only pray that other voices of reason will step up and demand to be heard. In the meantime, I hereby register a vote of "NO" in the court of public opinion on the issue of whether to designate asset managers as SIFIs."
Gallagher's letter comments, "To make matters worse for investors and the U.S. economy as a whole, FSOC isn't the only player with its thumb on the scale in the world of SIFI designations. FSOC carries out its self-appointed missions in the shadow of the FSB, an international body created in 2009 in the wake of the financial crisis ostensibly to make recommendations about the global financial system. Dominated by European central bankers, the FSB includes representatives from all of the G-20 countries (including, notably given recent geopolitical events, Russia), the Financial Stability Forum, and the European Commission. Not surprisingly for an institution dominated by bank and non-U.S. regulators, the SEC, while nominally a member of the FSB, does not have a seat at the "grown-ups' table," and our voice is consistently ignored unless we are telling them what they want to hear."
He says, "In addition to the general folly of attempting to force bank regulatory principles upon the capital markets, there are a number of specific reasons why it defies reason to designate asset managers in particular as SIFIs and subject them to prudential regulation. First, and most importantly, the resolution process for asset managers is vastly simpler than those for most other types of financial institutions. Asset management is an agency activity.... Assets are held by custodians on behalf of clients, not by the asset managers themselves. As such, unlike banks, asset managers do not have balance sheet obligations that complicate the unwinding process.... There are no investor assets in danger of being consumed by an imploding balance sheet. There is -- to put it as simply as possible -- no need for a backstop or bailout. It is also crucial to understand that asset managers do not participate directly in the capital markets. Unlike banks (and some insurance companies), asset managers do not lend money or act as counterparties. Therefore, they have lean balance sheets that do not carry the potential systemic risk of other capital-heavy financial institutions."
Gallagher writes, "People deposit money in banks to avoid risk, in the form of a federally insured guarantee on their deposits. People invest with asset managers in the capital markets because they seek risk and the corresponding potential for a higher return on their investment. These two fundamentally different objectives simply cannot both be achieved under the same regulatory paradigm. In addition, the activities of asset managers already are highly regulated and subject to extensive public disclosure requirements. The Investment Advisers and Investment Company Acts provide an effective, overarching regulatory framework that protects investors from the risk. The existing regulatory regime recognizes that asset managers are participants in the capital markets and is appropriately tailored to address the risks inherent in that role."
He concludes, "FSOC is charged in the Dodd-Frank Act with the responsibility to identify risks to the financial stability of the United States, to promote market discipline, and to respond to emerging threats to the stability of the United States financial system. Unfortunately, like its alter ego the FSB, FSOC has pushed the outer limits and overstepped its bounds in defining the scope of its mandate. It is time to acknowledge that "systemically important" is bank regulator speak for "too big to fail" -- or, alternatively, "bailout eligible." FSOC and the FSB are, in essence, determining which financial entities must stay solvent under any conditions and applying a one size fits all regulatory paradigm in an attempt to make failure of those entities impossible. This is irrational and shortsighted, especially given the vastly different resolvability considerations attendant to the wind-down of agency actors such as asset managers as compared to banks and other financial institutions."
Finally, Gallagher tells us, "The decisions made by FSOC, a body that will almost always be comprised exclusively or almost exclusively of members of the same party led by a member of the President's cabinet, take place behind closed doors with no checks or balances in place to safeguard against overreaching, no appeals process, and no disinterested fact finder. These factors ensure that there is no mechanism in place to stop the blatant regulatory creep that is taking place before our eyes. It is high time we all acknowledge that the FSOC process itself is far more dangerous to our financial markets than the purported risk factors it was purportedly created to address. Once again, although I have no vote in FSOC, in the court of public opinion, I vote NO."
