SEC Commissioner Gallagher Submits Comment Letter in Opposition to FSOC Process

SEC Commissioner Gallagher issued a comment letter criticizing the authority of the Financial Stability Oversight Council (“FSOC”) to designate nonbank entities as systemically important financial institutions (“SIFIs”). Commissioner Gallagher stated that although the SEC does not have a formal role in “FSOC’s misguided debate” over whether or not to designate asset managers as SIFIs, he called on regulators and market participants to engage in an “honest debate” regarding FSOC initiatives.

Commissioner Gallagher criticized the recent OFR Asset Management and Financial Stability Report, which found that asset management firms pose substantial risk to financial markets.  The report, he explained, inaccurately defines and describes the activities of participants in the asset management business by analyzing asset managers in a vacuum instead of in the context of broader financial markets.  In addition to the “myriad” inaccuracies and unsupported analyses contained in the report, Commissioner Gallagher stated that problems are compounded by the OFR’s “brazen refusal” to consider the comments and input from the SEC and other agencies tasked with regulating nonbank entities. He noted that litigation will surely follow any decision by FSOC to designate asset managers as SIFIs.

Commissioner Gallagher went on to say that it is “folly” to force bank regulatory principles upon capital markets since the resolution process for asset managers is vastly simpler than that of most other types of financial institutions.  He explained that asset management firms do not require a backstop or bailout because they are designed to manage risk and the potential for failure by providing enough of a cushion to ensure that a failed asset manager can liquidate in an orderly manner, allowing for the transfer of customer assets to another asset manager.

Commissioner Gallagher called the FSOC’s policy to apply a one-size-fits-all regulatory paradigm to all financial institutions “irrational” and “shortsighted” for not considering the different nature of financial entities.  He stated that the FSOC process itself is more dangerous to financial markets “than the purported risk factors it was purportedly created to address.”

Lofchie Comment:  The suggestion that asset managers could be determined to be systemically significant has been subject to broad and harsh criticism given that asset managers do not themselves own a material amount of assets. The stated justification for OFR’s surprising conclusion sheds light on the direction that OFR might take if it were to have the authority to regulate asset managers as SIFIs. The paragraph below is illustrative:

“[E]ngagement by a significant number of asset managers in riskier activities, could pose, amplify, or transmit a threat to the financial system. These threats may be particularly acute when a small number of firms dominate a particular activity or fund offering. . . .  Activities aimed at boosting returns through leverage, such as the use of derivatives, reliance on borrowing, or other means discussed below, could contribute to system-wide leverage and risk transfer.  (at page 7 of the OFR Report)

The direction of the OFR Report is undeniable.  While it does not say so directly, in light of the “risk” identified, the Report suggests that the government could regulate the investment allocation decisions made by investment advisers on behalf of private entities. This would seem an extraordinary power for the federal government to assert.  Query: should the government be allowed to regulate the investment decisions made by private entities, including perhaps allocating to particular advisers/entities the share of a “particular activity” in which they were permitted to engage? Such a possibility should raise concern.

See: Comment Letter; OFR Asset Management and Financial Stability Report.
See also: House Financial Services Subcommittee Chairmen Send Letter to FSB and FSOC Requesting Information on Methodologies Used to Designate G-SIFIs (May 12, 2014); FSOC Issues 2014 Annual Report (May 9, 2014); House Financial Services Committee Chairman Hensarling Urges Secretary Lew to Cease Using “Too Big to Fail” Designations (May 9, 2014).