Statement of CFTC Chairman Heath P. Tarbert on the New Activities-Based Approach to Systemic Risk
December 6, 2019
The Financial Stability Oversight Council (“FSOC”) has approved interpretive guidance (“Guidance”) on the designation of non-bank financial companies as systemically important financial institutions (“SIFIs”). I was pleased to vote for the Guidance for two reasons: because of what it does, and because of what it does not do.
The Guidance sets forth the activities-based approach that the FSOC intends to prioritize in addressing risks to financial stability. Under this approach, the FSOC will actively monitor financial markets to identify activities that could pose risks to U.S. financial stability. The FSOC will then work closely with the relevant financial regulatory agencies to mitigate any such risks.
Until now, the FSOC has focused on entity-based—rather than activities-based—systemic risk determinations. In its formative years, this approach made sense. The U.S. Government had recently bailed out several large, non-bank financial institutions. American taxpayers had borne the downside risk but none of the upside enjoyed by those firms.
But now we face new challenges. It is an axiom of financial markets that products move to the path of least regulation. A singular focus on particular entities inevitably leads to a “whack-a-mole” scenario in which risky activities are transferred out of highly-regulated entities and into less-regulated ones. In short, an approach that focuses solely on entity-by-entity designations virtually guarantees the FSOC will fail in its important mission to identify and mitigate threats to U.S. financial stability.
Although the 2008 financial crisis demonstrated the usefulness of entity-based designations, it also revealed a more acute need for an activities-based regulatory approach to systemic risk. Widespread loan issuance and securitization without adequate incentives for proper underwriting provides one example. Highly relevant to my own agency was the lack of margin held on over-the-counter (“OTC”) swaps—including swaps providing credit protection for the securitized loans I just mentioned. Indeed, a firm such as AIG would likely not have presented a systemic risk if it had held sufficient initial and variation margin at a third-party custodian. The futures markets experienced none of the dislocation that concurrently occurred in the OTC swaps markets, as futures trading activity was then subject to a comprehensive regulatory regime, including central clearing and minimum margin requirements.
Recognizing this, the Dodd-Frank Act swaps reforms that addressed systemic risk were largely activities-based rather than entity-based. Title VII of the Act required on-platform trading, clearing and/or margin, and transaction reporting for various categories of swaps-trading activity. In addition, Title VIII of the Act recognized the importance of employing activities-based designations alongside entity-based designations, specifically charging the FSOC to identify as systemically important “financial market utility” entities as well as “payment, clearing, or settlement activities.”
The Guidance reflects not only a consensus among FSOC members, but also an international consensus in favor of an activities-based approach to systemic risk. The Financial Stability Board (“FSB”), International Organization of Securities Commissions (“IOSCO”), and International Association of Insurance Supervisors (“IAIS”) have prioritized activities-based regulatory approaches in the insurance and asset management sectors. Like the Guidance, international approaches initially focus on activities-based policy recommendations but will ultimately address any residual entity-based sources of systemic risk, to the extent that such risks “cannot be effectively addressed by market-wide activities-based policies.”
This brings me to what the Guidance does not do. The Guidance does not eliminate entity-based designations. If it did, I would have voted against it. The FSOC’s power to designate non-banks as SIFIs will remain an important backstop for addressing systemic risk. Contrary to concerns voiced about the Guidance, the systemic risk analysis will not “always end” after an assessment of activity risk. Nor does the Guidance constitute a “doctrinal commitment that no non-bank intermediary can ever be ‘systemic.’” If an activities-based approach is inadequate to address the risk posed by a particular institution, then the option of SIFI designation remains fully available.
Too often in Washington, common sense does not translate into common practice. That disconnect has led to American taxpayers bearing a heavy financial burden. I therefore support the Guidance, which allows the FSOC to focus first on potential systemic risks of activities that span financial sectors, while also considering the risk posed by individual institutions.
 See, e.g., Anupam Chander & Randall Costa, Clearing Credit Default Swaps: A Case Study in Global Legal Convergence, 10 Chicago J. of Int’l Law 639, 649-50 (2010) (“Had AIG faced this margin discipline, it might not have taken on excess risk, and its counterparties would have suffered far lower losses even if AIG did default, since they would have been current through variation margin and would have had the buffer of initial margin while resolving their open positions.”).
 See, e.g., id. at 655-56; National Futures Association, Annual Report 3 (2009).
 See, e.g., Jeremy C. Kress, Patricia A. McCoy, & Daniel Schwarcz, Activities Are Not Enough! Why Non-Bank SIFI Designations Are Essential to Prevent Systemic Risk, Boston College Law School Legal Studies Research Paper No. 492 (Oct. 2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3264164 (“[M]any types of U.S. financial regulations are organized around activities, rather than firms. For instance, Dodd-Frank’s derivatives reforms generally target the activity of derivatives trading, not the entities that conduct this trading.”).
 12 U.S.C. § 5463(a)(1) (emphasis added).
 See, e.g., FSB, Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities (Jan. 2017); IAIS, Holistic Framework for the Assessment and Mitigation of Systemic Risk in the Insurance Sector (Nov. 2019); IOSCO, Recommendations for Liquidity Risk Management for Collective Investment Schemes (Feb. 2018).
 FSB, Next Steps on the NBNI G-SIFI Assessment Methodologies (July 2015).
 Systemic Risk Council, Comment Re: Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies (May 21, 2019).
 In fact, many contend two potential candidates for entity designation have been “hidden in plain sight” since the inception of the FSOC: Fannie Mae and Freddie Mac. See Peter J. Wallison, Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again (2015); see also Hearing Before the U.S. Senate Committee on Banking, Housing, and Urban Affairs: “Should Fannie Mae and Freddie Mac be Designated as Systemically Important Financial Institutions?” (June 25, 2019) (addressing whether the FSOC should designate Fannie Mae and Freddie Mac as SIFIs); Katy O’Donnell, POLITICO Pro Q&A: FHFA Director Mark Calabria, Politico (May 17, 2019) (quoting FHFA Director Mark Calabria: “I certainly think it’s appropriate for FSOC to deliberate on whether Fannie and Freddie should be designated. They’re large, important institutions that we’ve rescued once already, so I think that that’s a process that should happen.”); Alex J. Pollock, Time to Reform Fannie and Freddie is Now, American Banker (Dec. 29, 2017) (“If Fannie and Freddie are not SIFIs, then no one is a SIFI. They should be formally designated as such . . . .).
 While I support the Guidance, there is one analytical factor to which I will give less weight than the others in making an entity-based determination: “the likelihood of material financial distress at the company.” I believe the Dodd-Frank Act intended the FSOC to assess systemic risk under a baseline assumption of material financial distress. And as the preamble to the Guidance observes, many commenters noted that it is difficult to predict financial distress at an entity, particularly if caused by a broader financial crisis. I am also concerned that the FSOC’s determination that a company is likely to experience material financial distress could publicly raise questions regarding the company’s health. This public signal of concern could itself harm the company, creating a self-fulfilling prophecy. I therefore think this factor is best considered when imposing any relevant regulatory or supervisory measures upon the entity’s designation.