The SEC’s impasse over money market mutual fund reform may provide a test of some of the Financial Stability Oversight Council’s powers under Dodd-Frank. The FSOC has met to consider how to regulate the systemic risk posed by mutual funds. The FSOC, chaired by Treasury Secretary Geithner, has two options to try to jumpstart reform of a critical market that froze during the Panic of 2008.

Option 1: Declare Certain Large Funds as Systemically Significant

The first and more drastic action would be for the FSOC to use its powers to designate larger money market mutual funds as systemically significant under Section 113 of Dodd-Frank. This, in turn, would allow the Federal Reserve to regulate those institutions. Even the threat of losing power might be enough to spur the SEC to act (or convince Commissioner Aguilar to change his mind).

Wholesale designation of money-market mutual funds as per se systemically significant is not an option. When Dodd-Frank was passed, I heard some scholars talk about how Section 113 might be interpreted to allow for designation of an entire category of financial institution. That is not how the FSOC interpreted the statute when it promulgated regulations governing its process for designating non-banks as systemically significant. The FSOC Final Rules set a three stage procedure for determining when individual firms are systemically significant. At the first stage, the FSOC will only consider if a nonbank is systemically significant if it has $50 billion in total consolidated assets and meets one of five other quantitative thresholds (which range from notional value of credit default swaps in which the nonbank is the reference entity to a leverage ratio).

These thresholds – and the firm-by-firm approach generally – restrict the scope of the FSOC’s power considerably. An individual money market mutual fund would have to be both large enough and pose systemic concerns on its own to trigger a systemic designation. It is unclear whether designating only the largest money market funds – even if designation is actually accomplished – would achieve enough in terms of reducing the systemic threat of runs on money market funds as a class.

Indeed, the collective systemic risk of money market mutual funds would not allow the FSOC to act with respect to the entire industry. The too-big-to-fail concern may have overshadowed other problems like “too-correlated-to-fail” and the problems of herd behavior affecting financial firms. Many small non-banks can pose just as great dangers in terms of liquidity and solvency crises as one behemoth. But herd behavior does not elicit the same kind of visceral reaction as “bigness.”

Thus far, FSOC has not used its Section 113 power. (A number of large banks were automatically deemed systemically important under Dodd-Frank by virtue of their size. In July, FSOC designated several financial market utilities (think clearing companies) as systemically significant under Section 804 of Dodd-Frank.)  However, the FSOC's latest minutes indicate that the council is proceeding to the third and final stage with respect to a number of non-bank financial companies. 

Option 2: Issue Recommendations

Alternatively, FSOC could issue an official but a recommendation to the SEC. Dodd-Frank gave the FSOC the power to issue recommendations to financial regulatory agencies “to apply new or heightened standards and safeguards for financial activities or practices that could create or increase risks of significant liquidity, credit, or other problems spreading” among bank holding companies, nonbanks, and financial markets. (Dodd-Frank Section 112(a)(2)(K)); see also Section 120).  

Personally, I have been skeptical about how much punch this recommendation power packs. Dodd-Frank provides that the agency "shall impose the standards recommended" but can also decline to follow the recommendation. (Dodd-Frank Section 120 (c)(2)).  It is less clear what happens if the receiving agency does not "determine" that it will not follow the recommendation, but is instead deadlocked.  

At conferences, my colleagues at other schools have been more exuberant about the ability of recommendations to shape agency behavior. The money market mutual fund case will provide a test. Would an FSOC recommendation carry enough policy heft, moral suasion, political cover, and potential for embarrassment to cause the SEC (including Commissioner Aguilar) to change course?

(A recommendation from the FSOC might also help the SEC with the cost-benefit hurdle in the DC Circuit).

High Stakes

Both options carry considerable risk for the FSOC. What happens is the FSOC begins either the systemic designation or recommendation process and fails to get enough votes in the council? What would happen if the FSOC tries the systemic designation route, but suffers a loss in the appeals process in Federal court?  The recommendation path also poses dangers for the council: what would happen if the SEC declines the recommendation?

The first time for anything means considerable risk. However the FSOC acts, it will set a political and reputational -- if not a legal -- precedent.  At the same time, not acting sets a mighty precedent too.

This likely explains why many senior regulators have publicly pushed the SEC to act.

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