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A Republican judge's ruling threatens a key pillar of post-crisis financial regulation

André-Pierre du Plessy

Early this week, a federal district court judge handed down a ruling that — if it stands on appeal — could threaten one of the most fundamental pillars of post-crisis financial regulation in the United States.

MetLife, one of the largest insurance companies in America, had been designated as a "systemically significant financial institution" in need of heightened regulatory scrutiny, but now the court says it's off the hook.

That's big news. But even if the decision is overturned on appeal, which seems likely, what's really important is the fact that it was made in the first place. The decision underscores the extent to which the whole idea that the Great Crash of 2007 to 2008 proved the need for stricter regulation of the financial sector remains a deeply controversial subject in American partisan politics.

The divide within the Democratic Party between the Obama/Clinton school of thought on bank regulation and the Sanders/Warren wing has gotten more attention. But important as this dispute is, it's small compared with the gap between the Obama administration on the one hand and the financial sector's true political allies in the GOP and among a minority of moderate congressional Democrats.

This conservative opposition to Obama-era regulatory activism continues to exert political influence through Congress and the courts, and could largely unwind everything that's been done since the crisis if it takes the White House.

Why Dodd-Frank regulates insurance companies

One of several things we learned during the financial crisis is that major risks to the banking system of the United States can emerge from companies that are not formally banks. Many banks, for example, had sought to reduce their exposure to risk by entering into deals with AIG.

AIG was an insurance company, not a bank, and thus was regulated primarily by state insurance regulators rather than by federal bank regulators.

Insurance regulators primarily perform a consumer protection function, seeking to prevent companies from improperly denying claims, rather than a broad financial stability function. Consequently, there was in effect nobody minding the store with regard to AIG's exposure to risk.

That exposure turned out to be considerable, and AIG was pushed into bankruptcy by rising foreclosure rates. That, in turn, meant that AIG could not pay off the insurance contracts it had entered into with major banks. That meant that banks whose balance sheets looked sound on the theory that they had insurance with AIG were, in fact, going to fail.

The problem was solved with a hasty ad hoc federal takeover of AIG, which allowed the federal government to pay off AIG's debts and offer a kind of backdoor bailout to the banking system.

MetLife versus Financial Stability Oversight Council, explained

To prevent this in the future, the Dodd-Frank financial regulation overhaul allows a broad council of American financial regulators — the Financial Stability Oversight Council — to designate a financial company as systemically significant whether or not it is technically a bank, and subject it to federal financial stability regulation.

MetLife was one of several companies designated under this process, and it sued in federal court to get the designation undone.

On March 30, Judge Rosemary Collyer of the US District Court for the District of Columbia, a George W. Bush appointee, ruled that the designation was arbitrary and capricious and must be lifted. MetLife's stock soared on the announcement. Then on Thursday the court finally released the text of the judge's reasoning, prompting an unusual fiery counter-statement from Treasury Secretary Jack Lew and vows to appeal the decision.

Treasury officials are reasonably confident that they will win the case in the end. Seven of the 11 judges on the relevant appeals court were appointed by Democrats, and the Supreme Court is split 4-4 and unlikely to reverse an appeals court. But Collyer's logic, if it holds, would dangerously undermine the main goals of post-crisis regulation of large nonbank entities.

Treasury's case against Judge Collyer

The Treasury Department sees two big flaws in Collyer's reasoning.

First, she deemed it "arbitrary and capricious" for the FSOC to designate MetLife as systematically significant without identifying the likelihood of MetLife finding itself in distress. To the FSOC this completely misunderstands the purpose of designation.

Financial markets move quickly, and the regulatory process moves slowly — designation and designation-related litigation have played out on a calendar of years rather than months — so the FSOC cannot begin the designation process when problems become apparent. AIG was genuinely in perfectly sound financial shape 12 months before it went bust. There were mere months between its bad news earnings conference call at the end of the second quarter of 2008 and its intense liquidity crisis in September.

Second — and tellingly — Collyer charges that the FSOC failed to apply the standards of formal regulatory cost-benefit analysis to the designation. It is true that they didn't do this. They didn't do it because the statute does not require it, and financial reformers feel the cost-benefit analysis process is inappropriate to situations where the benefit is macroeconomic stability rather than injuries to a finite set of people or property. There is an ongoing legislative push by congressional Republicans and some moderate Democrats to change the law to require cost-benefit analysis, but this merely shows that the current law does not in fact call for this.

This is the big financial reform debate

Many pixels have been spilled over the argument between the dominant Obama/Clinton faction of the Democratic Party and the insurgent Warren/Sanders faction on the question of breaking up large financial institutions. This is a significant and interesting debate that echoes historic arguments between progressives and populists of about a century ago.

The question is essentially whether it's better to create a technocratically manageable finite problem set in which a small number of big institutions are stringently regulated, or if we should be more fundamentally suspicious of concentrated economic and political power and smash up the institutions into little ones that are less individually significant.

But the gap between these positions, while real, is small compared with the gap between either of them and the third view — summed by the impulse to apply cost-benefit scrutiny to prudential financial regulation — which is that no additional regulatory scrutiny is needed. This view, which dominates the Republican Party, holds that the crisis was somehow caused by federal affordable housing programs and the American economy has been crippled for years by excessive regulation of the financial sector.

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