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See also: “Fact Sheet: A Stronger Regulatory Framework for Shadow Banks” by Gregg Gelzinis

One of the many painful lessons of the 2007–2008 financial crash was that financial institutions outside of the traditional banking system could pose a devastating risk to financial stability. The failure or near failure of nonbank financial companies, including insurance company American International Group (AIG), investment bank Lehman Brothers, and finance company General Electric (GE) Capital, severely aggravated the crisis. Lehman Brothers’ catastrophic bankruptcy in September 2008 was one of the darkest moments of the crisis. The very next day, a teetering AIG was bailed out by taxpayers. These so-called shadow banks engaged in fragile bank-like activities and posed bank-like risks but faced significantly lighter regulatory safeguards than banks—which themselves were drastically underregulated. The crisis clearly and unequivocally showed that “too big to fail” was not only a banking problem but something that also applied to the failure of large, complex, and interconnected shadow banks. Policymakers could no longer doubt that the collapse of systemic nonbank financial companies could threaten the stability of the financial system and tear at the fabric of the economy.

Moreover, financial regulators with differing, and in some cases, overlapping jurisdictions were too siloed and as a consequence did not adequately communicate with one another. They instead focused on their respective pieces of the financial sector and were blind to risks that developed across jurisdictions or outside of any one regulator’s jurisdiction. No regulator or regulatory body was given the mandate to identify and address risks to the financial system as a whole. Some financial regulators did not, and still do not, even consider financial stability—in other words, promoting the normal functioning of the financial system to serve the economy—to be part of their mission.

A financial crisis is particularly dangerous because its impact extends beyond the financial system to harm the broader economy and, in particular, everyday Americans. Households, workers, and savers paid the price for this flawed regulatory regime. Unemployment shot up to 10 percent, 10 million homes were lost to foreclosure, and nearly $20 trillion in household wealth disappeared.¹ The real wealth of the average middle-class family shrank from 2007 to 2010, decreasing by nearly $100,000, or 52 percent.² The Federal Reserve Bank of San Francisco estimates that the financial crisis cost every American $70,000 in lost lifetime income.³ While topline economic indicators have recovered in the intervening years, the scars of the crisis remain and are seared into the memories of every American who lost a home, a job, or savings in the crash. And many families are not close to fully recovering economically.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 sought to address the many shortcomings in financial regulation, including some but not all of the gaps in shadow banking regulation and systemic risk oversight.⁴ The bill brought the derivatives markets out of the shadows, created new registration requirements for hedge funds and private equity firms, established a federal office to monitor the insurance industry and to negotiate international insurance agreements, created executive compensation restrictions for financial firms, and granted regulators the authority to wind down systemically important nonbanks in an orderly fashion—just to name a few. The central shadow bank and systemic-risk-related element of the bill, however, brought the disparate financial regulators together in a new body—the Financial Stability Oversight Council (referred to in this report as “FSOC” or “council”)—which was designed to monitor and address risks to the financial system wherever they may arise. The FSOC has several clear statutory responsibilities and tools, including the powerful authority to subject a systemically risky shadow bank to consolidated supervision and enhanced regulatory safeguards.⁵ During the Obama administration, FSOC Chairman Tim Geithner and his successor Jack Lew used the council’s mandate and authorities to improve communication among regulators, analyze emerging financial stability threats and vulnerabilities, and meaningfully strengthen the resilience of the financial system. The FSOC was used, as intended, to limit the chances of another devastating financial crisis.

The Trump administration, in contrast, has rejected the FSOC’s mission and has worked to undermine its authorities in several ways. As a result, the financial system is more vulnerable to risk in the nonbank financial sector.

The FSOC was structured around a tacit view that regulators committed to the council’s mission would always be in place. The experience over the past two years of deregulation under Treasury Secretary Steven Mnuchin has blown a hole through that conception. Congress should respond in kind by revitalizing the FSOC and strengthening the regulation of the shadow banking sector. It is not enough to simply undo Secretary Mnuchin’s misguided deregulation. The FSOC’s central tools have an embedded bias against stringent regulation of systemic shadow banks and have proven vulnerable to conservative judges who are intent on defanging regulatory authorities in favor of business interests. The council’s authorities should be reoriented toward protecting the economy from financial sector risks—and away from protecting the financial sector from prudent regulation. Moreover, the FSOC should be granted new authorities to tackle systemic risk in all of its forms. Essentially, the council’s design and authorities should be crafted to withstand a future deregulatory administration. If policymakers want to mitigate the economic boom, financial deregulation, and bust cycle, the FSOC has to be resilient to the political tides that drive financial deregulation.⁶

This report starts by outlining the lax oversight of nonbank financial companies and the systemic-risk regulatory gaps that existed before the 2007–2008 financial crisis. Next, the report charts the development of the FSOC after the crisis, its role and actions during the Obama administration, and the Trump administration’s efforts to erode the council. Finally, the report offers several paradigm-shifting proposals that would help prevent shadow banks from triggering another crisis.

Briefly, the proposals detailed in this report include:

Bolstering the FSOC’s shadow bank designation authority: Shadow banks that meet specific quantitative thresholds should be automatically subjected to enhanced supervision and regulation, tailored to their respective risk profiles. The FSOC should have the authority to de-designate firms on an individual basis if the council determines, after conducting a rigorous data-driven analysis, that material distress at the firm and the nature, scope, size, scale, concentration, interconnectedness, and/or mix of the activities at the firm would not threaten financial stability in a period of broader stress in the financial system. The public, however, should be granted legal standing to contest such de-designations.

Granting the FSOC authority over systemically risky activities: The FSOC should have direct rulemaking authority to regulate systemically risky activities across the financial sector. An activity’s primary regulator should supervise the implementation and ongoing compliance of the rules promulgated by the FSOC. If no one regulator has jurisdiction over the activity, the FSOC should determine the appropriate regulator to fulfill that supervisory role. The council should also have the authority to complete congressionally mandated rulemakings for which the primary regulator or regulators missed the deadline prescribed in statute.

Enhancing the FSOC’s institutional capacity: The council and the Office of Financial Research (OFR) should be given minimum staffing and budget floors. The floors should double the council’s budget and staffing and increase the OFR’s budget and staffing by about 50 percent, relative to Obama administration levels. The FSOC chair and OFR director should have discretion to set budget and staffing levels above such floors. The OFR director should no longer be required to consult with the treasury secretary on the agency’s budget and should be given additional authority to acquire and share regulatory data from and between FSOC members. 

Increasing the FSOC’s transparency: The council should be required to release transcripts of its meetings on a five-year time delay. The FSOC should be required to hold a public meeting and a press conference at least once per quarter. All voting members of the council should have to testify before Congress together annually on financial stability efforts, and they should have to either certify that their respective agencies are taking all reasonable steps to ensure financial stability and to mitigate systemic risk or detail the additional steps their agencies should take to do so.

Policies that would redesign the alphabet soup of financial regulators are important and worth advancing, but the perennial question of how best to streamline the current landscape of agencies falls outside the scope of this report. Given the immense institutional forces that work against reorganizing the array of agencies, beyond just the typical industry and political forces that oppose stronger regulation, it is crucial to also pursue policies that drastically improve the financial regulatory framework while building on the rails of the current architecture. The proposals outlined in this report would do just that for the regulation and supervision of the shadow banking sector.

While these proposals would substantially improve the safety and soundness of the financial system, it is worth stating clearly that targeting shadow banking risks alone is not enough. Congress and regulators must pursue policies that increase the stringency of regulations and restrictions on systemically important banks as well.⁷ Tighter banking regulations would both mitigate the ongoing risks posed by the core banking sector and further address the risks posed by the shadow banking sector, as the banking and shadow banking systems are deeply connected.

Improving the resiliency of the financial system and lowering the chances of another financial crisis through strong financial regulation is a pro-growth policy: It promotes long-term, sustainable economic growth. Workers, families, and savers would all benefit from tighter safeguards on the most systemically important financial institutions in this country.

Before the financial crisis, the dominant view among policymakers and academics was that only traditional commercial banks⁸ could pose systemic risk.⁹ Banking is an inherently fragile enterprise.¹⁰ Issuing liquid short-term liabilities—deposits—and investing in longer-term illiquid assets—loans—is tenuous.¹¹ Banks are also highly leveraged, meaning they utilize substantial levels of borrowing to fund their assets, leaving only a small cushion of equity to absorb potential losses.¹² This highly leveraged business model of liquidity and maturity transformation is prone to creditor runs and fire-sale dynamics.¹³ If short-term creditors pull their funds or refuse to roll over existing short-term debt, the bank must resort to selling its illiquid assets at fire-sale prices to generate cash quickly. The asset fire sales may erode the firm’s equity capital levels, increasing the incentive for more creditors to run as the firm is driven toward failure. These dynamics make banking a vulnerable business.

The failure of a bank directly affects the communities it serves. Bank failures lead to a reduction in the credit supply to businesses and households, which in turn depresses consumer spending and business investment.¹⁴ This disruption directly harms businesses, consumers, workers, and the economy.¹⁵ When a bank is large, complex, and deeply interconnected with the broader financial system, failure can be catastrophic not just for a local community but also for the entire U.S. economy.¹⁶ The fragile nature of the banking business model and its importance to the performance of the real economy necessitates the federal government’s role in ensuring the stability of the financial system. Taxpayers, through the Federal Deposit Insurance Corporation (FDIC), insure a share of bank deposits to limit the chances of depositor runs, and the Federal Reserve’s discount window provides solvent banks with emergency liquidity when needed.¹⁷ Accordingly, banks are more tightly regulated and supervised than typical commercial enterprises. Indeed, “free market” thinkers from Adam Smith to Milton Friedman recognized the need to regulate the banking sector to address its fragility and the dire consequences of bank failures on the economy. Banks face capital requirements, liquidity rules, risk-management requirements, supervision, and other rules to mitigate the chance of failure. Before the financial crisis, regulations on big banks were far too light. But there was at least an understanding that a bank could be systemically important, and a framework, albeit drastically underwhelming, was in place to mitigate such risks and deal with the failure of a commercial bank quickly to minimize economic harms.¹⁸

Nonbank financial companies can perform economic functions that are similar to those of traditional banks. They can provide credit to businesses and households, offer payment services, and manage risk. They also, at times, pose bank-like risks as well. Shadow banks may issue short-term money-like claims and engage in the type of maturity and liquidity transformation that makes banking so fragile. They may also employ substantial leverage, engage in complex financial activities, and be highly interconnected with the broader financial system. Before the financial crisis, however, the same type of regulatory scrutiny and safeguards that applied to banks were not in place for nonbank financial companies such as investment banks, insurance companies, finance companies, asset management firms, and hedge funds. Oversight of these shadow banks focused primarily on consumer, investor, and policyholder protection—not financial stability.¹⁹ Disclosure, registration, and fiduciary requirements were the central regulatory tools applied to such firms.²⁰ The lighter regulatory touch for nonbank financial firms was usually appropriate. The reasons differ by the specific type of nonbank, but generally speaking, policymakers assumed that the business models of nonbank financial firms were less vulnerable relative to banking, that the failure of such firms could pose less risk to the economy, and that the firms largely do not rely on explicit public support such as deposit insurance.

While these factors may hold true for many financial intermediaries, the crisis clearly showed that nonbank financial firms and activities can pose severe risks to the financial system and broader economy. Even though shadow banks had not caused wider stability issues before the crisis, there were some warning signs that policymakers should have taken more seriously. For example, the 1998 failure of Long-Term Capital Management (LTCM), a highly leveraged hedge fund, necessitated a private bailout orchestrated by the Federal Reserve Bank of New York to avoid destabilizing the financial system.²¹ Despite this warning sign, the shadow banking sector remained severely underregulated in the lead-up to the crisis.

Shadow banks helped spark the 2007–2008 crisis by originating subprime mortgages, packaging them into mortgage-backed securities, and distributing them throughout the financial system. They also exacerbated the crisis when creditors ran from the shadow banking sector, similar to old-fashioned depositor runs. The combination of size; interconnectedness with other financial firms; complexity of operations or assets; reliance on short-term funding and susceptibility to bank-like runs; leverage; and other factors made firms such as Lehman Brothers and AIG systemically important.²² In essence, “too big to fail” is not just a problem limited to traditional commercial banks. It is a problem with very large and complex financial institutions that pose systemic risks regardless of their specific corporate charter. The cases of AIG and Lehman Brothers are instructive.

The collapse of AIG

From 2000 to 2007, American International Group more than tripled in size, from $300 billion to more than $1 trillion in assets.²³ The international insurance conglomerate operated in more than 130 countries on the eve of the financial crisis and increasingly engaged in capital markets activities that were not central to the plain vanilla business of insurance.²⁴ AIG, like all insurance companies, was primarily regulated at the state level. State insurance regulators did not have adequate resources, expertise, authorities, and incentives to oversee a global financial conglomerate.²⁵ AIG’s holding company was lightly regulated at the federal level by the highly captured, and now-defunct, Office of Thrift Supervision.²⁶

AIG Financial Products (AIGFP), a London subsidiary, was heavily engaged in writing credit default swaps (CDS)—a type of over-the-counter derivative that provided purchasers protection against a security’s default—on subprime mortgage-backed securities.²⁷ This activity superficially resembled writing insurance but did not face the regulatory framework that came with writing bona fide insurance policies because AIGFP was not licensed as an insurance company, nor were the CDS treated as insurance policies for regulatory purposes. Moreover, the risks for insuring mortgage-backed securities were fundamentally more complex than the risks covered by traditional insurance. AIG’s activity both fed and fell victim to extreme risk-taking in complex financial markets. These credit default swaps enabled holders of mortgage-backed securities to hedge their risks and provided speculators a synthetic instrument to bet against the mortgage-backed securities. If the underlying mortgages remained healthy, AIG earned profits on the premiums it received for writing the CDS. Yet when the subprime mortgage market started to deteriorate, so too did AIG’s financial position. The company was required to start paying out on its CDS and as the housing market continued to worsen, AIG had to post additional collateral and margin against the declining value of the CDS positions.²⁸ This dynamic resembled a run on the institution as counterparties demanded more liquid assets, which further strained AIG’s finances because it only had so much cash on hand to meet these margin calls.

Moreover, AIG suffered substantial losses from its securities lending business.²⁹ AIG lent out the securities it held on its balance sheet in exchange for cash collateral from the borrower of the security. Instead of investing this cash collateral in safe, short-term assets such as Treasury securities, AIG invested it in supposedly safe—but actually illiquid and highly risky—mortgage-backed securities and other high-risk assets. When the security borrower returned the security, AIG had to return the cash collateral. Because the collateral was tied up in illiquid mortgage-backed securities that had lost value when the housing market collapsed, AIG took on losses and had to resort to fire sales to generate the cash. The securities borrowers often had the right to return the security to AIG and receive their cash at their own discretion.³⁰ So as AIG’s financial position deteriorated, more securities borrowers closed out their positions—again creating a bank-like run on the company. And no regulator was looking at these correlated risks.

It was clear at the beginning of September 2008 that AIG was going to fail and that its failure would transmit stress to its counterparties—other systemically important institutions—and throughout global financial markets. AIG was too big, interconnected, and complex to fail. On September 16, 2008, the Federal Reserve stepped in and provided the initial support that would end up constituting the largest bailout in U.S. history—$182 billion in taxpayer assistance.³¹ This case shows clearly that an underregulated shadow bank can threaten financial stability. AIG carefully structured its activities to fall within the gaps between regulatory silos.³² The result: extreme risk-taking involving financial products and activities that could join together the worst elements of a banking, real estate, and capital markets crisis.³³

Lehman Brothers’ failure

A day before the AIG bailout, Lehman Brothers—a $600 billion investment bank—filed for bankruptcy.³⁴ Lehman’s catastrophic failure sparked a full-fledged run on the global financial system.³⁵ Lehman’s business model and risk profile had distinct similarities to a traditional commercial bank, but it did not face the supervisory and regulatory framework that applied to such firms. Despite Lehman’s size, leverage, complexity, and interconnectedness—and the harm its failure could cause to the system—it was only lightly supervised by the U.S. Securities and Exchange Commission (SEC) through a weak voluntary program.³⁶ No regulator had the explicit authority or mandate to regulate investment banking holding companies.

The SEC, which regulated broker-dealers—a subsidiary of investment banking conglomerates—established a voluntary program for consolidated supervision and regulation of investment bank holding companies. The investment banking giants such as Lehman Brothers, Bear Stearns, and Goldman Sachs could opt in and opt out at their discretion. And those firms that did opt in faced wholly inadequate supervision and prudential regulatory safeguards. As SEC Chairman Chris Cox stated in 2008 when announcing the end of this regulatory framework, “The last six months have made it abundantly clear that voluntary regulation does not work.”³⁷ He went on to argue, “The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE [Consolidated Supervised Entities] program, and weakened its effectiveness.”³⁸ As with AIG, Lehman Brothers carefully designed its activities to fall within the gaps between effective regulatory regimes.

Lehman engaged in the type of leveraged maturity and liquidity transformation that makes banking such a fragile endeavor. The company funded long-term and illiquid positions in subprime mortgage-backed securities and commercial real estate investments with highly runnable short-term debt.³⁹ Much of this trading activity was proprietary, as Lehman traders placed outsize bets on the mortgage-backed securities and commercial real estate markets.⁴⁰ Before its collapse, Lehman relied on about $200 billion in overnight repurchase agreements—short-term collateralized loans—to fund its balance sheet.⁴¹ These repo transactions represented about one-third of Lehman’s overall funding, which left the firm in an extremely vulnerable position.

By 2007, Lehman was leveraged 30-to-1, meaning it had about $3 of loss-absorbing equity for every $100 of assets.⁴² The other $97 in assets were funded by debt. As the subprime housing market collapsed, Lehman’s assets lost value and creditors pulled their money from the firm by refusing to roll over short-term funding transactions.⁴³ Lehman was forced to sell off its illiquid assets at fire-sale prices to generate the cash needed to meet creditor demands. The company also faced liquidity pressures from its derivatives counterparties, who demanded increased margin and collateral. Lehman was highly interconnected with the broader financial system, in part due to its extensive derivatives operations. The firm held a staggering 900,000 derivatives positions across the globe.⁴⁴ The collapse in the value of its housing-related assets and the liquidity strain from the creditor run created a vicious cycle that drove Lehman into bankruptcy. Unlike the FDIC’s special authority to take over and wind down an insured bank in an orderly manner, no regulator had such authority for shadow bank failures.

Lehman’s bankruptcy filing set off a chain reaction of distress throughout the financial system. As Lehman spiraled, creditors looked at other investment banks with similar business models and fled—even if those institutions did not have significant direct exposure to Lehman Brothers. Experiencing similar duress, Merrill Lynch sold itself to Bank of America.⁴⁵ Both Goldman Sachs and Morgan Stanley became bank holding companies, in part to assure creditors that they would be better regulated and better supervised.⁴⁶