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From Securities Regulation Daily, April 10, 2015

Gallagher warns of power grab by prudential regulators

By Jacquelyn Lumb

Commissioner Daniel Gallagher today spoke to the University of Virginia’s School of Law about what he sees as a misguided quest to apply prudential regulation to asset managers. He explained that the asset management industry has become a target of prudential regulators and policymakers, both of which want to subject the “shadow banking” markets, of which the asset management industry is a significant part, to bank-like regulation.  Gallagher asserted that it will take both bold leadership and a dose of regulatory rationality to prevent this from happening.

Gallagher believes that prudential regulators are attempting to impose bank-like regulation on the capital markets based on a false narrative about the causes of the financial crisis. This narrative suggests that the SEC and other capital market regulators failed and that the capital market participants were a major cause of the financial crisis. Gallagher said this view overlooks the failed banks, the taxpayer dollars that propped up the too-big-to-fail commercial banks, and the failed federal housing policy that actually caused the financial crisis.

FSOC and FSB. The U.S. Financial Stability Oversight Council (FSOC) and the Basel-based Financial Stability Board (FSB) are the worst offenders, according to Gallagher. He said they have been seeking to designate asset managers or their activities as systemically important, which would subject them to the oversight of the Federal Reserve Board and other prudential regulators. The Fed, he noted, is the implementation arm of FSOC and chair of the FSB shadow banking workstreams.

Gallagher sees these designation attempts as a play for regulatory power and jurisdiction over a broad swath of the U.S. economy. They do not see the peril in reshaping the U.S. markets to resemble those of Europe, he advised.

Gallagher related the history of the emergence of FSOC since the enactment of the Dodd-Frank Act. He said its most pernicious power is the authority to subject non-bank financial institutions to prudential regulation by the Fed if they are deemed a threat to the financial stability of the U.S. economy. FSOC showed its willingness to impose its will on an independent regulator when it jumped into the debate about money market mutual fund regulation, he said, which fortunately did not advance to the adoption stage.

Asset management industry. Since then, FSOC has focused on whether certain asset management firms should be designated as systemically important financial institutions (SIFIs), and thereby be subject to enhanced prudential standards and supervision. Gallagher talked about what he characterized as the fatally flawed report by the Treasury’s Office of Financial Research (OFR) which inaccurately defined and described the activities and participants in the asset management business. The report grossly overstated the potential risks to the stability of the financial markets, he said. He also noted that OFR refused to consider the comments and input from the experts at the SEC, which has overseen the industry for 75 years.

Threat to capital markets. The FSB is engaged in a similar assault on non-bank financial service companies, according to Gallagher. He pointed out that European FSB members have a disproportionate influence on the Board. He said the FSB and IOSCO have also issued flawed consultation reports which use concepts with little relevance outside of the banking sector. He believes that the FSB has tailored its work to legitimize the FSOC’s efforts to import prudential regulation to the U.S. capital markets through the designation of non-banking entities as SIFIs. Gallagher noted that while the FSB is trying to force the prudential, bank regulatory construct into the capital markets, most of the European members have no capital markets to worry about.

The FSB chair has indicated that FSB’s edicts are binding on its members, but Gallagher said there is no basis in law for the FSB’s decisions to be binding on U.S. regulators. However, he pointed to FSOC’s symbiotic relationship with the FSB in which it supports FSB’s actions on the international stage and then uses those actions to justify regulation at home. This sets a dangerous precedent, Gallagher warned. It not only places unfair burdens on participants in the U.S. capital markets but also threatens the integrity of the U.S. constitutional system of government, in his view.

Gallagher said that since the passage of the Dodd-Frank Act, the government’s approach to financial regulation has been neither wise nor frugal, as espoused by Thomas Jefferson. Participants in the capital markets have not been free to regulate their own pursuits of industry and improvement, he said, and have been forced to pay far too much in regulatory costs.

Gallagher said the opaque decisions made by FSOC and FSB hide a blatant regulatory creep. In his view, the systemic risk designation process is far more dangerous to the financial markets than the purported risk factors it was created to address.

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