Abstract

The recent financial crisis demonstrated that, contrary to longstanding regulatory assumptions, nonbank financial firms—such as investment banks and insurance companies—can propagate systemic risk throughout the financial system. After the crisis, policymakers in the United States and abroad developed two different strategies for dealing with nonbank systemic risk. The first strategy seeks to regulate individual nonbank entities that officials designate as being potentially systemically important. The second approach targets financial activities that could create systemic risk, irrespective of the types of firms that engage in those transactions. In the last several years, domestic and international policymakers have come to view these two strategies as substitutes, largely abandoning entity-based designations in favor of activities-based approaches. This Article argues that this trend is deeply misguided because entity- and activities-based approaches are complementary tools that are each essential for effectively regulating nonbank systemic risk. Eliminating an entity-based approach to nonbank systemic risk—either formally or through onerous procedural requirements—would expose the financial system to the same risks that it experienced in 2008 as a result of distress at nonbanks like AIG, Bear Stearns, and Lehman Brothers. This conclusion is especially salient in the United States, where jurisdictional fragmentation undermines the capacity of financial regulators to implement an effective activities-based approach. Significant reforms to the U.S. regulatory framework are necessary, therefore, before an activities-based approach can meaningfully complement domestic entity-based systemic risk regulation.

*. Assistant Professor of Business Law, University of Michigan Ross School of Business. Kress was previously an attorney in the Federal Reserve Board’s Legal Division.

†. Liberty Mutual Insurance Professor, Boston College Law School. McCoy founded the Mortgage Markets group at the Consumer Financial Protection Bureau in 2011 and was responsible for mortgage policymaking at the Bureau.

‡. Fredrikson & Byron Professor of Law, University of Minnesota Law School. Schwarcz has testified before Congress on issues relating to entity-based nonbank designations on six different occasions, and he was one of four academic participants in the Presidential Memorandum Engagement Process for the 2017 United States Department of Treasury Report to the President on Financial Stability Oversight Council Designations. For helpful comments and suggestions, we thank Anat Admati, Hilary Allen, Michael Barr, Christopher Bruner, Gregg Gelzinis, Erik Gerding, Claire Hill, Michael Malloy, Heidi Mandanis Schooner, Steven Schwarcz, Art Wilmarth, David Zaring, and the audiences at presentations at The Wharton School, Tulane Law School, Center for International Governance Innovation, National Business Law Scholars Conference, Academy of Legal Studies in Business Annual Conference, Office of Financial Research—University of Michigan Annual Conference, and Villanova Workshop on Insurance and Contract Law. Thanks to Alexander Tibor for research assistance.

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