Introduction

On October 16, 2018, federal regulators released the largest U.S. insurance group, Prudential Financial, Inc., from enhanced government oversight. 1Open this footnote Close this footnote 1 Fin. Stability Oversight Council, Notice and Explanation of the Basis for the Financial Stability Oversight Council’s Rescission of Its Determination Regarding Prudential Financial, Inc. 2 (2018) [hereinafter Prudential De-Designation]. …Open this footnote Close Prudential had been the last remaining systemically important financial institution (SIFI)—a designation Congress created in the Dodd-Frank Act for nonbank financial companies that could threaten U.S. financial stability. 2Open this footnote Close this footnote 2 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 113, 124 Stat. 1376, 1398 (2010) (codified at 12 U.S.C. § 5323(a) (2017)). …Open this footnote Close By rescinding Prudential’s SIFI label, regulators signaled that Prudential no longer warrants the heightened capital, liquidity, and risk-management standards that accompany such a designation.

This Essay contends that the Trump Administration’s decision to overturn Prudential’s SIFI label was deeply misguided. While all of the other nonbank SIFIs—American International Group (AIG), General Electric Capital Corporation (GE Capital), and MetLife, Inc.—shrank or substantially simplified themselves to escape their designations, Prudential did neither. To the contrary, Prudential has only become more systemically important since its designation.

Overturning Prudential’s SIFI status was not only unwise, it was also illegal. In rescinding Prudential’s SIFI label, regulators (1) violated their established procedural rules, (2) relied on misleading quantitative analyses, and (3) ignored an important statutory factor that Congress required them to consider. Regulators’ misguided and unlawful decision to remove Prudential—an $832 billion, multinational insurance conglomerate—from federal oversight will now expose the financial system to the same types of risks it experienced in the lead-up to the financial crisis.

I. Nonbank SIFI Designations and De-Designations

Insurance companies, investment banks, and other nonbank financial firms were primary culprits in the 2008 financial crisis. 3Open this footnote Close this footnote 3 See Jeremy C. Kress, Patricia A. McCoy & Daniel Schwarcz, Regulating Entities and Activities: Complementary Approaches to Nonbank Systemic Risk, 92 S. Cal. L. Rev. (forthcoming 2019) (manuscript at 10-11), https://perma.cc/WN4N-FU36; Daniel Schwarcz & David Zaring, Regulation by Threat: Dodd-Frank and the Nonbank Problem, 84 U. Chi. L. Rev. 1813, 1824-30 (2017). …Open this footnote Close Nonbank mortgage companies issued hundreds of billions of dollars in subprime loans, investment banks packaged that debt into exotic securitizations, and insurance companies guaranteed these instruments through credit derivatives and other products. 4Open this footnote Close this footnote 4 See Kress et al., supra note 3 (manuscript at 10-11). …Open this footnote Close When the housing bubble burst, nonbanks like Bear Stearns, Lehman Brothers, and AIG were among the first firms to fail, triggering the broader panic.

After the crisis subsided, Congress addressed the problem of systemically important nonbanks in the Dodd-Frank Act. Lawmakers established the Financial Stability Oversight Council (FSOC), comprised of the heads of the major U.S. financial regulatory agencies. Congress directed FSOC to designate a nonbank financial company as a SIFI if the Council determines that the firm’s material financial distress or “the nature, scope, size, scale, interconnectedness, or mix of [its] activities” could threaten U.S. financial stability. 5Open this footnote Close this footnote 5 12 U.S.C. § 5323(a)(1). …Open this footnote Close Congress enumerated specific statutory factors the Council must consider, including the firm’s asset size, leverage, off-balance-sheet exposures, interconnectedness, and existing regulatory scrutiny. 6Open this footnote Close this footnote 6 See id. § 5323(a)(2). …Open this footnote Close

By law, any firm that FSOC designates as a SIFI becomes subject to consolidated supervision and regulation by the Federal Reserve, including risk-based capital, leverage, liquidity, and risk-management requirements. 7Open this footnote Close this footnote 7 See id. § 5365(b)(1). …Open this footnote Close These standards are more onerous than nonbanks’ baseline regulatory regimes and are designed to limit the stability risks that nonbank SIFIs pose to the financial system.

At least initially, the FSOC embraced its mission to identify nonbank SIFIs. The Council promulgated, through notice-and-comment rulemaking, formal procedures for evaluating a nonbank’s systemic importance. 8Open this footnote Close this footnote 8 12 C.F.R. pt. 1310 app. A (2018). …Open this footnote Close Then, in 2013, FSOC designated insurance-focused companies Prudential and AIG, as well as General Electric’s captive finance subsidiary, GE Capital, as nonbank SIFIs. 9Open this footnote Close this footnote 9 See Financial Stability Oversight Council: Designations, U.S. Dep’t Treasury, https://perma.cc/W9X6-ERQ6 (archived Dec. 7, 2018). …Open this footnote Close The Council designated MetLife, another insurance-focused company, the following year. 10Open this footnote Close this footnote 10 See id. …Open this footnote Close

FSOC’s reasoning for each of these designations was similar. FSOC concluded that material financial distress at any of the four companies could destabilize the financial system by (1) inflicting losses on counterparties with direct exposures to the firm and (2) triggering asset fire sales that might spread through the financial sector. 11Open this footnote Close this footnote 11 See Fin. Stability Oversight Council, Basis of the Financial Stability Oversight Council’s Final Determination Regarding American International Group, Inc. 6-7 (2013). …Open this footnote Close Thus, FSOC determined that enhanced Federal Reserve oversight was appropriate for each firm.

The four designees, unsurprisingly, resisted the nonbank SIFI label and accompanying Federal Reserve oversight. The firms complained of increased burdens associated with this added layer of regulation. Prudential, for example, estimated that its SIFI status resulted in $135 million in additional compliance costs per year. 12Open this footnote Close this footnote 12 See Katherine Chiglinsky & Jesse Hamilton, Prudential Last of the Non-Banks to Shed ‘Too Big to Fail’ Tag, Bloomberg (Oct. 17, 2018, 8:41 AM EDT), https://perma.cc/854D-4Z8M. …Open this footnote Close The companies likewise insisted that their SIFI status put them on an uneven playing field relative to competitors that operated free from enhanced regulation. 13Open this footnote Close this footnote 13 See, e.g., Steven A. Kandarian, Chairman, President, and CEO, MetLife, Inc., Address at the U.S. Chamber of Commerce Capital Markets Summit: Life Insurers as SIFIs: A Case of Mistaken Identity? (Apr. 10, 2013). …Open this footnote Close

Accordingly, several of the nonbank SIFIs challenged their designations. Prudential requested an administrative hearing to contest its proposed designation, but FSOC affirmed its SIFI status by a 7-2 vote. 14Open this footnote Close this footnote 14 See Zachary Tracer & Ian Katz, Prudential Financial Got Systemic Risk Label in 7-2 Vote, Bloomberg (Sept. 20, 2013, 3:03 PM EDT), https://perma.cc/YN4W-8M3H. …Open this footnote Close After losing its own administrative hearing, MetLife sued FSOC in federal district court, resulting in protracted litigation over its SIFI status. 15Open this footnote Close this footnote 15 See, e.g., Ryan Tracy, MetLife Case Challenging SIFI Designation Nears Hearing, Wall St. J. (Feb. 9, 2016, 1:35 PM ET), https://perma.cc/87BF-2ZAA. …Open this footnote Close

One by one, as the designated companies came to grips with their newfound SIFI status, the firms began to sell off parts and shift to less risky activities in an effort to escape the SIFI label. GE Capital, for example, shrank by more than half and substantially reduced its heavy reliance on risky short-term funding. 16Open this footnote Close this footnote 16 See Ted Mann & Joann S. Lublin, Why General Electric Is Unwinding Its Finance Arm, Wall St. J. (updated Oct. 13, 2015 11:44 PM ET), https://perma.cc/STN5-E4T8. …Open this footnote Close AIG likewise contracted by roughly 10 percent relative to when it was designated. 17Open this footnote Close this footnote 17 See Fin. Stability Oversight Council, Notice and Explanation of the Basis for the Financial Stability Oversight Council’s Rescission of Its Determination Regarding American International Group, Inc. 12 (2017) [hereinafter AIG De-Designation]. …Open this footnote Close Even MetLife, which eventually prevailed in its district court battle with FSOC, spun off its retail insurance segment, shrinking by nearly 20 percent in the process. 18Open this footnote Close this footnote 18 See Leslie Scism, MetLife to Shed Big Chunk of Life Unit, Wall St. J. (updated Jan. 12, 2016, 6:59 PM ET), https://perma.cc/XST2-YYU8; Leslie Scism, Breaking From MetLife, Brighthouse Has a Tough Task: Selling Insurance, Wall St. J. (Aug. 5, 2017, 8 AM ET), https://perma.cc/R3FL-2YSP. …Open this footnote Close

FSOC, in turn, de-designated these firms in recognition of their reduced systemic footprints. FSOC removed GE Capital’s SIFI label in 2016, and it did the same for AIG the following year. 19Open this footnote Close this footnote 19 See AIG De-Designation, supra note 17, at 2; Fin. Stability Oversight Council, Basis for the Financial Stability Oversight Council’s Rescission of Its Determination Regarding GE Capital Global Holdings, LLC 1 (2016). …Open this footnote Close After the Trump Administration’s policymakers took control of FSOC, the Council dropped its appeal of the MetLife case, effectively freeing MetLife from its SIFI status. 20Open this footnote Close this footnote 20 See Alistair Gray, Trump Administration Drops Appeal in MetLife ‘Too Big to Fail’ Case, Fin. Times (Jan. 19, 2018), https://perma.cc/DZ2J-XEMU. …Open this footnote Close Thus, just seven years after Dodd-Frank, nearly all of the nonbank SIFIs were free from federal oversight.

All, that is, except Prudential. In contrast to its former SIFI peers, Prudential neither shrank nor simplified itself. To the contrary, Prudential actually expanded its systemic footprint after becoming a SIFI. Prudential increased its asset size and its involvement in risky activities like repurchase agreements, securities lending, and derivatives. 21Open this footnote Close this footnote 21 See Jeremy Kress, Prudential Hasn’t Earned the Right To Shed SIFI Label, Am. Banker (Mar. 13, 2018, 9:29 AM EDT), https://perma.cc/R8QK-RAM8. …Open this footnote Close Prudential apparently calculated that it could escape its SIFI label simply by waiting until deregulatory policymakers controlled FSOC.

Prudential’s gamble paid off when Donald Trump won the presidency, earning the right to appoint new members to the Council. Trump selected nominees drawn from the financial sector and conservative legal circles, which had long criticized nonbank SIFI designations as burdensome and inequitable. 22Open this footnote Close this footnote 22 For a discussion of why criticisms of nonbank SIFI designations are overblown, see Kress et al., supra note 3 (manuscript at 45-47). …Open this footnote Close After these appointees took office, the chair of the Council derided nonbank SIFI designations as a “blunt instrument” for regulating systemic risk. 23Open this footnote Close this footnote 23 U.S. Dep’t of the Treasury, Report to the President of the United States Pursuant to the Presidential Memorandum Issued April 21, 2017, Financial Stability Oversight Council Designations 10 (2017). …Open this footnote Close Thus, in November 2017, the U.S. Department of the Treasury announced that FSOC would effectively stop relying on nonbank SIFI designations as a regulatory tool. 24Open this footnote Close this footnote 24 See id. at 19-21. …Open this footnote Close

On October 16, 2018, FSOC formally de-designated Prudential. Although the Council pointed to no material way in which Prudential had reduced its systemic footprint, it nonetheless “rescinded its final determination that material financial distress at Prudential could pose a threat to U.S. financial stability.” 25Open this footnote Close this footnote 25 See Prudential De-Designation, supra note 1, at 7-8. …Open this footnote Close And with that, that last remaining nonbank SIFI escaped federal oversight, and nonbank SIFI designations—a key post-crisis regulatory tool—fell into complete disuse.

II. Prudential’s Arbitrary and Capricious De-Designation

The Council’s decision to rescind Prudential’s SIFI status was deeply flawed. Three errors are particularly problematic. In reversing Prudential’s SIFI status, FSOC (1) violated its formal procedures by second-guessing the Council’s original assessment of Prudential’s systemic importance, (2) performed misleading quantitative analyses while dismissing more reliable indicators of Prudential’s systemic importance, and (3) ignored a critical statutory factor that Congress instructed the Council to consider. These flaws substantially undermine the Council’s conclusion that Prudential is no longer systemically important and render FSOC’s action arbitrary and capricious. 26Open this footnote Close this footnote 26 An agency’s decision is arbitrary and capricious if the agency did not rely on the factors Congress intended or the decision runs counter to the evidence before the agency. See Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 42-43 (1983). In addition, an agency may not “simply disregard rules that are still on the books.” FCC v. Fox Television Stations, Inc., 556 U.S. 502, 515 (2009). …Open this footnote Close

A. FSOC Violated Its Procedures by Second-Guessing Its Original Assessment of Prudential’s Systemic Importance

FSOC’s rescission of Prudential’s SIFI label was inappropriate because the Council ignored its established procedures for reassessing a nonbank SIFI’s systemic importance. In contrast to its previous de-designations—which hinged on GE Capital’s and AIG’s efforts to shrink and simplify themselves—FSOC does not even try to argue that Prudential had reduced its systemic footprint. Rather, FSOC’s rationale for rescinding Prudential’s SIFI label boils down to its belief that the Council erred in designating Prudential in the first place. FSOC, however, has foreclosed itself from engaging in this type of second-guessing in the formal procedures it adopted through notice-and-comment rulemaking.

FSOC does not deny that Prudential has done little to shrink or simplify itself since being designated as a SIFI. To the contrary, FSOC admits that Prudential’s systemic footprint has grown. According to the Council’s data, since 2013, Prudential’s total assets have risen 17 percent, repurchase agreements have increased 45 percent, securities lending is up 13 percent, and derivatives are up 37 percent. 27Open this footnote Close this footnote 27 See Prudential De-Designation, supra note 1, at 11, 16. …Open this footnote Close Repurchase agreements, securities lending, and derivatives were all sources of significant systemic risk during the financial crisis.

Rather than argue that Prudential has reduced its systemic footprint, FSOC instead insists that the Council erred when it originally designated Prudential. Indeed, the entire basis for FSOC’s decision—to the extent one can be discerned—boils down to its belief that the Obama Administration FSOC made a mistake in 2013. In particular, the Trump Administration FSOC disagrees with the Obama Administration’s assessment of the extent to which a forced asset liquidation by Prudential would disrupt markets or cause losses to other firms with similar holdings. According to the Trump Administration FSOC, the Obama Administration overestimated the extent to which Prudential customers would redeem their policies if Prudential were to experience distress. The Trump FSOC concludes that Prudential would not need to liquidate as many assets as previously assumed and therefore would be less likely to disrupt trading markets. 28Open this footnote Close this footnote 28 See id. at 35-42. …Open this footnote Close

The Council, however, is not supposed to second-guess itself in this way. To the contrary, FSOC has committed that it will rescind a SIFI designation only if the company’s systemic footprint has materially decreased. In its procedures for SIFI designations and de-designations, the Council stated that its reevaluation of a nonbank SIFI’s status “will focus on any material changes with respect to the nonbank financial company or the markets in which it operates since the Council’s previous review.” 29Open this footnote Close this footnote 29 See Authority To Require Supervision and Regulation of Certain Nonbank Financial Companies, 77 Fed. Reg. 21,637, 21,650 (Apr. 11, 2012). …Open this footnote Close FSOC’s reevaluation of Prudential, however, does not focus on these factors.

FSOC’s analysis does not show that Prudential has materially changed; if anything, it poses more systemic risk than ever. Nor does the Council show that changes in the markets in which Prudential operates have reduced its systemic importance. Rather, FSOC merely revises its conclusions about how many customers would redeem their policies from Prudential, and how those redemptions and Prudential’s ensuing fire sale would affect other market participants.

Having established formal procedures for evaluating the systemic importance of nonbank SIFIs, FSOC is not free to disregard those processes. Indeed, FSOC lost its legal battle over MetLife’s SIFI designation on the ground that FSOC had not followed its established procedures during MetLife’s designation process. 30Open this footnote Close this footnote 30 See MetLife, Inc. v. Fin. Stability Oversight Council, 177 F. Supp. 3d 219, 237-39 (D.D.C. 2016). …Open this footnote Close By second-guessing the Obama Administration’s determination, the Council illegally violated its procedures in Prudential’s case, as well.

B. FSOC Relied on Misleading Quantitative Analyses and Ignored More Reliable Indicators of Prudential’s Systemic Importance

Even if FSOC had not violated its procedural rules, Prudential’s de-designation would still be arbitrary and capricious because the Council based its decision on misleading evidence. FSOC’s justification for relieving Prudential of its SIFI label depends on specious empirical analyses and, conversely, disregards well-respected quantitative metrics on which the Council has previously relied.

1. FSOC Cites Misleading Empirical Analyses

FSOC’s assessment of Prudential’s systemic importance is based on deceptive empirical evidence. FSOC uses three quantitative tests to estimate how many Prudential customers would surrender their policies—and demand cash from Prudential—if the insurer were to experience distress. First, the Council uses historical surrender rates from AIG during the financial crisis; second, it uses surrender rates from several insurance companies that failed in the early 1990s; and third, it uses a credit rating agency’s proprietary model to assess Prudential’s liquidity risk. As noted above, FSOC concludes based on these assessments that relatively few policyholders would redeem their claims and the magnitude of Prudential’s ensuing asset fire sales would be low.

But each of FSOC’s three empirical tests is seriously flawed. First, AIG’s historical surrender rates dramatically underestimate how many policyholders would withdraw claims from Prudential if it were to experience distress. That is because the federal government stabilized AIG with an $85 billion bailout in September 2008, protecting AIG from the onslaught of withdrawals that Prudential would experience absent government support. 31Open this footnote Close this footnote 31 See Prudential De-Designation, supra note 1, at 38, 41. To its credit, the Council acknowledges that the government bailout limits the utility of the AIG example, but it nonetheless cites the example as support for de-designating Prudential. See id. at 38. …Open this footnote Close Second, the 1990s historical comparison is inapposite because the insurance companies that failed during that period were small and broader financial markets were stable, in contrast to the likely scenario if Prudential were to experience distress today. 32Open this footnote Close this footnote 32 See id. The Council likewise acknowledges these dissimilarities but still uses the 1990s example to support its conclusion. See id. …Open this footnote Close

Finally, FSOC’s reliance on the credit rating agency’s liquidity model is particularly troubling. The credit rating agency, A.M. Best, is not a financial stability regulator, and its model, therefore, may not be appropriate for assessing Prudential’s threat to financial stability. 33Open this footnote Close this footnote 33 See About A.M. Best, A.M. Best, https://perma.cc/5CDW-DHY8 (archived Dec. 12, 2018). …Open this footnote Close Crucially, FSOC admits that it knows little about the assumptions A.M. Best used to construct its model. 34Open this footnote Close this footnote 34 See Prudential De-Designation, supra note 1, at 40 n.125 (“A.M. Best analysts did not cite specific data or historical examples that were used to support the A.M. Best liquidity model assumptions . . . .”). …Open this footnote Close Regulators, therefore, have little reason to trust the model’s conclusions.

In lieu of these inappropriate metrics, FSOC could have constructed its own models to estimate the effect of Prudential’s potential fire sales. FSOC, however, did not even attempt to create its own empirical tests to assess Prudential’s liquidity risk, instead relying on these three flawed metrics. FSOC’s determination to rescind Prudential’s SIFI label therefore lacks rational empirical support.

2. FSOC Arbitrarily Rejects Indicia of Prudential’s Systemic Importance

FSOC not only relies on misleading empirical analyses, it also inappropriately disregards well-respected metrics of Prudential’s systemic importance. For example, Prudential ranks third among all U.S. financial companies in SRISK, one of the most commonly cited measures of a firm’s systemic footprint. 35Open this footnote Close this footnote 35 See Systemic Risk Analysis, V-LAB, https://perma.cc/HQQ5-8F72 (archived Dec. 7, 2018). …Open this footnote Close SRISK measures a firm’s expected capital shortfall given a severe market decline, based on its size, leverage, and risk. 36Open this footnote Close this footnote 36 See Christian Brownlees & Robert F. Engle, SRISK: A Conditional Capital Shortfall Measure of Systemic Risk, 30 Rev. Fin. Stud. 48, 49 (2017). …Open this footnote Close Prudential’s SRISK is roughly comparable to Morgan Stanley’s, and it ranks behind only Citigroup’s and Goldman Sachs’.

FSOC, however, inappropriately dismisses Prudential’s exceptionally high SRISK. FSOC insists that SRISK “does not necessarily capture [Prudential’s] interconnectedness with the broader financial markets.” 37Open this footnote Close this footnote 37 See Prudential De-Designation, supra note 1, at 49. …Open this footnote Close Moreover, FSOC claims that SRISK “does not fit the long-term nature of the insurance business model.” 38Open this footnote Close this footnote 38 See id. at 50. …Open this footnote Close

But FSOC’s dismissal of Prudential’s elevated SRISK is disingenuous—indeed, it is arbitrary and capricious—because FSOC cited SRISK favorably last year in its evaluation of AIG, another insurance company. In its decision de-designating AIG, FSOC heralded AIG’s negligible SRISK. 39Open this footnote Close this footnote 39 See AIG De-Designation, supra note 17, at 49 n.133. …Open this footnote Close The Council emphasized that before the crisis AIG’s SRISK had been equivalent to those of systemically important banks, but AIG had shrunk and its SRISK had fallen close to zero by 2013. 40Open this footnote Close this footnote 40 See id. …Open this footnote Close Having cited AIG’s diminished SRISK as a justification for its de-designation, the Council cannot arbitrarily disregard Prudential’s exceptionally high SRISK just a year later.

In sum, FSOC’s rationale for de-designating Prudential relies on questionable empirical analyses and, at the same time, inappropriately rejects more reliable evidence. These substantive deficiencies strongly suggest that the Council skewed its analysis to support its preordained conclusion in favor of removing Prudential’s SIFI label.

C. FSOC Ignored Congress’s Mandate To Consider Prudential’s Baseline Regulatory Regime

Finally, Prudential’s de-designation was improper because FSOC completely ignored one of the factors Congress required the Council to consider when assessing a nonbank’s systemic importance. Dodd-Frank enumerates several statutory factors that the Council must weigh when evaluating a nonbank, including the firm’s asset size, leverage, off-balance-sheet exposures, interconnectedness, and “the degree to which the company is already regulated by 1 or more primary financial regulatory agencies.” 41Open this footnote Close this footnote 41 See 12 U.S.C. § 5323(a)(2) (2017). …Open this footnote Close In this case, however, FSOC completely ignored its statutory mandate to consider Prudential’s existing regulatory scrutiny.

Prudential’s insurance subsidiaries, like all U.S. insurance companies, are regulated primarily by the states. Traditionally, however, U.S. insurance conglomerates like Prudential have not been regulated on a consolidated basis at the holding company level. 42Open this footnote Close this footnote 42 See Daniel Schwarcz & Steven L. Schwarcz, Regulating Systemic Risk in Insurance, 81 U. Chi. L. Rev. 1569, 1632-34 (2014); see generally Patricia A. McCoy, Systemic Risk Oversight and the Shifting Balance of State and Federal Authority over Insurance, 5 U.C. Irvine L. Rev. 1389, 1393-96 (2015) (discussing history of U.S. insurance regulation). …Open this footnote Close Commentators have criticized this gap in insurance regulation, suggesting, for instance, that the lack of consolidated regulation enabled AIG to amass excessive risks outside of its regulated insurance subsidiaries in the lead-up to the crisis. 43Open this footnote Close this footnote 43 See Schwarcz & Schwarcz, supra note 42, at 1634. …Open this footnote Close In fact, the absence of consolidated insurance holding company regulation was a key reason the Council originally designated Prudential in 2013. 44Open this footnote Close this footnote 44 See Fin. Stability Oversight Council, Basis for the Financial Stability Oversight Council’s Final Determination Regarding Prudential Financial, Inc. 11 (2013). …Open this footnote Close

In its de-designation of Prudential, however, FSOC points to new legislation enacted by Prudential’s home state of New Jersey in 2014. The new law authorizes the New Jersey Department of Banking and Insurance (DOBI) to supervise New Jersey-based insurance conglomerates on a consolidated, group-wide basis. 45Open this footnote Close this footnote 45 N.J. Stat. Ann. § 17:27A-5.2 (2018). …Open this footnote Close FSOC insists that, in contrast to 2013, the DOBI can now collect data on and monitor Prudential’s worldwide operations pursuant to this authority. 46Open this footnote Close this footnote 46 See Prudential De-Designation, supra note 1, at 57. …Open this footnote Close Indeed, the Council’s belief that Prudential is adequately supervised by the DOBI is central to its rationale for removing Prudential from the Federal Reserve’s jurisdiction.

FSOC, however, fundamentally misconstrues its statutory mandate. FSOC focuses on the extent to which the DOBI supervises Prudential, but Congress instructed it to consider the degree to which other agencies regulate the firm. Supervision and regulation are very different. Supervision refers to the oversight of an institution’s financial condition and compliance with relevant laws. 47Open this footnote Close this footnote 47 See What Is the Fed: Supervision and Regulation, Fed. Res. Bank S.F., https://perma.cc/UY4L-7LFH (archived Dec. 7, 2018). …Open this footnote Close Regulation, by contrast, refers to the setting of rules and guidelines applicable to the firm. 48Open this footnote Close this footnote 48 See id. …Open this footnote Close There are good reasons why Congress wanted FSOC to consider how Prudential is regulated instead of how it is supervised. Supervision is meaningless where, as here, the relevant agency lacks authority to require the nonbank to de-risk or improve its risk management.

Despite its statutory mandate, FSOC focuses solely on the extent to which the DOBI supervises Prudential. The Council does not even attempt to address Prudential’s baseline regulatory regime. Although the DOBI indisputably regulates Prudential’s New Jersey insurance subsidiary, its ability to regulate the parent holding company is unclear, at best. New Jersey law provides that DOBI may “[c]ompel development and implementation of reasonable measures designed to assure that [the parent holding company] is able to timely recognize and mitigate material risks.” 49Open this footnote Close this footnote 49 N.J. Stat. Ann. § 17:27A-5.2(e)(3). …Open this footnote Close This ambiguous language does not clearly authorize the DOBI to establish group-wide capital and liquidity rules for Prudential and other New Jersey-domiciled insurance conglomerates. 50Open this footnote Close this footnote 50 See Kress, supra note 21. …Open this footnote Close Nor does it clearly authorize the DOBI to stop Prudential affiliates from engaging in exotic non-insurance activities like AIG did in the lead-up to the crisis. 51Open this footnote Close this footnote 51 See id; see also Schwarcz & Schwarcz, supra note 42, at 1584-86 (discussing AIG’s non-insurance activities). …Open this footnote Close Critically, in the four years since New Jersey adopted this law, the DOBI has not even attempted to impose group-wide regulations on insurance holding companies.

FSOC fails to appreciate Prudential’s continued systemic importance because it ignores these shortcomings in the firm’s baseline regulatory regime. While the DOBI supervises Prudential, the New Jersey agency lacks clear authority to address the company’s weaknesses through regulation. The Council’s de-designation of Prudential was thus arbitrary and capricious because it inappropriately conflated state-level supervision with regulation.

Conclusion

This Essay has argued that the FSOC illegitimately rescinded Prudential’s SIFI label, thereby removing the company from Federal Reserve regulation and subjecting the financial sector to increased systemic risks. FSOC’s decision is arbitrary and capricious because the Council (1) violated its established procedures, (2) relied on misleading quantitative analyses, and (3) failed to consider a mandatory statutory factor.

The good news is that the Council’s action could be subject to judicial review. Although it may be difficult for an individual citizen to assert a claim against FSOC, 52Open this footnote Close this footnote 52 See, e.g., Lee v. Bd. of Governors of the Fed. Reserve Sys., 118 F.3d 905, 911-13 (2d Cir. 1997) (denying citizens’ standing to challenge a bank merger approved by the Federal Reserve). …Open this footnote Close a financial company has standing to challenge an agency’s action that eases regulations on a competitor. 53Open this footnote Close this footnote 53 See, e.g., Nat’l Credit Union Admin. v. First Nat’l Bank & Trust Co., 522 U.S. 479, 488 (1998) (holding that banks have standing to sue National Credit Union Administration for loosening credit unions’ membership requirements, thereby increasing competition for banks). …Open this footnote Close The competitor suffers a cognizable injury in fact when it loses profits due to enhanced competition by the de-regulated institution—in this case, Prudential. Thus, a court would review Prudential’s de-designation if one of its competitors—or a group of competitors—were to challenge FSOC’s flawed reasoning.

Granted, the likelihood of such a case being brought may be low. Even if Prudential’s competitors are injured because Prudential now operates with less regulatory burden, the costs borne by each individual competitor are probably negligible. It may be unlikely, therefore, that any competitor will have sufficient incentive to bring a costly lawsuit challenging Prudential’s de-designation. There is thus an asymmetry inherent in FSOC’s designation scheme: A company like MetLife has strong incentive to challenge its designation in court, but no one is likely to sue FSOC when the Council illegally de-designates a SIFI.

Vigilant congressional oversight, therefore, is the most promising pathway to hold FSOC accountable for improperly de-designating Prudential. The House Financial Services Committee and Senate Committee on Banking, Housing, and Urban Affairs should hold hearings to evaluate the legitimacy of Prudential’s de-designation. Moreover, each voting member of FSOC must annually submit a signed statement to Congress certifying that the Council is taking all reasonable steps to ensure financial stability. 54Open this footnote Close this footnote 54 See 12 U.S.C. § 5322(b) (2017). …Open this footnote Close Congress should carefully review these certifications and, if appropriate, require each FSOC voting member to testify about Prudential’s systemic importance. This type of oversight should be a priority for the Democratic Party after taking control of the House of Representatives in the 2018 midterm elections.

In sum, FSOC’s de-designation of Prudential was both unwise and illegal. The Council violated its established procedures, used misleading quantitative analyses, and ignored a crucial statutory factor—all in an effort to reach its preordained conclusion that Prudential should be removed from enhanced federal regulation. In doing so, the Council opened the financial system to the same risks that the country experienced in 2008. Congress and the courts should not tolerate this renewed threat to U.S. financial stability.

*Assistant Professor of Business Law, University of Michigan Ross School of Business. The author previously was an attorney in the Banking Regulation & Policy Group of the Federal Reserve Board’s Legal Division. For helpful comments and conversations, the author thanks Peter Conti-Brown, Gregg Gelzinis, Jeff Gordon, Patricia A. McCoy, Dan Schwarcz, Matthew Turk, and David Zaring. Thanks to Ali Habhab for excellent research assistance.