Regulation by Threat: Dodd-Frank and the Nonbank Problem

A central lesson of the global financial crisis is that banks are not the only financial firms that can endanger the broader financial system. The Dodd-Frank Act responded to this reality by empowering a council of financial regulators to designate individual nonbank financial institutions as systemically risky. Although the Financial Stability Oversight Council (FSOC) has exercised this authority only four times, it has occasioned controversy in court, in Congress, and among commentators. And with Donald Trump\u27s 2016 presidential victory, FSOC\u27s designation authority is now in danger of being radically altered or terminated completely. This Article defends the FSOC designation scheme, arguing that its critics misunderstand the mechanisms by which it helps to reduce systemic risk outside the banking sector. FSOC designation does not, and cannot, precisely identify firms that could pose a systemic risk to the financial system. FSOC\u27s broad discretion to impose costly sanctions on designated firms instead advances two quite different goals. First, it deters nonbank firms from seeking out systemically risky strategies or activities. Second, it holds financial regulators to account by threatening to intrude on their regulatory turf if they fail to address systemic risk on their own. We term this approach regulation by threat and suggest that it is appropriate when risks are hard to identify, the perils of mistake are great, and the downsides of misdiagnosis extreme. Moreover, we argue that the council\u27s discretion is better cabined by its structure- which features diverse membership, voting, review, and political safeguards-than by insistence on hard look judicial review or a cost-benefit requirement for individual designation decisions. The council offers a useful alternative mechanism to standard approaches to regulation