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The US financial system is policed by a number of sheriffs, each with its own jurisdiction, powers, and regulatory approaches. Banks, asset managers and insurers conduct a bewildering array of essential activities within and across state and national borders, justifying the many, many eyes watching their every move.

Too often, though, an approach intended to be collaborative in theory ends up disorganised and contentious in practice. Speaking to Central Banking magazine, Donald Kohn, a former vice-chair at the Federal Reserve, said: “It is very hard to coordinate across all these regulators, and it takes time ... There is a lot of deference and turf protection among them, and data is hardly shared at all.”

This frustrates efforts to monitor systemic financial risks — like climate change. Absent one overarching regulator that can lay down the law to all financial institutions, it’s tough to identify and restrain those environmentally-damaging activities and entities that threaten the industry as a whole.

The funny thing is, there is a federal authority that is supposed to focus on system-wide risks: the Financial Stability Oversight Council (FSOC). Set up in 2010 under the Dodd-Frank Act, the council — made up of top officials from all the major federal regulators and chaired by the Treasury secretary — has a three-pronged mission. First, to root out systemic threats posed by the collapse of a large financial institution, or through its ongoing activities. Second, to eliminate “too-big-to-fail” by making it clear to stakeholders that the US will not bailout troubled companies, and third to “respond to emerging threats to the stability of the US financial system”.

In order to fulfill its mandate, the FSOC has the power to designate non-bank firms — like insurers, asset managers and mortgage providers — as systemically important financial institutions (Sifis). Such firms are placed by law under the direct supervision of the Federal Reserve, and become subject to enhanced prudential standards, including risk-based capital minimums, concentration limits and liquidity requirements, among others.

The council also has the authority to impose stricter regulatory standards on those financial activities practiced by banks or non-banks it considers systemically risky. There’s a catch, though — the subject regulator(s) can choose not to implement the more stringent requirements as long as they submit an explanatory letter.

A history of strife

On paper, then, the council looks like the best-placed entity to address the systemic risk of climate change. Two characteristics that separate it from the other watchdogs make it particularly suited to the task: its singular mandate to preserve financial stability and its quasi-democratic structure. After all, since decisions made by the FSOC are made by all US regulators together, they have a legitimacy that should guarantee their uniform application across the supervisory system.

These features have made the FSOC a popular target of climate advocates — most recently Ceres, a non-profit which released an extensive report last week containing over 50 recommendations for financial regulators on tackling climate risk. Ceres argued the council should designate climate change as a systemic vulnerability and use climate risk factors to designate Sifis.

The FSOC’s present legal authorities give it the freedom to do so, but institutional and political barriers stand in the way. One challenge is the committee’s very composition. With the chairmanship in the hands of the Treasury, the FSOC will closely follow the White House’s lead. Without a supportive Treasury Secretary or President, it’d be hard to get something they don’t care about put on the agenda.

Then there’s the tortured history of the FSOC’s Sifi designations to contend with. The council may have the legal authority to target systemically risky firms, but the manner in which it went about labelling three insurers — AIG, Prudential and MetLife — as Sifis in years past provoked uproar. One member of the FSOC openly criticised his colleagues before a Congressional committee in 2015 for using a flawed designation standard that focused almost exclusively on the size of firms rather than their risk-taking activities.

The council’s missteps led MetLife to appeal its designation, and a subsequent ruling by a US federal court found that its Sifi tag had been applied in an “arbitrary and capricious” manner rather than in accordance with a coherent methodology.

This proved a dramatic blow to the FSOC’s authority. The setback prompted the council to review its designation process and last year it announced a shift in emphasis from systemic entities to systemic activities.

Bark but no bite

On the face of it, the change does not sound like it would hinder efforts to get the FSOC to tackle climate risk. Under this approach the council could simply identify climate-harming businesses, like lending to fossil fuel firms, brand them a threat and place restrictions on those that pursue them.

But in reality, the change in emphasis renders the FSOC effectively toothless. Remember, the council can only recommend supervisors apply more stringent regulations on systemic activities — it cannot compel them. In contrast, through the entity-designation tool it can make examples of systemic firms, and use them to warn off other institutions engaged in the same or similar activities.

Furthermore, even if a new administration brought in fresh faces and the revival of the entity-designation approach, it could just as easily run into the same roadblocks past councils did with MetLife. That is, without a clear, well-thought out assessment methodology, and the tools to identify and categorise climate-related risks, any climate Sifi designations could be challenged and overturned by the courts.

It can’t do it alone

What’s needed is a strong substructure of climate-related prudential regulation that the council can overlay its designation process on top of.

If the Securities and Exchange Commission, for instance, put together a green and brown taxonomy that clearly defined what a climate-harming financial activity was, the FSOC could map this to a firms’ asset portfolios to identify Sifis loaded with climate risks. Or the council could use the output of climate stress tests, which have been floated to policymakers at the Federal Reserve and the Commodity Futures Trading Commission (CFTC), to determine which non-banks are particularly vulnerable to transition or physical risks, offering another route to Sifi designation.

Reforms to the FSOC itself could also help chivy reforms along once these initial building blocks are put in place. For example, the council’s present composition encourages inertia, as each agency representative has an incentive to resist initiatives that would infringe on their bailiwick. Donald Kohn, again speaking to Central Banking, said an independent FSOC chair and a widening of the membership to include multiple people from each agency could help speed things along — the idea being any one regulator would be less likely to push back against FSOC recommendations if more senior members were included in the discussions.

In addition, the FSOC could set up a dedicated subcommittee to identify climate-related risks, much as the CFTC has done with its climate-related market risk subcommittee.

Such reforms necessitate a reopening of the Dodd-Frank Act, which may be tough with a divided Congress. But a few steps in the right direction have already been taken by Democratic lawmakers. For example Senator Brian Schatz introduced the Climate Change Financial Risk Act of 2019 last year, which among other innovations would mandate the FSOC establish a climate risk subcommittee that would report on the threat of climate change to the “efficiency, competitiveness and stability” of the US financial system.

Still, political will is needed to both build the underlying framework to support a more active FSOC and to reshape the council itself. Current regulations, and the council’s White House-dominated leadership, make it hard for change to occur from within. What’s needed is a changing of the guard, which can only come about following an election that ushers in a new generation of climate-conscious policymakers and regulatory heads.

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