April 15, 2020
This crisis has shattered any illusions that our post-financial crisis framework is resilient enough to withstand the challenges of the future. Coronavirus has, in particular, uncovered one of our most fundamental, persistent weaknesses: our continued inability to anticipate and prepare for new financial risks. For this ill-preparedness, we have powerful actors like BlackRock, the asset management giant and political titan, to thank. In an effort to avoid more stringent regulation, BlackRock and others not only evaded scrutiny for their own contributions to systemic risk, but virtually destroyed the mechanisms designed to examine such risk across the wider economy.
This coup went largely unnoticed but now, two freshman lawmakers, who have shown themselves to be remarkably attentive to corporate power, Rep. Chuy Garcia (D-IL) and Rep. Katie Porter (D-CA), are fighting back. Their new bill enables economic resilience and preparedness for shocks by automatically designating gargantuan financial institutions systemically important and by revitalizing essential resources like the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR). Measures like these will enhance our ability to anticipate and mitigate the myriad threats that are on the horizon, from climate change to future pandemics.
In the wake of the financial crisis, lawmakers set about correcting a number of the deficiencies that crashed the economy. The resultant bill, the Dodd-Frank Act, targeted many regulatory gaps directly, banning bets with customers’ federally-insured deposits, increasing capital requirements, and tamping down on leveraged lending. The law also automatically subjected banks with over $50 billion in assets to stress tests (i.e., likely resiliency in case of economic stress) and required that they adhere to more stringent regulatory standards.
At the same time, it addressed the regulatory apparatus’ structural weaknesses so that regulators would be better equipped to anticipate and prevent future crises. At the center of this effort was the creation of two new bodies, the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR).
FSOC brought together key financial regulators who managed specific types of the financial sector (e.g., housing, commodity derivatives, currency swaps, etc…) to encourage information-sharing so that each would have a more complete understanding of potential threats to financial stability across the economy. Dodd-Frank also vested FSOC with responsibility to determine whether to designate large non-bank financial institutions systemically important and to subject these to additional scrutiny. This recognized that “shadow banks” (e.g. insurance companies, hedge funds, and others) were at least partially responsible for the economy’s downfall.
While this mechanism to pool issue-specific expertise was a big step forward, lawmakers did not stop there. They also created the Office of Financial Research, a dedicated expert on financial stability. This team of researchers was tasked with proactively identifying and assessing potential threats that could crash the economy.
So what new financial phenomena or institutions might these regulators and researchers be investigating? Big, passive asset managers come to mind. While passive asset management existed prior to the financial crisis, it has grown immensely in the ensuing years. In 2008, the two largest asset managers, BlackRock and Vanguard, together had a little over $2 trillion in assets under management. A decade later, the two controlled a total of $12 trillion.
This tremendous growth rightfully caught regulators’ eye. In 2014, FSOC decided to take a look and to weigh whether this meteoric rise had earned these firms a place among the “systemically important.” As soon as BlackRock caught wind of this line of inquiry, however, it mounted a formidable counteroffensive and soon succeeded in getting regulators to turn their sights elsewhere. Simultaneously (and likely not unrelatedly), the Office of Financial Research’s progress building out its staff stalled.
The firm did not, however, rest there. After batting away one threat, it turned its attention to its long-term security from regulatory incursions by preparing to overrun the Clinton administration. In the years leading up to the 2016 election, BlackRock began to form a shadow cabinet, hiring senior officials from the Obama administration likely to receive senior appointments in a Clinton presidency for its ranks. It was also well-known that BlackRock’s CEO, Larry Fink had aspirations to be the next Treasury Secretary, and his name appeared frequently on lists of potential nominees.
Things didn’t work out as planned, but BlackRock has done well despite Clinton’s loss. Hillblazer and former BlackRock executive Craig Philips served as a Counselor to Treasury Secretary Steven Mnuchin for two years, a perch from which he held considerable sway. Even setting aside their inside man, however, BlackRock has had little to worry about from this administration. Trumpian regulators have shown no interest in expanding SIFI designations and have instead set about de-designating insurance giants like AIG and Prudential. Simultaneously, the administration accelerated OFR’s destruction by cutting staffing levels severely, all but ensuring that BlackRock wouldn’t face any new scrutiny either.
Let’s briefly consider a world in which BlackRock’s campaign had not been so successful. FSOC might have pressed ahead and designated BlackRock as systemically important. Given that the firm manages $7 trillion in assets, its risk management software directs just under $22 trillion, and it has now been put in charge of massive bailout programs twice in just over a decade, it would at least have been nice for regulators to give the issue serious consideration.
The Office of Financial Research could have also considered some of the risks that BlackRock’s central products, Exchange Traded Funds (ETFs), might pose, especially in times of crisis. ETFs have become extraordinarily popular over the course of the last decade, but as institutions and people flock to the product, financial researchers have begun to suggest that they might not be quite as safe as they seem. Researchers at the European Systemic Risk Board recently released a report outlining several mechanisms through which ETFs could pose a systemic risk. They conclude that ETFs may contribute to higher price volatility, contagion risks, and the materialization of operational risks amidst shocks. Although none of these risks seem to have yet manifested during this crisis, it is not clear that they necessarily will not down the road. The nature of great downside risks is that they only need to manifest once to matter greatly!
Aside from these BlackRock specific risk factors, a more adequately-resourced and public interest-minded Financial Stability Oversight Council (FSOC) and Office of Financial Research (OFR) might have foreseen some of the economy’s fragility to external shocks like a pandemic and suggested, or even mandated, steps to prepare.
But it didn’t, and here we are.
Meanwhile, BlackRock is only growing stronger, both financially and politically. Late last month, the Federal Reserve announced that BlackRock would advise its purchase of mortgage-backed securities and corporate bonds. Although BlackRock has agreed to refund any fees it earns from the Fed purchasing assets in its ETF portfolio, news of the arrangement set off a lucrative rush into BlackRock’s products, demonstrating the indirect benefits it will reap from the relationship.
This financial boon has rightfully received a great deal of attention, but just as concerning is the political benefit that BlackRock is likely to derive. Already, it seemed that BlackRock was forming a “shadow cabinet 2.0,” having recently brought on former Obama administration officials like Brian Deese, Tom Donilon, Wally Adeyemo, and others. With its new, elevated role in Washington, a BlackRock invasion seems even more likely.
Enter freshman representatives Garcia (D-IL) and Porter (D-CA). Unintimidated, they are taking on this formidable and newly empowered financial giant. Their bill, by automatically designating many large firms as systemically important and empowering our financial forecasters, will help ensure that we’re ready when it comes time for the next crisis.
And there will be a next one. Climate activists have been warning the broader policy community about the threat climate change will pose to economic stability for several years now. Coronavirus makes clear that it’s time to listen.