(Bloomberg View) -- A U.S. district judge in Washington may have poked a big hole in reforms aimed at protecting millions of Americans from the next financial crisis.

It's a troubling development, and one that the government must do what it can to reverse.

At issue is the part of the 2010 Dodd-Frank Act that gave the Federal Reserve oversight of all financial institutions whose collapse could seriously hurt the U.S. economy -- be they banks, insurers, whatever.

The law says this broad set of so-called systemically important institutions needs added scrutiny.

They do. The near-demise of insurer American International Group almost brought down the U.S. banking system, thanks to losses on derivatives positions that a fragmented regulatory system overlooked.

In 2013 and 2014, the Financial Stability Oversight Council, which brings together all the relevant federal regulators, designated three insurance companies -- AIG, Prudential Financial, and MetLife -- as systemically important.

The rationale was clear: They are intricately connected to the rest of the financial system through hundreds of billions of dollars in insurance products, debt contracts, securities holdings and derivatives -- exposures that could destabilize the financial system if the companies ran into trouble.

MetLife sued, and a federal judge has upheld its claim that designating the insurer as systemically important was "arbitrary and capricious."

In an opinion unsealed today, the judge agreed that the FSOC failed to do three things it should have: Properly assess MetLife's vulnerability to financial distress, precisely calculate whether such distress would result in losses "sufficiently severe" to harm the economy, and consider how the added cost of regulation could adversely affect the company.

The decision relies on a strange reading of Dodd-Frank and the FSOC's subsequent rulemaking.

First, the FSOC doesn't interpret systemic importance as requiring it to assess a company's vulnerability, just whether distress at a company could have system-wide consequences.

Second, calculating potential losses is beside the point: The whole purpose of the systemic designation is to allow the Fed -- though stress-testing and other means -- to do such calculations regularly and ensure that the company doesn't become unduly vulnerable.

Third, Dodd-Frank doesn't tell the FSOC to conduct a cost-benefit analysis -- though that would be a useful exercise, and the Fed has agreed to make its oversight of insurance companies less burdensome. The FSOC gave MetLife more than a year to plead its case, and it went to great lengths to explain its reasoning. This hardly seems arbitrary or capricious.

Details from the hearing offer some insight into the judge's thinking. At one point, the judge took issue with the crisis scenario implied in the FSOC's designation, saying that it assumed "the worst of the worst of the worst."

But that's exactly what a systemic-risk regulator is supposed to do. Also, assuming that a crisis could get bad enough to affect insurers doesn’t seem out of line. A systemic-risk model built by economists at New York University, for example, estimates that MetLife would fall nearly $50 billion short of the capital it would need to cope with a crisis like that of 2008.

The International Monetary Fund dedicated a whole chapter of its latest global financial stability report to the systemic risk posed by insurers.

The danger now is that other insurers will follow MetLife's example. To prevent that from happening, the FSOC will have to appeal the ruling. As it stands, regulators' ability to contain risks arising outside the traditional banking system is in question.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Instant Insights /

Does the MetLife ruling put the financial system at risk?

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