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

It's a troubling development, and one that the government mustdo 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 institutionswhose collapse could seriously hurt the U.S. economy -- be theybanks, insurers, whatever.

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

They do. The near-demise of insurer American International Groupalmost brought down the U.S. banking system, thanks to losses onderivatives positions that a fragmented regulatorysystem 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 intricatelyconnected to the rest of the financial system through hundreds ofbillions of dollars in insurance products, debt contracts,securities holdings and derivatives -- exposures that coulddestabilize the financial system if the companies ran intotrouble.

MetLife sued, and a federal judgehas upheld its claim that designating the insurer assystemically important was "arbitrary and capricious."

In an opinion unsealed today, the judge agreed that the FSOCfailed to do three things it should have: Properly assess MetLife'svulnerability to financial distress, precisely calculate whethersuch distress would result in losses "sufficiently severe" to harmthe economy, and consider how the added cost of regulation couldadversely affect the company.

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

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

Second, calculating potential losses is beside the point: Thewhole purpose of the systemic designation is to allow the Fed --though stress-testing and other means -- to do such calculationsregularly and ensure that the company doesn't become undulyvulnerable.

Third, Dodd-Frank doesn't tell the FSOC to conduct acost-benefit analysis -- though that would be a usefulexercise, and the Fed has agreed to make its oversight ofinsurance companies less burdensome. The FSOC gave MetLife morethan a year to plead its case, and it went to greatlengths to explain its reasoning. This hardly seems arbitraryor capricious.

Details from the hearing offer some insight into the judge'sthinking. At one point, the judge took issue with the crisisscenario 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 todo. Also, assuming that a crisis could get bad enough to affectinsurers doesn’t seem out of line. Asystemic-risk model built by economists at New YorkUniversity, for example, estimates that MetLife would fall nearly$50 billion short of the capital it would need to cope with acrisis like that of 2008.

The International Monetary Fund dedicated a whole chapter of itslatest global financial stability report to the systemic risk posedby insurers.

The danger now is that other insurers will follow MetLife'sexample. To prevent that from happening, the FSOC will have toappeal the ruling. As it stands, regulators' ability to containrisks arising outside the traditional banking system is inquestion.

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

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