* Yellen cites reduction in capital markets business
* FSOC voted to remove AIG's "systemically risky" label
* Yellen swung vote; other Obama appointees voted against (Adds context, quotes from other regulators)
WASHINGTON, Oct 2 (Reuters) - American International Group Inc poses less of a threat to financial stability because it shrank its assets by more than $500 billion, Federal Reserve Chair Janet Yellen said on Monday in explaining why she voted in favor of releasing the company from stricter oversight.
Her comments and others published by regulators on Monday shed light on a process financial firms say is too opaque and unaccountable, indicating big banks and insurers will have to downsize dramatically if they are to shake off the "systemically risky" label.
The comments also expose ongoing divisions among financial regulators over how to determine if a company is systemically risky a decade since the 2007-2009 global financial crisis began.
The U.S. Financial Stability Oversight Council (FSOC) said on Friday that AIG - which received a $182 billion U.S. government bailout during the crisis - is no longer critical to the health of the U.S. financial system. "Since the financial crisis, AIG has largely sold off or wound down its capital markets businesses, and has become a smaller firm that poses less of a threat to financial stability," Yellen said in the statement.
"The possibility of de-designation provides an incentive for designated firms to significantly reduce their systemic footprint," she added.
The FSOC, which comprises the heads of financial regulators across the federal government, requires a two-thirds majority to agree to remove a companys designation as a systemically important financial institution, or SIFI.
By law, any bank with over $50 billion in assets is automatically considered a SIFI, while the FSOC can apply the label to nonbanks on a case-by-case basis. The panel only once before has removed a SIFI designation, with GE Capital in 2016.
With four appointees of former President Barack Obama still holding FSOC seats, Yellen's vote proved decisive on Friday. The remaining three Obama appointees voted against while five Trump appointees voted in favor along with Treasury Secretary Steve Mnuchin, who chairs the council.
Jay Clayton, chairman of the Securities and Exchange Commission, recused himself.
The chairman of the Federal Deposit Insurance Corporation, Martin Gruenberg, who voted against, argued that AIG had actually increased its life insurance and annuity business exposure in recent years, according to comments released by the Treasury on Monday.
The director of the Federal Housing Finance Agency, Mel Watt, also voted against and even challenged the legality of whether six votes was sufficient under FSOC rules.
"In my view, the Council's decision represents a simple majority decision, not the two-thirds required by statute."
(Reporting by Michelle Price; Editing by Cynthia Osterman and Leslie Adler)