On November 3, 2023, the Financial Stability Oversight Council (the FSOC) published two documents that clarify how the FSOC interprets and plans to exercise perhaps its most powerful tool for managing risks to the US financial system: designating a nonbank financial company as a “systemically important financial institution” (SIFI) that, as such, will be subject to Federal Reserve regulation and supervision. The first, an Analytic Framework for Financial Stability Risk Identification, Assessment, and Response (the Framework), explains FSOC's substantive approach for identifying, assessing, and responding to potential risks to financial stability. The second, Guidance on Nonbank Financial Company Determinations (the Guidance), discusses the procedures the FSOC will use to make SIFI designations going forward.
The Framework and Guidance rescind and largely reverse changes made to FSOC’s designation framework in 2019 and comes amid a growing debate about the extent to which nonbank entities pose financial stability risks. Although FSOC’s earlier designations of nonbank SIFIs have been rescinded or overturned, the new framework has been widely interpreted to signal that renewed regulatory scrutiny of nonbank entities (including private equity funds, asset managers, hedge funds, alternative lenders and payment services companies) could be coming.
Below, we summarize the Framework and Guidance, after which we identify open questions and trends to watch. We will continue monitoring developments and provide additional updates as warranted.
The Framework – FSOC’s Substantive Standards
The Framework begins by offering a definition for the term “Financial Stability,” which appears but was not defined in the Dodd-Frank Act of 2013 – or in subsequent guidance by the FSOC. According to the Framework, it means: “the financial system being resilient to events or conditions that could impair its ability to support economic activity, such as by intermediating financial transactions, facilitating payments, allocating resources, and managing risks.”
The Framework then identifies the range of asset classes, institutions and activities FSOC will consider for purposes of monitoring risks to financial stability, including:
- markets for debt, loans, short-term funding, equity securities, commodities, digital assets, derivatives, and other institutional and consumer financial products and services;
- central counterparties and payment, clearing, and settlement activities;
- financial entities, including banking organizations, broker-dealers, asset managers, investment companies, private funds, insurance companies, mortgage originators and servicers, and specialty finance companies;
- new or evolving financial products and practices; and
- developments affecting the resiliency of the financial system, such as cybersecurity and climate-related financial risks.
After identifying such a broad range of asset classes and institutions as relevant to the analysis, the Framework lists the vulnerabilities that, according to the FSOC, could threaten financial stability, including: leverage; liquidity and maturity mismatch; financial interconnections (such as exposures of creditors, counterparties, investors, and borrowers); operational risks; complexity or opacity of markets, activities, or firms; inadequate risk management practices; concentration; and the destabilizing effect of activities that are “sizeable and interconnected with the financial system [and] can destabilize markets for particular types of financial instruments or impair financial institutions.”
The Framework lists four channels through which financial stability risks are most likely to spread, noting that FSOC considers these to be especially relevant when evaluating the financial stability risks of particular markets, activities, or entities. They are:
- Exposure: widespread exposure to specific types of financial instruments or asset classes that causes broad injury to market participants as defaults or widespread reductions in value occur.
- Asset liquidation: a rapid liquidation of financial assets that causes a significant and rapid reduction in asset prices that disrupts trading or funding in key markets or causes losses or funding problems for market participants.
- Disruptions in critical functions or services: loss of critical functions or services that are widely relied upon by market participants and for which there are no ready substitutes (also known as “substitutability risk”).
- Contagion: the perception of common vulnerabilities or exposures, such as business models or asset holdings that are similar or highly correlated, that spreads quickly and unexpectedly and leads to generalized loss of confidence in financial instruments or the financial system.
Once a risk to financial stability is identified, the Framework explains that FSOC may consider various tools and approaches to address it, including:
- Interagency coordination and information sharing to determine and implement appropriate actions by state or federal regulators;
- Making formal public recommendations to agencies or Congress to apply new or heightened standards and safeguards for a financial activity or practice;
- Determining, in accordance with the Guidance (as described below) and by a vote of the FSOC members, that a nonbank financial company is systemically important and should be subject to the Federal Reserve’s supervisory jurisdiction and prudential standards;
- Designating, after consultation with relevant regulators, a payment, clearing or settlement activity as systemically important; and
- Designating as systemically important any person that manages or operates a system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial.
The Guidance – Procedures for Making SIFI Designations
Unlike the Framework, FSOC issued the Guidance as a formal rule to be published in the Code of Federal Regulations. The Guidance sets out the process the agency plans to use when determining whether to designate a nonbank financial company as a SIFI as well as the rights afforded to entities under such review.
FSOC’s designation authority derives from section 113 of the Dodd-Frank Act, and the Guidance marks the third attempt to define its scope and requirements following earlier efforts in 2012 and 2019. It marks a sharp departure, however, from the approach taken in 2019. Then, under different leadership, FSOC established various procedural steps that the Guidance describes as "inappropriate prerequisites" to the exercise of its designation authority.
The first of those prerequisites was a requirement to conduct a cost-benefit analysis before exercising the agency’s designation authority. This requirement came in direct response to decisions in Metlife, Inc. v. Financial Stability Oversight Council, in which the federal District Court for Washington, DC overturned FSOC’s designation of one of the nation’s largest insurance companies – in part because FSOC had not weighed the costs of a SIFI designation for Metlife against the benefits to financial stability.
According to the Guidance, FSOC’s current leadership believes this cost-benefit analysis requirement to be unnecessary under the statute and “not reasonably estimable, useful, or warranted in [the] context” of addressing financial stability risks (noting as an aside that the district court’s holding is limited and not binding in the majority of federal judicial districts). Going forward, the agency will not engage in a separate cost-benefit analysis, apart from the factors it must consider under the statute, when making a SIFI designation.
The Guidance also rescinds requirements instituted in 2019 that FSOC must, before making a SIFI designation: (i) exhaust all available alternatives and (ii) assess a company’s likelihood of material financial distress.
To guide future consideration of nonbank SIFI designations, the Guidance establishes a two-stage process. In the first stage, a company selected for review will be notified by the FSOC and subject to a preliminary analysis. The company will be permitted (but not required) to submit information to the FSOC, and the FSOC will also consult with the company’s primary financial regulatory agency or home country supervisor, as applicable, regarding a potential designation.
Companies that are recommended for the second stage of review will undergo an in-depth examination by the FSOC, involving the assessment of additional information provided by the nonbank company. If the FSOC makes a proposed determination to designate the company as systemically important, the company may request a hearing, after which FSOC will make a final decision based on written and/or oral submissions. Nonbank companies designated as SIFIs will, under the Guidance, be reassessed on an annual basis to determine whether the designation should remain in effect.
FSOC’s authority to make SIFI designations grew out of the financial crisis of 2008-2009; not surprisingly, the agency’s initial designations of large insurance companies (e.g., MetLife, AIG, Prudential) reflected policymakers’ concerns during that era. In the current environment, however, regulators’ focus has shifted to a different set of financial intermediaries: private funds (in particular those active in private credit) and hedge funds. To date, regulatory actions to confront systemic risks associated with nonbank entities has been to regulate the availability of credit and other financial products from banks and broker dealers.
It is impossible to know whether or when FSOC will attempt to use the Framework and Guidance to designate private credit, equity, or hedge funds as SIFIs, which would have dramatic effects on their capitalization, leverage, activities, and investments. One thing is already clear, however: the industry is unlikely to accept any such designation without a fight1.