The Financial Stability Oversight Council on April 21, 2023, released for public comment a proposed analytic framework for financial stability risk identification, assessment and response (Proposed Framework)1 and proposed interpretive guidance on nonbank financial company determinations (Proposed Guidance) (together, Proposals).2 The Proposals would work in concert to alter the processes by which FSOC designates nonbank financial companies (nonbanks) as “systemically important financial institutions” (SIFIs) subject to regulation by the Federal Reserve. Four key changes in the Proposals would make the designation of nonbanks more “available” to FSOC, which could mean more designations and accompanying heightened regulatory compliance costs for the nonbanks subject to them.
The Dodd-Frank Wall Street Reform and Consumer Protection Act created FSOC with the purpose of identifying and addressing risks to financial stability and eliminating market expectations that the U.S. government will prevent losses in events of failure.3 In order to reduce risks to financial stability, Congress granted FSOC the power to designate nonbanks as SIFIs and subject them to supervision and prudential standards set by the Federal Reserve (designation), among other authorities.4 According to the standard set forth in Dodd-Frank, a designation may be made if FSOC determines that a nonbank’s (i) material financial distress or (ii) the nature, scope, size, scale, concentration, interconnectedness or mix of their activities could pose a threat to financial stability.5
In 2012, FSOC issued rules and interpretive guidance concerning its designation power (2012 Guidance).6 Following this, four nonbanks were designated as SIFIs: American International Group, Inc.; General Electric Capital Corporation; Prudential Financial, Inc.; and MetLife, Inc. MetLife successfully challenged its designation in federal court with the ruling resting on the grounds that FSOC “made critical departures from two of the standards it adopted” in the 2012 Guidance.7 The U.S. District Court for the District of Columbia also held that FSOC was required to consider the cost of designation to MetLife and failed to do so.8 In the wake of this decision, by 2018, FSOC had rescinded all four of the designations. In 2019, the 2012 Guidance was substantially revised (2019 Guidance) with the MetLife decision in mind and with the purpose to decrease future designations of nonbanks as SIFIs. Relevant provisions of the 2019 Guidance are discussed in the context of the current Proposals below.
The Proposed Guidance would replace the 2019 Guidance on designations of nonbanks contained in Appendix A (Appendix) to the rules on designations (Rules), whereas the Rules themselves would not be altered.9 The Appendix is a non-binding rule “except to the extent it sets forth rules of agency organization, procedure, or practice” which cannot be altered without proper notice and comment.10 The Proposed Framework purports to have no binding effect and would not affect the text of the Rules nor the Appendix.11 This is relevant especially to the first key change below.
As noted above, the Proposed Guidance and Proposed Framework, if adopted as proposed, would bring four key changes to designations of nonbanks as SIFIs.
First, the Proposals would limit the text of the Appendix solely to procedures on designations rather than including substantive risk analysis as well. Rather, the substantive analysis would be contained in the Proposed Framework. This analysis would then be made to broadly apply to all potential responses to threats to financial stability, such as leading interagency coordination and recommendations to agencies or Congress, not just SIFI designations, as is currently contemplated in the Appendix. The Proposed Guidance suggests that responses to threats to financial stability should be appropriately varied, including activity-based, entity-based or industry-wide approaches, but should also be analyzed through a unified framework because transmission channels and risk factors facilitating financial instability occur in various forms and conditions. FSOC stated in the release accompanying the Proposed Guidance that in the designation process it “will apply the statutory standard and considerations in any evaluation” of a nonbank for designation, seemingly setting this as the standard for any challenges to designation, rather than the wholly non-binding Proposed Framework.12
Second, the Proposals would remove the definition of “threat to the financial stability of the United States” from the Appendix. This would be replaced by the definition contained within the Proposed Framework which would change the term from meaning something that “would be sufficient to inflict significant damage to the broader economy” to something that “could impair [the financial system’s] ability to support economic activity.”13 The release accompanying the Proposed Guidance indicates that this change would be made to align with the duties of FSOC contained in Dodd-Frank.14 However, commenters have previously critiqued FSOC for drawing speculative conclusions that are not based on empirical data when analyzing threats to financial stability, and the change in this standard could evoke more of the same concerns.15
Third, the Proposals would eliminate the requirement for FSOC to focus on addressing risks to financial stability with an “activities-based approach.” This approach, implemented in the 2019 Guidance, mandates that FSOC prioritize all other means to respond to threats to financial stability over nonbank designations. FSOC is only able to evaluate nonbanks for SIFI designation if the primary regulator of the company in question does not adequately address the risk. Under the Proposed Guidance, this “prioritization scheme” would be discarded, though FSOC stated in the accompanying release that it would continue to “maintain its previous commitment to engaging extensively with existing regulators.”16 Additionally, other approaches would not need to be considered before utilizing the designation process. Removing the activities-based approach could raise questions as to why FSOC should supplant the role of existing federal regulation and regulators when they lack a similar level of knowledge and experience in regulating asset management firms.17
Fourth, the Proposals would no longer require FSOC to undertake the threshold test of cost-benefit analysis which includes assessing a nonbank’s “likelihood of material financial distress.” Under the 2019 Guidance, FSOC must consider and determine that the benefits of a designation outweigh the costs before initiating the SIFI designation process. The Proposed Guidance, however, would treat the costs of a designation as not being a “risk-related factor” of financial stability.18 The accompanying release reasons that the statutory text of Dodd-Frank determines the benefits of a designation outweigh the costs ipso facto, so long as the standard for a designation is met.19 Similarly, the Proposed Guidance would discard the requirement to determine the likelihood of a nonbank being in financial distress, replacing it with a determination of whether the nonbank could threaten financial stability assuming it was in material financial distress. In the accompanying release, FSOC questioned the feasibility of determining whether the costs outweigh the benefits and if it is reasonable to predict material financial distress given the rapidity of previous collapses.
Recently, FSOC and Chairperson Janet Yellen have demonstrated a focus on the financial stability risks posed by types of nonbanks that were not previously designated, such as hedge funds, money market funds and digital asset firms.20 This could suggest an increased willingness to consider designating a wider range of nonbanks. Given this, and the tenor of the Proposals, these types of large nonbanks, as well as asset managers, insurance providers, fintechs such as peer-to-peer payment companies and other similarly situated market participants, may wish to consider submitting comments to FSOC regarding the Proposals. Both Proposals may be adopted with modifications accounting for comments received, and potential litigation challenging FSOC’s final guidance or a designation may be predicated in part upon the substance of any comments. The Proposed Framework and Proposed Guidance were published in the Federal Register on April 28, 2023. Comments on the Proposed Framework and Proposed Guidance must be submitted by June 27, 2023.