On April 3, 2013, the Board of Governors of the Federal Reserve System(the "FRB") finalized rules1 outlining certain criteria that will be used inmaking a determination that a nonbank financial institution is systemically important to the Nation's financial stability, thus warranting heightened Federal regulation.

Background

As part of its overhaul of financial regulation in the U.S., the Dodd-FrankWall Street Reformand Consumer Protection Act established the Financial Stability Oversight Council ("FSOC"), an oversight body that includes the heads of the Nation's principal financial regulatory agencies. Dodd-Frank authorizes FSOC to subject a "nonbank financial company" that is "predominantly engaged in financial activities" to supervision by the FRB, as well as heightened financial regulatory requirements, if "material financial distress" at the nonbank financial company or the nature, scope, size, scale, concentration, interconnectedness, or mix of its activities could pose a threat to the Nation's financial stability (a company so designated, a "systemically important financial institution" or "SIFI").

"Predominantly engaged"

Under the new FRB rule, a firmis "predominantly engaged in financial activities" if

  • its consolidated annual gross financial revenues (generally, revenues derived fromdepositary or other financial activities) in either of its twomost recently completed fiscal years represent 85 percent or more of its consolidated annual gross revenues in that fiscal year or
  • its consolidated total financial assets (generally, assets related to depositary or other financial activities) as of the end of either of its twomost recently completed fiscal years represent 85 percent or more of its consolidated total assets as of such date (excluding cash and goodwill fromboth financial assets and total assets).

The foregoing determinationsmay bemade

  • in accordance with applicable accounting standards (GAAP, IFRS or other bodies of accounting guidance approved on a case-by-case basis by FSOC or the FRB) or
  • by FSOC or the FRB.

In determining whether the 85 percent thresholds described above are exceeded,

  • revenues and assets related to non-consolidated investments and
  • accounts receivable

are presumed to be "financial" in nature although such presumption can be rebutted upon a showing of evidence to FSOC or the FRB.

(In each of the foregoing instances where FSOC or the FRB can exercise discretion, FSOC is authorized to make the foregoing determinations in relation to Dodd-Frank's definition of "nonbank financial company," and the FRB is so authorized in the context of the definition of "significant nonbank holding company.")

"Financial activities"

For purposes of the foregoing definitions and tests, "financial activities" include, among other things,

  • lending or safeguardingmoney or securities,
  • insuring against loss and issuing annuities,
  • providing financial advisory services,
  • issuing instruments representing interests in pools of assets,
  • underwriting securities,
  • engaging in specified activities that the FRB has determined to be incidental to owning a bank,
  • merchant banking-related activities,
  • making portfolio investments of an insurance company,
  • lending assets other thanmoney or securities,
  • providing any device for transferring money and
  • arranging financial transactions for third parties.

"Significant Nonbank Financial Company"

The final rule defines "significant nonbank financial company" as

  • a nonbank financial company supervised by the FRB and
  • a nonbank financial company that had $50 billion or more in total consolidated assets as of the end of itsmost recently completed fiscal year.

In Dodd-Frank, the term"significant nonbank financial company" is used primarily in the context of determining whether another company is a SIFI. For instance, in determining whether a given firm ought to be designated as a SIFI, FSOC is required to consider the extent and nature of the transactions and relationships of such company with "other significant nonbank financial companies."

Impact on SIFI Determinations

Once a nonbank is determined to be "predominantly engaged in financial activities" pursuant to the above standards, it can be designated a SIFI. Pursuant to guidance2 issued by FSOC last year, SIFI determinations will bemade in accordance with the following criteria and procedures:

  • FSOC will take into account all of the relevant statutory considerations under Dodd-Frank3 when evaluating whether to designate a nonbank as a SIFI.
  • FSOC will consider three "channels" deemedmost likely to transmit to other firms and markets "the negative effects of [a nonbank's] distress," thereby posing a threat to U.S. financial stability. These comprise:
    • exposure of creditors, counterparties, investors or other market participants to the nonbank firm,
    • "disruptions caused" by the liquidation of its assets and
    • its inability or unwillingness to provide a critical function or service relied upon by market participants and for which there are no ready substitutes.
  • Companies will be considered for SIFI status not by formula but rather by a companyspecific evaluation,
  • FSOC will engage in a three-stage process.
    • In the first stage (Stage 1), FSOC will apply certain uniformquantitative criteria to the firm.
      • If these thresholds are exceeded as set forth below, FSOC will move on to the next stage; if the thresholds are not exceeded, the firmwill no longer be subject to the determination process and will not be designated a SIFI.
      • Where the firmis U.S.-based, the quantitative thresholds will apply to the firm's global assets, liabilities and operations. In contrast, for foreign nonbank financial companies, only the firm's U.S. assets, liabilities and operations will be measured.
      • In applying these tests to a fund (whether or not required to be registered under the Investment Company Act of 1940), FSOCmay "aggregate risks posed by separate funds that aremanaged by the same adviser". Furthermore, when applying the Stage 1 thresholds to an "asset manager," FSOC will "appropriately" consider the distinct nature of assets under management compared to the asset manager’s own assets.
      • Under the quantitative criteria, the nonbank fails the Stage 1 test, andmoves on to Stage 2, if it has at least $50 billion in total consolidated assets and any one of the following.
        • $30 billion in gross notional credit default swaps outstanding for which the nonbank is the reference entity;
        • $3.5 billion of derivative liabilities (to include embedded derivatives in the case of insurance companies; however, in Stages 2 and 3, FSOCmay take into account that these are not actual derivatives);
        • $20 billion in total debt outstanding;
        • 15 to 1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity; and
        • 10% short-termdebt ratio of total debt outstanding with amaturity of less than 12 months to total consolidated assets (excluding separate accounts),
    • If the firm is then required to undergo Stage 2, FSOC will conduct a subjective review to determine whether additional deliberation under Stage 3 is warranted. Stage 2 will use an "analytic framework" consisting of the following six categories:
      • size
      • interconnectedness,
      • substitutability,
      • leverage,
      • liquidity risk andmaturitymismatch, and
      • existing regulatory scrutiny.
    • Stage 3, if applicable to the firmin FSOC's discretion, will build on the Stage 2 analysis using quantitative and qualitative information collected directly fromthe nonbank financial company, in addition to the information considered during Stages 1 and 2.
  • Following the completion of the three stages for a given firm, but prior tomaking a determination, FSOCmay consult with the nonbank's "primary financial regulatory agency or home country supervisor" and consider the views of such regulators.