On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act"). This alert focuses specifically on some of the effects of the Reform Act on the regulation of systemic risk.

As is often the case with respect to landmark legislation, lawmakers left many of the key details of financial reform to regulation to be determined by the regulators. Various industry experts have estimated that the new law will require U.S. regulatory agencies to enact over 200 new regulations. Others have asserted that the rulemaking effort required to implement the Reform Act will be unprecedented in its scope and complexity and will exceed the efforts required to implement the post-September 11th measures and the Sarbanes-Oxley Act. As a result, U.S. regulatory agencies will be compelled to enact numerous regulations implementing the Reform Act and, in doing so, will have the opportunity to shape the ultimate effect of financial reform in many critical areas, many of which will have a profound impact on the regulation of systemic risk. In addition, the Financial Stability Oversight Council ("Council") is not yet operational, so there is much that remains unknown about how the Council will operate, and the changes that will be made to systemic risk regulation.

A. Establishment of the Financial Stability Oversight Council

The Reform Act established the Council to identify risks in market activities and to enhance oversight of the financial system. The Council consists of 10 voting members, including the Secretary of the Treasury, who serves as Chairman, and the heads of the Board of Governors of the Federal Reserve System ("Federal Reserve"), the Office of the Comptroller of the Currency, the Bureau of Consumer Financial Protection and the Securities and Exchange Commission, and 5 additional voting members. The Council, among other things, is authorized to make recommendations to the Federal Reserve regarding the establishment and enhancement of prudential standards and other requirements applicable to "systemically important" companies. The Council also has the authority to recommend that heightened standards be applied to financial activities and practices that the Council determines could create or increase the risk of financial problems.

 B. Systemically Important Companies

Title I of the Reform Act sets forth provisions that are applicable to "systemically important" bank holding companies ("BHCs") and nonbank financial companies.

1. Large Bank Holding Companies

BHCs with $50 billion or more in consolidated assets ("Large BHCs") are automatically designated as systemically important.1 The Federal Reserve has the authority to raise, but not lower, the $50 billion threshold.

2. Definition of "Nonbank Financial Company"

In addition, the Reform Act requires the Council to identify nonbank financial companies that are deemed systemically important ("Systemically Important Nonbank Financial Companies"). The process by which Systemically Important Nonbank Financial Companies are designated is set forth below. A nonbank financial company is defined in the Reform Act as a company, other than a BHC and certain other types of institutions, that is "predominantly engaged in financial activities." A company is "predominantly engaged in financial activities" if:

  • the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature (as defined in Section 4(k) of the Bank Holding Company Act of 1956, as amended ("BHC Act")) represents 85% or more of the consolidated annual gross revenues of the company; or
  • the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature represents 85% or more of the consolidated assets of the company.

Activities that are considered "financial in nature" under Section 4(k) of the BHC Act include, among others, (i) lending, exchanging, transferring, investing for others or safeguarding money or securities, (ii) securities underwriting, (iii) insurance activities, (iv) providing financial, investment or economic advisory services, (v) merchant banking activities and (vi) activities that are considered "closely related to banking" under the BHC Act, such as:

  • activities related to extending credit (such as real estate and personal property appraising and other services);
  • securities brokerage services;
  • investment advisory services;
  • fiduciary services; and
  • certain management advisory and data processing services.

Various types of entities would be considered nonbank financial companies under the foregoing definition and could potentially become subject to systemic risk regulation. For instance, savings and loan holding companies ("SLHCs") are considered nonbank financial companies. Thus, unlike BHCs, SLHCs are not automatically deemed "systemically important" if they have $50 billion or more in consolidated assets, but rather, are deemed "systemically important" if the Council so determines. In addition, nonbank financial companies may include both U.S. and foreign companies.

3. Designation of Systemically Important Nonbank Financial Companies

(i) Council Determinations

The Council, on a non-delegable basis and by a vote of not fewer than two-thirds of its voting members, may determine that

(i) the material financial distress at the nonbank financial company, or

(ii) the nature, scope, scale, concentration, interconnectedness, or mix of activities of the nonbank financial company,

could pose a threat to the financial stability of the United States and is, thus, systemically important.

In making this determination, the Council will consider a variety of factors, including, but not limited to:

  • the extent of the leverage of the company;
  • the amount and nature of the company's financial assets;
  • the amount and types of the company's liabilities;
  • the extent and nature of the off-balance sheet exposures of the company;
  • the extent and nature of the transactions and relationships of the company with other Systemically Important Nonbank Financial Companies and Large BHCs; and
  • the importance of the company as a source of credit for households, business and state and local governments and as a source of liquidity for the U.S. financial system.

The Council will provide the nonbank financial company being evaluated with written notice of the proposed determination including an explanation of the basis of the determination that the company is being deemed systemically important, and must provide an opportunity for a hearing. Any determination by the Council that a nonbank financial company is systemically important can be appealed. The Council must, at least annually, reevaluate each determination that a nonbank financial company is systemically important and rescind any such determination if the Council determines, by the same vote required for the initial determination, that such nonbank financial company no longer should be deemed systemically important.

(ii) BHCs that Become Systemically Important Nonbank Financial Companies

BHCs that were Large BHCs as of January 1, 2010 and that received assistance or participated in the TARP Capital Purchase Program will automatically be deemed Systemically Important Nonbank Financial Companies if they cease to be BHCs at any time after January 1, 2010. In this case, such BHCs would become Systemically Important Nonbank Financial Companies without any action by the Council.

(iii) Intermediate Holding Companies

Once a nonbank financial company is deemed systemically important, the Federal Reserve must require such Systemically Important Nonbank Financial Company to establish an intermediate holding company if it determines that the establishment of such intermediate holding company is necessary to appropriately supervise activities that are financial in nature or incidental thereto or to ensure that Federal Reserve supervision does not extend to any commercial activities of such Systemically Important Nonbank Financial Company. In this case, the intermediate holding company would be under the Federal Reserve's supervision, but the parent would not.

4. Anti-evasion Provision

The Council, on its own initiative or at the request of the Federal Reserve, may determine, on a nondelegable basis and by a vote of not fewer than two-thirds of its voting members, that financial activities conducted directly or indirectly (i) by any U.S. company or (ii) by any foreign company, if the activities are conducted in the United States, would pose a threat to the financial stability of the United States, and thus, such financial activities should be supervised by the Federal Reserve.

C. Heightened Prudential Standards Applicable to Large BHCs and Systemically Important Nonbank Financial Companies

Once a company is deemed to be subject to the systemic risk provisions of the Reform Act in one of the manners described above, it will become subject to a variety of new and/or enhanced requirements and limitations, as set forth in the remainder of this client alert. Systemically Important Nonbank Financial Companies and Large BHCs would become subject to enhanced prudential standards, as set forth in Title I of the Reform Act, and Systemically Important Nonbank Financial Companies would become subject to supervision by the Federal Reserve (although any SLHCs that are deemed systemically important will already be subject to supervision by the Federal Reserve, which will become the primary regulator of all SLHCs under the Reform Act).

In order to mitigate risks to the financial stability of the United States, the Federal Reserve will, on its own or by recommendation by the Council, establish heightened prudential standards and disclosure requirements applicable to Systemically Important Nonbank Financial Companies and Large BHCs. Such standards may be more stringent than those applied to BHCs and nonbank financial companies that do not pose similar risks to the financial stability of the United States. Such heightened prudential standards may include increased:

  • risk-based capital requirements;
  • leverage limits;
  • liquidity requirements;
  • contingent capital requirements;
  • resolution plans and credit exposure report requirements;
  • concentration limits;
  • public disclosure;
  • short-term debt limits;
  • overall risk management requirements; and
  • any other prudential standards as the Federal Reserve determines are appropriate.

The Federal Reserve must take into account the floors and other requirements set forth in Section 171 of the Reform Act, generally referred to as the "Collins Amendment," when establishing enhanced risk-based and leverage capital standards, which generally means that such enhanced standards may not be lower than those to which depository institutions are currently subject. The Federal Reserve, in consultation with the Council, may exempt a Systemically Important Nonbank Financial Company or Large BHC from such risk-based capital and leverage capital standards if such standards are deemed inappropriate for such company based on its activities. The Federal Reserve is also authorized to differentiate among companies on an individual basis or by category when establishing such enhanced prudential standards.

D. Resolution Plans and Credit Exposure Reports

Systemically Important Nonbank Financial Companies and Large BHCs must prepare extensive orderly resolution plans ("Resolution Plans"), which must be approved by the Federal Reserve and the Federal Deposit Insurance Corporation ("FDIC"). Resolution Plans are nonbinding on bankruptcy courts, receivers or similar authorities. The Resolution Plan provisions of the Reform Act will not be effective until July 21, 2013.

Resolution Plans must include:

  • information regarding the extent to which any insured depository institution affiliated with the company is adequately protected from risks arising from the activities of any nonbank subsidiaries of the company;
  • descriptions of the company's ownership structure, assets, liabilities and contractual obligations;
  • identification of the cross-guarantees tied to different securities, major counterparties and a process for determining to whom the collateral of the company is pledged; and
  • any other information that the Federal Reserve and the FDIC jointly require.

The FDIC and the Federal Reserve will review a company's Resolution Plan to determine whether it would facilitate an orderly resolution under the United States Bankruptcy Code. If the Resolution Plan is found to be deficient, the company must resubmit its Resolution Plan. If a company fails to adopt an acceptable Resolution Plan, the FDIC and the Federal Reserve may impose more stringent capital, leverage or liquidity requirements, or restrictions on growth, activities or operations on the company until such time as the company resubmits a plan that remedies the deficiencies. After the foregoing requirements and restrictions are imposed on a company, the FDIC and Federal Reserve may require the company to divest assets if the company's Resolution Plan is deficient and a suitable Resolution Plan is not resubmitted within two years.

Systemically Important Nonbank Financial Companies and Large BHCs must also submit periodic credit exposure reports to the Federal Reserve, the Council and the FDIC. Such reports must report on the nature and extent to which:

  • the company has credit exposure to other Systemically Important Nonbank Financial Companies and Large BHCs; and
  • other Systemically Important Nonbank Financial Companies and Large BHCs have credit exposure to that company.

E. Mitigation of Risks to Financial Stability

If the Federal Reserve determines that a Systemically Important Nonbank Financial Company or Large BHC poses a grave threat to the financial stability of the United States, the Federal Reserve, upon an affirmative vote of not fewer than two-thirds of the voting members of the Council, will:

  • limit the ability of the company to merge with, acquire, consolidate with or otherwise become affiliated with another company;
  • restrict the ability of the company to offer one or more financial products;
  • require the company to terminate one or more activities;
  • impose conditions on the manner in which the company conducts one or more activities; or
  • if the Federal Reserve determines that the foregoing actions are inadequate to mitigate the threat to the financial stability of the United States, require the company to sell or otherwise transfer assets or off-balance sheet items to unaffiliated entities.

Before the foregoing actions are taken, the company would be provided notice and opportunity for a hearing.

F. Reports and Examinations

The Reform Act provides that the Council may require any Large BHC and Systemically Important Nonbank Financial Company and any subsidiary thereof to submit reports under oath to keep the Federal Reserve informed as to:

  • the financial condition of the company or subsidiary;
  • systems of the company or subsidiary for monitoring and controlling financial operating and other risks;
  • the extent to which the activities and operations of the company or subsidiary pose a threat to the financial stability of the United States; and
  • compliance by the company or subsidiary with the systemic risk requirements of Title I of the Reform Act.

In addition, the Federal Reserve may examine any Systemically Important Nonbank Financial Company and any subsidiary thereof to inform the Federal Reserve of:

  • the nature of the operations and financial condition of the company and any subsidiary;
  • the financial, operational, and other risks of the company or subsidiary that may pose a threat to the safety and soundness of such company or subsidiary to the financial stability of the United States;
  • the systems for monitoring and controlling such risks; and
  • compliance with the systemic risk requirements of Title I of the Reform Act.

To the extent possible, in carrying out the foregoing report and examination requirements, the Federal Reserve must use reports and supervisory information that a Systemically Important Nonbank Financial Company or subsidiary thereof has provided to other federal or state regulatory agencies or information that is otherwise attainable.

The Federal Reserve would also have the authority to examine all Large BHCs, as their primary federal regulator.

G. Limitation on Credit Exposure

The Federal Reserve, by regulation, must prescribe standards that would prohibit each Systemically Important Nonbank Financial Company and Large BHC from having credit exposure to any unaffiliated company that exceeds 25% of the capital stock and surplus of the company.

H. Permanent Self Funding

Beginning on July 21, 2013, the Secretary of the Treasury will establish, by regulations, and with the approval of the Council, an assessment schedule, including the assessment base and rates, applicable to Large BHCs and Systemically Important Nonbank Financial Companies, in order to collect assessments equal to the total expenses of the Office of Financial Research within the Department of the Treasury. Such assessment schedule must take into account differences among such companies, based on the considerations set forth above for establishing the prudential standards applicable to such companies.

I. Risk Committees

The Reform Act also requires the creation of risk committees ("Risk Committees") for publicly traded Systemically Important Nonbank Financial Companies and publicly traded BHCs with total consolidated assets of $10 billion or more. The Federal Reserve may impose the requirement on publicly traded BHCs with a lower threshold of assets, at its discretion, to promote sound risk-management practices.

Risk Committees must:

  • be responsible for the oversight of the enterprise-wide risk management practices of the company;
  • include such number of independent directors as the Federal Reserve may determine appropriate; and
  • include at least one risk management expert with experience in identifying, assessing, and managing risk exposures of large, complex firms.

The Federal Reserve must issue final rules to carry out the Risk Committee provision within two years after the enactment of the Reform Act, and such rules must take effect within 27 months after the enactment of the Reform Act, subject to an extension by up to 6 months by the Treasury Secretary.

J. Stress Tests

The Reform Act requires the Federal Reserve to conduct annual "stress tests" on every Systemically Important Nonbank Financial Company and Large BHC in which it is determined whether such institutions have the capital necessary, on a total consolidated basis, to absorb losses as a result of adverse economic conditions. In addition, each Systemically Important Nonbank Financial Company and Large BHC will be required to conduct internal stress tests semi-annually and report the results thereof to the Federal Reserve and its primary financial regulatory agency. All other financial companies with assets of $10 billion or more that are regulated by the primary federal bank regulators must conduct annual stress tests. Implementing regulations will set forth standards for the stress tests and requirements that institutions publish a summary of the results of their stress tests.

K. Timeline

Now that the Reform Act has become law, the regulatory implementation phase has begun. While a few of the Reform Act’s provisions became effective immediately, many provisions of the Reform Act will become effective in stages over the next 6 to 24 months as the U.S. regulatory agencies issue the implementing regulations required under the Reform Act. To find out more information about the Reform Act’s effective dates and regulatory deadlines, please visit Sonnenschein's interactive Reform Act timeline. This timeline was designed to help our clients gain a better understanding of the many steps required to effectively navigate the regulatory implementation process.