As one of its first official acts, the Financial Stability Oversight Council (“Council”) has issued an advance notice of proposed rulemaking (“ANPR”) inviting public comment on the criteria it should use in designating sys-temically important nonbank financial companies (“Significant Nonbanks”), which will be made subject to prudential regulation pursuant to Title I of the Dodd-Frank Act. The Council also has issued a request for information and public comment (“Volcker Request”) regarding the study and recom-mendations (“Volcker Study”) it is required to make in regard to Section 619 of the Act, the so-called “Volcker Rule.” Comments on both the ANPR and the Request are due by November 5, 2010. For further analysis of these areas of the Act, see our Analysis of Financial Regulatory Reform Leg-islation for American Bankers Association.

Significant Nonbank Designation ANPR

The Dodd-Frank Act sets forth a number of factors that the Council must consider in designating Sig-nificant Nonbanks, but the manner in which the Council interprets and applies these factors may determine whether particular nonbank financial companies are selected and, more generally, how broad an impact the Dodd-Frank Act may have on the U.S. financial services industry. If a nonbank financial company is determined to be systemically significant, it will be regulated to various degrees, including as to its capital requirements and ulti-mate resolution, by the Federal Reserve Board and, in certain respects, by other agencies, includ-ing the FDIC. So, the stakes of the rulemaking are significant.

The ANPR presents an important opportunity for nonbanking financial services organizations to par-ticipate by presenting 15 topics for comment, con-sisting of the following:

  • Metrics – How should the Council measure the factors it is required to consider under the Dodd-Frank Act?  
    • The Council may be considering devel-oping a matrix of supporting and miti-gating systemically significant factors similar to the Civil Money Penalty Matrix used by the Federal bank regulatory agencies. Thus, the relative weight of factors relied upon by the Council should be carefully considered by com-menters.  
  • Eligibility – What types of nonbank financial companies should the FSOC evaluate? Should the evaluation standards vary across industries?  
  • Foreign Nonbank Companies – Are there unique international considerations when designating foreign nonbank financial com-panies?  
  • Exclusions – Are there simple standards that can be used to exclude certain nonbank fi-nancial companies from consideration for possible designation?
    • This topic may be of particular interest as a way to mitigate the uncertainty created by the Dodd-Frank Act for nonbank financial compa-nies and their shareholders, creditors and counterparties when such companies are “on the bubble” for selection. For example, should nonbank financial companies be sub-ject to a minimum $50 billion asset size, as is the case with bank holding companies (“BHCs”), in order to be eligible to be desig-nated as a Significant Nonbank?  
  • Size, Scope and Scale – How should a nonbank fi-nancial company be measured? Should measure-ments be risk-weighted, off-balance-sheet expo-sures be considered and the amount and concen-tration of assets under management be factors? If so, how should side arrangements and implicit obligations to provide financial support to spon-sored or managed funds be evaluated?  
    • For example, do off-balance-sheet exposures or assets under management, which are not considered when determining whether a BHC is subject to enhanced supervision, present a different risk profile than on-balance-sheet assets and liabilities?  
  • Significance as a Funding Source – How should the Council measure a nonbank financial com-pany’s role as a source of credit for households, businesses, and governments and as a source of liquidity, including its role as a source of credit for low-income, minority and underserved com-munities?  
  • Interconnectedness – What types of exposure to other companies should be considered, and how should such exposure be measured?  
    • The economic crisis of 2008 put a spotlight on the risks posed by a company whose fail-ure could have a broad or cascading impact across other large firms or industries. As a result, the empirical approach used by the Council to qualitatively measure and evaluate such relationships is likely to be of particular significance in designating Significant Non-banks.  
  • Leverage – Should this evaluation standard vary across industries? Should leverage standards that apply to banking organizations, such as Basel III recommendations, be considered?  
  • Liabilities – How should funding concentrations and excessive reliance on a particular type of funding be measured? Are there relevant mitigat-ing factors?  
    • A liquidity crisis can have a highly destabiliz-ing impact even if a company has satisfactory asset quality. Here again, the methods used to evaluate the pros and cons of various fund-ing strategies are likely to be of particular significance in the Significant Nonbank des-ignation process.  
  • Existing Regulation – Is coverage by existing fi-nancial regulation a relevant consideration? Are certain areas of regulation particularly significant?  
    • Existing financial regulation would appear to be highly relevant, particularly to the extent that turf wars among the regulators repre-sented on the Council become a factor in Council actions.  
  • Public Disclosure – How important is enhanced transparency to a nonbank financial company and its risk management practices?  
  • Bailouts – Is a nonbank financial company’s par-ticipation in government programs to restore the functioning of the U.S. financial system a relevant consideration?  
  • Best Practices – Are there methods to evaluate in-terconnectedness and risk concentrations used by certain companies or industries that could be more broadly applied?  
  • Definitions – Should the Council define “material financial distress” or “financial stability?”  
  • Additional Factors – Are there other relevant risk-related factors to be considered when designating Significant Nonbanks?  

Volcker Rule Study

The Volcker Rule prohibits “banking entities” from en-gaging in proprietary trading and from investing in, sponsoring or maintaining certain additional relation-ships with hedge funds and private equity funds. The Volcker Rule will have a far reaching impact on the fi-nancial services industry. See Dodd-Frank’s Limitations on Risk Taking: An Analysis of the Volcker Rule’s Re-strictions on Proprietary Trading and Investments In and Sponsorship of Hedge Funds and Private Equity Funds. The Volcker Study will give the Council an oppor-tunity to address some of the contradictory features of the Volcker Rule or suggest important clarifications.  

The Dodd-Frank Act calls for the Volcker Study to be completed no later than six months after its enactment.

The release of the Volcker Study will, in turn, trigger a nine month period for the regulatory agencies to issue final rules implementing the Volcker Rule. As a result, the Volcker Request offers industry participants an im-portant first bite at the apple in helping shape the rules that will govern the actual application of the Volcker Rule.

The Volcker Request seeks public comment on the 12 questions summarized below. While some of these questions are very specific, others are open-ended, pro-viding industry participants an opportunity to comment not just on the details but also on the broader frame-work of the Volcker Rule. As the precise concerns under-lying the Volcker Rule are not clearly spelled out in the Rule or limited legislative history, and in many respects the actual prohibitions of the Volcker Rule do not appear to be well-aligned with the apparent concerns, com-menters would be well-advised to address both types of questions. By doing so, industry participants may be able to help the Council and the financial regulatory agencies construct a rational set of carefully tailored rules that achieve an agreed upon set of narrow objec-tives without needlessly interfering with the ability of banking entities to engage in legitimate, valued business activities.

  • Volcker Study General Goals – The first question asks for comment on the seven goals for the Vol-cker Study as set forth in Section 619(b) of the Dodd-Frank Act. Briefly, these goals are to (i) en-hance safety and soundness of banking entities, (ii) minimize risk that a banking entity will engage in unsafe and unsound activities, (iii) limit inap-propriate transfers of federal subsidies to unregu-lated entities, (iv) reduce conflicts of interest with customers, (v) limit activities that have caused undue risk or loss or might reasonably be ex-pected to create undue risk or loss, (vi) accom-modate insurance companies subject to state in-surance regulation, and (vii) appropriately time the divestiture of illiquid assets.  
  • Key Factors and Considerations – The Volcker Re-quest seeks comment on the key factors and con-siderations that should be taken into account in making recommendations on the proprietary trad-ing portions of the Volcker Rule and, separately, on the private equity and hedge fund portions of the Volcker Rule.  
  • Definitions of Key Terms – This question identifies fifteen terms and phrases used in the Volcker Rule and requests input on the factors and con-siderations that should inform decisions on the definitions of those terms.  
  • General Limitations on Permitted Activities – This question asks what factors and considerations should be taken into account when making de-terminations as to whether transactions or activi-ties would involve a material conflict of interest, a material exposure to high-risk assets or high-risk trading strategies, or a threat to safety and soundness.  
  • Additional Capital and Quantitative Limitations – What are the relevant factors and considerations relating to the possible imposition of additional capital or quantitative limitations on those pro-prietary trading or hedge and private equity fund activities that are permitted under the Volcker Rule?  
  • Identifying and Limiting Risk – The Volcker Re-quest seeks input from industry participants on (i) the types of practices, transactions, and struc-tures that have historically been or may in the fu-ture be associated with increased risks, (ii) those practices, policies and procedures that histori-cally have exacerbated or mitigated risks or losses, and (iii) those practices, policies, and pro-cedures that might be useful in the future to limit undue risk or losses.  
  • Anti-Evasion Factors and Considerations – What should be taken into account in developing safe-guards against evasion of the Volcker Rule?  
  • International Implications – This request focuses generally on the international implications of ap-plying the Volcker Rule to banking entities that operate outside the United States.  
    • Interestingly, three specific situations are mentioned: a domestic banking entity with access to foreign exchanges; a foreign affili-ate of a domestic banking entity; and a for-eign nonbank financial company, but no ref-erence is made to foreign banking entities.  
  • Timing of Divestitures of Illiquid Assets – What timing issues are raised in connection with the di-vestiture of illiquid assets?  
  • Other Qualitative or Quantitative Factors – The Volcker Request concludes with an open-ended invitation for commenters to submit their views with respect to any qualitative of quantitative fac-tors that should be considered.