On October 11, 2011, the Financial Stability Oversight Council (FSOC) released its second notice of proposed rulemaking (NPR)1 on designating nonbank systemically important financial institutions (SIFIs) to be supervised by the Board of Governors of the Federal Reserve System. Under section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, nonbank SIFIs subject to possible FSOC designation include insurance companies, savings and loan holding companies, hedge funds, and asset managers.2

Under Dodd-Frank, FSOC can require a nonbank financial company3 to be supervised by the Federal Reserve and subject to heightened prudential standards if FSOC determines the company meets either of two "Determination Standards." The "First Standard" is that material financial distress at the nonbank financial company could pose a threat to the financial stability of the United States. The "Second Standard" is that the nature, scope, size, scale, concentration, interconnectedness, or mix of activities of the nonbank financial company could pose a threat to the financial stability of the United States.

FSOC previously released an NPR regarding designation of nonbank financial companies as systemically important on January 26, 2011.4 FSOC released this second NPR rather than finalizing the rule because it made significant changes to the previous approach. In particular, this most recent NPR provides a more detailed framework that FSOC will use in its determinations of whether a nonbank financial company could pose a threat to U.S. financial stability and provides additional opportunities for public comment.

The NPR clarifies the meaning of key phrases used in the Determination Standards, reviews the statutory criteria FSOC must consider in determining whether a Determination Standard has been met, and a sets forth a six category analytic framework that is designed to incorporate each of the statutory criteria. The NPR also describes the three-stage determination process that FSOC plans to apply in most situations.5 Nonbank financial companies that exceed certain financial threshold limits can expect to reach at least stage two of the determination process. 

Statutory considerations

Section 113 of the Dodd-Frank Act specifies quantitative and qualitative factors that FSOC must consider in order for it to conclude a Determination Standard has been met6:

  • Extent of leverage;
  • Off-balance-sheet exposures;
  • Transactions and relationships with other significant bank and nonbank financial companies;
  • The importance of the company as a source of credit and liquidity for the U.S.;
  • The importance of the company as a source of credit for low-income, minority, or underserved communities;
  • The extent to which asset ownership is diffuse, or to which assets are managed, rather than owned;
  • Activities, including the nature, size, mix, and interconnectedness of those activities;
  • Existing regulation by one or more primary financial regulators;
  • Financial assets;
  • Liabilities, including reliance on short-term funding; and
  • Any other risk-related factors deemed by FSOC.

Six category framework

The NPR describes a six category framework that FSOC has developed which groups together the Dodd-Frank statutory considerations. Some statutory considerations often fall into more than one of the six categories. The categories are:

  • Interconnectedness. Interconnectedness captures direct or indirect linkages between financial companies that may be conduits for the transmission of the effects resulting from a nonbank financial company's material financial distress or activities. 
  • Substitutability. Substitutability captures the extent to which other firms could provide similar financial services and includes an analysis of market share.    Size. Captures the amount of financial services or financial intermediation provided by a nonbank financial company.
  • Leverage. Leverage captures a company's exposure or risk in relation to its equity capital. 
  • Liquidity risk and maturity mismatch. Liquidity risk refers to the risk that a company will be unable to satisfy its short-term funding needs and includes an examination of a nonbank financial company's liquid assets. A maturity mismatch refers to the difference between the maturities of a company's assets and liabilities.     
  • Existing regulatory scrutiny. FSOC will consider the extent to which nonbank financial companies are subject to existing regulation, including consolidated supervision.  

Three of the six categories – size, substitutability, and interconnectedness – are meant to assess the potential impact of the nonbank financial company's financial distress upon the broader economy. The remaining categories – leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny of the nonbank financial company – are meant to assess the vulnerability of a nonbank financial company to financial distress. FSOC intends to use these six categories as a guide in its evaluation of whether a particular nonbank financial company meets either Determination Standard. The NPR provides sample metrics for each of the six categories with the caveat that the sample metrics are not exhaustive and many not apply to all nonbank financial companies under evaluation.

Three-stage determination process

The NPR sets forth a three-stage determination process through which FSOC will apply the Determination Standards. In stage one, quantitative thresholds that are broadly applicable across the financial sector will be used to determine which nonbank financial companies will be subject to further review.7 A nonbank financial company can expect to be identified in stage one for further review in stage two if it meets or exceeds both the total consolidated assets threshold of $50 billion ($50 billion in global total consolidated assets for U.S. nonbank financial companies or $50 billion in U.S. total consolidated assets for foreign nonbank financial companies), and any one of the following:

  • $30 billion in gross notional credit default swaps (CDS) outstanding;
  • $3.5 billion in derivative liabilities (after accounting for master netting agreements and collateral);
  • $20 billion of outstanding loans borrowed and bonds issued;
  • 15-to-1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity; or
  • 10% ratio of short-term debt to total consolidated assets (excluding separate accounts).

Nonetheless, and not surprisingly, FSOC retains the flexibility in limited cases to determine a company meets stage one standards without applying the uniform quantitative thresholds.

In stage two, FSOC will conduct a comprehensive analysis of the potential for the nonbank financial company to pose a threat to U.S. financial stability. Generally, this analysis will be based on quantitative and qualitative information available through existing public and regulatory sources, including information available through the new Office of Financial Research (OFR),8 and information provided voluntarily by the identified companies. The six category analytic framework described above will be applied in stage two evaluations.

Stage three will build on stage one and two analyses by using quantitative and qualitative information obtained directly from the nonbank financial company. FSOC will work with OFR or the appropriate regulatory agency in gathering information during the stage three process. If FSOC is unable to determine based on such information whether a U.S. nonbank financial company poses a threat to U.S. financial stability it may request that the Federal Reserve conduct an examination of the nonbank financial company. At the conclusion of stage three, FSOC will determine whether to subject a nonbank financial company to Federal Reserve supervision and oversight based on the results of the analyses conducted during each stage of review.9 Nonbank financial companies subject to stage three review will receive a Notice of Consideration that the company is under consideration for a Proposed Determination. 

The issuance of a Proposed Determination requires a two-thirds vote of the FSOC voting members.10 Following a Proposed Determination, FSOC will issue a written notice of the proposed determination, which will include an explanation of the basis for the determination.11 The nonbank financial company may request a hearing to contest the Proposed Determination. Upon completion of the record and the FSOC's analysis, the FSOC either will publicly issue a Final Determination to the nonbank company that it is subject to Federal Reserve supervision, or inform the company that it is no longer under consideration.12

Nonbank financial companies the FSOC has determined subject to Federal Reserve supervision will, among other things, be subject to enhanced capital and liquidity requirements, and be required to file resolutions plans (known as living wills) with the FDIC and Federal Reserve.

Key terms

The NPR clarifies the meaning of two key phrases used in the Determination Standards: "threat to the financial stability of the United States" and "material financial distress." 

"Threat to the financial stability of the United States"

FSOC will consider a "threat to the financial stability of the United States" to exist if there would be an impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy. Three so-called channels are identified as likely to facilitate the transmission of the negative effects of a nonbank financial company's material financial distress or activities to other financial firms and markets:

  • Exposure. A nonbank financial company's creditors, counterparties, investors, or other market participants could have material significant exposure to the nonbank financial company, and thereby pose a threat to U.S. financial stability. Potential metrics for calculating exposure include: total consolidated assets, credit default swaps outstanding, derivative liabilities, loans and bonds outstanding, and the company's leverage ratio.
  • Asset liquidation. Addresses instances where a nonbank financial company holds assets that, if liquidated quickly, would significantly disrupt trading or funding in key markets or cause significant losses or funding problems for other firms with similar holdings due to falling asset prices. Potential metrics for calculating include: total consolidated assets and short-term debt ratio.
  • Critical function or service. A nonbank financial company is no longer able or willing to provide a critical function or service that is relied upon by market participants (including the provision of liquidity to the U.S. financial system, the provision of credit to low-income, minority, or underserved communities, or the provision of credit to households, businesses, and state and local governments). FSOC expects to apply company-specific analyses with respect to this channel.        

FSOC intends to exercise its discretion in evaluating and considering additional channels through which a nonbank financial company may transmit the negative effects of its material financial distress or activities and thereby pose a threat to U.S. financial stability. 

"Material financial distress"

For purposes of the First Standard, "material financial distress" exists when a nonbank financial company is in imminent danger of insolvency or defaulting on its financial obligations. FSOC intends to assess the impact of a nonbank financial company's material financial distress in the context of a period of overall stress in the financial services industry and a weak macroeconomic environment.13

What you need to know now

Nonbank institutions that may be considered for a determination by FSOC should evaluate whether the institution triggers the stage one quantitative thresholds. Because FSOC's determination is not limited to those thresholds, institutions that are close to the thresholds should consider any other relevant information in an assessment.

Institutions that have a strong likelihood of meeting stage one and moving on to stage two consideration may want to consider one or more of the following responses:

  • Adjust business to make determination less likely given the NPR's guidelines;
  • Acknowledge likelihood of determination for Federal Reserve supervision and begin preparations for supervision similar to that currently in place for bank holding companies; or
  • Submit comments to the NPR prior to the December 19, 2011 deadline, suggesting modifications to the proposal, such as changes to the quantitative thresholds, the six category framework, or defined terms. 

Conclusion

We expect a significant number of comments to the NPR given the diverse groups within the financial services industry potentially impacted by the rulemaking. Some of those commentators will seek adjustment of the quantitative measures. Some will likely seek additional certainty with respect to FSOC's determination process, while FSOC will wish to retain flexibility in order to be able to appropriately respond to future unforeseen events in the financial markets. The challenge in an increasingly crowded regulatory landscape will be balancing those concerns.