Insights

In crafting financial reform legislation, Congress focused on managing systemic risk – that is, identifying when certain institutions are so intertwined with the well being of the financial system that their failure poses far-reaching and devastating ramifications to the entire U.S. economy. In order to reduce systemic risk in the U.S. financial system, Congress created a new federal regulator, the Financial Stability Oversight Council, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The FSOC is charged with identifying banks and nonbank financial companies that pose this type of systemic risk so that these entities can be subject to heightened regulatory supervision. These entities are referred to as systemically important financial institutions, or SIFIs. Nonbanks that are designated as SIFIs will be subject to prudential regulation and supervision by the Federal Reserve Board. Prudential regulation, or risk-based regulation, is a concept that is well established in the banking industry but will be a new concept for nonbank consumer finance companies.

On October 11, 2011, the FSOC issued its second notice of proposed rulemaking concerning identification of nonbank SIFIs. The proposed rule sets out the general standard for nonbank SIFI designation, the framework under which nonbanks will be reviewed for potential SIFI designation, and the process that the FSOC will follow in designating nonbank SIFIs. The following summary focuses on the analysis and thresholds that will apply to U.S. companies; slightly different standards apply to foreign companies.

General Rule: A nonbank financial company will be designated as an SIFI subject to prudential regulation and supervision by the Board if the FSOC determines that “material financial distress at the nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company, could pose a threat to the financial stability of the United States.” In effect, there are two standards under which a nonbank financial company can be designated as an SIFI – under the “material financial distress” standard or because of the “nature, scope, size, scale, concentration, interconnectedness, or mix of the activities” of the company.

Framework: In determining whether a U.S. nonbank financial company meets either standard set forth above, the FSOC will consider the following with respect to the company and its subsidiaries:

• the extent of the leverage of the company;
• the extent and nature of the off-balance-sheet exposures of the company;
• the extent and nature of the company’s transactions and relationships with other significant nonbank financial companies and significant bank holding companies;
• the importance of the company as a source of credit for consumers, businesses, and state and local governments, as well as a source of liquidity for the U.S. financial system;
• the importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the company’s failure would have on the availability of such credit;
• the extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
• the nature, scope, size, scale, concentration, interconnectedness, and mix of the company’s activities;
• the degree to which the company is already regulated by one or more primary financial regulatory agencies (e.g., federal banking agencies, SEC, CFTC, state insurance agencies);
• the amount and nature of the company’s financial assets;
• the amount and types of the company’s liabilities, including the degree of reliance on short-term funding; and
• any other risk-related factors that the FSOC deems appropriate.

In analyzing each of the considerations set forth above, the FSOC will focus on the following six categories: size, interconnectedness, lack of substitutes, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny. Three categories – size, substitutability, and interconnectedness – will assess how the company’s financial distress would impact the broader economy. The remaining categories – leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny – will show whether the company is vulnerable to financial distress.

Process: In applying this framework, the FSOC will analyze nonbank financial companies in three different stages.

In the first stage, the FSOC will apply six uniform quantitative thresholds to nonbank financial companies using publicly available data to identify institutions that should be subject to further evaluation. The proposed thresholds are: (1) global total consolidated assets of $50 billion for U.S. nonbank financial companies; (2) $30 billion in gross credit default swaps outstanding; (3) $3.5 billion in derivative liabilities; and (4) $20 billion in outstanding loans borrowed and bonds issued.

In the second stage of the review, the FSOC will look at the potential threat that the companies pose to the financial stability of the U.S. The FSOC will base this determination on information provided voluntarily by the companies and information that is publicly available or available from the companies’ current regulators.

Finally, in the third stage of the review, the FSOC will request information directly from the nonbank financial company to conduct a more in-depth analysis of whether the company presents potential risk to the stability of the U.S. financial system. At this stage, each company under review will receive a notice of consideration, stating that the FSOC is considering whether to designate the company a nonbank SIFI. Before making any determination, the FSOC will consult with the company’s primary regulator.

The FSOC, by a two-thirds vote, can make a proposed determination with respect to a company. The FSOC will issue written notice of any proposed determination to the company, including an explanation of the basis for the determination. The company can request a hearing to contest a proposed determination. After making a proposed determination, the FSOC will hold another vote (after a hearing, if a hearing is requested) and again, by two-thirds majority, can make a final determination that the company is subject to prudential regulation and supervision by the Federal Reserve Board.

Meghan S. Musselman is a partner in the Maryland office of Hudson Cook, LLP. She can be reached at 410-865-5403 or by email at mmusselman@hudco.com.