At an open session at the Treasury Department, the United States Financial Stability Oversight Council (FSOC), chaired by Secretary Timothy Geithner, approved a final rule1 laying out the process and criteria under which FSOC will identify those non-bank financial firms that are subject to Federal Reserve Board supervision and enhanced prudential standards pursuant to Section 165 of the Dodd-Frank Act.
Once designated, such nonbank firms will join bank holding companies with assets in excess of US$50 billion as being systemically important firms whose material financial distress or failure, or whose nature, scope, size, scale, concentration, interconnectedness or mix of activities could pose a threat to the financial stability of the United States.
While not mandated, relevant provisions of the Dodd-Frank Act contemplate the ability for the Federal Reserve Board to utilize an individualized approach to enhanced supervision and regulation based on recommendations from FSOC derived from FSOC’s assessment of a given firm and the respective capital structure, riskiness, complexity and mix of activities undertaken by each.
The final rule, approved on April 3, 2012, follows FSOC’s issuance of an advanced notice of proposed rulemaking on October 6, 2010,2 a proposed rulemaking released on January 26, 20113 and a second notice of proposed rulemaking and proposed interpretive guidance on October 18, 2011.4 Collectively, the proposals garnered almost 130 public comments and resulted in the final rule.
In prepared comments delivered at the meeting, Secretary Geithner noted that the final rule represents “an important tool provided in Dodd-Frank for extending the parameter of transparency oversight and prudential supervision over parts of the financial system that can be a particularly important source of credit to the economy and potentially important source of risk in crisis.”
Notwithstanding significant requests for reconsideration set forth in the public comments, the final rule adopted by FSOC is very consistent with the standards and structure proposed in the most prior proposed rulemaking and proposed interpretive guidance issued last October.
Regulators will evaluate nonbank financial firms that are “predominantly engaged in financial activities” through a three-stage process. Section 102(a)(6) of the Dodd-Frank Act provides that a firm is predominantly engaged in financial activities if either (i) 85 percent or more of it annual consolidated gross revenues are derived from financial activities, including ownership of insured depository institutions; or (ii) 85 percent or more of the consolidated assets are related to financial activities, as well as the ownership of insured depository institutions. The Federal Reserve Board is required to further refine these standards through rulemaking, and it issued a supplemental notice of proposed rulemaking and request for comment on that specific requirement on April 2, 2012, the day before FSOC’s adoption of the final rule.5
In Stage One, FSOC will assess a “broad group of nonbank financial companies” with total consolidated assets of $50 billion or more. Companies that also satisfy one or more of the following thresholds will be elevated to Stage Two:
US$30 billion in gross notional credit default swaps outstanding for which the firm is the reference entity
US$3.5 billion of derivative liabilities
US$20 billion in total debt
A 15-to-1 leverage ratio of total consolidated assets (absent separate accounts) to total equity and
10 percent short-term debt ratio of total debt outstanding with a maturity of less than one year to total consolidated assets (absent separate accounts)
In Stage Two, FSOC will use publicly available data to “conduct a robust analysis of the potential threat that each of those nonbank financial companies could pose to US financial stability,” assessing characteristics such as conduct, interconnectedness among firms, size and concentration risk, to target a universe of nonbank financial firms. FSOC will also assess the impact that resolving the firm could have on financial stability in this stage.
In Stage Three, FSOC will deliver a notice to a selected firm that is being considered for proposed determination under the final rule. In response to such notice, the firm may submit qualitative information that serves as evidence refuting the FSOC’s consideration of the potential the firm poses a threat to United States financial stability, such as resolvability, the opacity of its operations, complexity, and the extent and nature of its existing regulatory scrutiny.
Importantly, FSOC refused to accommodate industry request that such notice include a discussion of the basis for FSOC’s determination. Instead, the final rule concludes that, “it would be premature to explain the basis of the nonbank financial company’s identification for further consideration because the decision to review a nonbank financial company in Stage 3 does not represent a formal determination.”6 Similarly, the final rule rejected comments calling for notice to be given to firms that are evaluated under Stage Two, and in so doing FSOC stated that Stage Three “provides a sufficient opportunity for nonbank financial companies to participate in the Determination Process.” The basis for any determination, however, is only made available to the firm after the Stage Three review is completed and the determination is final. In making a final determination, FSOC may consult with the firm’s primary financial regulators or home country supervisor “as appropriate,” and consider the views of the firm – however, neither of these factors are required.
While the structure and process for determination is quite elaborate, FSOC retained a controversial provision in the final rule allowing it to designate any firm as subject to enhanced supervision and regulation if it poses a threat to United States financial stability, notwithstanding the fact that it may not meet the defined criteria.
With the rules now final, both Treasury Secretary Geithner and Deputy Treasury Secretary Neal Wolin reportedly informed the press that FSOC determinations for nonbank financial firms may begin before the end of this year.
For more information about the FSOC rules, please contact:
John J. Clarke, Jr.
5 See this page.
6 FSOC does not intend to publicly disclose the identity of any nonbank financial company that is under evaluation prior to a final determination due, in part, to the potential for the market to misinterpret the disclosure.