Financial Stability Oversight Council Issues Proposed Rule on Which Non-Bank Financial Companies Will Be Subject to Regulation

By Jeffrey M. Werthan on October 14, 2011

Posted in Banking, Dodd-Frank Developments

On October 11, the Financial Stability Oversight Council (the Council) approved a second notice of proposed rulemaking (NPR) and proposed interpretive guidance on its authority to require supervision and regulation of certain nonbank financial companies. In response to comments that the Council received on its first NPR, issued in January, the Council is issuing a second notice of proposed rulemaking and proposed interpretive guidance to provide (i) additional details regarding the framework that the Council intends to use in the process of assessing whether a nonbank financial company could pose a threat to U.S. financial stability, and (ii) further opportunity for public comment on the Council’s proposed approach to the determination process.

Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) authorizes the Council to require a nonbank financial company to be supervised by the Board of Governors of the Federal Reserve System (the Board) and be subject to prudential standards if the Council determines that (i) material financial distress at the nonbank financial company, or (ii) 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 (the Determination Standards). The Council stated that it "intends to interpret the term “company” broadly. (The Dodd-Frank Act provides that a company is “predominantly engaged” in financial activities if either (i) the annual gross revenues derived by the company and all of its subsidiaries from financial activities, as well as from the ownership or control of insured depository institutions, represent 85 percent or more of the consolidated annual gross revenues of the company; or (ii) the consolidated assets of the company and all of its subsidiaries related to financial activities, as well as related to the ownership or control of insured depository institutions, represent 85 percent or more of the consolidated assets of the company. The Board is charged with interpreting the term "predominantly engaged in financial activities" and has solicited comment with respect thereto.)

Under the Dodd-Frank Act, if a company is selected under either of the two criteria above, it will be subject to reporting requirements of the Office of Financial Research and regulation by the Board, which includes registration, reporting and examination, as well as heightened prudential standards. In addition, such companies will be treated as bank holding companies under Section 3 of the Bank Holding Company Act for purposes of acquisitions. Finally, the Council by a two thirds vote may impose conditions on any activity and may require the company to break up if the company is determined to pose a "grave threat" to U.S. financial stability.

Under the first Determination Standard, the Council may subject a nonbank financial company to supervision by the Board of Governors and prudential standards if the Council determines that “material financial distress” at the nonbank financial company could pose a threat to U.S. financial stability. The Council believes that material financial distress exists when a nonbank financial company is in imminent danger of insolvency or defaulting on its financial obligations. For purposes of considering whether a nonbank financial company could pose a threat to U.S. financial stability under this Determination Standard, the Council intends to assess the impact of the nonbank financial company’s material financial distress in the context of a period of overall stress in the financial services industry and in a weak macroeconomic environment.

Under the second Determination Standard, the Council enunciated in its guidelines (attached as an appendix to the proposed rule) six thresholds for consideration under the second Determination Standard:

Total Consolidated Assets. The Council intends to apply a size threshold of $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.
Credit Default Swaps Outstanding. The Council intends to apply a threshold of $30 billion in gross notional credit default swaps (CDS) outstanding for which a nonbank financial company is the reference entity. Gross notional value equals the sum of CDS contracts bought (or equivalently sold).
Derivative Liabilities. The Council intends to apply a threshold of $3.5 billion of derivative liabilities. In accordance with Accounting Standards Codification 815, derivative liabilities equals the fair value of any derivatives contracts in a negative position after taking into account the effects of master netting agreements and cash collateral held with the same counterparty on a net basis, if elected.
Loans and Bonds Outstanding. The Council intends to apply a threshold of $20 billion of outstanding loans borrowed and bonds issued.
Leverage Ratio. The Council intends to apply a threshold leverage ratio of total consolidated assets (excluding separate accounts) to total equity of 15 to 1. The Council intends to exclude separate accounts from this calculation because separate accounts are not available to claims by general creditors of a nonbank financial company.
Short-Term Debt Ratio. The Council intends to apply a threshold ratio of debt with a maturity of less than 12 months to total consolidated assets (excluding separate accounts) of 10 percent.

Notwithstanding the thresholds listed above, the Council stated that "the Council does not believe that a determination decision can be reduced to a formula. Each determination will be made on a firm-specific basis, taking into account qualitative, as well as quantitative, information that the Council deems relevant to a particular nonbank financial company." Applying a three-stage process of review, the Council also stated that "[i]n all instances, the Council reserves the right, in its discretion, to subject any nonbank financial company, irrespective of whether such company was identified in Stage 1, to further review if the Council believes that further analysis of the company is warranted to determine if the company could pose a threat to U.S. financial stability." Stages 2 and 3 will involve additional analysis of companies selected. Companies selected have notice and hearing rights to contest selection, and the Council has emergency rights to select companies under certain circumstances. The Dodd-Frank Act requires an annual evaluation of companies selected to determine whether a selection should be rescinded.

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