FSOC proposes revamping systemic risk designation process

On March 13, 2019, the Financial Stability Oversight Council (FSOC) published in the Federal Register proposed revised interpretive guidance (Proposed Guidance) on how the FSOC would assess risks to the US financial system, prioritizing an activities-based approach, rather than focusing on identifying specific systemically important financial institutions (SIFIs), which come under the FRB’s purview for enhanced regulation.

The FSOC, composed of federal and state financial services agencies (financial regulators), was established pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, to:

(A) identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace;

(B) promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the Government will shield them from losses in the event of failure; and

On April 11, 2012, the FSOC published interpretive guidance regarding how it would conduct the SIFI determination process and Supplemental Procedures in 2015. Under those guidelines, between 2013 and 2014, the FSOC initially designated four nonbank financial companies as SIFIs, which designations were lifted in subsequent years. Previous blog posts on the designated SIFIs can be found here, here, here and here. At the President’s direction, Treasury Secretary Mnuchin undertook a review of the FSOC determination process and issued a report in November 2017, “Financial Stability Oversight Council Designations,” and many of the recommendations in that report have found their way into the Proposed Guidance.

According to the commentary accompanying the Proposed Guidance, the March 13 proposals revise and update the 2012 Interpretive Guidance and incorporate certain provisions of the 2015 Supplemental Procedures.

There are several key changes from what had been the established systemic risk determination process, but the change likely being seen as the most important of them is that under the Proposed Guidance, the focus will change to an activities-based approach. Specific entities still could be designated as SIFIs but only if an activities-based approach will not address the identified potential risk or threat.

Activities-Based Approach

The Proposed Guidance describes a two-step activities-based approach. In Step One, FSOC will “monitor diverse financial markets and market developments, in consultation with relevant financial regulatory agencies, to identify products, activities, or practices that could pose risks to financial stability.”

The analysis will focus on what the Proposed Guidance characterizes as four “framing questions:” (1) potential risk trigger factors, (2) how adverse effects of such potential risk may be transmitted to financial markets or their participants, (3) the effects the potential risk could have on the financial system, and (4) whether the adverse effects of such potential risk could impair the US financial system such that those effects could harm the US economy’s nonfinancial sector.

If that analysis does produce a potential risk, then in Step Two of the activities-based approach, the FSOC will work with the relevant financial regulators to implement actions to address said potential risk. If the FSOC determines that the regulators’ actions are insufficient, it can publicly issue recommendations, albeit nonbinding, to the regulators to apply new or heightened standards and safeguards for a financial activity conducted by a bank holding company or nonbank financial company. The Proposed Guidance specifically states that any recommendations it does make will be consistent with the relevant financial regulator’s statutory mandate.

SIFI Determinations

Under the Dodd-Frank Act, the FSOC may designate a nonbank financial company as a SIFI, and thus subject to supervision by the Federal Reserve Board and prudential standards, if it determines that (1) material financial distress at the nonbank financial company could pose a threat to U.S. financial stability (the ‘‘First Determination Standard’’), or (2) the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company could pose a threat to US financial stability (the ‘‘Second Determination Standard’’). The Proposed Guidance focuses on the First Determination Standard, noting that “threats to financial stability . . . are most commonly propagated through a nonbank financial company when it is in distress.”

The Proposed Guidance does not eliminate the SIFI determination process, but evaluating a specific nonbank financial entity for SIFI designation is expected to occur under a limited set of circumstances: (1) the FSOC’s collaboration with the financial regulators described in Step 2 of the activities-based approach did not adequately address the potential risk that had been identified by FSOC, or the potential threat does not come within the legal authority or jurisdiction of a financial regulator and (2) the potential threat could be addressed by the FSOC making a SIFI determination for one of more nonbank financial companies.

If the evaluation of systemic risk gets to this point, the revised two-stage SIFI determination process will include a cost-benefit analysis by the FSOC prior to a determination and an assessment of the extent to which a particular SIFI designation may promote US financial stability. During Stage One of the determination process, the FSOC will provide notice to the nonbank financial company that it is under SIFI review, and intends for FSOC staff to meet with the nonbank financial company to discuss the key risks that had been identified thus far. While not required at that point, the nonbank financial company will be able to submit what it considers to be relevant information for the FSOC to consider in the determination process.

In Stage Two, the FSOC will undertake a more in-depth evaluation, issuing a “Notice of Consideration” to a nonbank financial company that it is under review for a potential SIFI designation, and requesting that the nonbank financial company provide information that the FSOC deems relevant to its evaluation. At this stage, the FSOC’s review will focus on “whether the nonbank financial company could pose a threat to U.S. financial stability because of the company’s material financial distress or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company.”

The FSOC also will consult with the relevant financial regulators during the designation determination process and if it feels that the financial regulators have been able to adequately address the potential identified risks, the FSOC could discontinue its review before a determination is made.

If the FSOC votes to issue a Proposed Determination of a SIFI designation to the nonpublic financial company, the FSOC will inform the company and the company’s financial regulator, and publish its explanation for the issuance of the Proposed Determination. The company may request a nonpublic hearing to contest the Proposed Determination.

If the FSOC votes to issue a Final Determination of a SIFI designation to the nonpublic financial company, it will inform the company and the company’s financial regulator of the decision and the basis for the designation, and issue a public decision. Under Dodd-Frank, the nonbank financial company may contest its designation as a SIFI in US District Court.

Due Date for Comments

Comments are due by May 13, 2019. Embedded in the commentary are 38 specific questions about the Proposed Guidance’s provisions, which commenters, if they wish, can use to assist them in framing their responses.