On January 29, 2020, the Financial Stability Oversight Council (FSOC)’s finalization of its guidance on how it would assess risks to the US financial system became effective. The Final Guidance, as did the proposed guidance, now focuses on an activities-based approach to assessing such risk, rather than focusing on identifying specific systemically important financial institutions (SIFIs). Our blog post on the proposed guidance from March 2019 may be found here.

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

Under the original guidelines first adopted in 2012 and later supplemented in 2015, between 2013 and 2014, the FSOC 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.

Treasury Secretary Steven 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, and, subsequently, the Final Guidance.

The most fundamental change is to move to an activities-based approach to calculating systemic risk. It should be noted that such an activities-based approach could affect the activities of bank holding companies as well as nonbank financial companies.

The Final Guidance emphasizes in several places that the FSOC will work closely with the financial regulators during the entire process, including developing an assessment of any potential systemic risk and determining whether the financial regulators have adequate authority under current laws and regulations that could be used to mitigate any identified potential risk.

Specific nonbank financial companies still could be designated as SIFIs, but only if an activities-based approach will not address the identified potential risk.

Activities-Based Approach

The Final Guidance retains the two-step systemic risk assessment process set forth in the proposed guidance, with some modifications and clarifications.

Step One

Step One retains the proposed monitoring process in which the 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 Final Guidance retains the proposed guidance’s four “framing questions” to focus the FSOC’s analysis, slightly revised:

  1. How could the potential risk be triggered, such as by a sharp devaluation in certain classes of financial assets
  2. How adverse effects of such potential risk may be transmitted to financial markets or market participants, and what are the exposures in the markets to that potential risk
  3. What is the potential impact of such identified risk on the financial system as a whole, such as whether it would be broad-based across the markets, or more concentrated and are there current market practices or regulations that could mitigate the risk
  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

Step Two

If that analysis does produce a potential risk, then in Step Two, the FSOC will work with the relevant financial regulators to implement actions to address said potential risk, with the goal being for the financial regulators to take appropriate action to mitigate the risk, such as revising regulations or modifying their supervision of companies or markets. Even if there are only a limited number of companies engaging in the potentially risky activity, the FSOC would seek a more broad-based solution that would address the underlying risks across all companies that engage in that activity.

After such analysis, if the FSOC determines that the financial regulators’ actions remain inadequate to address the identified risk, it can, in consultation with the appropriate financial regulator, publicly issue formal recommendations to apply new or heightened standards and safeguards for a particular financial activity or practice conducted by a bank holding company or nonbank financial company. Such recommendation may be broad-based or more specifically tailored.

Some, but not all, of the financial regulators are required to do a cost-benefit analysis of any revision to their regulations. If the agency in question does not have that requirement, then prior to issuing the recommendations, the FSOC at this stage itself would undertake such an analysis.

SIFI Determinations

If the FSOC determines that the foregoing steps do not address adequately a potential threat that has been identified by the FSOC, or if the potential threat is beyond the jurisdiction of the financial regulators, and the risk can be addressed by a SIFI determination, then the FSOC will evaluate the particular nonbank financial company for a SIFI determination.

The FSOC will consider its statutory mandate in designating a particular company to be a systemic risk by determining 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’’).

As with the proposed guidance, the Final Guidance focuses on the First Determination Standard, again noting that “threats to financial stability . . . are most commonly propagated through a nonbank financial company when it is in distress.”

First, the FSOC will notify a nonbank financial company that it is being considered for a SIFI designation. The FSOC will conduct a preliminary analysis based on quantitative and qualitative information available to it primarily through public and regulatory sources. 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.

If the FSOC decides to continue the SIFI designation process for that nonbank financial company, it will advise the company that it is being considered for a proposed determination that it could pose a threat to the stability of the US financial system. This stage would involve evaluation of information submitted by the company.

As it has all along in the process, the FSOC will continue to confer 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 by two-thirds of its members to issue a written notice of a Proposed Determination of a SIFI designation to the nonbank financial company, the FSOC will inform the company and the company’s financial regulator, and publish its non-confidential 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 nonbank 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 with any confidential information redacted. The FSOC will reevaluate that SIFI determination every year and rescind the determination if the FSOC determines the company no longer meets the statutory determination for a SIFI determination. A SIFI may request a review earlier than annually “in the case of an extraordinary change” that results in a material decrease in the SIFI’s threat to the US financial system.