On April 21, 2023, the Financial Stability Oversight Council (“FSOC” or the “Council”) voted unanimously to issue for public comment two proposals: (1) a framework that describes how the FSOC intends to identify, assess, and respond to potential risks to financial stability (“Analytic Framework”); and (2) new interpretive guidance on the FSOC’s procedures for designating nonbank financial companies for supervision and enhanced prudential regulation by the Board of Governors of the Federal Reserve System (“Federal Reserve”) (“Proposed Guidance”).1
The Dodd-Frank Act authorized the FSOC, with a two-thirds vote, to designate nonbank financial companies that could pose a threat to the financial stability of the United States for supervision and enhanced prudential regulation by the Federal Reserve. In issuing the Analytic Framework and Proposed Guidance, the FSOC aims to simplify its decision-making process and make it easier for it to designate companies. Comments on both proposals are due 60 days after their publication in the Federal Register.
The FSOC’s issuance of these two proposals signals a renewed effort by Treasury Secretary Janet Yellen, who chairs the FSOC, to reinvigorate the FSOC’s designation process for nonbank financial companies. Currently, there are no companies subject to designation by the FSOC. During the Obama Administration, the FSOC voted to designate four companies, but those designations have all been either rescinded by the FSOC or struck down by a federal court. The Analytic Framework and the Proposed Guidance are designed to eliminate limits adopted by the FSOC in 2019 on its discretion to designate companies and insulate future designations from judicial challenges.
Although Secretary Yellen did not indicate the types of firms she would like the FSOC to assess for possible designations, FSOC member and Consumer Financial Protection Bureau Director Rohit Chopra singled out nonbank mortgage companies and hedge funds as the types of firms the FSOC should evaluate and potentially designate.2 Similarly, FSOC member and Securities and Exchange Commission Chair Gary Gensler recommended that the FSOC examine “large, interconnected, highly-levered hedge funds, the associated repo markets for financing, the prevalence of low to zero haircuts in such funding, and the extension of leverage from banks and prime brokers.”3
This Legal Update summarizes the Analytical Framework and the Proposed Guidance.
I. The Proposed Guidance.
Section 113 of the Dodd-Frank Act sets forth a list of factors that the FSOC is required to consider when determining if a nonbank financial company presents a threat to the financial stability of the United States but also allows the FSOC to consider any other factors it deems appropriate. The FSOC first issued rules and interpretative guidance for implementing Section 113’s designation authority in 2012 and issued supplemental procedures to these rules in 2015. In 2019, the FSOC rescinded the 2015 supplemental procedures and issued new guidance in place of the 2012 guidance (“2019 Guidance”).4
The Proposed Guidance would revise the 2019 Guidance by making three key changes:
- Elimination of the “activities-based approach,” which requires the FSOC to attempt to have federal and state regulators address identified risks to financial stability before the FSOC could designate a nonbank financial company.5 Under the Proposed Guidance, the FSOC would still likely use its discretion to engage with federal and state agencies on how they could address identified systemic risks, but it would no longer be required to do so.
- Elimination of the 2019 Guidance’s description of the FSOC’s analytic approach to evaluating the risks presented by nonbank financial companies.6 The Proposed Guidance is limited to procedures for FSOC designations while the substantive analysis the FSOC would utilize to conduct risk assessments would be moved to the Analytic Framework.
- Elimination of the requirement to conduct a cost-benefit analysis of a nonbank financial company’s material distress prior to designating the company.7 In the Guidance Proposal, the FSOC stated that cost-benefit analysis is not required by statute and that this type of analysis is inherently imprecise because “it is not feasible to estimate with any certainty the likelihood, magnitude, or timing of a future financial crisis.”8
By removing the activities-based approach, the Proposed Guidance would establish a two-stage process for the FSOC to designate nonbank financial companies. In the first stage, the FSOC will conduct a preliminary analysis of the risks a company could pose to financial stability. The FSOC will use the risk assessment framework established in the Analytic Framework to identify companies for stage one review.9 Sixty days prior to a vote of the FSOC on whether to proceed to stage two, the FSOC will notify a company that it is subject to a preliminary analysis, provide the company with its findings, and give the company an opportunity to voluntarily provide information to the FSOC.10
Should the Council vote to proceed to stage two, the company will receive a notice that the FSOC has selected it for more in-depth review. For this review, the FSOC will evaluate the company using information obtained from the company.11 Once this review is complete, the FSOC will vote on a proposed determination, and ultimately a final determination, each requiring a two-thirds vote to advance to the next stage.12 A company may request a confidential hearing between the preliminary and final determinations.13 A company is designated only after the FSOC votes in favor of a final determination to designate the company for supervision and enhanced prudential regulation by the Federal Reserve.
II. The Analytic Framework.
The Analytic Framework discusses how the FSOC intends to identify, assess, and respond to potential financial stability risks. However, the Analytical Framework specifically states that it does not impose binding obligations on the FSOC but, rather, “is intended to help market participants, stakeholders, and other members of the public better understand how the Council expects to perform certain of its duties.”14
The Analytic Framework grants the FSOC greater flexibility on how it conducts risk assessments, removing limitations imposed by the 2019 Guidance. For example, it does not contain the 2019 Guidance’s discussion of how the resolvability and existing regulation of the company could affect the FSOC’s assessment of whether to designate a nonbank financial company.15 It also eliminates the 2019 Guidance’s definition of “threat to financial stability of the United States” as meaning “the threat of an impairment of financial intermediation or of financial market functioning that would be sufficient to inflict severe damage on the broader economy” (emphasis added).16 The Proposed Guidance argues that the Dodd-Frank Act states that the FSOC only needs to determine if a threat could pose a risk to financial stability.
The Analytic Framework also sets forth the step-by-step process by which the FSOC evaluates risks.17 To identify risks, the FSOC will monitor a range of potential risks to financial stability, which may include:
- Markets for debt, loans, short-term funds, equity securities, commodities, digital assets, derivatives, and other institutional and consumer financial products and services
- Central counterparties and payment, clearing, and settlement activities
- Financial entities, including banking organizations, broker-dealers, asset managers, investment companies, insurance companies, mortgage originators and servicers, and specialty finance companies
- New or evolving financial products and practices
- Developments affecting the resiliency of the financial system, such as cybersecurity and climate-related financial risks
Sectors and activities that the FSOC views as presenting risk to the financial system are often presented in the FSOC’s reports.18
Once the FSOC identifies a potential risk to financial stability, it then will move to assessing the risk. This assessments will be fact-specific, but the Analytic Framework indicates that the FSOC will consider factors such as leverage, liquidity risk and maturity mismatch, the degree of interconnectedness between institutions, operational risk, inadequate risk management, concentrations of risk in a small number of entities, and destabilizing activities (including trading practices and activities involving moral hazard and conflicts of interest).19 The FSOC also will review whether the identified vulnerabilities can be transmitted to other areas of the financial system.20
Once the risks are assessed, FSOC will consider a range of responses. However, the Analytic Framework does not indicate how the FSOC is likely to respond to a particular risk. Rather, the Analytic Framework states that the FSOC “may take different approaches to respond to a risk, and may use multiple tools” depending on the circumstances.21 Among the responses the FSOC will consider are recommending that regulators address the risks through existing authorities; recommending Congress pass legislation to address the risks; designing nonbank financial companies under Section 113; or designating financial market utilities, or payment, clearing, and settlement activities under Section 804 of the Dodd-Frank Act.22
III. Implications and Next Steps.
The Analytic Framework and the Proposed Guidance are subject to notice and comment but are likely to be finalized nearly as proposed, as FSOC members’ statements at its April 23 meeting signaled strong support for both proposals. Once the proposals are finalized, the FSOC would be in a position to designate companies subject to any potential legal challenges. Accordingly, any nonbank financial company with significant assets should consider conducting a self-assessment to understand its risk of being designated by the FSOC. At this time, FSOC members have indicated a focus on hedge funds and nonbank mortgage companies. Hence, the leading companies in these categories could receive notices from the FSOC that it has begun assessing their potential systemic risks. Because the Proposed Guidance, if finalized, would enable the FSOC to conduct faster assessments, any such company would be well advised to be prepared to engage quickly with the FSOC to ensure that it understands the company’s risk profile and has an accurate understanding of the company’s risk management strategies.