FSOC Overhauls Standards for Designating Nonbanks as Systemically Important

On November 3, 2023, the Financial Stability Oversight Council (FSOC) released (i) a new “analytic framework” that sets forth how it will identify and assess potential risks to U.S. financial stability and (ii) updated guidance on how it will make designations of nonbank financial companies as systemically important.  Below is our “quick take” on FSOC’s release. 

Analytic Framework for Identifying and Assessing Potential Risks to Financial Stability

• FSOC’s monitoring for potential risks to financial stability may cover a wide range of asset classes, institutions and activities, as listed below: 
  • markets for debt, loans, short-term funding, 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, private funds, insurance companies, mortgage originators and servicers, and specialty finance companies; 
  • new or evolving financial products and practices; and 
  • developments affecting the resiliency of the financial system, such as cybersecurity and climate-related financial risks.
• While the evaluation of any potential risk to financial stability is “highly fact-specific," FSOC has identified a non-exclusive list of the “vulnerabilities and metrics” that it expects to consider:
  • Leverage – quantitative metrics relevant for assessing leverage may include ratios of assets, risk-weighted assets, debt, derivatives liabilities or exposures, and off-balance sheet obligations to equity; 
  • Liquidity Risk and Maturity Mismatch – quantitative metrics may include the scale of financial obligations that are short-term or can become due in a short period, the ratio of short-term debt to unencumbered short-term high-quality liquid assets, amounts of funding available to meet unexpected reductions in available short-term funding, and amounts of transactions that may require the posting of additional margin or collateral; 
  • Interconnections – quantitative metrics may include total assets, off-balance-sheet assets or liabilities, total debt, derivatives exposures, values of securities financing transactions, and the size of potential requirements to post margin or collateral, as well as metrics related to the concentration of holdings of a class of financial assets may also be relevant; 
  • Operational Risks – quantitative metrics may include statistics on cybersecurity incidents or the scale of critical infrastructure; 
  • Complexity or Opacity – quantitative metrics may include the extent of intercompany or interaffiliate dependencies for liquidity, funding, operations, and risk management; the number of jurisdictions in which activities are conducted; and numbers of affiliates; 
  • Inadequate Risk Management – quantitative metrics may include levels of exposures to particular types of financial instruments or asset classes and amounts of capital and liquidity; 
  • Concentration – quantitative metrics may include market shares in segments of applicable financial markets; and 
  • Destabilizing Activities – no metrics were identified, but FSOC notes that certain activities that are “sizeable and interconnected with the financial system” can destabilize markets for certain types of financial instruments or impair financial institutions. 

Interpretive Guidance on Nonbank SIFI Designations

• Elimination of various roadblocks to designations:
  • Interpretive guidance from 2019 stated that before considering a nonbank financial company for potential designation, FSOC would have to exhaust all available alternatives by prioritizing an “activities-based approach,” perform a cost-benefit analysis, and assess a company’s likelihood of material financial distress.  FSOC has determined that these steps are not legally required or appropriate and would unduly hamper the exercise of its statutory authority to make designations. 
  • Interpretive guidance from 2019 defined “threat to the financial stability of the United States” as requiring a finding of “severe damage on the broader economy.”  FSOC now regards this definition as overly restrictive and in conflict with its statutory purpose to respond to emerging threats to financial stability. 
• No categorical exclusions for asset managers, insurers, or other firms: 
  • Despite the urging of some industry commenters, FSOC declined to categorically exclude any particular financial sectors or types of nonbank financial companies from its assessment of potential threats to financial stability.  
  • Specifically cited by FSOC were: life insurers, property and casualty insurers, reinsurers, asset managers, nonbank mortgage lenders, nonbank mortgage servicers, mutual funds (including money market mutual funds), private funds, fintech companies (including certain payment providers), and issuers of asset-backed securities. 
• Process for Nonbank Financial Company Designations
  • FSOC “generally expects” to use a two-stage process when determining whether to subject a nonbank financial company to Federal Reserve supervision and prudential standards. 
    • Stage 1 – During the first stage of the process, a nonbank financial company identified for review would be subject to a preliminary analysis, based on quantitative and qualitative information available to FSOC primarily through public and regulatory sources.  FSOC will notify the firm at least 60 days before FSOC votes on whether to evaluate the company further in the second stage of review, to provide the company with an opportunity to voluntarily submit relevant information to FSOC and to meet with staff who are leading FSOC’s analysis. 
    • Stage 2 – Following Stage 1, any nonbank financial company that is selected for additional review will receive notice that it is under “in-depth evaluation” for a proposed designation.  This second stage involves significant engagement with the company under review and its primary financial regulator.  FSOC will submit to the company a request for information, and the company will be provided an opportunity to submit information it deems relevant (e.g., financial activities, legal structure, counterparty exposures, resolvability, existing regulatory oversight).  FSOC will make staff representing its members available to meet with the representatives of the company, including to explain the evaluation process and the framework for FSOC’s analysis.
  • Proposed and Final Designations – At the end of Stage 2, FSOC may consider whether to make a proposed designation of the nonbank financial company.  A proposed designation requires a vote of two-thirds of FSOC’s voting members then serving, including an affirmative vote by the Secretary of the Treasury.  If FSOC makes a proposed designation, FSOC will provide the company with a written explanation of the basis of the proposed determination, and the nonbank financial company may request a written or oral hearing.  After any requested hearing, FSOC may vote to make a final designation, which again requires a vote of two-thirds of FSOC’s voting members then serving, including an affirmative vote by the Secretary of the Treasury. FSOC will publicly release the written explanation of the basis for any final designation.
  • Annual Reevaluations of Designations – FSOC will reevaluate a designation at least annually and rescind the designation if it determines that the company no longer meets the statutory standards for a designation (i.e., either material financial distress at the company, or the nature, scope, size, scale, concentration, interconnectedness, or the mix of the company’s activities, posing a threat to U.S. financial stability).  FSOC expects that its reevaluation process will focus on whether any material changes that have taken effect—including changes at the company, changes in its markets or its regulation, changes in the impact of relevant factors, or otherwise—result in the company no longer meeting the standards for a determination. During FSOC’s annual reevaluations, the company will have an opportunity to meet with FSOC representatives to discuss the review and submit information.  FSOC representatives will endeavor to provide feedback on the extent to which any company proposals to mitigate identified risks may address the risks.  Further, if FSOC votes not to rescind a designation, it will provide the company with a written explanation addressing the material factors in the analysis.  Finally, FSOC will provide each nonbank financial company subject to an FSOC determination an opportunity for an oral hearing once every five years at which the company can contest the determination.

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