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Davis Polk Discusses FSOC Proposals on Nonbank SIFIs

The Financial Stability Oversight Council unanimously approved two proposals for public comment regarding FSOC’s authority to designate nonbank financial companies for Federal Reserve supervision and regulation, as summarized in our deck. These proposals would reverse key aspects of changes made during the Trump administration to the nonbank financial company designation framework and procedures.

Key takeaways from the proposals

Select aspects of the 2019 Nonbank Designation Guidance

 

Topic

2019 Nonbank Designation Guidance

 

Prioritization of an activities-based approach

─   FSOC “prioritize[s] its efforts to identify, assess and address

potential risks and threats to U.S. financial stability through…an

activities-based approach” and expects to consider nonbank

designations “only if a potential risk or threat cannot be

adequately addressed through an activities-based approach.”

Cost-benefit

analysis

—               Designation Authority. The 2019 Nonbank Designation Guidance requires FSOC to determine, prior to any designation, that the expected benefits to financial stability from the entity-based designation justify the expected costs that the designation would impose.

—               Recommendation Authority. The 2019 Nonbank Designation Guidance provides that before making a recommendation to a federal regulatory agency pursuant to Section 120 of the Dodd-Frank Act for new or heightened standards and safeguards, FSOC will ascertain whether the primary financial regulatory agency would be expected to perform a cost-benefit analysis of the actions it would take in response to FSOC’s contemplated recommendation. If no such analysis is expected, then FSOC performs the cost-benefit analysis itself prior to making a final recommendation. When FSOC conducts its own analysis, itmakes a recommendation under Section 120 of the Dodd-FrankAct only if it believes that the results of its assessment of benefits and costs support the recommendation.

Interpretation of “threat to U.S.

Financial

stability”

─    The 2019 Nonbank Designation Guidance Proposal interprets

the term “threat to the financial stability of the United States

(a statutory standard under Section 113 of the Dodd-Frank

Act used to designate a nonbank financial company as a

SIFI) to mean a “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).

 

SIFI designation procedures

 

 

—               The existing SIFI designation process as set forth in the 2019 Nonbank Designation Guidance includes the following attributes:

§  Two Stage Process:

—              Stage 1 involves a preliminary analysis of the nonbank financial company based primarily on public or regulatory quantitative and qualitative information, and provides opportunities for the nonbank financial company to engage with FSOC staff; and

—              Stage 2 involves (1) an in-depth examination of the basis for the designation of a nonbank financial company that moved through Stage 1, in which the company is involved; (2) a vote of the FSOC members on the proposed designation of the nonbank financial company; (3) a hearing in the case the nonbank financial company requests one following the proposed designation; and (4) a vote of the FSOC members on the final designation of the nonbank financial company.

§  Removal of Threshold Criteria. The streamlined approach set forth in the 2019 Nonbank Designation Guidance eliminated a threshold stage under guidance issued in 2012 (the 2012 Nonbank Designation Guidance) pursuant to which FSOC used a set of uniform, quantitative metrics to identify nonbank financial companies to be subjected to the more qualitative, company-specific evaluations in subsequent stages, as discussed in more detail in the  Appendix.

§  Likelihood of Financial Distress. FSOC assesses the likelihood of a nonbank financial company’s material financial distress when evaluating the entity for a potential designation.

§  Transparency and Engagement. The 2019 Nonbank Designation Guidance includes procedural elements intended to facilitate additional engagement with entities under consideration and transparency into FSOC’s processes, including providing entities with greater visibility into the aspects of their business that may pose risks to U.S. financial stability.

§  De-designation Processes. FSOC further defined procedures for an “off ramp” from designation, including annual reevaluations, in which FSOC may rescind its SIFI designation if an entity or its regulators take steps to mitigate the potential risks identified in FSOC’s written explanation of the basis for itsdesignation.

 

Summary of the proposals

 

Topic Changes reflected in the proposals
Prioritization of an activities-based approach

—               The Proposals together clarify that FSOC’s nonbankdesignation authority would not be de-prioritized ascompared to an activities-based approach.

—               While elements of the basic framework (i.e., the identification, assessment and addressing of financial stability risk) and certain other considerations, such as manner of risk transmission, would be retained as part of the Proposals, the Proposed Risk Analytic Framework would put designation authority on a co-equal footing with the other authorities available to the FSOC.

—               In addition, the Nonbank Designation Guidance Proposal would eliminate guidance that prioritizes an activities-based approach.

Cost-benefit

analysis

—               Designation Authority. FSOC would not be required to analyze whether the expected benefits to financial stabilityfrom the entity-based designation justify the expected costs.

—               Recommendation Authority. FSOC would no longer be required to conduct a cost-benefit analysis in instances where an existing financial regulatory agency is not required to make a cost-benefit analysis, before issuing a recommendation pursuant to Section 120 of the Dodd-Frank Act.

Interpretation of “threat to U.S.

Financial

stability”

─    The Nonbank Designation Guidance Proposal would remove

the definition of “threat to U.S. financial stability” set forth in the

2019 Nonbank Designation Guidance, stating that the definition

“contrasts sharply with the statutory standard under section

113 of the Dodd-Frank Act, which calls on [FSOC] to determine

whether there ‘could’ be a threat to financial stability.”
─     FSOC specifies that it “would expect to evaluate a ‘threat to

the financial stability of the United States’ with reference to the

description of financial stability provided in” the Proposed Risk

Analytic Framework.

 

SIFI designation procedures

 

 

─     The Nonbank Designation Guidance Proposalretains   

        certain procedural aspects of the 2019 Nonbank

Designation Guidance, including the following:

§   The Nonbank Designation Guidance Proposal has the same structure of a two-stage nonbank financial company designation process.

§   As in the 2019 Nonbank Designation Guidance, theNonbank Designation Guidance Proposal does notreintroduce a threshold stage included in the 2012 Nonbank Designation Guidance in which a set of uniform, quantitative metrics were used to identify nonbank financial companies to be subjected to additional review by FSOC. See Appendix for the quantitative metrics set forth in the 2012 Nonbank Designation Guidance.

§   The procedural aspects to facilitate engagement with and transparency from FSOC throughout the designation process stayed largely the same. The Nonbank Designation Guidance Proposal would add some additional engagement and transparency mechanisms, such as clarifying the period in which the FSOC must provide notice to a company under review of the vote to proceed from Stage 1 to Stage 2 of the designation process.

§   The Nonbank Designation Guidance Proposal retains the process for annual reevaluation and potential de- designation of a designated nonbank financial company in the case that an entity or its regulators take steps to mitigate the potential risks identified in FSOC’s written explanation of the basis for its designation.

—               The Nonbank Designation Guidance Proposal would no longer require FSOC to assess the likelihood of a nonbank financial company’s material financial distress.

 

Proposed risk analytic framework 

Appendix: Threshold criteria to SIFI designation process

This post comes to us from Davis, Polk & Wardwell LLP. It is based on the firm’s memorandum, “FSOC revisits its nonbank ‘systemically important financial institution’ designation framework,” dated May 2, 2023, and available here. 

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