Designation of Systemically Important Nonbank Financial Companies Under Dodd-Frank: Financial Stability Oversight Council Issues Revised Proposal on Designation of Systemically Important Nonbank Financial Companies

Sullivan & Cromwell LLP - October 18, 2011

On October 11, 2011, the Financial Stability Oversight Council unanimously approved a second notice of proposed rulemaking and related interpretive guidance under the Dodd-Frank Act regarding the designation of systemically important “nonbank financial companies.” The new proposal, which was published in the Federal Register of October 18, 2011, describes the manner in which the Council proposes to apply the relevant statutory standards and the processes and procedures it intends to employ in carrying out its authority to designate systemically important nonbank financial companies. These designated companies are required to comply with enhanced prudential standards and are subject to consolidated supervision by the Board of Governors of the Federal Reserve System. Comments on the Council’s proposal are due by December 19, 2011.

Among the nonbank financial companies potentially subject to a systemically important designation by the Council are savings and loan holding companies, insurance companies, private equity firms, hedge funds, asset management companies, financial guarantors, and other U.S. and non-U.S. nonbank companies deemed to be “engaged primarily” in activities that are financial in nature.

Significantly, unlike the original rule proposal issued by the Council earlier this year, the revised proposal incorporates a set of “uniform quantitative thresholds” that the Council proposes to use as a filter to identify the universe of nonbank financial companies that will initially be subject to further review – and, potentially, a systemically important determination – by the Council.

The designation process involves three “Stages.” In Stage 1, the Council will apply the quantitative thresholds to a “broad group” of nonbank financial companies. A nonbank financial company with $50 billion or more in “total consolidated assets” will be subject to further evaluation in Stage 2 if the company also meets or exceeds any one of the five other quantitative thresholds: (i) it is the reference entity with respect to $30 billion or more of outstanding credit default swaps, (ii) it has $3.5 billion or more of derivative liabilities, (iii) it has $20 billion or more of outstanding loans/bonds, (iv) it has a leverage ratio of 15 to 1 or greater, or (v) it has a short-term debt-to-assets ratio of 10% or more.

A nonbank financial company identified for further review in Stage 1 will be subject in Stage 2 to a more granular, institution-specific analysis of the individual company’s risk profile, involving quantitative analysis and qualitative judgment by the Council. This analysis will be conducted within a framework that divides the statutory considerations for designation into six “categories”: size, interconnectedness, substitutability, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny. For each of these categories sample metrics are provided (without quantification) in the interpretive guidance.

The proposal specifically notes that, although the proposed Stage 1 quantitative thresholds will initially be applied uniformly to all nonbank financial companies, they may not be appropriate for the risk assessment of hedge funds and private equity firms and suggests that the Council may eventually establish an additional set of metrics or thresholds designed to evaluate hedge funds, private equity firms, and their advisers. The Council may also issue additional metrics or thresholds for asset management companies.

The proposal indicates that these quantitative thresholds will help nonbank financial companies predict whether they will be considered for designation as systemically important. The Council retains the authority, however, to designate any nonbank financial company for heightened prudential supervision, including a company that does not satisfy the proposed quantitative thresholds. Moreover, the Council is authorized to make “emergency” determinations, the consideration of which would not be subject to the quantitative thresholds or the three-stage process.

The Council will provide each nonbank financial company deemed to merit further evaluation in Stage 3 with written notice that it is being considered for determination and an opportunity to provide written materials explaining why the Council should not adopt a proposed determination. If the Council nevertheless proceeds to make a “proposed determination,” it must provide a second notice, including an explanation of the basis for the proposed determination, and the opportunity for the nonbank financial company to request an informal “evidentiary hearing” before the Council to contest the proposed determination.

Both a proposed determination and a final determination require at least a two-thirds majority vote of the Council, including the affirmative vote of the Treasury Secretary. Any final determination (but apparently not a proposed determination) will be announced publicly and is subject to limited judicial review.