A&B Abstract:

On April 21, 2023 the Financial Stability Oversight Council (hereinafter “FSOC” or “Council”) issued for public comment (1) a proposed analytic framework setting forth FSOC’s approach to identifying, evaluating, and addressing potential risks to financial stability (“Proposed Analytic Framework”), and (2) proposed revisions to FSOC’s existing 2019 interpretive guidance that FSOC would use when deciding whether to designate a nonbank financial company for enhanced prudential standards and Federal Reserve supervision (“Proposed Interpretive Guidance”). Comments concerning the new proposed framework are due by June 27, 2023. Given the recent bank failures, it should come as no surprise that federal regulators are focusing on financial risks to U.S. stability across various sectors, including nonbank mortgage lenders and servicers.

Background

Following the 2007-2009 financial crisis, the Dodd-Frank Act created FSOC, an interagency panel of top U.S. financial regulators, to monitor excessive risks to U.S. financial stability and facilitate intergovernmental cooperation to effectively address those risks. The Dodd-Frank Act empowers the Council to designate a nonbank financial company subject to certain prudential standards and supervision by the Federal Reserve’s Board of Governors. The Dodd-Frank Act lists 10 factors that Council must consider before making such designation.  To date, the Council has used this authority sparingly.  According to Treasury Secretary Janet Yellen, the Council’s revisions will make it easier to use its nonbank designation authority, eliminating “inappropriate hurdles as part of the designation process” that exist under the current guidance issued in 2019.

As the country is in the midst of a regional bank crisis, it would not be unreasonable to conclude that the Council may use its authorities less sparingly than in the past. The Council’s annual reports specifically address the potential risks of nonbank companies, supports the updated requirements issued by the Federal Housing Finance Authority, Ginnie Mae and the CSBS Model State Regulatory Prudential Standards for Nonbank Mortgage Servicers, and recommends that relevant federal and state regulators continue to enhance or establish information sharing in responding to distress at a mortgage servicer.  Indeed, in June 2022, FSOC restarted its Nonbank Mortgage Servicing Task Force, an interagency group to facilitate coordination and additional market monitoring of nonbank servicers.

The Proposed Analytic Framework

The Proposed Analytical Framework, which is not a formal rule, broadly describes how FSOC “identifies, evaluates, and responds to potential risks to U.S. financial stability, whether they come from activities, individual firms, or otherwise.”  The Council’s statutory mandate includes the duty to monitor a wide class of assets, such as new or evolving financial products and practices, and nonbank financial companies, such as mortgage originators and servicers, at several key pressure points. A non-exhaustive list of these potential risk factors and the indicators that FSOC intends to monitor includes:

• Leverage, assessed by levels of debt and other off-balance sheet obligations that may create instability in the face of sudden liquidity restraints.
• Liquidity Risks & Maturity Mismatches, measured by the ratios of short-term debt to unencumbered liquid assets and the amount of additional funding available to meet unexpected reductions in available short-term funds.
• Interconnections, measured by the extent of exposure to certain derivatives, potential requirements to post margin or collateral, and overall health of the balance sheet.
• Operational Risks, measured by the failure to implement proper controls related to financial market infrastructures and the vulnerability of cybersecurity incidents.
• Complexity & Opacity, such as the extent to which transactions occur outside of regulated sectors, in a grey area of overlapping or indefinite jurisdiction, or are structured in such a way that cannot be readily observed due to complexity or lack of disclosure.
• Inadequate Risk Management, such as the failure to maintain adequate controls and policies or the absence of existing regulatory oversight.
• Concentration, measured by the market share for the provision of important services within segments of applicable financial markets and the risk associated with high concentration in a small number of firms.
• Destabilizing Activities, such as trading practices that substantially increase volatility in a particular market, especially when a moral hazard is present.

Just as FSOC will consider all the factors listed above as sources of potential financial risk contagion, it will also assess the transmission of those risks to broader market sectors and other specific entities based on certain metrics. This non-exhaustive list of transmission risk factors includes:

• The level of direct and indirect exposure of creditors, investors, counterparties, and others to particular instruments or asset classes.
• Rapid asset liquidation and the snowball effect of a widespread asset sell off across sectors.
• The potential consequences of interruption to critical functions or services that are relied upon by market participants for which there is no substitute.
• The potential for financial contagion arising from public perceptions of vulnerability and loss of confidence in widely held financial instruments.

Once a financial risk has been identified, FSOC may use various tools to mitigate such risk depending on the circumstances.  For instance, FSOC may work with the relevant federal or state regulator to seek to address the risk. Where a regulator can sufficiently address such risk in a timely manner, FSOC will encourage regulators to do so.  Through formal channels, the Council can make a public recommendation to Congress or regulatory agencies to apply new standards or heightened scrutiny to a known risk within their jurisdiction. Where no clear-cut regulatory oversight exists, the Council may make legislative recommendations to Congress to address the risk. These formal recommendations to agencies or Congress, made pursuant to section 120 of the Dodd-Frank Act, are also subject public notice and comment.

In addition to nonbinding recommendations for action to the appropriate financial regulatory authorities, FSOC is empowered to make a “nonbank financial company determination,” by a two-thirds vote, that a specific company shall be supervised by the Federal Reserve Board of Governors and subject to enhanced prudential standards. This designation can be made upon FSOC’s finding that:

• Material financial distress at the nonbank financial company could pose a threat to the financial stability of the United States; or
• The nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company could pose a threat to financial stability in the United States.

Nonbank Financial Company Designation Interpretative Guidance

The Proposed Interpretive Guidance is procedural in nature relating to nonbank financial company designation.  It would define a two-stage process FSOC will use to make a firm-specific “nonbank financial company determination” discussed in FSOC’s Proposed Analytic Framework. The Council recognized that in the past, it “has used this authority sparingly, but to mitigate the risks of future financial crises, the Council must be able to use each of its statutory authorities as appropriate to address potential threats to U.S. financial stability.”  The Proposed Interpretive Guidance, if adopted, would change the 2019 guidance in the following three ways:

• First, under the current guidance, FSOC is committed to relying on federal and state regulators to address problematic nonbank financial company activity before considering whether a designation is appropriate. The new guidance removes this prioritization and allows FSOC to consider an entity for a designation proactively, without first relying on regulators to act before FSOC begins deliberating.
• Second, FSOC has issued the Proposed Analytic Framework discussed above to revise its process for monitoring risks to U.S. financial stability. This comprehensive new framework replaces that found in Section III of the 2019 interpretive guidance.
• Third, FSOC has reversed course and is eliminating its current practice of conducting a cost-benefit analysis and an assessment of the likelihood of material financial distress prior to making its determination. FSOC has concluded that these processes are not required by Section 113 of the Dodd-Frank Act. FSOC defines “material financial distress” as a nonbank financial company “being in imminent danger of insolvency or defaulting on its financial obligations.” In eliminating the “likelihood” assessment required by the 2019 guidance, the Council would now presuppose a company’s material financial distress and then evaluate what consequences could follow for U.S. financial stability.

With respect to the formal process for nonbank financial company determinations, the Proposed Interpretive Guidance contemplates a two-stage process that FSOC would use once they decide to review a company for a potential designation.

Stage One:  FSOC would conduct preliminary analysis of a company that has been identified for review based on quantitative and qualitative information available publicly and regulatory sources. FSOC would notify the company no later than 60 days before a vote is held to evaluate the company for Stage Two.  A company under review may submit information for FSOC’s review and may request to meet with FSOC staff and members agencies responsible for the analysis.  When evaluating a company in Stage One, the Council’s Nonbank Designations Committee may decide whether to analyze the risk profile of the company as a whole or to consider the risk posed by its subsidiaries as separate entities, depending on which entity the Council believes poses a threat to financial stability. At Stage One, FSOC is statutorily obligated to collect information from any relevant, existing regulators that oversee the company’s activities concerning the specific risks the Council has identified.

Stage Two: Any nonbank financial company selected for additional review would receive notice that the company is being considered for supervision by the Federal Reserve and enhanced prudential standards. The Proposed Interpretive Guidance says that “[t]he review will focus on whether material financial distress at the nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company, could pose a threat to U.S. financial stability.” At this point, if a company is under consideration for a Proposed Determination it would receive a formal Notice of Consideration from the Council.

The Council would begin its Stage Two review by consulting with the U.S. Treasury Department’s Office of Financial Research (OFR) and relevant financial regulators to ascertain the risk profile of the company. This information would remain confidential throughout the process, and, once interagency coordination has produced all available information, the company would be invited to submit any relevant information to the Council. These submissions “may include details regarding the company’s financial activities, legal structure, liabilities, counterparty exposures, resolvability, and existing regulatory oversight. . . . Information relevant to the Council’s analysis may include confidential business information such as detailed information regarding financial assets, terms of funding arrangements, counterparty exposure or position data, strategic plans, and interaffiliate transactions.” Council staff from the FSOC Deputies Committee would be available to meet with representatives of the company and would disclose the specific focus of the Council’s analysis.

Finally, if FSOC preliminarily designates the company for supervision by the Federal Reserve and subjects it to enhanced prudential standards, the company would be able to request a nonpublic hearing after which FSOC may vote to make a final designation. FSOC would conduct an annual review for any company designated by the Council to determine whether continued Federal Reserve supervision and enhanced prudential standards are still appropriate. This annual review period would afford the company the opportunity to meet with Council representatives and present information or make a written submission to the Council about its efforts to mitigate risk. If the Council decides to sustain the designation, it would present the company with a written explanation for its decision.

Takeaway

Given the current 2023 regional banking crisis, it is no surprise that federal regulators are focusing on potential risks to financial stability.  In FSOC’s 2021 and 2022 annual reports, nonbank mortgage companies have been identified as a potential risk.  The Federal Housing Finance Agency and Ginnie Mae have both updated their minimum financial eligibility requirements for seller/servicers and issuers with such requirements taking effect with varying effective dates later in 2023 and 2024.  States also have started to adopt prudential regulatory standards for nonbank mortgage servicers.  The Council appears to be signaling that additional supervision could occur if existing protections do not adequately mitigate risks.

*We would like to thank Summer Associate, Noah LeGrand, for their contribution to this blog post.

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