- The Financial Stability Oversight Council unanimously approved an analytic framework for financial stability risk identification, assessment and response and interpretive guidance on nonbank financial company determinations on November 3, 2023.
- The guidance makes it easier for FSOC to designate nonbank financial companies as systemically important (and therefore subject to supervision by the Federal Reserve and prudential standards) by relaxing strict regulations on designations adopted in 2019 under the Dodd-Frank Act.
- FSOC may now pursue designation of nonbanks as systemically important instead of prioritizing all other means to respond to threats to financial stability.
- The guidance no longer requires FSOC to perform a cost-benefit analysis assessing a nonbank’s “likelihood of material financial distress.”
- FSOC also adopted a nonbinding, analytical framework which describes financial stability risk identification, assessment and response more broadly than solely designations.
The Financial Stability Oversight Council unanimously approved an analytic framework for financial stability risk identification, assessment and response (Framework)1 and interpretive guidance on nonbank financial company determinations (Guidance)2 on November 3, 2023. The Framework will be used to guide FSOC in addressing any risks to financial stability, whereas the Guidance will apply particularly to the designation process. However, the Framework and Guidance work in concert to alter the processes by which FSOC designates nonbank financial companies (nonbanks) as “systemically important financial institutions” (SIFIs) subject to supervision by the Federal Reserve and prudential standards. Secretary of the Treasury and FSOC Chair Janet Yellen stated that adoption of the Framework and Guidance will “increase the transparency of [FSOC’s] work and establish a durable process for [its] use of its designation authority, strengthening [its] ability to promote a resilient financial system.3 Four key components of the Framework and Guidance could result in more designations and accompanying heightened regulatory compliance costs for the nonbanks subject to them. Although there are minor changes from the proposed versions of the Framework and Guidance, they were largely approved as proposed.
Background
The Dodd-Frank Wall Street Reform and Consumer Protection Act created FSOC with the purpose of identifying and addressing risks to financial stability and eliminating market expectations that the U.S. government will prevent losses in events of failure.4 In order to reduce risks to financial stability, Congress granted FSOC the power to designate nonbanks as SIFIs and subject them to supervision and prudential standards set by the Federal Reserve (designation), among other authorities.5 According to the standard set forth in Dodd-Frank, a designation may be made if FSOC determines that a nonbank’s (i) material financial distress or (ii) the nature, scope, size, scale, concentration, interconnectedness or mix of their activities could pose a threat to financial stability.6
In 2012, FSOC issued rules and interpretive guidance concerning its designation power (2012 Guidance).7 Following this, four nonbanks were designated as SIFIs: American International Group, Inc.; General Electric Capital Corporation; Prudential Financial, Inc.; and MetLife, Inc. MetLife successfully challenged its designation in federal court with the ruling resting on the grounds that FSOC “made critical departures from two of the standards it adopted” in the 2012 Guidance.8 The U.S. District Court for the District of Columbia also held that FSOC was required to consider the cost of designation to MetLife and failed to do so.9 In the wake of this decision, by 2018, FSOC had rescinded all four of the designations. In 2019, the 2012 Guidance was substantially revised (2019 Guidance) with the MetLife decision in mind and with a focus on an activities-based approach that was intended to reduce the “potential for competitive market distortions that could arise from entity-specific designations.”10 Relevant provisions of the 2019 Guidance are discussed in the context of the approved Framework and Guidance below.
The Guidance replaces the 2019 Guidance on designations of nonbanks contained in Appendix A (Appendix) to the rules on designations (Rules).11 The Appendix is a non-binding rule “except to the extent it sets forth rules of agency organization, procedure, or practice” which cannot be altered without proper notice and comment.12 Crucially, the Rules themselves remain unchanged by the adoption of the Guidance. The Framework purports to have no binding effect and would not affect the text of the Rules nor the Appendix.13 This is relevant especially to the first key change below.
Four Key Changes from the 2019 Guidance
First, the Framework and Guidance limit the text of the Appendix solely to procedures on designations rather than including substantive risk analysis as well. Instead, substantive risk analysis is now contained in the Framework and is broadly applicable to all potential responses to threats to financial stability. Such responses include leading interagency coordination and making recommendations to agencies or Congress, not just SIFI designations, as was contemplated by the Appendix according to the 2019 Guidance. The Guidance suggests that responses to threats to financial stability should be appropriately varied, including activity-based, entity-based or industry-wide approaches, but should also be analyzed through a unified framework because transmission channels and risk factors facilitating financial instability occur in various forms and conditions. FSOC stated in the release accompanying the Guidance that in the designation process it “will apply the statutory standard,” seemingly setting this as the standard for any challenges to designation, rather than the wholly non-binding Framework.14
Second, the Framework and Guidance remove the definition of “threat to the financial stability of the United States” from the Appendix. This is replaced by the definition stated in the Framework Release which changes the term from meaning events or conditions that “would be sufficient to inflict significant damage to the broader economy” to those that “could ‘substantially impair’ the financial system's ability to support economic activity.”15 The release accompanying the Guidance indicates that this change is made to align with the duties of FSOC contained in Dodd-Frank.16 However, commenters have previously critiqued FSOC for drawing speculative conclusions that are not based on empirical data when analyzing threats to financial stability, and the change in this standard could evoke more of the same concerns.17
Third, the Framework and Guidance eliminate the requirement for FSOC to focus on addressing risks to financial stability with an “activities-based approach.” This approach, implemented in the 2019 Guidance, mandates that FSOC prioritize all other means to respond to threats to financial stability over nonbank designations. Further, the 2019 Guidance allows FSOC to evaluate nonbanks for SIFI designation only if the primary regulator of the company in question does not adequately address the risk. The Guidance discards this “prioritization scheme,” though the accompanying release notes it “does not make designation [FSOC’s] default method of addressing risks to financial stability” and it “does not eliminate [FSOC’s] use of an activities-based approach to address risks to financial stability.”18 Additionally, other approaches do need to be considered before utilizing the designation process. Removing the activities-based approach could raise questions as to why FSOC should supplant the role of existing federal regulation and regulators when it lacks a similar level of knowledge and experience in regulating asset management firms.19
Fourth, the Framework and Guidance no longer require FSOC to undertake the threshold test of cost-benefit analysis, which includes assessing a nonbank’s “likelihood of material financial distress.” Under the 2019 Guidance, FSOC must consider and determine that the benefits of a designation outweigh the costs before initiating the SIFI designation process. The Guidance, however, treats the costs of a designation as not being a “risk-related factor” of financial stability.20 The accompanying release reasons that the statutory text of Dodd-Frank determines that the benefits of a designation outweigh the costs ipso facto, so long as the standard for a designation is met.21 Similarly, the Guidance discards the requirement to determine the likelihood of a nonbank being in financial distress, replacing it with a determination of whether the nonbank could threaten financial stability assuming it was in material financial distress.
Differences from the Proposed Framework and Guidance
There are some notable changes from the Framework and Guidance, as proposed, to their final adopted forms. Based on comments received, the Framework Release adds additional clarity that “threats to financial stability” are interpreted to mean “events or conditions that could ‘substantially impair’ the financial system’s ability to support economic activity,” whereas the proposed Framework did not include this language and did not include the “substantially” qualifier in the text of the accompanying release. In other changes to the Framework, FSOC included in the Framework additional sample metrics on how it assesses vulnerabilities, further discussion on transmission channels and more emphasis on its engagement with regulators. As a response to comments, the Guidance includes language indicating that any information a nonbank provides to FSOC during the process for determining whether that nonbank should be designated “may enable the company to act to mitigate any risks to financial stability and thereby potentially avoid becoming subject to [an FSOC] determination.”22
Conclusion
Recently, Secretary Yellen and FSOC broadly have demonstrated a focus on the financial stability risks posed by types of nonbanks that were not previously designated, such as hedge funds, money market funds and digital asset firms.23 This could suggest an increased willingness to consider designating a wider range of nonbanks. The Framework became effective on November 14, 2023, and the Guidance will become effective on January 16, 2024.
1 Analytic Framework for Financial Stability Risk Identification, Assessment, and Response, 88 F.R. 78026 (Nov. 3, 2023) (Framework Release). The Framework became effective on November 14, 2023.
2 Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies, 88 F.R. 80110 (Nov. 3, 2023) (Guidance Release). The Guidance will become effective on January 16, 2024.
3 Sec’y of the Treas. Janet Yellen, Remarks by Secretary of the Treasury Janet L. Yellen at the Open Session of the meeting of the Financial Stability Oversight Council (Nov. 3, 2023).
4 12 U.S.C. §§ 5321-22.
5 Id. at §§ 5323, 5365.
6 Id. at § 5323(a)(1).
7 Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies, 77 F.R. 21637 (Apr. 11, 2012).
8 MetLife, Inc. v. Fin. Stability Oversight Council, 177 F. Supp. 3d 219, 230, 233-39 (D.D.C. 2016) (reasoning that the 2012 Guidance required FSOC to assess MetLife’s vulnerability to material financial distress and determine MetLife’s counterparties would be impaired).
9 Id. at 239-42 (citing Michigan v. EPA, 576 U.S. 743 (2015), and determining cost is an appropriate risk-related factor which must be considered under Dodd-Frank).
10 Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies, 84 F.R. at 71767 (Dec. 30, 2019).
11 The rules on designation are found at 12 C.F.R.§§ 1310.1-23, and the Guidance is attached to the Rules as Appendix A. Secretary Yellen, in her remarks accompanying adoption of the Guidance said that the 2019 Guidance contained prerequisites for designation that “were not contemplated by the Dodd-Frank Act and that are based on a flawed view of how financial risks develop and spread” which are eliminated by the Guidance. See supra note 3.
12 Id. at Appendix A. According to a 2019 amendment to the Rules, FSOC issued the Proposed Guidance for public comment because it alters the text of the Appendix. Id. at § 1310.3.
13 FSOC took the view that the Proposed Framework did not need to be issued for public comment because it does not alter the text of the Rule or Appendix but stated that it did so “in the interest of transparency and accountability.” 88 F.R. 26305, n. 2.
14 Guidance Release at 80116. Dodd-Frank imposes eleven considerations for evaluation of designation of nonbanks. 12 U.S.C. § 5323(a)(2).
15 Emphasis added. Compare 12 C.F.R. 1310 Appendix A, Section III(a) with Framework Release at 78028.
16 See Guidance Release at 80118 (stating that the definition in the 2019 Guidance was “unwarranted” and “contrasts sharply with the statutory standard under section 113 of the Dodd-Frank Act”).
17 See, e.g., Metlife, Inc. at 237 (“FSOC never projected what the losses would be, which financial institutions would have to actively manage their balance sheets, or how the market would destabilize as a result.”); Commissioner Daniel M. Gallagher, U.S. Securities and Exchange Commission, Letter regarding Public Feedback on OFR Study on Asset Management Issues (May 15, 2014) (“virtually all of the commenters on the [2013] OFR Report thus far have sharply criticized the absence of empirical data underlying the generalizations advanced by the report and the flawed methodology used to analyze systemic risk”).
18 See Guidance Release at 80111.
19 In response to comments regarding application of the activities-based approach to asset managers received on the proposed 2019 Guidance, FSOC noted that it “will enable [FSOC], working together with financial regulatory agencies, to appropriately consider specific attributes of particular industries, business models, and existing regulatory frameworks, including the factors highlighted in the public comments regarding insurance and asset management.” 2019 Guidance at 71746.
20 One of the eleven considerations for evaluation of designation of nonbanks is a catch-all provision: “any other risk-related factors that [FSOC] deems appropriate.” See supra note 14.
21 See Guidance Release at 80121. This seemingly contradicts the ruling in MetLife, Inc. v. Fin. Stability Oversight Council, and by extension, Michigan v. EPA. See supra note 8. FSOC attempted to provide a distinction in the Guidance by stating that costs are not an appropriate risk-related factor to consider, but this argument appears to ignore the court’s reasoning which read a cost-benefit analysis into Dodd-Frank. Id.; Guidance Release at 80123. The Guidance Release also highlighted language from an appeal to the MetLife decision stating: “This Court is one of 94 United States District Courts, comprising several hundred judges, and its Opinion is not binding on others; the Opinion stands on its own persuasive value, to the extent it has any.”
22 See Guidance Release at 80113.
23 See, e.g., Sec’y of the Treas. Janet Yellen, Remarks at the National Association for Business Economics 39th Annual Economic Policy Conference (Mar. 30, 2023); FSOC, Report on Digital Asset Financial Stability Risks and Regulation (Oct. 3, 2022); FSOC, Statement on Nonbank Financial Intermediation (Feb. 4, 2022).
