In Short
The Situation: Over the course of 2023, the Financial Stability Oversight Council ("FSOC") took steps that increase the risk of nonbank financial companies and financial activities being designated as systemically important and thereby being subjected to additional regulatory requirements and supervision.
The Result: FSOC finalized significant changes to the procedural and substantive guidance it follows when assessing the systemic risk profile of a financial activity or company and when designating the latter as systemically important.
Looking Ahead: FSOC continues to expand in resources and scope, increasing the likelihood of invasive and unnecessary oversight or regulation of affected companies.
Created in the wake of the 2008 financial crisis, Congress charged FSOC with analyzing risks to U.S. financial stability. It empowered FSOC to designate nonbank financial companies as systemically important financial institutions ("Nonbank SIFIs") and thus subject to Federal Reserve supervision and enhanced prudential standards. FSOC also has the power to recommend additional regulatory requirements for financial activities that it deems a risk to financial stability. As such, FSOC is an important mechanism for increasing regulatory requirements across an industry or extending bank-like regulatory and supervisory requirements to nonbank financial companies without any further Congressional action.
On November 3, 2023, FSOC finalized changes to its existing guidance on nonbank designations and adopted a new analytic framework for identifying financial stability risks. Although FSOC solicited public comment on both documents, the only material modification it made to its initial proposals in response to comments was to define what constitutes a threat to U.S. financial stability. FSOC addressed this comment by choosing a definition that lowered the threshold for what constitutes a "threat" beyond prior FSOC iterations of that definition, thus increasing the range of companies and activities that FSOC could deem pose a threat to U.S. financial stability in the future.
Among other things, these guidance documents are intended to "remove unwarranted hurdles to designation imposed by [Trump-era] Guidance." They do so by removing the "activities-based approach" of earlier guidance in which FSOC had committed to prioritize identifying potential risks on a "system-wide" basis, and then allow "relevant financial regulatory agencies" to address the risks identified, and deprioritize the option of classifying entities as Nonbank SIFIs to address those risks. FSOC also eliminated earlier commitments to conduct a cost-benefit analysis and to assess the likelihood of a nonbank's distress or failure before making a designation. The designations guidance and analytic framework remain subjective and unpredictable to stakeholders.
FSOC's staff and budget have more than doubled during the Biden administration. The fiscal year 2024 budget notes FSOC has 49 full-time equivalents (in addition to the resources of its member agencies upon which it can draw). With FSOC's six staff committees and a medley of newly created working groups and task forces—notably covering hedge funds, digital assets, open-end funds, and nonbank mortgage servicing—financial services industries should anticipate a bureaucratic appetite for increasingly granular information, at a minimum.
FSOC's focus on increasingly detailed information-gathering is already apparent at the banking agencies, whose heads are FSOC members. For example, the three Federal banking agencies recently proposed modifying bank financial reporting obligations to provide more granular reporting on bank loans to nondepository financial institutions, such as insurance companies, mortgage companies, private equity funds, hedge funds, broker-dealers, real estate investment trusts, marketplace lenders, special purpose entities, and other financial vehicles. This is entirely consistent with FSOC's 2023 Annual Report, which recommended "banking agencies continue monitoring bank exposures to [nonbank financial institutions]."
FSOC is unlikely to limit its actions to information collection exercises and precatory recommendations to primary financial regulatory agencies. FSOC member and Consumer Financial Protection Bureau Director Rohit Chopra has commented that the fact that no nonbanks are currently designated as systemically important is a sign of FSOC's failure. Another FSOC member, Federal Deposit Insurance Corporation Chairman Martin Gruenberg, has observed that the "most effective and balanced way to enhance the stability of the entire financial system" would be to subject nonbanks, such as open-ended mutual funds, money market funds, leveraged investment vehicles, nonbank lenders, financial technology firms, securitization vehicles, and insurance companies, to "greater transparency, stronger oversight and appropriate prudential requirements"—prudential requirements being code for bank-like capital, liquidity, and risk management standards. For many nonbanks, the only legal mechanism to do so absent further legislation is FSOC designation.
On top of these internal pressures, politicians are also urging FSOC to act. In a letter to FSOC Chair Janet Yellen ahead of FSOC's decision to finalize its designation guidance and analytic framework, Senator Elizabeth Warren (D-Mass) noted that "finalizing the proposed interpretive guidance is not enough" and informed FSOC that it "must also exercise its designation authority to effectively carry out its responsibility of addressing potential risks to the U.S. financial system." It is reasonable to assume that political and bureaucratic pressure on FSOC to take further action will only increase over the course of 2024.
All signs point to FSOC flexing its strength in the coming year. Any expanded systemic risk regulation will come with considerable costs for key pieces of the financial services industry. Companies affected by these changes have options, especially in the event FSOC exceeds its statutory power, reverses course without adequate explanation, or fails to follow procedural requirements.
Three Key Takeaways
- Based on the groundwork laid in 2023, the continued bureaucratic investment in its operations, and political pressure to act ahead of the 2024 elections, FSOC may take action with regard to specific nonbank companies, financial activities, or particular industries over the course of the year.
- Companies targeted by FSOC—whether for entity designation, additional activities regulation, or even mere information collection—should analyze and preserve all options available to them, including at the initial stage of any FSOC process.
- To that end, companies should consider legal remedies, litigation options, lobbying efforts, and changes in business activities to mitigate potential risks associated with a reinvigorated FSOC.
