Systemically Important Nonbank Financial Institutions: FSOC Approves Final Rule

On April 11, 2012, the Financial Stability Oversight Council (the "Council") gave more shape to the framework of systemic risk regulation by publishing a final rule (the "Rule") that sets forth the process for the designation of nonbank financial institutions as systemically important. Once designated, these systemically important financial institutions ("SIFIs") will be supervised by the Federal Reserve Board (the "Board") in much the same way that it supervises bank holding companies with $50 billion or more in consolidated assets. This supervision will involve the use of more rigorous "enhanced prudential standards" than apply to bank holding companies below the $50 billion floor. The Board proposed such standards earlier this year. Large nonbank financial companies should review the Rule with care, given the onerous consequences of designation and the intricacies of the designation process.

The designation of nonbank financial firms as SIFIs is one tool, but perhaps not the most efficient tool, for addressing systemic risk in the financial services industry. The Dodd-Frank Act Wall Street Reform and Consumer Protection Act ("Dodd-Frank" or the "Act") provides two other tools: the identification and regulation of systemically risky activities across all financial institutions and authority to resolve distressed SIFIs in an organized manner outside the bankruptcy and bank receivership processes.

Because many firms are likely to engage in any given line of business that presents a high level of risk, the identification and regulation of these activities across the financial services industry is the most effective way to address systemic risk. The regulators will be able to collect information on how several firms operate the business and manage the attendant risks, which will enable the regulators to establish a sophisticated industry-wide approach. By contrast, the designation of particular firms will focus on idiosyncrasies and unique risks to financial stability that can only be handled on an institution-specific basis. This approach will create at best a materially smaller body of knowledge that can be applied to the regulation of other large firms. Nevertheless, the Council has chosen to concentrate on the designation of nonbank financial firms as presenting threats to U.S. financial stability. The review of activities that may lead to systemic risk seems to be a lower priority.

Important consequences will flow from designation as a SIFI. Designation would adversely affect the ability of these institutions to compete with their undesignated competitors due to increased costs and supervisory impact on their decision making process. Under the Rule, a significant number of large financial firms could be pulled into the Council's designation process. The Rule establishes quantitative thresholds to identify firms subject to the process, which appear to be at least in part "reverse engineered" based on experiences from the financial crisis. However, the metrics would also sweep up firms that would pose widely divergent levels and types of risk to financial stability, including many firms that do not warrant designation. Moreover, the Council has made clear that the universe of covered firms may go beyond those firms that meet the quantitative thresholds.

The Council has declined to provide any kind of exemption or safe harbor for sectors of the financial services industry that would seem to present no real threat to financial stability, either because regulation of particular activities would more effectively and more equitably address any risks posed, or because the bank holding company model would not effectively address any risks posed.

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