Designation of Systemically Important Nonbank Financial Companies Under Dodd-Frank

Editor’s Note: H. Rodgin Cohen is a partner and senior chairman of Sullivan & Cromwell LLP focusing on acquisition, corporate governance, regulatory and securities law matters. This post is based on a Sullivan & Cromwell LLP publication; the full version, including footnotes, is available here.

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 today’s Federal Register, 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.

I. Background

Under Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd- Frank”), the Financial Stability Oversight Council (the “Council”), an interagency body chaired by the Secretary of the Treasury, is authorized to require that a “nonbank financial company” be subject to heightened prudential standards and supervision by the Federal Reserve if the Council determines that the nonbank financial company is systemically important, i.e., the company could “pose a threat to the financial stability of the United States.”

The Council must conclude that such a threat could arise (i) as a result of “material financial distress” at the company and/or (ii) as a result of the “nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the . . . nonbank financial company.” The interpretive guidance refers to these as the two statutory “Determination Standards.” In making a determination, Dodd-Frank directs the Council to conduct an institution-specific risk analysis based on the following statutory considerations:

  • the extent of the leverage of the company;
  • the extent and nature of the off-balance sheet exposures of the company;
  • the extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
  • the importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;
  • the importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
  • the extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
  • the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
  • the degree to which the company is already regulated by one or more primary financial regulatory agencies;
  • the amount and nature of the financial assets of the company;
  • the amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
  • any other risk-related factors that the Council deems appropriate.

A similar set of statutory considerations applies to the designation of “foreign nonbank financial companies,” although they are generally tailored to the U.S. operations of such companies.

A proposed or final determination by the Council that a company is systemically important requires an affirmative vote of at least two-thirds of the voting members serving, including the affirmative vote of the Treasury Secretary.

Previous Rulemakings

The Council previously issued two other rulemakings regarding the exercise of its authority under Section 113: an Advance Notice of Proposed Rulemaking on October 6, 2010 (the “ANPR”), and a subsequent Notice of Proposed Rulemaking on January 26, 2011 (the “First NPR”). Numerous public commenters and certain Members of Congress were critical of the ANPR and the First NPR, including arguing that neither proposal provided sufficiently detailed guidance regarding the criteria and metrics the Council intended to use in making determinations.

In response, the Council has promulgated a Second Notice of Proposed Rulemaking (the “Revised NPR”), which supersedes the First NPR, and new interpretive guidance (the “Guidance,” and together with the Revised NPR, the “Revised Proposal”), which provide greater detail regarding the manner in which the Council intends to apply the statutory considerations and the process it proposes to follow with respect to making systemic determinations – including the proposed use of “quantitative thresholds” and establishment of a three-stage process for making determinations.

II. The Revised Proposal

A. Stage 1: Council to Apply Quantitative Thresholds

As noted above, in Stage 1 the Council proposes to apply a set of “quantitative thresholds” to a “broad group” of nonbank financial companies as a filter for identifying those companies that will be subject to further evaluation. According to the Guidance, “[t]he purpose of Stage 1 is to enable the Council to identify a group of nonbank financial companies that are most likely to satisfy one of the Determination Standards.” The quantitative thresholds relate to four of the six “framework categories” that the Council would apply in Stage 2 (described in more detail below) – size, interconnectedness, leverage, and liquidity risk/maturity mismatch – and were chosen because of their applicability to different types of financial markets and industries, the current availability of data, and the Council’s belief that they provide a “meaningful initial assessment . . . regarding the potential for a nonbank financial company to pose a threat to financial stability in diverse financial markets.” The quantitative thresholds are not designed to relate to the framework categories of existing regulatory scrutiny or substitutability.

A nonbank financial company that satisfies a total consolidated assets threshold and meets or exceeds at least one of the five other thresholds will be subject to further evaluation in Stage 2.

“Quantitative Thresholds”

  • Total Consolidated Assets:
    • U.S. Nonbank Financial Companies: $50 billion in total global consolidated assets;
    • Foreign Nonbank Financial Companies: $50 billion in U.S. total consolidated assets.
  • Five Other Thresholds:
    • CDS Outstanding: $30 billion or more in gross notional value of outstanding CDS for which the nonbank financial company is the reference entity.
    • Derivative Liabilities: $3.5 billion or more, measured as the fair value of any derivatives contracts in a negative position taking into account master netting agreements and cash collateral held with the same counterparty on a net basis. Although this threshold only captures a company’s current exposure, the Council intends to establish a new State 1 threshold that will capture potential future exposure once the SEC and CFTC have finalized their rules governing “major swap participants” and “major security-based swap participants.”
    • Loans and Bonds Outstanding: $20 billion or more (while the Guidance notes that had this threshold been in place at the time, it would have captured many nonbank financial companies that experienced material financial distress during the financial crisis, including Bear Stearns, Countrywide, and Lehman Brothers, we note that it would also have captured other companies that experienced relatively little distress).
    • Leverage Ratio: 15 to 1 minimum ratio of total consolidated assets (excluding separate accounts) to total equity.
    • Short-Term Debt Ratio: threshold ratio of short-term debt (i.e., maturity of less than twelve months) to total consolidated assets (excluding separate accounts) of 10%.

In Stage 1, the Council intends to rely solely on publicly-available information and information provided by regulatory sources.

Although the Council initially intends to apply the quantitative thresholds uniformly to all nonbank financial companies, it acknowledges that the proposed thresholds “may not provide an appropriate means to identify a subset of nonbank financial companies for further review in all cases across all financial industries and firms.” Accordingly, the Council “may, in limited cases, initially evaluate nonbank financial companies in Stage 1 based on other firm-specific qualitative or quantitative factors, such as substitutability and existing regulatory scrutiny.”

Application of Thresholds to Certain Companies

Although the Stage 1 quantitative thresholds would appear to capture a number of insurance companies, some of the six framework categories to be employed in Stage 2 would seem to mitigate against their designation by the Council, including “existing regulatory scrutiny.”

The preamble to the Revised NPR states that “financial guarantors, asset management companies, private equity firms, and hedge funds . . . may pose risks that are not well-measured” under the proposed quantitative thresholds. Accordingly, the Council will consider whether to establish “an additional set of metrics or thresholds tailored to evaluate hedge funds and private equity firms and their advisers.” The Council notes that less data is generally available for hedge funds and private equity firms, but indicates that, in developing any such additional metrics or thresholds, it intends to review financial disclosures that private fund advisers will be required to file with the SEC and CFTC beginning in 2012.

With respect to asset management companies, the Council and its member agencies, together with the Office of Financial Research, “will consider what threats exist, if any, and whether such threats can be mitigated by subjecting such companies to Board of Governors supervision and prudential standards or whether they are better addressed through other regulatory measures.” The preamble also notes that the Council “may issue additional guidance . . . regarding potential additional metrics and thresholds relevant to asset manager determinations.”

As noted, the Council proposes initially to apply the $50 billion “total consolidated assets” threshold uniformly to all nonbank financial companies in Stage 1, regardless of whether the Council ultimately establishes revised or additional metrics or thresholds for hedge funds, private equity firms, or asset managers. It would appear that, at least for purposes of this initial screening, a key question is whether, and how, funds managed by a nonbank financial company would be consolidated. The Guidance states, in a footnote, that the Council “may consider investment funds managed by a nonbank financial company as a single entity for purposes of applying the quantitative thresholds if their investments are identical or highly similar.” This raises at least two related questions regarding consolidation. First, among the funds managed by a nonbank financial company, which will be deemed to have “identical or highly similar investments” and therefore be subject to consolidation? And second, which, if any, of the managed funds (regardless of whether they are themselves consolidated for purposes of the Stage 1 thresholds) may then be consolidated with the assets of the manager?

B. Stage 2: Institution-Specific Assessment

In Stage 2, the Council intends to evaluate the risk profile and characteristics of each individual company that met the Stage 1 thresholds under a wide range of quantitative and qualitative industry- and companyspecific factors. Like the First NPR, the Revised NPR proposes an analytic framework that divides the statutory considerations into six “categories,” which will guide the Council’s institution-specific evaluation in Stage 2. The six framework categories are: size, interconnectedness, substitutability, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny.

The Council believes the first three categories (size, interconnectedness, and substitutability) assess the potential impact of a nonbank financial company’s material financial distress on the broader economy. The latter three (leverage, liquidity/maturity mismatch, and existing regulatory scrutiny) are intended to evaluate a nonbank financial company’s vulnerability to financial distress.

Proposed “Sample Metrics”

The Guidance expands on this framework by providing “sample metrics” the Council may use for evaluating each of the six categories.

Framework Category Sample Metrics

(Amount of financial services or financial intermediation provided)

  • Total consolidated assets or liabilities, as determined under the applicable financial reporting standards
  • Total risk-weighted assets, as appropriate for different industry sectors
  • Off-balance sheet exposures where there is a risk of loss, including lines of credit
  • Extent to which assets are managed rather than owned and extent to which such ownership is diffuse
  • Direct written premiums as reported by insurance companies (all lines of business)
  • Risk in force, which is the aggregate risk exposure from risk underwritten in insurance related to certain financial risks, such as mortgage insurance
  • Total loan originations, by loan type, number, and dollar amount

(Direct or indirect linkages between financial companies that may be conduits for the transmission of the effects of the nonbank financial company’s material financial distress or activities)

  • Counterparty exposure (including derivatives, reinsurance, loans, securities borrowing/lending, and lines of credit that facilitate settlement/clearing activities)
  • Number, size, and financial strength of counterparties
  • Identity of principal contractual counterparties (reflecting the concentration of the company’s assets financed by particular firms and the importance of counterparties to the market)
  • Aggregate gross or net derivatives exposures and number of derivatives counterparties
  • Gross notional amount of outstanding CDS for which the company is the reference entity
  • Outstanding loans borrowed/bonds issued
  • Reinsurance obligations (reflecting reinsurance risk assumed from non-affiliates net of retrocession)

(Extent to which other firms could provide similar financial services in a timely manner at a similar price and quantity if the nonbank financial company withdraws from a particular market)

  • Market share of the company and its competitors in the market under consideration
  • Stability of market share across firms in the market over time
  • Market share of the company and its competitors for products/services that serve a substantially similar economic function as the primary market under consideration

(Exposure or risk in relation to equity capital)

  • Total assets and total debt relative to total equity
  • Gross notional derivatives exposure and off-balance sheet obligations relative to total equity or net assets under management
  • Ratio of risk to statutory capital (relevant to certain insurance companies)
  • Changes in leverage ratios
Liquidity Risk/Maturity Mismatch

(Risk that a company may not have sufficient funding to meet its short-term needs, either through cash flow, maturing assets, or assets salable at prices equivalent to book value, or through its ability to access funding markets)

  • Fraction of assets classified as Level 2 and Level 3 under applicable accounting standards (reflecting how much of the balance sheet is composed of hard-to-value and potentially illiquid securities)
  • Liquid asset ratios
  • Ratio of unencumbered/highly-liquid assets to net cash outflows under a short-term stress scenario
  • Callable debt as a fraction of total debt
  • Asset-backed funding versus other funding
  • Asset-liability duration and gap analysis
  • Short-term debt as a percentage of total debt and total assets
Existing Regulatory Scrutiny

(Extent to which the company is already subject to regulation, including the consistency of such regulation across nonbank financial companies within a sector, across different sectors, and providing similar services, and the statutory authority of those regulators)

  • Existence of consolidated supervision
  • For investment funds, whether the fund or manager is registered with the SEC, CFTC, or a bank or insurance regulator
  • For insurance companies, an assessment of the number of primary regulatory agencies and the number of “lead state” regulators
  • For entities based outside the U.S., “the extent to which the company is subject to prudential standards on a consolidated basis in its home country, administered and enforced by a comparable foreign supervisory authority”
  • Existing regulators’ ability to impose detailed and timely regulatory reporting obligations, capital or liquidity requirements, enforcement actions, and resolutions

C. Stage 3: Proposed And Final Determinations

After completion of the Stage 2 analysis, any nonbank financial company selected for additional scrutiny will move to Stage 3 and receive a notice from the Council that it is being considered for a “Proposed Determination.” The Stage 3 review will focus on whether one or both of the Determination Standards have been met and will involve analysis of information collected directly from the subject company, along with information collected during Stages 1 and 2.

In Stage 3, the Council will also review at least three risk-transmission “channels” identified as being “most likely to facilitate the transmission of the negative effects of a nonbank financial company’s material financial distress or activities to other financial firms and markets”:

  • Exposure: Creditors, counterparties, investors, or other market participants that have exposure to the company that is significant enough to result in their material impairment and thereby pose a threat to U.S. financial stability (metrics to include total consolidated assets, CDS outstanding, derivative liabilities, loans/bonds outstanding, and leverage);
  • Asset Liquidation: The company holds assets that, if liquidated quickly, would significantly disrupt trading or funding in key markets or cause significant losses or funding problems for other firms with similar holdings due to falling asset prices (metrics to include total consolidated assets and short-term debt ratio);
  • Critical Function or Service: The company is no longer able or willing to provide a critical function/service that is relied upon by market participants and for which there are no ready substitutes (company-specific analysis, including a review of the “competitive landscape” in the relevant market, the company’s market share, and the ability of other firms to replace those services).

The first and third of these factors would apparently also be considered in Stage 2.

The Council also intends to perform a “resolvability evaluation” for each company in the “Stage 3 Pool,” that is, “an assessment of the complexity of the nonbank financial company’s legal, funding, and operational structure, and any obstacles to the rapid and orderly resolution of a nonbank financial company in a manner that would mitigate the risk that [its] failure would have a material adverse effect on financial stability.”

Notice of Consideration

As noted above, the Council will send every company in the Stage 3 Pool a written “Notice of Consideration” for a proposed determination, which will include a request for additional information, potentially including confidential business information, internal assessments, internal risk management procedures, funding details, counterparty exposure or position data, strategic plans, resolvability, potential acquisitions/dispositions, and certain other anticipated changes to the company’s structure.

Once a company has received the Notice of Consideration, it will have an opportunity to submit written materials contesting the consideration of a Proposed Determination, including materials concerning whether the company meets the standards for a determination.

Notice of Proposed Determination

When the Council deems its evidentiary record to be complete (and has so informed the subject company), it may issue a written Notice of Proposed Determination, receipt of which by the company triggers a formal appeals process involving the right to request an informal “evidentiary hearing” before the Council. Unlike the Notice of Consideration, this second notice must include an explanation of the basis for the Proposed Determination. The Council must make a Proposed Determination within 180 days after the date on which the Council deemed the evidentiary record to have been complete.

Final Determination

Within 60 days of the evidentiary hearing (if requested), the Council must consider its Final Determination. Any Final Determination adopted by the Council will be announced publicly. Within 30 days after receiving a Notice of Final Determination, the subject company may file an action in an appropriate federal district court seeking to rescind the Final Determination on the grounds that it was arbitrary and capricious. Within 180 days of a Final Determination, the company must register with the Federal Reserve.

Reevaluation and Rescission

The Council must, not less frequently than annually, reevaluate each currently effective determination of a systemically important nonbank financial company and rescind any such determination if the Council determines that the nonbank financial company no longer meets either of the Determination Standards. Any determination of the Council to rescind requires at least a two-thirds majority vote of the Council, including the affirmative vote of the Treasury Secretary.

Public Comment

Comments on the Revised Proposal are due by December 19, 2011. The Council seeks public comment on key concepts and terms, the six-category framework and the Stage 1 quantitative thresholds, as well as the procedures the Council intends to follow in making determinations.


The Revised NPR provides no indication of the timing of the Stage 1 or Stage 2 reviews, the supplementary Stage 2 analysis, or the possible development of additional metrics for private equity firms, hedge funds, or asset management companies.

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