FSOC Proposals Renew Threat of Nonbank "Systemically Important" Designations

The Dodd-Frank Act, Designation, and the MetLife Decision

In the wake of the 2008 financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). One of the hallmarks of Dodd-Frank was its focus on systemic risk, including its creation of FSOC. Charged with analyzing risks to U.S. financial stability, Congress also empowered FSOC to designate nonbank financial companies as systemically important ("Nonbank SIFIs") and thus subject to Federal Reserve supervision and enhanced prudential standards. In 2013, FSOC designated four nonbanks as systemically important: GE Capital, AIG, Prudential, and MetLife.

MetLife challenged its designation, and the U.S. District Court for the District of Columbia agreed with it, rescinding MetLife's designation in 2016. In doing so, the court held that FSOC deviated from its own guidance and failed to weigh the costs to MetLife of its designation with any benefits to U.S. financial stability. FSOC subsequently modified its guidance and procedures in 2019 in light of the MetLife decision. 

FSOC's Proposals

The Proposals comprise a "proposed analytic framework" for identifying financial stability risks ("Analytic Framework") and a "notice of proposed interpretive guidance" that contains a framework for making Nonbank SIFI determinations ("Designation Guidance").

Regarding the Designation Guidance, the formal two-step process for designating nonbanks is largely consistent with prior guidance: (i) FSOC notifies the nonbank that is being considered and conducts a preliminary analysis; and (ii) after notifying the nonbank it has moved to the next step, FSOC conducts more in-depth evaluation. Newly designated companies may request a hearing and a vote.

However, the updated Designation Guidance includes several important changes to FSOC's standards.

Activities-based approach: 

• Pursuant to the 2019 guidance, FSOC focuses on an "activities-based approach." The "activities-based approach," as FSOC described it in 2019, means that FSOC will 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. 
• Under the Designation Guidance, FSOC would no longer bind itself in all cases to following this "activities-based approach" before Nonbank SIFI designation. Under the Designation Guidance, FSOC expects to continue to work with other financial services regulators, but would no longer formally deprioritize Nonbank SIFI designations as an option to respond to perceived risks.

Cost-benefit analysis: 

• The 2019 guidance states that FSOC would conduct a cost-benefit analysis before making a Nonbank SIFI designation.
• The Designation Guidance eliminates this requirement, noting "evaluating the potential costs and benefits of a designation with reasonable specificity is not possible before a designation, and it is unlikely that performing a cost-benefit analysis for a nonbank financial company would yield a balanced picture."

Assessment of likelihood of distress: 

• The 2019 guidance states that FSOC would assess the likelihood of a nonbank's distress or failure before making a Nonbank SIFI designation.
• The Designation Guidance eliminates this requirement.

The Analytic Framework is largely consistent with the 2019 guidance and sets forth the following key vulnerabilities (and identifies corresponding sample metrics) FSOC will look for in evaluating systemic risk: 

• Leverage;
• Liquidity risk and maturity mismatch;
• Interconnectedness;
• Operational risk;
• Complexity or opacity;
• Inadequate risk management;
• Concentration; and
• Destabilizing activities.

The Analytic Framework also identifies four "transmission channels" for negative effects of risk to financial stability, and suggests that FSOC might deal with each differently: direct and indirect exposures to risk, rapid liquidation of assets at fire-sale prices, disruptions to critical functions or services with no ready substitutes, and contagion arising from perception of vulnerabilities.

Industry Response

In an accompanying statement, FSOC Chair Janet Yellen emphasized that the Proposals will increase transparency, explaining that they represent the first time FSOC has issued a document setting forth its approach to identifying, assessing, and mitigating risks to financial stability. Nevertheless, the designation process and the analytic framework for financial stability risk contained in the Proposals remain inherently subjective and unpredictable, leaving nonbanks to await next steps from FSOC on how it will apply the Proposals.

The Designation Guidance would make it easier for FSOC to make a Nonbank SIFI designation, and thereby impose onerous rules on nonbank financial institutions, such as asset managers, investment funds, private equity sponsors, nonbank lenders, insurers, digital asset firms, and payments companies. Such firms and others can submit comments by June 27, 2023, in order to highlight this uncertainty or other concerns or input regarding the Proposals.