Five Key Questions That Congress Left to the New Financial Stability Oversight Council

1. Thursday, August 19, 2010
SPOTLIGHT ON: TOO BIG TO FAIL
Five Key Questions That Congress Left to the New Financial
Stability Oversight Council
From the Patton Boggs Financial Services Public Policy Practice Group
As the multi-year Dodd-Frank Act rulemaking phase of Financial Regulatory Reform begins, the
Patton Boggs Financial Services Public Policy Practice Group is pleased to share with you the
first in a series of short discussions about the major decisions that Congress left to the regulators.
The regulatory phase provides avenues for stakeholders to share their comments and concerns
about proposed rules and to educate regulators on the impact of their potential rules. The Patton
Boggs Financial Services Public Policy Practice Group is well-positioned to effectively advocate
on an array of substantive and policy issues that will come before the regulators.
Please let us know if you have questions about this topic or other issues addressed in the
financial regulatory reform legislation.
With passage of legislation in the early 1990s to resolve the savings and loan crisis, Congress
sought to eliminate the notion that no depository institution is too big or too important to be
allowed to fail. With the collapse of private Fed-coordinated recapitalization of Long Term Capital
Management in 1998, and the collapse of several brokerage firms and several government
coordinated bailouts of other large financial companies, it became apparent that even a nonbank
financial company (NBFC) could in fact be too “interconnected” or "systemically significant” to be
allowed to fail. In Title I of the Dodd-Frank Act, Congress is again attempting to address the “too-
big-to-fail” problem. This time around Congress has put in place a legal regime where any
systemically significant NBFC or large bank holding company is identified in advance so it can be
monitored and regulated by the Federal Reserve. Under the new regime any institution or product
posing a significant systemic risk will be addressed before it poses any risk to the financial
system. Moreover, upon the occurrence of a “grave” risk, such previously identified institutions
can be forced to cease risky activities or face forced divestiture of one or more risky subsidiaries
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2. Patton Boggs LLP Dodd-Frank Regulatory Rulemaking Update | August 6, 2010
or affiliates. Anointed with this auspicious responsibility is a new quasi-regulator called the
Financial Stability Oversight Council (FSOC).
This week’s spotlight attempts to highlight some of the most important issues that the Obama
administration will have to address in delegating authority to the FSOC and the Federal Reserve
under Title I of the Dodd-Frank Act.
One of the key responsibilities of the FSOC is to monitor, manage and reduce the level of
systemic risk inherent in the U.S. financial system. To do so, it is empowered to identify, monitor
and address systemic risks posed by large, complex financial firms as well as products and
activities that spread risk across financial firms and markets. The FSOC is also authorized to
designate systemically significant NBFCs to be supervised by the Federal Reserve, and to make
recommendations to the Federal Reserve and other federal regulators regarding heightened
prudential standards. Unlike other new entities created by the Act, however, it is unclear when the
FSOC must begin performing its responsibilities.
FIVE KEY QUESTIONS
That Congress Left to the New Financial Stability Oversight Council
1. Which nonbank financial companies will see their financial activities regulated by the
Federal Reserve and subject to higher prudential standards?
Only time will tell how broad a net the FSOC will decide to throw in order to capture
additional key financial market participants. However, it is clear today that large insurance
companies, hedge funds, mutual funds and asset management companies and certain
unregulated funds should consider that the FSOC and the Fed may come knocking at their
door. Under the Act, the FSOC can determine that a NBFC (including a foreign company)
shall be supervised by the Federal Reserve and subjected to higher prudential standards so
long as the FSOC first determines that the “material financial distress or failure” of the
company, or the “nature, scope, size, scale, concentration, interconnectedness, or mix of
activities” at the company could pose a threat to the U.S. financial system. However, the
FSOC’s authority to subject NBFCs to Fed regulation is limited to those NBFCs that are
“predominantly engaged in financial activities” as defined in section 4(k) of the Bank Holding
Company Act. Under this standard, a company is considered “predominantly engaged in
financial activities” if at least 85 percent of its consolidated annual gross revenues are
derived from, or 85 percent of its consolidated assets are related to, activities that are
financial in nature.
In making a determination that a company should be designated as systemically significant
the FSOC will consider:
o the extent of the leverage of the company;
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3. Patton Boggs LLP Dodd-Frank Regulatory Rulemaking Update | August 6, 2010
o the extent and nature of the off-balance sheet exposures of the company;
o the extent and nature of the transactions and relationships of the company with other
significant nonbank financial companies and significant bank holding companies;
o the importance of the company as a source of credit for households, business and
state and local governments, and as a source of liquidity to the U.S. financial
system;
o the importance of the company as a source of credit for low-income, minority or
underprivileged communities;
o the extent to which assets are managed rather than owned by the company;
o the nature, scope, size, scale, concentration, interconnectedness and mix of
activities of the company;
o the degree to which the company is already regulated by one or more primarily
financial regulatory agencies;
o the amount and nature of the financial assets of the company;
o the amount and types of liabilities of the company, including degree of reliance on
short term funding; and
o any other risk-related factors that the FSOC deems appropriate.
Clearly, the FSOC will have wide discretion in making its determination (despite the right to
public notice and a hearing) and it will look to the Federal Reserve and other regulators that
have representatives on the FSOC for an initial recommendation regarding what specific
firms should be captured by the new regime. In particular, large insurance companies,
consumer finance companies, asset management firms, hedge funds and private equity
funds should all anticipate the possibility that they may one day be covered.
2. What types of prudential standards may the FSOC recommend be implemented by
the Federal Reserve?
Here, the Act provides the Fed with a wide range of supervisory tools. Under the Dodd-
Frank Act, the FSOC may make recommendations to the Federal Reserve regarding the
establishment and refinement of prudential standards and reporting and disclosure
requirements for NBFCs supervised by the Federal Reserve as well as large interconnected
bank holding companies. These requirements may be more stringent than those applicable
to other companies that do not pose similar risks to the financial stability of the United
States, and may increase in stringency depending on factors such as nonfinancial activities
and affiliations of the company or whether the company owns an insured depository
institution. The recommendations of the FSOC may include: (i) risk based capital
requirements; (ii) leverage limits; (iii) liquidity requirements; (iv) mandatory resolution plan
(i.e. a “living will”) and credit exposure report requirements; (v) concentration limits; (vi) a
contingent capital requirement; (vii) enhanced public disclosures; (viii) short-term debt limits;
and (ix) overall risk management requirements. The FSOC must also conduct a study as to
the feasibility, benefits, costs and structure of a contingent capital requirement for NBFCs
supervised by the Federal Reserve and large, interconnected bank holding companies.
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4. Patton Boggs LLP Dodd-Frank Regulatory Rulemaking Update | August 6, 2010
3. What types of companies will be required to submit reports to the FSOC?
Again, we expect the FSOC to act fairly aggressively and these reporting obligations could
very well be imposed on NBFCs that have not yet been deemed systemically significant.
The FSOC is commissioned to identify risks to the U.S. financial system and respond to
these risks accordingly. To identify these risks, the FSOC has broad power to gather
information through the Office of Financial Research (OFR). The FSOC is permitted under
the law to require reports from any financial company to assess threats to that company or
the financial market. Further, bank holding companies with assets of $50 billion or more and
NBFCs supervised by the Federal Reserve may also be required to file certified reports
including a description of: (i) the financial condition of the company; (ii) systems for
monitoring and controlling financial, operating and other risks; (iii) transactions with any
subsidiary that is a depository institution; and (iv) the extent to which the activities and
operations of the company and any subsidiary thereof, could, under adverse circumstances,
have the potential to disrupt financial markets or affect the overall financial stability of the
United States. To the extent that the FSOC can use reports provided to other Federal or
State regulatory agencies, externally audited or otherwise reported publicly, the FSOC
should use those reports. Any reports provided to the FSOC would remain confidential.
4. What authority is FSOC granted to guard against new risky financial practices?
The FSOC is permitted to recommend more stringent regulation by a financial regulatory
agency of specific financial activities if the FSOC determines that the activity could increase
the risk of significant liquidity, credit or other problems spreading across bank holding
companies or NBFCs, financial markets, or low-income, minority or underserved
communities. The FSOC must consult with the primary financial regulatory agency in charge
of regulating the bank holding company or nonbank financial company, and the FSOC must
provide for a notice and comment period for any proposed recommendation to apply new or
heightened standards and safeguards against any financial activity or practice. The primary
financial regulatory agency must impose the recommendation, however, after this process
or explain in writing to the FSOC within 90 days why the agency has determined not to
follow the recommendation.
5. What other steps can the FSOC take to mitigate risk posed by a systemically
important company if it poses a grave or immediate threat to the U.S. financial
system?
If the Federal Reserve determines that the bank holding company with more than $50 billion
in assets (or a NBFC it currently supervises) poses a grave threat to the U.S. financial
system, the FSOC may grant by a 2/3 vote the Federal Reserve permission to (i) limit the
ability of a such bank holding company or a NBFC to enter into a merger, acquisition or
consolidation; (ii) restrict the ability of such company to offer a particular financial product;
(iii) require such company to terminate certain financial activities; or (iv) impose conditions
on how such company conducts certain of its financial activities. If these measures are
deemed inadequate, the Federal Reserve may also require the NBFC or large bank holding
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5. Patton Boggs LLP Dodd-Frank Regulatory Rulemaking Update | August 6, 2010
company to sell or otherwise transfer assets or off-balance-sheet items to unaffiliated
entities.
DID YOU KNOW?
Several Other Interesting Facts about the Financial Stability Oversight Council’s
Regulatory Authority
1. Operational Fees. Two years after enactment, the Treasury Secretary and FSOC will
establish a fee schedule to be assessed on systemically important companies to fund the
expenses of the OFR and FSOC.
2. Ongoing Study of Effects of Limiting the Size and Complexity of Financial Institutions: The
Dodd-Frank Act requires the Treasury Secretary, as chairperson of the FSOC, to conduct
an ongoing study of the economic impact of regulations imposed to reduce systemic risk.
Reports must be presented to Congress within 180 days after enactment and every five
years thereafter.
3. Council Indecision: The Federal Reserve is authorized to conduct an examination of a U.S.
nonbank financial company for the sole purpose of determining whether the company
should be supervised. However, they are only authorized to engage in such an examination
in situations where the FSOC is unable to determine whether the financial activities of a
U.S. nonbank financial company pose a threat to the financial stability of the United States
based on information available from the OFR and financial regulators.
ABOUT PATTON BOGGS
Widely-recognized as the nation’s number-one public policy firm, Patton Boggs is at the
intersection of government and business. Our professionals are known for their skill in assessing
how actions on Capitol Hill and the Executive Branch will affect companies on Main Street and
Wall Street. Our experience, both broad and deep, extends to the legislative and regulatory
issues that affect financial services businesses throughout the United States and the world—
insight and “capitol intelligence” that is critical in today’s tumultuous global marketplace. Our
knowledge and experience working both with (and within) various government agencies, enables
us to seek an array of policy solutions, particularly when the client requires more than
conventional resolution strategies.
For more information on this topic or other Financial Services Public Policy issues,
please contact:
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6. Patton Boggs LLP Dodd-Frank Regulatory Rulemaking Update | August 6, 2010
Don Moorehead, Vice Chairman, Patton Boggs and Co-Chair, Private Capital and Investment
Practice Group
Micah S. Green, Co-Chair Financial Services and Tax Practice
Jonathan Babu, Associate
Gregg S. Buksbaum, Partner
Todd Cranford, Of Counsel
Eric Foster, Partner
Vincent Frillici, Senior Policy Advisor
Joshua Greene, Partner
Laurence E. Harris, Senior Counsel
Matthew Kulkin, Associate
Erin McGrain, Associate
Neil Potts, Associate
Travis Seegmiller, Associate
Carol R. Van Cleef, Partner
Lindsey Weber, Associate
Kirsten Wegner, Associate
www.pattonboggs.com
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