Dodd-Frank Regulatory Rulemaking: Financial Reform's Second Act


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

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Dodd-Frank Regulatory Rulemaking: Financial Reform's Second Act

  1. 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 1
  2. 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; 2
  3. 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. 3
  4. 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 4
  5. 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: 5
  6. 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 6