The Dodd-Frank Wall Street Reform and Consumer Protection Act created the Financial Stability Oversight Council (FSOC). The June 30, 2010 Joint Explanatory Statement of the Committee of Conference Title I, which established a specific framework for ensuring financial stability, consists of three subtitles.
• Subtitle A establishes a Financial Stability Oversight Council to monitor potential threats to the financial system and provide for more stringent regulation of nonbank financial companies and financial activities that the council determines, based on consideration of risk-related factors, pose risks to financial stability.
• Subtitle B establishes an Office of Financial Research that supports the council by collecting information, conducting research, and analyzing data.
• Subtitle C provides a specific, more stringent supervisory framework for regulating large, interconnected bank holding companies, nonbank financial companies that the council subjects to more stringent regulation, and activities and practices that the council determines may pose systemic threats.
While its portfolio appears narrow and its visibility is somewhat lower than that of the Federal Reserve Board (Fed), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC), the Financial Stability Oversight Council is a stealth group with enormous power.
The council consists of 10 voting members: Secretary of the Treasury (chair), the heads of the Fed, FDIC, OCC, SEC, CFTC, National Credit Union Association (NCUA), Federal Housing Finance Agency (FHFA) and Consumer Financial Protection Bureau (CFPB), and an independent member appointed by the president having insurance expertise, and five non-voting members including the heads of the newly established Office of Financial Research (OFR) and the Federal Insurance Office, and a state banking, insurance and securities regulator.
It is funded through the Office of Financial Research, which after two years of funding by the Fed became self-funding on July 21, 2012 through assessments on systemically-important banks and nonbanks. The council must act with a 2/3 majority including the vote of its chair, the Treasury Secretary, on important matters. The only oversight is congressional (i.e., if any serious disputes arise regarding its oversight authority, they must be resolved by Congress). For example, the financial protection bureau issues a new rule which FSOC supports and the market objects.
As indicated in the conference report mentioned above, the overall mission of the council is to fill a major gap in our financial services regulatory system: spotting potential weaknesses in our industry that may not be apparent to any individual regulator, and dealing with same; identifying nonbank financial companies that play a major role in our financial system and authorizing the Fed to regulate them in the same way it regulates bank holding companies; and establishing the financial research office to create and provide a sophisticated system to collect financial and related data on our financial system and make the same available to our financial system regulators.
Dodd-Frank generally requires the oversight council (i) identify “risks to the financial stability of the United States”; (ii) “promote market discipline”; and (iii) “respond to emerging threats to the stability of the United States financial system.”
The main thrust of this provision is to charge the oversight council, by thinking “inside and outside of the box” with making sure that we will be able to avoid the type of thinking that failed to anticipate the 2008 Great Recession (e.g., that consumer real estate values would never decline). Another objective is to change the thinking of market participants “that the Government will shield them from losses in the event of failure” (i.e., eliminate the “Too Big to Fail” concept). (Some have argued that council designation of a nonbank financial institution will do just the opposite, renewing the moral hazard of too big to fail).
Section 113 of Dodd-Frank provides that the council may determine that a “nonbank financial company” shall be supervised by the Fed and subject to the enhanced capital and other provisions of law if the council determines that “material financial distress” at such company, or its size and make up, “could pose a threat to the financial stability of the United States.”
A company meeting this determination is a “significantly-important financial institution.” As such, it will be subject to proposed regulations issued by the Fed (in addition to any current regulator) outlining the enhanced prudential standards that will be applicable.
Dodd-Frank goes on to list the criteria that the council must consider in order to make such determination. Basically, to be subject to such determination, a nonbank financial company must have 85 percent or more of gross revenues or assets that are “financial in nature.” The Fed has proposed rules (that have not yet been finalized) to define which revenues and assets would meet the “financial in nature” test. Thus, the definition of “financial in nature” becomes crucial.
The guidance accompanying the oversight council’s final rule, issued on April 3, 2012, provides that a nonbank financial company must meet both of the following tests to be considered for significant financial institution designation: (i) total U.S. assets of at least $50 billion and (ii) at least one of the following: $3 billion or more in outstanding credit default swaps; $3.5 billion or more in derivative liabilities; $20 billion or more in total debt outstanding; a minimum 15 to 1 leverage ratio (assets to equity); or a minimum 10 percent short-term debt ratio.
The oversight council has indicated that “fewer than 50″ nonbank financial companies meet these initial criteria. It is expected that the first designations will be made by year end (see below). However, the Fed has not yet finalized two other rule making requirements: (i) to define “financial in nature”; and (ii) to establish the enhanced prudential standards to which significant financial institutions will be subject.
An overview of this process is as follows: Stage One is the period during which the council crunches numbers and makes other investigations to determine which companies meet the tests and could qualify as significantly-important financial institution; Stage Two is when the council advises a particular company that it is being considered for the designation and offers the company an opportunity to provide additional information that might be useful to assist in deciding on its designation; and Stage Three when the council, after reviewing such additional information, makes such designation.
Nonbank financial companies that meet the Stage One financial criteria noted above then move to the next stage which consists of quantitative and qualitative evaluation based on six categories of requirements: the first three of which deal with size, suitability and interconnectedness of the company (i.e., assessing its potential to put financial stress on the U.S. economy) and the second with the leverage, liquidity and maturity mismatch of the company (i.e., assessing the vulnerability of the company to financial distress).
At this stage of the process, a company that the council finds to meet this criteria may furnish it with information it believes is relevant for the council to make a fully informed decision.
Assuming the company meets this level of the review process, the council will advise it of an imminent potential designation.
At this point, the council, by a 2/3 vote, may designate the company as a significantly-important financial institution. The company will then have the right to request an expedited non-public hearing to appeal the designation, the result of which would be final.
It is interesting to note that on Sept. 28 the oversight council voted to “move forward with the third and final phase of such a plan.” However there is some confusion over whether this means that a list of proposed or final designees has been created, or something less.
A Treasury spokesman, following such meeting, said: “The council will notify the companies that were advanced” but does not intend to publicly announce the “name of any nonbank financial company that is under evaluation before a final designation of such company.” (American Banker, “Who Will FSOC Target as Systemically Important?” Sept. 28) AIG has made public that the council has notified it that it is under consideration for a systemic designation.
Commentators express concern as to exactly how the Fed will regulate a designated significantly-important financial institution (i.e., how much of Dodd-Frank will be applied to it?)
The first such designation will mark the first time that a nonbank entity will be subjected to prudential (i.e., safety and soundness) regulation by the Fed. A real cultural shock! Imagine a staff of Fed examiners seeking to take up permanent residence at the nonbank’s headquarters and worldwide offices (as is their practice with banks).
Office of Financial Research
As indicated above, the financial research office is a creature of Treasury which has been late getting off the ground. As yet, its proposed director has not been approved by the Senate because of concern about its mandate.
The reason for its creation in Dodd-Frank is to address the concern that the absence of the centralized collection and analysis of financial data may have played a role in delaying the identification of the potential systemic threats to the stability of the U.S. financial system leading up to the recession. Lehman Brothers and AIG are cited as examples. The perfect solution: financial and related data would be available at the push of a button and create a holistic picture of a particular market (or market segment), instrument or entity (e.g., Lehman).
The lack of support for the financial research office is partially due to the concern that it would supplant the bank regulators gathering of financial services information (unlike the position of the Consumer Financial Protection Bureau which statutorily takes over most of the consumer protection functions of the bank regulators) and privacy concerns (the risk of access would provide a successful intruder with a tremendous amount of information on any particular financial information collection).
To date its seems that the research office is moving carefully and some of the earlier concerns may have abated. All in all this approach seems worthwhile if it is handled properly, and would be an efficient way to collect, store and use this information.
The Government Accountability Office , Congress’ investigative arm, recently faulted the council and the research office, saying they need to improve transparency and they “need to do a better job sharing key financial risk indicators with other regulators, communicating with the public, assigning other agencies responsibility for tracking specific risk, and setting specific performance goals.” (Wall Street Journal, “Risk Panel Comes Under Fire,” Sept. 4, 2012).
Treasury responded that both organizations are “firmly committed” to openness and transparency and “although both organizations have accomplished much, we recognize there is still much to do.”
While the accountability office criticism appears accurate, the reaction will probably mellow when the first significant institutions are identified. It seems worth noting that the lack of transparency in the oversight council designation process has left nonbanks receiving a notice and having to make their own decision on whether such notice is a disclosable event. As of Oct. 4, only AIG has disclosed.
The oversight council has taken up a failed rule making by the SEC, a council voting member, on the issue of how to deal with money-market mutual funds. The SEC tried, but failed to issue rules to deal with mutual funds valuation and related issues because of opposition from several SEC commissioners.
Does this mean that the oversight council will now “drop down” and take over the regulatory responsibilities of certain of its members (the SEC)? If it does, was this the intent of Dodd-Frank? Some commentators believe that if a bank regulator fails to act in a critical situation, the council must be willing to step in and respond to the situation, either directly or through another regulator. An awesome power! Time will tell.
In my opinion, the oversight council’s main strength is getting all of our financial services regulators together under one roof and forcing them to take on tough issues. Its main weaknesses are that it needs seven (out of 10) votes to do anything important, and that the only oversight on its activities is Congress (and the time consuming legislative process).
Clyde Mitchell is an adjunct professor of banking law at Fordham University School of Law, and a retired banking partner at White & Case.