FSOC Systemic Risk Framework and Interpretive Guidance on Nonbank SIFI Designations

On April 21, 2023, the Financial Stability Oversight Council ("FSOC") issued two important proposals[1] regarding the designation of a nonbank financial firm as a systemically important financial institution ("nonbank SIFI") under Section 113 of the Dodd-Frank Act ("DFA").[2] The announcement signals a renewed effort by the FSOC in its approach to overseeing the safety and soundness of the U.S. financial system. 

• The first proposal would establish a new analytical framework[3] under DFA § 112[4] to provide greater transparency to the public about how the FSOC identifies, assesses, and addresses potential risks to financial stability, regardless of whether the risk stems from activities or firms, and
• The second proposal would update interpretative guidance[5] on the procedures for designating nonbank financial companies for Federal Reserve supervision and enhanced prudential standards.

The new framework and interpretative guidance would be a significant shift from the existing FSOC guidance on financial stability, representing an effort to address the previous, uncured deficiencies identified in the designation process, including the FSOC's failure to designate under section 113 four prominent nonbank financial firms. If adopted, the proposal's framework and interpretive guidance would presumably result in an increase in the Federal Reserve's oversight of the activities of designated firms and, possibly, an expansion of the number of nonbank financial firms that could be designated by the FSOC compared to its previous efforts.

Analytical Financial Stability Risk Framework

In the proposed risk analysis framework, the FSOC states that it is taking a "broader approach to identifying, evaluating, and addressing potential risks to U.S. financial stability … without regard to the origin of a particular risk, including whether the risk arises from widely conducted activities or from individual entities, and regardless of which of the FSOC's authorities may be used to address the risk."[6] In short, the changes would allow regulators a broader and more open-ended approach to identify, evaluate, and address financial stability risks.

Identifying Potential Risks

The FSOC announced it will evaluate the potential risks posed by a broad range of financial products and services across the financial sector. For its assessment of potential risks, the FSOC noted "potential risks to financial stability may cover a broad range of asset classes, institutions, and activities,"[7] including:

• Markets for financial products and services (e.g., debt, loans, short-term funds, equity securities, etc.);
• Central counterparties and payment, clearing, and settlement activities;
• Banks, broker-dealers, asset managers, investment companies, insurance companies, and other financial firms;
• New or evolving financial products and practices; and
• Developments affecting the resiliency of the financial system, i.e., cybersecurity and climate-related financial risks.[8]

Assessing Potential Risks

In assessing the potential risks arising from the assets, activities and institutions noted above, the FSOC identified a number of potential vulnerabilities that most commonly contribute to the identified risks noted above. These vulnerabilities, which the FSOC will consider in its review of the potential risks, include:

• Leverage risk;
• Liquidity risk and maturity mismatch;
• Interconnections (either direct or indirect) with other parties;
• Operational risks (e.g., cybersecurity vulnerabilities);
• Complexity or opacity (e.g., scope of activities, jurisdiction, funding structures, etc.);
• Lax risk management (with capital and liquidity as metrics);
• Concentration risk; and
• Destabilizing activities (e.g., trading practices that create volatility or involve moral hazards or conflicts of interest).[9]

The final element of the FSOC proposal relates to the risk of transmission of potential risks to financial markets or market participants. With respect to risk of transmission, the FSOC noted it will review the impact of the following four channels:

• Exposures to "creditors, counterparties, investors, and other market participants can result in losses in the event of a default or decreases in asset valuations";
• Asset liquidation, especially if rapid or reliant on short-term funding;
• Critical functions or services "for which there are no ready substitutes that could provide the function or service at a similar price and quantity"; and
• Contagions, which include the perception of common vulnerabilities or exposures (e.g., highly similar or correlated business models or asset holdings) or which indicate "a loss of confidence in financial instruments treated as substitutes for money."

Addressing Potential Risks

The actions the FSOC may take to address a financial stability risk will depend on the nature of the vulnerability. If a vulnerability originates from activities widely conducted in a particular market or market sector over which a regulator has adequate authority, then an activity-based or industrywide response may be adequate to address the issue. However, if the issue involves financial activities of a small number of entities, where the impairment of one entity could threaten the stability of all the entities in the market or market sector, as well as the financial system, then an entity-based response may be the most effective route. The FSOC has the tools and flexibility to use them as it deems appropriate to address real or potential risk.

The proposal highlights several areas where the FSOC may take action to address potential systemic risks. First, the agency intends to promote greater interagency coordination and information sharing with relevant federal and state financial regulatory agencies. The FSOC is also empowered to issue non-binding recommendations under DFA § 120 to other regulatory agencies and/or Congress.[11] Finally, pursuant to DFA § 113 and the accompanying proposal on nonbank financial company designations (see below), the FSOC has the authority to designate a nonbank financial firm as systemically important for certain activities in the financial services sector. The FSOC may also delegate a financial market utility ("FMU") as systemically important, as well as designate payment, clearing, and settlement activities that are, or are likely to become, systemically important.

Revised Process for Nonbank SIFI Designations

The proposed update of the interpretive guidance on nonbank SIFI designations is intended to establish a durable process for determining the nonbank financial firms that will be subject to Federal Reserve supervision and enhanced prudential standards. A nonbank SIFI will be supervised by the Federal Reserve and be subject to prudential standards if the FSOC determines that: (1) material financial distress at the nonbank financial company could pose a threat to the financial stability of the United States; or (2) the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company could pose a threat to the financial stability of the United States.[12]

This (second) proposal focuses exclusively on the procedures the FSOC will apply in connection with the designation process, setting forth a two-stage framework:

• Under the first stage, a nonbank financial firm identified for designation review would be subject to a "preliminary review" of certain qualitative and quantitative information available through public and regulatory sources. At the beginning of this process, the firm will be notified of the FSOC's review and will be provided the opportunity to submit relevant information. The FSOC will also consult with the firm's primary financial regulatory agency in connection with the preliminary review.

• Under the second stage, a nonbank financial firm selected for "additional review" would be notified that they are being considered for designation, and will be requested to provide additional information in connection with the review process.[13]

Following the second stage of the process, the FSOC will be able to make either a proposed or final designation of the firm (or elect not to designate). If the FSOC makes a proposed designation, the firm may request a hearing to challenge the proposed designation. Once designated, a firm will be advised by the FSOC to work with the Federal Reserve to mitigate the identified risks and the FSOC will conduct an annual reevaluation of each designation to determine if such risks have been mediated.

Conclusion/Action Plan

The FSOC announced its intent to take a more active role in managing systemic risks and making regulatory determinations regarding firms in the financial services sector. The impact of the proposals appears to be limited to large nonbank financial firms, including certain FMUs and companies that engage in payments, clearing, and settlement activities. It would be prudent for a company possibly subject to designation to review the questions raised in the request for comment (see below) posed by the FSOC in the two proposals. Companies deemed FMUs as well as large payments companies should pay particular attention to the proposals. Comments are due on both proposals on June 27, 2023. We will continue to monitor updates in this space.

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Questions for Comment

FSOC Proposed Analytic Framework for Financial Stability Risk Identification, Assessment, and Response

1. Will the Proposed Analytic Framework enable the Council to achieve its statutory purposes and perform its statutory duties? Should the Proposed Analytic Framework address additional topics? Are there topics the Proposed Analytic Framework addresses but should not?

2. The Proposed Analytic Framework states that financial stability can be defined as the financial system being resilient to events or conditions that could impair its ability to support economic activity, such as by intermediating financial transactions, facilitating payments, allocating resources, and managing risks. Are there other definitions of  "financial stability" the Council should consider?

3. The Council's monitoring for potential risks to financial stability may cover an expansive range of asset classes, institutions, and activities, some of which are noted in the Proposed Analytic Framework. Are there asset classes, institutions, and activities not listed in the Proposed Analytic Framework the Council should monitor for potential risks to financial stability?

4. The Proposed Analytic Framework lists certain vulnerabilities that most commonly contribute to risk to financial stability: leverage; liquidity risk and maturity mismatch; interconnections; operational risks; complexity and opacity; inadequate risk management; concentration; and destabilizing activities. Are the Council's descriptions of these vulnerabilities appropriate? Should the Proposed Analytic Framework address additional vulnerabilities?

5. The Proposed Analytic Framework also provides sample metrics associated with the listed vulnerabilities. Are the proposed sample metrics appropriate for the purposes described in the Proposed Analytic Framework? Are there additional sample metrics that the Proposed Analytic Framework should incorporate?

6. The Council has identified four channels as most likely to facilitate the transmission of the negative effects of a risk to financial stability: exposures; asset liquidation; critical function or service; and contagion. Do the transmission channels listed in the Proposed Analytic Framework capture the most likely ways in which the negative effects of a risk to financial stability could be transmitted to other firms or markets? Should the Council consider additional transmission channels?

7. With respect to the vulnerabilities and transmission channels identified in the Proposed Analytic Framework, are there potential interactions between or among these vulnerabilities and transmission channels that the Proposed Analytic Framework should address?

Questions for Comment

FSOC Proposed Interpretive Guidance on Nonbank Financial Company Determinations

1. Does the proposal described above not to include in the interpretive guidance a description of the Council's substantive analytic approach to evaluating nonbank financial companies in the context of a designation under section 113 of the Dodd-Frank Act, in favor of a separate framework that describes the Council's analytic approach without regard to the origin of a particular risk or the authority the Council may use to mitigate such risk, allow the Council to achieve its statutory purposes? Should the Council's proposed approach be modified for other considerations?

2. Are there additional statutory terms beyond "company," "nonbank financial company supervised by the Board of Governors," and "material financial distress" for which the Council should set forth its interpretation in the Proposed Guidance?

3. Would the Council's elimination of the 2019 Interpretive Guidance's interpretation of "threat to the financial stability of the United States" as meaning "the threat of an impairment of financial intermediation or of financial market functioning that would be sufficient to inflict severe damage on the broader economy" enable it to achieve its statutory purposes? When the Council interprets the statutory phrase "threat to the financial stability of the United States," are there additional factors it should consider?

4. Would removal of the prioritization of the "activities-based approach" from the interpretive guidance enable the Council to achieve its statutory purposes? Should the Council's proposed approach be modified for other considerations?

5. Are there additional steps the Council should take to ensure all of its authorities for addressing potential risks to U.S. financial stability are equally available and appropriately exercised?

6. Would the proposed staff-level process for identifying nonbank financial companies for preliminary evaluation enable the Council to achieve its statutory purposes? Does the Proposed Guidance identify the appropriate procedures the Council should follow as it considers a company for potential designation? Are there other means of identifying companies for preliminary review the Council should consider, such as the application of specific metrics for different sectors of the nonbank financial system?

7. If the Council were to establish a set of uniform quantitative metrics to identify nonbank financial companies for further evaluation, as it did through the Stage 1 thresholds in the 2012 Interpretive Guidance, what metrics should the Council consider?

8. Does the Council's proposal described above to remove from the interpretive guidance provisions the discussion of the Council conducting a cost-benefit analysis and assessing the likelihood of a company's material financial distress allow the Council to achieve its statutory purposes? Should the Council's proposed approach be modified for other considerations?

9. Are there additional points the Council should consider regarding the usefulness, practicality, or feasibility of conducting a cost-benefit analysis regarding the designation of a company under section 113?

10. What data or factors should the Council consider in evaluating the potential risk to U.S. financial stability that could be posed by the failure of a company, should that company experience material financial distress?

11. If the Council were to identify a nonbank financial company as likely to experience material financial distress, what, if any, effects would such identification have when it became public knowledge?

*Michael Buckalew is a regulatory analyst with Davis Wright Tremaine LLP.