Since the 2023 spring bank failures, the federal banking agencies have tinkered with significant bank regulations and guidance—ranging from capital, bail-in measures, and resolution planning to climate-risk stress testing, community investments, and corporate governance. These changes would generally undo tailoring, as it was formerly known, so that banks with more than $100 billion in total assets would be subject to similar heightened requirements or expectations.
Having focused on bank risks to the U.S. financial system, the federal agencies that make up the Financial Stability Oversight Council (FSOC) are now focusing on risks that non-banks could pose to financial stability. New final interpretive guidance updates the FSOC's procedures to designate a non-bank financial company (company) for Federal Reserve supervision and prudential standards and unwinds 2019 provisions that were more favorable for these entities.
The FSOC's latest moves come alongside a separate CFPB proposal to extend bank-like consumer protection requirements and prohibitions to certain tech companies and fintechs (coverage forthcoming). This alert summarizes the process and factors envisioned in the FSOC guidance and what they mean for non-bank participants in the financial services industry.
- What designation means. When the FSOC designates a company for Federal Reserve supervision and prudential standards, the company will be subject to a more invasive relationship with the federal government (supervision) and a more onerous set of requirements and restrictions (regulations) than it was previously. These could include bank-like capital and liquidity requirements, stress testing, and restructuring through intermediate holding companies, among other measures. Any other company that acquires (directly or indirectly) a majority of the assets or liabilities of a company that has been so designated would similarly be subject to Federal Reserve supervision. Designation is possible for U.S. and non-U.S. entities.
- Threats must not be immaterial. While threats must not merely be immaterial impairments of the financial system, any event or condition that could impair the ability of the U.S. financial system to support economic activity is fair game. In addition to financial innovation and complexity, operational risks may become more important as cyber and critical infrastructure threats grow. Particular financial sectors or types of companies are not categorically excluded.
- The FSOC is an interagency body with broad powers. The FSOC includes as voting members the U.S. Treasury Secretary (FSOC chair); the Federal Reserve Board chairman; the Comptroller of the Currency; the CFPB director; the chairs of the FDIC, SEC, CFTC, and NCUA; the FHFA director; and an independent insurance expert. Other, nonvoting members serve in an advisory capacity.
- The involvement of the current CFPB director as a voting member is notable. Director Chopra previously served as an FTC commissioner. He recently proposed regulations for the tech industry and warned of the "dangers of allowing very large non-banks to issue private money outside of the banking system and to wield inordinate control over payments rails."
- Issues on the FSOC's mind. Since 2020, the FSOC has issued reports or statements about the secondary mortgage market activities, money market mutual funds, climate-related financial risk, non-bank financial intermediation, and digital assets.
- Activities-based vs. entity-based approaches. Under the previous 2019 guidance, the FSOC was seen as focused more on activities rather than specific entities. But under the new guidance, the FSOC may designate either specific entities or general activities. For instance, the FOSC has taken an activities-based approach in recommending actions to address risk relating to crypto-assets and climate-related financial risks, among others. It has previously used an entity-based approach to designate eight financial market utilities and four companies.
- No cost-benefit considerations. The FSOC took pains in the preamble to unwind previous guidance that would have it conduct cost-benefit analysis before exercising its designation power. This issue may be raised in future litigation, however.
- No consideration of the likelihood of material financial distress. The 2019 guidance provided that the FSOC would assess a company's likelihood of material financial distress. The FSOC today finds such an exercise to be a "futility" and will essentially presuppose the company's material financial distress.
- Separate payment, clearing, and settlement activity designation authority. The FSOC has additional authority under the Dodd-Frank Act to designate certain payment, clearing, and settlement activities. These activities may include calculating and communicating unsettled financial transactions between counterparties, netting transactions, providing and maintaining trade, contract or instrument information, the management of risks and activities associated with continuing financial transactions, transmittal and storage of payment instructions, and other, similar functions as determined by the FSOC. This statutory authority is in addition to the general non-bank designation process described in this alert.
What the FSOC Looks For
The FSOC also released an analytic framework that supplements the guidance to explain how the FSOC monitors, assesses, and responds to potential risks to financial stability, whether from widely conducted activities or from individual firms. It notes a range of asset classes, institutions, and activities, including:
- Markets for debt, loans, short-term funding, equity securities, commodities, digital assets, derivatives, and other institutional and consumer financial products and services
- Central counterparties and payment, clearing, and settlement activities
- Financial entities, including banking organizations, broker-dealers, asset managers, investment companies, private funds, insurance companies, mortgage originators and servicers, and specialty finance companies
- New or evolving financial products and practices
- Developments affecting the financial system's resiliency (e.g., cybersecurity, climate)
The FSOC further explains that it has identified certain vulnerabilities that commonly contribute to potential risks to financial stability:
- Liquidity and maturity mismatch
- Operational risks
- Complexity or opacity
- Inadequate risk management
- Destabilizing activities
The FSOC has also identified various channels, among others, through which the adverse effects of potential risks to financial stability could be transmitted to financial markets or market participants:
- Asset liquidation
- Critical function or services
Overview of the Designation Process
The designation largely follows a two-stage process whereby the FSOC evaluates in increasing detail the target entity/activity, with opportunities for the target to provide information for the FSOC's consideration, as well as mandatory information requests as the process continues.
Stage 1—Preliminary Evaluation: Identification for review and engagement with the company. A company identified for review is subject to a preliminary analysis, based on quantitative and qualitative information available to the FSOC, primarily through public and regulatory sources. The FSOC will notify the company at least 60 days before the FSOC votes on whether to evaluate the company further in the second stage of review, to provide the company with an opportunity to voluntarily submit relevant information to the FSOC and to meet with staff who are leading the FSOC's analysis.
Stage 2—In-Depth Evaluation: Engagement with the company and regulators. A company that is selected for additional review will receive notice that the company will be subject to in-depth evaluation during the second stage of review. This stage involves significant engagement with the company under review and its primary financial regulator (if any). The FSOC will submit to the company a request for information, and the company will be provided an opportunity to submit relevant information and meet with FSOC staff.
Proposed and Final Determination
At the end of Stage 2, the FSOC may consider whether to make a proposed designation for the company. A proposed designation requires a vote of two-thirds of the FSOC and its chairperson.
If the FSOC makes a proposed designation, the FSOC will provide the company with a written explanation of the basis of the proposed determination, and the company may request a written or oral hearing. After any requested hearing, the FSOC may vote to make a final designation, which again requires a two-thirds vote, including its chairperson. The FSOC will publicly release the written explanation of the basis for any final designation.
Annual reevaluations of designations. Designated companies (and their regulators) are encouraged to take steps to mitigate the identified risks. The FSOC will reevaluate any designation at least annually and rescind it if the company no longer meets the statutory standards for a designation. During these reevaluations, the company will have an opportunity to meet with FSOC representatives to discuss the review and submit information. FSOC representatives will provide feedback on the extent to which any company proposals to mitigate identified risks may address those risks. If the FSOC votes not to rescind a designation, the FSOC will provide the company with a written explanation. Every five years, a company with a designation will have the opportunity for an oral hearing.
The process for designation should be taken seriously, with appropriate engagement at each stage. The consequences of designation will be a major change for companies that are not used to the level of regulatory and supervisory scrutiny that banks and their affiliates navigate.
Companies that are particularly complex or critical to the financial system, or engage in activities that might be deemed as such, and that could pose a threat to U.S. financial stability, should review the FSOC guidance, analytic framework, and recent reports and studies and consider how to manage the various risks the FSOC highlights.