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

    View Authors 20 August 2010

    FIVE KEY QUESTIONS That Congress Left to the New Financial Stability Oversight Council

    • 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:

    • the extent of the leverage of the company;
    • the extent and nature of the off-balance sheet exposures of the company;
    • the extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
    • 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;
    • the importance of the company as a source of credit for low-income, minority or underprivileged communities;
    • the extent to which assets are managed rather than owned by the company;
    • the nature, scope, size, scale, concentration, interconnectedness and mix of activities of the company;
    • the degree to which the company is already regulated by one or more primarily financial regulatory agencies;
    • the amount and nature of the financial assets of the company;
    • the amount and types of liabilities of the company, including degree of reliance on short term funding; and
    • 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.