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March 13, 2019

FSOC and the Systemic Risk of Nonbank Companies

In a response to the difficulties it experienced in identifying nonbank systemically important entities, the Financial Stability Oversight Council (FSOC) has proposed[i] a new procedure for detecting and dealing with potential risks such entities may cause. Before subjecting any nonbank entities to the supervision of the Federal Reserve Board, FSOC proposes to evaluate the risks to the financial system that may be caused by activities conducted by everyone in the system and to deal ad hoc with any risks that are discovered. Only if the ad hoc remedies prove insufficient will FSOC attempt to identify specific entities for which supervision by the Federal Reserve Board and the imposition of more substantial regulation might successfully reduce the systemic risk they are thought to cause. A range of procedures will be followed before imposing such regulation, and more specific procedures for removal from heightened supervision will become a part of the revised focus on individual entities.

The activities being surveilled will be those thought to pose a risk to financial stability, defined as an impairment of “financial intermediation or financial market functioning to a degree that would be sufficient to inflict significant damage on the broader economy.”[ii] Later in the proposal, the level of threatened damage required is referred to as “severe.”[iii] This is in keeping with the way Dodd-Frank has been interpreted, but it should be noted that Dodd-Frank itself does not expressly link financial stability to the state of the underlying economy. The issue of whether the status of the financial system itself provides a sufficient basis for imposing additional regulation is left unresolved at this stage, although the second stage of analysis (the potential designation stage) does in fact consider impairment of financial intermediation or of financial market functioning as an issue in itself.

The kinds of activities deemed worthy of review are identified as lending, creating excessive leverage, short-term funding, guaranteeing financial performance and operating market utilities, and the markets and functions that are thought to be of interest include those for corporate and sovereign debt, equity, structured products, derivatives, short-term funding, payment, clearing, settlement, new products and practices (perhaps fintech) and “developments affecting the resiliency of financial market participants.”[iv] The emphasis on such activities is intended to remove the designation of systemically important nonbank companies to a level of analysis that is both later in time and based on the results obtained from the monitoring of marketplace activities in general. Interestingly, in Dodd-Frank itself[v] the activities of interest are those of “large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.”

Once risks have been tentatively identified, they will be evaluated in terms of their relationships to a number of categories, such as valuation or credit risk, leverage, maturity mismatch or liquidity risk, counterparty risk, interconnectedness, operational risk and volatility. In turn, these categories will be employed to tease out factors such as causation, adverse effects, the nature, severity and scope of impact and the possibility of damage to the non-financial sector.

Once potential risks have been identified from such an analysis of activities, FSOC proposes to “work with”[vi] state and federal regulators in an as yet undefined manner to address the risk. This is likely to involve persuading the non-voting members of FSOC that represent state insurance, banking and securities commissions to urge cooperation from their fellow commissioners and other members of state government, a step which raises interesting questions about the possible development of a new, hybrid, national level of regulation. If the results of working with regulators are inadequate, FSOC may issue nonbinding recommendations to primary financial regulatory agencies or report to Congress.

An activity-focused approach of the kind described in the Proposal and sketched above will depend in part for its effectiveness on the amount, nature and manipulability[vii] of the data to be collected. Although large amounts of data are available in various forms at each of the regulators, and although even anecdotal evidence is likely to be somewhat useful, it is unclear whether the right kinds and amounts of data currently exist even at the federal level in a form that would allow FSOC to perform the kind of analysis it describes in the Proposal. Availability at the state level is even more questionable (except, to some extent, for insurance companies) since the scope of prudential supervision is generally less extensive than at the federal level. Even if large amounts of data are available in currently standardized form it is unclear whether the data can be analytically manipulated in a way that in effect allows the dynamic modeling of the financial system, which is what the Proposal seems ultimately to require. Gathering the necessary data and constructing a useful model may require the use of software developed for such a purpose.

Only after taking steps of the kind described above would FSOC consider subjecting specific nonbank financial companies to additional supervision and regulation. The process of making such a determination utilizes the standards in Section 120(a) of Dodd-Frank, referred to above. The first standard considers the effect on the financial system of material financial distress at the nonbank financial company; the second standard refers to the general role of the company in the financial system. FSOC proposes to rely primarily on the first or distress standard because it believes that “threats to financial stability (such as asset fire sales or financial market disruptions) are most commonly propagated through a nonbank financial company when it is in distress.”[viii] Studying propagation certainly simplifies certain types of analysis by focusing on the assets and functions of the relevant company and on the way the market and the general public might react. An understanding of how the market is likely to react to the weakness or failure of a nonbank company is, however, certainly also important, and obtaining such an understanding will likely require a thorough application of the second standard. In particular, the details of asset composition and interconnectedness are derived from that standard. This may re-introduce some of the issues that hampered FSOC’s previous attempts to designate specific nonbank companies as systemically significant. Disputes about the importance and effects of the role of such designees in the financial markets characterized the debates about the usefulness of designating insurers or asset managers as systemically important.

The factors which FSOC proposes to consider when applying the distress standard are those listed in Dodd-Frank. These include:

  • transmission channels (exposures held both others, indirect contagion due to position in the financial network, the effects of asset liquidation as affected by the liquidity of the assets and liabilities of the company in question, the potential for fire sales, and whether or not the relevant company provides a critical function or service);
  • the complexity and resolvability of the company;
  • any existing regulatory scrutiny to which the company is subject;
  • the costs and benefits (in each case, to both the company and the economy) of designating the company as systemically important; and
  • the likelihood of material financial distress.

The determination process itself is proposed to be divided into stages. In Stage 1, FSOC and other regulators will identify a company for review and then hold preliminary discussions with the company and its regulators. If the initial identification seems justified after these discussions, FSOC will evaluate the company in greater depth based on qualitative and quantitative information (generally collected by the Office of Financial Research) provided by the company and its regulator(s) or by the company’s home country supervisor. If the initial identification remains justified by the analysis of the more extensive information provided, FSOC, by a vote of two-thirds of its voting members (which do not include the representatives of the state commissions), may determine that the company shall be designated as systemically important, after which the company may request a hearing. Another two-thirds vote is then required to make the determination final. Any final determination will be reviewed annually by a procedure that allows the affected company to contest the determination. In addition to allowing a company to exit the status of being systemically important, annual determinations have an interesting conceptual effect: They suggest that, for nonbank companies at least, being systemically important is a matter of somehow being weak, but fixable, as opposed to the treatment of large bank holding companies as systemically important per se. This aspect of the determination structure is not discussed in the Proposal.

The Proposal contains both the formal wording of the intended policy and explanations of the choices FSOC has made. In addition, it sets forth several sets of well-formulated questions to elicit helpful comment. Careful answers could be very useful in the development or modification of the approaches the Proposal sets forth.



[i] The proposal is entitled “Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies” (Proposal) and is available at

[ii] Proposal, p. 42.

[iii] Id., p. 46.

[iv] Id., p. 43.

[v] Section 112(a).

[vi] Proposal, p. 44.

[vii] In the technical sense of being able to aggregate, perform calculations with and otherwise mathematically or statistically analyze.

[viii] Id., p. 46.