Fed Needs to Rethink Proposed Nonbank Rules

In Title I of the Dodd-Frank Act, Congress gave the Federal Reserve Board the task of implementing prudential standards for designated nonbank systemically important financial institutions. For an agency expert in banking, regulating financial firms as diverse as insurers or hedge funds presents entirely new tasks. The difficulty of this role is apparent in the pending Dodd-Frank section 165 rulemakings. The Fed has proposed detailed requirements for systemic bank holding companies, but nothing similar for NSIFIs.  Instead, it simply proposes that domestic and foreign NSIFIs would be subject to "tailored" versions of these bank-centric rules.

In proceeding this way, the Fed has missed an opportunity for a win-win result and left nonbanking firms, particularly insurance organizations, in the dark. These NSIFI proposals also provide many grounds under the Administrative Procedure Act for a reviewing court to overturn any final NSIFI rule and return the Fed to the drawing board. The legally necessary and practical path for the Fed now is to issue re-proposed NSIFI rules.

Section 165 provides the right approach, but the proposals do not follow it. Section 165(a)(1)(A) calls for the Fed to establish  prudential standards for NSIFIs and  bank SIFIs  that­ are "more stringent than the standards and requirements applicable to nonbank financial companies and bank holding companies that do not present similar risks to the financial stability of the United States."

Because no existing regulatory standards apply to both nonbanking and banking firms, this provision necessarily calls for  apples-to-apples regulation — enhanced standards for banking organizations based on existing banking regulation, and enhanced standards for, as an example, insurance organizations, based on existing insurance regulation. As representatives and senators have recently underscored, Congress does not intend insurance organizations to be regulated like banking organizations.

Other provisions flesh out this approach. Section 165(b)(3) states: "In prescribing prudential standards . . . the [Fed] shall—(A) take into account differences among" NSIFIs and bank SIFIs. Section 165(b)(3)(D) provides that the Fed shall "adapt the required standards as appropriate in light of any predominant line of business" of a NSIFI.  

Instead of implementing this framework, the NSIFI proposals cite only section 165(a)(2) "tailoring",  under which the Fed "may . . . differentiate among companies on an individual basis or by category, taking into consideration their capital structure, riskiness, complexity, financial activities (including the financial activities of their subsidiaries), size and any other risk-related factors" as the Fed deems appropriate.  Under this provision, the Fed would impose adapted bank SIFI rules on NSIFIs.  However, under section 165(a)&(b), tailoring is meant to be used to adapt existing nonbank standards for NSIFIs,  based on  their  predominant lines of business.

Under Dodd-Frank, the Fed may well become an insurance regulator, but should not develop the substance of such regulation alone. It could work with the National Association of Insurance Commissioners, insurance regulators and the new Federal Insurance Office to determine the extent to which existing insurance risk-based regulation could satisfy Dodd-Frank requirements and to develop any needed new or modified requirements. For example, existing insurance risk-based capital requirements may already provide for enhanced requirements for the most risky insurers.

While insurance holding companies currently may not be subject to regulatory capital standards, they are increasingly subject to insurance regulatory scrutiny, including for enterprise risk.  For a company whose subsidiaries are predominantly insurers, a regime based on existing insurance standards will be more effective than a bank-centric one. Under a win-win approach, the Fed would adopt and enforce insurance NSIFI regulation developed by or with insurance regulators, and these requirements should be both familiar and more acceptable to insurance NSIFIs.