Dodd-Frank oversight council wants to make it harder to designate nonbanks

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WASHINGTON — The Financial Stability Oversight Council published a proposal Wednesday to broadly revise its process for designating nonbanks as systemically important financial institutions, while formally emphasizing a preference for activities-based regulation of nonbanks.

The council issued proposed interpretive guidance meant to replace its existing interpretive guidance regarding nonbank financial company designations. Treasury Secretary Steven Mnuchin, who serves as chairman of the council, said the changes would help regulators identify and address real and potential risks to the financial system.

“Today’s proposal would make significant improvements to how the Council identifies, assesses, and responds to potential risks to U.S. financial stability,” Mnuchin said in a statement. “The result of significant collaboration among Council members, these changes will help ensure that the Council accomplishes its mission efficiently and effectively.”

Nonbanks designated as SIFIs would be subject to heightened regulatory standards and supervised by the Fed.

Under the FSOC's current guidance, nonbanks that are under consideration for designation go through a three-stage evaluation process. In Stage 1, FSOC staff consider the potential risks of a firm internally, without notifying the firm that it is under evaluation; in Stage 2, firms are notified of their evaluation and are asked for documentation and invited to respond to council concerns; Stage 3 culminates in formal designation. The proposal would eliminate Stage 1, effectively beginning the designation process with firm notification and evaluation.

The proposal would also require the FSOC to include a cost-benefit analysis as part of its designation and would permit the council to designate a firm “only if the expected benefits justify the expected costs of the designation,” according to an FSOC release. The new guidance would also require the council to conduct an analysis demonstrating a firm’s actual potential for insolvency and the effect of that insolvency on the broader financial system.

Yet perhaps the most significant change in the new proposed guidance is a formal emphasis on activities-based regulation of nonbanks — that is, identifying and regulating activities that pose a risk to the financial system regardless of the institutions engaging in them. The proposal would allow the FSOC to designate an individual firm as a SIFI only after it has determined that it cannot address a systemic risk through an activities-based approach.

“This approach will enable the Council to more effectively identify and address the underlying sources of risks to financial stability, rather than addressing risks only at a particular nonbank financial company that may be designated,” the FSOC proposal said.

Regulators have had a long and tumultuous relationship with nonbank SIFI designations. In the aftermath of the financial crisis, lawmakers were eager to address what were widely seen as regulatory blind spots regarding nonbanks, notably illustrated by the billions of federal dollars spent to shore up insurance giant American International Group during the height of the crash. That led to the FSOC's creation under the Dodd-Frank Act and the council's power to designate systemically risky nonbank firms.

AIG, GE Capital and insurer Prudential were each designated as SIFIs in 2013, and insurance firm MetLife was designated in December 2014. But the tide turned when MetLife fought its designation in court and won in 2016. GE Capital restructured itself and was dedesignated by the FSOC that same year. Regulators then dedesignated AIG in 2017 and Prudential last October.

Across the industry, the debate over the best way to supervise risk in the nonbank financial sector has raged for some time. Industry officials have long touted the benefits of an activities-based approach over individual designations, while many consumer advocates say both forms of oversight are necessary.

Government officials have also raised questions about the merits of the two approaches. For instance, former Fed Gov. Daniel Tarullo opined in a speech in 2015 that an activities-based approach to systemic risk posed by nonbank asset management firms would be a more natural fit than designating every firm in the industry individually.

“If there are [risks], it's almost surely the case that response should be something that addresses directly ... the nature of those risks, which is likely to be a marketwide phenomenon,” Tarullo said at the time.

The FSOC also issued a separate direct final rule mandating that any changes to its interpretive guidance on nonbank designations be published for public comment. The council will take comment on the proposed guidance published Wednesday for 60 days following publication in the Federal Register.

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