WASHINGTON — In 2012, the Federal Reserve issued a proposal designed to force changes at banks and systemically important nonbanks that showed early signs of financial distress.

Since then, the proposal — required by the Dodd-Frank Act and hailed by many as an important backstop to ensure regulators keep a close watch on bank holding companies — appears to have vanished. The Fed has made little to no mention of it, and it's not clear when or even if the central bank plans to finalize it.

Its absence presents a problem, according to observers.

“Their failure to finalize their guidance is just breathtaking,” said Dennis Kelleher, president of the public advocacy group Better Markets. “It’s just head-scratching the way the leading bank regulator hasn’t finalized one of its most important protections for taxpayers.”

Section 166 of the Dodd-Frank Act

At issue is Section 166 of Dodd-Frank, a measure that was designed to force regulators to take actions early when it saw a bank holding company was getting into trouble. The idea has its roots in the savings and loan crisis of the late 1980s, when regulators were widely criticized for allowing problems at financial institutions to fester rather than fixing them early.

In response, Congress passed the Federal Deposit Insurance Corp. Improvement Act in 1991, which included provisions requiring FDIC and other bank regulators to take “prompt corrective action” against flagging banks in order to reduce the potential of a more dramatic failure — and drain on the FDIC's resolution fund — later on.

When Congress drafted Dodd-Frank, Section 166 was intended to apply that same principle to bank holding companies and nonbanks designated as systemically important financial institutions by the Financial Stability Oversight Council.

There are important differences between the early remediation rules outlined in Section 166 and the prompt corrective action requirements in the FDIC Improvement Act. For one, the act's language is expansive and specific, while Section 166 is much more abstract, leaving more to the Fed to decide.

Karen Shaw Petrou, managing partner at Federal Financial Analytics, said all of the macroprudential rules that the Fed enacted over the past seven years, including new capital and liquidity requirements under Section 165 of Dodd-Frank, rely on the assumption that the Fed would be dutifully watching for signs of distress and act accordingly. Without Section 166 rules, she said, those assumptions are misplaced.

“The sooner regulators intervene as a bank starts to fall apart, the less costly the bank failure and the less probable its broader systemic risk,” Petrou said. “If you put in place all of the stuff in 165, and the agencies issued all the rules but did nothing about it, then what was the point? Section 166 was supposed to be the point.”

But Michael Krimminger, partner with Cleary Gottlieb and a former top official at the FDIC, said the extent to which either prompt corrective action or early remediation binds regulators' hands is often overstated. Regulators do tend, however, to avoid issuing regulations that limit their discretion, and with good reason; crises by their nature are different every time. That reluctance may have contributed to the seeming disappearance of the 166 rules, he said.

“If I were the Fed, I would have concern about trying to be too specific,” Krimminger said. “The statute includes the direction to establish a ‘series of specific remedial actions,’ but that can create difficulties if specificity undercuts the flexibility you need, because different crises and different challenges that banks have can take different forms. You want to have flexibility there.”

One banking industry official, who declined to be named speculating on the reasoning behind the Fed’s actions as they relate to Section 166, said a more likely explanation is that the Fed effectively baked the section into almost all of its 165 rules.

The Liquidity Coverage Ratio, for example, has a provision whereby if a bank holding company's liquid assets fall below 100% of the agency’s monthly operating costs for three consecutive days, it must submit a plan for remediating that shortfall to its regulator. The Capital Conservation Buffer rule, which was completed in 2013, similarly has a prescriptive link between how far below the capital buffer a bank holding company is and how much of a dividend it may pay to shareholders. That’s precisely the kind of provision Section 166 seems to have been designed to elicit, the source said.

“It’s hard to find anything in [166] that’s not already covered by stuff that’s out there,” the source said.

The source added that the Fed’s stress testing program actually takes the idea of remedial action a step further, not only proscribing what actions might have to be taken in the event of material stress at a firm but preemptively stopping such stress from ever arriving by holding the firms accountable for hypothetical capital shortfalls.

While the section remains on the books, the source said, the Fed is unlikely to face any consequences for not enacting regulations explicitly based on it because no such consequences are spelled out in the law itself.

“When Congress wants an agency to do something … there are consequences if they don’t. There are no consequences here if they don’t,” the source said. “Frankly, my own recommendation would be, if Congress is looking for something in Dodd-Frank that seems to have not been necessary, this section would be on that list for review.”

The House-passed Financial Choice Act — House Financial Services Committee Chair Jeb Hensarling’s signature Dodd-Frank modification bill — makes no mention of Section 166, and Senate Banking Committee Chair Mike Crapo, R-Idaho, has also not mentioned the section as one marked for revision or repeal. Spokespersons for both committees did not respond to requests for comment.

The Fed could theoretically issue a rule indicating that the requirements of Section 166 have already been met by way of the agency’s various Section 165 rules, though there is no indication that the Fed is pursuing such a path. A spokesman for the Federal Reserve declined to comment.

Krimminger said the nature of funding at the bank holding company level also suggests a reason why the Section 166 rules are a little different from prompt corrective action. In the S&L crisis, banks continued to accept funding — that is, take deposits — even though they were effectively insolvent, thus putting average depositors at risk. Bank holding companies are getting their funding from the market, he said, and if the market gets spooked, the kind of incremental remedial action contemplated by Section 166 won’t change its mind.

“If you’ve got a holding company that’s insolvent and the government hasn’t bailed it out in some fashion, the market eventually is going to cut off wholesale funding for key subsidiaries,” Krimminger said. “While the companies are much more resilient now … that’s going to be the real triggering factor, when the market decides it’s not going to fund it anymore. The market can be slow to catch on, but when they do, they bite back really hard.”

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