WASHINGTON — More than a year and a half after Congress enacted the Dodd-Frank Act, regulators finalized a critical rule Tuesday detailing how they will identify nonbank financial firms that pose a threat to the system.
Members of the Financial Stability Oversight Council, an interagency group headed by Treasury Secretary Tim Geithner, approved the rule after a brief public debate.
Geithner described the regulation, which will subject systemically-important nonbanks to supervision by the Federal Reserve Board, as an "important tool" in protecting the economy.
"This rule, this designation, this interpretive guidance is an important tool provided in Dodd-Frank for extending the parameter of transparency oversight and prudential supervision over parts of the financial system that can be a particularly important source of credit to the economy and potentially important source of risk in crisis," Geithner said at the meeting.
Regulators learned a hard lesson during the financial crisis as certain nonbank institutions, which were left unsupervised and faced few regulations, fell into distress, causing financial markets to seize up and creating a negative spillover to other institutions.
"These nonbank financial companies were not subject to the type of regulation and consolidated supervision applied to bank holding companies, nor were there effective mechanisms in place to resolve the largest and most interconnected of these nonbank financial companies without causing further instability," the rule says.
The final rule outlines a three-stage process in designating nonbank firms, which could include insurance companies, hedge funds and private-equity firms as systemically important financial institutions. It closely resembles the last draft released by regulators in October, according to Lance Auer, a Treasury official who presented the rule to regulators at the meeting.
The council will use several criteria to make its initial identification during stage one. All nonbank firms must have at least $50 billion of global total consolidated assets to be potentially considered systemically risky.
A firm must pass that test, as well as meet at least one of the following thresholds: $20 billion in total debt outstanding, a minimum leverage ratio of 15 to 1, or $30 billion in gross notional credit default swap outstanding to trigger a closer look by regulators.
Regulators can also weigh a number of other considerations, including whether it believes the company could pose a threat to financial stability.
"The council believes that Stage 1 thresholds will help a nonbank financial company predict whether such company will be subject to additional review by the council," the rule states.
To be sure, the council said that meeting some or all of the criteria would not necessarily mean a company would be identified as a SIFI. Moreover, it said it added specific thresholds to bring more transparency to the designation process.
After the initial evaluation, the council will begin to consider each individual company's risk profile and characteristics based on a wide-range of company specific information.
If it moves on to the final stage, a firm would receive a notice from the council for additional information like internal risk management procedures, resolvability, or potential acquisitions that could pose risk to the financial stability of the U.S. Following that analysis, the council would vote on the company's designation, which would require a two-thirds majority and approval from the chairman of the council.
Regulators cautioned that it would be make determinations on a case-by-case basis.
"The Council does not believe that a determination can be reduced to a formula," the rule said.
Rather, each identification process will be made based on "a company-specific evaluation" and will take into account qualitative and quantitative information the council feels is important for each company.
Few clues were provided by regulators on which firms exactly would be targeted by the new process. But Geithner reiterated the council's plans to make the first of these designations this year.
Once designated by the Council, these firms will face a tougher set of supervisory standards and will be required to prepare and file a plan with regulators to safely unwind the company if it's on the brink of failure. Still, it's unclear exactly what additional capital and liquidity requirements those nonbank firms identified as SIFIs will now face under the Fed's supervision.
Last December, the central bank released a batch of rules under Dodd-Frank that would provide stricter capital and liquidity requirements for large banking companies. Those rules, with some conditions, will apply to nonbank companies, as well.