Regulators Move Closer to Deciding Who's 'Too Big to Fail'

Regulators are moving closer to putting the “Systemically Important Financial Institutions” label on several large non-bank financial institutions, subjecting them to increased capital requirements and a host of other heightened regulations.

Earlier this month the Financial Stability Oversight Council published a final rule that set out the criteria and the process it will use to determine which firms will be considered SIFIs, known to some as “too big to fail.” The rule implements a provision in the Dodd-Frank Act, which created the FSOC to identify and respond to risks in the U.S. financial system, as well as to promote market discipline.

The rule puts in place several thresholds and potential red flags that could be used to open non-bank financial firms, such as insurers and hedge funds, to the increased regulatory scrutiny. Among the criteria are firms with total consolidated assets of $50 billion or more, $3.5 billion or more of derivative liabilities, and more than $20 billion in total debt.

“This interpretive guidance is an important tool provided in Dodd-Frank for extending the perimeter 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 a potentially important source of risk,” said Treasury Secretary Tim Geithner at the FSOC's April 3 meeting where the final rule was approved.

Large insurers, hedge funds, asset management firms, and other financial firms designated as SIFIs would be subject to supervision by the Federal Reserve and must maintain higher capital reserves, adopt a “living will” that describes a detailed recovery and resolution plan in the event of failure, and several other regulatory requirements that the Federal Reserve has already put in place for large banks.

Boards and managements of SIFIs will have greater responsibility for meeting higher standards of risk management and compliance. “The bar has certainly gone up,” says Jitendra Sharma, head of global financial risk management for KPMG.

Financial firms designated as SIFIs also will have to come to grips with the new reality of having federal regulators potentially taking up residence inside their firms. “It's pretty intrusive,” says Ernie Patrikis, a partner in the bank and insurance regulatory practice of law firm White & Case. For companies that have never been subject to prudential supervision, they are in for a “rude awakening,” he says.

The final rule, which generally follows the same structure as the proposed rule issued in October, establishes a three-step process for determining whether a non-bank will be designated as a SIFI. In the first stage, the FSOC will assess financial institutions with total consolidated assets of $50 billion or more, as mandated by Dodd-Frank. The FSOC estimates that fewer than 50 non-bank financial companies meet that threshold.

“Despite promises of transparency, regulators have not responded to requests for a more open process, including our requests for a public hearing to consider the process, legal, and economic questions that have yet to be answered.”

—David Hirschmann,

President,

CCMC

Companies will then undergo further scrutiny if they additionally satisfy at least one of the following criteria:

$30 billion or more in gross notional credit default swaps outstanding;

$3.5 billion of derivative liabilities;

$20 billion or more in total debt;

A 15-to-1 or greater leverage ratio; or

At least a 10 percent ratio of short-term debt to assets.

American International Group, MetLife, and Prudential Financial are just a few of the companies that are expected to meet that threshold. Those and other companies singled out by those measures would then be subject to more robust analysis, using public data and information gathered by regulators to obtain a clearer picture of their systemic relevance and risk. The data that would be assessed includes the company's size; interconnectedness; substitutability; leverage; liquidity risk; and existing regulatory scrutiny.

One controversial provision in the final rule, however, allows the FSOC to designate any company as a SIFI, irrespective of whether it meets the stated criteria. The FSOC also rejected industry requests that notification be provided to companies when they fall into stage two.

“They'll be doing all this work in secret without getting any information from the company,” says Patrikis. The FSOC reasoned, however, that stage three provides “sufficient opportunity for non-bank financial companies to participate in the determination process.”

In the third and final stage, the FSOC said it would send written notices to those companies that are potential candidates for SIFI designations. The final rule rejected requests for greater transparency in the reasoning behind a SIFI determination.

“It would be premature to explain the basis of the non-bank financial company's identification for further consideration, because the decision to review a non-bank financial company in stage three does not represent a formal determination,” the final rule stated.

In the third stage, however, companies may request a hearing to refute the determination, which would trigger a second vote by the FSOC. The final rule makes clear that any hearings to contest designations will not be open to the public.

ABOUT THE FSOC

The Financial Stability Oversight Council was established under the Dodd-Frank Act. The Council is charged with identifying threats to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the United States financial system.

The collaborative body is chaired by the Treasury Secretary and brings together the expertise of federal financial regulators, state regulators, and an insurance expert appointed by the President.

The FSOC consists of 10 voting members—nine federal financial regulatory agencies and an independent member with insurance expertise—and five non-voting members. Voting members include:

Treasury Secretary;

Chairman of the Federal Reserve System's Board of Governors;

Comptroller of the Currency;

Director of the Consumer Financial Protection Bureau;

Chairman of the Securities and Exchange Commission;

Chairperson of the Federal Deposit Insurance Corporation;

Chairperson of the Commodity Futures Trading Commission;

Director of the Federal Housing Finance Agency;

Chairman of the National Credit Union Administration Board; and

An independent member with insurance expertise that is appointed by the President and confirmed by the Senate for a six-year term.

Non-voting members include the director of the OFR; director of the Federal Insurance Office; a state insurance commissioner selected by the state insurance commissioners; a state banking supervisor chosen by the state banking supervisors; and a state securities commissioner designated by the state securities supervisors. The state non-voting members have two-year terms.

The FSOC will report to Congress annually and as appropriate on particular topics, in which the chairperson will testify on the FSOC's activities and emerging threats to financial stability.

—Jaclyn Jaeger

The challenge for a company that wants to refute a SIFI determination will be to prove that the firm will not have a significant effect on the financial market in the event that it fails, says Patrikis. It may be worth explaining to federal regulators, for example, the company's operational transparency and the extent and nature of its existing regulatory scrutiny, he says.

Two technical changes were included in the final rule that were not in the proposed rule. In cases where the parent company of a firm deemed to be systemically important is not primarily a financial services company, the FSOC will designate just the subsidiary a SIFI. And foreign financial firms will be evaluated based on their U.S. assets, rather than their global assets.

Data Demand

It's clear why some firms will want to contest the designation. Firms that are labeled SIFIs are going to have far more extensive reporting requirements than non-SIFI firms, says Sharma. “Those institutions have to develop much more seamless, more sustainable robust infrastructure for complying with these reporting requirements,” he says.

A white paper published by Deloitte further described just how onerous this process can be: “Systems will likely need the capacity to manage meta-data, records, and reference data. Scalable infrastructure will have to be built to run reliable and repeatable processes, including modeling and stress testing tools, data-aggregation engines, reporting tools, and collaborative technologies.”

SIFIs will also need to increase the resources they devote to compliance systems. “Companies may have to hire more staff to do analytical work,” says Patrikis.

Business advocacy groups had fought for a more quantifiable process to designate SIFIs, fearing that a subjective standard would create confusion and sweep more companies into its nets. The U.S. Chamber of Commerce's Center for Capital Markets Competitiveness said it was disappointed that many of the FSOC's decisions were made behind closed doors. “Despite promises of transparency, regulators have not responded to requests for a more open process, including our requests for a public hearing to consider the process, legal, and economic questions that have yet to be answered,” said David Hirschmann, president of the CCMC.

“This rule may force companies to start changing their business model or cease offering certain products and services,” said Hirschmann.

Stephen Zielezienski, senior vice president and general counsel for the American Insurance Association, argued in a comment letter that the rule was overly broad. "AIA maintains the position that property-casualty insurers engaged in regulated insurance activities do not pose a threat to financial stability and therefore should be screened out of the SIFI designation process.”

“As we have stressed all along, AIA believes that if members of the FSOC correctly incorporate and apply risk-related factors in the final rule, they will conclude that property-casualty insurers are not the types of companies that should be subjected to heightened prudential supervision,” Zielezienski wrote.

Bob DeFillippo, chief communications officer for Prudential Financial, expresses a similar worry. “Our chief concern has always been that insurance companies—like Prudential—are not treated the same as banks,” he says.

Still, some companies say they are bracing for the changes ahead. “We are reviewing the FSOC's guidance, but we are prepared for whatever designation they may determine for us,” says Russell Wilkerson, managing director of communications for GE Capital.

With the rules now final, attention turns to which companies will actually face additional oversight, which Geithner has said should happen by the end of this year.