Alert October 12, 2010

Financial Stability Oversight Council Seeks Comment on the Volcker Rule and Issues Notice of Proposed Rulemaking Regarding Criteria for Designation as Systematically Significant Nonbank Financial Companies

The Financial Stability Oversight Council (the "FSOC") established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Act") to identify threats to the financial stability of the U.S., promote market discipline by elminating expectations on the part of shareholders, creditors, and counterparties that the government will shield them from losses in the event of failure, and respond to emerging risks to the stability of the U.S. financial system held its first meeting on October 1, 2010.  Following the meeting, the FSOC issued (1) a request for information (the “Volcker ROI”) regarding matters related to the implementation of Section 619 of the Act, which is commonly referred to as the “Volcker Rule” (the “Volcker Rule”), and (2) a notice of proposed rule making (the “ANPR”) regarding the criteria the FSOC will consider in designating certain non-bank financial companies for heightened supervision.  Each of the Volcker ROI and the ANPR are described below.

Request for Information Regarding the Volcker Rule

The Volcker Rule amended the Bank Holding Company Act to add a new Section 13 that bars banking organizations from engaging in proprietary trading and sponsoring and investing in hedge funds and private equity funds, except as permitted under certain limited exceptions.  The Act requires that the FSOC conduct a study (the “FSOC Study”) and make recommendations on implementing the Volcker Rule provisions to achieve specified goals, such as protecting the safety and soundness of banking entities, protecting taxpayers and consumers, and enhancing financial stability.  Under the Volcker Rule, each of the OCC, FDIC, FRB, SEC and the Commodity Futures Trading Commission, must consider the findings of the FSOC Study in developing and adopting regulations to implement the Volcker Rule.  For a more detailed discussion of the Volcker Rule, please refer to the July 28, 2010 Special Edition of the Alert.

The FSOC Study is due to be completed by January 22, 2011.  In connection with the conduct of the FSOC Study, the FSOC has requested comments on each of the following:

  1. How the Volcker Rule can best serve to: (i) promote and enhance the safety and soundness of banking entities; (ii) protect taxpayers and consumers and enhance financial stability by minimizing the risk that insured depository institutions (and their affiliates) will engage in unsafe and unsound activities; (iii) limit the inappropriate transfer of federal subsidies from institutions that benefit from deposit insurance and liquidity facilities of the federal government to unregulated entities; (iv) reduce conflicts of interest between the self-interest of banking entities and nonbank financial companies supervised by the FRB (“Nonbank Financial Companies”), and the interests of the customers of such entities and companies; (v) limit activities that have caused, or might reasonably be expected to cause, undue risk or loss in banking entities and Nonbank Financial Companies; (vi) appropriately accommodate the business of insurance within an insurance company, subject to regulation in accordance with the relevant insurance company investment laws, while protecting the safety and soundness of any banking entity with which such insurance company is affiliated and of the U. S. financial system; and (vii) appropriately time the divestiture of illiquid assets that are affected by the implementation of the Volcker Rule.
  2. What key factors and considerations should be taken into account in making recommendations on implementing the proprietary trading provisions of the Volcker Rule?
  3. What key factors and considerations should be taken into account in making recommendations on implementing the provisions of the Volcker Rule that restrict the ability of banking entities to invest in, sponsor or have certain other covered relationships with private equity and hedge funds?
  4. What factors and considerations should inform recommendations on the definition of certain key terms, including, “banking entity,” “hedge fund,” “private equity fund,” “such similar fund,” and “proprietary trading”?
  5. What factors and considerations should be taken into account as indicative that a transaction, class of transactions or activity: (i) would involve or result in a material conflict of interest between a banking entity (or a Nonbank Financial Company) and its clients, customers or counterparties; (ii) would result, directly or indirectly, in a material exposure by a banking entity (or a Nonbank Financial Company) to high-risk assets or high-risk trading strategies; or (iii) would pose a threat to the safety and soundness of a banking entity (or a Nonbank Financial Company)?
  6. What factors and considerations should be taken into account in making recommendations on whether additional capital and quantitative limitations are appropriate to protect the safety and soundness of banking entities or Nonbank Financial Companies engaged in activities permitted under the Volcker Rule?
  7. Which practices, types of transactions or corporate structures in general have historically accounted for or involved increased risks or may account for or involve increased risks in the future?
  8. What practices, policies or procedures have historically been utilized that may have mitigated or exacerbated risks or losses, or might be useful in limiting undue risk or loss in the future?
  9. What factors and considerations should be taken into account in making recommendations to safeguard against evasion of the Volcker Rule?
  10. How should the international context be considered when implementing the Volcker Rule? Are there any factors or considerations that should be taken into account regarding the application of the Volcker Rule to banking entities or nonbank financial companies that operate outside the U. S.? What issues does implementation of the Volcker Rule present with respect to (i) domestic banking entities that have access to foreign exchanges, (ii) foreign affiliates of domestic banking entities, and (iii) foreign non-bank financial companies?
  11. What timing issues are raised in connection with the divestiture of illiquid assets affected by the prohibitions of the Volcker Rule, and how might such issues be appropriately addressed?

Request for Comments on Notice of Proposed Rulemaking Regarding Criteria for Designation as Systematically Significant Nonbank Financial Companies

Section 113 of the Act (“Section 113”) gives the FSOC the authority to determine that a nonbank financial company is systemically significant and require that such nonbank financial company be subject to regulation by the FRB, including heightened and broadened prudential standards and other restrictions.  For a nonbank financial company to be considered systemically significant, the FSOC must determine that the failure, nature, scope, size, scale, concentration, interconnectedness or mix of activities of the nonbank financial company could pose a threat to the financial stability of the U.S.  Section 113 of the Act requires that, when making such a determination, the FSOC must consider certain factors including: the company’s leverage, the nature of the assets and liabilities of the company, the company’s reliance on short-term funding, the nature of the company’s activities, its interconnectedness with other systemically significant financial companies and its importance as a source of credit and liquidity.  For a more detailed discussion of Section 113 and its requirements, please refer to the July 28, 2010 Special Edition of the Alert.

The FSOC issued the ANPR to gather information as it begins to establish the specific criteria and analytical framework by which it will designate nonbank financial companies for enhanced supervision under the Act.  The FSOC has not requested comments on the procedural requirements of Section 113; however, the FSOC has requested comments on the questions set forth below related to the criteria for designation as a systemically significant nonbank financial company.

  1. What metrics, quantitative or qualitative, should be used by the FSOC to measure the factors required by Section 113 when making determinations under Section 113, and should certain factors be weighted more heavily than other factors?
  2. What types of nonbank financial companies should be reviewed for designation under Section 113?  Should the analytical framework, considerations, and measures used by the FSOC vary across industries or time? If so, how?
  3. What role should international considerations play in designating foreign nonbank companies? Are there unique considerations for foreign nonbank companies that should be taken into account?
  4. Are there simple metrics that should be used to determine whether nonbank financial companies should be considered for designation?
  5. How should the FSOC measure and assess the scope, size, and scale of nonbank financial companies? 
  6. How should the FSOC measure and assess the nature, concentration, and mix of activities of a nonbank financial company?  Are there specific measures of market concentration that can be used by the FSOC to determine the importance of a company as a source of credit for households, businesses, and State and local governments, and as a source of liquidity for the U. S. financial system? 
  7. How should the FSOC measure and assess the interconnectedness of a nonbank financial company?
  8. How should the FSOC measure and assess the leverage of a nonbank financial company? 
  9. How should the FSOC measure and assess the amount and types of liabilities, including the degree of reliance on short-term funding of a nonbank financial company?  
  10. How should the FSOC take into account the fact that a nonbank financial company (or a subsidiary or affiliate) is already subject to financial regulation in the FSOC’s decision to designate a firm?  Are there particular aspects of prudential regulation that should be considered as particularly important (e.g., capital regulation, liquidity requirements, consolidated supervision)?  Should the FSOC take into account whether the existing regulation of the company comports with relevant national or international standards?
  11. Should the degree of public disclosures and transparency be a factor in the assessment?  Should asset valuation methodologies (e.g., level 2 and level 3 assets) and risk management practices be factored into the assessment? 
  12. How should the government’s extension of financial assistance to nonbank financial companies be considered in designating companies?
  13. Please provide examples of best practices used in evaluating and considering various types of risks that could be systemic in nature. 
  14. Should the FSOC define “material financial distress” or “financial stability”? If so, what factors should be considered in developing those definitions? 

Request for Comments

Comments in response to the Volcker ROI and on the ANPR are due to the FSOC by November 5, 2010.