Alert October 18, 2011

Financial Stability Oversight Council Proposes Three-Part Test to Identify Systemically Important Non-Banks Requiring FRB Supervision

The Federal Stability Oversight Council (“FSOC”) issued a proposed rule (the “Proposed Rule”) that would establish a three-stage analysis to identify non‑bank financial firms whose failure could trigger wider instability in U.S. financial markets (“non‑bank systemically important financial institutions,” or “non-bank SIFIs”).  Section 113 of the Dodd‑Frank Act (“Section 113”) authorizes the FSOC to require a non-bank financial company to be supervised by the FRB if the FSOC determines that material financial distress at the company or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company could pose a threat to the financial stability of the United States.  Section 113 is mainly aimed at avoiding a reprise of the Lehman Brothers bankruptcy in September 2008, which sent shock waves through financial markets and the U.S. economy.  Section 113 is designed to help the FSOC identify such problems before they threaten the system as a whole.

The Proposed Rule consists of a three-stage screening process to identify which non-bank firms might qualify as a SIFI.  The first stage (“Stage 1”) would involve specific quantitative thresholds, and help the FSOC identify companies that need a further review.  Stage 1 would weed out most firms, based on a basic two-part profile— in which a firm would move to the next step in the screening process if it met an asset test, and any one of several other quantitative thresholds.  The Stage 1 asset test marker is $50 billion in global assets for U.S. firms, or $50 billion in assets in the United States for foreign non-bank financial firms.  A firm of that size need only meet one other threshold to move into the second stage of the FSOC’s consideration.  The other quantitative thresholds are: (i) $30 billion or more in gross notional credit default swaps (CDS), which are insurance-like bets on specific credit transactions; (ii) $3.5 billion of derivative liabilities (calculated after accounting for netting agreements and cash collateral); (iii) $20 billion of outstanding loans taken or bonds issued; and (iv) a minimum 15-1 assets-to-equity leverage ratio.

Firms identified as potential risks in Stage 1 would then go through a second stage with a deeper analysis that includes qualitative factors, such as consultations with primary regulators.  Finally, the third stage would involve a decision by the FSOC whether to designate the firm as a non-bank SIFI.  Any firm designated as a non-bank SIFI could request a hearing and try to convince the FSOC to modify its determination.

Comments on the Proposed Rule are due by December 19, 2011.