The Financial Stability Oversight Council has adopted a final rule that went into effect on May 11, 2012 describing the framework that the Council intends to use to determine whether a non-bank financial company is systemically important to the US financial system and whose failure could pose a threat to the U.S. financial stability.  The consequences of being designated a systemically important company is that the Federal Reserve is given the authority to impose risk based capital requirements, leverage limits, liquidity requirements, resolution plans, concentration limits, a contingent capital requirement; enhanced public disclosures; short-term debt limits; and overall risk management requirements.

The Council adopted a three-stage process for making its determination. The first stage is designed to narrow the universe of non-bank financial companies by establishing certain size or other quantitative thresholds. The second stage applies the analytic framework (i) size, (ii) interconnectedness, (iii) substitutability, (iv) leverage, (v) liquidity risk and maturity mismatch, and (vi) existing regulatory scrutiny to determine whether company could pose a risk to U.S. financial stability. The third stage will utilize qualitative and quantitative information obtained directly from the companies through the Office of Financial Research.

The quantitative thresholds a company would need to get past the stage 1 review are as follows:

Total Consolidated Assets. $50 billion.

Credit Default Swaps Outstanding. $30 billion in gross notional credit default swaps (‘‘CDS’’) outstanding for which a nonbank financial company is the reference entity. Gross notional value equals the sum of CDS contracts bought (or equivalently sold). If the amount of CDS sold on a particular nonbank financial company is greater than $30 billion, this indicates that a large number of institutions may be exposed to that nonbank financial company and that if the nonbank financial company fails, a significant number of financial market participants may be affected. This threshold was selected based on an analysis of the distribution of outstanding CDS data for nonbank financial companies included in a list of the top 1,000 CDS reference entities.

Derivative Liabilities. The Council intends to apply a threshold of $3.5 billion of derivative liabilities. Derivative liabilities equal the fair value of derivative contracts in a negative position. For nonbank financial companies that disclose the effects of master netting agreements and cash collateral held with the same counterparty on a net basis, the Council intends to calculate derivative liabilities after taking into account the effects of these arrangements. This threshold serves as a proxy for interconnectedness, as a nonbank financial company that has a greater level of derivative liabilities would have
higher counterparty exposure throughout the financial system.

Total Debt Outstanding. The Council intends to apply a threshold of $20 billion in total debt outstanding. The Council will define total debt outstanding broadly and  regardless of maturity to include loans (whether secured or unsecured), bonds, repurchase agreements, commercial paper, securities lending arrangements, surplus notes (for insurance companies), and other forms of indebtedness. This threshold serves as a proxy for interconnectedness, as nonbank financial companies with a large amount of outstanding debt are generally more interconnected with the broader financial system, in part because financial institutions hold a large proportion of outstanding debt. An analysis of the distribution of debt outstanding for a sample of nonbank financial companies was performed to determine the $20 billion threshold. Historical testing of this threshold demonstrated that it would have captured many of the nonbank financial companies that encountered material financial distress during the financial crisis in 2007–2008, including Bear Stearns, Countrywide, and Lehman Brothers.

Leverage Ratio. The Council intends to apply a threshold leverage ratio of total consolidated assets (excluding separate accounts) to total equity of 15 to 1. The Council intends to exclude separate accounts from this calculation because separate accounts are not available to claims by general creditors of a nonbank financial company. Measuring leverage in this manner benefits from simplicity, availability and comparability across industries. An analysis of the distribution of the historical leverage ratios of large financial institutions was used to identify the 15 to 1 threshold. Historical testing of this threshold demonstrated that it would have captured the major nonbank financial companies that encountered material financial distress and posed a threat to U.S. financial stability during the financial crisis, including Bear Stearns, Countrywide, IndyMac Bancorp, and Lehman Brothers.

Short-Term Debt Ratio. The Council intends to apply a threshold ratio of total debt outstanding (as defined above) with a maturity of less than 12 months to total consolidated assets (excluding separate accounts) of 10 percent. An analysis of the historical distribution of the short-term debt ratios of large financial institutions was used to determine the 10 percent threshold. Historical testing of this threshold demonstrated that it would have captured a number of the nonbank financial companies that faced short-term funding issues during the financial crisis, including Bear Stearns and Lehman Brothers.

The Council is required to notify the non-bank financial companies in writing of their designation as systemically important and the companies may request an opportunity for a written or oral hearing before the Council to contest the designation. If the Council makes a final determination with respect to a nonbank financial company, the company may, not later than 30 days after the date of receipt of the notice of final determination bring an action in the United States district court for the judicial district in which the home office of such nonbank financial company is located, or in the United States District Court for the District of Columbia, for an order requiring that the final determination be rescinded. Judicial review is quite limited, however, in that the review of such an action shall be limited to whether the final determination was arbitrary and capricious.

The final rule still leaves a great deal of ambiguity for companies seeking to determine whether they will be covered or not. For example, will large insurance companies be covered or will the fact that they are subject to an existing regulatory supervision by state insurance commissioners be sufficient to knock them out in the second stage? The Council noted that it was not adopting any sort of industry-wide exclusion and indicated that the evaluation of any non-bank company would be company-specific.  Likewise, the Council is analyzing the extent to which there are potential threats to U.S. financial stability arising from asset management companies. This analysis is considering what threats exist, if any, and whether such threats can be mitigated by subjecting such companies to Board of Governors supervision and prudential standards, or whether they are better addressed through other regulatory measures.