The Dodd-Frank Act: Application of Bank Supervision and Regulation
to Systemic Nonbank Financial Companies

By Christopher J. Bellini*

Enacted on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) comprehensively reforms and restructures the U.S. financial regulatory system. As part of this effort, Title I of the Act establishes the new Financial Stability Oversight Council (the “Council”). The Council is made up of ten voting members – nine federal financial regulatory agencies and an independent member with insurance expertise – and five nonvoting members.[i] The Council’s purposes include: (i) identifying risks and responding to emerging threats to the financial stability of the United States and its financial system; and (ii) promoting market discipline by ending government loss shielding for shareholders, creditors and counterparties of financial companies (that is, eliminating the concept of “too big to fail”).

To this end, a main power of the Council is to designate entities as systemically significant nonbank financial companies that will be subject to Federal Reserve Board supervision. As a result, going forward under the U.S. financial regulatory system, the applicability of intensive bank-like supervision and regulation will no longer be limited to entities affiliated with banks or other insured depository institutions.

Instead, the kinds of companies subject to such supervision, regulation, examination and enforcement will be expanded to include any systemically significant nonbank company “predominantly engaged” in financial activities.[ii] As discussed below, these companies will also be subject to “prudential standards” promulgated by the Federal Reserve. Such a “nonbank financial company” could, for example, include: (i) an insurance company; (ii) a securities firm; (iii) a mutual fund group; (iv) a private equity or hedge fund group; or (iv) a finance or lending company.

Under the Act, the new Council will designate a systemically significant entity as a covered nonbank financial company if the Council determines that material financial distress at such an entity, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the entity, could pose a threat to the financial stability of the United States. The Act provides a nonexclusive list of items the Council must consider in making such a determination. Most importantly, in addition to the specific statutory items analyzed in the table below, the list may include “any other risk-related factors that the Council deems appropriate.” Accordingly, the range of factors that the Council may consider is open-ended and in the discretion of the Council.

Notice of Proposed Rulemaking.

On January 18, 2011, the Council released a notice of proposed rulemaking (“NPR”) that sets forth the proposed criteria and analytical framework for the Council to designate an entity as a nonbank financial company under the Act. The NPR text may be found at:http://www.treasury.gov/initiatives/Documents/Nonbank%20NPR%20final%2001%2013%2011%20formatted%20for%20FR.pdf.

As part of its decision-making process, the Council, acting through the new Office of Financial Research, may require the submission of reports from entities to assist it in determining whether the entity is a covered nonbank financial company or for the purpose of assessing the extent to which a financial activity or financial market that the entity participates in poses a threat to the financial stability of the United States. The Council may also request that the Federal Reserve examine a company for these purposes.

Analytical Framework for Assessing Systemic Importance.

The NPR’s proposed analytical framework is organized around six broad categories. Per the NPR, “Each of the proposed categories reflects a different dimension of a firm’s potential to experience material financial distress, as well as the nature, scope, size, scale, concentration, interconnectedness and mix of the company’s activities.” Each of the statutory factors or other discretionary factors selected is relevant to, and would be considered as part of, one or more categories within this analytical framework.

The six systemically important categories are:

1. Size;

2. Lack of substitutes for the financial services and products the company provides;

3. Interconnectedness with other financial firms;

4. Leverage;

5. Liquidity risk and maturity mismatch; and

6. Existing regulatory scrutiny.

The criteria in the first three categories seek to assess the potential for spillovers from the firm’s distress to the broader financial system or real economy. The criteria in the second three categories seek to assess how vulnerable a company is to financial distress. The Council, using its judgment, would evaluate nonbank financial companies in each of the six categories, using quantitative metrics where possible.

Thus, this approach incorporates both quantitative measures and qualitative judgments. Per the NPR, “[A]s part of the qualitative judgment, the Council would consider potential spillovers that could occur from financial distress or failure of the company in normal times, as well as those that could occur in times of widespread financial stress.” By way of illustration of the framework, the table below provided in the NPR sets forth the statutory factors for assessing a U.S. nonbank financial company and then aligns them with one or more of the six analytical categories in the framework.

Statutory factors:	Category or categories in which this factor would be considered:
(A) the extent of the leverage of the company;	Leverage
(B) the extent and nature of the off-balance-sheet exposures of the company;	Size; Interconnectedness
(C) the extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;	Interconnectedness
(D) the importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;	Size; Lack of substitutes
(E) the importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;	Lack of substitutes
(F) the extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;	Size; Interconnectedness
(G) the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;	Size; Lack of substitutes; Interconnectedness
(H) the degree to which the company is already regulated by 1 or more primary financial regulatory agencies;	Existing regulatory scrutiny
(I) the amount and nature of the financial assets of the company;	Size; Interconnectedness
(J) the amount and types of the liabilities of the company, including the degree of reliance on short-term funding;	Liquidity risk and maturity mismatch; Size; Interconnectedness
(K) any other risk-related factors that the Council deems appropriate	Appropriate category or categories based on the nature of the additional risk-related factor

Importantly, determinations using this analytical framework are to be based on whether the firm could pose a threat to the financial stability of the United States in accordance with the Act. Thus, if a firm would not pose such a threat, then implicating a statutory factor or category should not be sufficient for a firm to be designated a covered nonbank financial company.

For example, take the case of a firm that is a highly significant entity in the United States with respect to the statutory factor of “the importance of the company as a source of credit for low-income, minority, or underserved communities,” and assume the impact that the failure of such company would have is significant on the availability of credit in such communities because of a lack of substitutes. Nonetheless, this would not be sufficient for the firm to be designated a covered nonbank financial company if it did not otherwise pose a threat of systemic risk to the financial stability of the United States.

The Council also recognized that the application of the framework should be adapted for the risks presented by a particular industry sector and the business models present in each sector. Thus, any metrics that are utilized will be industry specific and “likely will differ across industry sectors.” Accordingly, the most important determinants or metrics for a company and its industry remain to be developed as part of the determination process and the implementation of the standards established under the Act. The Council is also required to review these metrics on a periodic basis and revise them as appropriate.

Consequences of Being Deemed Systemic.

The consequences of being deemed a systemic nonbank financial company are extensive. Essentially, the corporate governance, management and operations of such an entity become subject to Federal Reserve oversight and approval. As part of its supervisory and regulatory authority, the Federal Reserve generally can take the following actions with respect to a nonbank financial company and any subsidiary thereof: (1) require submission of reports; (2) examine such companies; and (3) take enforcement actions against such companies.

Moreover, the Federal Reserve must establish so-called “prudential standards” for systemic nonbank financial companies including increasingly stringent standards as the risk to the financial stability of the United States increases from such a company. The mandatory areas for which prudential standards must be adopted includes capital, leverage, liquidity, risk management, credit exposures, concentration limits, public disclosures, and short-term debt limits. This list is nonexclusive and the Federal Reserve may also impose any other prudential standard it believes to be appropriate. Accordingly, the Federal Reserve has plenary authority in this area.

In addition, the Federal Reserve’s prior approval is required for a nonbank financial company to acquire, make certain investments in or have control relationships with (i) banks; and (2) nonbanking entities engaged in financial activities having total consolidated assets of $10 billion or more. A nonbank financial company is also subject to certain management interlock prohibitions with nonaffiliated entities. Finally, if the Federal Reserve and the Council determine that a nonbank financial company poses a grave threat to the financial stability of the United States, the Federal Reserve shall:

1. Limit the ability of the company to merge with, acquire, consolidate with, or otherwise become affiliated with another company;

2. Restrict the ability of the company to offer a financial product or products;

3. Require the company to terminate one or more activities;

4. Impose conditions on the manner in which the company conducts one or more activities; or

5. If (1)-(4) are inadequate, require the company to sell or otherwise transfer assets or off-balance sheet items to unaffiliated entities.

Overall, for an entity that is designated as a nonbank financial company under the Act – in particular an entity not currently subject to government supervised enterprise-wide risk management or comprehensive consolidated supervision – it is difficult to conceive of a more traumatic conversion. Essentially, the management and operations of such an entity will have to be altered at all levels of the organization to take into account and satisfy its new regulatory regime.

* Christopher J. Bellini is the Co-Chair of the firm-wide Financial Institutions Group of Gibson, Dunn & Crutcher LLP. Mr. Bellini represents financial services and other clients in a variety of matters, including government investigations, enforcement actions and capital requirements, mergers and acquisitions, strategic investments, new products and services, legislation, and regulation. Mr. Bellini teaches international banking at Georgetown University Law Center.

[i] The voting members are:

- The Secretary of the Treasury, who serves as the Chairperson of the Council;
- The Chairman of the Federal Reserve Board;
- The Comptroller of the Currency;
- The Chairman of the Securities and Exchange Commission;
- The Chairperson of the Federal Deposit Insurance Corporation;
- The Chairperson of the Commodity Futures Trading Commission;
- The Director of the Federal Housing Finance Agency;
- The Chairman of the National Credit Union Administration Board;
- The Director of the new Consumer Financial Protection Bureau created under the Act; and
- An independent member with insurance expertise.

The nonvoting members who serve in an advisory capacity are:

- The Director of the new Office of Financial Research created under the Act;
- The Director of the new Federal Insurance Office created under the Act;
- 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.

[ii] Section 102(a)(6) of the Act states: “A company is predominantly engaged in financial activities if--

(A) the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, from the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated annual gross revenues of the company; or

(B) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, related to the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated assets of the company.”

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Christopher J. Bellini

Christopher J. Bellini