FSOC Criticized by Government Accountability Office, but GAO Report Misses Critical Substantive Improvements; FRB Begins to Identify Prudential Regulation for SIFIs
The U.S. Government Accountability Office just issued a report on the Financial Stability Oversight Council’s (“FSOC”) systemically important financial institution (“SIFI”) designation process, entitled “Further Actions Could Improve the Nonbank Designation Process” (“Report”). The Report documents numerous process, documentary and transparency deficiencies in which improvements would indeed be welcome.
Our involvement in the designation process suggests that there are further critical substantive areas that should be enhanced, which would in fact be advantageous to both the company being evaluated and the FSOC. From the FSOC’s perspective, good governance will increase public confidence in the process and may lessen the likelihood that a federal court would invalidate a designation. Many of these suggestions have recently been discussed with the FSOC, most notably in a set of meetings that the FSOC called on November 12, 2014, which have been referenced in several press accounts.
In that regard, on Tuesday, November 25, 2014, the Federal Reserve Board (“FRB”) issued a press release inviting public comment on enhanced prudential standards for the regulation and supervision of a specific SIFI that the FSOC has already designated for supervision by the FRB.
This proposal would finally identify the enhanced prudential standards that will be applied to SIFIs. In this particular case, the proposed order would generally apply standards similar to those that apply to large bank holding companies, as well as additional prudential standards related to the “unique aspects related to the company’s activities, risk profile, and structure”. Those standards include additional independence requirements for the board of directors, and restrictions on intercompany transactions.
What the Report Says
The Report describes the universe of companies under consideration in the last two years:
- In the Stage 1 analysis conducted in June 2012, using information generated by the Office of Financial Research (“OFR”) and other sources, the FSOC identified fewer than 50 nonbank financial companies that qualified for a Stage 2 evaluation.
- FSOC began Stage 2 evaluations of 14 of those companies and completed the process for eight companies.
- FSOC issued final designations for three of those companies, and five were deemed not to require further analysis at the time and did not advance to a Stage 3 evaluation.
- As of September 2014, FSOC had five evaluations in process. The Stage 3 analysis was completed for one company, which received a proposed determination.
- Four other companies were still being evaluated in Stage 2 as of that time.
- The Report provides some important insights into the process, including the absence of centrally collected data on the staff members of the constituent agencies of the FSOC who conducted the evaluations.
What the Report Does Not Say
The Report does not touch upon areas and recommendations that may improve the fairness of the designation process, including the following:
- The empirical basis for FSOC jurisdiction should be established at the beginning of the process so that the company understands how it satisfies the 85% test established by the statute for a “nonbank financial company.”
- Unless and until the FRB finalizes the form of prudential regulation that it will use to reduce systemic risk created by non-bank financial companies, which process it has just begun, FSOC cannot demonstrate that a company’s risk profile and impact on systemic stability will be lessened by such regulation and, therefore, should defer such designations.
- Similarly, since a party cannot fairly rebut the conclusions underlying an FSOC determination unless it knows what prudential requirements will be applied to it, it should not be put in a position of having to argue against designation until all regulatory pieces are in place.
- The FSOC and its constituent agencies should adopt internal rules that require the involvement of Board members and governors, commissioners and agency officials in the determination of the constituent agency head’s vote.
- Consultation with the company’s principal federal or state regulatory agency should be: (i) on the record; (ii) conducted pursuant to standardized procedures and informational templates; (iii) shared by the FSOC with the agency; (iv) documented in writing; and (v) shared with the company so that it can respond to that consultation on the record.
- The designation of a company should require the affirmative vote of not only the Secretary of the Treasury, but also the principal regulatory agency representative that sits on the FSOC.
- The FSOC should conduct a cost benefit analysis as a part of every designation in order to present a record that is logically and legally defensible.
Based on the facts set forth in the Report, there are still a significant number of companies that are eligible for Stage 2 analysis. How the FSOC’s re-analysis of its process and substantive approach impact those evaluations is yet to be seen. Perhaps equally significant may be the change in control of the U.S. Senate and how it impacts the dynamics between Congress and the FSOC.