Thursday, October 13, 2011

FSOC Proposes Process for Enhanced Regulation of Hedge Funds and Other Nonbank Financial Companies

The Financial Stability Oversight Council (“FSOC”) has reproposed a rule and proposed guidance concerning the methodology by which it will determine whether a nonbank financial company must be supervised by the Federal Reserve Board (“FRB”). Pursuant to the Dodd-Frank Act, the FSOC may require a nonbank financial company to be supervised by FRB and be subject to prudential standards if it determines that material financial distress at the nonbank financial 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.

Under the proposal, the FSOC would apply a three-stage process in making its determinations regarding the application of additional oversight. First, the FSOC will use a uniform quantitative analysis to determine if a given company should be further evaluated. The analysis requires a finding that a nonbank financial company has total consolidated assets of at least $50 billion and possesses a specifically prescribed amount of outstanding credit default swaps, derivative liabilities, or outstanding loans and issued bonds, or meets a certain leverage ratio or short-term debt ratio. The first stage may also involve evaluation of other firm-specific factors, including size and interconnectedness, leverage, liquidity risk, and existing regulatory scrutiny.

If a company meets the quantitative threshold, the FSOC will then conduct a comprehensive analysis of the potential for the identified nonbank financial company to pose a threat to U.S. financial stability. Finally, if it appears that potential systemic problems exist, the FSOC will contact the company to directly collect additional information to further analyze of whether the company should be subjected to FRB supervision.

The FSOC proposal suggests that money market funds will not be designated as systemically important because even a large company will not be designated as systemically important if it does not carry significant debt or enter into derivatives contracts, and money market funds generally do not engage in either of these practices. However, large funds or groups of asset management companies that do incur substantial debt or make significant use of leverage or derivatives are at risk for a determination requiring enhanced regulatory oversight.

Going forward, the FSOC will consider whether it should establish additional metrics tailored to specific types of financial institutions, including hedge funds and private equity funds, and whether it should offered additional guidance in connection with the changes.

The period for comments on the proposal will remain open for 60 days.

This post was contributed by our colleauge Amy Leisinger