Fund Industry Concerned that House Reform Legislation Could Sweep Mutual Funds into Strict Systemic Risk Regulation

The mutual fund industry has criticized provisions of the Wall Street Reform and Consumer Protection Act, HR 4173, that could sweep large funds into strict prudential systemic risk regulation. The Investment Company Institute said that the legislation could subject mutual funds to wholly inappropriate forms of bank-like regulation were regulators, however improbably, to deem mutual funds to be a source of systemic risk. The ICI believes that mutual funds do not create broad systemic risks for the financial system since even the largest funds lack the interconnected web of relationships that is so crucial in spreading risks throughout the financial system.

In addition, the ICI said that provisions in the legislation allowing the FDIC to assess fees on financial companies with at least $50 billion in assets could unfairly require mutual funds and their shareholders to contribute to a dissolution fund for failing financial institutions. Mutual funds do not and cannot fail in a manner that would require payments to funds or their shareholders out of any such dissolution fund, emphasized the ICI.

Specifically, Section 1105 of the Act authorizes the new systemic risk regulator, the Financial Services Oversight Council, to impose strict standards on financial holding companies that pose a grave threat to financial stability or the US economy. The Council is authorized to impose conditions on fund activities or even terminate fund activities, or restrict the ability of a fund to offer a financial product. If all else fails to address the systemic risk, the Council may order the divestiture of business units, assets or branches.

If a financial holding company subject to stricter standards fails to implement a plan for mitigating systemic risk within a reasonable timeframe, the Council must direct the Federal Reserve Board to take such actions as necessary to ensure compliance with the plan.

There are safeguards built into the Act. For example, the Council can act only after notice and a hearing. In addition, the Council must consider a number of factors when determining if the financial holding company poses a grave systemic risk, including the amount and nature of the company's financial assets, liabilities, and off-balance sheet exposures, reliance on leverage, the company's interconnectedness with other financial and non-financial companies; the company's importance as a source of credit and liquidity for the financial system, and the extent to which prudential regulations mitigate the risk posed.

A financial holding company also has the right to ask a federal judge to rescind the strict prudential standards imposed on it. Rescission must be based on a judicial finding that the standards were imposed in an arbitrary and capricious manner.

In addition, in deciding what mitigating actions to impose on a financial holding company, the Council must consider the need to maintain the international competitiveness of the US financial services industry and the extent to which other countries with a significant financial services industry have established corresponding regimes to mitigate threats to financial stability posed by financial companies

The dissolution fund that has triggered concern in the mutual fund industry is set up under Section 1603 of the Act to fund the orderly dissolution of failed financial firms. The fund is administered by the FDIC, which has the exclusive authority to impose assessments on financial companies with $50 billion in assets to build and maintain the fund

In consultation with the Financial Services Oversight Council, the FDIC must use a risk matrix in setting the fee assessments that takes into account, among other things, the risks presented by the financial company to the financial system, including the extent to which the financial company is leveraged; the potential exposure to sudden calls on liquidity precipitated by economic distress; and the amount, maturity, volatility, and stability of the company's financial obligations to, and relationship with, other financial companies.