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FSOC Approves Analytic Framework for Financial Stability Risks and Guidance on Nonbank Financial Company Designations

BY: Nanci Weissgold, Anoush Garakani, Aileen Ng

A&B Abstract:

On November 3, 2023 the Financial Stability Oversight Council (hereinafter “FSOC” or “Council”) unanimously approved final versions of: (1) the new Analytic Framework for Financial Stability Risk Identification, Assessment, and Response (“Analytic Framework”); and (2) the updated Guidance for Nonbank Financial Company Determinations (“Nonbank Designations Guidance”). The Analytic Framework was published today in the Federal Register and is effective immediately, and the Nonbank Designations Guidance will be effective 60 days after publication in the Federal Register.

Given the recent bank failures, it should come as no surprise that federal regulators are focusing on financial risks to U.S. stability across various sectors, including nonbank mortgage lenders and servicers.

Background

Following the 2007-2009 financial crisis, the Dodd-Frank Act created FSOC, an interagency panel of top U.S. financial regulators, to monitor excessive risks to U.S. financial stability and facilitate intergovernmental cooperation to effectively address those risks. Chaired by the Treasury Secretary and consisting of 10 voting members (comprised of the U.S. prudential regulators including, among others, the Consumer Financial Protection Bureau (“CFPB”)) and 5 nonvoting members, one of the Council’s statutory purposes is to specifically oversee large, interconnected bank holding companies or nonbank financial companies that pose potential risks to U.S. financial stability and, given the broad statutory mandate, the Council’s monitoring may cover an expansive range of asset classes, institutions, and activities, such as:

  • Markets for debt, loans, and other institutional and consumer financial products and services;
  • Central counterparties and payment, clearing, and settlement activities;
  • Financial entities, including banking organizations, broker-dealers, mortgage originators and services;
  • New or evolving financial products and practices; and
  • Developments affecting the resiliency of the financial system, such as cybersecurity and climate-related financial risks.

The Dodd-Frank Act empowers the Council to designate a nonbank financial company subject to certain prudential standards and supervision by the Federal Reserve’s Board of Governors. The Dodd-Frank Act lists 10 factors that Council must consider before making such designation.  To date, the Council has used this authority sparingly.  According to Treasury Secretary Janet Yellen, the Council’s updated Nonbank Designations Guidance will make it easier to use its nonbank designation authority, eliminating “several prerequisites to designation … that were not contemplated by the Dodd-Frank Act and that are based on a flawed view of how financial risks develop and spread” that exist under the previous guidance issued in 2019.

As the country experienced a regional bank crisis earlier this year, it would not be unreasonable to conclude that the Council may use its authorities less sparingly than in the past. The Council’s annual reports specifically address the potential risks of nonbank companies, support the updated requirements issued by the Federal Housing Finance Authority, Ginnie Mae and the CSBS Model State Regulatory Prudential Standards for Nonbank Mortgage Servicers, and recommend that relevant federal and state regulators continue to enhance or establish information sharing in responding to distress at a mortgage servicer.  Indeed, in June 2022, FSOC restarted its Nonbank Mortgage Servicing Task Force, an interagency group to facilitate coordination and additional market monitoring of nonbank servicers.

The Finalized Analytic Framework

The finalized Analytic Framework, which is not a formal rule, broadly describes the approach FSOC expects to take in “identifying, assessing, and responding to certain potential risks to U.S. financial stability,” and interprets “financial stability” to mean the “financial system being resilient to events or conditions that could impair its ability to support economic activity, such as by intermediating financial transactions, facilitating payments, allocating resources, and managing risks.”  The Council’s statutory mandate includes the duty to monitor a wide class of assets, such as new or evolving financial products and practices, and nonbank financial companies, such as mortgage originators and servicers, at several key pressure points.

Following consideration of public comments on the proposed Analytic Framework, which we previously discussed, the finalized Analytic Framework reflects several key changes from the proposed Analytic Framework, which include:

  • A description of the term “threat to financial stability” that builds on the proposed interpretation, specifically, to mean events or conditions that could “substantially impair” the financial system’s ability to support economic activity;
  • Additional examples of the types of quantitative metrics FSOC will consider to assess vulnerabilities that contribute to risks to financial stability;
  • Clarification on the relationship between the vulnerabilities and the four transmission channels (discussed below) by highlighting vulnerabilities that may be particularly relevant to a channel; and
  • An emphasis on the importance of FSOC’s engagement with state and federal financial regulatory agencies as it assesses potential risks and the extent to which existing regulation may mitigate those risks.

Under the finalized Analytic Framework, a non-exhaustive list of potential risk factors and the indicators that FSOC intends to monitor includes:

  • Leverage, assessed by levels of debt and other off-balance sheet obligations that may create instability in the face of sudden liquidity restraints.
  • Liquidity Risks & Maturity Mismatches, measured by the ratios of short-term debt to unencumbered liquid assets and the amount of additional funding available to meet unexpected reductions in available short-term funds.
  • Interconnections, measured by the extent of exposure to certain derivatives, potential requirements to post margin or collateral, and overall health of the balance sheet.
  • Operational Risks, measured by the failure to implement proper controls related to financial market infrastructures and the vulnerability of cybersecurity incidents.
  • Complexity or Opacity, such as the extent to which transactions occur outside of regulated sectors, in a grey area of overlapping or indefinite jurisdiction, or are structured in such a way that cannot be readily observed due to complexity or lack of disclosure.
  • Inadequate Risk Management, such as the failure to maintain adequate controls and policies or the absence of existing regulatory oversight.
  • Concentration, measured by the market share for the provision of important services within segments of applicable financial markets and the risk associated with high concentration in a small number of firms.
  • Destabilizing Activities, such as trading practices that substantially increase volatility in a particular market, especially when a moral hazard is present.

Just as FSOC will consider all the factors listed above as sources of potential financial risk contagion, it will also assess the transmission of those risks to broader market sectors and other specific entities based on certain metrics. This non-exhaustive list of transmission risk factors includes:

  • Exposures: The level of direct and indirect exposure of creditors, investors, counterparties, and others to particular instruments or asset classes.
  • Asset liquidation: Rapid asset liquidation and the snowball effect of a widespread asset sell off across sectors.
  • Critical function or service: The potential consequences of interruption to critical functions or services that are relied upon by market participants for which there is no substitute.
  • Contagion: The potential for financial contagion arising from public perceptions of vulnerability and loss of confidence in widely held financial instruments.

Despite receiving comments recommending that the Analytic Framework specifically address climate-related risk, FSOC declined to do so, explaining that it believes potential risks related to climate change may be assessed under other factors such as through the “interconnections” vulnerability factor and the “exposures” transmission channel.  Similarly, FSOC declined to specifically discuss risks to the financial needs of underserved families and communities because it expects that such risks would be considered under the “critical function or service” transmission channel.

Once a financial risk has been identified, FSOC may use various tools to mitigate such risk depending on the circumstances.  For instance, FSOC may work with the relevant federal or state regulator to seek to address the risk. Where a regulator can sufficiently address such risk in a timely manner, FSOC will encourage regulators to do so.  Through formal channels, the Council can make a public recommendation to Congress or regulatory agencies to apply new standards or heightened scrutiny to a known risk within their jurisdiction. Where no clear-cut regulatory oversight exists, the Council may make legislative recommendations to Congress to address the risk. These formal recommendations to agencies or Congress, made pursuant to section 120 of the Dodd-Frank Act, are also subject public notice and comment.

In addition to making nonbinding recommendations for action to the appropriate financial regulatory authorities, FSOC is empowered to make a “nonbank financial company determination,” by a two-thirds vote, that a specific company shall be supervised by the Federal Reserve Board of Governors and subject to enhanced prudential standards. This designation can be made upon FSOC’s finding that:

  • Material financial distress at the nonbank financial company could pose a threat to the financial stability of the United States; or
  • The nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company could pose a threat to the financial stability in the United States.

Nonbank Financial Company Designation Final Interpretative Guidance

The finalized Nonbank Designations Guidance is procedural in nature relating to nonbank financial company designation.  It defines a two-stage process FSOC will use to make a firm-specific “nonbank financial company determination” discussed in FSOC’s Analytic Framework. In the proposed interpretive guidance issued for public comment in April 2023, the Council recognized that in the past, it “has used this authority sparingly, but to mitigate the risks of future financial crises, the Council must be able to use each of its statutory authorities as appropriate to address potential threats to U.S. financial stability.”  The Nonbank Designations Guidance will change the 2019 guidance in the following three ways:

  • First, under the current guidance, FSOC is committed to relying on federal and state regulators to address problematic nonbank financial company activity before considering whether a designation is appropriate. The new guidance removes this prioritization and allows FSOC to consider an entity for a designation proactively, without first relying on regulators to act before FSOC begins deliberating.
  • Second, FSOC has finalized the Analytic Framework discussed above to revise its process for monitoring risks to U.S. financial stability. This comprehensive new framework replaces that found in Section III of the 2019 interpretive guidance. Because the new guidance is focused on the procedural process for making nonbank financial company designations, the substantive analytic factors applied by FSOC in its assessments will be contained in the separate Analytic Framework document.
  • Third, FSOC has reversed course and is eliminating its current practice of conducting a cost-benefit analysis and an assessment of the likelihood of material financial distress prior to making its determination. FSOC has concluded that these processes are not required by Section 113 of the Dodd-Frank Act. FSOC defines “material financial distress” as a nonbank financial company “being in imminent danger of insolvency or defaulting on its financial obligations.” In eliminating the “likelihood” assessment required by the 2019 guidance, the Council will now presuppose a company’s material financial distress and then evaluate what consequences could follow for U.S. financial stability.

With respect to the formal process for nonbank financial company determinations, the finalized Nonbank Designations Guidance describes a two-stage process that FSOC will use once they decide to review a company for a potential designation.

Stage One:  FSOC will conduct a preliminary analysis of a company that has been identified for review based on quantitative and qualitative information available publicly and regulatory sources. FSOC will notify the company no later than 60 days before a vote is held to evaluate the company for Stage Two.  A company under review may submit information for FSOC’s review and may request to meet with FSOC staff and members agencies responsible for the analysis.  When evaluating a company in Stage One, the Council’s Nonbank Designations Committee may decide whether to analyze the risk profile of the company as a whole or to consider the risk posed by its subsidiaries as separate entities, depending on which entity the Council believes poses a threat to financial stability. At Stage One, FSOC is statutorily obligated to collect information from any relevant, existing regulators that oversee the company’s activities concerning the specific risks the Council has identified.

Stage Two: Any nonbank financial company selected for additional review will receive notice that the company is being considered for supervision by the Federal Reserve and enhanced prudential standards. The Nonbank Designations Guidance says that “[t]he review will focus on whether 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 U.S. financial stability.” At this point, if a company is under consideration for a Proposed Determination it will receive a formal Notice of Consideration from the Council.

The Council will begin its Stage Two review by consulting with the U.S. Treasury Department’s Office of Financial Research (OFR) and relevant financial regulators to ascertain the risk profile of the company. This information would remain confidential throughout the process, and, once interagency coordination has produced all available information, the company will be invited to submit any relevant information to the Council. These submissions may include “details regarding the company’s financial activities, legal structure, liabilities, counterparty exposures, resolvability, and existing regulatory oversight. . . . Information relevant to the Council’s analysis may include confidential business information such as detailed information regarding financial assets, terms of funding arrangements, counterparty exposure or position data, strategic plans, and interaffiliate transactions.” Council staff from the FSOC Deputies Committee will be available to meet with representatives of the company and will disclose the specific focus of the Council’s analysis, although the areas of analytic focus may change based on the ongoing analysis.

Finally, if FSOC preliminarily designates the company for supervision by the Federal Reserve and subjects it to enhanced prudential standards, the company will be able to request a nonpublic hearing after which FSOC may vote to make a final designation. FSOC will conduct an annual review for any company designated by the Council to determine whether continued Federal Reserve supervision and enhanced prudential standards are still appropriate. This annual review period will afford the company the opportunity to meet with Council representatives and present information or make a written submission to the Council about its efforts to mitigate risk. If the Council decides to sustain the designation, it will present the company with a written explanation for its decision.

Takeaway

Given the 2023 regional banking crisis, it is no surprise that federal regulators are focusing on potential risks to financial stability.  In FSOC’s 2021 and 2022 annual reports, nonbank mortgage companies have been identified as a potential risk.  The Federal Housing Finance Agency and Ginnie Mae have both updated their minimum financial eligibility requirements for seller/servicers and issuers with such requirements taking effect with varying effective dates later in 2023 and 2024.  States also have started to adopt prudential regulatory standards for nonbank mortgage servicers.  By voting through the Analytic Framework and Nonbank Designations Guidance, the Council signals that it remains vigilant to weaknesses in the financial system and will utilize a variety of tools and approaches to strengthen its supervision over companies if existing protections do not adequately mitigate financial stability risks.  Indeed, CFPB Director and voting member of the Council, Rohit Chopra, has expressed strong support for the actions taken and points out that the Council currently has “a total of zero shadow banks” designated as systemically important and that could pose a threat to financial stability which, according to Director Chopra, will most likely change once the Council implements the new guidance and conducts evaluations to identify shadow banks that meet the statutory threshold for enhanced oversight.

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