On October 6, 2010, the new Financial Stability Oversight Council (FSOC) created by the Dodd-Frank Act issued its first two releases on important issues in the implementation of the Dodd-Frank Act. The FSOC is the organization created by the Dodd-Frank Act to oversee the U.S. financial markets. Its members include the Secretary of the Treasury; the Chairs of the Federal Reserve Board, FDIC, SEC, CFTC and NCUA; the Comptroller of the Currency; and the Directors of the Bureau of Consumer Financial Protection and the Federal Housing Finance Agency.1 The first of the two FSOC releases concerns the Volcker Rule, which limits the ability of banks to engage in proprietary trading and to invest in or sponsor hedge funds or private equity funds. The second release concerns the FSOC’s designation of nonbank financial companies as systemically significant, and therefore subject to supervision and oversight by the Federal Reserve Board. These releases address two of the most contentious and controversial issues to be resolved in the many rulemaking processes necessary to implement the Dodd-Frank Act. The comment period for both releases closes on Nov. 5, 2010 — less than one month from now.
The Volcker Rule, named for former Federal Reserve Board Chairman Paul Volcker, generally prohibits banks from engaging in proprietary trading, although the ban does not apply to all types of securities. The Volcker Rule also bars banks from acquiring or retaining equity, partnership or other ownership interest in or sponsoring a hedge fund or a private equity fund, although this bar has some exceptions, for example for funds entirely for bank trust, fiduciary and investment advisory customers. The Volcker Rule was (and remains) controversial because it addresses potential threats that are generally agreed not to have played any significant role in the 2008 credit crisis. Rather, it is meant to address concerns about possible sources of a future financial crisis. Section 619 of the Dodd-Frank Act requires the FSOC to complete a study of issues affecting the implementation of the Volcker Rule within the six months following passage of the Act (in other words, by January 2011). The FSOC’s notice is designed to elicit information to inform this study.
The FSOC’s notice and request for information is only three pages long in the Federal Register.2 However, it asks a number of key implementation questions about which practitioners have been concerned. What exactly is “proprietary trading” in a firm’s “trading account?” How does it differ from permitted “underwriter or market making” to support “the reasonably expected near-term demands of clients?” What are permissible “risk-mitigating hedging activities?” What is a “hedge fund” or a “private equity fund?” How long will it take to divest “illiquid assets?” What constitutes an impermissible “material conflict of interest” or an impermissible “material exposure. . . .to high-risk assets or high-risk trading strategies?” What capital or other quantitative limits are appropriate for permitted proprietary trading and hedge fund/private equity fund operations, for banks and systemically significant non-bank financial companies? Are there types of transactions or structures that pose the most risks, and are there practices, policies and procedures that can mitigate those risks? How should the Volcker Rule be implemented in the context of multinational entities, including domestic banks with foreign operations, and foreign non-bank financial companies active in this country?
Systemically Significant Nonbank Financial Companies
Section 113 of the Dodd-Frank Act gives the FSOC the ability to designate nonbank financial companies as subject to supervision and regulation by the Federal Reserve Board. This authority was adopted in recognition of the fact that during the 2008 credit crisis, difficulties at nonbank financial firms such as Lehman Brothers and AIG had systemic effects on the financial system as a whole. The difficulty is in determining which nonbank financial firms pose these systemic risks — an issue that the Dodd-Frank Act deferred entirely to the FSOC.
Similar to the Volcker Rule release, the FSOC’s advance notice of proposed rulemaking on systemically significant nonbank financial companies is only three pages long.3 But again, it asks questions about which many observers have been concerned. What is “material financial distress” and “financial stability?” How should the FSOC measure the scope, size and scale of nonbank financial companies? Is there a threshold below which the FSOC should not even consider whether nonbank financial companies might be systemically significant? Should some industries be evaluated differently from others? Should the FSOC look at managed assets (at hedge funds, private equity funds and mutual funds) in determining significance, and should it consider implicit guarantees, such as the support some investment managers provided to their money market funds in 2008? Should the FSOC consider which firms in fact participated in the government financial stabilization programs during the financial crisis?
The FSOC’s release also asks: How should the FSOC measure market concentration for the credit markets, and for credit to low-income and underserved communities? How should the FSOC measure interconnectedness, both with the economy as a whole, and among other significant financial firms? How should the FSOC measure and assess leverage, off-balance sheet liabilities, reliance on short-term funding, stability of funding, and how well matched are a company’s liabilities and assets? Should regulated entities be treated differently from unregulated entities, and does it matter if that regulation includes capital, liquidity or consolidated supervision? How do private sector firms evaluate and limit systemic and counterparty risks? Once again, how should the FSOC evaluate foreign and multinational firms in evaluating systemic risk?
The FSOC’s releases on the Volcker Rule and on systemically significant nonbank financial companies pose important questions. However, those releases provide little insight on how the FSOC may answer those questions, although we do note a particular focus on the asset management industry in the release on systemically significant companies. The FSOC’s decisions on both sets of issues will have far-reaching effects on the future of the U.S. financial services markets. In both cases, the FSOC must issue detailed proposals for notice and comment before they can adopt final rules. However, we urge our clients to review these releases and consider commenting on them now, before the various constituencies on the FSOC have become locked into final positions. Comments are due to the FSOC in 30 days, by Nov. 5, 2010.
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This article was originally published by Bingham McCutchen LLP.