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Regulators one step closer to naming SIFIs

by William McConnell | Published April 4, 2013 at 9:49 AM

The Federal Reserve Board on Wednesday set a key rule that will enable financial regulators to determine which nonbank financial firms are critical to the financial system and must submit to additional government oversight.

The rule approved Wednesday defines when a company is "predominantly engaged in financial activities." Nonbank financial firms that meet the definition will be subjected to consolidated supervision by the Federal Reserve if the Financial Stability Oversight Council designates them as "systemically important financial institutions."

A firm will be considered significant if it has $50 billion or more in total consolidated assets or has operations or risk exposures that the FSOC believes will harm the U.S. financial system if the institution fails.

Banks and bank holding companies already face substantial oversight from federal regulators and there is less controversy surrounding the designation of banks and their holding companies as SIFIs.

Establishing which nonbank companies are eligible to be deemed SIFIs removes a key hurdle to the FSOC making its designations. The Dodd-Frank Wall Street reform law enacted in 2010 established that the FSOC can designate a nonbank firm for supervision by the Federal Reserve only if it is "predominantly engaged in financial activities."

Under the rule announced Wednesday, a company is considered to be predominantly engaged in financial activities if 85% or more of the company's revenues or assets are related to activities that are defined as "financial in nature" under the Bank Holding Company Act. The rule largely adopts the approach of an April 2012 proposal but includes some minor changes. Most noteworthy, the Fed decided that engaging in physically settled derivatives transactions generally will not be considered a financial activity. The change was meant to protect companies that use derivatives to hedge against supply price changes such as farmers and manufacturers. Operations that attempt to profit from derivatives trading would still be classified as financial in nature.

The list of other activities that will be considered financial in nature include lending, investing for others, insuring against loss or harm, providing financial or investment advisory services, selling interests in pools of assets, underwriting, and servicing loans. The Fed's full list of activities takes up 12 pages.

Jaret Seiberg, an analyst for Guggenheim Securities LLP, said the nonbank firms likely to be designated as SIFIs are GE Financial, Prudential Financial Inc., American International Group Inc. and MetLife Inc. He said BlackRock Inc. and Pacific Investment Management Co. LLC, or PIMCO, also face a "real risk" of being designated.

The Fed has authority to make SIFIs shed operations deemed too risky, increase capital levels to account for the risk level of other operations, and map out living wills that can be used to wind down the institutions should they fail. The firms also will be required to submit reports to the Federal Reserve, the FSOC, and the Federal Deposit Insurance Corp. on the company's credit exposure to other significant nonbank financial companies and significant bank holding companies as well as the credit exposure of such significant entities to the company.

Seiberg predicted in a research note that eventual designations may initially cause negative market reactions but called those worries "overblown." He said the Fed is expected to tailor its supervisory regime for each firm to its individual business model and the nature of the risks it has incurred.

Wednesday's rule also defined the terms "significant nonbank financial company" and "significant bank holding company." Those definitions are important because the factors the FSOC must consider when determining whether to designate a nonbank financial company for Fed supervision is the extent and nature of the company's transactions and relationships with other significant nonbank financial companies and significant bank holding companies.

Although the new definition of what constitutes a firm primarily engaged in financial activities takes effect May 6, FSOC is not expected to designate any nonbank firms as SIFIs for some time. "The designation clearly carries a whole lot of burden, so many firms will try to fight this," said Kevin Petrasic, a partner at Paul Hastings LLP.

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