FSOC proposes changes to non-bank regulation loopholes

In light of recent market turbulence, the Financial Stability Oversight Council has set out proposals that will bolster its ability to assess the systemic importance of non-bank financial organizations for Fed oversight.

02 May 2023 5 mins read
By Jennie Clarke

The Financial Stability Oversight Council (the FSOC) has voted unanimously to issue proposals that will change the way that it assesses financial stability risks, especially those posed by non-bank institutions. Following considerable market turbulence over the last few months, the FSOC is exploring ways to make it easier to bring non-bank institutions within the regulatory sphere, including hedge funds, insurers, and private equity firms.

In addition to proposals surrounding risks posed by non-bank institutions, the FSOC is also exploring proposals that will provide greater transparency to the public around how it “identifies, assesses, and addresses potential risks to financial stability”.

Commenting on the proposals, FSCO Treasury Janet Yellen said that they would make the Council “better equipped to handle risks to the financial system, whether they come from activities or firms”.

What do the FSOC’s proposals entail?

The FSOC has set out two proposals.

Firstly, it is exploring a new analytical framework.

Secondly, it is looking at new ways to bring non-bank financial companies into the regulatory perimeter, where necessary.

For the new analytical framework, the FSOC hopes to provide transparency to the public on how the Council carries out its duties. This proposal intends to educate market participants and the wider public on how the Council identifies, assesses, and responds to potential risks. As well as expanding out the range of asset classes that the Council monitors, this proposal specifies the vulnerabilities that the Council expects to consider when evaluating potential risks to financial stability.

Under the second proposal, that concerning non-bank financial companies, the FSOC is reviewing rules that authorize it to designate a non-bank financial company for Federal Reserve Supervision where it determines that “that material financial distress at the 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.”

In short, the proposals aim to make it easier for the Council to designate non-bank institutions as systemically important – therefore making it easier to subject them to Fed supervision. This is especially relevant for hedge funds and insurers who, because of an ongoing lack of regulatory oversight, hold the potential to cause far-reaching market disruption in the event of failure, if spill- overs were to occur.

The proposals, Yellen suggests, would put the regulatory body in a position of proactivity rather than reactivity where turbulence occurs.

“The authority for emergency intervention is critical. But equally as important is a supervisory and regulatory regime that can help prevent financial disruptions from starting and spreading in the first place”.

Why is the FSOC exploring new frameworks?

The recent collapse of Silicon Valley Bank (SVB) still looms large in the hearts and minds of many compliance officers. The pace at which SVB was drained of funds – caused partly by a social media- based run on the bank – was a timely reminder of the current state of modern banking frameworks. For some, SVB’s collapse brought back memories of the global financial crash of 2008 in which global weaknesses in financial services and compliance were exposed.

SVB has had a similar effect on the regulatory landscape. As Yellen notes:

“These developments have reminded many of the fear and uncertainty that can accompany financial disruptions […] the developments underscored the importance of our work on financial stability: to continue to improve the resilience of a financial system that can support the economy through good and bad times.”

With that in mind, financial regulators are looking afresh at the current financial services environment and probing for weaknesses.

One such weakness, which the FSOC seeks to address, is posed by Trump-administration era changes to financial rules and regulation. 2019 amendments to financial regulation, according to Yellen, “created inappropriate hurdles” that are neither “useful” nor “feasible”.

At present, the current process through which FSOC is able to determine the systemic importance of non-bank institutions can take up to six years to complete. This is an “unrealistic timeline”, given the pace of innovation, which could prevent regulators intervening in an emerging risk “before it’s too late”. Under the new proposals, this process would be streamlined – allowing the regulatory body to keep up with the pace of change within the organizations it oversees.

Along with time delays, 2019 amendments also saw a rolling back of the liquidity and capital requirements for banks who held between $100bn and $250bn in assets – a measure that the current Biden administration has called for the reversal of, and that the Federal Reserve’s Vice Chair of Supervision is reportedly reconsidering.

What happens next?

The two proposals will now go to a 60-day period of public comment, before further action is considered.

What does this mean for firms?

Regulation is a double-edged sword, and while many will welcome a revisiting of rolled-back regulation – others will doubtless be denouncing the FSOC as we speak. For now, the proposals remain just that, and implement no new obligations on firms, non-bank or otherwise.

However, it is useful to consider the FSOC’s proposals as a blueprint for upcoming regulatory direction and assume that non-bank organizations, especially larger or societally significant ones, may soon face greater regulatory scrutiny. Firms that have long been able to operate in the fringes of regulation, may soon be consumed. Such firms should take stock of their current compliance efforts and consider areas of weaknesses. As regulatory organizations seek to become more proactive, so too should the firms that fall under their regulatory umbrella.

Global Relay provides compliance technology for regulated organizations of all shapes and sizes, speak to the team to find out more.

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Published 02 May 2023

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