This post is an in-depth follow up to Scott’s article “Trump Has Been Elected: What Next For Financial Services?” that ran in Bloomberg.  The original article can be found here.

As the financial services sector and Republican politicians draft the obituary of the Dodd-Frank Act, it remains to be seen whether that landmark legislation will be survived by the Financial Stability Oversight Council (“FSOC”). Whether FSOC itself survives the advancing wave of deregulation, however, it seems increasingly likely that the FSOC’s reasons for existing will not.

Section 111 of the Dodd-Frank Act created the inter-agency FSOC, made up of the heads of eight independent financial regulators and chaired by the Secretary of the Treasury. In general, the FSOC is tasked with identifying and responding to risks to the financial stability of the U.S. financial system and with encouraging discipline in the financial services market.  Like the Department of Homeland Security, the FSOC was created to centralize across federal agencies the analysis and response to financial security threats.

In particular, the FSOC was vested with the authority to determine whether a bank or nonbank financial institution with more than $50 billion in assets is subject to heightened regulation as a “systemically important financial institution” or “SIFI.” SIFIs are the latest incarnation of financial institutions that have long been called “too big to fail,” because they are critically important to our financial system.

In its short life, the FSOC has voted to designate four nonbank financial companies as systemically important: American International Group, Inc., General Electric Capital Corporation, Inc., Prudential Financial, Inc., and MetLife, Inc.  In 2016, the FSOC voted to rescind that designation for GE Capital, since it significantly restructured itself over the past three years.  Also in 2016, a D.C. federal district court overturned the FSOC’s designation that MetLife – the largest life insurance company in the United States – was a SIFI.  The district court concluded that the FSOC’s designation was based on “fundamental violations of established administrative law” and therefore was “arbitrary and capricious.”  That decision is now on appeal.  As a result, only two nonbank companies remain in the category “systemically important.”

The FSOC also was empowered to designate financial market utilities (or FMUs) as systemically important. The FSOC has designated eight clearing services – such as the Clearing House Payments Company, the Chicago Mercantile Exchange, and the Depository Trust Company – as systemically important FMUs without incident.

House Republicans have criticized the FSOC as a “politicized” structure and part of a “‘shadow regulatory system’ that is both contrary to democratic principles and harmful to the U.S. economy.” Following the November elections, House Financial Services Committee Chair Jeb Hensarling claimed the FSOC is not “adding value to our economy” and as a result it should be tossed “in the trash bin.”  “I do not believe any institution in America is too big to fail,” according to Representative Hensarling.

In the 114th Congress, House Republicans introduced legislation that called for:

  • limiting when the FSOC can designate a nonbank financial institution for heightened supervision;
  • allowing a financial services company to eliminate risk on its own rather than being designated “systemically important”;
  • making the FSOC subject to the traditional congressional budget and appropriation process; and
  • replacing the $50 billion threshold for bank SIFI designations with a multi-factor test.

Earlier this year, Representative Hensarling introduced the “Financial CHOICE Act of 2016,” which passed his Financial Services Committee and goes even further than his Republican colleagues’ other proposals. Among other forms of deregulation, the CHOICE Act would retroactively repeal the FSOC’s authority to designate nonbank financial companies as “systemically important.”  Similarly, the CHOICE Act would retroactively repeal Title VIII of the Dodd-Frank Act, which gives the FSOC authority to designate financial market utilities as systemically important.  In short, the CHOICE Act would legislate away the FSOC’s most important reasons for existing.

Representative Hensarling is preparing to introduce a revised version of the CHOICE Act (what he calls a “2.0 version”) early in the new Congress. Increasing congressional oversight and neutering the FSOC as a distinct regulator can be expected to be part of the legislation.  Republican legislators will need to offer some concessions to Democrats in order to avoid a filibuster, but the regulatory power of the FSOC will hardly be seen as a grenade worth falling on for the Democrats.  In spite of its important statutory mandate, the structure and authority of the FSOC is something only a Washington bureaucrat could love.  At least for the FSOC, government regulation of institutions that are too big to fail has likely become too big to survive.

In May, we reported on the judicial rescission of MetLife’s designation as an entity “too big to fail,” and noted that the court’s decision provided designated companies with a framework to challenge their designation.  Another effective option is to fundamentally change the nature of the business, which is what GE Capital Global Holdings, LLC (“GE”) has done over the past three years.  As a result, on June 28, 2016, the Financial Stability Oversight Council (“FSOC”) determined that GE is no longer too big to fail and released GE from the heightened regulatory standards and oversight imposed upon designated entities.  This is first time FSOC has released an entity from the “SIFI” designation.

Three years ago, the FSOC identified GE as a systemically important institution whose failure would pose a threat to the country’s financial stability and accordingly, would be subject to a heightened level of regulatory scrutiny, additional capital requirements, and other government oversight. In response, however, GE transformed itself.  Working with FSOC staff to assure that its changes would result in a rescission as part of FSOC’s annual reevaluations of GE’s status, GE made deliberate and significant changes to its business to minimize the risk to the U.S. economy.  Its efforts included detangling itself from various financial markets, divesting business lines, and significantly restructuring its operations and corporate structure.  In March 2016, GE requested that FSOC rescind its designation.  Three months later, the FSOC agreed.  Now, only two non-financial institutions remain SIFIs, and experience has proven two paths to de-designation:  direct legal challenge or substantial, targeted business restructuring.

FSOC’s rescission of GE’s designation provides some insight into what factors matter most for liberating a company from the designation’s enhanced standards.  One takeaway is that it matters not just to reduce the size of the organization, but how that reduction minimizes potential threat to the country’s financial stability.  FSOC found that GE had “fundamentally changed its business” and become a “much less significant participant in financial markets and the economy.”  GE’s march to de-designation tracked the core areas of risk that FSOC identified when it first designated GE as too big to fail:

  • In 2013, GE had total assets that exceed $549 billion; now, it has divested more than 50 percent of those assets, while at the same time nearly tripling the percent of its liquid assets.
  • GE was once the most substantial player in the commercial paper market; now, its presence is nominal.
  • At one point, distress at GE could have caused money market funds to buck the dollar; now, no money market funds hold GE commercial paper, eliminating that risk.
  • GE once had lines of credit at over fifty banking institutions; now, GE has just a single line of credit to its parent, significantly reducing its direct interconnectedness with large financial institutions (though the parent has lines of credit at over forty banks).
  • GE’s financing operations had touched over 56 million consumers and businesses; now, its financing transactions relate only to its industrial activity (e.g., aircraft-related lending).
  • GE’s funding model had a significant (and systemically dangerous) focus on short-term funding; now, GE has increased reliance on long-term debt.
  • GE’s corporate structure was so complex that distressed restructuring would have been virtually impossible, with the ability to maintain going concern value sacrificed; now, GE has a simplified corporate structure that would lend itself to distressed restructuring, if necessary.

All this is not to say that GE is small, by any means:  the FSOC reiterated that GE remains a substantial and complex market participant.  The focused yet substantial shift in the nature and scope of GE activities, however, has extricated GE from SIFI status and will allow it to continue to sharpen its focus on its core industrials business.

 

The determination by the Financial Stability Oversight Council (“FSOC”) that MetLife, Inc. (“MetLife”) could “pose a threat to the financial stability of the United States” was recently rescinded by the District Court for the District of Columbia.[1] Administrative law provided the grounds for the court’s conclusion that, in designating MetLife as “too big to fail,” FSOC failed to follow: (1) recent Supreme Court precedent requiring consideration of the costs and benefits of an administrative action; and (2) the agency’s own guidance.  The court’s decision provides a framework for other designated companies who have received a similar designation and seek to challenge that status.[2]  The decision also poses a hurdle for further designations by FSOC, which, in addition to following its own guidance, must consider whether the costs of designation to the company outweigh the benefits of heightened regulation.

Background

Dodd-Frank[3] established FSOC to, among other things, identify risks to financial stability in the United States that could “arise from the material financial distress or failure” of nonbank financial companies.[4]  A nonbank financial company designated by FSOC as too big to fail becomes subject to Federal Reserve supervision and heightened regulatory standards, such as higher capital requirements.  In 2012, FSOC issued the Guidance for Nonbank Financial Company Determinations (the “Guidance”), which organized ten statutory factors into six categories, further subdivided into two groups.[5]  FSOC intended the first group “to assess the potential impact of the nonbank financial company’s financial distress on the broader economy,” and the second group “to assess the vulnerability of a nonbank financial company to financial distress.”

In 2014, after more than a year of meetings between FSOC and MetLife, the evaluation of more than 21,000 pages of materials, and a hearing, FSOC designated MetLife as a “nonbank financial company.” FSOC anchored its conclusion on four findings:  (1) exposed counterparties would potentially suffer substantial losses if MetLife underwent material financial distress; (2) this financial distress would potentially cause MetLife to liquidate assets rapidly, upsetting capital markets; (3) the existing regulatory framework would not stop either (1) or (2) from occurring; and (4) “MetLife’s complexity would hamper its resolution and thus ‘prolong uncertainty, requiring complex coordination among numerous regulators, receivers, or courts that would have to disentangle a vast web of intercompany agreements.’”  With this designation, MetLife joined the ranks of American International Group, Prudential Financial Inc., and General Electric, the only other entities to have been designated nonbank financial companies.

MetLife filed a complaint against FSOC challenging the designation. On March 30, 2016, the District Court found that FSOC’s determination was “arbitrary and capricious” and rescinded MetLife’s designation.

Standard of Review

Under Dodd-Frank, district courts may rescind FSOC’s designation only upon a conclusion that it was “arbitrary and capricious.” This narrow and highly deferential standard of review requires only that the court find a rational basis for FSOC’s decision.  To rescind, the court must find that FSOC departed from its prior policy or rules without providing sufficient justification.

With respect to MetLife, the District Court concluded that FSOC’s designation process was “fatally flawed.” FSOC “critical[ly] depart[ed]” from standards previously adopted in its guidance, and FSOC’s intentional disregard of the “downside cost” considerations to designating MetLife ignored recent Supreme Court standards.

Cost-Benefit Analysis Necessary For Dodd-Frank Administrative Decisions

FSOC’s intentional exclusion of cost considerations rendered its determination arbitrary and capricious under recent Supreme Court precedent. The Supreme Court’s decision in Michigan v. Environmental Protection Agency provided that cost-benefit analyses may be imputed:  a statute’s use of the word “appropriate” “naturally and traditionally includes consideration of all relevant factors.” [6]  The Supreme Court found cost to be an “important aspect of the problem” and noted that “any disadvantage could be termed a cost.”  In its analysis, however, FSOC ignored cost considerations, arguing that Dodd-Frank does not require FSOC to perform a cost-benefit analysis.

MetLife argued that the heightened regulatory standards associated with its designation would “impos[e] billions of dollars in cost [that] could actually make MetLife more vulnerable to distress.” FSOC’s designation actually did “foist[] ‘billions of dollars’ of regulatory costs” upon MetLife.  The District Court explained that, because the “cost-benefit analysis is a central part of the administrative process,” “cost must be balanced against benefit because ‘[n]o regulation is ‘appropriate’ if it does significantly more harm than good.”[7]  The District Court found it “impossible” to determine whether FSOC’s designation of MetLife as systemically important “does significantly more harm than good.”  Significantly, the District Court anticipated that the line of cases on which FSOC anchored its disregard of cost is unlikely to survive Michigan.

FSOC’s Process “Critically” Departed From Its Guidance

The District Court determined that FSOC’s analysis deviated materially from the analytical, dual-group process established in the Guidance. FSOC ignored the grouping entirely and applied all six categories as if they “were meant only ‘to assess the potential effects of a company’s material financial distress.’”  The court found this to be “undeniably inconsistent” and “inarguably different” from the framework established by the Guidance.  According to the District Court, “[t]he distinction [in the Guidance] was clear:  FSOC intended the second group of analytical categories to assess a company before it became distressed and the first group to assess the impact of such distress on national financial stability.”

The District Court also found that, when analyzing MetLife’s potential threat to the financial system, FSOC failed to apply the standards delineated in the Guidance. The Guidance interpreted the statutory phrase “could pose a threat to the financial stability of the United States”[8] to mean that a nonbank financial company could only be deemed a threat “if there would be an impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy.”[9]  The Guidance explains that “significant damage on the broader economy” could occur through one of three “transmission channels:” (1) exposure,[10] (2) asset liquidation,[11] or (3) critical function or service.[12]  The District Court concluded that FSOC not only failed to “abide by that standard,” it “hardly adhered to any standard when it came to assessing MetLife’s threat to U.S. financial stability.”  For example, in its analysis of the exposure channel, FSOC “merely summed gross potential market exposures” while failing to consider mitigating factors, like collateral.  FSOC also applied the phrase “could sustain losses” throughout its analysis, but it neglected to quantify the losses in any way.  Such generalized assumptions were found to “pervade the analysis” so that “every possible effect of MetLife’s imminent insolvency was summarily deemed grave enough to damage the economy.”  The District Court concluded that, although the mode of thinking reflected by FSOC’s analysis was “entirely consistent” with Dodd-Frank, it “was not the standard invoked by FSOC.”  And thus, FSOC’s assumption of damage, without explaining how it would result, was “in contravention of the Guidance.”

Final Considerations

The Court’s rescission of FSOC’s determination provides two potential paths for institutions seeking to avoid or appeal a designation of systemic importance. If an entity can show that the costs of heightened regulation exceed the potential benefit of that regulation, FSOC’s determination can potentially be avoided or rescinded.  The necessity of a cost-benefit analysis may be the linchpin entities need to argue against designation under Dodd-Frank.  Furthermore, because the MetLife decision presents the Guidance as FSOC’s roadmap for designation, companies should look closely at the Guidance to assure that their operations do not lend themselves to designation or that a designation has not been inappropriately made.

[1].      MetLife, Inc. v. Financial Stability Oversight Council, Civil Action No. 15-0045 (RMC) (D.D.C. March 30, 2016).

[2].      Shortly after the MetLife decision, General Electric—one of four nonbank entities to ever earn the designation—filed a request with FSOC for the rescission of its designation as too big to fail.

[3].      Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376-2223, codified at 12 U.S.C. §§ 5301 et seq. (2010)

[4].      FSOC consists of the heads of certain federal financial regulatory bodies, including the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, the Chairman of the Securities and Exchange Commission, and the Chairperson of the Federal Deposit Insurance Corporation. https://www.treasury.gov/initiatives/fsoc/about/Pages/default.aspx

[5].      77 Fed. Reg. 21,637 (FR); codified at 12 C.F.R. § 1310. The six categories are:  interconnectedness, substitutability, size, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny.  76 Fed. Red. 4,555 (Jan 26, 2011).  12 C.F.R. § 1310 App. A.II.d.

[6].      Michigan v. Environmental Protection Agency, 135 S. Ct. 2699 (2015).

[7].      The Federal Reserve recently proposed a new rule that would affect financial contracts like those that destabilized financial markets after Lehman Brothers Holdings, Inc.’s 2008 collapse.  The proposed rule preemptively applies the cost-benefit analysis required by Michigan and is intended to reduce the risk when large financial institutions fail.  It explicitly considers the relatively small cost of the rule against the benefits to financial stability. See Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 12 CFR Parts 217, 249, and 252.

[8].      12 U.S.C. § 5323(a)(1).

[9].      12 C.F.R. §1310 App. A.II.a.

[10].    The Guidance defines the “exposure channel” to mean: “A nonbank financial company’s creditors, counterparties, investors, or other market participants have exposure to the nonbank financial company that is significant enough to materially impair those creditors, counterparties, investors, or other market participants and thereby pose a threat to U.S. financial stability.” 12 C.F.R. §1310 App. A.II.a.

[11].    The Guidance describes how financial distress could destabilize the U.S. through the “asset liquidation channel”:  “A nonbank financial company holds assets that, if liquidated quickly, would cause a fall in asset prices and thereby significantly disrupt trading or funding in key markets or cause significant losses or funding problems for other firms with similar holdings.  This channel would likely be most relevant for a nonbank financial company whose funding and liquid asset profile makes it likely that it would be forced to liquidate assets quickly when it comes under financial pressure.”  12 C.F.R. §1310 App. A.II.a.

[12].    Op. at 9; 12 C.F.R. §1310 App. A.II.a.