US Treasury publishes takeover guidelines for ‘systemically important’ nonbanks

The two-stage process is based on analysis of common risks and 'transmission channels.'

The Biden administration has laid out a two-stage process by which federal regulators may take over a stricken private equity, hedge or other nonbank funds to protect the wider economy.

Officials on the Department of Treasury’s Financial Stability Oversight Council voted Friday to approve two guidance documents explaining when and how authorities will designate a nonbank financial institution “systemically important.”

The first is an interpretive guidance document. It lays out the two stages nonbank firms can expect to go through if regulators worry they pose a systemic risk to the economy. The second document says that regulators will analyze a firm’s resilience to eight common vulnerabilities – including leverage, “liquidity risk and maturity mismatch,” concentration, “operational risks” and others – against the firm’s “transmission channels.”

Sec 113 of the Dodd-Frank Act says nonbank firms are “systemically important” if their “material financial stress – or the nature, scope, size, scale, concentration, interconnectedness, or mix of its activities” – threatens economic stability. Such companies are subject to “consolidated supervision” and “enhanced prudential standards” by the Federal Reserve.

Those laws and rules came after the Great Recession. The Trump administration took a much softer approach to systemic risk, adopting guidelines that required regulators to consider a dizzying array of factors and to conduct a cost-benefit analysis before taking over a wobbly company. Friday’s vote replaces those guidelines.

‘Black box’

“Nonbank financial institution” is a broad category that includes insurance companies, currency exchanges and pension plans. Since Dodd-Frank took effect, only four companies have ever been designated “systemically important,” all of them insurers. By the numbers, though, the new guidelines threaten investment advisers the most. According to an April analysis by the International Monetary Fund, investment funds (including money market and hedge funds) account for about 15 percent of the world’s nonbank assets. Insurance companies and pension funds are the next largest sectors, accounting for 9 percent each, the IMF says.

Private fund advocates fought against Friday’s guidelines and condemned them immediately after the vote. They’re “flawed,” Managed Fund Association President and CEO Bryan Corbett said in an email statement, and “will hurt financial stability.” The two-stage “black box designation process,” he added, “introduces uncertainty for market participants, harming their ability to deliver for their investors, including pensions, foundations, and endowments.”

“For the health of the U.S. capital markets,” Corbett said, “FSOC should set aside its entity designation focus and continue to work with primary regulators to address risk.”

Under Friday’s interpretative guidance, regulators will give nonbank firms 60 days’ notice before the Council votes on whether to move the company into stage two, “an in-depth review of a nonbank financial company using information collected directly from the company.”

During that second stage, the Council can consider a so-called “proposed determination,” which would require a two-thirds vote of the Council. The company can then request an administrative hearing before the Council to challenge the designation. From there, the process moves to a “final determination.” A final determination requires a two-thirds Council majority and also a “yes” vote from the Council’s chair, the new guidelines state. After that, the company’s “systemically important” designation will be reviewed every year, the guidelines state.