Financial Stability Improvement Act of 2009

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House draft


On Friday, the House Committee on Financial Services continued its mark-up of the Financial Stability Improvement Act of 2009. For the most part, the amendments considered were relatively non-controversial. The Committee’s mark-up sessions are scheduled to resume tomorrow.

The Committee passed an amendment offered by Chairman Barney Frank (D-MA) designed to ensure that systemically important institutions are only publicly identified when restrictions are simultaneously imposed upon those institutions. The amendment was widely supported as an alternative to creating a list of systemically important firms, a requirement that many Committee members opposed.

The Committee also passed a second amendment offered by Chairman Frank that would moderate the power wielded by the Federal Reserve in proportion to powers delegated to other regulators. The amendment would require that the Board of Governors of the Federal Reserve “consult with other Federal financial regulatory agencies” when creating standards that are likely to have a “significant impact on a functionally regulated subsidiary” of a financial holding company.

Several minor amendments were also adopted dealing with issues ranging from reporting requirements of the Financial Services Oversight Counsel to protection of employees in the event of the merger of the OCC and OTS.

A Republican amendment in the nature of a substitute to the Committee draft is currently pending but is not expected to pass the Committee. The Republican amendment would, among other things, amend the bankruptcy code to allow for the unwinding of financial institutions through bankruptcy and amend the Federal Reserve’s emergency powers under Section 13 of the Federal Reserve Act.

When the Committee resumes the mark-up on November 17, 2009, further amendments are expected to primarily concern the powers granted to the Federal Reserve under the Act and which companies would be subject to the Act.

Legislative overview

House Financial Services Committee Chairman Barney Frank introduced a discussion draft of the Financial Stability Improvement Act of 2009 (the "Act"), which addresses the regulation of systemic risk and the resolution of systemically important financial institutions. The Act also contains important provisions regarding thrift and industrial loan company charters, credit risk retention in connection with securitization transactions and the merger of the OTS into the OCC. The Act incorporates several pieces of the financial regulatory reform legislation proposed by the Obama Administration that were discussed in the July 28, 2009 Alert and the August 4, 2009 Alert.

The House Financial Services Committee has already held hearings on the Act, which included testimony by the Treasury Secretary and the heads of each of the federal banking agencies. Chairman Frank has scheduled a markup of the Act next week and hopes to have a vote on the Act as early as this week.

Financial Services Oversight Council

The Act would create the Financial Services Oversight Council (the "Council"), which would identify financial companies and financial activities that pose a threat to financial stability, and would subject those companies and activities to heightened prudential oversight, standards and regulation. The Council would also subject systemically important financial market utilities and payment, clearing and settlement activities to heightened oversight, standards and regulation. The Treasury Secretary would serve as the chair of the Council, whose other members would include the Chairman of the FRB, the Comptroller of the Currency, the Director of the OTS until it would be merged into the OCC, the Chairman of the FDIC, the Chairman of the SEC, the Chairman of the CFTC, the Director of the Federal Housing Finance Agency and the Chairman of the National Credit Union Administration. A state insurance commissioner and a state banking supervisor would also serve as non-voting members of the Council for terms of no longer than two years. The Council is designed to have the ability to coordinate responses by these member agencies to mitigate identified threats to financial stability and would annually report to Congress on significant financial market developments and potential emerging threats to the stability of the financial system.

The Council would not conduct examinations or enforce applicable laws with respect to any one institution, but would instead focus on identifying issues that threaten the broader economy. Rulemaking, examination and enforcement authority over systemically important financial institutions would be vested in the FRB. Although the FRB would write and enforce new regulations for systemically important financial institutions, the Council would advise Congress on financial regulation, monitor companies and activities that should be subject to tougher standards and issue formal recommendations that particular agencies should adopt. The federal financial agencies would be required to provide a written explanation to the Council within 60 days following such a recommendation stating the actions it had taken in response to the recommendation or the reason it did not adopt the recommendation. In the event of a dispute among agencies, the Act would allow the Council to make a binding decision. Under the original proposal by the Obama Administration, the interagency council could have advised the FRB or other regulators, but had no power over them.

The Council would not be an agency of the federal government and accordingly would not be subject to the Administrative Procedures Act, Freedom of Information Act or other such statutes governing the procedures of federal agencies. The Act also provides that the Council would not be subject to the Federal Advisory Committee Act. The staff of the Council would be detailed from the Treasury Department and other agencies. Funding for the Council would be provided equally from its voting members.

Systemic Risk Oversight And Regulation

The Act subjects financial firms or activities that pose significant risks to the financial system to heightened, comprehensive scrutiny by federal regulators. Such heightened standards would be imposed through a variety of options intended to be tailored to the specific threat posed to the financial system, as opposed to a "one size fits all" approach. The Administration and the House Financial Services Committee stated that regulators' "inability to see developments outside their narrow 'silos' allowed the current crisis to grow unchecked." Accordingly, the Act is designed to ensure constant communication and the ability to look across markets for potential risks through enhanced information gathering and sharing requirements for the Council and for all financial regulators, including the SEC and CFTC. The Council and the FRB would have the authority to require the submission of periodic and other reports from any financial company for the purpose of determining whether the company or a financial activity or market it participates in pose a threat to financial stability. The FRB would have the ability to recommend that the other federal financial regulators adopt heightened prudential standards for activities that are identified as posing a threat to U.S. financial stability or to the U.S. economy. The FRB would have back-up authority to step in if regulators do not act quickly to address developing problems identified by the Council.

As discussed above, the Act provides that the FRB would have rulemaking, examination and enforcement authority over systemically important financial institutions. The Act also provides that the FRB would have additional authorities to regulate systemically important payment, clearing and settlement systems. The FRB would be authorized to prescribe risk management standards for systemically important financial institutions and, after consulting with the Council and the relevant supervisory agency, for systemically important payment, clearing and settlement systems conducted by financial institutions. The Act would give the FRB the power to direct any large financial holding company to sell or transfer assets, or stop certain activities if the FRB determined there could be a "threat to the safety and soundness of such company or to the financial stability of the United States." The FRB would have the power to impose risk-based capital requirements, leverage limits, liquidity and concentration requirements. Such concentration requirements would prohibit systemically important financial institutions from having credit exposure to an unaffiliated company that exceeds 25 percent of the institution's capital stock and surplus, or a lower level if the FRB determines it to be prudent. Treasury Secretary Timothy Geithner stated in his testimony before the House Financial Services Committee that such heightened standards "would provide strong incentive for these firms to shrink, simplify and reduce their leverage." The FRB could also recommend that the primary federal regulator for any subsidiary of a financial holding company raise capital standards and take other actions. If the agency did not comply with such recommendation, it would have to provide a written explanation to the FRB and the Council within 60 days. The FRB would also have the power to place any systemically important financial institution it determines to be critically undercapitalized into bankruptcy.

The Act does not provide specific requirements that would subject a financial company to heightened prudential standards. Rather, the Council may subject any financial company to heightened prudential standards if it determines that material financial distress at the company or the nature, scope or mix of the company's activities could pose a threat to financial stability of the economy. The heightened prudential standards could also be imposed on a foreign financial company that owns or controls a federal or state branch, subsidiary or operating entity that is identified as being systemically significant. When determining whether a company should be subject to the heightened prudential standards, the Act provides that the Council should consider (i) the amount and nature of the company's financial assets; (ii) the amount and nature of the company's liabilities, including the degree of reliance on short-term funding; (iii) the extent and nature of the company's off-balance sheet exposures; (iv) the extent and nature of the company's transactions and relationships with other financial companies, (v) the company's importance as a source of credit for households, businesses, and state and local governments and as a source of liquidity for the financial system; (vi) the nature, scope and mix of the company's activities; and (vii) any other factors that the Council deems appropriate. The Council would periodically review the list of systemically important financial institutions to determine whether they should remain subject to heightened prudential standards.

The Act prohibits the disclosure of the identity of the systemically important financial institutions subject to these heightened standards. However, many commentators have noted that those institutions which are publicly-held would probably have to disclose that they are subject to the heightened prudential standards under the SEC's reporting requirements. In his testimony before the House Financial Service Committee, FRB Governor Daniel Tarullo noted that "through some disclosure to shareholders and analysts, it's likely most, if not all institutions, will be known to the public." Secretary Geithner agreed, stating that "[i]t won't be a secret that they're held to tougher standards, it's very important that they are held to the tougher standards and you know that they're held to tougher standards." Chairman Frank, however, observed that the disclosure of the identity of those institutions would exacerbate moral hazard. "There's the argument that, once people know that certain institutions are of a certain size, they'll be protected," he said; "[t]hat's why many of us rejected the notion that there be a list published beforehand."

Consolidated Regulation Of Bank Holding Companies

The Act is designed to consolidate regulation of bank holding companies to prevent companies from avoiding regulation under the Bank Holding Company Act of 1956, as amended (the "BHCA"). The Act would remove the Gramm-Leach-Bliley Act restraints on the FRB's authority over companies subject to consolidated regulation and would provide specific authority to the FRB and other federal financial agencies to regulate bank holding companies for financial stability purposes and to address potential problems.

Supervision Of Thrifts

Under the Act, in an attempt to prevent "regulatory arbitrage" the OTS would be merged into the OCC within one year of the Act's enactment. Unlike the Administration's proposal, the Act preserves the mutual and stock thrift charters, which would be regulated under a new division of the OCC headed by a deputy comptroller. Savings and loan holding companies would be supervised by the FRB. All functions of the OTS relating to the supervision and regulation of state savings associations would be transferred to the FDIC. The Act provides that federal mutual holding companies would be allowed to elect to waive dividend payments to the top tier mutual interest. The seat on the Board of the FDIC, which is currently held by the Director of the OTS, would be transferred to the Chairman or a Governor of the FRB.

Industrial Loan Companies And Non-bank Banks

The Act would close exemptions in the BHCA for industrial loan companies and other non-bank financial institutions. Commercial enterprises that currently own thrifts, non-bank banks, industrial loan companies, and other similar financial institutions but are not currently subject to bank holding company regulation would not have to divest such financial institutions, but would have to be restructured to create an intermediate bank holding company to hold all financial activities and would face limits on transactions between the bank holding company and any commercial affiliates.

Companies would have 90 days following the enactment of the Act to restructure or register as a bank holding company. If a company does not comply within 90 days, which the FRB could extend by an additional 180 days, it would have 180 days to divest its financial institution. Going forward, the Act would prohibit any additional commercial companies from owning banks, thrifts, industrial loan companies, or other specialty bank charters.

Credit Risk Retention For Securitizations

The Act directs the federal banking regulators and the SEC to write rules jointly requiring creditors to retain ten percent or more of the credit risk associated with any loans that are transferred or sold, including for the purpose of securitization. The regulators would be permitted to adjust the level of risk retention above or below ten percent, but could not adjust such level below five percent. In the case of securitizations that are not originated by creditors, regulators would require the securitizer to retain the credit risk.

Resolution Of Systemically Important Financial Institutions

The Act provides for the orderly resolution of failing systemically important financial institutions to ensure that the stability of the overall financial system is protected and is intended to end the idea that some institutions are "too big to fail." The Act provides that, following a determination by the Treasury Secretary, the FDIC would resolve failing systemically important financial institutions in order to unwind existing contracts, address creditors' claims, and ensure that parties required to bear losses do so.

Under the Act, the Treasury Secretary could only make the determination to resolve a systemically important financial institution for the purpose of financial stability, not to preserve that particular institution. The Act also provides for the removal of the management responsible for the failure of the institution.

The Act is designed to create a more flexible resolution process that would help prevent contagion and disruption to the entire system and the overall economy unlike traditional bankruptcy, which the Administration and Chairman Frank believe does not account for complex interrelationships of such large financial firms and may endanger financial stability. The Act also provides that systemically important financial institutions would be required to prepare resolution plans that would have to be updated annually.

Costs associated with the resolution of systemically important financial institutions would be repaid first from the assets of the failed firm at the expense of shareholders and creditors and, to the extent of any shortfall, from assessments on financial firms with assets of $10 billion of more.

The Administration has indicated that such assessments would be levied over a flexible repayment period to avoid the potential procyclical effect of such assessments.

In her testimony to the House Financial Services Committee, FDIC Chairman Sheila Bair argued that a permanent resolution fund managed by the FDIC should be established, similar to the Deposit Insurance Fund, which would be pre-funded by regular risk-based assessments on financial institutions with assets of at least $10 billion.

Chairman Frank has stated that he will offer an amendment providing for up-front assessments on financial institutions with assets of over $10 billion.

Secretary Geithner has reiterated his opposition to such up front assessments.

Chairman Bair further argued that such a resolution fund should be authorized to borrow from the Treasury Department and any borrowings would be repaid by the financial institutions that must contribute to the resolution fund.

Limits On Section 13(3) Of The Federal Reserve Act

The Act would require the FRB to obtain the prior written consent of the Secretary of the Treasury before it provides temporary liquidity assistance pursuant to section 13(3) of the Federal Reserve Act. Such assistance would be confined to generally available facilities rather than assistance to a particular financial institution and would only be used to provide liquidity to solvent institutions during period of severe stress in the financial markets or the U.S. economy. In his testimony to the House Financial Services Committee, Governor Tarullo emphasized the importance of the FRB, "as the nation's central bank, [to] retain its longstanding authority to address broader liquidity needs within the financial system under section 13(3) when necessary to maintain financial stability."


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