By Terry Flanagan

Firms Balk at Fed Oversight

Bar is set too low, industry group says.

Financial markets firms say that the bar for determining whether a non-bank financial company should be subject to Fed supervision is set too low.

FinReg authorizes the Financial Stability Oversight Council (FSOC) to determine that a nonbank financial company will be supervised by the Board of Governors and be subject to prudential standards if two standards are met.

Under the first standard, the FSOC may subject a nonbank financial company to Fed supervision if it determines that “material financial distress” at the company could pose a threat to the financial stability of the United States.

Under the second standard, the FSOC may make a determination based on the nature, scope, size, scale, concentration, interconnectedness or mix of the company’s activities.

The Financial Services Roundtable, an industry trade group, claims that the rules would subject many firms to supervision solely because of their use of derivatives.

The FSOC rules set a “tripwire” of $3.5 billion for derivatives liabilities, above which firms could be subject to Fed supervision.

“We believe that the $3.5 billion tripwire for derivatives liabilities is too low for larger companies,” the Financial Services Roundtable said. “For larger companies, losses from $3.5 billion derivatives portfolio are not sufficient to endanger the company or to meet the definitions of ‘threat to the financial stability of the United States’ or ‘material financial distress.’”

As an alternative to a fixed $3.5 billion tripwire, the Roundtable recommends that the Council adopt a tripwire based upon a percentage of the size of the company.  For example, if the percentage is set at 7 percent, the tripwire would be $3.5
billion for a company with $50 billion in consolidated assets, and $7 billion for a company with $100 billion in consolidated assets.

It’s also unclear whether the definition of a derivative liability would include derivatives embedded in contracts where there is no derivative counterparty and thus no exposure to the financial markets.

“The Council may have unintentionally brought into scope embedded derivatives with no counterparty risk,” the Roundtable said. “We recommend the language regarding the derivative liability threshold exclude these types of embedded derivatives.”

An embedded derivative is a provision in a contract that modifies the cash flow of a contract by making it dependent on some underlying measurement. Like traditional derivatives, embedded derivatives can be based on a variety of instruments, from common stock to exchange rates and interest rates.

In an appendix to the proposed rule, the FSOC issued “guidance” for nonbank financial company determinations. The guidance outlines a three-stage process of increasingly in-depth evaluation leading to a determination.

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