Why the Fed Won’t Say How It Will Regulate Nonbank SIFIs

The Federal Reserve Board finalized a massive set of new rules for banks this week governing everything from capital and liquidity requirements to stress tests.

But left unaddressed was how those new regulations would apply to nonbank firms, such as American International Group, GE Capital and Prudential, which are designated as systemically important.

"They're clearly not ready to do the rule now," said Oliver Ireland, a partner at Morrison Foerster and former associate general counsel at the Fed. "I think that it's a very difficult task."

The issue is one of the biggest unanswered questions concerning the post-financial crisis regulatory system. Under the Dodd-Frank Act, the Financial Stability Oversight Council has the power to name nonbank firms as systemically risky, but the Fed must decide how to supervise those companies. The FSOC has already designated three firms, but the Fed has not revealed what new standards they will face.

See also: Berkshire Said to Face Start of U.S. Systemic-Risk Scrutiny

At its board meeting on Tuesday, the central bank postponed addressing the issue, instead giving itself broad flexibility on how to proceed. Officials said they might utilize two options. They could either draft a separate rule that will pertain strictly to nonbank financial companies or issue an order for each individual firm based on a particular threat the Fed may perceive.

The Fed could drill down further and opt to do several rules based on either specific industries or activities.

Many deemed the Fed's approach to the issue as appropriate given the fact only three nonbanks have been designated as systemically important financial institutions.

See also: Top 5 Trends for 2014 – Regulation

Mary Miller, undersecretary for domestic finance at the Treasury Department, recently told the Senate Banking Committee that "a lot of attention has been paid to the business models, a lot of attention has been paid to the fact that you can't have that one size fits all approach to capital."

With so many firms in different lines of business and various corporate structures, observers said regulators need more time to understand the different risks before drafting meaningful rules.

"I don't think they've got it all figured out yet," said Douglas Landy, a partner at Milbank, Tweed, Hadley & McCloy. "They're definitely going to do it. They just haven't developed a framework for it yet."

Gil Schwartz, a partner at Schwartz & Ballen and a former attorney for the Fed, said the agency needs time to understand how to proceed given the differences among the firms.

"It really does require additional thought," said Schwartz. "You just can't impose bank-like standards without giving significant thought."

Earlier this month, Fed Gov. Daniel Tarullo told the Senate panel that regulators have been seeking to customize the rules for savings and loan companies, some of which are owned by insurance companies, and for firms designated by the FSOC.

One of the stumbling blocks facing the Fed, however, is the Collins amendment — a provision in the Dodd-Frank Act that imposes a floor for capital requirements for all institutions.

"We are trying to tailor, as we best we can, the capital requirement to take account of A) the particular product that insurance companies offer that banks do not, and B) the different business model," said Tarullo, at the hearing.

Several lawmakers have already stoked fears that the Fed will apply prudential rules intended for banks on firms like insurance companies, harming them in the process.

Observers said that the Fed's decision to postpone how such rules will apply may indicate they are leaning toward regulating SIFIs on a case-by-case basis through orders and other supervisory actions.

"I don't think there's another approach," said Ireland. "If you tried to do it by rules, the rules would be so sketchy and limited you would still be doing most of it by order and might not as well be doing that right."

During the meeting, Fed Gov. Sarah Bloom Raskin was the only board member to ask a question about the transparency of how the agency would proceed with its future plans when it comes to nonbank supervision.

Mike Gibson, director of banking supervision and regulation at the Fed, said the agency would make its process public, but ultimately regulators have not yet decided how it would do so.

Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc., said that exchange was critical, particularly given that Raskin has been nominated by Obama to serve as deputy Treasury secretary, and if confirmed would play a vital role on the FSOC.

This story first appeared at American Banker.