A key political hot button throughout the regulatory reform debate has been the treatment of firms that are viewed as posing systemic risk to the United States financial services industry.  The government assistance provided to some larger firms was a polarizing item to the American public, and there was widespread call for increased oversight of these institutions.

Out of the debate grew the Financial Stability Oversight Council, which is the central body of the conference text of the Financial Stability Act of 2010, a part of the regulatory reform bill.  This council, which will be composed of high ranking officials from various governmental and regulatory authorities, including the Federal Reserve, the OCC, the FDIC, the SEC, and the new Consumer Financial Protection Bureau, will serve as the “new sheriff in town” with respect to large financial institutions (with consolidated assets of $50 billion or more) and other large nonbank financial companies that the council deems necessary to place under regulatory oversight.  The Secretary of the Treasury will serve as Chairperson of the council.

Among the purposes delineated for the council is “to promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties of such [regulated] companies that the Government will shield them from losses in the event of failure.”  The primary tool to be used by the council in achieving this purpose is placing certain large firms under Federal Reserve supervision.

The Federal Reserve will develop prudential standards to help mitigate the risks presented by these large firms.  The council will make recommendations to the Federal Reserve with respect to the prudential standards.  These recommendations may relate to risk-based capital, leverage, and liquidity, among other things.  In addition, with approval of the council, the Federal Reserve may limit a firm’s ability to expand through mergers and acquisitions, restrict its ability to offer certain products and services, require termination of one or more financial activities or impose conditions on such activities,  and, if deemed necessary, require spin-offs of assets or off-balance sheet items held by a firm.

A key function of the council will be determining which nonbank financial companies will fall under the supervision of the Federal Reserve.  Generally, the council may determine that a nonbank financial company should be regulated by the Federal Reserve if the council determines that material financial distress of the company, or the nature, size and scope of the activities of the firm, could pose a threat to the financial stability of the United States.  Factors to be reviewed in the determination include the extent of leverage of the company, the extent and nature of the company’s off-balance sheet activities, the importance of the company as a source of credit, and other risk-related factors.

The determination of which nonbank financial companies will be brought under the regulation of the Federal Reserve will be made by the council by a two-thirds vote, which must include the affirmative vote of the Chairperson.  This veto power will amplify the importance of the Secretary of the Treasury in financial regulation.  Because of the broad discretion given to the council in the bill, the activities of the council and the reactions by firms that may be brought under the prudential standards established by the Federal Reserve will be very interesting to observe.

In addition, the market will closely watch the prudential standards to be developed for the regulated firms in accordance with the council’s recommendations.  These standards will be intended to mitigate risks to the financial system and also eliminate expectations of government assistance for these firms.  In order to accomplish these goals, one might expect conservative regulation of these systemically important institutions.