FSOC Releases Proposed Rules and Guidance on
Designation of Systemically Important Nonbank
Financial Companies
October 24, 2011
On October 11, 2011, the Financial Stability Oversight Council (the “FSOC”) issued a second
notice of proposed rulemaking and interpretive guidance (the “NPR”) regarding the standards
and process that it will use to determine whether a nonbank financial company1 should betreated as “systemically important” and, therefore, subject to supervision by the Board ofGovernors of the Federal Reserve System (the “Federal Reserve”) and prudential standards inaccordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act (“DoddFrank”). The FSOC issued a notice of proposed rulemaking earlier this year on this topic, which
was criticized as being too vague. Although the body of the regulation included in the NPR
remains somewhat skeletal, primarily repeating the statutory language, the FSOC added anappendix that provides significant additional guidance on how it will make suchdeterminations. In particular, the NPR outlines a three-stage process that the FSOC intends tofollow in non-emergency situations and provides a detailed description of the analysis theFSOC intends to conduct during each stage of its review. Comments on the FSOC’s proposal
are due by December 19, 2011.

THREE-STAGE DETERMINATION PROCESSThe NPR proposes a three-stage process by which the FSOC will determine whether todesignate a nonbank financial company for supervision by the Federal Reserve and prudential
standards. In Stage 1, the FSOC will seek to identify nonbank financial companies that meritindividual review by applying six uniform quantitative thresholds (discussed below), using
publicly available and regulatory data. If the FSOC determines that a company meets therequirements of Stage 1, it will proceed to Stage 2 of its review, conducting an individual review
based on a broad range of qualitative and quantitative, company- and industry-specificinformation, available primarily through public and regulatory sources. A nonbank financial
company that meets the requirements of Stage 2 will proceed to Stage 3, a comprehensive
review that incorporates information collected directly from the company on a confidential
basis. At the conclusion of a review that reaches Stage 3, the FSOC will determine whether or1Title I of Dodd-Frank defines a “nonbank financial company” as a domestic or foreign company thatis “predominantly engaged in financial activities” in the United States, other than bank holding
companies and certain other types of firms. In general, “predominantly engaged” means 85% ofconsolidated annual gross revenues or total assets are from financial activities. The FSOC intends tointerpret the term “company” broadly, to include any corporation, limited liability company,
partnership, business trust, association (incorporated or unincorporated), or similar organization.

Memorandum – October 24, 2011

not to designate the nonbank financial company and thereby subject it to Federal Reserve
supervision and prudential standards. Designated companies will have rights of appeal.

STANDARD UNDER DODD-FRANK AND THE FSOC’S PROPOSED SIXFACTOR ANALYSIS
Dodd-Frank authorizes the FSOC to subject a nonbank financial company to supervision by theFederal Reserve and prudential standards if the FSOC determines that either: (i) “materialfinancial distress” at the nonbank financial company or (ii) the nature, scope, size, scale,concentration, interconnectedness, or mix of the nonbank financial company’s activities could
pose a threat to the financial stability of the United States.
Section 113 of Dodd-Frank lists ten considerations that the FSOC must take into account inmaking such determination,2 which the FSOC has condensed into a six-category analyticalframework: (i) interconnectedness, (ii) substitutability3, (iii) size, (iv) leverage, (v) liquidity risk
and maturity mismatch, and (vi) existing regulatory scrutiny.

QUANTITATIVE STANDARDS FOR STAGE 1
The first stage in the FSOC’s determination process involves a review of certain quantitative
information relating to a particular nonbank financial company. Because the FSOC is relying on
quantitative thresholds using publicly available data in the first stage, nonbank financial
companies should be able to assess whether they are likely to be subject to further evaluation by
the FSOC, though, as noted below, the FSOC also has authority to consider information that is
not captured by these quantitative thresholds.
The FSOC has identified six quantitative thresholds, deriving from four of its analytical factors(size, interconnectedness, leverage, and liquidity risk and maturity mismatch). The FSOC will

2The statutory factors are: (i) the extent of the leverage of the company; (ii) the extent and nature of
the off-balance sheet exposures of the company; (iii) the extent and nature of the transactions andrelationships of the company with other significant nonbank financial companies and significant
bank holding companies; (iv) the importance of the company as a source of credit for households,
businesses, and state and local governments and as a source of liquidity for the U.S. financial system;(v) the importance of the company as a source of credit for low-income, minority, or underserved
communities, and the impact that the failure of such company would have on the availability ofcredit in such communities; (vi) the extent to which assets are managed rather than owned by thecompany, and the extent to which ownership of assets under management is diffuse; (vii) the nature,
scope, size, scale, concentration, interconnectedness, and mix of the activities of the company; (viii)
the degree to which the company is already regulated by one or more primary financial regulatory
agencies; (ix) the amount and nature of the financial assets of the company; (x) the amount and typesof the liabilities of the company, including the degree of reliance on short-term funding; and (xi) any
other risk-related factors that the FSOC deems appropriate.

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The NPR describes “substitutability” as the extent to which other firms could provide similar
financial services in a timely manner at a similar price and quantity if the nonbank financial company
withdraws from a particular market.
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Memorandum – October 24, 2011progress to Stage 2 of its review if the company meets both the “total consolidated assets”
threshold and any one of the five other quantitative thresholds, as set forth below:
Total Consolidated Assets. $50 billion in global total consolidated assets for U.S. nonbank
financial companies or $50 billion in U.S. total consolidated assets for foreign nonbank
financial companies. This threshold is consistent with the Dodd-Frank threshold of $50
billion in assets for subjecting bank holding companies to enhanced prudential
standards.

Credit Default Swaps Outstanding. $30 billion in gross notional credit default swaps(“CDS”) outstanding for which the nonbank financial company is the reference entity.
Gross notional value equals the sum of CDS contracts bought (or equivalently sold).

Derivative Liabilities. $3.5 billion of derivative liabilities. In accordance with AccountingStandards Codification 815, derivative liabilities equals the fair value of any derivatives
contracts in a negative position after taking into account the effects of master netting
agreements and cash collateral held with the same counterparty on a net basis, if elected.

Loans and Bonds Outstanding. $20 billion of outstanding loans borrowed and bonds
issued.

Leverage Ratio. A minimum leverage ratio of total consolidated assets (excludingseparate accounts) to total equity of 15 to 1. The FSOC intends to exclude separate
accounts from this calculation because separate accounts are not available to claims bygeneral creditors of a nonbank financial company.

Short-Term Debt Ratio. Finally, the FSOC intends to apply a threshold ratio of debt witha maturity of less than 12 months to total consolidated assets (excluding separateaccounts) of 10 percent.

The NPR does not clearly specify whether the FSOC will look only to balance sheet assets forpurposes of the test of $50 billion in total consolidated assets. The plain meaning of the phrase
suggests the FSOC intends to use total consolidated assets as determined using applicablefinancial reporting standards. In its discussion of the size criterion within its overall analyticalframework, however, the FSOC stated:
Size is conventionally measured by the assets, liabilities and capital of the firm.
However, such measures of size may not provide complete or accurate
assessments of the scale of a nonbank financial company’s risk potential. Thus,
the [FSOC] also intends to take into account off-balance sheet assets andliabilities and assets under management in a manner that recognizes the uniqueand distinct nature of these classes. Other measures of size, such as numbers ofcustomers and counterparties, may also be relevant.4

476 Fed. Reg. 64264, 64280 (Oct. 18, 2011).
Page 3Memorandum – October 24, 2011

In responses to the NPR, industry participants are likely to seek clarification as to whether theFSOC plans to use only balance sheet assets or include assets under management for purposesof Stage 1.
In addition to the quantitative thresholds noted above, the FSOC may, in limited cases, initiallyevaluate nonbank financial companies in Stage 1 based on other firm-specific qualitative orquantitative factors, such as substitutability and existing regulatory scrutiny.
The quantitative measures described in the NPR are subject to change, as more information
becomes available to the FSOC. The NPR acknowledges, for example, that while the FSOC will
apply the Stage 1 thresholds to all types of nonbank financial companies, including financial
guarantors, asset management companies, private equity firms, and hedge funds, thesecompanies may pose risks that are not well measured by the quantitative thresholds approach.
In the case of private equity and hedge funds, the FSOC intends to consider whether to establish
an additional set of metrics or thresholds tailored to better evaluate these companies, once they
begin reporting to the FSOC in 2012 using the new Form PF. In the case of derivatives
exposures of nonbanking financial companies, new derivatives regulations are being developedby the Securities and Exchange Commission and Commodity Futures Exchange Commission,and the FSOC may establish new Stage 1 thresholds based on factors that better capture current
and potential future exposures from outstanding derivatives once those regulations arecomplete.
***This memorandum is for general informational purposes and should not be regarded as legal advice. Furthermore,
the information contained in this memorandum does not represent, and should not be regarded as, the view of any
particular client of Simpson Thacher & Bartlett LLP. Please contact your relationship partner if we can be ofassistance regarding these important developments. The names and office locations of all of our partners, as well as
additional memoranda, can be obtained from our website, www.simpsonthacher.com.

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Memorandum – October 24, 2011

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