Notice of Proposed Rulemaking Regarding Authority To Require Supervision and Regulation of Certain Nonbank Financial Companies

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1 February 25, 2011 Via Electronic Delivery Financial Stability Oversight Council c/o United States Department of the Treasury Office of Domestic Finance 1500 Pennsylvania Avenue, N.W. Washington, D.C Attention: Comments Re: Notice of Proposed Rulemaking Regarding Authority To Require Supervision and Regulation of Certain Nonbank Financial Companies Dear Sir or Madam: The Clearing House Association L.L.C. ( The Clearing House ), 1 an association of major commercial banks, appreciates the opportunity to provide comments to the Financial Stability Oversight Council (the Council ) in response to its Notice of Proposed Rulemaking (the NPR ) regarding the Council s authority under Section 113 of the Dodd Frank Wall Street Reform and Consumer Protection Act (the Act ) 2 to designate certain nonbank financial companies ( NBFCs ) as systemically important and to require enhanced supervision of such NBFCs. We previously submitted comments in response to the Council s Advance Notice of Proposed Rulemaking (the ANPR ) regarding the same subject. 3 We appreciate the opportunity to reiterate several observations and suggestions from our ANPR comment letter and to comment on the analytical framework 4 set forth in the NPR. We also respectfully suggest that the Council, as it proceeds to designate appropriate NBFCs as promptly as practicable, consult with 1 Established in 1853, The Clearing House is the nation s oldest banking association and payments company. It is owned by the world s largest commercial banks, which collectively employ 1.4 million people in the United States and hold more than half of all U.S. deposits. The Clearing House Association L.L.C. is a nonpartisan advocacy organization representing through regulatory comment letters, amicus briefs and white papers the interests of its owner banks on a variety of systemically important banking issues. Its affiliate, The Clearing House Payments Company L.L.C., provides payment, clearing and settlement services to its member banks and other financial institutions, clearing almost $2 trillion daily and representing nearly half of the automated clearing house, fundstransfer and check image payments made in the U.S. See The Clearing House s web page at for additional information. 2 Pub. L. No , 113, 124 Stat (2010). Section and title numbers refer to corresponding portions of the Act in the form in which it was enacted or as proposed in the NPR, as appropriate, unless the context otherwise requires. 3 See Letter from The Clearing House to the Council dated November 5, 2010 (our ANPR comment letter ), available at 4 See 76 Fed. Reg

2 Financial Stability Oversight Council 2 February 25, 2011 financial industry participants in the development of emerging analytic models and set forth its reasoning for any designation explicitly and publicly. Finally, we support the view that designating an NBFC as systemically important does not carry with it implied government support or too big to fail status. I. Designation of Systemically Important NBFCs The judicious exercise of the Council s designation authority is a critical pillar of the systemic regulatory architecture established under the Act. This task is also very challenging, as there are neither one size fits all definitions of systemic importance nor objective standards that can be applied in all cases. As we described in more detail in our ANPR comment letter, the Clearing House believes that the Council s designation authority should generally be exercised subject to the considerations set forth, in part, below. As a general observation, we believe that the suggested analytical framework in the NPR for evaluating the statutory factors under Section 113 is largely consistent with the basic approach we espoused in our ANPR comment letter, particularly with respect to several of the six broad categories outlined in the preamble to the proposed rule. A. Size, Activities and Interconnectedness We strongly concur that an NBFC s size is an important but neither exclusive nor threshold consideration, as contemplated under the first broad category in the NPR framework. 5 We also agree that the Council should consider, in addition to size, an institution s interconnectedness, as contemplated under the third broad category in the NPR framework. 6 As we noted in our ANPR comment letter, an assessment based on these core criteria should be supplemented by other important factors, such as the nature, scope, scale, concentration, and mix of an NBFC s activities. B. Dependency The Council should also consider the closely related concept of dependency, which, in turn, is similar to the second of the six proposed broad categories in the NPR framework; namely, a lack of substitutes for the financial services and products the company provides. 7 However, by dependency we refer to a somewhat broader concept: namely, that the risk that the material financial distress of a company, or the abrupt cessation of a critical activity or function that it performs, would reasonably be expected to trigger truly systemic consequences arising out of either (i) materially adverse effects on many of the company s counterparties, which effects would have a deleterious secondary impact on an important market, or (ii) an inability to replicate readily an activity or function performed by the company and critical to the 5 Ibid. 6 Ibid. 7 Ibid.

3 Financial Stability Oversight Council 3 February 25, 2011 financial system. We urge the Council to consider not solely the latter but both of these aspects of dependency in order to analyze systemic importance comprehensively. C. The NPR framework; consideration of pre existing regulation The Clearing House appreciates that the analytical framework set forth in the preamble to the proposed rule focuses on size, substitutability, and interconnectedness (the first group ) as the criteria that seek to assess the potential for spillovers from a firm s distress to the broader financial system or real economy. 8 The three other enumerated categories leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny (the second group ) are, in our view, correctly described as criteria that seek to assess how vulnerable a company is to financial distress. 9 We submit that the categories in the second group are more likely to aid the Council in determining the probability, as opposed to the systemic effects, of an NBFC s failure. Therefore, we believe that, while it is proper to consider all six categories listed in the preamble in an evaluation of the systemic importance of an NBFC, the first group should be at the core of the designation framework. Subject to the caveat below regarding prior regulation, the second group should be used to inform the conclusions drawn based on the first group. For example, the financial distress or failure of an NBFC would not necessarily have any systemic ramifications if it is small, its distress or failure does not affect other entities, and substitutes for the financial services and products that it provides are readily available. Further, as we discussed in our ANPR comment letter, whether a company is already subject to prudential financial regulation is appropriate in determining both the degree to which an already designated company should be regulated for systemic risk and the nature of such systemic regulation, not whether a company should be designated as systemically significant in the first place. We submit that a designation of systemic importance should not be influenced by either the manner or extent of a company's regulation, except possibly to the extent that the company is a subsidiary of a systemically important bank holding company or nonbank financial company that is already subject to the enhanced prudential supervision provisions of Title I. We accept that Section 113 requires the Council to consider prior regulation in making a determination of systemic importance. However, we believe that this factor should not be given too much weight in the Council s considerations, in part because Section 113 does not state how prior regulation should influence systemic importance designation. In particular, Section 113 does not require that more regulated companies be less likely to be designated as systemically significant. D. Resolution under the orderly liquidation authority As detailed in our ANPR comment letter, we believe that the systemic risk posed by an institution is most closely correlated to whether, were the institution to experience material financial distress, there would be a reasonable prospect that it would be resolved under the 8 Ibid. (emphasis added). 9 Ibid. (emphasis added).

4 Financial Stability Oversight Council 4 February 25, 2011 orderly liquidation authority provisions in Title II (the OLA ). This test of an institution s systemic importance correlates directly to the need for it to be subject to heightened systemic regulation. Accordingly, we believe that the list of systemically important NBFCs should be, at a minimum, sufficiently expansive to capture all institutions that have a reasonable prospect of being subject to the OLA. Of course, the enhanced prudential regulation that applies to NBFCs that are designated as systemically important significantly reduces the chances of a systemically significant firm failure requiring OLA resolution, while the absence of such enhanced prudential regulation for appropriate NBFCs would heighten the risk of a systemic failure. E. Determinations of systemic importance should not depend on charter or structure Finally, we reiterate that the systemic importance of any institution is fundamentally a function of what the institution actually does, as opposed to its nominal legal form or business model. We urge the Council, in exercising its designation authority, to focus on the activities in which an NBFC engages and not to determine in advance whether any particular business model or charter poses, or is likely or unlikely to pose, systemic risk. II. Scope of Designations; Timing and Process Considerations A. Breadth of systemic importance designation We continue to consider it critically important to define systemic importance with sufficient breadth to ensure that the full range of the Act s supervisory tools are brought to bear on the identification and regulation of material risks to the stability of the financial system. Section 113 requires the Council to monitor for new types of systemic risk that may emerge from any area of the financial system, including areas that may not currently be adequately regulated. To limit the Council s designations to only those types of NBFCs that have previously manifested systemic importance would be to embrace a regulatory strategy devoted to fighting the last war. Moreover, failing to designate an appropriately broad range of NBFCs would further encourage the expansion of the so called shadow banking system, in which nonbanks provide many of the same financial products as those offered by regulated banking organizations but do so largely outside the purview of the financial regulatory apparatus and often with a high degree of leverage and opacity. B. Prompt designation We recommend that, to the maximum extent feasible, systemically important NBFCs be identified as promptly as practicable and, as other NBFCs emerge as systemically important, on an ongoing basis. Doing so would (a) reduce systemic risk more quickly, (b) allow creditors and counterparties to appropriately consider the legal and economic implications of the OLA, (c) create a broader base over which to spread potential resolution costs and thereby minimize

5 Financial Stability Oversight Council 5 February 25, 2011 disruption of the financial system and (d) create a level playing field among systemically important institutions. III. Prudential Standards Should Be Tailored to Specific Institutions Section 115 authorizes the Council to make recommendations to the Board of Governors of the Federal Reserve System concerning the establishment and refinement of the prudential standards and requirements applicable to designated NBFCs and large, interconnected bank holding companies In so doing, the Act specifically authorizes the Council to differentiate among companies on an individual basis. 10 We strongly encourage the Council to avail itself of this authority to distinguish among institutions to help ensure that, similar to the designation process itself, the regulation of systemically important NBFCs and covered bank holding companies is not conducted on a one size fits all basis. IV. Ongoing Development of a Specific Framework for Designation We understand that the details of the framework for designation and enhanced regulation of systemically important NBFCs are still under development by the Council and other regulators. Although the NPR, and in particular the analytical framework in the preamble to the proposed rule, are a step forward in that process, the NPR does not set out any specific tools, models or other concrete designation metrics. We commend the Council s desire to avoid narrow or rigid approaches to designation of systemic importance. Nevertheless, we recognize that analytical models must continue to be developed for systemic importance analysis, however discretionary their use by the Council may be. While, as set forth above, we support prompt designation of appropriate NBFCs, we respectfully ask that, as the Council develops these models, it consult not only with the academic community, but also with all stakeholders and participants in the financial industry. Furthermore, as the Council designates NBFCs for enhanced regulation, it should explain its reasoning explicitly and publicly. Doing so would enhance the Council s developing reputation for transparency and equitable treatment, increase the market s confidence in regulatory decisions and decrease uncertainty, demonstrate that the regulatory structure created by the Act is serving its intended purpose, and thereby help to increase systemic stability. V. Systemic Importance Designation Does Not Imply Government Support Some state that the Council should not designate a broad set of NBFCs as systemically important because of the false perception that such designation confers not only a degree of implied government support, but also too big to fail status. We understand that such sentiments are not expressed by the Council in the NPR or elsewhere. Nonetheless, we want to take this opportunity to reiterate that the express provisions of the Act require that resolution under the OLA does not confer on any firm any benefit that might be described as a bail out. We further submit that, on the contrary, a broad conception of systemic importance would 10 Sec. 115(a)(2)(A).

6 Financial Stability Oversight Council 6 February 25, 2011 ensure an equitable regulatory framework that would help prevent systemically dangerous firm failures and eliminate regulatory arbitrage. As a threshold matter, the use of the OLA is subject to a determination of the broad systemic risk that a company s potential failure poses. Absent such a finding, the OLA cannot be invoked, and the company, whether or not designated as systemically important under Section 113, can only be resolved under standard insolvency law. Moreover, even in those instances when OLA procedures are used, nothing resembling a bail out would ensue. On the contrary, Sections 204 and 206, as well as the Federal Deposit Insurance Corporation s interim final rule implementing the OLA, 11 make clear that the losses that result from a systemically important firm s failure would be borne by its counterparties, shareholders and creditors. To the extent that any expenditures are incurred in connection with an OLA resolution, they will be recouped from assessments on failed companies and systemically important firms, as applicable. 12 Therefore, rather than laying the groundwork for a future bail out, a designation of systemic importance ensures that any NBFC that poses sweeping risk is properly regulated in advance of a potential failure to prevent the adverse externalities that would otherwise adhere to an unregulated, but still systemically important, NBFC. VI. Conclusion The Council should base its designations of NBFCs as systemically important primarily on a firm s size, interconnectedness, dependency and reasonable prospects of ever being subjected to the OLA s special resolution provisions. These factors, which directly evaluate a firm s impact on the financial system in the event of distress, should be the core elements of a determination of systemic importance, although an evaluation of a firm s vulnerability to financial distress should be used to inform the designation. The extent to which an NBFC is subject to prudential supervision should not be a factor in deciding whether to designate it as systemically important. Decisions regarding systemic designation should be made as promptly as practicable. Systemic importance should be defined with sufficient breadth to ensure that the Council best fulfills its statutory mandate. Finally, if the Council develops concrete analytical models for systemic designation, it should do so in consultation with all financial industry participants and make public the methodology behind designations of systemically important NBFCs. * * * Fed. Reg. 4207, implementing 12 C.F.R. Part See Section 210(o).

7 Financial Stability Oversight Council 7 February 25, 2011 Thank you for considering the views expressed in this letter. We appreciate the opportunity to share our views and would be happy to discuss any of them further at your convenience. If you have any questions, please contact me at (212) or Mark.Zingale@TheClearingHouse.org or Eli Peterson, Vice President and Regulatory Counsel, at (202) or Eli.Peterson@TheClearingHouse.org. Sincerely, Senior Vice President and Associate General Counsel cc: Hon. Timothy Geithner, Financial Stability Oversight Council, and Secretary, Department of the Treasury Hon. Ben Bernanke Vice, Financial Stability Oversight Council, and, Federal Reserve Board Hon. Sheila Bair Federal Deposit Insurance Commission Hon. Gary Gensler Commodity Futures Trading Commission Hon. Mary Schapiro Securities and Exchange Commission Mr. John Walsh Acting Comptroller Office of the Comptroller of the Currency Mr. Edward DeMarco Acting Director Federal Housing Finance Agency

8 Financial Stability Oversight Council 8 February 25, 2011 Hon. Debbie Matz National Credit Union Administration Mr. John P. Ducrest Commissioner Louisiana Office of Financial Institutions, on behalf of the Conference of State Bank Supervisors Ms. Susan E. Voss Commissioner Iowa Insurance Division, on behalf of the National Association of Insurance Commissioners Mr. David Massey Deputy Administrator North Carolina Securities Division, on behalf of the North American Securities Administrators Association Hon. Austan Goolsbee Council of Economic Advisers Ms. Karen Shaw Petrou Managing Partner Federal Financial Analytics, Inc. H. Rodgin Cohen, Esq. Partner Sullivan & Cromwell LLP Samuel R. Woodall III, Esq. Legislative Counsel Sullivan & Cromwell LLP The Clearing House Association Advisory Group on Nonbank SIFI Designation The Clearing House Association Bank Regulatory Committee The Clearing House Association Government and Legislative Affairs Committee The Clearing House Association CFO Summit Participants Paul Saltzman Executive Vice President and General Counsel Head of The Clearing House Association