FSOC to Revisit Nonbank SIFI Designation Guidance
Plus: FTX's Mystery Acquisition of a Small U.S. Bank
FSOC to Revisit Nonbank SIFI Designation Guidance
The WSJ reported on Wednesday that the Financial Stability Oversight Council is considering changes to its approach to designation of nonbank systemically important financial institutions that would “ease or repeal Trump-era” changes made by FSOC to the process for doing so. According to the Journal report, the FSOC revisions are in the early stages but a proposal could come during the first few months of 2023.
As the article notes, many of the current heads of the regulatory agencies which constitute the FSOC are on record recently as opposing the 2019 FSOC revisions (which I’ll refer to in this post as the 2019 Guidance), so on one level this is not surprising. What is notable, though, is that we also have on the record a detailed comment letter on this topic from now-Treasury Secretary Yellen written in 2019 along with former Treasury Secretaries Geithner and Lew, as as well former Federal Reserve Board Chair Bernanke.
The 2019 letter took issue with “four significant changes” that were proposed, and ultimately adopted, by the Trump-era regulators. Secretary Yellen’s commentary on these points may therefore serve as a good preview of what a 2023 FSOC proposal would look to change.
Activities-Based Reviews
The 2019 Guidance provides that, before the FSOC would consider designating a nonbank entity as systemically important under Section 113 of the Dodd-Frank Act, the Council will first “prioritize” an activities-based approach, and would pursue entity-based designations only “in rare instances, such as if the products, activities, or practices of a company that pose a potential threat to U.S. financial stability are outside the jurisdiction or authority of financial regulatory agencies.”
The 2019 Guidance establishes a framework such that if FSOC’s activities-based approach does identify a potential risk to U.S. financial stability FSOC will:
first work with the relevant financial regulatory agencies at the federal and state levels to seek the implementation of appropriate actions to address the identified potential risk from the activity;
if that does not work, make nonbinding recommendations under Section 120 of the Dodd-Frank Act to the regulators to “apply new or heightened standards or safeguards” to the activity;
if that still does not work, then and only then consider an entity-based designation, in line with the cost-benefit standards discussed further below.
Secretary Yellen’s 2019 comment letter argues that this approach raises at least two issues.
First, Secretary Yellen believes activity-based approaches, though sometimes helpful, are insufficient to fully address financial stability risks.
Activity-based rules, guidance, and supervision will often be the best choice to reduce risks in the system. In our experience this was true when we examined a number of asset-management activities and broader risks from cybersecurity.
But activity-based approaches cannot address risks that are tied to the funding, leverage, and combination of activities within a corporation. To illustrate, consider the example of Lehman Brothers heading into the crisis: the span and magnitude of Lehman’s activities that played a key role in the crisis included its roles in the subprime mortgage backed securities markets, commercial real estate financing, credit derivatives, and issuance of commercial paper in money markets. … [R]regulations addressing each of these activities have been pursued since the crisis but some of those rules, for instance SEC derivatives rules, have still not been completed a decade later and many of them required statutory changes to give regulators new authority.
Even with these activities-based rules, none of them would have affected Lehman’s ability to reach 31x leverage ratios or to operate with dangerously thin levels of liquidity. Without designation authority, standards on capital and liquidity cannot be imposed on a nonbank financial company. The designation authority enables the tools of safety and soundness, and the nature of safety and soundness oversight is that it applies to the operations of a firm as a whole.
Second, Secretary Yellen argues that, even if activity-based regulation did not suffer from the problems identified above, the process as laid out in the 2019 Guidance “would take 6 years or more” to complete - a timeline that is “unworkable given the realities in the financial markets.”
Consideration of the Likelihood of Failure
Under the 2019 Guidance, if the FSOC does get to a point where an entity-level designation is under consideration, FSOC will conduct a cost-benefit analysis of whether “the expected benefits to financial stability from Federal Reserve supervision and prudential standards justify the expected costs that the determination would impose.”
As part of this review, the 2019 Guidance requires that the FSOC “assess the likelihood of a firm's material financial distress, in order to assess the extent to which a determination may promote U.S. financial stability.”
Secretary Yellen believes that this intention of considering the likelihood of failure is misguided:
As with nuclear power plants, if we wait until failure is reasonably likely at a firm, it’s too late to do much about it. …
In addition, there are a host of practical challenges in assessing the likelihood of a firm’s distress: the distress or failure of large firms occurs so rarely that estimates of their likelihood will inherently be imprecise. Moreover, as the previous discussion shows, experience proves that markets and regulators often fail to foresee the vulnerabilities of individual firms until fairly late. The market-implied probabilities of default of AIG, Fannie, and Freddie were extremely low even into 2007, when the crisis was already unfolding. …
Finally, a requirement to assess that a firm’s distress is sufficiently likely would make designation a signal of serious concerns about a firm’s financial health. Investors and counterparties will assume that regulators have more and better information and have concluded that there are serious concerns regarding the likelihood of a particular firm's failure. That pattern would be self-defeating on its own terms: being required to assess the likelihood of failure as a key component of the designation would mean that it would be very difficult to designate a healthy firm; but designating a firm that is already weak would mean it would be too late for designation to help.
Further, Secretary Yellen argues that requiring FSOC to consider the likelihood of material financial distress is contrary to the statute:1
[I]f we wait until failure is reasonably likely at a firm, it’s too late to do much about it. For this reason, the Dodd-Frank Act clearly requires that we assume the material financial distress of a firm and determine whether a firm in the midst of such distress could pose a threat to financial stability.
Personal opinion disclosure: I have not been as concerned about the 2019 FSOC revisions as some of my friends and colleagues, but this point is one where I have always thought they had the better of the argument. In evaluating risks posed by a firm, the statute does seem to direct that FSOC takes as a given that the firm would be in material financial distress, and to in that context consider the effects such distress would have.
In any case, in the interest of equal time, here is FSOC’s 2019 response to these sorts of comments. Essentially, the argument is that the statute gives FSOC broad authority to take any risk-related factor into account when making a determination, and likelihood of distress is therefore a permissible consideration.
Several commenters stated that the Dodd-Frank Act requires the Council to assume the material financial distress of a nonbank financial company. One commenter stated that the Council has a duty to designate a nonbank financial company when the Council determines that the company could pose a risk to financial stability if it fails, and that the Council does not need to predict the probability of failure or the mechanism for that failure. The Council has authority under section 113 of the Dodd-Frank Act, including under section 113(a)(2)(K), which authorizes the Council to consider “any other risk-related factors that the Council deems appropriate,” to consider the vulnerability of a nonbank financial company to material financial distress as part of the Council’s analysis.
Cost-Benefit Analysis
Beyond the narrower point about whether it makes sense to assess the likelihood of material financial distress, now-Secretary Yellen also took issue with the imposition of cost-benefit analysis requirements more generally, saying that the cost-benefit standard now reflected in the guidance implies “false precision.” According to Secretary Yellen, “[t]here is no realistic way to predict probability of a specific firm's role in a specific financial crisis, especially in a context where financial crises are once-in-a-generation events.”
Off-Ramps
Finally, the 2019 Guidance includes “off-ramps” at both the pre-designation and post-designation stages. In the pre-designation phase, the company would be made aware of the potential risks the FSOC has identified, and would be given an opportunity to mitigate those risks and thus avoid a designation. In the post-designation phase, the FSOC envisions the following off-ramp:
[I]n the event the Council makes a final determination regarding a company, the Council intends to encourage the company or its regulators to take steps to mitigate the potential risks identified in the Council’s written explanation of the basis for its final determination. Except in cases where new material risks arise over time, if a company adequately addresses the potential risks identified in writing by the Council at the time of the final determination and in subsequent reevaluations, the Council should generally be expected to rescind its determination regarding the company.
The 2019 letter from Secretary Yellen worries these off-ramp discussions will be more contentious than FSOC imagines, and will expose the financial regulators to litigation risk.
A general principle of financial regulation is that regulators should set standards for activities and companies, but that management teams, employees and shareholders should make choices about business strategy within the context of those standards. The FSOC’s responsibility is to evaluate a company based on its activities and risk profile and to determine whether a company meets the statutory standard and, if so, to require supervision. However, we note that in most scenarios, the FSOC and the company will have differing views of the risks, and the off-ramp conversations proposed in guidance would likely be contentious – increasing litigation risk in an environment where there is no statutory basis and no clear legal framework.
How Feasible Are These Changes?
Taken together, then, based on her previous public statements, Secretary Yellen would prefer to make a number of changes to the 2019 Guidance. As the WSJ notes, this effort is “likely to generate pushback, potentially even legal challenges, from industry firms and Republican officials who view the panel with skepticism, portraying it as unaccountable and nontransparent.”2
Without opining on the merits of the case that could be made against FSOC if it does move forward with changes to the 2019 Guidance, I will just highlight a few potential obstacles likely on the staff’s mind as they devise changes.
Need for Notice and Comment
The way the FSOC rules in question work is that there is a set of regulations (at 12 CFR Part 1310) implementing FSOC’s statutory designation authority, and then there is an Appendix A with interpretive guidance about how that authority will be applied. The changes discussed earlier in this post were all to the interpretive guidance found at Appendix A.
But FSOC in 2019 also amended the regulation itself to add a new Section 1310.3, which provides:
The Council shall not amend or rescind appendix A to this part without providing the public with notice and an opportunity to comment in accordance with the procedures applicable to legislative rules under 5 U.S.C. 553.
Of the obstacles discussed in this post, this is probably the least significant one, as I am guessing FSOC likely would have felt pressure to submit revisions to the interpretive guidance for public comment, just as it did in 2011 when first adopting the proposed guidance. Still, it is worth noting this because it means that, at a minimum, a 2023 effort by FSOC to revise the 2019 Guidance is likely to take a while.
When Is an Agency Allowed to Change its Mind?
The 2019 Guidance includes an acknowledgement that the interpretive guidance is generally not a binding rule, except to the extent it sets forth rules of agency organization, procedure or practice. Nonetheless, the 2019 Guidance says that “[i]f the Council were to depart from the interpretative guidance, it would need to provide a reasoned explanation for its action, which would ordinarily require acknowledging the change in position.”
For this proposition the 2019 Guidance cites to FCC v. Fox Television, a 2009 Supreme Court case. The 5-4 decision in that case, written by Justice Scalia, explained that an agency’s change of position need not be based on reasoning that is “better” than its prior reasoning. Instead, an agency need only acknowledge that it is making a change and show that there are good reasons for making the change.3
I will confess I am far beyond my area of expertise here, but if the law as described by Justice Scalia in 2009 is still the law, this does not seem to imply an insurmountable task for FSOC if it decides to move away from the 2019 Guidance. Is FCC v. Fox Television still the rule for the current Court? I have no idea!
The Metlife Case
Of course, the above may be complicated by the fact that in 2016 a federal judge in Washington, DC held that FSOC’s designation of MetLife as a non-bank SIFI was arbitrary and capricious, and thus unlawful.
The Court will rescind the Final Determination on two grounds. First, FSOC made critical departures from two of the standards it adopted in its Guidance, never explaining such departures or even recognizing them as such. That alone renders FSOC’s determination process fatally flawed. Additionally, FSOC purposefully omitted any consideration of the cost of designation to MetLife. Thus, FSOC assumed the upside benefits of designation (even without specific standards from the Federal Reserve) but not the downside costs of its decision.
Therefore, according to one federal judge, FSOC is required to conduct at least some sort of analysis of the costs of a potential designation, even if the statute does not explicitly require such an analysis.
The MetLife decision was never reviewed on the merits by the DC Circuit, and even FSOC in 2019 seemed to be hesitant to say that MetLife should be regarded as fully binding on future FSOC action:
Finally, several commenters argued that the Council should interpret section 113 of the Dodd-Frank Act in a manner that is consistent with MetLife v. FSOC, while several others argued it should not. Where appropriate, the Final Guidance reflects the Council’s view regarding the extent to which it should adopt the analysis from that judicial decision.
On the other hand, one area where FSOC did explicitly decide to adopt the district court’s analysis was with respect to costs of designation:
The U.S. District Court for the District of Columbia in MetLife v. FSOC held that the Council had acted in an arbitrary and capricious manner. … The Final Guidance seeks to ensure that future Council determinations comport with the court’s decision and consider costs.
As with the other obstacles discussed in this post, I do not think MetLife presents an insurmountable barrier to FSOC revising its guidance. At the least, though, it may play into Treasury’s strategy for pursuing revisions.
FTX’s Mystery Stake in a U.S. Bank
Note to readers as of 1 pm PST on November 27, 2022: There have been two updates since I wrote this post.
First, according to an interview Janvier Chalopin, Moonstone’s Chief Digital Officer, did later Friday with Protos after this post was initially published, FTX’s investment of $11.5 million was at a $115 million valuation, giving FTX only 10% of the company.
Second, on Sunday Janvier Chalopin did a Twitter spaces interview (starts ~ 35 minutes in) in which he explained that the investment was for just below 10% of the company (~44 minute mark) and that regulators were informed of the transaction, but that no formal approval was required (~48 minute mark). Chalopin also states that the bank is in the process of getting approval to custody digital assets (~51 minute mark).
These statements, if true, would answer a number of the questions I noted in the original post, while raising others. In the interest of transparency, I am leaving the original post as is, even though I am now no longer as confident in its conclusions.
Also on Wednesday the New York Times had an article about an $11.5 million investment made by the FTX-affiliated Alameda Research Ventures in the holding company of Farmington State Bank, a tiny Washington state-chartered bank.4
Among the many surprising assets uncovered in the bankruptcy of the cryptocurrency exchange FTX is a relatively tiny one that could raise big concerns: a stake in one of the country’s smallest banks.
The bank, Farmington State Bank in Washington State, has a single branch and, until this year, just three employees. It did not offer online banking or even a credit card.
The article closes with a quote from Camden Fine:
“The fact that an offshore hedge fund that was basically a crypto firm was buying a stake in a tiny bank for multiples of its stated book value should have raised massive red flags for the F.D.I.C., state regulators and the Federal Reserve,” said Camden Fine, a bank industry consultant who used to head the Independent Community Bankers of America. “It’s just astonishing that all of this got approved.”
I agree with Fine that it seems that something was missed, but it is a confusing situation and thus for understandable reasons I am not sure his quote accurately reflects who erred here, or how they did so. Part of the confusion stems from the fact that there are a few different transactions at issue, so let’s look at them in turn.
2020 Chalopin Investment
First, in 2020, the parent company of Farmington State Bank was acquired by Guvjec Investment Corporation. It is not clear from the name, but the NYT explains that the man behind this acquisition was “Jean Chalopin, who, along with being a co-creator of cartoon cop Inspector Gadget in the 1980s, is the chairman of Deltec Bank, which, like FTX, is based in the Bahamas. Deltec’s best-known client is Tether, a crypto company with $65 billion in assets offering a stablecoin that is pegged to the dollar.”
This investment was approved by the Federal Reserve Bank of San Francisco acting under delegated authority. Given the … questions … around Deltec and Tether, you could raise reasonable arguments about whether red flags should have been sighted at this stage, but the point here is that, so far at least, things proceeded by the book in terms of required applications.
2021 Membership Application
In 2021, Farmington State Bank applied to become a member of the Federal Reserve System, meaning that its federal regulator would change from the FDIC to the Federal Reserve Board. This application was approved by the Federal Reserve Bank of San Francisco acting under delegated authority.
Membership applications are generally formalities. Given the context here, you could again ask whether red flags should have been raised, but this is another application that looks have to proceeded by the book.
2022 Alameda Acquisition
In March 2022, Farmington State Bank, now doing business as Moonstone Bank, announced that its parent company had “raise[d] $11.5M in private equity funding from Alameda Research Ventures.” It is here where the mystery comes in, as based on the public record there is no record of any regulatory application being filed in connection with this equity investment.
It is tough to find any justification for why an application would not have been required. In particular, the holding company’s pre-acquisition equity was tiny (total equity capital of $6.2 million at 12/31/2022) and I do not see any way the math would have worked for Alameda to acquire a stake of this size, even a fully non-voting stake, without tripping a presumption of control under the Bank Holding Company Act and Regulation Y.
The only thing I can think of is that, given the less-than-best-in-class approach to compliance and corporate separateness at FTX and its affiliated entities, maybe the investment was not actually made by Alameda Research Ventures as a corporate entity, but was instead made by various FTX-and Alameda-associated individuals in some sort of complicated structure in which no individual - viewed on their own - had control. I do not think even that explanation (which to be clear I have no evidence for) works, however, because under the regulations such an investment should still have attracted scrutiny as an investment by a group acting in concert.
So if it is the case that an application simply was never filed, I think this represents a failure by the Federal Reserve Board, the Federal Reserve Bank of San Francisco and, to a lesser extent, the Washington state regulator (and maybe the Maryland state regulator?5). But contrary to the quote from Mr. Fine, I do not think the failure necessarily extends to the FDIC, and the failure by the Board and the Reserve Bank is not that they approved an application (at least not in 2022), but rather that they allowed an acquisition to proceed without requiring an application in the first place.
Other Thoughts
I have a few other thoughts about this to conclude, but first I want to be fair to the Board and Reserve Bank by acknowledging that we do not know what has been happening out of the public eye. If it was an error by the regulators, I think it is a bad one, but maybe there are facts that will come out which make clear this was not an error at all, or at least is an error the regulators are already working to address.
In any case, other thoughts and questions I have about the situation:
Maybe missing the March investment was understandable, especially if the transaction closed immediately. By the time the Reserve Bank heard about it, the investment could already have been made. (I admit that the NYT article this week was the first I’d heard of the situation.)
But even if the initial investment was missed, shouldn’t the subsequent call reports filed by the bank and the financial statements filed by the holding company have raised questions?
The holding company’s statements, which it files with the Federal Reserve only every six months, reflect a significant increase in equity between December 2021 and June 2022.
Likewise, the bank’s quarterly call reports reflect significant equity investments over the course of this year from the parent company, along with a significant increase in deposits that, per the NYT article, mostly “came from just four new accounts.”
I would hope all this would have raised questions about where this new money was coming from, and maybe it did, but there is no public sign of that at the moment.
Even setting aside the need for an application from Alameda to acquire the holding company, was the bank required to file an application under Regulation H before it pivoted from being a sleepy community bank to a tech-focused bank with grand ambitions, including plans to “accelerate crypto adoption” by issuing a stablecoin?6 Under Regulation H, a state member bank requires permission from the Federal Reserve Board before it may "cause or permit any change in the general character of its business or in the scope of the corporate powers it exercises at the time of admission to membership."
In guidance released earlier this year, the Board suggested that an intention to begin engaging in crypto-asset related activities will often count as a change in character of business - see footnote 9 here.
I am not exactly sure when the bank decided to change its business model, so maybe the timing here was such that the bank was already engaged in crypto-asset related activities at the time it became a member bank in 2021. Or maybe as part of its membership application it sought permission to, in the future, change its business model accordingly. Still, if we are ticking through the list of things that may have been missed, it is worth asking about this too.
Finally, if the Federal Reserve did make a mistake here, should it affect how we think about other investments in small banks by crypto firms? For instance, in late September the crypto lender Nexo entered into what it called a “transformative deal” to acquire “a stake in the bank holding company that owns Summit National Bank.”
No application was filed with the Federal Reserve Board or the OCC.7
My assumption on reading about Nexo’s investment in September was that, notwithstanding Nexo’s grand language, this was a carefully structured minority investment, designed to avoid both (1) being regarded as having control under the BHC Act and (2) tripping the threshold at which a Change in Bank Control Act filing would be required.
If forced to guess, I would still think that is probably true. But if the Board and Reserve Banks8 have indeed been missing situations that require applications, the Nexo investment and others like it seem like something now worth asking new questions about. This is especially so for the Nexo investment from a a control perspective given that there may be business relationship issues here.9
Emphasis in the original. (Albeit underlined rather than bolded; there is no underlining option in Substack.)
“Skepticism” is perhaps putting it mildly. See, for instance, this 2014 speech from a Republican SEC Commissioner referring to the FSOC as an “Unaccountable Capital Markets Death Panel.”
From the opinion:
In overturning the Commission’s judgment, the Court of Appeals here relied in part on Circuit precedent requiring a more substantial explanation for agency action that changes prior policy. The Second Circuit has interpreted the Administrative Procedure Act and our opinion in State Farm as requiring agencies to make clear “ ‘why the original reasons for adopting the [displaced] rule or policy are no longer dispositive’ ” as well as “ ‘why the new rule effectuates the statute as well as or better than the old rule.’ ” 489 F. 3d, at 456–457 (quoting New York Council, Assn. of Civilian Technicians v. FLRA, 757 F. 2d 502, 508 (CA2 1985); emphasis deleted). The Court of Appeals for the District of Columbia Circuit has similarly indicated that a court’s standard of review is “heightened somewhat” when an agency reverses course. NAACP v. FCC, 682 F. 2d 993, 998 (1982). …
We find no basis in the Administrative Procedure Act or in our opinions for a requirement that all agency change be subjected to more searching review. … To be sure, the requirement that an agency provide reasoned explanation for its action would ordinarily demand that it display awareness that it is changing position. An agency may not, for example, depart from a prior policy sub silentio or simply disregard rules that are still on the books. See United States v. Nixon, 418 U. S. 683, 696 (1974). And of course the agency must show that there are good reasons for the new policy. But it need not demonstrate to a court’s satisfaction that the reasons for the new policy are better than the reasons for the old one; it suffices that the new policy is permissible under the statute, that there are good reasons for it, and that the agency believes it to be better, which the conscious change of course adequately indicates.
In addition to the oddities cited by the NYT, this local news article about the bank from 2010 also includes a few fun nuggets. For instance:
The bank stopped making mortgage loans sometime in the 2000s “because the paperwork became too onerous, President John Widman said.”
The bank at the time was owned by “Archie Chan, a British citizen who lives in Hong Kong.” “Chan bought the bank in 1995, when he was looking for a chartered Washington bank that might become a platform for international banking. That did not happen…”
“Brad Williamson, Division of Banking director for the Washington Department of Financial Institutions, said Farmington must meet the same regulatory standards as much larger banks. But as a small bank that sticks to its knitting, the level of concern is low, he said. ‘They’re not very high on our radar screen in terms of risk,’ Williamson said.”
Despite the fact that the bank is based near Spokane, Washington, the parent company is a Maryland bank holding company. I do not know anything about Maryland law, but it sure looks like a controlling acquisition of a Maryland BHC requires state regulatory approval. (See here for an activist investor complaining about it.) Usually this sort of state approval is just a formality and the real action happens at the federal level, but you might expect Maryland to have at least noticed.
Note that Moonstone’s activities at the moment appear to be more limited. The press release linked above includes a note in bold saying “At present, and until further notice, Moonstone Bank is ONLY offering commercial USD accounts for Fluent.”
The OCC did earlier in 2022 approve an application first filed by the national bank in December 2021 to undergo a substantial change in assets. I don’t think the timing works for this to have related to the Nexo acquisition, however.
Summit National Bank and its parent company are located in Wyoming, so if this is an issue it would in the first instance be a matter for the Federal Reserve Bank of Kansas City, rather than the one in San Francisco.
The “deal will allow Nexo to offer its US retail and institutional clients services that include bank accounts, asset-backed loans, card programs, as well as escrow and custodial solutions through Summit National Bank.”