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Strengthening financial stability
During the financial crisis, the financial institution failures and breakdowns in several key financial markets caused devastating damage to the economy. For that reason, many Dodd-Frank Act provisions focus on promoting financial stability.
The Act established the Financial Stability Oversight Council, which is chaired by the Secretary of the Treasury and includes the heads of the other federal financial regulatory agencies including the Chairman of the Federal Reserve. As part of the new macroprudential policy framework, the Council is charged with identifying threats to the nation’s financial stability, promoting market discipline, and responding to emerging risks to the stability of the financial system. One aspect of this approach includes recommending enhancements to supervisory standards for large, interconnected companies.
A critical component of the Council’s responsibility to promote financial stability is identifying systemically important financial institutions and financial market utilities that could potentially have a significant impact on the overall financial system.2 Utilities include institutions engaged in payment, clearing, or settlement. The Dodd-Frank Act defines systemically important entities as all bank holding companies with over $50 billion in assets and all nonbank financial companies that the Council designates as such. The Federal Reserve already supervises all bank holding companies. The Act adds to the Federal Reserve authority by giving it responsibility to supervise systemically important nonbank financial companies.
As a Council member, the Federal Reserve is helping develop the procedures for identifying and monitoring systemically important financial institutions and utilities. The Federal Reserve is also working with other regulatory agencies on rules affecting certain financial markets. For example, it is consulting with the Securities and Exchange Commission and the Commodity Futures Trading Commission on rules to enhance the safety and efficiency of derivatives markets through such measures as improved transactions reporting and requiring standardized derivatives contracts to be centrally traded and cleared.
In response to these expanded responsibilities, the Federal Reserve Board recently created a new Office of Financial Stability Policy and Research, which will monitor financial developments across a range of markets and institutions, and coordinate with the Council and other agencies to strengthen systemic oversight. This office brings together economists, banking supervisors, market experts, and others across the Federal Reserve System to support the Board's financial stability responsibilities.
Implementing more robust prudential supervision
The Dodd-Frank Act also requires tougher prudential standards for financial institutions. These standards are designed to reduce the risks encountered by financial institutions and improve risk management practices. The Act places special emphasis on more rigorous standards for systemically important financial institutions as defined by the Financial Stability Oversight Council. For these institutions, the Federal Reserve is establishing new rules in such areas as capital, leverage, liquidity, resolution plans, and credit concentration limits. In addition, as part of macroprudential supervision, supervisors will place greater emphasis on monitoring the interconnections among large financial institutions. They will also monitor market developments that pose common risks for these institutions.
During the financial crisis, the Federal Reserve and other federal banking agencies conducted a stress test of the largest banking organizations. The Supervisory Capital Assessment Program, or SCAP, assessed the ability of these institutions to weather an economic downturn of unexpected severity. It helped supervisors determine how much additional capital some of these institutions needed and provided useful information to financial markets. Under the Dodd-Frank Act, the Federal Reserve will continue to conduct supervisory stress tests annually as an integrated part of the standard supervisory process. The Act also requires certain designated financial institutions to conduct their own tests semiannually. Large regional financial institutions with assets between $10 billion and $50 billion will have to conduct annual stress tests and maintain a risk committee of their boards of directors.
The Federal Reserve’s supervision of the country’s largest banking companies has been intensifying for several years, and the Dodd-Frank Act has helped to reinforce the enhancements already implemented and planned. For example, the Federal Reserve commonly deploys bank supervisors from several Reserve Banks to conduct simultaneous examinations of similar business lines across large institutions operating in different parts of the country, a process known as a horizontal review. The 2009 stress test expanded on this by employing a multidisciplinary perspective that took advantage of a broad range of skills within the Federal Reserve, an approach that generated improved potential loss estimates and capital calculations. Publication of the results and subsequent moves by the financial institutions to raise capital reduced uncertainty within the banking system.
The Federal Reserve will continue to take this multidisciplinary approach to supervision, both for horizontal reviews and to carry out the stress tests mandated by the Dodd-Frank Act. In addition to these macroprudential supervisory efforts, more resources are being applied to supervision of individual institutions. For example, economists and quantitative analysts are participating more in examinations. The Federal Reserve has also put in place additional data resources that can be used to analyze institution-specific and market-specific areas of concern. Further regulatory reforms, such as the enhanced capital and liquidity requirements of the new multilateral Basel III regulatory framework, will create additional opportunities for collaboration across disciplines.
The Dodd-Frank Act fundamentally changed the Federal Reserve’s approach to its consolidated supervision responsibilities. Consolidated supervision focuses on protecting insured depository institutions from the risks associated with the operations of affiliated nonbanking units within a bank holding company structure.
The Act expanded the Federal Reserve’s consolidated supervision mandate to include protecting the overall financial system from threats. It also clarified the existing mandate for supervising the nonbank subsidiaries of holding companies to focus on the safety and soundness of the holding company. In addition, the Act eliminated the so-called "Fed-lite" provisions that were established with the Gramm-Leach-Bliley Act of 1999. These provisions limited the Federal Reserve’s direct supervision of holding company nonbank subsidiaries that are regulated by other agencies, such as broker-dealers examined by the Securities and Exchange Commission.
The Federal Reserve will continue to rely on the work of other agencies to the fullest extent possible. The Dodd-Frank Act eliminates prior limitations on authority to examine, obtain reports from, or take enforcement actions against such functionally regulated subsidiaries.
2. On January 18, 2011, the FSOC proposed the criteria and framework (with a 30-day comment period). On February 8, 2011, the Federal Reserve proposed a rule related to the FSOC's designation of systemically important nonbank financial companies for consolidated supervision by the Board (which was sent out for comments through March 30, 2011).