A proposed methodology for the identification of nonbank, noninsurance financial institutions that pose systemic risks to the global economy appears unlikely to affect a large number of institutions, according to Fitch Ratings.

The framework, outlined by the Financial Stability Board (FSB) in a consultative paper last week, includes preliminary sector-specific criteria for designation as a systemically important financial institution (SIFI) that would likely affect only a small number of nonbank institutions (finance companies, securities firms, regulated funds and hedge funds) with total assets exceeding very high thresholds. However, the proposed treatment of large asset managers (as opposed to their funds), stands out as an area where additional clarity from global regulators will be required before a full understanding of the FSB methodology is possible.

The paper included specific proposed guidelines for the identification of institutions whose large size, complexity or interconnectedness may pose risks for the broader financial system in the event of the firm's failure. Specific size thresholds were proposed to serve as an initial filter to identify finance companies (fincos), broker-dealers, traditional asset managers and hedge funds that warrant additional consideration. In addition, other indicators include use of leverage, complexity, counterparty risk, substitutability and cross-jurisdictional issues.

We see little or no future impact from the SIFI designation framework among the largest firms in the U.S., where the number of institutions with assets exceeding the $100 billion threshold is very small. Among the institutions that meet the size threshold are Fannie Mae and Freddie Mac, which are under government conservatorship and unlikely to be named SIFIs. GE Capital, already deemed to be a SIFI, along with American Express and Ally Financial (both reviewed under the bank SIFI framework) are also among the largest institutions.

Ford Motor Credit, which will likely be viewed differently as a result of Ford's ownership of the finco subsidiary, also has assets exceeding $100 billion. In Europe, there are only a few fincos that come close to the asset limit, notably some of the largest auto captives.

Aside from Goldman Sachs and Morgan Stanley, already designated as global SIFIs, no other securities firms are expected to meet the proposed size and complexity standards outlined by the FSB.

With respect to the asset management sector, the FSB proposal appears to be primarily focused at the fund level, which appears different from a prior comment by the U.S. Treasury Department's Office of Financial Research (OFR), which focused on systemic risk at the asset management company level. That said, the FSB will explore whether the focus should apply more broadly at the fund family or asset manager level.

We estimate that there are only 14 U.S. funds that would exceed the threshold, and thus attract additional examination of their potential systemic importance. However, if the focus is at the asset manager level, the number of U.S. firms that could potentially be impacted would be materially higher. Regardless of whether the focus is ultimately on asset management companies or their funds under management, there will likely be active discussion among regulators and market participants as to the extent to which either introduces systemic risk or simply transmits the views and acts of their investors.

In our view, regulated open-end and closed-end funds do not present a significant source of systemic risk based on the indicators the FSB cited as potential signals of heightened systemic risk. Regulated open-end funds do not use excessive leverage, net counterparty exposures are minimal, and, for most asset classes, substitutability does not appear to be an issue. Regulated closed-end funds use leverage, but it is limited and subject to tight regulatory constraints under the Investment Company Act of 1940. On the other hand, certain large and leveraged hedge funds could pose broader systemic risk in times of market stress and are an appropriate area of focus.

The FSB worked together with the International Organization of Securities Commissions (IOSCO) to develop the proposal. The methodology is open for public comment until April 7.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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