The Financial Stability Oversight Council’s (FSOC) latest proposal to revise how it designates nonbank financial institutions reflects a broader shift toward an “activities‑based” approach to identifying systemic risk, with implications for how regulators assess risks in markets such as OTC derivatives.
“The Council has a vital mission – identifying and responding to potential threats to the stability of the financial system before they can translate into real economic harms,” Treasury Secretary Scott Bessent said in announcing the proposal. He added that the shift would “focus first on risks that arise from specific activities and practices across markets, rather than single out individual firms.”
FSOC first put an activities-based framework in place in 2019, before later revisiting firm-specific designations in subsequent years. The latest proposal would reinstate that earlier structure while adding new elements, including a formal cost-benefit analysis and a pre-designation “off-ramp” that gives companies an opportunity to address risks before being labeled “systemically important”.
The Investment Company Institute (ICI), which represents mutual funds, ETFs, and other regulated investment vehicles, called the guidance “a welcome and much needed step toward a more transparent and tailored regulatory framework.” ICI highlighted the activities-based approach, the cost-benefit analysis, and the pre-designation off-ramp as key features that give companies clarity and the ability to address risks proactively.
In recent years, episodes of market stress have highlighted how leverage and liquidity pressures can pile up outside traditional banks. During the Treasury market disruption in March 2020, for example, relative-value hedge fund trades, often implemented using repurchase agreements and derivatives, came under pressure as funding conditions tightened. The Bank for International Settlements noted that “a key driver was the rapid unwinding of so‑called relative value trades… As volatility and margin calls surged, liquidity in futures markets evaporated, causing mark-to-market losses for relative value investors who had sold futures and bought bonds.”
These episodes have shaped how policymakers think about risk in markets where exposures are distributed across counterparties. In OTC derivatives in particular, positions are often bilateral or centrally cleared but still interconnected, making it difficult to isolate risk within a single entity.
Industry groups have argued that this is precisely why an activities-based approach is more effective. In a joint letter responding to earlier FSOC guidance, several trade associations wrote that systemic risks “are more likely to arise from a particular activity or practice conducted across multiple firms or markets” than from one institution alone.
The Council’s proposal also seeks to address concerns about transparency and process. Under the new framework, FSOC said it would conduct a cost-benefit analysis before making any designation and would assess the likelihood of a firm’s financial distress as part of that process. It would also outline steps companies could take to mitigate identified risks before any formal designation is made.
Those additions respond to longstanding criticism from parts of the industry and some policymakers. Former SEC Commissioner Paul Atkins previously said designation authority “should be exercised with great care,” warning that it can carry significant consequences for firms.
The proposal will be open for public comment for 45 days after publication in the Federal Register, setting up what is likely to be another round of debate over how best to monitor risk in a financial system.
