Bare "systemic" proposal keeps hedge funds guessing

WASHINGTON Tue Feb 8, 2011 4:52pm EST

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WASHINGTON (Reuters) - Regulators on Tuesday put a bit more flesh on a bare-bones plan to determine which market players other than banks, such as hedge funds, should be deemed systemic risks and face closer government scrutiny.

The Federal Reserve released a proposal on how the United States would pick out these "systemic" firms, including a two-year test to determine if a firm's predominant business is financial.

But the proposal leaves insurers and hedge funds guessing if they will fall under the stricter regulatory regime.

Under the Dodd-Frank financial reform law passed last year, the newly created U.S. risk council has the power to create a list of firms that are so big and interconnected they could impact the stability of financial markets.

The Federal Reserve will police these firms and they could be dismantled by the government if they start to topple. The idea is that orderly liquidation would prevent chaos in financial markets such as occurred when Lehman Brothers went bankrupt in September 2008.

Bank holding companies with assets of $50 billion or more automatically fall under supervision. That means firms such as Goldman Sachs Group Inc and JPMorgan Chase & Co would likely be covered.

Big financial firms that fall outside the banking world have been making their pitch to the Fed on why they should not be considered for supervision.

BlackRock Inc, the world's biggest money manager, visited the Fed in November and told staff that asset management companies are not that interconnected to the rest of the financial markets.

But firms falling into a gray area are getting anxious for answers.

Late last month, representatives from hedge funds Paulson & Co and D.E. Shaw & Co met the Fed to try to get clarity on how firms would be picked as "systemic," according to a posting on the Fed's website detailing meetings with the public on regulatory reform.

"They expressed concerns that confusing information was circulating about both the process and likely analytical approach to designating (non-bank systemically important financial institutions), contributing to market uncertainty," the Fed said in its posting.

However, the proposal put out by the Fed is unlikely to calm these concerns.

"It appears to me what they are trying to do is define broad criteria to give them maximum options," said David Hirschmann, a senior vice president at the U.S. Chamber of Commerce.

Hirschmann said what the markets need is clarity.

TWO-YEAR TEST

On Tuesday, the Fed put out for public comment some proposals on how to better define the "systemic" designation.

The Fed's proposal will aid the Financial Stability Oversight Council -- the council of U.S. financial regulators with 10-voting members -- that is ultimately responsible for picking systemic firms.

The Fed's proposal would create some bright lines on whether a firm is predominantly engaged in financial activities -- just one factor determining if a firm is systemic.

The proposal includes a test to determine if a firm's gross financial revenue was 85 percent or more of its annual gross revenue in either of the two most recently completed fiscal years. A firm would also meet this test if its total financial assets represent 85 percent or more of total assets.

As part of the proposal, the Fed attempts to define "financial" activities. These include acting as a financial advisor, providing financial data services, managing a mutual fund and making a market in securities, among others.

The Fed was careful not to be too prescriptive in its proposal, saying it could judge "on a case-by-case basis" whether a firm is predominantly engaged in financial activities, injecting more uncertainty.

The Fed said it would seek comment on the proposed rule through March 30.

(Reporting by Dave Clarke; editing by Andre Grenon)

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