Dodd-Frank Enhanced Prudential Standards for Foreign Banking Organizations

Editor’s Note: Margaret E. Tahyar is a partner in Davis Polk & Wardwell LLP’s Financial Institutions Group. This post is based on a client memorandum by a team of attorneys at Davis Polk; the full publication, including footnotes, is available here. Key aspects of the Federal Reserve’s proposal for foreign banks are illustrated in a set of Davis Polk visuals, available here.

Following closely on the heels of Federal Reserve Governor Daniel K. Tarullo’s November 2012 speech, the Federal Reserve has proposed a tiered approach for applying U.S. capital, liquidity and other Dodd-Frank enhanced prudential standards, including single counterparty credit limits, risk management, stress testing and early remediation requirements, to the U.S. operations of foreign banking organizations with total global consolidated assets of $50 billion or more (“Large FBOs”). Most Large FBOs would have to create a separately capitalized top-tier U.S. intermediate holding company (“IHC”) that would hold all U.S. bank and nonbank subsidiaries. A Large FBO with combined U.S. assets of less than $10 billion, excluding its U.S. branch and agency assets, would not be required to form an IHC.

The IHC would be subject to U.S. capital, liquidity and other enhanced prudential standards on a consolidated basis. In addition, the Federal Reserve would have the authority to examine any IHC and any subsidiary of an IHC. Although the U.S. branches and agencies of a Large FBO’s foreign bank would not be required to be held beneath the IHC, they too would be subject to liquidity, single counterparty credit limits and, in certain circumstances, asset maintenance requirements. Large FBOs not required to form an IHC would also be subject to many of the new enhanced prudential standards.

This memorandum provides an overview of key aspects of the Federal Reserve’s proposal, which would become effective on July 1, 2015. We invite you to also read the accompanying diagrams and tables for a visual representation of these new requirements, available here. The comment period for the proposal ends on March 31, 2013.

  • Diagram 1 illustrates the structural application of the proposed requirements to the U.S. operations of a Large FBO.
  • Diagram 2 illustrates a possible structure under the proposal for a tiered FBO that controls another Large FBO.
  • Diagram 3 illustrates new requirements that would apply to a Large FBO with a limited U.S. footprint.
  • Diagram 4 illustrates new requirements that would apply to a Large FBO with a major U.S. footprint.
  • Table 1 summarizes the applicability of the proposed requirements to FBOs of different sizes.
  • Table 2 sets forth the different methods for calculating various asset thresholds used in the proposal.
  • Tables 3 and 4 summarize the proposed early remediation framework.

Requirement to Establish a Top-Tier U.S. IHC

  • This requirement would apply to any Large FBO with combined U.S. assets of $10 billion or more, excluding its U.S. branch and agency assets. The proposal would generally require a Large FBO to organize under a single top-tier U.S. IHC all its U.S. subsidiaries other than its interests in foreign commercial subsidiaries with activities in the United States, known in U.S. banking law as Section 2(h)(2) subsidiaries. A Large FBO with combined U.S. assets of less than $10 billion, excluding assets held by its U.S. branches and agencies, would not be required to form an IHC. The proposed method for calculating this asset threshold is set forth in Table 2.
  • U.S. Requirements, Supervision, Examinations and Reporting: The IHC would be subject to U.S. capital, liquidity and other Dodd-Frank enhanced prudential standards on a consolidated basis, as further described below. The IHC would be subject to umbrella supervision by the Federal Reserve and would be subject to regulatory reporting and inspection requirements comparable to those that apply to a U.S. bank holding company (“BHC”). The Federal Reserve noted that it is conducting a review of existing supervisory guidance to identify guidance that may be relevant to the operations and activities of an IHC that does not have a U.S. bank subsidiary. It proposes to apply such guidance to IHCs on a rolling basis, either by revising and reissuing the guidance or by publishing a notification that refers to the applicable guidance.
  • Structural Tailoring: Upon written request by an FBO, the Federal Reserve would consider whether the circumstances – including where an FBO controls another FBO that has separate U.S. operations or where applicable law prohibits an FBO from holding one or more of its U.S. subsidiaries through a single IHC – warrant permitting the FBO to establish multiple IHCs or use an alternative organizational structure to hold its U.S. subsidiaries. The proposal’s general provisions further provide that if an FBO owns more than one foreign bank, the Federal Reserve may apply the requirements in the proposal in a manner that takes into account the separate operations of such foreign banks.

IHC Subject to U.S. BHC Capital Requirements

  • U.S. BHC Capital Requirements Apply to IHC: An IHC, regardless of whether it controls a U.S. bank, would be subject to the same U.S. risk-based and leverage capital standards that apply to a U.S. BHC. Accordingly, an IHC that crosses the applicability thresholds under the advanced approaches capital rules, currently based on Basel II’s advanced internal ratings-based approach for credit risk and advanced measurement approaches for operational risk, and the market risk capital rules, currently based on Basel 2.5, would be required to use those rules to calculate its risk-based capital requirements, subject to the Collins Amendment capital floor.
  • D-SIB Surcharge: The Federal Reserve stated that it may also, through a future rulemaking, apply a capital surcharge in the United States to an IHC that is determined to be a domestic systemically important bank (“D-SIB”), consistent with the Basel Committee’s D-SIB regime or a similar framework.
  • U.S. Basel III Proposals: U.S. banking regulators recently proposed comprehensive revisions to the U.S. bank capital framework that would implement many aspects of Basel III and move all U.S. banking organizations toward a modified, U.S. version of the standardized approach for credit risk under Basel II. A Davis Polk memorandum on the U.S. Basel III proposals is available here.
  • Multiple Capital Regimes: Among other things,the permanent capital floor imposed by the Collins Amendment and Dodd-Frank’s prohibition on reliance on external credit ratings has resulted in significant U.S. departures from the international Basel capital framework and the capital regulations in other major jurisdictions. Imposing uniquely U.S. capital standards on the IHC of a Large FBO that is subject to home country capital standards on a group-wide consolidated basis would likely give rise to challenging operational and compliance issues.
  • Federal Reserve’s Capital Plan Rule: An IHC with total consolidated assets of $50 billion or more would be subject to the Federal Reserve’s capital plan rule. The proposed method for calculating this asset threshold is set forth in Table 2. The capital plan rule would require such an IHC to submit annual capital plans to the Federal Reserve demonstrating the IHC’s ability to maintain capital above the Federal Reserve’s minimum risk-based capital and leverage ratios under both baseline and stressed conditions over a minimum nine-quarter, forward-looking planning horizon. An IHC that is unable to satisfy the capital plan rule’s requirements generally may not make any capital distributions until it provides a satisfactory capital plan to the Federal Reserve. As is the case with an FBO’s U.S. BHC subsidiary that will be subject to the Federal Reserve’s capital planning rules, this proposal may make it more difficult for a Large FBO to repatriate excess capital from an IHC.
  • Certify Capital Adequacy on a Consolidated Basis: A Large FBO must certify that it meets capital adequacy standards established by its home country supervisor on a consolidated basis and that those standards are consistent with the Basel capital framework, including Basel III and any future amendments to said framework. A Large FBO must also report on a quarterly basis its risk-based capital ratios, risk-weighted assets and total assets to the Federal Reserve. If the Federal Reserve determines that these conditions are not met, it may impose conditions or restrictions on the Large FBO’s U.S. operations. The proposal would not apply the U.S. leverage ratio to an FBO at the consolidated level. The Federal Reserve noted, however, that the leverage ratio under Basel III is expected to be implemented internationally in 2018. At that time, the proposal would require a Large BHC to certify or otherwise demonstrate that it complies with the Basel III leverage ratio.
  • G-SIB Surcharge Certification: The Federal Reserve may, through a separate rulemaking, introduce a consolidated capital surcharge certification requirement for a Large FBO that is designated by the Basel Committee and the Financial Stability Board as a global systemically important bank (“G-SIB”).

Liquidity Requirements for U.S. Operations of a Large FBO

  • Liquidity Risk Management: A Large FBO with combined U.S. assets of $50 billion or more must meet liquidity risk management standards that are broadly similar to the Federal Reserve’s December 2011 enhanced prudential standards proposal for domestic firms (“Domestic Proposal”). Specifically, the risk management standards would require the Large FBO, with respect to its “combined U.S. operations,” to adopt specific corporate governance practices regarding liquidity risk management, produce comprehensive cash flow projections, develop specific limits relating to liquidity metrics, establish procedures for monitoring collateral and its availability, liquidity risk exposures and funding needs, and intraday liquidity risk exposures, and maintain a contingency funding plan. The liquidity risk management standards would impose certain responsibilities on the Large FBO’s U.S. risk committee and U.S. chief risk officer.
  • Liquidity Stress Testing: A Large FBO with combined U.S. assets of $50 billion or more must conduct, at least monthly, stress tests of its cash flow projections separately for all its U.S. branches and agencies (“U.S. Branch and Agency Network”) and for its IHC. The stress test results would be used to determine the size of the liquidity buffers, discussed below, and to inform the Large FBO’s contingency funding plan. The proposal imposes general requirements for the stress scenarios, assumptions and time horizons that the Large FBO must incorporate into its liquidity stress tests. Unlike the current calibration of the Basel III liquidity coverage ratio, however, the proposal does not prescribe standardized, one-size-fits-all assumptions about the Large FBO’s cash inflows and outflows under stressed conditions. Instead, similar to the Domestic Proposal, the proposal requires liquidity stress tests to be tailored to, and provide sufficient detail to reflect, the capital structure, risk profile, complexity, activities, size and other relevant characteristics of the combined U.S. operations of the Large FBO and, as appropriate, the Large FBO as a whole. The Large FBO would be required to report to the Federal Reserve the results of the stress tests for its combined U.S. operations and the amount of the liquidity buffer, discussed below, for its combined U.S. operations, as well as, on a quarterly basis, the results of any internal liquidity stress tests and establishment of liquidity buffers required by its home country regulators.
  • Local U.S. Liquidity Buffers: A Large FBO with combined U.S. assets of $50 billion or more must maintain a liquidity buffer for its U.S. Branch and Agency Network and a separate buffer for its IHC. Each liquidity buffer must consist of “highly liquid assets” that are unencumbered and that are sufficient to meet the “net stressed cash flow need” over the first 30 days of its stress test horizon. The Large FBO’s U.S. Branch and Agency Network must maintain the first 14 days of its 30-day buffer in the United States, but would generally be permitted to meet the remainder of the requirement at the parent consolidated level, provided that the Large FBO has demonstrated to the Federal Reserve that it or an affiliate could provide the residual liquid assets to its U.S. Branch and Agency Network if needed. In contrast, the IHC of the Large FBO must maintain the full 30-day buffer in the United States.
  • Basel III’s Quantitative Liquidity Ratios: In future rulemakings, the Federal Reserve intends to implement Basel III’s quantitative liquidity standards, including the liquidity coverage ratio and the net stable funding ratio, for the U.S. operations of “some or all” Large FBOs with combined U.S. assets of $50 billion or more, consistent with the international timeline. It remains to be seen how these U.S. liquidity requirements would interact with any consolidated liquidity requirements implemented by a Large FBO’s home country regulator. As with the Domestic Proposal, the Federal Reserve also requested comments on whether it should, pursuant to its Dodd-Frank enhanced prudential standards authority, adopt a short-term debt limit in addition to, or in place of, the Basel III liquidity requirements.
  • Large FBOs with Limited U.S. Footprint: A Large FBO with combined U.S. assets of less than $50 billion would be required to report the results of an internal liquidity stress test, either on a consolidated basis or for its combined U.S. operations, to the Federal Reserve on an annual basis. The internal stress test must be conducted in a manner consistent with the Basel Committee’s principles for liquidity risk management. If the Large FBO does not satisfy this requirement, it must limit the net aggregate amount owed by its head office and its non-U.S. affiliates to its combined U.S. operations to 25% or less of the third-party liabilities of its combined U.S. operations, on a daily basis.

Single Counterparty Credit Limits

  • The proposed single counterparty credit limits would apply to an IHC and the combined U.S. operations of a Large FBO. A Large FBO would have to ensure compliance with these requirements by its IHC and combined U.S. operations on a daily basis and submit to the Federal Reserve monthly reports showing daily compliance.
  • 25% Limits for IHC and Combined U.S. Operations: An IHC, together with its subsidiaries, would be prohibited from having an aggregate net credit exposure to any unaffiliated counterparty, together with its subsidiaries, in excess of 25% of the IHC’s consolidated capital stock and surplus. In addition, the combined U.S. operations of a Large FBO, together with any subsidiary of an entity within the combined U.S. operations, would be prohibited from having an aggregate net credit exposure to any unaffiliated counterparty, together with its subsidiaries, in excess of 25% of the consolidated total regulatory capital of the Large FBO.
  • Stricter Limits for Exposures Between Major Counterparties: The proposal would impose a more stringent credit exposure limit between a major IHC or the combined U.S. operations of a major FBO, together with their respective subsidiaries, and any unaffiliated major counterparty, together with its subsidiaries. This more stringent limit would be set to be consistent with the stricter limit established for major U.S. BHCs and for nonbank financial companies supervised by the Federal Reserve following a systemic designation by the Financial Stability Oversight Council (“FSOC”).
  • Calculating Credit Exposure: The types of credit transactions subject to single counterparty credit limits and the methods for calculating gross and net credit exposure arising from these transactions are broadly similar to the Domestic Proposal. Accordingly, the proposal would not permit Large FBOs to use risk-sensitive, supervisor-approved internal models to calculate their credit exposure arising from derivative transactions and would instead require them to use the current exposure method (“CEM”), a look-up table approach that was first introduced in Basel I nearly a quarter of a century ago. Moreover, notwithstanding the G20 commitments regarding the central clearing of standardized derivatives, the proposal would not exempt exposures to central counterparties from single counterparty credit limits.
  • Exposures to U.S. Federal Government and Home Country Sovereign Are Exempted: The limits would apply to credit exposures to foreign sovereign governments and U.S. state and local governments. The limits would not apply, however, to exposures to the U.S. federal government, including U.S. federal government agencies as well as Fannie Mae and Freddie Mac, while in conservatorship. The limits also would not apply to exposures to a Large FBO’s home country sovereign, including the central government, an agency, department, ministry or central bank.
  • Quantitative Study on Single Counterparty Credit Limits: On the one hand, the Federal Reserve stated that any differences between the proposal and the Domestic Proposal generally reflect the different regulatory framework under which FBOs operate and do not signal how the Domestic Proposal would be finalized. On the other hand, the Federal Reserve acknowledged the large volume of comments it received on the single counterparty credit limit framework in the Domestic Proposal, including comments on the proposed calculation methodologies and the stricter 10% threshold for exposures between major counterparties. The Federal Reserve’s staff stated that they are preparing a quantitative impact study on single counterparty credit limits to help inform the rulemaking process. Notably, the Federal Reserve chose not to quantify the stricter limit for major counterparties in this proposal, except to note that it would be consistent with the one applicable to domestic firms.
  • Future Rulemakings: In future rulemakings, the Federal Reserve will propose credit exposure reporting requirements for Large FBOs. The Federal Reserve also noted that the Basel Committee is examining single counterparty credit limit regimes across jurisdictions and evaluating potential international standards. If an international agreement on this issue is reached, the Federal Reserve stated that it may amend this proposal, as necessary, to achieve consistency with the international approach.

Risk Management and Risk Committee Requirements

  • U.S. Risk Committee: A publicly traded FBO with total global consolidated assets of $10 billion or more and a Large FBO, regardless of whether its stock is publicly traded, would each be required to annually certify to the Federal Reserve that it maintains a U.S. risk committee that oversees the risk management practices of the FBO’s combined U.S. operations and has at least one member with appropriate risk management expertise. In general, the FBO may maintain its U.S. risk committee either as:
    • A committee of its global board of directors, on a stand-alone basis or as part of its enterprise-wide risk committee; or
    • A committee of the board of directors of its IHC, if applicable.
  • Additional U.S. Risk Committee Requirements: A Large FBO with combined U.S. assets of $50 billion or more would be subject to additional U.S. risk committee requirements. Among other things, the U.S. risk committee of such a Large FBO would have to review and approve the risk management practices of its combined U.S. operations, oversee the operation of an appropriate risk management framework for the combined U.S. operations, including the proposed liquidity risk management standards, and would have to include at least one independent member. The independence requirement would apply regardless of where the U.S. risk committee is located. The Federal Reserve requested comments on a number of alternative risk management structures to the proposed U.S. risk committee requirement.
  • U.S. Chief Risk Officer: A Large FBO with combined U.S. assets of $50 billion or more would be required to appoint a U.S. chief risk officer responsible for implementing and maintaining the risk management framework and practices for the Large FBO’s combined U.S. operations, including the proposed liquidity risk management standards. Among other requirements, the U.S. chief risk officer would be required to have appropriate risk management expertise, and would have to report directly to the U.S. risk committee and to the Large FBO’s global chief risk officer or equivalent management official(s), unless the Federal Reserve approves an alternative reporting structure.
  • Existing Supervisory Guidance: The Federal Reserve emphasized that the risk management requirements contained in this proposal supplement its existing risk management guidance and supervisory expectations for FBOs.

Stress Testing Requirements

  • Dodd-Frank Stress Tests for IHCs: An IHC would be subject to the Federal Reserve’s Dodd-Frank stress testing rules as if it were a U.S. BHC. As a result, an IHC with total consolidated assets of more than $10 billion but less than $50 billion would be subject to annual company-run stress tests under the Federal Reserve’s final stress testing rule for U.S. BHCs in that size range. Likewise, an IHC with total consolidated assets of $50 billion or more would be subject to annual supervisory stress tests and semi-annual company-run stress tests under the Federal Reserve’s final stress testing rule for similarly sized U.S. BHCs. The Federal Reserve’s stress testing rules require firms to publish summaries of their company-run stress test results. In addition, the Federal Reserve publishes summaries of supervisory stress test results. A Davis Polk memorandum on the Federal Reserve’s instructions for the 2013 Dodd-Frank stress testing and capital planning cycle is available here.
  • Home Country Stress Tests for Certain Large FBOs: The U.S. Branch and Agency Network of a Large FBO with combined U.S. assets of $50 billion or more would be subject to a 108% asset maintenance requirement as well as any intragroup funding restrictions or additional liquidity requirements imposed by the Federal Reserve unless the Large FBO satisfies certain conditions related to stress testing. These conditions include:
    • The Large FBO is subject to and passes an annual stress test conducted by its home country regulator or conducted by the FBO and reviewed by its home country regulator;
    • The Large FBO provides certain information to the Federal Reserve regarding its stress tests; and
    • If, on a net basis, the Large FBO’s U.S. Branch and Agency Network provides funding to its head office and non-U.S. affiliates, the Large FBO must provide more detailed information regarding its stress tests and demonstrate to the Federal Reserve that it has adequate capital to withstand stressed conditions.
  • Home Country Stress Tests for Smaller FBOs: The U.S. Branch and Agency Network of an FBO with total consolidated assets of more than $10 billion but with combined U.S. assets of less than $50 billion would be subject to a 105% asset maintenance and certain other requirements unless the FBO is subject to and passes an annual stress test conducted by its home country regulator or conducted by the FBO and reviewed by its home country regulator.

Debt-to-Equity Limitation

  • In the event that the FSOC determined that a Large FBO posed a grave threat to U.S. financial stability and that the imposition of a debt-to-equity requirement was necessary to mitigate such risk, within 180 days after such a determination, subject to any extension granted by the Federal Reserve
    • The Large FBO’s IHC would be required to maintain a debt-to-equity ratio of no more than 15-to-1; and
    • The Large FBO’s U.S. Branch and Agency Network would be required to maintain a 108% asset maintenance requirement.

Early Remediation Framework

  • Early Remediation Triggers: The combined U.S. operations of a Large FBO would be subject to early remediation triggers based on the Large FBO’s and IHC’s capital ratios relative to applicable minimum requirements, stress test results, liquidity and risk management weaknesses and market indicators. The proposed early remediation triggers are summarized in Table 3. The Federal Reserve stated that it expects to notify the Large FBO’s home country supervisor, the primary regulators of its U.S. offices and subsidiaries and the FDIC as the Large FBO’s U.S. operations enter into or change remediation levels.
  • Early Remediation Actions: A Large FBO with combined U.S. assets of $50 billion or more that exceeds an early remediation trigger would be subject to a set of nondiscretionary remediation actions imposed on its U.S. operations. These proposed remediation actions are summarized in Table 4. A Large FBO with combined U.S. assets of less than $50 billion would not be automatically subject to remediation actions.

Implementation Timing

  • For FBOs with total global consolidated assets of $50 billion or more as of July 1, 2014, the proposal’s enhanced prudential standards and the IHC requirement, if applicable, would apply beginning on July 1, 2015.
  • FBOs that cross the $50 billion total global consolidated assets threshold after July 1, 2014, would be required to form an IHC beginning 12 months after they reach the $50 billion threshold, unless accelerated or extended by the Federal Reserve. These FBOs generally would be required to comply with the proposed enhanced prudential standards beginning on the same date they are required to establish an IHC.

Application to Foreign Nonbank SIFIs

  • The proposal also would apply to foreign nonbank financial companies supervised by the Federal Reserve following a systemic designation by the FSOC (“Foreign Nonbank SIFIs”). The Federal Reserve, however, will clarify how the proposal would apply to a Foreign Nonbank SIFI following its systemic designation. The proposal also includes criteria to be considered by the Federal Reserve in determining whether to impose the IHC requirement on a Foreign Nonbank SIFI. To date, no systemic designations have been made with respect to foreign nonbank financial companies.

Broader Implications of the Proposal

The proposal, if adopted, could have profound negative implications not only for the U.S. operations of FBOs, but also for U.S. banking organizations doing business outside the United States. It would likely contribute and add fuel to the growing trend towards regionalization of global banking, thereby complicating and increasing the cost of providing cross-border banking services. These broader implications are explored in a Davis Polk memorandum discussing Federal Reserve Governor Daniel K. Tarullo’s November 2012 speech, which previewed the basic elements of the proposal.

 

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