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.

…continue reading: Dodd-Frank Enhanced Prudential Standards for Foreign Banking Organizations

The Federal Reserve launched the 2013 capital planning and stress testing process for large bank holding companies (“BHCs”) with the publication, on November 9, 2012, of two sets of instructions: one set for the 19 BHCs that participated in the 2011 Comprehensive Capital Analysis and Review (“CCAR”) process (“CCAR BHCs”) and another set for the 11 other U.S.-domiciled, top-tier BHCs with total consolidated assets of $50 billion or more that did not participate in the 2011 CCAR process (“non-CCAR BHCs”). On the same day, the Federal Reserve joined with other U.S. banking agencies to announce that recent proposals to implement Basel III in the United States will not become effective on January 1, 2013.

The Federal Reserve’s instructions for the CCAR BHCs, which reveal how the Dodd-Frank Act’s stress testing requirements will be integrated with the Federal Reserve’s capital planning requirements, are instructive for the non-CCAR BHCs that will become subject to Dodd-Frank stress-testing requirements in the 2014 capital planning cycle. Similarly, nonbank financial companies designated by the Financial Stability Oversight Council (“FSOC”) for supervision by the Federal Reserve will be subject to Dodd-Frank stress-testing requirements and, under a proposal by the Federal Reserve, would also be required to submit annual capital plans to the Federal Reserve.

For the CCAR BHCs, the two most significant changes from the 2012 process are:

…continue reading: Fed Begins 2013 CCAR Capital Planning Process for Large Banks

On November 9, 2012, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued instructions and guidance for:

• the Comprehensive Capital Analysis and Review program for 2013 (“CCAR 2013”) applicable to the 19 bank holding companies (“BHCs”) with total assets of $50 billion or more that were previously subject to CCAR and the Supervisory Capital Assessment Program (“SCAP”); and
• the Capital Plan Review program for 2013 (“CapPR 2013”) applicable to an additional 11 BHCs with total assets of $50 billion or more that were not subject to prior CCARs or SCAP, but were subject to CapPR in 2012.

CCAR 2013 and CapPR 2013 are both being conducted under the Federal Reserve’s previously adopted Capital Plan Rule. In addition, elements of CCAR 2013 are being implemented in conjunction with the Federal Reserve’s newly finalized Stress Test Rules adopted pursuant to the separate stress test requirements of sections 165(i)(1) and (2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The following is an outline of certain notable aspects of the CCAR 2013, CapPR 2013 and their respective instructions.

In certain instances, the instructions and guidance for CCAR 2013 and CapPR 2013 contain new provisions, while in others, the new instructions are largely congruous with procedures for previous CCAR and CapPR iterations. Important aspects of CCAR 2013 instructions include:

…continue reading: Capital Plans and Stress Test Rules

Summary

In October 2012, the Board of Governors of the Federal Reserve System (the “FRB”) published in the Federal Register final rules implementing the requirements of Section 165(i)(1) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) concerning supervisory stress tests to be conducted by the FRB (the “Annual Supervisory Stress Test Rule”) and Section 165(i)(2) of Dodd-Frank regarding semi-annual company-run stress tests (the “Semi-Annual Company-Run Stress Test Rule,” and, together with the Annual Supervisory Stress Test Rule, the “Stress Test Rules”). The Stress Test Rules apply to bank holding companies (“BHCs”) with total consolidated assets of $50 billion or more (“Large BHCs”) and nonbank financial companies designated by the Financial Stability Oversight Council (“Designated SIFIs,” and together with Large BHCs, “Covered Companies”). Concurrent with the Stress Test Rules, the FRB, Office of the Comptroller of the Currency (“OCC”) and Federal Deposit Insurance Corporation (“FDIC,” and together with the FRB and OCC, the “Agencies”) published separate final rules implementing the requirements of Section 165(i)(2) of Dodd-Frank regarding annual company-run stress tests (the “Annual Company-Run Stress Test Rules”) for supervised entities (BHCs, savings and loan holding companies (“SLHCs”) and depository institutions) with average total consolidated assets greater than $10 billion other than Covered Companies (together “Covered Institutions”). The Stress Test Rules and Annual Company-Run Stress Test Rules have substantial implications for capital planning, including capital distributions.

The specific application of the rules generally depends on the type of entity involved (for example, BHC, depository institution, or SLHC), the size of the institution and its applicable regulator. In summary, the requirements of the Stress Test Rules and Annual Company-Run Stress Test Rules are as follows:

…continue reading: Supervisory and Company-Run Stress Test Requirements

On October 19, 2012, the Office of the Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve Board (“Board”) approved final rules, which were proposed for comment in January of this year, [1] implementing the Dodd-Frank Act’s company-run stress testing requirements for all insured depository institutions with total consolidated assets of $10 billion or more. [2] In addition, the Board has simultaneously published final stress-testing rules, covering the Dodd-Frank Act’s requirements for Board-run and
company-run stress-testing requirements for banking organizations with more than $50 billion in total consolidated assets. [3]

Most of the changes between the proposed rules and the final rules involve the procedures and timelines, rather than the substance, of the required stress-testing. Highlights of the regulatory actions include:

…continue reading: Final Rules from the Federal Banking Agencies

The Federal Reserve on December 20 issued its proposal to implement heightened prudential requirements for the largest US financial institutions as a result of the ongoing financial crisis. These institutions will have to design and implement compliance, recordkeeping and reporting procedures for the new standards in addition to the multitude of new restrictions imposed by such reforms as the Volcker Rule. The following summarizes the new proposal, identifies the portions applicable to various types of covered financial institutions and outlines the various requirements applicable to each type. Covered institutions may take some solace, though perhaps not much, in the fact that many of the requirements are consistent with emerging international standards for supervision of large financial companies.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) requires that the Board of Governors of the Federal Reserve System (“Federal Reserve”) impose enhanced supervisory requirements on the largest bank holding companies – in general, those with at least $50 billion, but with respect to certain requirements, those with at least $10 billion assets – and those nonbank financial companies designated as requiring supervision as though they were bank holding companies. [1] The Federal Reserve’s proposal (the “Proposal”) provides detail on how several of the requirements would be implemented. [2] Comments are due by March 31, 2012.

…continue reading: Tightening the Limits on Big US Banks

On November 22, 2011, the Board of Governors of the Federal Reserve System (the “Board”) published a final rule (the “Final CCAR Rule”) requiring most bank holding companies (“BHCs”) with $50 billion or more of total consolidated assets (“Covered BHCs”) to submit annual capital plans, with their related stress test requirements, to the appropriate Federal Reserve Bank and to generally obtain regulatory approval before making capital distributions, which include dividends and purchases of capital securities and instruments. The Final CCAR Rule expands the capital plan requirements from 19 to 34 BHCs, including, for the first time, foreign-owned BHCs. In addition, the Board released (i) two sets of instructions (the “Instructions”) that provide guidance on compliance with capital requirements in the Final CCAR Rule, one for Covered BHCs that did not participate in the 2011 Comprehensive Capital Analysis and Review (“CCAR” and such BHCs, the “non-CCAR BHCs”) and another for the 19 Covered BHCs that participated in the 2011 CCAR (the “CCAR BHCs”) and (ii) the data templates (namely, the FR Y- 14A and FR Y-14Q) that will be used to collect data from the CCAR BHCs to support the data collection contemplated by the Final CCAR Rule. The Final CCAR Rule generally incorporates the core features of the Board’s June 17, 2011 proposal regarding capital planning (the “Proposed CCAR Rule”).

…continue reading: Federal Reserve Capital Plan and Stress Test Requirements

The United States government is now permitting ten of America’s biggest banks to repay about $70 billion of the capital injected into them last fall. This decision followed the banks having passed the so-called “stress tests” of their financial viability, which the US Treasury demanded, and the success of some of them in raising the additional capital that the tests suggested they needed.

Many people have inferred from this sequence of events that US banks – which are critical to both the American and world economies – are now out of trouble. But that inference is seriously mistaken.

In fact, the US stress tests didn’t attempt to estimate the losses that banks have suffered on many of the “toxic assets” that have been at the heart of the financial crisis. Nevertheless, the US model is catching on. In a meeting this month, finance ministers of G-8 countries agreed to follow the US and perform stress tests on their banks. But, if the results of such tests are to be reliable, they should avoid the US tests’ fundamental flaw.

Until recently, much of the US government’s focus has been on the toxic assets clogging banks’ balance sheets. Although accounting rules often permit banks to price these assets at face value, it is generally believed that the fundamental value of many toxic assets has fallen significantly below face value. The Obama administration came out with a plan to spend up to $1 trillion dollars to buy banks’ toxic assets, but the plan has been put on hold.

It might have been hoped that the bank supervisors who stress-tested the banks would try to estimate the size of the banks’ losses on toxic assets. Instead, supervisors estimated only losses that banks can be expected to incur on loans (and other assets) that will come to maturity by the end of 2010. They chose to ignore any losses that banks will suffer on loans that will mature after 2010. Thus, the tests did not take into account a big part of the economic damage that the crisis imposed on banks.

…continue reading: Toxic Tests

Buoyed by the results of the “stress tests” conducted by banks’ supervisors, markets now appear optimistic about the capital positions of U.S. banks. Unfortunately, however, this renewed optimism has a shaky foundation. By design, the stress tests have avoided estimating the declines in the value of many toxic assets owned by banks. As a result, U.S. banks could well be in much worse shape than has been suggested by the stress tests.

The report announcing the results of stress tests stresses that supervisors conducted “a deliberately stringent test” and examined the ability of banks to absorb losses even under an “adverse” scenario with a deeper and more protracted downturn than under the current consensus estimate. The report concludes that, with a modest aggregate addition of $75 billion in common equity, the banks will be well capitalized at the end of 2010 even under the adverse scenario.

While the focus on the “adverse” scenario might represent a conservative approach, another estimation choice led to under-counting of banks’ expected losses. In reaching an estimate of $600 billion for banks’ aggregate losses, the report focuses on estimating “losses due to failure to pay obligations” rather than “discounts related to mark-to-market values.”

Thus, for a bank with a $1 billion portfolio of real estate loans due in 2010, if the supervisors estimated that only half of the face amount will be repaid, they added $500 million to their estimate of losses. However, for a bank that has “troubled assets” with $1 billion face value that do not become due until after 2011, supervisors did not attempt to come up with a precise estimate of the extent to which, at the end of 2010, the economic value of the troubled assets will fall below the $1 billion face value.

This approach overlooks a substantial amount of economic damage imposed on banks by the crisis. Indeed, to the extent that the government’s new program for restarting the market for troubled assets will provide market transactions for troubled assets with long maturities, mark-to-market rules might require banks to recognize this or next year the declines in economic value of their troubled assets with long maturities. But even if banks are able to avoid recognizing these declines in value on their financial statements until after 2010, there will still be such economic losses. A bank may be an economic zombie even if its financial statements do not yet show it.

The report acknowledges this major problem in a footnote, noting that its estimated losses “are not full lifetime losses … because the projections are for a two-year forward horizon and thus do not capture losses occurring beyond the end of 2010.” Trying to defend this limitation, it notes that the profile of the adverse scenario “includes a return to positive real GDP growth within the two years,” and that a two-year horizon thus “seems likely to capture a large portion of losses from positions held as of the end of 2008.”

Even if positive real GDP growth resumes after 2010, however, some of the assets backing banks’ 2008 positions–residential and commercial real estate, as well as the assets of nonfinancial firms–may remain far below their 2008 levels, and banks may consequently have to bear large losses on their long-maturity assets for years to come.

Furthermore, even accepting that the two-year horizon does capture a “large portion” of aggregate losses to banks’ 2008 positions, it still fails to include the remainder and possibly large portion of these losses. For example, if the “large portion” happens to be 60%, then the banks’ total estimated losses, and the additional capital that they need, are higher by $400 billion than the report’s estimates of $600 billion and $75 billion respectively.

The report also adds that the “the impact of some losses after 2010 is also captured through the calculation of the need of 2010 reserves.” But without estimating the economic losses to troubled assets with post-2010 maturities, which the supervisors did not do, it is not possible to stipulate the level of reserves that will fully cover these losses.

To get a full picture of the banks’ situation, bank supervisors should estimate also the decline in the economic value of banks’ positions with longer maturities. Only then will the stress tests be able to deliver reliable figures for the additional capital necessary to make the banking sector healthy and vigorous. Until such an analysis is done, it would be important to avoid the premature conclusion that the U.S. baking system is largely out of the woods.

The Treasury’s recently announced Financial Stability Plan reshapes the ground rules for capital injections into financial institutions, increases the size and scope of a previously announced non-recourse lending facility by the Federal Reserve, launches the idea of a public-private investment fund to purchase legacy or toxic assets from financial institutions and sets aside funds for the homeowner assistance plan outlined by President Obama on February 18. As has been widely noted, however, the plan is long on aspiration but short on detail.

Among the new features of the plan is a mandatory comprehensive “stress test” for banking institutions with assets in excess of $100 billion. Although “stress testing” is a term of art in the financial services and risk management realm and is an element of the risk-based approach taken by Basel II, the sense in which it will be applied by Treasury is unclear. The memorandum explores the possible meaning.

The plan also contemplates, but does not detail, ongoing measures to further enhance public disclosure of financial health. Political calls for more disclosure in the current environment, however, disguise the complexity of the issues that will have to be sorted out in order to arrive at a functional solution. Some of these challenges discussed in the memorandum include the possible necessity of international coordination in order to shape new norms for financial institution disclosures and the implications of the ongoing debate over mark-to-market accounting and dynamic provisioning.

In an effort to restart the currently illiquid market for legacy assets, Treasury announced the creation of the Public-Private Investment Fund. The key new feature of this initiative, compared to earlier discussions regarding an aggregator bad bank, is an element of private capital participation, although the specifics of this public-private partnership are still unclear. The memorandum discusses some of the challenges, including whether pricing mechanisms will indeed be easier to design due to private sector involvement.

Hardly any market has been more affected by the recent market turmoil than the private label securitization market. The pendulum appears to have swung from a failure of the financial markets to properly recognize and price the huge risks of certain securitization classes to a situation where securities backed by any asset class not also explicitly or implicitly backed by the government are virtually impossible to bring to the market. While banks have been broadly accused of being responsible for reduced lending activity, latest data published by Treasury shows that in fact, the absence of a functioning securitization market is the greatest contributor to a decline in lending. Therefore, it should come as no surprise that the implementation of a facility announced by the Federal Reserve in November of last year to revive the asset-backed securities markets, the Term Asset-Backed Securities Loan Facility, is greatly anticipated. The memorandum discusses salient features of the facility, including the manner in which it will allow for the participation of unregulated funds, and its potential expansion as part of the government’s plan.

The memorandum is available here.