Enhanced Prudential Standards

On February 18, 2014, the Board of Governors of the Federal Reserve System (the “FRB”) approved a final rule (the “Final Rule”) implementing certain of the “enhanced prudential standards” mandated by Section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or “Dodd-Frank”). The Final Rule applies the enhanced prudential standards to (i) U.S. bank holding companies (“U.S. BHCs”) with $50 billion (and in some cases, $10 billion) or more in total consolidated assets and (ii) foreign banking organizations (“FBOs”) with (x) a U.S. banking presence, through branches, agencies or depository institution subsidiaries, and (y) depending on the standard, certain designated amounts of assets worldwide, in the United States or in U.S. non-branch assets. The Final Rule’s provisions are the most significant, detailed and prescriptive for the largest U.S. BHCs and the FBOs with the largest U.S. presence—those with $50 billion or more in total consolidated assets and, in the case of FBOs, particularly (and with increasing stringency) for FBOs with combined U.S. assets of $50 billion or more or U.S. non-branch assets of $50 billion or more.

The Final Rule’s provisions are considerably more noteworthy for FBOs than for U.S. BHCs. In the case of U.S. BHCs, a number of the enhanced prudential standards have previously been finalized and are (or will shortly be) in effect, in particular, the revised U.S. Basel III-based risk-based and leverage capital rules and the capital planning and company-run and supervisory stress testing requirements previously implemented by the FRB. The Final Rule implements, as new requirements for U.S. BHCs, only Section 165’s risk management requirements (including requirements, duties and qualifications for a risk management committee and chief risk officer), liquidity stress testing and buffer requirements, and the potential application of a 15-to-1 debt-to-equity limit for a U.S. BHC deemed by the Financial Stability Oversight Council (the “FSOC”) to pose a grave risk to the financial stability of the U.S. Many, if not most, of these items have already been effectively implemented through supervisory guidance.

For FBOs, the Final Rule incorporates a fundamentally different approach to the regulation of their U.S. operations. Of most significance is the requirement that an FBO having U.S. non-branch assets of $50 billion or more (raised from the $10 billion threshold initially proposed) establish in the United States an intermediate holding company (“IHC”) for its U.S. subsidiaries that must be organized under U.S. law and, with certain limited exceptions, will be subject to the full range of U.S. regulatory requirements applicable to U.S. BHCs of comparable size under Dodd-Frank Section 165 and/or otherwise, including leverage and risk-based capital standards, stress testing, risk management and certain liquidity requirements. In addition, all FBOs with at least $10 billion in worldwide consolidated assets will be subject to a layered and escalating set of capital, stress testing and liquidity and risk management requirements, depending on their respective amount of worldwide consolidated assets and U.S. assets. For example:

• FBOs with worldwide consolidated assets of $10 billion or more but less than $50 billion must be subject to a home-country capital adequacy stress testing regime that meets certain FRB-defined standards or else face asset maintenance requirements at its U.S. branch;
• Publicly traded FBOs with total consolidated assets of $10 billion or more and FBOs with total consolidated assets of $50 billion or more, whether or not publicly traded, are also required to maintain a committee of its global board of directors on a stand-alone basis or as part of its enterprise-wide risk committee that oversees risk management policies of its U.S. operations;
• FBOs with worldwide consolidated assets of $50 billion or more but combined U.S. assets of less than $50 billion must also (i) certify to the FRB that they are subject to and in compliance with risk-based and leverage capital requirements in their respective home jurisdictions that are substantially equivalent to those promulgated by the Basel Committee on Banking Supervision (the “Basel Committee”) or face various restrictions on their U.S. operations if they are unable to do so and (ii) report to the FRB the results of internal liquidity stress tests for either their consolidated operations or the combined U.S. operations or else be subject to limits on the net amount owed by their non-U.S. offices to their U.S. offices; and
• FBOs with worldwide consolidated assets of $50 billion or more and combined U.S. assets of $50 billion or more that also are required to form an IHC must (i) maintain a U.S. risk committee either at the IHC board level or at the FBO parent board level to approve and oversee the risk management framework and policies of the combined U.S. operations, including as to liquidity risk, (ii) appoint a U.S. chief risk officer having certain defined qualifications, and (iii) be subject to various liquidity stress testing and buffer, contingency funding plan, and cash-flow projection requirements.

As discussed below, a more detailed summary of these escalating requirements and their levels of applicability is set forth in the complete publication in Annex B.

Although the FRB postponed some of the most important implementation deadlines (as described below) for FBOs, the planning and implementation process, especially for FBOs with a larger non-banking presence in the U.S., will be a significant and complex undertaking and likely require a great deal of effort and management attention, even before the effectiveness of specific requirements. It will also be important for any FBO subject to the IHC requirement to recognize the potential tax implications that may arise in interposing an IHC into its organizational structure or otherwise reorganizing the FBO’s organizational structure under an IHC.

The Final Rule does not include final rules establishing single counterparty credit limits (“SCCL”) or the early remediation frameworks that would have been applied to U.S. BHCs and FBOs under the FRB’s previous proposals. The FRB stated that these rules are still under development and will be addressed in future rulemakings. The Final Rule also does not address enhanced prudential standards for non-bank financial companies designated by the FSOC for supervision by the FRB. In the Preamble to the Final Rule (the “Preamble”), the FRB indicated that it will establish enhanced prudential standards for these entities at a later date by either rule or order.

The effective date of the Final Rule is June 1, 2014, although compliance with most of the new requirements will be phased in between 2015 and 2018.

Significant Changes and Other Notable Provisions

The FRB issued for public comment two separate proposals to implement the Dodd-Frank Act’s “enhanced prudential standards” for large U.S. BHCs and FBOs. On January 5, 2012, the FRB issued proposed rules to implement the provisions of Sections 165 and 166 [1] of the Dodd-Frank Act for U.S. BHCs with total consolidated assets of $10 billion or more and for non-bank financial firms designated by the FSOC (the “Proposed U.S. Rule”). On December 28, 2012, the FRB issued a separate set of proposed rules to implement the provisions of Sections 165 and 166 for FBOs with total consolidated assets of $10 billion or more and foreign non-bank financial companies designated by the FSOC (the “Proposed FBO Rule” and, together with the Proposed U.S. Rule, the “Proposals”). [2] The FRB received more than 100 public comments on the Proposed U.S. Rule and more than 60 public comments on the Proposed FBO Rule.

The most substantial changes made in the Final Rule, as compared to the Proposals, relate primarily to the treatment of FBOs, and the Final Rule defers implementation of certain parts of the Proposals as they relate to FBOs as well:

• Size Threshold for Forming an IHC. The Proposed FBO Rule would have required an FBO with global consolidated assets of $50 billion or more and combined U.S. non-branch assets of $10 billion or more to establish an IHC. The Preamble notes that many commenters argued that the proposed threshold was too low and that the U.S. operations of entities with $10 billion of U.S. non-branch assets do not present risks to U.S. financial stability. After taking these comments into consideration and reviewing the statutory considerations in Section 165, the FRB raised the threshold for imposition of the IHC requirement from $10 billion in U.S. non-branch assets to $50 billion. If this threshold is met, the creation of an IHC is required whether or not an FBO controls an insured depository institution subsidiary in the U.S.
• Implementation Deadlines Extended for FBOs.Under the Final Rule, the FRB postponed some of the key implementation deadlines, most notably:
  • The Proposed FBO Rule would have required an FBO that met the asset thresholds as of July 1, 2014 to establish an IHC by July 1, 2015 unless that deadline were extended by the FRB, and an FBO that crossed the asset thresholds after July 1, 2014 would have been required to establish an IHC within 12 months unless that deadline were accelerated or extended by the FRB. In response to comments requesting a longer transition period, the Final Rule extends the initial compliance date for FBOs that currently meet the asset threshold by one year to July 1, 2016. By July 1, 2016, an FBO must transfer to the IHC its entire “ownership interest” in any U.S. BHC subsidiary, any insured depository institution subsidiary, and U.S. subsidiaries holding at least 90% of the FBO’s U.S. non-branch assets not owned by such U.S. BHC subsidiaries or insured depository institution subsidiaries. “Ownership interest,” however, is not specifically defined in the Final Rule. An FBO must hold its ownership interests in all U.S. subsidiaries, other than so-called “2(h)(2) subsidiaries” and “DPC branch subsidiaries,” through its IHC by July 1, 2017.
  • An FBO with U.S. non-branch assets of $50 billion or more as of June 30, 2014 must submit an implementation plan by January 1, 2015, outlining its proposed process for establishing an IHC. The Final Rule includes the possibility of limited case-by-case relief for ownership interests in U.S. subsidiaries that cannot be transferred to the IHC, including a timeline and description of all planned capital actions and strategies for capital accretion for the IHC to achieve the applicable risk-based and leverage capital requirements. The Final Rule includes the possibility of limited case-by-case relief for ownership interests in U.S. subsidiaries that cannot be transferred to the IHC, which may be conditioned on to-be-determined supervisory requirements and/or FBO commitments as to these subsidiaries.
  • Generally speaking, FBOs currently are not subject to leverage capital requirements in their home countries. To address concerns regarding compliance with leverage capital requirements proposed for IHCs, the Final Rule delays application of leverage capital requirements to IHCs until January 1, 2018, consistent with the FRB’s approach to the timing of the effectiveness of the supplementary leverage ratio in the revised U.S. capital rules adopted in July 2013 and the Basel Committee’s Basel III international leverage ratio implementation. However, each bank holding company or insured depository institution that is controlled by an FBO is otherwise required to comply with existing capital and capital planning requirements, and a bank holding company controlled by an FBO must comply with the enhanced prudential standards applicable to it because it is also a U.S. BHC beginning on January 1, 2015 and until the IHC becomes subject to the new parallel requirements applicable to IHCs. [3]
  • The Final Rule also generally delays the application to IHCs of the capital plan and Dodd-Frank Act company-run and supervisory stress test requirements. The first capital plan filing appears to be required to be made, according to the Preamble, in January 2017 [4] and the first Dodd-Frank company-run stress test filing must be made, according to the Final Rule, in January 2018 and subject to the FRB’s supervisory stress test thereafter. However, each existing subsidiary bank holding company and insured depository institution otherwise subject to the capital plan rule and stress test requirements and controlled by an FBO prior to October 1, 2017 must comply with the stress test requirements through September 30, 2017.
  • The FRB may accelerate the application of the leverage and stress test requirements to an IHC if it determines that an FBO has taken actions to evade the application of the Final Rule, for example, by transferring assets from an existing U.S. BHC to the IHC.
  • An FBO with U.S. non-branch assets that equal or exceed $50 billion after July 1, 2014 has two years to establish an IHC under the Final Rule, instead of the 12 months provided by the Proposed FBO Rule.
• Liquidity Buffer. The Proposed FBO Rule would have established a 30-day liquidity buffer requirement and required U.S. branches and agencies of FBOs to maintain the first 14 days of their30-day liquidity buffer in the U.S. while permitting the U.S. branches and agencies to meet the remainder of this requirement at the parent consolidated level. The Final Rule, however, requires U.S. branches and agencies of FBOs to maintain a liquidity buffer only for days 1 through 14 of a 30-day stress scenario (which must be held in the U.S. as initially proposed). The Final Rule still requires the IHC to maintain its entire 30-day buffer in the U.S.

In addition, the Final Rule includes changes that are applicable to both U.S. BHCs and FBOs, provides for the establishment of separate enhanced prudential standards for non-bank financial companies designated by the FSOC to be developed by rule or order at a later date, and leaves several provisions applicable to U.S. BHCs and FBOs to be addressed by future rulemakings:

• Capital Requirements. The Final Rule references the previously adopted Basel III-based final capital rules, capital plan (“CCAR”) and stress test requirements (“DFAST”), as meeting the Section 165 enhanced prudential requirements for U.S. BHCs.
• Liquidity Requirements. Overall, the Final Rule’s liquidity stress testing and 30-day liquidity buffer provisions remain substantively more flexible than the proposed liquidity coverage ratio (“LCR”) rules, [5]particularly with respect to the calculation of net cash outflows. However, the FRB did not expand (as some commenters requested) the scope of qualifying assets. The Final Rule’s liquidity provisions (including stress testing) and contingency funding plan provisions are stated to be “complementary” to the LCR rules and are supposed to reflect institutions’ specific risks (conceptually similar to the company-run stress tests and the supervisory stress testing exercise).Other important changes/clarifications to the liquidity requirements include:
  • The Preamble clarifies that a U.S. BHC may include Federal Home Loan Bank (“FHLB”) advances in its contingency funding plan.
  • Assets used as hedges for other positions and those pledged to an FHLB can still count in the calculation of the liquidity buffer.
  • Highly liquid assets (“HLA”) pledged to a company covered by the enhanced prudential standards as collateral can be used as HLA for the liquidity buffer (and not treated as encumbered) if the covered company is able to re-hypothecate the HLA.
  • Diversification requirements do not apply to U.S. Treasury and agency securities.
  • Assets that qualify as good “high quality liquid assets” for LCR purposes generally qualify for the liquidity buffer, but are still subject to other requirements of the Final Rule—for example, diversification and appropriateness of assets for the liquidity risk profile of the institution.
  • Failure to meet the 100% LCR requirement is a trigger for the contingency funding plan.
  • The Preamble to the Final Rule leaves open the question of how the LCR proposal, once finalized, will be applied to IHCs and how and whether it will be applied to U.S. branches.
• Risk Management and Risk Committee Requirements. The Final Rule adopts most aspects of the Proposals with respect to risk management and risk committee requirements. However, in response to comments, the Final Rule makes revisions to certain elements of the Proposals involving the duties of boards of directors, risk committees and chief risk officers to more closely align them with the traditional oversight responsibilities of a board of directors and committees thereof as well as senior management. For example, the board of directors is now charged with approving liquidity risk tolerance as opposed to setting it.
• Non-bank Financial Companies Supervised by the FRB. The Proposals provided that the standards applicable to U.S. BHCs and FBOs would serve as the baseline for enhanced prudential standards applicable to U.S. and foreign non-bank financial companies designated by the FSOC. The Preamble acknowledges, however, that companies designated by the FSOC may have a range of businesses, structures, and activities, that the types of risks to financial stability posed by non-bank financial companies will likely vary, and that the enhanced prudential standards applicable to U.S. BHCs and FBOs may not be appropriate for all non-bank financial companies and, in particular, those predominantly involved in insurance activities. Accordingly, the FRB has opted to postpone the development and application of enhanced prudential standards for FSOC-designated non-bank financial companies. The FRB intends to separately issue an order or rule imposing standards tailored to each non-bank financial company or category of non-bank financial companies designated by the FSOC, taking into account the business model, capital structure and risk profile of the designated company or companies. [6]
• Single Counterparty Credit Limits. The Final Rule does not implement the single counterparty credit limits (“SCCLs”) mandated by Section 165. According to the Preamble, the FRB is continuing its development of SCCLs for U.S. BHCs and FBOs based on the results of a previously conducted quantitative impact study and the Basel Committee’s initiative to develop a regulatory framework governing large credit exposures that is intended to apply to all global banks. [7]
• Early Remediation Requirements. The Final Rule does not implement the proposed early remediation requirements of Section 166 of the Dodd-Frank Act. The FRB indicated that it is working on integrating the various remediation levels with the new Basel III-based U.S. final capital rules adopted in July 2013 and that it continues to review comments received on the Proposals with respect to early remediation requirements.
• Limits on Short-Term Debt. The Final Rule does not implement limits on short-term debt, although the FRB indicated that it is “continuing to study and evaluate the benefits to systemic stability from imposing limits on short-term debt.”

The table attached to the complete publication as Annex A provides an overview of the key requirements of the Final Rule applicable to U.S. BHCs and highlights certain changes in these requirements from the Proposed U.S. Rule. The table attached to the complete publication as Annex B provides an overview of the key requirements of the Final Rule applicable to FBOs and highlights certain changes in these requirements from the Proposed FBO Rule.

Other Observations

At the open meeting at which the Final Rule was adopted, FRB Governor Dan Tarullo predicted that, “in the coming months,” the FRB will consider final or proposed rules covering other elements of the FRB’s “ongoing effort under Section 165 of the Dodd-Frank Act to put in place a set of prudential standards for large banking organizations that become progressively more stringent as the systemic importance of the regulated entity increases”—including, the imposition of risk-based capital surcharges for global systemically important banks (“G-SIBS”), [8] further possible revisions to the Basel III-based supplemental leverage ratio, required minimum levels of long-term debt, and implementation of Basel III-based quantitative liquidity standards—presumably the LCR and the companion Basel III net stable funding ratio proposal.

Also at the meeting, FRB staff stressed that, in crafting the requirements of the Final Rule applicable to FBOs, the FRB sought to strike a balance between the need to prevent or mitigate risks to the financial stability of the U.S. that could arise from the material financial distress or failure of large interconnected financial institutions, on the one hand, and the respect for longstanding principles of national treatment and competitive equality, and the potential costs of compliance, on the other hand. In particular, with respect to the leverage capital requirements, FRB staff maintained that, consistent with the principle of national treatment, the Final Rule generally imposes the same leverage capital requirements on IHCs as it does on U.S. BHCs. FRB staff also pointed out that several large U.S. BHCs with business models similar to the largest U.S. operations of FBOs (that is, large broker-dealers coupled with a relatively smaller U.S. depository institution) are already subject to the leverage capital requirements and have adapted their business models to those requirements without disrupting the U.S. financial markets. FRB staff also argued, however, that the longer transition period to comply with the leverage capital requirements would give FBOs additional time to bolster their capital positions and thereby minimize the overall impact of the leverage capital requirements on IHCs.

Finally, in response to questions raised during the open meeting by FRB Chair Janet Yellen and FRB Governor Sarah Bloom Raskin concerning the potential for regulatory arbitrage (specifically the potential for an FBO to move “risky” activities into a U.S. branch or agency), FRB staff indicated that they intend to monitor carefully how FBOs adapt their operations in response to the IHC requirement, including whether FBOs relocate activities from their U.S. subsidiaries into U.S. branches and agencies, and respond appropriately through supervisory and/or other means to such issues.

Endnotes:

[1] Dodd-Frank Section 166 requires the FRB, in consultation with the FSOC and the Federal Deposit Insurance Corporation, to “prescribe regulations establishing requirements to provide for the early remediation of financial distress” of bank holding companies and designated non-bank companies encompassed by Section 165’s requirements. Although the Proposals included early remediation provisions, the FRB indicated in the Preamble that it will finalize those provisions at a later date.
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[2] Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 594 (Jan. 5, 2012). See our Client Memorandum, “Federal Reserve Issues Proposed Rules Implementing Enhanced Prudential Supervision Regime,” dated December 22, 2011, available at http://www.sullcrom.com/files/Publication/9302aa5a-e29c-4b55-8020-28042c4aa822/Presentation/PublicationAttachment/d14671a2-7d80-4bef-bade-2966a2d2104a/SC_Publication_Systemically_Important_Financial_Companies_12-22-11.pdf. Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Non-bank Financial Companies, 77 Fed. Reg. 77628 (December 28, 2012). See our Client Memorandum, “Regulation of U.S. Operations of Non-U.S. Banks,” dated December 16, 2012, available at https://www.sullcrom.com/files/Publication/e12d4ab6-7303-4e2c-9bac- 88f9cc5c0704/Presentation/PublicationAttachment/75e7266e-91bf-4919-aa89-e4f91a78572d/SC_Publication_Regulation_of_US_Operations_of_ Non_US_Banks.pdf. See our Client Memorandum, “Regulatory Capital Surcharge for Global Systemically Important Banks,” dated July 26, 2011, available at http://www.sullcrom.com/files/Publication/d2074741-d55b-4c97-b42d- eb2da2520b50/Presentation/PublicationAttachment/35640a9d-58dc-4371- 8466-ecfb6a6e8500/SC_Publication_Bank_Capital_Requirements_7-26-11.pdf.
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[3] In addition, if an FBO designates an existing U.S. bank holding company as its top-level IHC (as permitted by the Final Rules) instead of, for example, interposing a newly created IHC between the FBO and its U.S. subsidiaries, including the BHC, the provisions of Section 171 of the Dodd-Frank Act (the so called “Collins Amendment”) would not appear to permit the delay of the generally applicable leverage capital requirements until 2018 for such BHC which would then become the IHC.
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[4] We note that although the Preamble literally states that an IHC “formed by July 1, 2016 will be required to submit its first capital plan in January 2017,” there is some ambiguity as to whether the interaction between Section 252.153(e)(2)(ii) of the Final Rule and 12 C.F.R. § 225.8(b) (the FRB capital plan rule) would otherwise require the first IHC capital plan to be filed in January 2018—at the same time as when the Dodd-Frank company-run and supervisory stress test requirements are effectively implemented for an IHC under the transition provisions of Section 252.153(e)(1)(ii)(C)(1) of the Final Rule.
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[5] Liquidity Coverage Ratio: Liquidity Risk Measurement, Standards, and Monitoring (Oct. 24, 2013). See our Client Memorandum, “Federal Reserve Issues Basel III Liquidity Coverage Ratio Proposal for Large U.S. Banks,” dated October 29, 2013, available at http://www.sullcrom.com/Basel-III-Liquidity-Framework-10-29-2013/.
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[6] The FRB noted, however, that such standards may be quite similar to the Final Rules for designated non-bank financial companies whose activities more closely resemble those of BHCs.
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[7] See Basel Committee, Supervisory framework for measuring and controlling large exposures, (March 2013), available at http://www.bis.org/publ/bcbs246.htm.
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[8] See our Client Memoranda, “Basel Committee Updates Framework for Assessing a Common Equity Surcharge on Global Systemically Important Banks,” dated July 26, 2013, available at http://www.sullcrom.com/files/Publication/7f8be67a- 0232-4204-8ad0-956d8038267c/Presentation/PublicationAttachment /35b56b97-9940-4f60-ad4b-96002e8d4b81/SC_Publication_Bank_Capital_ Requirements.pdf; “Regulatory Capital Surcharge for Global Systemically Important Banks,” dated July 26, 2011, available at http://www.sullcrom.com/files/Publication/d2074741-d55b-4c97-b42d-eb2da2520b50/Presentation/PublicationAttachment/35640a9d-58dc-4371-8466-ecfb6a6e8500/SC_Publication_Bank_Capital_Requirements_7-26-11.pdf; “Basel Committee Issues Final Rule Regarding Common Equity Surcharge for Global Systemically Important Banks,” dated November 10, 2011, available at http://www.sullcrom.com/files/upload/Banking-Capital-Requirements-11-10-11.pdf.
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