Single-Counterparty Credit Limits Rule

On March 4^th, the Federal Reserve Board (FRB) reproposed its single-counterparty credit limits (SCCL) rule. The reproposal comes several years after two earlier versions (in 2011 and 2012), [1] and almost two years after the related large exposures framework issued by the Basel Committee on Banking Supervision (BCBS). [2] It is intended to reduce systemic risk by limiting a large banking organization’s credit exposure to any single counterparty as a percentage of the bank’s capital. The reproposal would apply to large banking organizations with over $50 billion in total consolidated assets, including US bank holding companies (BHCs), intermediate holding companies (IHCs), and foreign banking organizations’ (FBOs) combined US operations. [3]

Overall the reproposal is a mixed bag for the industry, relaxing several requirements and retaining others when compared with previous proposals and the BCBS framework. The net industry effect (by FRB’s estimate) is an excess credit exposure of approximately $100 billion over the reproposal’s limits.

Exposure limits for the largest firms align with BCBS’s large exposure framework. The reproposal increases the exposure limit between the largest institutions (i.e., those with at least $500 billion in assets) from the previously proposed 10% to %15. [4] This is an improvement for these institutions, and is also supported by the results of a quantitative impact study released by the FRB in connection with the reproposal. For all other exposures, the reproposal retains the earlier proposed 25% limit, which is also consistent with BCBS limits.

A tougher limit for large institutions. The reproposal adopts BCBS’s more stringent Tier 1 capital (T1C) measure as the denominator of the SCCL ratio for US BHCs and IHCs with at least $250 billion in total consolidated assets, or $10 billion in on-balance sheet foreign exposures (i.e., advanced approaches (AA) institutions under the US Basel III capital rules). However, for smaller institutions—those with total consolidated assets between $50 and $250 billion—the reproposal retains the earlier proposals’ more lenient measure of total regulatory capital plus allowance for loan and lease losses. This tiered approach continues to drive home the FRB’s agenda of more stringent requirements for the largest institutions.

Large US firms allowed more flexibility in calculating OTC derivatives exposures. For over-the-counter (OTC) derivatives transactions that are subject to qualifying master netting agreements, the reproposal allows an institution to calculate its exposure using any methodology that the institution is allowed to use under the US Basel III capital rules. This means that AA BHCs would be allowed to calculate these exposures using internal models. However, this may leave IHCs of comparable size (i.e., US assets of at least $250 billion) at a disadvantage, as these institutions must use the more stringent current exposure method (CEM) unless they are approved to use AA.

More favorable treatment for exposure to QCCPs—a nod to clearing. Whereas prior proposals were silent on the issue, the reproposal exempts trade exposures to a qualified central counterparty (QCCP) [5] from the exposure calculation as does the BCBS large exposure framework. This includes potential future exposure arising from transactions cleared by a QCCP and pre-funded default fund contributions. The reproposal notes that this exemption was driven by the concern that banking organizations would otherwise have to spread activity across a greater number of central counterparties, thus reducing the benefits of central clearing (e.g., multilateral netting).

Consolidation of counterparties gets more complicated. Under the reproposal, an institution should aggregate its exposures to a counterparty with others that are “economically interdependent” with the counterparty, if the institution’s exposure to the counterparty exceeds 5% of the institution’s capital measure (which is consistent with the BCBS approach, but new from prior US proposals). The economically interdependent determination is based on a multitude of factors. [6] This will no doubt be challenging, as the required factors differ from those considered for aggregation internally, and would require institutions to acquire additional information about their counterparties. In addition to aggregation based on economic interdependence, the reproposal retains the requirement that exposures to multiple counterparties be aggregated and treated as one when one counterparty owns or controls at least 25% of the other counterparty’s voting shares or capital (as opposed to BCBS’s 50% threshold). Therefore, as a whole US aggregation requirements are now tougher than BCBS framework’s.

Smaller institutions provided relief with respect to exposure reporting, but no relief for exposure calculation. The reproposal retains the earlier proposals’ exposure daily calculation requirement. All firms are required to calculate their net credit exposures taking into account fluctuations in the market value of eligible collateral (e.g., debt, GSE-issued securities, equity, and convertible bonds) and eligible guarantees, credit and equity derivatives, and bilateral netting agreements. Smaller institutions (i.e., those with less than $250 billion in assets and $10 billion in on-balance sheet foreign exposures) get some relief in the form of quarterly reporting of these calculation (versus the earlier proposals’ monthly reporting). However, larger firms must still report their compliance with these calculations requirements on a monthly basis.

The exemption for US government exposure is extended to other sovereigns. The reproposal exempts exposures to sovereigns from SCCL calculations, as long as the sovereigns are assigned a zero risk weight under the standardized approach. This is a considerable easing from the prior proposals, which only exempted exposures to the US government (and to GSEs while in conservatorship) and FBOs’ exposures to their home country sovereign. The largest institutions with a global footprint will benefit the most from this change due to their exposure to non-US sovereigns (via investment portfolio holdings and collateral received).

Improved measurement of credit derivatives exposures. In another win for the industry, the reproposal introduces a new treatment for credit default swaps (CDS) entered into by an institution to mitigate its exposure to a nonfinancial counterparty. Under earlier proposals, an institution’s net exposure to any counterparty (financial or nonfinancial) would be reduced by the notional amount of an eligible CDS referencing that counterparty. Simultaneously, the institution’s exposure to the protection seller would increase by the same amount (i.e., the notional value of the CDS). In the case of a CDS referencing nonfinancial counterparties, the reproposal maintains the first “leg” of this transaction (i.e., reduction in exposure equal to the notional CDS amount) but allows the institution to calculate the second leg (i.e., its exposure to the protection seller) using the methodology applicable to the institution under the US Basel III capital rules (i.e., internal models for AA institutions, and CEM for others). [7]

The reproposal introduces a requirement for measuring SPV exposures that is consistent with BCBS. Generally, the reproposal would require an institution to recognize an exposure to an SPV in an amount equal to the value of its investment in the SPV. In addition, if a large institution can demonstrate that its exposure to each underlying investment in an SPV is less than 0.25% of the institution’s capital measure (i.e., T1C), the SPV can be treated as a separate entity. Otherwise the institution must “look through” the SPV—i.e., recognize (and aggregate) exposures to the issuer of each individual asset held by the SPV. Large institutions are further required to recognize exposures to issuers whose failure or distress would result in a reduction in the value of the institution’s investment in the SPV (e.g., credit enhancement providers).

The FRB continues to disallow risk-sensitive methodologies for securities financing transaction (SFTs). The reproposal retains the earlier proposals’ standardized approach as the methodology for calculating the net credit exposure for SFTs (e.g., repos, reverse repos and securities lending/borrowing transactions). This includes the use of standardized supervisory haircuts (instead of internal estimates) and accounting for market fluctuations in the value of any eligible collateral. This approach is consistent with the FRB’s move away from internal models in favor of more standardized and transparent approaches over the past few years.