By Joseph Neu
The US Federal Reserve’s long anticipated proposed rules on regulation and supervision of large bank holding companies and systemically important non-bank financial firms were released for comment on December 20. These rules were mandated by the Dodd-Frank Act (Sections 165 and 166) and cover issues including risk-based capital and liquidity requirements, stress test assessments, single-counterparty credit limits, early remediation requirements and risk governance guidelines.
The proposed rules are open to comment through the end of March. Once finalized, many of the enhanced standards are expected to be implemented within a year.
While the proposed rules target US bank holding companies with $50bn in assets or more, certain provisions (in particular, stress testing) would apply to institutions with just $10bn in assets. Foreign-owned US subsidiaries operating as bank-holding companies are also covered and foreign banks generally should expect related guidance soon.
In addition, non-banks to be supervised by the Fed per the recommendation of the Financial Stability Oversight Council will be considered “covered companies” under the proposed rules.
Treasurers at companies not covered should also read the proposed rules to get a better sense of how their financial activities with “covered companies” will be impacted.
Given the potential extent of this impact, the Center for Capital Markets Competitiveness, created by the US Chamber of Commerce, has asked the Fed in one of the early comment letters to extend the comment period an additional 60 days. This would allow non-banks that “are not as conversant with the issues related to the vastness and complexity of the Proposal” more time to assess the impacts before commenting.
Key Measures and Impacts
The following are some of the key measures the Fed is proposing and potential impacts.
- Capital requirements. In phase one, covered companies will be subjected to a rule issued last November that requires them to develop annual capital plans, conduct stress tests, and maintain adequate capital, including a tier one common risk-based capital ratio greater than 5 percent under both expected and stressed conditions. Phase two will be an implementation of Basel’s risk-based capital surcharge framework.
Impact: An expectation of being “fully-capitalized” in adverse scenarios illustrated by stress tests will only encourage further deleveraging, a pull-back from credit commitments and a propensity to refrain from high-risk or capital intensive businesses — plus, this impact will be magnified when market events signal adverse scenarios. In other words, they will exacerbate a credit crunch when credit is needed most.
Similar effects will come from liquidity requirements and remediation rules that force actions when key ratios or triggers identified by stress testing are breached.
- Liquidity requirements. Pre-Basel III guidelines, covered companies are to be subjected to liquidity risk-management standards similar to the interagency guidance issued in March 2010. These require institutions to conduct regular liquidity stress tests and set internal quantitative limits to manage liquidity risk.
Impact: Demand for quality liquid paper is already sky-high, mitigating returns for those needing to invest in it, and the proposed rules encourage this to continue. Customers of covered companies, however, should expect liquidity-positive business to get a higher share-of-wallet score.
- Single-counterparty credit limits. Credit exposure to a single counterparty would be limited as a percentage of regulatory capital. The limit would be 25 percent of capital stock plus surplus for most institutions, but much tighter for the largest.
Impact: The broad scope of Dodd-Frank’s credit exposure definition requires the Fed to be able to exempt certain transactions. For example, without an exemption for intraday exposures, the payment system would grind to a halt. Meanwhile, since tools to mitigate credit risk offset exposure for purposes of the limit, these rules spur demand for collateral, guarantees and credit derivatives while others curb availability. The current bias toward transactions that diversify counterparties should also continue.