Citing the Dodd-Frank Act’s objective of ending “too big to fail”, the Federal Reserve released a proposed rule (Proposed Rule) during the final quarter of 2015 to impose new requirements on the largest financial institutions with operations in the US – the so-called global systemically important banks (GSIBs). The Proposed Rule would apply to eight GSIBs in the US and to the US operations of foreign GSIBs. The new requirements fall into four categories:
A requirement that GSIBs issue a minimum amount of long-term debt (LTD);
A requirement that GSIBs maintain a minimum amount of total loss-absorbing capacity (TLAC);
A “clean holding company” requirement prohibiting a Covered BHC or Covered IHC (defined below) from entering into certain types of transactions discussed below; and
A requirement that banking institutions subject to Federal Reserve supervision deduct unsecured debt issued by a Covered BHC or Covered IHC from their regulatory capital calculations.
Nonbank systemically important financial institutions subject to Federal Reserve supervision would not be covered by any of the Proposed Rule’s requirements.
For US firms, the top-tier bank holding company of a GSIB (Covered BHC) would be required to issue and maintain eligible LTD instruments to external third- party investors, to facilitate the process of recapitalising the firms’ critical operations upon failure, in an amount not less than the greater of (a) the sum of 6% plus
the Covered BHC’s GSIB surcharge multiplied by the Covered BHC’s total risk-weighted assets, or (b) 4.5% of the Covered BHC’s total leverage exposure. To be eligible, an LTD instrument may not have any complex features that would reduce its ability to absorb losses, including features that would cause the instrument to be treated as a structured note or which would have terms that are credit-sensitive, permit conversion to equity, or
provide certain rights to accelerate payment. Eligible LTD instruments must be unsecured, governed by US law, and issued directly by the Covered BHC. In addition, eligible LTD instruments must have a maturity greater than one year and any LTD instrument with a remaining maturity of between one and two years is subject to a 50% reduction for purposes of calculating compliance with the applicable percentage requirements. Covered BHCs would be required to make certain public disclosures
of the fact that their LTD would be expected to absorb losses ahead of other liabilities, including the liabilities of the Covered BHC’s subsidiaries.
For foreign firms, the Proposed Rule would apply to any intermediate holding company required to be formed under the Federal Reserve’s enhanced prudential standards rule that is controlled by a top-tier foreign banking organisation that the Federal Reserve determines would be designated as a GSIB under its GSIB surcharge rules or the Basel Committee on Banking Supervision’s assessment methodology (Covered IHC).
Unlike Covered BHCs, Covered IHCs would be required to issue the necessary debt instruments to a foreign parent company (but not necessarily to the top-tier entity) rather than to external, third-party investors.
A Covered IHC would be required to maintain eligible internal LTD in an amount not less than the greater
of (a) 7% of its total risk-weighted assets; (b) 3% of its total leverage exposure; or (c) 4% of its average total consolidated assets, as calculated for purposes of the US tier 1 leverage ratio. The LTD eligibility requirements for Covered IHCs are generally the same as those for Covered BHCs, with the additional requirements that LTD instruments must be issued to a foreign parent entity, must be subordinated to all of the Covered IHC’s third-party liabilities, and must include a contractual provision, approved by the Federal Reserve, permitting the Federal Reserve to require the Covered IHC to cancel the LTD or convert it to tier 1 capital.
Total loss-absorbing capacity
For US firms, the Proposed Rule defines TLAC as the sum of a Covered BHC’s tier 1 capital issued directly by the Covered BHC and its eligible LTD instruments. To meet the TLAC requirement, each Covered BHC must maintain outstanding TLAC in an amount not less than
the greater of (a) 18% of its total risk-weighted assets, or (b) 9.5% of its total leverage exposure. Thus, while a GSIB would be required to meet the LTD requirement described above, it may meet the TLAC requirement by further increasing its LTD, increasing its tier 1 capital, decreasing its total risk-weighted assets or total leverage exposure, or through some combination thereof.
In addition, each Covered BHC would be required to hold a TLAC buffer of 2.5% of risk-weighted assets composed solely of tier 1 capital. However, under existing capital requirements, GSIBs are already required to maintain a common equity tier 1 capital conservation buffer equal to 2.5% of risk-weighted assets. Thus, any Covered BHC that meets existing capital requirements and the existing capital conservation buffer would not need to increase its tier 1 capital to meet the TLAC buffer requirement.
For foreign GSIBs, TLAC is defined as the sum of a Covered IHC’s tier 1 capital issued to a foreign parent entity that controls the Covered IHC and its eligible LTD instruments. The amount of TLAC that a Covered IHC is required to maintain depends on whether the Covered IHC (or any of its subsidiaries) is expected
to be resolved in a failure scenario, rather than being maintained as a going concern while a foreign parent entity is instead resolved. If the Covered IHC will itself be resolved, it must maintain TLAC in an amount not less than the greater of (a) 18% of the Covered IHC’s total risk-weighted assets; (b) 6.75% of the Covered IHC’s total leverage exposure (if applicable); or (c) 9% of the Covered IHC’s average total consolidated assets, as calculated for purposes of the US tier 1 leverage ratio.
If the Covered IHC is not expected to enter resolution itself, it would be required to maintain TLAC in an amount not less than the greater of (a) 16% of the its total risk-weighted assets; (b) 6% of its total leverage exposure; or (c) 8% of its average total consolidated assets. Covered IHCs are required to hold a TLAC buffer of 2.5% of risk-weighted assets composed solely of tier
1 capital, but, like Covered BHCs, they would not need to increase their capital if they are already in compliance with existing requirements.
Note, the Proposed Rule’s TLAC and LTD requirements represent a different approach from that taken under the TLAC proposal produced by the Financial Stability
Board (FSB). The FSB’s proposed standard included an expectation that GSIBs would meet at least one-third of the TLAC requirement with LTD rather than equity, but did not contain any specific LTD requirement on a
standalone basis. Thus, while the Proposed Rule permits some flexibility in determining how to meet the TLAC requirement, it contains a more stringent requirement that TLAC include a specified minimum amount of
LTD. This distinction may be particularly relevant for foreign GSIBs operating under a more permissive TLAC standard outside the US.
Clean holding company
In addition to the LTD and TLAC requirements, both Covered BHCs and Covered IHCs would be subject to “clean holding company” requirements that prohibit
them from engaging in certain transactions that impede an orderly liquidation. In general, this would prohibit them from issuing short-term debt, qualified financial contracts, certain guarantees of subsidiary liabilities, or liabilities guaranteed by a subsidiary. With regard to US GSIBs, the Proposed Rule would also cap the total value of each Covered BHC’s non-TLAC third-party liabilities that can be pari passu with, or junior to, its LTD at 5% of the value of its total TLAC. Like the requirement that Covered IHC LTD be subordinated to a Covered IHC’s third-party liabilities, the 5% cap is intended to address any concerns with a Covered BHC’s unsecured creditor hierarchies.
With the goal of limiting the risk of financial sector contagion, the Proposed Rule would impose deductions in the regulatory capital treatment of investments in unsecured debt instruments issued by Covered BHCs, including both LTD instruments and other unsecured debt instruments. Under the Proposed Rule, all Federal Reserve-regulated institutions, including state member banks, BHCs, savings and loan holding companies, and IHCs, with over $1 billion in total consolidated assets, must deduct such instruments from their regulatory capital calculations. As proposed, the requirement would not apply to institutions regulated by the FDIC or the OCC. However, the preamble to the Proposed Rule states that the Federal Reserve will consult with the FDIC and OCC to ensure consistent treatment among
all banking institutions; therefore, any final rule will likely apply to other types of depository institutions in the future.
If finalised, the proposed TLAC requirement would become effective on January 1 2019, with a phase-in period between that date and January 1 2022. The LTD, clean holding company and capital deduction requirements would become effective January 1 2019. Parties interested in commenting on the Proposed Rule should be aware that comments are due no later than February 1 2016.
FDIC PROPOSES TO INCREASE RESERVE RATIO THROUGH SURCHARGE ON LARGE BANKS
The FDIC’s Deposit Insurance Fund (DIF) is funded through quarterly assessments on insured banks and is reduced by the FDIC’s operating expenses and losses associated with resolving failed banks. The amount of the DIF must be equal to or greater than the minimum reserve ratio, which is expressed as a percentage of total estimated insured deposits. Section 334 of the Dodd- Frank Act authorises the FDIC to implement measures necessary to raise the DIF from a minimum reserve ratio of 1.15% to 1.35% by September 30, 2020. Section 334 further requires the FDIC to offset the impact of raising the reserve ratio on insured depository institutions
with less than US$10 billion in total consolidated assets (Small Banks). During the fourth quarter of 2015, the FDIC published a proposed rule (Proposed Rule) that would implement the requirements of Section 334 by imposing a deposit insurance assessment surcharge on insured depository institutions with total consolidated assets of US$10 billion or more (Large Banks) and providing assessment credits to Small Banks if the reserve ratio meets 1.40%.
Under the Proposed Rule, Large Banks will be required to pay a surcharge on their normal quarterly deposit insurance assessments beginning in the quarter after the reserve ratio reaches 1.15%. As of September 30 2015, the DIF’s reserve ratio was 1.09%, and is expected to reach 1.15% in fourth quarter 2015 or first quarter 2016. The surcharge would be equal to an additional 1.125 basis points per quarter (4.5 basis points annually) on a Large Bank’s regular assessments. The FDIC estimates that the
additional 4.5 basis point surcharge would raise the DIF reserve ratio to 1.35% within eight quarters (i.e. before the end of 2018). If the reserve ratio does not reach 1.35% by December 31, 2018, the FDIC will impose an additional, one-time shortfall assessment on Large Banks on March 31 2019, to be paid by June 30 2019.
Previously, in February 2011, the FDIC released a final rule adopting a schedule of lower deposit insurance assessment rates that would take effect once the reserve ratio reaches 1.15%. Once the reserve ratio reaches 1.15%, the combined effect of the Proposed Rule and the FDIC’s prior rule would be to reduce regular assessment rates overall, while effectively raising rates on Large Banks through the surcharge. To further offset the cost of raising the reserve ratio for Small Banks, the Proposed Rule would establish a system of credits to the Small Banks’ quarterly assessments. For each quarter the
DIF reserve ratio is at least 1.40%, each Small Bank will receive a credit to its assessment based on the portion of its prior assessments that contributed to raising the reserve ratio from 1.15% to 1.35%. The credit will be applied by reducing a Small Bank’s regular assessments by half a basis point per quarter. If a Small Bank’s assessment rate were less than two basis points annually the credit would be used to fully offset its assessments, but at no point would an assessment be less than zero.
LARGE INSTITUTION SUPERVISION COORDINATING COMMITTEE RELEASES REVIEW FINDINGS
In 2010, the Federal Reserve formed the Large Institution Supervision Coordinating Committee (LISCC) to coordinate its supervision over domestic bank holding companies and foreign banking organisations that pose
a systemic risk to US financial stability and nonbank financial institutions designated as systemically important by the Financial Stability Oversight Council (collectively “SIFIs”). The LISCC’s Operating Committee (“OC”) is responsible for setting supervisory priorities, overseeing the execution of supervisory activities, and vetting
the ratings and messages sent to supervised SIFIs. In November 2014, the Federal Reserve announced it would conduct a review to ensure SIFI examinations were consistent, sound and based on all relevant information, with the specific objectives of (a) determining whether LISCC decision-makers received the information needed
to ensure consistent and sound supervisory decisions; and (b) determining whether adequate methods are in place for those decision-makers to be aware of material matters requiring reconciliation of divergent views relating to SIFI supervision. On November 24 2015, the Federal Reserve published a summary report of the review’s findings.
With regard to the first objective, the review found that some LISCC supervisory teams employed sound
practices, including maintaining examination work papers that were complete, accurate, and well organised, and thoroughly analysing how firm-provided information and meetings with firm management affected a firm’s risk profile, ratings, and planning for future supervisory work. The review also identified other supervisory teams with inconsistent practices, such as insufficient or missing documentation in support of particular supervisory determinations.
With regard to the second objective, the review found that the vast majority of supervisory staff interviewed felt empowered to express divergent views, but that neither the Reserve Banks or the LISCC OC had formalised a process for raising and documenting dissenting views.
The review produced several recommendations for remedying these inconsistencies, including drafting an LISCC OC Program Manual describing uniform operating and documentation standards, strengthening examiner training with a curriculum specific to SIFI supervision, and adopting policies to encourage divergent views on supervisory matters.
WHAT TO WATCH FOR IN 2016 IN US FINANCIAL REGULATION: IMPORTANT CHANGES TO AML RULES FOR INVESTMENT ADVISERS IN 2016
The Financial Crimes Enforcement Network of the
U.S. Department of the Treasury (FinCEN) published a proposed rule in August 2015, which scoped certain investment advisers into the definition of “financial institution” and subjected them to certain requirements under the anti-money laundering (AML) program and Bank Secrecy Act (BSA). The comment period for
the proposed rule ended on 2 November 2015, during which time the agency received 31 comments from trade associations, banking and non-banking organisations,
credit unions, and individuals, among others.
In the proposed rule, FinCEN would require investment advisers that are registered or are required to be registered with the Securities and Exchange Commission (SEC) (generally those with US$100 million or more in regulatory assets under management, or those not regulated by a state authority) to maintain AML programs and to file reports of suspicious activity. FinCEN noted, however, that it may consider expanding the scope in the future to include small and mid-sized advisers because they are also at risk for “abuse by money launderers, terrorist financers, and other illicit actors.” By including SEC-regulated investment advisers in the definition of “financial institution” under the BSA at this time, FinCEN would also require these investment advisers to abide by the requirements of the BSA that are generally applicable to financial institutions and allow for coordination between FinCEN and the SEC for application and examination of the requirements. By amending the definition of “financial institution”, FinCEN believes that it is closing the door to potential terrorist financers
or money launderers who could otherwise be taking advantage of investment advisers’ lack of AML programs and/or BSA compliance to gain access to the U.S. financial system.
FinCEN also proposes to delegate its authority over the enforcement of the rule to the SEC, which already regulates the registered investment advisers to whom this rule applies. Under the BSA, regulated institutions are required to monitor and report suspicious activity and comply with Currency Transaction Report (CTR) filings, the recordkeeping requirements for certain transmittals of funds over US$3,000, and information sharing requests pursuant to the USA PATRIOT Act. The new requirement for investment advisers to file CTRs replaces the existing Form 8300 for the receipt of cash or negotiable instruments in an amount greater than US$10,000. The risk-based AML requirements that would be applicable to investment advisers include a written AML program, approved by the board of
directors or trustees of the investment adviser and made available to FinCEN or the SEC upon request. At this time, FinCEN is not imposing the burdensome customer identification program requirements or certain other requirements of the BSA on investment advisers, but expects to do so in subsequent rulemaking issued jointly with the SEC.
In connection with the proposed rule, FinCEN posed several questions to potential commenters regarding the risk for abuse by money launderers and terrorist financers; whether the rule adequately captures the
institutions that are most vulnerable to this risk; whether foreign advisers should also be captured in the definition of “financial institution”; and what the potential burden may be on the regulated institutions. These and other issues will likely be addressed in the final rule, which will likely be published by FinCEN in 2016.
As proposed, investment advisers would have six months from the date on which the rule becomes final to implement and comply with its requirements. We also anticipate further joint rulemakings between SEC and FinCEN in the coming months.
RIGHTING FINANCIAL REGULATORY HARMONISATION
As a result of the 2008 economic troubles, many nations have moved to reform financial regulations. DLA Piper experts have worked on many of these related matters all across the world. While that work continues, there
is a new urgency for regulators to harmonise such rules and regulations.
The first week of January saw stock markets beaten badly – many having the worst opening weeks in history. Some of that was, at least in part, fuelled by regulatory changes in China. On 8 July 2015, the Chinese Securities Regulatory Commission placed a six-month ban on larger shareholders (those exceeding 5% of a stock) from selling stock. The impact is that well over 75% of shareholders were banned from selling. While the economy of China continued weakening, those shareholders became progressively anxious. Many sought to sell, but were powerless to do so. Then, as smaller investors supposed the prohibition would end in early January, and that potentially upwards of 150 billion yuan (roughly US$25 billion) could be sold, they sought to sell prior to a potentially massive sell-off.
On Monday, 4 January 2016, new circuit breakers (limit ups and downs on how much the market could move) were triggered. Trading was paused, but resumed as the Shanghai Composite Index fell like a stone nearly 7%. On Thursday, 7 January 2016, the 7% threshold was breached and all trading was stopped – only a half hour into the trading day!
The lesson from this is two-fold. Firstly, regulators shouldn’t try to influence trading, much less prices. Secondly, regulators should work with other national regulators to harmonise financial regulations to the extent practicable.
Balancing a free market and an authoritarian regulatory approach is a delicate matter, as well as an elusive endeavour. At the same time, there are many other national regulators who have been over much of this before. There are others around the world who have experience that can be helpful in how regulations might be crafted. Many of those lessons have been learned after being burned. Furthermore, the International Organization of Securities Commissions can be helpful in coordinating greater harmonisation efforts.
While national regulators are not required to harmonise with other national regulators, it is becoming increasingly apparent that if such is not done, we will continue to
see aberrations in regulatory structures which will have ripple impacts throughout the world.
Please contact firstname.lastname@example.org for further information.