US BANKING AGENCIES TO CONSIDER BASEL COMMITTEE’S PROPOSED REVISIONS TO CREDIT - RISK WEIGHTING METHODOLOGY

The Basel framework’s standardised approach to measuring credit risk (the Standardised Approach) prescribes a consistent methodology for calculating a bank’s required regulatory capital based on the risk level of its assets.

In response to the global financial crisis, the BCBS revised the Basel framework’s approach to regulatory capital as part of the package of reforms known as Basel III. In the US,

the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (the Banking Agencies) adopted revisions to the Standardised Approach on 2 July 2013, as part of a final rule implementing several aspects of Basel III.

On 22 December 2014, the BCBS released a proposal (the Proposal) suggesting revisions to the Standardised Approach to further improve the risk-weighting calculations. The primary objective of the Proposal is to reduce reliance on external credit ratings in risk calculations, with additional goals of increasing risk sensitivity, reducing national discretion, strengthening the link between the Standardised Approach and internal ratings-based approaches, and enhancing comparability among banks. The Proposal puts forward new objective measurements, or “risk drivers,” to calculate the risk of assets in several of the main exposure classes. Under Section 939A of the Dodd-Frank Act, the Banking Agencies removed references to credit ratings as a measure of credit-worthiness in their regulations and therefore, US implementation of the Standardised Approach already includes risk drivers that do not rely on credit ratings. Interestingly, the risk drivers proposed by the BCBS employ different alternatives to credit ratings than those adopted by the Banking Agencies:

  • Bank Exposures: Under the Proposal, risk weighting would not be based on the credit rating of the bank or of its sovereign, and would instead be based on a look-up table of risk weights between 30 per cent and 300 per cent on the basis of (1) a capital adequacy ratio; and (2) an asset quality ratio. In the US, risk weighting for bank exposures is determined according to the OECD’s credit risk classification of the bank’s home country.
  • Corporate Exposures: The Proposal would calculate the risk of corporate exposures based on a look-up table of risk weights between 60 per cent and 300 per cent on the basis of (1) revenue; and (2) leverage. Risk sensitivity would be increased through special treatment for certain types of specialised lending exposures. By contrast, all corporate exposures currently receive 100 per cent risk weighting in the US.
  • Exposures Secured by Residential Real Estate: Currently, residential real estate secured exposures receive a 35 per cent risk weighting under the Basel framework. The Proposal would change this to calculate the risk of these exposures using a look-up table with risk weights ranging from 25 per cent to 100 per cent based on (1) loan-to-value; and (2) debt- service coverage ratios. In the US, all residential real estate secured exposures receive a 100 per cent risk weighting, unless they are (a) first-lien mortgages; (b) on owner-occupied or rented property; (c) made in accordance with prudent underwriting standards; (d) not 90 days or more past due or in non-accrual status; and (e) not restructured or modified (with the exception of certain government loan modification programmes); in which case they receive 50 per cent risk weighting.
  • Exposures Secured by Commercial Real Estate: The Proposal suggests two possible approaches for these exposures, either (1) treating them as unsecured exposures to the counterparty, with national discretion for preferential risk weighting under certain conditions, or (2) using a look-up table with risk weights from 75 per cent to 120 per cent on the basis of loan-to-value ratio. The US subdivides risk weighting for commercial real estate secured exposures into various subcategories, ranging from 50 per cent for certain types of multifamily residential exposures to 150 per cent for high volatility commercial real estate exposures.

On the same day that the BCBS released the Proposal, the Banking Agencies also released a statement that they will be considering the Proposal with the goal of developing a stronger and more transparent risk-based capital framework for the largest banking institutions. It remains to be seen what effect, if any, the BCBS Proposal will have on the US approach to risk-based capital calculations, but the Banking Agencies stated that any change to the

US rules would be made in a manner consistent with the US notice and comment process. Parties interested in commenting on the Proposal should be aware that comments are due no later than 27 March 2015.

LOOKING AHEAD TO NEW US FINANCIAL REGULATION

The first session of the 114th Congress has convened, and Republicans have control of the House and Senate for the first time since 2006. With their new majorities, Republican leaders are determined to show that they can govern effectively. High on their legislative agenda is reducing the regulatory burden on the economy and scaling back what they perceive as the regulatory overreach of the Dodd-Frank financial reform law.

Since the enactment of Dodd-Frank in 2010, the Obama Administration and Congressional Democrats have resisted any changes to the law. In the last two years, the Republican House has passed a long list of bills to revise portions of the law, but the Senate blocked every Dodd-Frank change passed by the House. However, the total ban on Dodd-Frank revisions changed in the lame-duck session last month. First, Congress included an amendment to the 2015 omnibus spending bill which blocked a requirement that banks “push-out” certain swaps activities to nonbank affiliates. Despite opposition from many, the provision stayed in the bill and was signed into law by the President. Then, Congress cleared a bill with bipartisan support to provide the Federal Reserve with more flexibility in setting capital standards for insurance companies.

Finally, last week Congress added an amendment to the Terrorism Risk Insurance Act extension bill which exempts end users from Dodd-Frank derivatives rules.

An attempt by Senator Elizabeth Warren (D-MA) to delete the provision was rejected by a 31-66 vote, with 13 Democrats voting against Warren.

With Republicans now in full control of Congress, further changes to Dodd-Frank can be expected. Full repeal or major changes to Dodd-Frank are not likely. The President has promised to oppose any proposals that “water down” his financial reform, and has threatened to veto any attempt to undermine Dodd-Frank. However, Congress can still be expected to move ahead on a number of changes to Dodd-Frank which could attract bipartisan support and gain 60 or more votes in the Senate.

Many Congressional Democrats will oppose any changes to Dodd-Frank. However, a number of Democrats could support some changes, particularly changes supported by financial regulators, who now believe that some provisions of the law are unworkable and need to be changed. In addition, the new Congress is much different than the one which enacted Dodd-Frank. Only 31 of the 60 Senators and 131 of the 237 House members who voted for Dodd-Frank in 2010 are still in office today.

The House Financial Services Committee chaired by Representative Jeb Hensarling (R-TX) will likely approve numerous bills to amend Dodd-Frank, and the full House will likely pass most or all of these bills. The key will be the Senate Banking Committee, where Senator Richard Shelby (R-AL) has taken over as Chairman. Senator Shelby opposed Dodd-Frank and has been a vocal critic of many of the law’s provisions, including the structure and funding of the Consumer Financial Protection Bureau. He has supported regulatory relief for small and medium-sized banks, and he is a supporter of cost-benefit analyses for all new financial regulations. His challenge will be shaping Dodd-Frank reforms which can attract enough Democratic support to pass the Senate and avoid a Presidential veto.

The following are potential Dodd-Frank reforms which could be considered in the new Congress:

  • Financial Stability Oversight Council (FSOC) reforms: A number of proposals have been made to curb the authority of FSOC, including one to rescind its authority to designate nonbank financial firms as systemically important financial institutions (SIFIs) subject to enhanced supervision by the Federal Reserve. Other proposals would require FSOC to give firms an early warning notice that they may be designated as a SIFI, and require public hearings on SIFI designation proposals.
  • SIFI Threshold: Under Dodd-Frank, all bank holding companies with more than US$50 billion in consolidated assets are automatically designated as SIFI and subject to enhanced levels of regulation and supervision. A number of proposals have been made to raise the asset threshold for enhanced supervision to US$100 billion, or higher, or to use criteria other than asset size for the designation. Financial regulators, including Federal Reserve Board Governor Daniel Tarullo, have supported raising the threshold to allow the Fed to focus on the largest institutions.
  • Volcker Rule: A senior Federal Reserve Board official said recently that implementation of the Volcker Rule was the Fed’s “greatest challenge” this year, and numerous proposals can be expected to delay portions of the rule beyond the statutory implementation date of July 2015. The Federal Reserve announced last month that it would delay the conformance period for banking entities’ covered funds activities, and Congress is considering a proposal to delay the conformance date for collateralised loan obligations, which has already been delayed once. Also, Congress could act on a proposal to exempt community banks from the Volcker Rule, exempting banks and thrifts with less than US$10 billion in assets.
  • CFPB Reform: Although many Democrats will resist any changes, Republicans can be expected to pursue changes to the structure and funding of the Consumer Financial Protection Bureau. One proposal would replace the Director of the bureau with a board of commissioners; another would subject the funding of the bureau to the annual appropriations process. Another proposal would establish an independent Inspector General for the CFPB.
  • Regulatory Relief: A regulatory relief package for small banks could turn out to be the vehicle for a number of these other Dodd-Frank reforms. Financial regulators have pledged to work with Congress on legislation to reduce “unnecessary burdens” on smaller banks. The House Financial Services Committee is planning to move a regulatory relief bill, and Senate Banking Committee Chairman Shelby has long argued that Dodd-Frank “hurts small and medium-sized banks that had nothing to do with the financial crisis”.

Treasury Secretary Jake Lew has said that the Administration will oppose any bill that undermines the Dodd-Frank financial reforms. But the new Republican Congress is determined to pursue bipartisan changes to fix the most glaring problems with the law, particularly changes supported by financial regulators. A Dodd-Frank reform bill which focuses on relief for community banks but which includes other substantive changes could attract enough Democratic support to avoid a Presidential veto.

CCP RECOGNITION IN THE US AND THE EU: EqUIVALENCE THROUGH DEFERENCE

Last year saw the first authorisations of EU Central Counterparty Clearing Houses (CCPs), triggering the first clearing obligation procedure under Article 5(2) of EMIR. A CCP cannot operate in Europe if it does not meet authorisation and recognition criteria under EMIR Articles 14 (authorisation) and 25 (recognition).

Under EMIR, a CCP established outside of the EU may provide clearing services to clearing members established in the European Union only if the ESMA recognises the CCP as a ‘third country CCP’.

The objective is to create an efficient and stable international regulatory framework for the global derivatives market by lowering the chances of market fragmentation and regulatory arbitrage between countries.

Status of Non-EU CCP Recognition

On 30 October 2014, the first wave of the EC’s ‘equivalence’ decisions were granted to four Asian jurisdictions (Hong Kong, Singapore, Australia and Japan) through four provisional implementing acts. The US is still waiting for CCP equivalence from ESMA. Why would the EU recognise CCPs in those jurisdictions but not in the US?

If the EU does not grant equivalence status to the US, US CCPs will not be considered ‘Qualifying CCPs’ (QCCPs) in accordance with the Capital Requirements Directive (CRD IV) and Basel III risk-weightings. This means that

European banks would incur significant costs to clear through US CCPs. This also means that US CCPs would be ineligible to clear contracts subject to the EU clearing mandate.

EMIR Requirements

Article 25 requires CCPs in third countries who provide clearing services to EU-based clearing members or trading venues to be recognised as ‘equivalent’ by ESMA. This means that the EU must determine that the third country’s CCP requirements satisfy the same objectives as that in the EU in order to provide a strong CCP framework that promotes financial stability. The assessment of equivalence is done in an outcome-based approach which means that there is no requirement for identical rules. Once equivalent status is granted through an implementing act and a cooperation agreement is established between ESMA and the relevant jurisdiction, a market participant will be able to satisfy its clearing obligations under EMIR by submitting a trade with an authorised CCP in that third country.

CFTC Requirements

In the US, under the Derivatives Clearing Organisation authorisation process, a CCP must apply to the CFTC to become a Designated Clearing Organisation (DCO) or obtain an exemption in order to serve a US person. A substituted compliance regime would allow non-US entities to comply with comparable non-US rules, in lieu of complying with US CFTC rules, when dealing with US counterparties. To make a substituted compliance determination, the CFTC must determine that the foreign jurisdiction’s requirements “are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by” the CFTC’s own rules.

Status of Discussions

Many issues of substituted compliance are in the pipeline between the EU and the US and are part of the larger debate to come regarding EU-US CCP recognition. Additionally, there are many new rules that have cross- border implications on both sides of the Atlantic.

For example, EU officials interpret the CCP equivalence test to mean that the US should not require US registration of EU clearinghouses. There are presently three clearinghouses in the EU that are also registered with the CFTC. Regulators have also identified broader issues in discussions regarding cross-border harmonisation. More precisely, in the EC press release announcing the recognition of CCPs in Australia, Hong Kong, Japan and Singapore, Michel Barnier, European Commissioner for Internal Markets and Services, indicated:

“Today’s decisions show that the EU is willing to defer to the regulatory frameworks of third countries, if they meet the same objectives as EU rules. We have been working in parallel on assessing twelve additional jurisdictions and finalizing those assessments is a top priority. This includes the US: we are in close and continued dialogue with our colleagues at both the SEC and CFTC as we develop our assessments of their respective regimes and discuss their approaches to deference.”

It is widely accepted that both sides also need to enhance cooperation in the joint supervision of dual registrants. There is already precedent for this in past collaborative examinations and information sharing. Dual registration has existed for more than a decade, and dual regulation and oversight should not hinder liquid and vibrant markets. It should provide markets with added confidence by ensuring effective and practical regulatory oversight.