The Board of Governors of the Federal Reserve System (Federal Reserve) recently issued a final rule that will fundamentally change the way in which non-U.S. banks are regulated and supervised in the United States. Pursuant to section 165 of the Dodd-Frank Act, the Federal Reserve has issued regulations for the enhanced prudential supervision of large bank holding companies (ie those which hold USD50billion or more of total consolidated assets). Section 165 applies generally to covered financial institutions regardless of where they are organized, but the Federal Reserve has decided to apply its provisions to non-
U.S. banks much more aggressively than its manner of supervising foreign banks in the past. In particular, every non-U.S. bank with a substantial presence in the United States (ie those which hold USD50bn or more of total U.S. assets, not including assets held in U.S. branches and agencies) will be required to establish an intermediate holding company (IHC) to hold its U.S.-based banking and nonbanking subsidiaries. An IHC will be subject to supervision by the Federal Reserve—including compliance with risk-based capital, leverage, liquidity, and other requirements and restrictions—on substantially the same terms as U.S. bank holding companies.
Non-U.S. banks now face the prospect of increased capital and liquidity requirements, reduced lending capacity, and increased operating and compliance costs in the United States. Even non-U.S. banks that already hold their U.S. operations through a separate holding company are likely to face greater costs and additional restrictions. For example, a non-U.S. bank may be required to engage in substantial restructuring in order to place all of its U.S. banking and nonbanking subsidiaries under an IHC and may incur significant operating expenses and tax liabilities in the process. Capital held in an IHC may not be available to support global operations outside the United States, which may increase global financing costs. The U.S. branches and agencies of a non-U.S. bank will remain outside of any IHC structure but will face heightened liquidity standards. There may be other equally fundamental effects due to the final rule.
The Federal Reserve’s aggressive position reflects its reading of recent U.S. banking history, including the events of the financial crisis. According to the Federal Reserve, the role of non-U.S. banks in the U.S. financial system has shifted substantially over the last 15 years or so—from primarily extending credit to U.S. borrowers and holding U.S.-based assets—to primarily issuing short-term obligations and obtaining funding used to finance operations and extend credit outside the United States. During the financial crisis, many U.S. and non-U.S. financial institutions had difficulty rolling over their short- term obligations. Non-U.S. banks that were unable or unwilling to provide external support to their U.S. operations became substantial borrowers from the Federal Reserve discount window and from other government- supported liquidity facilities. To prevent a recurrence, the Federal Reserve has determined that it is necessary that non-U.S. banks hold sufficient capital in the United States and observe other requirements and limitations to ensure that their U.S. operations can withstand a period of financial distress on a stand-alone basis.
The Federal Reserve is not blind to the costs and difficulties that the final rule may impose on non-U.S. banks. Many commenters on the proposed rule— including central banks and banking supervisory authorities in several countries—objected to various provisions of the proposed rule and proposed alternatives. In response, the Federal Reserve raised the IHC requirement threshold amount from USD10bn to USD50bn of total U.S. assets, which has reduced the number of non-U.S. banks that will be required to establish an IHC. In addition, certain risk management requirements have been relaxed, and the deadlines for compliance have been extended. These concessions notwithstanding, the Federal Reserve has largely maintained its “bottom line” of imposing a new, more U.S.-centric model of foreign bank supervision. As Federal Reserve Governor Daniel K. Tarullo, the leader of the rule-writing effort, explained in his written statement supporting the final rule, “the most important contribution we can make to the global financial system is to ensure the stability of the U.S. financial system.”
As stated above, section 165 of the Dodd-Frank Act applies to bank holding companies which hold USD50bn or more of total consolidated assets (Large BHCs).* The definition of bank holding company in the Dodd-Frank Act includes a non-U.S. bank or company that is treated as a bank holding company for purposes of the Bank Holding Company Act pursuant to section 8(a) of the International Banking Act of
1978. As a result, a non-U.S. bank that maintains a branch or agency or controls a commercial lending company in the United States, and the parent of any such foreign bank, is treated as a Large BHC if it holds USD50bn or more of total consolidated assets on a global basis. The Federal Reserve has estimated that 24
top-tier U.S. bank holding companies and 100 non-U.S. banks are Large BHCs.
In determining whether a non-U.S. bank holds USD50bn or more of assets in the U.S. (not including assets held in its
U.S. branches and agencies), and whether the IHC requirement applies, a non-U.S. bank may consolidate claims and liabilities among its U.S. subsidiaries as if an IHC was in place. The Federal Reserve has estimated that 15 to 20 non-U.S. banks will be required to establish an IHC.
* Section 165 also applies to nonbank financial companies that are designated by the Financial Stability Oversight Council under section 113 of the Dodd-Frank Act as systemically important and are thereby made subject to supervision by the Federal Reserve. To date, three nonbank financial companies have been so designated, none of which is a foreign nonbank financial company. Additional nonbank financial companies are under review, and such reviews are expected to be ongoing.
Section 165 directs the Federal Reserve to adopt enhanced prudential standards for the institutions described above, which standards are required to be more stringent than those applicable to financial institutions that do not present similar risks to U.S. financial stability.‡ The standards must increase in stringency based on the nature of the activities and features of the Large BHC (such as its size, scale, and interconnectedness). The enhanced prudential standards are required to address risk-based capital, leverage capital, liquidity, risk management, stress testing, and single counterparty credit limits. In addition, the Federal Reserve must impose a 15:1 debt-to-equity limit if the Financial Stability Oversight Council (FSOC) determines that a particular institution poses a “grave threat” to U.S. financial stability, and the Federal Reserve may establish such additional standards as it determines to be appropriate, including a requirement to issue contingent capital instruments, limits on short-term debt, and enhanced public disclosure requirements.
The most significant provision in the final rule for the largest non-U.S. banks is undoubtedly the “additional” requirement that they establish IHCs to hold their U.S.- based banking and nonbanking subsidiaries. In
exceptional cases, a non-U.S. bank may be permitted to establish more than one IHC to accommodate the current structure of its U.S. operations. In general, the final rule adopts enhanced prudential standards with regard to risk- based capital, leverage capital, liquidity, risk management, and capital stress testing. Other required standards regarding single counterparty credit limits and early remediation have been deferred, and optional standards to address the additional concerns that the Federal Reserve has been directed to consider have not been adopted. Two other standards required under section 165, regarding resolution planning and credit exposure reports, have been previously addressed in relation to Large BHCs in general, and IHCs must comply with those requirements as well.
‡ Section 166 of the Dodd-Frank Act requires the Federal Reserve to adopt standards for the early remediation of Large BHCs and nonbank financial companies that are supervised by the Federal Reserve that experience financial distress, in order to minimize the probability that they will become insolvent and may cause harm to
U.S. financial stability. The Federal Reserve has not yet issued a final rule under section 166.
Federal Reserve takes aggressive position on non-U.S. banks – February 2014
In general, non-U.S. banks will become fully subject to the final rule beginning July 1, 2016. However, the capital stress test requirements will not apply to IHCs until the stress test cycle beginning October 1, 2017, and the enhanced leverage capital requirement will not apply until January 1, 2018. On the other hand, non-U.S. banks which hold USD50bn or more of U.S. non-branch assets as of June 30, 2014 must submit an implementation plan to the Federal Reserve by January 1, 2015.
organize its IHC by July 1, 2016. At that time, the IHC must hold all ownership interests that its parent bank may have in any U.S. bank holding company subsidiary and
U.S. bank subsidiary as well as 90% of all of its parent bank’s other non-branch U.S. assets. Any remaining non- branch U.S. assets must be transferred to the IHC by July 1, 2017. Non-U.S. banks that become subject to the IHC requirement after July 1, 2015 will have 24 months in which to comply in full.
Any non-U.S. bank that meets or exceeds the threshold for the formation of an IHC on July 1, 2015 must
The Dodd-Frank Act requires the Federal Reserve to impose enhanced risk-based capital and leverage requirements on non-U.S. banks which hold USD50bn or more of total consolidated assets, and the final rule requires an IHC for a non-U.S. bank—even if the IHC does not have a subsidiary bank—to comply with these requirements as if it was a U.S. bank holding company. Only those capital instruments that the Federal Reserve has recognized in its capital rules for U.S. bank holding companies may be used to satisfy an IHC’s capital requirements.
An IHC is not required to comply with the advanced approach risk-based capital rules that the Federal Reserve has adopted for bank holding companies which hold USD250bn or more of total consolidated assets or USD10bn or more of on-balance sheet foreign exposures. However, other requirements that typically apply to
financial institutions that are subject to the advanced approach—including the countercyclical capital buffer requirement—will apply.
Under the final rule and the Federal Reserve’s general risk-based and leverage capital rules incorporated thereby, an IHC is required to maintain the following minimum ratios:
In order to avoid limitations on capital distributions and discretionary bonus payments to its executive officers, an IHC also must maintain a capital conservation buffer, consisting of additional Tier 1 common equity in an
amount greater than 2.5% of risk-based assets. In addition, an IHC that would qualify as an advanced approach financial institution must maintain: (a) a minimum supplementary leverage ratio of 3%, which takes into account off-balance sheet exposures; and (b) a countercyclical capital buffer during periods of excessive credit growth, consisting of Tier 1 common equity in an amount up to 2.5% of risk-based assets.
An IHC is subject to the Federal Reserve’s general requirement that U.S. bank holding companies which hold USD50bn or more of total consolidated assets must submit an annual capital plan. An IHC that is organized by July 1, 2016, must submit its first capital plan in January 2017. This requirement is currently in effect for
U.S. bank holding companies, but a U.S. bank holding company that is a subsidiary of a non-U.S. bank and does not observe minimum capital requirements by reliance on the Federal Reserve’s Supervision and Regulation Letter 01-01 (January 5, 2001) (which permits such a company to rely instead on the capital adequacy of its parent company) which then becomes an IHC is not required to comply with the capital plan requirement until July 21, 2015.
Under this requirement, an IHC must submit a capital plan that demonstrates its ability to meet all applicable minimum risk-based capital requirements under both
baseline and stressed conditions over a minimum period of nine calendar quarters. An IHC that does not meet these requirements may not make any capital distributions except as permitted by the Federal Reserve. While a non-U.S. parent bank is expected to provide capital support to its IHC—such as through guarantees and keepwell agreements—an IHC may not rely on such agreements as sources of capital in demonstrating its ability to meet its minimum capital requirements. Separately, a non-U.S. bank which holds USD50bn or more of total consolidated assets must certify or otherwise demonstrate to the Federal Reserve that it meets capital adequacy standards at the consolidated level that are consistent with the Basel Capital Framework. A non-U.S. bank that does not comply may have conditions or restrictions placed on its U.S. activities or business operations
Federal Reserve takes aggressive position on non-U.S. banks – February 2014
A non-U.S. bank which holds: (a) total consolidated assets of USD10bn or more and also has outstanding a class of publicly traded securities; or (b) total consolidated assets of USD50bn or more and combined
U.S. assets of less than USD50bn, must certify to the Federal Reserve on an annual basis that it maintains a
U.S. risk committee of its board of directors (or equivalent home country governance structure) that oversees the risk management policies of its combined
U.S. operations. It also must certify that the U.S. risk committee has at least one member with experience in identifying, assessing, and managing the risk exposures of a large and complex firm. Experience in a nonbanking or nonfinancial field may satisfy this requirement. The non-U.S. bank also must take measures to ensure that its combined U.S. operations implement the policies of the
U.S. risk committee and report sufficient information to enable the committee to discharge its responsibilities.
For a non-U.S. bank which holds combined U.S. assets of USD50bn or more, the U.S. risk committee must review and periodically approve the risk management policies of its combined U.S. operations under a risk management framework that is commensurate with the size, capital structure, activities, complexity, and other risk-related features of those operations. The risk management framework for U.S. operations must be consistent with the non-U.S. bank’s global risk management framework, and the non-U.S. bank may rely on its enterprise-wide
risk management policies to provide risk management for its U.S. operations if its policies and procedures meet the minimum requirements in the final rule. However, if a non-U.S. bank establishes an IHC for its U.S. operations, then the IHC must have its own risk committee to oversee its risk function. The risk committee of an IHC may be used to fulfill the risk management responsibilities of the non-bank U.S. for its combined U.S. operations.
For a non-U.S. bank with U.S. operations of this size, the
U.S. risk committee must have: (a) at least one member with experience in identifying, assessing, and managing the risk exposure of a large and complex financial firm; and (b) at least one independent member. An independent member is a person who is not a current or former officer or employee of the non-U.S. bank or its affiliates or a member of the immediate family of a current or former executive officer. A larger non-U.S. bank also must have a U.S. chief risk officer, who may be employed by the IHC, any U.S. subsidiary if there is no IHC, or a U.S. branch or agency. The U.S. chief risk officer must report directly to the U.S. risk committee and to the non-U.S. bank’s global chief risk officer, unless the Federal Reserve approves an alternative structure. The primary responsibility of the U.S. chief risk officer must be to oversee risk management of the combined U.S. operations, and he or she must be in a position to serve as a single point of contact for the Federal Reserve.
As part of its responsibilities, the U.S. risk committee of a non-U.S. bank which holds combined U.S. assets of USD50bn or more is responsible for overseeing the liquidity risk management processes of its U.S. operations—including those at its U.S. branches and agencies. At least annually, the U.S. risk committee must review and approve strategies, policies, and procedures that are designed to determine whether the tolerance of the U.S. operations for liquidity risk is appropriate to the nature of those operations and to their role in the U.S. financial system. The U.S. risk committee should consider tradeoffs between the costs and benefits of liquidity and should see that U.S. management understands the policy for managing such tradeoffs. The
U.S. risk committee or a designated subcommittee is also responsible for reviewing and approving at least annually a contingency funding plan for the combined U.S. operations.
The U.S. chief risk officer of a non-U.S. bank with U.S. operations of this size must review the strategies established by senior management for managing the liquidity risk of the combined U.S. operations and regularly report thereon to the U.S. risk committee. The
U.S. chief risk officer must also review and approve each significant new business line and product in the U.S. before it is implemented or introduced and must review all significant business lines and products at least annually to determine that they remain within the established liquidity risk tolerance of U.S. operations. At least quarterly, the U.S. chief risk officer must review internal reports describing the liquidity risk profile of the combined U.S. operations.
A non-U.S. bank with larger U.S. operations is also required to establish an independent review function to evaluate the liquidity risk management of its combined
U.S. operations. The review function must address all relevant elements of liquidity risk management, including the identification, measurement, and reporting of liquidity
risk, adherence to policy, compliance with law and sound business practices, and reporting of noncompliance and other material liquidity risk management issues.
Such a non-U.S. bank must establish and maintain limits on the potential sources of its liquidity risk. The limits should identify specific types of risk, such as may be related to specific instruments, types of counterparties, time horizons, or off-balance sheet exposures, and should set limits appropriate to the nature of the combined U.S. operations. The U.S. operations must be monitored for intraday liquidity risk exposure.
The non-U.S. bank also is required to prepare comprehensive cash flow projections for its combined
U.S. operations and to establish and maintain a
contingency funding plan to address the liquidity needs of the U.S. operations during a liquidity stress event. The plan is intended to direct a non-U.S. bank’s response to a liquidity crisis, identify alternative liquidity sources, and outline steps to be taken to ensure that its liquidity sources will be sufficient to fund its operating costs and meet its commitments in the U.S. while minimizing additional costs and disruption. A non-U.S. bank also must periodically test its contingency funding plan—such as through “table-top” exercises—and update the plan at least annually.
Liquidity stress tests must be conducted on a monthly basis. The testing must address both market stress and stress that is unique to the U.S. operations, and it must cover at least four time horizons—overnight, 30 days, 90 days, and one year. Stress testing must be conducted separately for the combined U.S. operations, the U.S. branches and agencies, and the IHC (if any). The U.S. branches and agencies and the IHC must hold separate liquidity buffers of highly liquid assets equal to their respective net stressed cash flow needs as identified by the liquidity stress testing. U.S. and U.S.-backed securities qualify as highly liquid assets; other sovereign
Federal Reserve takes aggressive position on non-U.S. banks – February 2014
debt securities are not specifically qualified, but the Federal Reserve has stated that it expects that soverign debt that is of high quality will be accepted. The liquidity buffer for the U.S. branches and agencies must cover the first 14 days of a stress scenario, and the buffer for the IHC must cover the first 30 days.
An annual liquidity stress test must be conducted by non-
U.S. banks which hold USD50bn or more of total consolidated assets but less than USD50bn of combined
U.S. assets. The stress test is required to incorporate
30-day, 90-day, and one-year time horizons, but not overnight exposure.
An IHC is subject to the same annual and semi-annual stress testing and related reporting and disclosure requirements as the Federal Reserve adopted in 2012 for Large BHCs generally. This includes an annual company- run stress test applying scenarios supplied by the Federal Reserve and a second company-run stress test conducted at mid-cycle applying scenarios developed by the IHC. The IHC must publicly disclose a summary of the results of the annual stress test under the severely adverse scenario, and must also disclose a summary of the results of the mid-cycle stress test, regardless of whether the IHC is publicly traded. If a non-U.S. bank has a U.S. bank holding company subsidiary that is subject to the Federal Reserve’s stress testing requirements, the subsidiary remains subject to those requirements until the stress testing cycle for IHCs begins in 2017.
The U.S. branches and agencies of a non-U.S. bank which holds more than USD50bn of combined U.S. assets must also be subject to stress testing by the non-
U.S. bank’s home country supervisor or a comparable internal evaluation. Key information regarding the results of the stress testing must be reported to the Federal Reserve. Additional information must be reported to the Federal Reserve if the U.S. branches and agencies serve as net funding sources for the parent bank. If a non-U.S. bank does not satisfy these requirements, its U.S. branches and agencies must maintain eligible assets (as defined) equal to not less than 108% of their average total third-party liabilities.
Annual stress testing requirements also apply to non-U.S. banks which hold USD50bn or more of total consolidated assets but less than USD50bn of combined U.S. assets. However, if such a bank does not satisfy the requirements, its U.S. branches and agencies must maintain eligible assets equal to not less than 105% (rather than 108%) of average total third-party liabilities. Smaller non-U.S. banks also are subject to stress testing requirements.
If the FSOC determines that a non-U.S. bank poses a grave threat to U.S. financial stability and that such a requirement is necessary to mitigate the risk that the non-
U.S. bank poses, the Federal Reserve is required to impose a debt-to-equity limit on its IHC (if any) or its
U.S. subsidiaries. No later than 180 days after receiving written notice from the FSOC (or the Federal Reserve on behalf of the FSOC), the IHC or U.S. subsidiaries must achieve and maintain a ratio of total liabilities to total equity capital less goodwill of not more than 15:1. In
addition, the U.S. branches and agencies of the non-U.S. bank must maintain eligible assets equal to not less than 108% of their average total third-party liabilities. A
non-U.S. bank may request up to two 90-day extensions of the compliance period, which requests must be made not less than 30 days before the expiration of the compliance period then in effect. A non-U.S. bank requesting an extension must demonstrate its good faith efforts to comply and that an extension would be in the public interest.
The final rule requires certain non-U.S. banks to maintain substantial additional capital and liquidity in the United States on a permanent basis, rather than relying on the global consolidated capital of their non-U.S. parents. The
overall result is an aggressive position taken by the Federal Reserve that fundamentally changes the supervision of non-U.S. banks operating in the United States.