On November 2, 2018, the Federal Reserve Board finalized a new rating system (NRS) for large financial institutions (LFIs). The NRS is very similar to the Fed's original August 2017 proposal, with one key difference concerning the amount of time a firm will have to remediate deficiencies that could result in the loss of "well managed" status.
The NRS is intended by the Fed to:
- Fully align with the Fed's current supervisory programs and practices, which are based upon the LFI supervision framework's core objectives of reducing the probability of LFIs failing or experiencing material distress and reducing the risk to US financial stability
- Enhance the clarity and consistency of supervisory assessments and communications of supervisory findings and implications and
- Provide transparency related to the supervisory consequences of a given rating.
The NRS applies to BHCs with total consolidated assets of $100 billion or more; all non-insurance, non-commercial SLHCs with total consolidated assets of $100 billion or more; and US IHCs of FBOs with combined US assets of $50 billion or more established pursuant to Regulation YY.
For BHCs and US IHCs of FBOs which are subject to the NRS and are included in the LISCC framework, the Fed will begin assigning ratings using new LFI rating system in early 2019. For BHCs and US IHCs of FBOs which are subject to the NRS and are not included in the LISCC framework, the Fed will continue to use the RFI rating system for ratings in 2019 and will assign ratings using the final LFI rating system beginning in early 2020.
The NRS will evaluate and assign ratings for three components (LFI Components, which are discussed in more detail below):
- Capital Planning & Positions
- Liquidity Risk Management & Positions
- Governance & Controls
Each LFI component will be assigned a rating along a four-level scale (which is described in more detail below):
- Broadly Meets Expectations
- Conditionally Meets Expectations
- Deficient – 1
- Deficient – 2
The NRS has a number of significant differences from the old RFI/C(D) rating system. First, there is no overall composite rating; an LFI must rate as "Broadly Meets Expectations" or "Conditionally Meets Expectations" for all three LFI Components to be considered "well managed."Second, unlike the RFI rating system, the LFI Components will have no subcomponent ratings. Finally, the NRS has no separate "Impact" rating assigned to assess the potential impact of the firm's non-DI entities on its DI subsidiary institution(s) MORE DETAIL ON THE LFI COMPONENTS
Capital Planning and Positions Component
- In developing this rating, the Fed will evaluate:
- Capital planning: Extent to which a firm maintains sound capital planning practices through effective governance and oversight; effective risk management and controls; maintenance of updated capital policies and contingency plans for addressing potential shortfalls; and incorporation of appropriately stressful conditions into capital planning and projections of capital positions and
- Capital positions: Extent to which a firm's capital is sufficient to comply with regulatory requirements, and to support its ability to meet its obligations to depositors, creditors, and other counterparties and continue to serve as a financial intermediary through a range of conditions.
- Commentary Even if the firm meets minimum regulatory capital requirements, the Fed may still determine that a firm does not meet expectations regarding its capital position in light of its idiosyncratic activities and risks. Any findings from supervisory stress testing, such as CCAR or similar activities, will represent inputs into the Capital Planning and Positions component rating. However, with respect to any firm that may be subject to a qualitative review of its capital planning practices, there is no automatic link between the results of that review and the firm's capital rating.
Liquidity Risk Management & Positions Component
- In developing this rating, the Fed will evaluate:
- Liquidity risk management: The extent to which a firm maintains sound liquidity risk management practices through effective governance and oversight; effective risk management and controls; maintenance of updated liquidity policies and contingency plans for addressing potential shortfalls; and incorporation of appropriately stressful conditions into liquidity planning and projections of liquidity positions; and
- Liquidity positions: The extent to which a firm's liquidity is sufficient to comply with regulatory requirements, and to support its ability to meet current and prospective obligations to depositors, creditors and other counterparties through a range of conditions.
- Commentary As for all component ratings, horizontal and firm-specific examination work conducted under the LISCC liquidity program, which is inclusive of the horizontal work covered under the CLAR, will represent a material input into a firm's liquidity rating. Unlike CCAR, the LISCC liquidity program's assessment does not result in an objection or non-objection; rather, it results in supervisory findings communicated to the firm, which may include "matters requiring attention" and "matters requiring immediate attention," as applicable.
Governance and Controls Component
- In developing this rating, the Fed will evaluate the effectiveness of a firm's
- Board of directors
- Management of business lines and independent risk management and controls; and
- Recovery planning (for domestic LISCC firms only).
- Commentary This rating assesses a firm's effectiveness in these areas: aligning strategic business objectives with the firm's risk appetite and risk management capabilities; maintaining effective and independent risk management and control functions, including internal audit; and promoting compliance with laws and regulations, including those related to consumer protection; and otherwise providing for the ongoing resiliency of the firm. The NRS contains extensive details concerning board effectiveness and the effective management of business lines and independent risk management and controls.
MORE DETAIL ON LFR RATING SCALE
Broadly Meets Expectations
- Firm's practices and capabilities broadly meet supervisory expectations, and the firm possesses sufficient financial and operational strength and resilience to maintain safe-and-sound operations through a range of conditions.
- Firm may be subject to identified supervisory issues requiring corrective action. These issues are unlikely to present a threat to the firm's ability to maintain safe-and-sound operations through a range of conditions.
Conditionally Meets Expectations
- Certain, material financial or operational weaknesses in a firm's practices or capabilities may place the firm's prospects for remaining safe and sound through a range of conditions at risk if not resolved in a timely manner during the normal course of business (meaning the firm has the ability to resolve these issues through measures that do not require a material change to the firm's business model or financial profile, or its governance, risk management or internal control structures or practices).
- The Fed does not intend for a firm to be assigned a "Conditionally Meets Expectations" rating for a prolonged period, and will work with the firm to develop an appropriate timeframe to fully resolve the issues leading to the rating assignment and obtain an upgrade to Broadly Meets Expectations.
- Failure to resolve the issues in a timely manner would most likely result in downgrade to a "Deficient" rating, since the inability to resolve the issues would indicate the firm does not possess sufficient financial or operational capabilities to maintain its safety and-& soundness through a range of conditions.
- It is recognized that completion and validation of remediation activities for select supervisory issues – such as those involving IT modifications – may require an extended time horizon.
- Appropriate and effective risk mitigation techniques must be utilized in the interim to maintain safe-and-sound operations under a range of conditions until remediation activities are completed, validated, and fully operational.
Deficient – 1
- Financial or operational deficiencies in a firm's practices or capabilities put the firm's prospects for remaining safe and sound through a range of conditions at significant risk.
- Firm is unable to remediate these deficiencies in the normal course of business, and remediation would typically require the firm to make a material change to its business model or financial profile, or its practices or capabilities.
- A firm with a "Deficient-1" rating is required to take timely corrective action to correct financial or operational deficiencies and to restore and maintain its safety and soundness and compliance with laws and regulations, including those related to consumer protection.
- Strong presumption that a firm with a "Deficient-1" rating will be subject to an informal or formal enforcement action, and could be a barrier for a firm seeking Fed approval to engage in new or expansionary activities.
Deficient – 2
- Financial or operational deficiencies in a firm's practices or capabilities present a threat to the firm's safety and soundness, or have already put the firm in an unsafe and unsound condition.
- Required to immediately implement comprehensive corrective measures, and demonstrate the sufficiency of contingency planning in the event of further deterioration.
- Strong presumption that a firm with a "Deficient-2" rating will be subject to a formal enforcement action, and the Fed Reserve would be unlikely to approve any proposal to engage in new or expansionary activities.
The NRS provides more details on how the LFI Rating Scale will be applied to each LFI Component.