Insights from Winston & Strawn

FRB Stress Testing Model Validation Procedures Cited as Inadequate by Internal Report

The Board of Governors of the Federal Reserve System (“FRB”) was recently examined by the FRB’s Office of Inspector General (“OIG”) particularly with respect to the models used in the FRB’s stress testing of large financial institutions.  The OIG subsequently cited the FRB for insufficient model risk management in the areas of staffing, model validation, controls and internal communication.

The concept of the FRB subjecting banks to stress-testing was a key element of the FRB's increased supervision following the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).  Not only is stress testing a crucial part of the FRB’s supervisory program for Bank Holding Companies (“BHCs”), but it also acts to de facto establish capital requirements for regulated BHCs and thereby impacts their business plans and profitability.

The report cited the FRB as having a limited number of staff wih the appropriate training to conduct the reviews.  This (i) potentially created a dependency on certain personnel, (ii) posed a problem that reviewers were subject to familiarity bias and (iii) meant standards that had been in place were morelikely to not be reviewed on an ongoing basis for currency and appropriateness.

The OIG Report also cited a lack of basic controls over the stress testing models, stating that the models were sometimes subject to late-stage changes, some of which could be considered material changes, and which could occur (i) without certain FRB staff being informed of such changes and/or (ii) without such changes to the model being validated for accuracy.

The OIG Report found that “there was a lack of common understanding between the [responsible FRB units] on roles, responsibilities, and accountability for managing the model inventory…. [and the Board] does not currently have written policies or procedures related to model inventory management. Therefore, …the standards outlined in SR Letter 11-7 have not been satisfied.”

This lack of control and consistency is particularly troubling on at least three fronts. 

  1. First, there is an element of irony as the FRB would cite any of their supervised institutions with a matter requiring attention (and possibly a matter requiring immediate attention) for similar failures;
  2. Second, due process issues may be involved as the content of the models may be ill-defined and/or poorly communicated within the FRB, and may be undisclosed to the financial institutions, such that financial institutions are being reviewed under and subject to regulatory action based on standards that are unknown to them and, to a certain degree, may be unknowable. 
  3. Third, as noted in an August article in the Economist, the FRB’s authority and powers over banks have grown by leaps and bounds over the past six years, and have, at best, somewhat hazily defined borders.  It is an unenviable position for financial institutions to be faced with a largely unchecked regulator, particularly one who appears to have organizational competency concerns in such a fundamental area. 

Recently, news of this report has received significant media attention, first in the Wall Street Journal, and now in the International Business TimesReuters, and others.  For a copy of the Executive Summary or the Full Report from the OIG, please see Federal Reserve Report.

Feature: Financial Stability Board and Federal Reserve Issue Recommendations Regarding Total Loss-Absorbing Capacity for Global Systemically Important Banks

Following months of speculation, the Financial Stability Board (“FSB”) issued its final recommendations for the Total Loss-Absorbing Capacity (“TLAC”) requirements for global systemically important banks (“G-SIBs”) in November.  The final standard takes steps to eliminate the notion that a bank is “too big to fail” by establishing a framework for G-SIBs that enter resolution to retain sufficient loss-absorbing and recapitalization capacity to avoid the need for public funds to rescue the bank, reducing the threat to the stability of the financial system.

The FSB’s final TLAC standard sets a minimum percentage of an institution’s risk-weighted assets and liabilities that must be readily available to fund the institution during resolution.  The final standard will be implemented incrementally, allowing G-SIBs three years to reach the final minimum TLAC requirements after setting an initial threshold percentage. Under the final recommendations, G-SIBs will be required to maintain a TLAC requirement of at least 16% of their risk-weighted assets by January 1, 2019. The TLAC requirement will increase to at least 18% of risk-weighted assets by January 1, 2022. In addition, G-SIBs’ minimum TLAC must also reflect a leverage ratio of at least 6% by January 1, 2019, rising to at least 6.75% by January 1, 2022. The implementation timeline for G-SIBs in emerging market economies is slightly longer, with G-SIBs required to meet the first phase percentage thresholds for risk-weighted assets and leverage ratio by January 1, 2025, and the final minimum requirements by January 1, 2028.

Although the publication of the FSB’s final TLAC standard was highly anticipated, the FRB issued its own proposed TLAC standard for domestic G-SIBs over a week in advance of the FSB’s standard.  Under the FRB’s proposal, domestic G-SIBs would also be required to hold a limited TLAC amount of at least 18% of risk-weighted assets; however, the FRB’s proposal sets a higher leverage ratio by requiring the TLAC amount to reflect a total leverage exposure of at least 9.5%. The FRB’s proposal also extends modified requirements to the U.S. operations of foreign G-SIBs, requiring these entities to hold a TLAC amount of at least 16% of risk-weighted assets, 6% of total leverage exposure and 8% of average total consolidated assets. The FRB’s proposal imposes “clean holding company” requirements on the parent companies of domestic G-SIBs to prevent them from entering into certain financial arrangements that might present difficulties during a resolution, including banning the issuance of short term debt to external investors and entering into derivatives contracts with external counterparties. Comments on the proposed rules should be submitted on or before February 1, 2016.

The impact of the FRB’s proposed rule and the FSB’s final TLAC standard on the financial sector is not yet clear. Initial reports suggest that G-SIBs will need to raise approximately $1.2 trillion to meet TLAC requirements under the FSB’s standard, while the FRB estimates that domestic G-SIBs currently face a $120 billion shortfall in complying with its proposed rules. However, market participants cited by Reuters point out that the way in which individual countries develop and change their insolvency frameworks will determine the amount of TLAC debt G-SIBs will need to raise.

In addition to the potential need for banks to raise significantly more debt, some critics fear the TLAC requirements may result in unforeseen consequences for the financial sector. Just days following the release of the FRB’s proposal, Bloomberg reported that Standard & Poor’s has initiated a credit review of eight U.S. G-SIBs, based largely on the implication that taxpayer support will no longer be available to failing institutions, which may result in lower credit ratings for these institutions. Other critics note that the FRB’s proposal penalizes banks that rely on deposits rather than debt for funding, which may result in additional costs to these institutions as well as an increased likelihood that these banks may take on additional risks to increase earnings. Some critics question the ability of the TLAC requirements to stave off a major financial crisis in which several banks fail simultaneously as well as the complexity of the system proposed under the rules.

While supporters agree that the effectiveness of the new requirements in the face of another financial crisis is uncertain, they argue that the new rules represent an important first step. David Dayen, writing for Salon, notes that “capital requirements cannot be the single solution to potential problems,” but they indicate that “reformers are putting regulators on the proper track, building walls to protect the public.” The strength of these walls, as well as what other supports will be necessary to bolster them, will become more apparent as governments and banks take steps to implement the new requirements.

Banking Agency Developments


OCC Updates Guidance on Risk Assessment System

On December 3rd, the Office of the Comptroller of the Currency (“OCC”) updated its guidance regarding its Risk Assessment System (“RAS”). The OCC’s updated RAS guidance is one of the agency’s responses to the recommendations in “An International Review of OCC’s Supervision of Large and Midsize Institutions.” OCC Bulletin.

OCC and Other Agencies Publish Final Rule to Establish Minimum Margin Requirements

On December 3rd, the OCC, FRB, the Federal Deposit Insurance Corporation (“FDIC”), the Farm Credit Administration, and the Federal Housing Finance Agency are publishing a final rule to establish minimum margin requirements for registered swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants subject to agency supervision. The OCC’s final rule applies to national banks, federal savings associations, and their subsidiaries. The effective date for the final rule is April 1, 2016, but the phase-in of the minimum margin requirements will not begin until September 1, 2016. OCC Bulletin.

Comptroller of the Currency Discusses Efforts to Reduce Regulatory Burden

On December 2nd, OCC Comptroller of the Currency Thomas J. Curry discussed efforts to reduce regulatory burden during an interagency outreach meeting conducted under the Economic Growth and Regulatory Paperwork Reduction Act. Curry Remarks.

OCC Releases Calendar Year 2016 Fees and Assessments Structure

On December 1st, the OCC released a bulletin informing all national banks, federal savings associations, and federal branches and agencies of foreign banks of fees and assessments charged by the OCC for calendar year 2016. The bulletin becomes effective on January 1, 2016. OCC Bulletin.


FDIC Issues List of Non-Member Banks Examined for Compliance with Community Reinvestment Act

On December 3rd, the FDIC issued its list of state non-member banks that were recently evaluated for compliance with the Community Reinvestment Act (“CRA”), a 1977 law that is intended to encourage insured banks and thrifts to meet local credit needs. The list covers evaluation ratings that the FDIC assigned to institutions in September 2015. CRA Compliance List.

Federal Reserve

FRB Approves Final Rule Specifying Procedures for Emergency Lending

On November 30th, the FRB approved a final rule specifying its procedures for emergency lending under Section 13(3) of the Federal Reserve Act. The FRB’s authority to engage in emergency lending has been limited under the Dodd-Frank to programs and facilities with “broad-based eligibility” that have been established with the approval of the Secretary of the Treasury. Dodd-Frank also prohibits lending to entities that are insolvent and imposes certain other limitations. The final rule provides greater clarity regarding the Board’s implementation of these and other statutory requirements. The final rule will take effect on January 1, 2016. Federal Reserve Press Release.

FRB Proposes Rule Requiring Large Banking Organizations to Publicly Disclose Several Measures of Their Liquidity Profile

On November 24th the FRB announced that it proposed a rule requiring large banking organizations to publicly disclose several measures of their liquidity profile. These measures will be the first required public disclosure of a quantitative liquidity risk metric for large banking organizations. Comments on the proposal will be accepted through February 2, 2016. Federal Reserve Press Release.

Treasury Department Developments


CFPB Monthly Complaint Snapshot Examines Bank Account and Service Complaints

On November 24th, the Consumer Financial Protection Bureau (“CFPB”) released its latest monthly consumer complaint snapshot, highlighting bank account and service complaints. The report shows that many consumers are experiencing problems opening up and managing accounts, while other consumers found their accounts closed without explanation. This month’s snapshot also highlights trends seen in complaints coming from Connecticut. As of Nov. 1, 2015, the CFPB has handled over 749,400 complaints across all products. CFPB Press Release.

Securities and Exchange Commission


Volcker Rule Guidance

On November 20th, the federal financial regulators published new guidance concerning the implementation of Section 619 of Dodd-Frank, more commonly known as the Volcker Rule,  which prohibits certain institutions from engaging in proprietary trading. The guidance addresses the treatment of residual market-making positions if a banking entity exits a market-making business and the applicability of restrictions on covered transactions with covered funds.  See, e.g., CFTC Guidance. See also SEC Volcker Rule FAQs (containing all Securities and Exchange Commission (“SEC”) staff guidance on the Volcker rule).

No-Action Letters

Investment Management Company May Not Exclude Climate Change Shareholder Proposal

On November 24th, the SEC’s Division of Corporation Finance issued its response to a no-action request filed by global investment management company Franklin Resources, Inc. in which it asked SEC staff not to recommend that the SEC pursue enforcement action against it for excluding from its 2016 Proxy Materials a shareholder proposal that would require the company to issue a report noting incongruities between its proxy voting practices and its policy positions on climate change. The Division declined to concur with Franklin’s position that the proposal could be excluded under several subsections of Securities Exchange Act Rule 14a-8, including the ordinary business exclusion under Rule 14a-8(i)(7), noting that the proposal focuses on a significant policy issue. According to a report in Reuters, the decision could encourage investors at other asset management firms to push similar measures to draw increased attention to climate issues.

Aguilar Dispenses Helpful Tips to New Commissioners

On November 30th, SEC Commissioner Luis A. Aguilar issued a statement on the brink of his departure from the SEC in which he offered advice to new SEC Commissioners on navigating the agency as well as “a set of principles, thoughts, and ideas” to help shorten a new Commissioner’s learning curve. Aguilar Statement.

Statements and Speeches

Email Privacy Act Would Hamper SEC Investigations, Ceresney Claims

On December 1st, SEC Division of Enforcement Director Andrew Ceresney testified before the U.S. House of Representatives Judiciary Committee regarding the proposed Email Privacy Act, which seeks to modernize elements of the Electronic Communications Privacy Act to provide stronger privacy protections. Ceresney argued that the provisions of the proposed legislation requiring government entities to obtain a criminal warrant to access email and other electronic communications from internet service providers (“ISPs”) would severely hamper the ability of civil law enforcement agencies to conduct investigations and enforcement proceedings. Cereseny urged legislators to consider revisions to the proposed legislation that would allow civil agencies to subpoena electronic communications from ISPs and allow investigation targets an avenue to challenge those subpoenas in judicial proceedings. Ceresney Testimony.

Other Developments

SEC, FINRA, and MSRB Will Host Compliance Outreach Program for Municipal Advisors

The SEC, the Financial Industry Regulatory Authority (“FINRA”), and the Municipal Securities Rulemaking Board (“MSRB”) announced that they will jointly host a compliance outreach program for municipal advisors on February 3, 2016, in Philadelphia. The program, which will include a live webcast accessible through the SEC’s website, will provide municipal advisors the opportunity to engage in discussions with the three regulators regarding recent exam findings, regulatory issues, and compliance practices. SEC Press Release.

Money Market Fund Statistics

On December 1st, the SEC’s Division of Investment Management published money market fund statistics based on data as of October 31, 2015. Money Market Fund Statistics Report.

Commodity Futures Trading Commission

No-Action Relief

Conditional No-Action Relief Granted to Wells Fargo Bank

On November 20th, the Commodity Futures Trading Commission’s (“CFTC”) Division of Swap Dealer and Intermediary Oversight, the Division of Clearing and Risk, and the Division of Market Oversight (the “Divisions”) granted no-action relief to Wells Fargo Bank, N.A., a registered swap dealer, with respect to certain transaction-level requirements for certain swaps with non-U.S. counterparts. CFTC Letter No. 15-64.

Other Developments

CFTC Unanimously Approves Proposed Rule on Automated Trading

On November 24th, the CFTC unanimously approved proposed rules that mark a comprehensive regulatory response to the evolution of automated trading on U.S. designated contract markets (“DCMs”). The proposed rules, collectively known as Regulation Automated Trading or Regulation AT, represent a series of risk controls, transparency measures, and other safeguards to enhance the U.S. regulatory regime for automated trading. The notice of proposal will be open for a 90-day public comment period. CFTC Press Release. See also Reuters Story.

Federal Rules Effective Dates

December 2015 - February 2016

Click here to view table.

Exchanges and Self-Regulatory Organizations

Chicago Board Options Exchange

CBOE Proposes Expansion of End of Week/End of Month Pilot Program

On November 30th, the SEC announced a proposed rule change filed by the Chicago Board Options Exchange (“CBOE”) that would expand the CBOE’s End of Week/End of Month Pilot Program to permit P.M. settled options on broad-based indexes eligible for options trading to expire on any Wednesday of the month other than Wednesdays that fall on the last trading day of the month. Comments should be submitted on or before December 24, 2015. SEC Release No. 34-76529.

Depository Trust Company

DTC Proposes Changes to Acknowledgment of End-of-Day Net-Net Settlement Balances Process by Settling Banks

On November 23rd, the SEC published for comment a proposed rule change by the Depository Trust Company (“DTC”) that would mitigate risk to the DTC in settlement by amending the DTC Settlement Service Guide to provide that any Settling Bank that does not affirmatively acknowledge its end-of-day net-net settlement balance by the defined cutoff time or notify DTC of its refusal to settle for any Participant for which it is the designated Settling Bank would be deemed to have acknowledged its end-of-day net-net settlement balance. Comments should be submitted on or before December 21, 2015. SEC Release. No. 34-76510.

Financial Industry Regulatory Authority

FINRA Approved to Publish OTC Equity Data Executed Outside Alternative Trading Systems

On November 25th, FINRA advised that the SEC has approved its proposed amendments to Rules 6110 and 6610, which will permit FINRA to publish the remaining equity volume executed over-the-counter (“OTC”) by member firms, including the trading activity of non-alternative trading system electronic systems and internalized trades. On April 18, 2016, FINRA will make available on its website all data as of April 4, 2016. FINRA Regulatory Notice 15-48.

FINRA Reminds Firms of Best Execution Obligations in Fixed Income Securities Transactions

On November 20th, FINRA published guidance to remind firms of their obligation to provide the best execution for their customers’ orders in equities, options and fixed income securities. The guidance also addresses recent issues in the fixed income market, including how the availability of electronic systems to facilitate trading and pre-trade transparency impact their best-execution obligations. FINRA Regulatory Notice 15-46.

International Securities Exchange

ISE Exchanges Would Require Market Makers to Obtain Approval Before Resuming Trading After Activation of Speed Bump

On November 23rd, the SEC provided notice of International Securities Exchange, LLC’s (“ISE”) and ISE Gemini, LLC’s separately proposed changes to their respective rules that would require Clearing Member approval for Primary Market Makers (“PMM”) and Competitive Market Makers (“CMM”) to resume trading and quoting after a market-wide speed bump is triggered. Comments should be submitted on or before December 21, 2015.

ISE Proposes Changes to Appointment of Back-Up Primary Market Makers

On November 23rd, the SEC requested comment on a proposed rule filed by ISE that would allow a CMM that has been appointed to act as an Alternative PMM to voluntarily act as a Back-Up PMM in options series in which it is quoting when the appointed PMM fails to have a quote in the system. Comments should be submitted on or before December 21, 2015. SEC Release No. 34-76508.

International Swaps and Derivatives Association

ISDA Signs Memorandum of Understanding with China Futures Association

On December 4th, the International Swaps and Derivatives Association (“ISDA”) announced that it has entered into a Memorandum of Understanding (“MOU”) with the China Futures Association (“CFA”).  The MOU creates a framework for the exchange of information, the exchange of staff and training, and the co-hosting of educational industry conferences to strengthen cooperation between the ISDA and CFA. ISDA Press Release.

ISDA OTC Derivatives Compliance Calendar Updated

On December 1st, the ISDA published an updated version of its OTC Derivatives Compliance Calendar.

ISDA and IIFM Release New Hedging Standard from Islamic Cross Currency Swaps

On November 26th, the ISDA and the International Islamic Financial Market (“IIFM”) published the ISDA/IIFM Islamic Cross Currency Swap, a new Islamic hedging product standard for use in Islamic hedging transactions. The standard will allow parties to raise funds through a Shari’ah-compliant contract in one currency against another Shari’ah-compliant contract in a different currency and represents a wider effort by the ISDA and IIFM to provide the Islamic finance industry with documentation and product templates to manage risk in transactions arising from currency and profit rate mismatches.  ISDA Press Release.

ISDA Reports Increased Use of Electronic Execution Venues and Central Counterparties in IRD and CDS Trades

On November 23rd, the ISDA published its SwapsInfo Quarterly Review for the third quarter of 2015, which analyzes publicly available data to gauge the impact of regulatory changes on interest rate derivatives (“IRD”) and credit default swap (“CDS”) index trading activity. The report indicates that the number of trades transacted on electronic execution venues and cleared through central counterparties increased during the quarter.  ISDA SwapsInfo Quarterly Review.

National Futures Association

NFA Offers Guidance on Completing Annual Affirmation Requirement for Exempt CPOs and CTAs

On December 1st, the National Futures Association (“NFA”) issued guidance for registered commodity pool operators (“CPOs”) and commodity trading advisors (“CFAs”) regarding the process for submitting the required annual affirmation for entities operating under an exemption or exclusion from CPO or CTA registration under CFTC regulations. The affirmation must be completed within 60 days of the calendar year end, which falls on February 29, 2016. NFA Notice I-15-26.


NYSE Details Changes to Disciplinary Rules and Process

November 23rd, the New York Stock Exchange LLC (“NYSE”) released a third Information Memo regarding the transition of certain surveillance, investigation and enforcement functions from FINRA to NYSE Regulation. The Information Memo outlines proposed changes to its existing disciplinary rules and the process for disciplinary proceedings after January 1, 2016. The proposed rule changes include allowing disciplinary actions to be investigated and prosecuted by NYSE Regulation; placing responsibility for authorizing complaints and settlements with NYSE Regulation’s Chief Regulatory Officer (“CRO”); explaining that the CRO and regulatory staff will function independently of the commercial interests of the exchange; and adding provisions to prevent conflicts of interest when an NYSE Regulation staff member resigns. NYSE Information Memo 15-8.

Municipal Securities Rulemaking Board

MSRB Offers Guidance on Best-Execution Rule

On November 20th, the MSRB released guidance to assist municipal securities dealers in implementing requirements under the MSRB’s new “best execution” rule, which will require dealers to seek the most favorable terms reasonably available for their retail customers’ transactions. The guidance explains the application of best-execution concepts, such as the standard of “reasonable diligence,” to municipal securities transactions, as well as the exemption for transactions with sophisticated municipal market professionals. MSRB Press Release.

Options Clearing Corporation

SEC Authorizes OCC to Incorporate Variations in Implied Volatility in Its Margin Methodology

On December 3rd, the SEC provided notice that it would not object to the advance notice filed by the Options Clearing Corporation proposing that the Options Clearing Corporation will modify its margin methodology by expanding the use of variations in implied volatility within its System for Theoretical Analysis and Numerical Simulations for substantially all option contracts available to be cleared by the Options Clearing Corporation that have a residual tenor of less than three years. SEC Release No. 34-76548.

Industry News

Report Finds That Corporations Use Big Civil Legal Settlements to Deduct Billions From Tax Bills

On December 3rd, The New York Times reported on the finding that corporations are using large civil legal settlements with federal regulators as a way to deduct billions of dollars from their American tax bills, mainly because the regulators do not prohibit the practice in the settlements’ terms. According to the U.S. PIRG report, while corporations paid a collective $80 billion to resolve federal charges of wrongdoing, approximately $48 billion of that amount was eligible as a deduction. Corporate Settlements.

New Rules on Reporting the Dismissals of Brokers Will Begin on December 12th

On December 1st, The New York Times reported that, in an effort by securities regulators to make background information about brokers more accessible to consumers, new rules will significantly shorten the window of time within which brokerage firms have to report the details of a broker’s departure from their firm. Beginning December 12th, brokerage firms will have to report the details of a broker’s termination in three business days, which is down from 15 business days. Dismissals.

SEC to Intensify Investigation Into Trading of Pre-IPO Shares

On December 1st, The Wall Street Journal reported on the SEC’s probe of the trading of pre-IPO shares. In a November 25th court filing, the SEC ordered an unregistered brokerage firm under investigation, NetCirq LLC, to comply with an SEC subpoena. According to the filing, the SEC is broadly investigating whether trading of pre-IPO shares could violate securities laws under Dodd-Frank because some of the transactions could be considered “swaps,” or agreements whose value is tied to a future event. SEC ProbeSEC Litigation Release.