SUMMARY The Federal Reserve recently released a final policy statement describing the framework it will follow in setting the amount of the countercyclical capital buffer (“CCyB”) under its capital rules1 for private-sector credit exposures located in the United States (the “final policy statement”).2 The CCyB is a macroprudential policy tool that is intended to address risks to the broader financial system and to be used to increase the resilience of large banking organizations when the Federal Reserve sees an elevated risk of above-normal losses. The CCyB supplements minimum capital requirements and other capital buffers and functions as an expansion of the capital conservation buffer. The CCyB applies to banking organizations that are subject to the advanced approaches capital rules (generally those with more than $250 billion in assets or $10 billion in on-balance-sheet foreign exposures), and to any depository institution subsidiary of such banking organizations. In relation to the version initially proposed in December 2015 (the “proposed policy statement”), the final policy statement incorporates a number of important changes and the accompanying release clarifies a number of points in response to industry comments.3 Notable changes and clarifications include: Future increases of the CCyB are expected to be subject to notice and comment rulemaking procedures. Any future action by the Federal Reserve to set the level of the CCyB above zero is expected to be taken through a public notice and comment rulemaking, or through an order issued in accordance with the Administrative Procedure Act that provides each affected institution with actual notice and an opportunity to comment, in each case with a comment period that is generally expected to be at least 30 days. Future increases of the CCyB will be triggered when systemic vulnerabilities are “meaningfully above normal.” The Federal Reserve expects to activate the CCyB when systemic vulnerabilities are “meaningfully above normal,” as opposed to when systemic vulnerabilities are “somewhat above normal,” which was the trigger in the proposed policy -2- Bank Capital Requirements September 14, 2016 statement. The Federal Reserve also explained that systemic vulnerabilities would be considered “meaningfully above normal” if such vulnerabilities were “above normal and were either already at, or expected to build to, levels sufficient to generate material unexpected losses in the event of an unfavorable development in financial markets or the economy.”4 The Federal Reserve expects any future increases of the CCyB to be gradual. The final policy statement also provides that activating the CCyB at a time when systemic vulnerabilities are “meaningfully above normal” would most likely allow the Federal Reserve to “progressively raise the CCyB level if vulnerabilities become more severe.”5 Rather than initially setting the CCyB near the upper end of its potential range, the Federal Reserve would instead introduce incremental increases to “provide additional flexibility” for banking organizations to adjust to increases6 and to allow them “to augment their capital primarily through retained earnings.”7 However, if vulnerabilities in the financial system are “building rapidly,” adjustments to the CCyB may be larger or more frequent.8 Any proposal to increase the CCyB will seek comment on the quantitative and qualitative indicators informing the proposed increase. The Federal Reserve confirmed that any future proposal to increase the CCyB will include a discussion of the quantitative and qualitative indicators that may inform the Federal Reserve’s assessment of economic conditions and its determinations with respect to the CCyB. The Federal Reserve will also seek comment on the interpretation of those indicators. The CCyB will be removed or reduced when the conditions that led to its activation abate or lessen. The Federal Reserve clarified in the final policy statement that it expects to remove or reduce the CCyB when the conditions that led to its activation abate or lessen and when the release of CCyB capital would promote financial stability, noting that “for the CCyB to be most effective, [it] should be deactivated or reduced in a timely manner.”9 In any determination to increase the CCyB, the Federal Reserve will consider the appropriateness of the CCyB as a policy tool and the effects of its application. The Federal Reserve will consider whether the CCyB (i) is the most appropriate of the available policy instruments to address identified financial system vulnerabilities, (ii) could be expected to increase other systemic vulnerabilities, or (iii) would be most effective if used in conjunction with other policy tools. The Federal Reserve expects to make decisions about the appropriate level of the CCyB jointly with the OCC and the FDIC, and expects that the CCyB amount will be the same for covered depository institution holding companies and insured depository institutions. The Federal Reserve also indicated that it would address separately adjustments to the CCyB relating to foreign private-sector credit exposures and that it may consider reporting requirements relating to foreign credit exposures at a later date. BACKGROUND The CCyB was established for large, internationally active banking organizations in July 2013 under the Federal Reserve’s revised regulatory capital rules set forth in Regulation Q10 as a macroprudential policy tool that the Federal Reserve can use to augment capital requirements “during periods of rising vulnerabilities in the financial system” and reduce when such vulnerabilities abate “or when the release of the CCyB would promote financial stability.”11 The CCyB is a Basel III-based concept that functions as an expansion of the capital conservation buffer, which requires banking organizations to hold a buffer of common equity tier 1 capital in addition to the minimum risk-based capital ratios to avoid limits on capital distributions and certain discretionary bonus payments.12 Like the capital conservation buffer, each -3- Bank Capital Requirements September 14, 2016 quartile of the CCyB is associated with increasingly stringent limitations on capital distributions and certain discretionary bonus payments.13 In Regulation Q, the Federal Reserve established the calculation methodology for the CCyB, set the initial amount of the CCyB at zero and set forth the CCyB’s additional terms, including: Effective Dates: A determination to increase the CCyB generally will be effective 12 months from the date of announcement, unless the Federal Reserve determines that economic conditions warrant an earlier or later effective date. However, a determination to decrease the amount of the CCyB will become effective the day after the Federal Reserve’s decision to decrease the CCyB or the earliest permissible date under applicable law or regulation, whichever is later.14 12-Month Sunset: The amount of the CCyB for U.S.-based credit exposures will return to zero percent 12 months after the effective date of the last CCyB adjustment, unless the Federal Reserve announces a decision to maintain the then-current amount or adjust it again before the expiration of the 12-month period.15 Weighting: The applicable CCyB amount for a subject banking organization is equal to the weighted average of the CCyB amounts established by the Federal Reserve for each of the national jurisdictions where the banking organization has private-sector credit exposures. The weighting by jurisdiction is calculated by dividing the total risk-weighted assets for the organization’s private-sector credit exposures located in a jurisdiction by the total risk-weighted assets for all of the organization’s private-sector credit exposures.16 The Federal Reserve will adjust the CCyB amount for private-sector credit exposures to reflect decisions made by foreign jurisdictions consistent with the due process requirements outlined in Regulation Q.17 Adjustment Determination Factors: The Federal Reserve will base any decision to adjust the CCyB amount on a range of macroeconomic, financial, and supervisory information indicating an increase in systemic risk including, but not limited to: (i) the ratio of credit to gross domestic product, (ii) a variety of asset prices, (iii) other factors indicative of relative credit and liquidity expansion or contraction, (iv) funding spreads, (v) credit condition surveys, (vi) indices based on credit default swap spreads, (vii) options implied volatility, and (vii) measures of systemic risk.18 Transitional Cap: A cap equal to 2.5 percent of risk-weighted assets is being phased in such that the maximum potential amount of the CCyB for U.S.-based credit exposures will be: 0.625 percent in 2016; 1.25 percent in 2017; 1.875 percent in 2018; and 2.5 percent in 2019 and thereafter.19 KEY ELEMENTS OF THE FRAMEWORK The final policy statement describes the framework the Federal Reserve will use—including the factors it will consider and the indicators it will monitor—in setting the amount of the CCyB for U.S. private-sector credit exposures at a level above zero. The final policy statement also provides information on the background, scope and objectives of the CCyB, as well as information on how the Federal Reserve plans to communicate proposed changes in the CCyB to the public and monitor the effects of the CCyB in the United States. In addition to monitoring the financial and macroeconomic quantitative indicators set forth in its Regulation Q, the Federal Reserve states in the final policy statement that it intends to use “empirical models that translate a manageable set of quantitative indicators of financial and economic performance -4- Bank Capital Requirements September 14, 2016 into potential settings for the CCyB” as part of a “comprehensive judgmental assessment of all available information” in connection with its deliberations.20 Such models may include those that: Rely on small sets of indicators, such as the nonfinancial credit-to-GDP ratio, its growth rate, and combinations of the credit-to-GDP ratio with trends in the prices of residential and commercial real estate; and Consider larger sets of indicators, “which have the advantage of representing conditions in all key sectors of the economy, especially those specific to risk-taking, performance, and the financial condition of large banks.”21 The final policy statement further notes that the types of indicators and models considered in assessments of the appropriate level of the CCyB are likely to “change over time based on advances in research and the experience of the [Federal Reserve] with this new macroprudential tool.”22 Because the CCyB is intended to address cyclical, rather than structural, vulnerabilities, the final policy statement identifies “two central factors” for the Federal Reserve to consider in determining whether the CCyB is the most appropriate of available policy instruments: Whether advanced approaches institutions are exposed—either directly or indirectly—to the vulnerabilities identified in the comprehensive judgmental assessment or by the quantitative indicators that suggest activation of the CCyB; and Whether advanced approaches institutions are contributing—either directly or indirectly—to these highlighted vulnerabilities.23 The Federal Reserve plans to consult with the OCC and the FDIC on their separate analyses and on the extent to which advanced approaches banking organizations supervised by the Federal Reserve are “either exposed to or contributing to” identified financial system vulnerabilities before setting the CCyB for the institutions it supervises.24 The final policy statement describes the framework for determining the CCyB for U.S. private-sector credit exposures; the Federal Reserve intends to address separately CCyB adjustments made by foreign jurisdictions, as needed. OBSERVATIONS AND IMPLICATIONS The final policy statement retains “systemic vulnerabilities” as the reference point for setting the CCyB, and the release discusses when such vulnerabilities would be considered “meaningfully above normal,” the revised trigger for application of the CCyB. The final policy statement and the release do not, however, detail what constitutes “normal” levels of systemic vulnerabilities, further expound upon the broad, subjective standard used to describe when such vulnerabilities would be considered “meaningfully above normal” or explain with specificity the empirical bases that will inform the necessarily subjective judgment about the level of systemic vulnerabilities—which is based on the assumption that Federal banking regulators will be able to identify systemic vulnerabilities and determine their relative severity ex ante. -5- Bank Capital Requirements September 14, 2016 In addition, although the final policy statement reiterates that the objective of the CCyB is to “provide additional resilience for advanced approaches institutions, and by extension the broader financial system,” neither the final policy statement nor the release explain how imposing more stringent capital requirements on a subset of large banking organizations would improve the overall resilience of the broader U.S. financial system, particularly given the significant credit intermediation provided by other banking organizations, financial services companies and non-bank entities in the United States.