Legal Update March 24, 2016 Federal Reserve Re-proposes Single-Counterparty Credit Limits for US and Non-US Banking Organizations On March 5, 2016, the Board of Governors of the US Federal Reserve System (Federal Reserve) re-proposed a rule, originally proposed in 2011, that would implement the single-counterparty credit limits (SCCL) contained in section 165(e) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) (SCCL Proposal).1 The SCCL Proposal would impose limits on the aggregate amount of credit exposure that a covered company may have to an unaffiliated counterparty.2 Depending on the size of the covered company and its counterparty, these limits will range from 25% of consolidated total capital to 15% of tier 1 capital, as calculated for regulatory capital purposes. The Federal Reserve initially proposed SCCL rules in 2011 (for large US bank holding companies (BHCs)) and 2012 (for large foreign banking organizations (FBOs)) as part of a broader package of enhanced prudential standards required by Section 165 of the DoddFrank Act.3 The Federal Reserve subsequently deferred action on the SCCL rules when it adopted its final enhanced prudential standards rule in 2014 in order to take into account the significant comments received on its earlier proposals, the global “large exposure” standard issued by the Basel Committee on Bank Supervision (BCBS) in April 2014 (the BCBS LE Standard), and the results of the Federal Reserve’s own quantitative impact studies.4 Commenters criticized the 2011 and 2012 SCCL proposals for being insufficiently sensitive to the risks associated with particular types of credit exposures, and therefore for being overbroad in their impact. The SCCL Proposal incorporates several important modifications to the earlier proposals that would reduce the impact of the SCCL on covered companies, and potentially opens the door to further liberalizations by requesting comment on several key issues, including whether the SCCL should even be applied to FBOs to FBOs already subject to the BCBS LE Standard. Nevertheless, the SCCL Proposal remains complex, and compliance will be burdensome and, for some institutions, may require potentially significant reductions in existing exposures. Definition of Covered Company. The SCCL Proposal would apply to (i) any BHC with at least $50 billion in total consolidated assets, (ii) any FBO with at least $50 billion in total consolidated assets on a global basis, or (iii) any IHC with total consolidated assets of at least $50 billion.5 Covered companies would be further divided into three tiers that would be subject to increasingly stringent versions of the SCCL: Covered companies with at least $50 billion but less than $250 billion in total consolidated assets and less than $10 billion in total onbalance sheet foreign exposures (Smaller Covered Companies); 2 Mayer Brown | Federal Reserve Re‐proposes Single‐Counterparty Credit Limits for US and Non‐US Banking Organizations Covered Companies with at least $250 billion in total consolidated assets or at least $10 billion in total on-balance sheet foreign exposures (Larger Covered Companies); and Covered companies that are either (i) a globally systemically important BHC (G-SIB) under Method 1 of the Federal Reserve’s G-SIB surcharge rule or (ii) an FBO or IHC with total consolidated assets of $500 billion or more (Major Covered Companies). While the definition of covered company would be based on an FBO’s global consolidated assets, the counterparty limits would apply only to credit exposures of the FBO’s combined US operations and would be measured against the FBO’s parent-level regulatory capital. Combined US operations would include any IHC (including its subsidiaries) owned by the FBO, as well as any US branches or agencies of the FBO. On the one hand, FBO groups would have the benefit that the exposure of their combined US operations would be measured against the group’s global capital rather than against localized capital in the United States. On the other hand, as is the case with other aspects of the enhanced prudential standards, the SCCL Proposal may be viewed as having a disproportionate impact on FBOs with large global operations but small US operations because they would be subject to the most restrictive tier of SCCL rules (e.g., an FBO with $515 billion in global assets whose US presence is limited to a single $15 billion US branch would be a Major Covered Company subject to the most restrictive limits of the SCCL).6 Additionally, larger FBOs with IHCs will be subject to a different type of disproportionate impact because they will face restrictions at both the IHC level and at the combined US operations level. Nonbank financial companies supervised by the Federal Reserve are not included in the definition of “covered company,” although the Federal Reserve intends to apply credit limits to them in the future. Credit Exposure Limits. The SCCL Proposal would limit the credit exposures of covered companies as follows: Smaller Covered Companies would be prohibited from having aggregate net credit exposure to an unaffiliated counterparty of more than 25% of the covered company’s “total capital stock and surplus” (defined below). Larger Covered Companies would be prohibited from having aggregate net credit exposure to an unaffiliated counterparty of more than 25% of the covered company’s tier 1 capital. The Federal Reserve believes that use of a tier 1 rather than total capital-based limit is appropriate in this context because the SCCL for larger companies should be based on a measure of capital available to absorb losses on a going-concern basis. Major Covered Companies would be prohibited from having an aggregate net credit exposure of more than 15% (an increase from 10% in the earlier proposals) of the Major Covered Company’s Tier 1 capital to a Major Counterparty (defined below), and 25% of the Major Covered Company’s tier 1 capital to any other counterparty. Under the SCCL Proposal, “capital stock and surplus” is the sum of a BHC’s or IHC’s (i) total (i.e., Tier 1 and Tier 2) regulatory capital (as calculated under the capital adequacy guidelines applicable to that company under Regulation Q or YY) and (ii) the balance of the BHC’s allowance for loan and lease losses (ALLL) that is not included in tier 2 capital under the applicable Regulation Q guidelines. For FBOs, 3 Mayer Brown | Federal Reserve Re‐proposes Single‐Counterparty Credit Limits for US and Non‐US Banking Organizations capital stock and surplus is defined as total regulatory capital of the FBO parent as reported on its most recent FR Y-7Q filing. Tier 1 capital is defined the same as in Regulation Q for BHCs and Regulation YY for IHCs and FBOs.7 Definition of Counterparty. The SCCL would apply to credit exposures between a covered company and an unaffiliated counterparty. Counterparty would be broadly defined to include any natural person, company, US state and municipal government or instrumentality, non-US sub-national government or instrumentality or non-US national government that is not assigned a 0% risk weight under the regulatory capital rules. Effectively, only the US federal government, non-US national governments subject to a 0% risk weight,8 and the non-US national government of an FBO’s home country would be exempt counterparties under the SCCL Proposal. The SCCL would generally apply to all credit exposures between a covered company and a counterparty. A special, more restrictive version of the SCCL would apply to Major Covered Company credit exposures to “Major Counterparties.” Major Counterparties would be defined as (i) BHCs designated by the Federal Reserve as global systemically important bankholding companies,9 (ii) FBOs that have the characteristics of G-SIBs under the BCBS’s methodology10 or that the Federal Reserve determines would be globally systemically important at an IHC or FBO level, and (iii) nonbank financial companies supervised by the Federal Reserve.11 Scope of Counterparties. Consistent with the 2011 and 2012 proposals, credit exposures to any counterparty would be aggregated with exposures to any person the counterparty (i) owns, controls, or holds with power to vote 25% or more of a class of voting securities; (ii) owns or controls 25% or more of the total equity; (iii) is under common control; or (iv) consolidates for financial reporting purposes. If an investment fund or vehicle meets these definitions, that fund or vehicle would need to be aggregated with the counterparty. “Economically interdependent” counterparties. Consistent with the BCBS LE Standard, if total exposures to a single counterparty exceeded 5% of the covered company’s eligible capital (i.e., total regulatory capital plus ALLL or tier 1 capital), then, under the SCCL Proposal, the covered company would be required to add to that single exposure all exposures to other counterparties that are “economically interdependent” with the first counterparty. Counterparties would be economically interdependent if the failure, default, insolvency, or material financial distress of one counterparty would cause the failure, default, insolvency, or material financial distress of the other counterparty, taking into account certain factors that are set forth in detail in the SCCL Proposal. To avoid evasion of this requirement, the Federal Reserve may also make a determination that one or more unaffiliated counterparties of a covered company is economically interdependent with the covered company. Counterparties connected by certain control relationships. A covered company would be required to aggregate exposures of an unaffiliated counterparty with all exposures to other counterparties that are connected to the first counterparty by the following control relationships: (i) the presence of voting agreements; (ii) the ability of one counterparty to significantly influence the appointment or dismissal of another counterparty’s administrative, management or governing body, or the fact that a majority of members of the governing body have been appointed solely as a result of the exercise of the first counterparty’s voting rights; and (iii) the ability of one counterparty to exercise a controlling influence over the management or policies of another counterparty. As with economically interdependent counterparties, 4 Mayer Brown | Federal Reserve Re‐proposes Single‐Counterparty Credit Limits for US and Non‐US Banking Organizations the Federal Reserve may determine that one or more unaffiliated counterparties of a covered company are connected by control relationships. Attribution requirement. Under a statutory attribution provision incorporated in the SCCL Proposal, covered companies would be required to treat a transaction with any person as a credit exposure to a counterparty, to the extent the proceeds of the transaction are used for the benefit of, or transferred to, that counterparty. Covered Credit Exposures. Credit exposures would include: (i) all extensions of credit to a counterparty, including loans, deposits, and lines of credit (excluding uncommitted lines of credit); (ii) all repurchase agreements, reverse repurchase agreements, and securities borrowing and lending transactions with a counterparty; (iii) all guarantees, acceptances, or letters of credit (including any “endorsement” or standby letters of credit) issued on behalf of a counterparty; (iv) all purchases of or investments in securities issued by the counterparty; (v) credit exposure to a counterparty in connection with a derivative transaction, as well as credit exposure to a reference entity, where the reference asset is an obligation or equity security of a reference entity; and (vi) any other similar transaction that the Federal Reserve determines to be a credit exposure for these purposes. Calculation of Aggregate Net Credit Exposure. Aggregate net credit exposure would be defined as the sum of all net credit exposures of a covered company to a single counterparty. To calculate aggregate net credit exposure, a covered company or entity would first calculate its gross credit exposure to the counterparty on each credit transaction in accordance with the SCCL Proposal’s requirements. The covered company or entity would then subtract from its gross credit exposure amount all eligible risk mitigants (e.g., qualifying master netting agreements, eligible collateral, eligible guarantees, eligible credit derivatives and eligible equity derivates, and other eligible hedges) with the counterparty. Finally, the covered company or entity would add all net credit exposures to the counterparty. Changes to Calculation Methodology. The SCCL Proposal is significantly more granular in its approach to calculating credit exposures in comparison to the 2011 and 2012 proposals. While this approach may increase the complexity of calculations covered companies must perform to comply with the rule, it should narrow the wide-ranging effect of the rule that was contemplated in the original 2011 and 2012 proposals by more closely aligning SCCL exposure to actual exposure. For example, for derivative transactions subject to a qualifying master netting agreement, the SCCL Proposal would allow (i) BHCs and IHCs to calculate gross credit exposure using any methodology that the covered company is permitted to use under the Federal Reserve’s risk-based capital rules and (ii) FBOs to calculate gross credit exposure using (a) any methodology the FBO is permitted to use for calculating the exposure at default amount or (b) a gross credit exposure methodology included in the Proposal. The result would be to give BHCs (and only BHCs) the choice to use the internal model method in Regulation Q, rather than the “current exposure method,” which was the only option provided in the 2011 and 2012 proposals and contains built-in assumptions that typically overstate actual derivatives exposure.12 Exposures to Funds and Securitizations. The SCCL Proposal would require Larger Covered Companies to analyze their credit exposure to the issuers of the underlying assets in a special purpose vehicle (SPV) in which it has invested or to which it otherwise has credit exposure. If the exposure is more than 0.25% of Tier 1 capital, the Larger Covered Company would have to apply a “look-through approach” and recognize an exposure to each issuer of the assets held by the SPV. 5 Mayer Brown | Federal Reserve Re‐proposes Single‐Counterparty Credit Limits for US and Non‐US Banking Organizations Exemptions. As noted above, exposures to the US federal government, non-US national governments subject to a 0% risk-weight, and the national government of an FBO’s home country would be exempt from the SCCL. The SCCL Proposal would exempt intraday credit exposures and trade exposures to qualifying central counterparties (QCCPs) that are related to a covered company’s clearing activity. The SCCL Proposal also would exempt credit exposures to Fannie Mae and Freddie Mac, but only while those entities remain in government conservatorship. Compliance. Larger Covered Companies would be expected to comply with the SCCL on a daily basis and would be required to submit monthly reports to the Federal Reserve that document this compliance. Smaller Covered Companies would need to demonstrate compliance on a quarterly basis and report quarterly to the Federal Reserve. Under a 90-day “safe harbor” provision, a covered company with credit exposure to a counterparty that exceeds the SCCL due to a decrease in the covered company’s capital or because of a merger by the covered company or the counterparty with a previously independent entity could restructure the credit exposure to reduce it below the SCCL without being deemed to have violated the rule.13 Key Differences from BCBS LE Standard. Although the SCCL Proposal tracks the BCBS LE standard in many respects, there are some key distinctions which, if retained, could have significant competitive consequences: The SCCL Proposal uses a covered company’s total capital stock and surplus for the denominator of the credit exposure limit of Smaller Covered Companies, while the BCBS LE Standard does not apply at all to noninternationally active banks (which would generally include Smaller Covered Companies).14 The SCCL Proposal applies the more restrictive 15% credit exposure limit to the US operations of FBOs and IHCs with total consolidated assets of $500 billion or more, while the BCBS LE Standard applies the 15% limit only to G-SIBs. The SCCL Proposal continues to require aggregation of counterparties using the 25% voting shares ownership test from the Bank Holding Company Act’s control test, while the BCBS LE Standard uses a 50% ownership threshold. The SCCL Proposal retains the current exposure method for calculating derivatives exposure, while the BCBS LE Standard uses the SA-CCR. The SCCL Proposal exempts exposures to non-US national governments subject to a 0% risk weight and the national government of an FBO’s home country, while the BCBS LE Standard exempts exposures to all national governments. The SCCL Proposal exempts trade exposure to QCCPs related to the covered company’s clearing activity, while the BCBS LE Standard defers the topic of QCCP exposures for further consideration. Timing. Comments on the SCCL Proposal are due by June 3, 2016. Covered companies would be required to comply within one (Larger Covered Companies and Major Covered Companies) or two (Smaller Covered Companies) years of the final rule’s effective date.15 Accordingly, it seems unlikely that any covered companies will need to comply with the SCCL before the end of 2017. 6 Mayer Brown | Federal Reserve Re‐proposes Single‐Counterparty Credit Limits for US and Non‐US Banking Organizations For more information about the topics raised in this legal update, please contact any of the following lawyers. David Sahr +44 20 3130 3496 email@example.com Tom Delaney +1 202 263 3216 firstname.lastname@example.org Jeffrey Taft +1 202 263 3293 email@example.com Scott Anenberg +1 202 263 3303 sanenberg @mayerbrown.com Alicia Kinsey +1 202 263 3356 firstname.lastname@example.org Matthew Bisanz +1 202 263 3434 email@example.com 1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, §165(e), 124 Stat. 1376, 1427-29 (codified at 12 USC.§ 5365(e)). Section 165(e) requires the Federal Reserve to adopt rules that limit the aggregate credit exposure that large banking organizations may have to individual counterparties. It is intended to address the concern that the failure of a large BHC or FBO could pose a systemic risk to the US financial system if individual counterparties had very large credit exposures to the BHC/FBO and its affiliates. 2 Single-Counterparty Credit Limits for Large Banking Organizations, 81 Fed. Reg. 14,328 (proposed March 4, 2016), available at https://www.gpo.gov/fdsys/pkg/FR- 2016-03-16/pdf/2016-05386.pdf. 3 Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 594 (proposed December 22, 2011); Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies, 77 Fed. Reg. 76,628 (proposed December 17, 2012). 4 Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking Organizations, 79 Fed. Reg. 17,240 (March 27, 2014). See Mayer Brown’s Federal Reserve Issues Final Regulation Implementing DoddFrank Section 165 Enhanced Prudential Standards for Large US and Non-US Banking Organizations. The SCCL Proposal also takes into account the Office of the Comptroller of the Currency’s June 2013 revisions to the national bank lending limits rules. See Lending Limits, 78 Fed. Reg. 37,930 (June 25, 2013); BCBS, Supervisory framework for measuring and controlling large exposures (April 15, 2014). 5 Federal Home Loan Banks would be expressly exempted from the definition of a covered company. 6 Notably, BHCs will not be Major Covered Companies unless they are deemed a G-SIB under the Federal Reserve’s G-SIB surcharge rules, which is a considerably more nuanced test than the pure $500 billion asset size threshold that would be applied to FBOs and IHCs. 7 12 C.F.R. § 217.2. 8 Foreign sovereigns with a 0% risk-weight are those that are (i) rated 0 or 1 under the Organization for Economic Cooperation and Development’s (OECD) Country Risk Classification (CRC) or (ii) unrated in the CRC, but are OECD members. See OECD, Country Risk Classification (October 30, 2015), available at http://www.oecd.org/tad/xcred/crc.htm. 9 See Implementation of Risk-Based Capital Surcharges for Global Systemically Important Bank Holding Companies, 80 Fed. Reg. 49,082 (August 14, 2015). 10 BCBS, Global systemically important banks: updated assessment methodology and the higher loss absorbency requirement (July 3, 2013). 11 See FSOC, Designations (July 27, 2015), available at https://www.treasury.gov/initiatives/fsoc/designations/P ages/default.aspx. 12 The Federal Reserve expects to consider the benefits of incorporating the BCBS Standardised Approach for Counterparty Credit Risk (SA-CCR) for measuring credit exposure to a derivatives counterparty into the SCCL rule when it considers revising Regulation Q to reflect the SACCR more broadly. 13 During this 90-day period, a BHC, IHC, or combined US operations of an FBO would not be permitted to engage in additional credit transactions with that counterparty without permission from the Federal Reserve. The Federal Reserve would not grant permission unless it determined that the credit transactions were necessary or appropriate to preserve the safety and soundness of the covered company or US financial stability. 7 Mayer Brown | Federal Reserve Re‐proposes Single‐Counterparty Credit Limits for US and Non‐US Banking Organizations 14 LE Standard expressly permits national regulators to apply stricter variations of the standard or to apply the standard to a broader set of banks. 15 The proposal also contains a phase-in period for a company that becomes a covered company after the effective date of the final rule. The newly covered company would not be required to comply with the SCCL until the first day of the fifth calendar quarter after it becomes a covered company. 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