Federal Reserve adopts final rule implementing enhanced prudential standards for certain domestic bank holding companies and foreign banking organizations

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ADVI SORY February 2014
Dodd-Frank
What You
Need To Know
Federal Reserve Adopts Final Rule Implementing Enhanced
Prudential Standards for Certain Domestic Bank Holding
Companies and Foreign Banking Organizations
On February 18, 2014, the Board of Governors of the Federal Reserve System (the
Board) approved its final rule implementing enhanced prudential standards for certain
domestic bank holding companies and foreign banking organizations (the Final Rule).
While the Final Rule does not implement every provision of the December 2011 and
December 2012 proposed rules,1 the Final Rule still requires enhanced standards of
liquidity, risk management, and capital for covered institutions. Compliance with certain
of the provisions of the Final Rule begins January 1, 2015.
I. Scope of the Final Rule
Generally, sections 165 and 166 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the Dodd-Frank Act)2 require the Board to establish enhanced prudential
standards for bank holding companies and foreign banking organizations with a
banking presence in the United States with consolidated assets of US$50 billion or
more, and nonbank financial companies the Financial Stability Oversight Council (the
FSOC) designates as systemically important financial institutions (SIFIs) and subject to
supervision by the Board.3 Although the Final Rule applies to bank holding companies
and foreign banking organizations, it does not set out specific regulations for SIFIs
subject to the Board’s supervision. Rather, the Final Rule states that the Board will
assess the business model, capital structure, and risk profile of SIFIs on a case-bycase
basis to determine how to apply the enhanced prudential standards and whether
a tailored approach would be more appropriate. The fewer the differences between a
SIFI and a bank holding company, the more likely the enhanced prudential standards
will apply as written.
1 Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed.
Reg. 594 (proposed Jan. 5, 2012) (to be codified at 12 C.F.R. § 252); Enhanced Prudential Standards
and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial
Companies, 77 Fed. Reg. 76628 (proposed Dec. 28, 2012) (to be codified at 12 C.F.R. § 252).
2 Pub. L. No. 111-203, 124 Stat. 1376 (2010).
3 See 12 U.S.C. § 5365.
Federal Reserve Adopts Final Rule Implementing Enhanced Prudential Standards for | 2
Certain Domestic Bank Holding Companies and Foreign Banking Organizations
II. Provisions of the Final Rule
A. Enhanced Prudential Standards for
Certain Bank
Holding Companies
1. Capital Planning and Stress-testing
Requirements
The Final Rule incorporates the capital planning and
stress-testing requirements adopted previously by the
Board. These requirements require a bank holding
company with consolidated assets of US$50 billion
or more (covered bank holding companies) to submit
annually a plan to the Board demonstrating the company’s
ability to maintain capital above minimum risk-based
capital ratios during stressed conditions, and to test the
plan during supervisory and company-run stress tests.4
The minimum risk-based capital ratios are those set forth
in the revised capital framework: a minimum common
equity tier 1 capital ratio of 4.5%; a minimum tier 1 ratio
of 6%; and a leverage ratio of 4%.5
2. Risk Management and Risk Committee
Requirements
Publicly traded bank holding companies with consolidated
assets of US$10 billion or more must establish risk
committees that will oversee, approve, and periodically
review risk management policies and frameworks. For
covered bank holding companies, the risk committee must
be a separate committee of its board of directors, and
report at least quarterly directly to its board of directors. The
risk management policies and framework must establish
procedures for risk-management governance, practices,
control mechanisms, and monitoring infrastructure in a
manner that reflects a company’s structure, risk profile,
complexity, activities, and size.
The risk committee must be chaired by an independent
director who (i) is not currently, or within the previous
4 12 C.F.R. §§ 225.8, 252.
5 See Regulatory Capital Rules: Regulatory Capital, Implementation of
Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective
Action, Standardized Approach for Risk-weighted Assets, Market
Discipline and Disclosure Requirements, Advanced Approaches
Risk-Based Capital Rule, and Market Risk Capital Rule, 78 Fed. Reg.
62018 (Oct. 11, 2013) (codified at 12 C.F.R. § 217).
three years, an officer or employee of the bank holding
company; “(ii) is not a member of the immediate family
… of a person who is, or has been within the last
three years, an executive officer of the bank holding
company … ; and (iii)(A) is an independent director under
[17 C.F.R. § 229.407(a)], if the bank holding company has
an outstanding class of securities traded on an exchange
registered with the [SEC] as a national securities
exchange under [15 U.S.C. § 78f]; or (B) would qualify
as an independent director under the listing standards
of a national securities exchange … if the bank holding
company does not have an outstanding class of securities
traded on a national securities exchange.”6
Additionally, the risk committee must have at least one
member with risk-management expertise in a financial
firm commensurate with the characteristics of the
company, and at least one member with experience in
identifying, assessing, and managing risk exposures of
large, complex firms. For bank holding companies with
assets equal to or greater than US$10 billion and less
than US$50 billion, experience in a nonfinancial field
is sufficient to meet the requirement. Covered bank
holding companies must also appoint a chief risk officer
to implement risk management policies and practices.
The chief risk officer will report both to the chief executive
officer and the risk committee.
On January 10, 2014, the Office of the Comptroller of
the Currency (OCC) published proposed guidelines that
would formalize heightened supervisory expectations for
national banks, federal savings associations,7 and federal
branches of foreign banks each with total consolidated
assets of US$50 billion or more.8 The heightened
6 12 C.F.R. § 252.22(d)(2).
7 The Final Rule applies the previously adopted company-run stress
test requirements to domestic and foreign savings and loan holding
companies (SLHCs) with consolidated assets of US$10 billion or
more. Other than the company-run stress test, the Final Rule does
not apply enhanced prudential standards to SLHCs. The Board,
however, stated that it may apply enhanced prudential standards to
SLHCs in the future if it determines that doing so is consistent with
the safety and soundness of such companies.
8 OCC Guidelines Establishing Heightened Standards for Certain Large
Insured National Banks, Insured Federal Savings Associations, and
Insured Federal Branches, 79 Fed. Reg. 4282 (Jan. 27, 2014).
Federal Reserve Adopts Final Rule Implementing Enhanced Prudential Standards for | 3
Certain Domestic Bank Holding Companies and Foreign Banking Organizations
expectations include detailed requirements for covered
institutions to establish a risk governance framework
that applies to all facets of the institution from support
services to the board of directors. The OCC’s proposed
guidelines go beyond the requirements of the Final Rule
and include additional requirements such as establishing
an independent risk management department, a strategic
risk plan, and an internal audit plan. Also, the OCC
proposed guidelines permit a covered institution to use its
parent company’s risk framework if the parent company’s
framework meets the OCC’s proposed guidelines, and
the covered institution can show that its risk profile is
substantially similar to the risk profile of its parent holding
company.9
3. Liquidity Requirements
Under the Final Rule, the board of directors of covered
bank holding companies must implement liquidity risk
management processes; review and approve liquidity
risk management strategies, policies, and procedures;
and set risk tolerances annually. The board of directors is
also responsible for reviewing and approving contingency
liquidity funding plans, a task formerly assigned to the risk
committee under the proposed rules. The contingency
plan consists of policies and procedures for managing a
liquidity crisis, such as alternate sources of funding, and
must be tested during liquidity stress tests.
The Final Rule does not set a particular limit for liquidity
risk, although it specifies that companies must consider
their size, complexity, capital structure, risk profile, and
activities when setting their liquidity risk limit.10 Covered
9 For additional discussion on the OCC’s proposed guidelines, see
Arnold & Porter, Advisory: OCC Proposes Heightened Supervisory
Standards for Large Insured National Banks, Insured Federal
Savings Associations and Insured Federal Branches (Feb. 6, 2014)
available at http://www.arnoldporter.com/publications.cfm?action=
advisory&u=OCCProposesHeightenedSupervisoryStandards
forLargeInsuredNationalBanksInsuredFederalSavingsAssociations
andInsuredFederalBranches&id=1112.
10 The Board has, however, issued a proposed rule that implements
a liquidity requirement affecting bank holding companies with
assets of US$50 billion or more that is consistent with the liquidity
coverage ratio standard established by the Basel Committee. See
Liquidity Coverage Ratio: Liquidity Risk Measurement, Standards,
bank holding companies must establish an independent
review process to evaluate at least annually the adequacy
and effectiveness of its liquidity risk management program.
Senior management is responsible for reviewing and
approving new products and business lines and their
effect on liquidity risk. After implementation, senior
management must annually review the liquidity risk of new
products and business lines that may have a significant
effect on the company’s liquidity risk profile.
The Final Rule requires covered bank holding companies
to maintain highly liquid assets as a buffer to protect
against a liquidity crisis. The buffer must be sizable
enough to meet the company’s cash outflows for 30
days under a range of liquidity stress scenarios. Covered
bank holding companies must conduct monthly liquidity
stress tests on their cash-flow projections11 under
three scenarios tailored to the companies’ specific
vulnerabilities over several time horizons. Companies
must use the results of the tests to set and adjust their
liquidity buffer.
4. Debt-to-Equity Limitation
If the FSOC determines that a bank holding company is a
“grave threat” to the financial stability of the Unites States,
the Final Rule requires that the bank holding company
maintain a debt-to-equity ratio of 15-to-1. Under the Final
Rule, “debt” and “equity” have the same meaning as “total
liabilities” and “total equity capital” in a company’s reports
of financial condition.
B. Enhanced Prudential Standards for
Foreign Banking Organizations
1. Intermediate Holding Company Requirement
Under the Final Rule, foreign banking organizations with
total assets of US$50 billion or more and U.S. non-branch
assets of US$50 billion or more (covered foreign banking
organizations) must form or designate a U.S. intermediate
and Monitoring, 78 Fed. Reg. 71818 (proposed Nov. 29, 2013).
11 The Final Rule also requires bank holding companies to develop
comprehensive cash-flow projections.
Federal Reserve Adopts Final Rule Implementing Enhanced Prudential Standards for | 4
Certain Domestic Bank Holding Companies and Foreign Banking Organizations
holding company, and transfer all ownership interests in
any U.S. subsidiary to the intermediate holding company.
The Final Rule defines “subsidiary” as any company
directly or indirectly controlled by another company,12
and “control” is defined under the Bank Holding Company
Act.13 Upon petition, the Board will authorize covered
foreign banking organizations at its discretion to use
alternate structures or multiple intermediate holding
companies.
Covered foreign banking organizations may still hold
subsidiaries under section 2(h)(2) of the Bank Holding
Company Act and DPC branch subsidiaries outside the
intermediate holding company. Additionally, the Final Rule
does not require covered foreign banking organizations
to transfer assets held through a U.S. branch or agency
to the intermediate holding company. Foreign banking
organizations that meet or exceed the US$50 billion
non-branch asset threshold as of July 1, 2015 have
until the following year, July 1, 2016, to reorganize its
subsidiaries under an intermediate holding company.
Those organizations that meet or exceed the threshold
after July 1, 2015 must come into compliance by the first
day of the ninth quarter after reaching the asset threshold.
Intermediate holding companies will be subject to the
same risk-based and leverage capital requirements as
bank holding companies, as well as the capital planning
rule. They will not, however, be subject to the advanced
approaches risk-based capital rules. The Final Rule
mandates compliance with the capital requirements by
January 1, 2018. Similar to the enhanced prudential
standards described above for bank holding companies,
intermediate holding companies must form a risk
committee for risk management, appoint a U.S.-based
chief risk officer, implement a liquidity risk management
framework, conduct liquidity stress tests, and maintain
a thirty-day liquidity buffer to cover cash-flows under
stressed conditions. U.S. branches and agencies,
however, need only hold a liquidity buffer sufficient to
12 12 C.F.R. § 252.2(s).
13 12 U.S.C. § 1841(a)(2).
cover the first fourteen days of a thirty-day liquidity
stress horizon. Intermediate holding companies must
also conduct stress tests in accordance with existing
regulations, but compliance is not mandated until October
1, 2017.14 Lastly, the Final Rule subjects intermediate
holding companies to a debt-to-equity ratio of 15-to-1.
III. Significant Changes from the
Proposed Rules
The Final Rule made several significant changes to the
2012 proposed rules. Included among those significant
changes are the following:
„„ Nonbank financial companies are not automatically
subject to the enhanced prudential standards of the
Final Rule. However, upon the FSOC’s designation
as a SIFI to be supervised by the Board, the Board
will assess the business model, capital structure,
and risk profile of SIFIs on a case-by-case basis
to determine how to apply the enhanced prudential
standards and whether a tailored approach would be
more appropriate.
„„ The Final Rule delays implementing the proposed
single counterparty credit limits and early remediation
requirements.
„„ Under the Final Rule, the U.S. asset threshold for
forming an intermediate holding company is US$50
billion instead of US$10 billion as originally proposed.
„„ The deadline for forming intermediate holding
companies was extended by one year to July 1, 2016.
„„ Intermediate holding companies are not subject to the
leverage capital requirements until January 1, 2018.
„„ The foreign parents of U.S. branches and agencies
are no longer required to hold remaining portions of
the liquidity buffer.
Conclusion
The Final Rule implements a number of complex
requirements that apply to both domestic and foreign
banking institutions, and seems to focus predominantly
14 See 12 C.F.R. § 252, Subparts F through H.
© 2014 Arnold & Porter LLP. This Advisory is intended to be a
general summary of the law and does not constitute legal advice.
You should consult with counsel to determine applicable legal
requirements in a specific fact situation.
Federal Reserve Adopts Final Rule Implementing Enhanced Prudential Standards for | 5
Certain Domestic Bank Holding Companies and Foreign Banking Organizations
on implementing controls to detect and manage liquidity
and other potentially systemic risks. Covered bank holding
companies and covered foreign banking organizations
must carefully determine what and when requirements
apply to them, and anticipate how these structural and
capital changes will impact lending and other activities.
If you have any questions about any of the topics discussed in
this advisory, please contact your Arnold & Porter attorney or
any of the following attorneys:
David F. Freeman, Jr.
+1 202.942.5745
[email protected]
Richard M. Alexander
+1 202.942.5728
[email protected]
Kevin F. Barnard
+1 212.715.1020
[email protected]
A. Patrick Doyle
+1 202.942.5949
[email protected]
Howard L. Hyde
+1 202.942.5353
[email protected]
Brian P. Larkin
+1 202.942.5990
[email protected]
Kevin Hall
+1 202.942.5627
[email protected]