Editor’s Note:On Friday, November 2, the Fed Board finalized a new rating system for large financial institutions. A special edition of BRNT that reports on the new rating system will be published soon.

This regular publication from DLA Piper focuses on helping banking and financial services clients navigate the ever-changing federal regulatory landscape.

  • Fed proposes risk-based changes to supervision of large banks. The Fed Board and other banking regulators on October 31 published and invited public comment on two proposals intended to create a framework that more closely links the regulations for large banking organizations to their risk profiles, reducing compliance requirements for firms with less risk while maintaining more stringent requirements for those with more risk. The proposed framework would set up a tiered structure of tailored requirements based on four main categories for bank holding companies with more than $100 billion in total consolidated assets. Besides asset size, the sorting of firms into categories would also be based on such factors as cross-jurisdictional activity, reliance on short-term wholesale funding, nonbank assets, and off-balance sheet exposure. The first of the two proposals, issued by the Fed Board alone, would tailor the application of prudential standards to US BHCs and apply enhanced standards to certain large savings and loan holding companies. The second draft notice, issued jointly by the Fed with the FDIC and OCC, would modify the application of the agencies' capital and liquidity rules. In addition to the texts of the proposal, the Fed produced a chart that spells out proposed requirements for firms in the various categories, including one for US G-SIBs and four other categories based on amount of assets, and lists the names of the specific firms that fall within each of the categories. US operations of foreign banking organizations are not covered by the proposed framework, but will be addressed in a separate future proposal. The proposals are being issued pursuant to the Dodd-Frank overhaul – officially known as the Economic Growth, Regulatory Reform, and Consumer Protection Act – enacted earlier this year. While it raised the minimum threshold for enhanced prudential standards application from $50 billion to $250 billion, the law gave the Fed discretion over how to apply the standards to banks between $100 billion and $250 billion.

The new categories: Firms in the lowest risk category, with $100 billion to $250 billion in assets, would no longer be subject to standardized liquidity requirements, and no longer required to conduct company-run stress test, and their supervisory stress tests would be moved from an annual to a two-year cycle. Those in the next lowest risk category, non-GSIBs with $250 billion or more in assets, would have their standardized liquidity requirements reduced but remain subject to a range of enhanced liquidity standards. Their required company-run stress tests would move to a two-year cycle, rather than semi-annually, but they would remain subject to annual supervisory stress tests. Firms in the highest risk categories, including the G-SIBs, would not see any changes to their capital or liquidity requirements.

The vote at the Fed Board's October 31 open meeting was 3-1 in favor of issuing the new proposals, with Chairman Jerome Powell, Vice Chairman Richard Clarida and Vice Chairman for Supervision Randal Quarles voting in favor, and Lael Brainard, the only remaining appointee of President Barack Obama on the Board, voting against.

Quarles said the cumulative effect of the proposed changes would result in a decrease of $8 billion of required capital, or a change of 0.6 percent, out of some $1.3 trillion in capital held by large bank holding companies. "Fundamentally, these proposals embody an important principle: the character of regulation should match the character of a firm," Quarles said in his opening statement at the meeting.

But Brainard, in her statement, said the proposals went beyond the statutory mandate of the Dodd-Frank overhaul "by relaxing regulatory requirements for domestic banking institutions that have assets in the $250 to $700 billion range and weakens the buffers that are core to the resilience of our system. This raises the risk that American taxpayers again will be on the hook."

Retiring House Financial Services Committee Chairman Jeb Hensarling (R-TX) said the package of proposals "provides much needed clarity as banks continue to struggle with overlapping and duplicative regulatory requirements. I wish the proposal went further, but it represents a much-need tailored approach to regulatory supervision."

Comments on the proposals will be accepted through January 22, 2019.

  • Fed's Quarles to face Congressional questioning. Quarles will have an opportunity to fully brief members of Congress on the new supervisory framework and other items on the Fed's regulatory agenda when he appears before the House Financial Services Committee on November 14 and the Senate Banking Committee on November 15. Quarles will be providing his required semi-annual testimony to the committees on the Fed's regulatory agenda. The upcoming semi-annual testimony will be the first that Quarles provides on Capitol Hill since the passage in May of the Dodd-Frank overhaul law (though he recently testified before the Banking Committee on a range of issues as part of a panel of regulators on the implementation of the new law). In addition to adopting the regulatory framework for banks with between $100 billion and $250 billion in assets, another action mandated by the banking deregulation law is for regulators to establish a leverage ratio requirement of between 8 and 10 percent specifically for community banks. Quarles has indicated that a multi-agency proposal on the leverage ratio is expected in the near term.
  • State bank regulators sue OCC to block fintech charters. The Conference of State Bank Supervisors has filed suit against the OCC seeking to prevent the agency from granting Special Purpose National Bank charters to entities that operate as nonbanks, arguing that such charters exceed the authority granted by Congress. In filing the October 25 complaint in the US District Court for the District of Columbia, CSBS joins the New York state Department of Financial Services in going the route of litigation in an effort to prevent OCC from granting the charters to companies, especially those in the fast emerging financial technology sector, to engage in non-depository banking. "Common sense and the law tell us that a nonbank is not a bank," said John Ryan, CSBS president and CEO. "Thus, CSBS is calling on the courts to stop the unlawful, unwarranted expansion of powers by the OCC." CSBC argues that the National Bank Act and other federal banking laws authorize the OCC to charter only institutions that engage in the "business of banking," which requires an institution to receive deposits. The new charter is for fintechs that do not take deposits. CSBS notes that many such companies currently operate as nonbanks licensed at the state level and that Congress has not granted the OCC authority to award bank charters to nonbanks. CSBS and New York regulators had previously filed suit against OCC in 2017, before the charter proposal was finalized, and were rebuffed by the courts since the policy was not yet in effect. OCC officials, including Comptroller Joseph Otting, have rejected the state regulators' claims about the OCC's lack of authority, and maintain that OCC is preparing to start reviewing applications for the charters by the end of this year.

For more information and background on this ongoing dispute, please see the October 22 and September 24 editions of Bank Regulatory News and Trends.

  • Fed official warns of risks of material loosening in leveraged loan market. A senior Fed professional staff member has expressed concerns about a material loosening of terms and weaknesses in the risk management of the $1.3 trillion market for higher risk loans used in private-equity deals. Todd Vermilyea, a senior associate director in the Fed's Division of Supervision and Regulation where he leads the Risk, Surveillance, and Data sections, warned against the proliferation of loans with weak covenants, known as "covenant-lite" or "cov-lite" loans, which he described as "loans that do not contain financial performance safeguards for the lender, such as specific commitments to maintain financial ratios related to debt service." Once reserved for the highest quality borrowers, cov-lite structures now account for as much as 80 percent of the market, according to some estimates. "How cov-lite loans would perform in a downturn is not well understood because data are not available," Vermilyea said in remarks at the Loan Syndications and Trading Association 23rd Annual Conference on October 23 in New York. Vermilyea cited two other trends that he and other regulators are "observing that are leading us to take a closer look at business and risk management practices in the leveraged finance market.": incremental facilities, which add further debt onto an existing loan; and "EBITDA (earnings before interest, tax, depreciation and amortization) add backs," loan adjustments that inflate borrowers' profits but could overstate their ability to repay loans. "The risks posed by these various contractual provisions could be mitigated with the appropriate risk management controls," he said. "Some of these provisions could even be beneficial to the borrower – and are, presumably, benefits borrowers are willing to pay for – representing opportunities for originating firms. However, the presence of these practices, especially without the appropriate controls, may lead to safety and soundness concerns." Vermilyea noted that leveraged loans account for $1.3 trillion of the $4.5 trillion syndicated credit market.
  • Banking industry urges changes to proposed Volcker Rule 2.0. As the public comment period on a proposed rewrite of the Volcker Rule regulations drew to a close on October 17, federal regulators received extensive comments from banking and financial services industry advocates calling for changes to the draft new rule. Among the heavyweights weighing in with lengthy recommendations were the Financial Services Forum, the Bank Policy Institute and the Securities Industry and Financial Markets Association. Earlier this year, the five agencies with authority over the Volcker Rule regulations that stemmed from Dodd-Frank – the Fed, FDIC, OCC, CFTC and SEC – issued a planned modification intended to make compliance easier for many firms and relieving smaller banks altogether. As reported in previous editions of Bank Regulatory News and Trends, leading Republican members of the Senate Banking and House Financial Services committees who support scaling back many of the Volcker requirements have criticized the agencies' proposed rewrite as inadequate, particularly on the question of how the term "covered fund" is defined – an issue also addressed by the industry organizations. In its comments, SIFMA expressed the view, generally shared by the other organizations, that the definition is "significantly overbroad and unduly complex," preventing banks from providing asset management services, customer facilitation services and long-term debt and equity financing indirectly through fund structures – "even though they are expressly permitted to do so directly," as SIFMA states. The Forum, in its statement, also called for elimination of the proposed accounting test and streamlining compliance burdens.
  • FDIC set to launch office to encourage innovation. The FDIC is planning to establish an office of innovation to help banks develop new ways to deliver products and services in the fintech era. FDIC Chair Jelena Williams announced the proposal at an October 23 ABA conference in New York, according to published reports. McWilliams was quoted as saying "I smile every time someone says 'fintech' because technology in banking is not new. Banks have been on the cutting edge of innovation since their founding." But she lamented what she called a "regulatory framework where we have actually discouraged banks from innovating for a number of years," adding that "innovation has happened outside of the banking" sector, while community banks in particular have lacked the resources and incentives to be bigger players in technological and other industry innovations. Although the FDIC has not released additional information on the proposed office, McWilliams's public remarks are the latest sign that regulators increasingly recognize the need for the regulatory regime to better understand, support and promote changes in technology and other innovations to meet the evolving needs and expectations of consumers and other stakeholders.