On May 24, 2018, President Trump signed into law the first major financial services reform bill since the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) in 2010. The Economic Growth, Regulatory Relief, and Consumer Protection Act (the “Reform Law”) is not a wholesale repeal of the Dodd-Frank Act, but it does modify or eliminate certain requirements on community and regional banks and nonbank financial institutions in particular that have been perceived to be especially burdensome. The hallmark of the Reform Law is the increase, from $50 billion to $250 billion, of the threshold at which a large banking organization automatically becomes subject to enhanced prudential standards. The Reform Law contains several other important provisions, including:
- Exempting banks with less than $10 billion in total consolidated assets from the Volcker Rule and easing certain naming restrictions;
- Exempting certain deposits held by custodial banks from the calculation of the supplementary leverage ratio;
- Reducing reporting and supervision requirements applicable to community banks; and
- Easing certain securities law requirements.
The Reform Law (S.2155) passed the Senate in March (67-31) and was passed by the House of Representatives on May 22, 2018 (258-159) without amendment to the version passed by the Senate.
A broader regulatory relief bill, the Financial CHOICE Act of 2017 (“CHOICE Act 2.0”), passed the House in June 2017. CHOICE Act 2.0 would have made much more significant changes to the Dodd-Frank Act, including eliminating the Volcker Rule altogether, providing regulatory relief to banks that maintain a higher leverage ratio, and repurposing the Financial Stability Oversight Council (“FSOC”) by, among other changes, stripping it of its ability to designate nonbank financial companies for enhanced prudential standards as well as repealing all designations previously made, and generally altering its membership and power structure.
Perhaps recognizing that CHOICE Act 2.0 faced challenges in passing the Senate, the House subsequently passed dozens of bills on various aspects of financial services reform, several of which were added to the Reform Law prior to Senate passage, and some of which were not incorporated.
At this point, while passage of another comprehensive regulatory reform bill appears unlikely, House Financial Services Committee (“HFSC”) Chairman Jeb Hensarling is reportedly assembling a follow-up package of additional reforms. Some of Chairman Hensarling’s desired measures have already found their way into the House’s fiscal year 2019 appropriations bill, including provisions that would consolidate rulemaking authority for the Volcker Rule with the Federal Reserve, limit FSOC’s ability to subject nonbank financial firms to enhanced prudential standards, delay a credit union capital rule, and prohibit the Securities and Exchange Commission ( “SEC”) from compelling traders to turn over source code absent a subpoena. The appropriations bill would also bring the Bureau of Consumer Financial Protection into the appropriations process.
Highlights of the Reform Law
Enhanced Prudential Standards
Asset Threshold Generally
A key highlight of the Reform Bill is to increase, from $50 billion to $250 billion, the asset threshold at which enhanced prudential standards apply to a bank holding company. The Federal Reserve would retain discretion to impose enhanced standards on organizations with $100 billion or more in assets. The treatment of foreign banking organizations is addressed further below.
Section 165(a) of the Dodd-Frank Act required the Federal Reserve to establish enhanced prudential standards for nonbank financial entities it supervises and for bank holding companies with total consolidated assets of $50 billion or more that are more stringent than those applied to other entities. Generally, bank holding companies above the threshold have been subject to higher capital, liquidity, and other requirements.
Section 401 of the Reform Law amends Section 165 of the Dodd-Frank Act (and makes certain other technical and conforming amendments) to increase that $50 billion asset threshold to $250 billion in total assets. However, the Reform Law also authorizes the Federal Reserve to apply, by order or rule, any of the enhanced prudential standards to any bank holding company or bank holding companies with total consolidated assets of $100 billion or more if the Federal Reserve makes certain findings regarding the financial stability of the United States or the safety and soundness of the bank holding company. In prescribing enhanced prudential standards, the Federal Reserve must take into consideration the capital structure, riskiness, complexity, financial activities (including the financial activities of subsidiaries), size, and any other risk-related factors that the Federal Reserve deems appropriate. Moreover, the Reform Law specifies that nothing in Section 401 limits the Federal Reserve’s authority to tailor or otherwise differentiate among companies in prescribing prudential standards under Section 165 or any other law. The Reform Law further specifies that nothing in Section 401 limits the supervisory, regulatory or enforcement authority of the Federal Reserve, the Federal Deposit Insurance Corporation (“FDIC”) or the Office of the Comptroller of the Currency (“OCC”) (collectively, the “Federal Banking Agencies”) to further the safe and sound operation of the institutions they supervise
Treatment of G-SIBs
Section 401 stipulates that any bank holding company, regardless of asset size, that has been identified as a “global systemically important” bank holding company (“G-SIB”) under 12 C.F.R. § 217.402 shall be treated as a bank holding company with $250 billion or more in total consolidated assets for purposes of the changes prescribed by Section 401 and various other provisions of specified statutes.
Treatment of Foreign Banking Organizations
The Reform Law also includes an important (and controversial) clarification as to how foreign banks are treated under the new threshold. Currently, the Federal Reserve has imposed heightened prudential standards on foreign banking organizations with more than $50 billion in total consolidated assets. The clarification states that the Reform Law does not impact the Federal Reserve’s current regulation of foreign banking organizations as it applies to foreign banking organizations with total consolidated assets of $100 billion or more or otherwise limit the authority of the Federal Reserve to (1) require a foreign banking organization with $100 billion or more in total assets to establish a U.S. intermediate holding company, (2) implement enhanced prudential standards with respect to such organizations, or (3) tailor regulation for such organizations. It remains to be seen how the Federal Reserve will amend its regulations regarding foreign banking organizations in light of the Reform Bill.
Changes to Specific Enhanced Prudential Standards
- Credit Exposure Reports. Section 401 amends the Dodd-Frank Act to state that the Federal Reserve “may” require certain credit exposure reports regarding the nature and extent of a nonbank financial company supervised by the Federal Reserve or bank holding company’s credit exposure to other significant nonbank financial companies and significant bank holding companies. The Dodd-Frank Act required the Federal Reserve to obtain such reports from certain large banking organizations subject to enhanced prudential standards. The definition of “significant” bank holding companies and nonbank financial companies is set forth in Part 242 of the Federal Reserve’s regulations and is based on a threshold of $50 billion in total consolidated assets.
- Risk Committee Requirement. The Dodd-Frank Act required the Federal Reserve to promulgate regulations requiring publicly-traded bank holding companies with $10 billion or more in total consolidated assets to establish a risk committee that would meet certain requirements. The Reform Law increases that threshold to $50 billion.
- Stress Testing. The Dodd-Frank Act required nonbank financial companies supervised by the Federal Reserve and bank holding companies with $50 billion or more in total consolidated assets to be subject to a Federal Reserve stress test and a company-run stress test, in each case that considers a baseline, adverse and severely adverse set of conditions. Under the Reform Law, only nonbank financial companies supervised by the Federal Reserve and bank holding companies with $250 billion or more in total consolidated assets are subject to supervisory and company-run stress testing, and they are no longer required to consider an adverse condition. The Reform Law also changes the frequency of company-run stress tests for such companies from a semi-annual to a “periodic” basis. Moreover, other federally regulated financial companies with $10 billion or more in assets have been required to conduct annual company-run stress tests. The Reform Law changes the threshold from $10 billion to $250 billion for such federally regulated financial companies, and only requires such stress tests on a periodic basis. However, the Reform Law explicitly provides that the Federal Reserve is required to conduct supervisory stress tests on bank holding companies with total consolidated assets of between $100 billion and $250 billion, but on a “periodic” basis, and under adverse economic conditions.
- Leverage Limitation. The Dodd-Frank Act provided that the Federal Reserve require bank holding companies with total consolidated assets of $50 billion or more or other institutions it supervises to maintain a debt to equity ratio of no more than 15:1 upon a finding by the FSOC that such company poses a grave threat to the financial stability of the United States and that the imposition of such a requirement is necessary to mitigate the risk that such company poses to the financial stability of the United States. While this provision has apparently never been invoked, the Reform Law increases the threshold for bank holding companies to $250 billion.
The Reform Law specifies that the changes prescribed by Section 401 will take immediate effect for bank holding companies with total consolidated assets of less than $100 billion and will otherwise take effect 18 months after the Reform Law is enacted. However, for bank holding companies with total consolidated assets of $100 billion to $250 billion, the Federal Reserve has discretion in tailoring the enhanced prudential standards and may by order exempt such institutions from the enhanced prudential standards before the 18-month period expires. Federal Reserve Chairman Jerome Powell has stated that the Federal Reserve intends to create a framework for such institutions within 18 months, after assessing where systemic and regional risk might exist. Various other provisions of the Reform Law also have a delayed effective date
Supplementary Leverage Ratio
The Reform Law also affords relief to certain custody banks in calculating their supplementary leverage ratio (“SLR”). Under Section 402, the Federal Banking Regulators must amend their respective capital regulations to specify that funds of a custodial bank that are linked to fiduciary or custodial and safekeeping accounts and that are deposited with a central bank (i.e., the Federal Reserve, the European Central Bank, or central banks of certain OECD member countries) will not be taken into account when calculating the SLR applicable to the custodial bank. Currently, all institutions subject to the SLR must take such funds into account in calculating the SLR.
“Custodial bank” is defined as any depository institution holding company predominately engaged in custody, safekeeping, and asset servicing activities, including any insured depository institution subsidiary of such holding company. This provision reflects a departure from earlier versions of the Reform Law and has the effect of excluding from the exemption banks with large custodial activities, but that are not “predominately engaged” in such activities. Section 402 also makes clear that the Federal Banking Agencies will be able to tailor or otherwise adjust the SLR (or any other leverage ratio) for noncustodial banks.
Volcker Rule – Small Bank Exemption
Section 203 excludes certain small banking institutions from the Volcker Rule. The Volcker Rule, among other things, prohibits banking entities from (a) engaging in proprietary trading, or (b) acquiring or holding ownership interests in or sponsoring hedge funds or private equity funds (subject to certain exceptions). The Reform Law excludes from these Volcker Rule prohibitions those banking entities that do not have and are not controlled by companies that have: (1) more than $10 billion of total consolidated assets; and (2) total trading assets and trading liabilities of more than five percent of total consolidated assets, as reported on the most recent applicable regulatory filing.
Volcker Rule – Naming Restrictions
The Reform Law further amends the Volcker Rule by removing naming restrictions in certain instances in which a banking entity would otherwise be allowed to organize and offer a hedge fund or private equity fund. The naming restriction generally prohibits such a fund from sharing a name with the banking entity that sponsors it or with an affiliate of such banking entity.
Section 204 permits a banking entity that is an investment adviser to a hedge fund or private equity fund to share the same name (or a variation of the same name) with the fund provided that: (1) the investment adviser is not a company that is or controls an insured depositary institution, or a company treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978 (the “IBA”); (2) the investment adviser does not share the same name or variation of the same name as any insured depository institution, company that controls an insured depository institution or any company that is treated as a bank holding company for purposes of Section 8 of the IBA; and (3) the shared name does not have the word “bank” in its name.
Liquidity Coverage Ratio
Section 403 adds a new subsection to Section 18 of the Federal Deposit Insurance Act (“FDIA”) regarding the treatment of municipal obligations as high-quality liquid assets. Specifically, a municipal obligation is to be treated as a level 2B liquid asset if the obligation, as of the date of calculation, is both “liquid and readily-marketable” as defined in 12 C.F.R. § 249.3 and “investment grade” as defined in 12 C.F.R. § 1.2. The Reform Law requires the FDIC, the Federal Reserve and the OCC to amend within 90 days the final U.S. Liquidity Coverage Ratio rule, as well as the final rule regarding the treatment of U.S. Municipal Securities as High-Quality Liquid Assets for purposes of the U.S. Liquidity Coverage Ratio, to reflect this amendment. The Reform Law further prescribes that this treatment of municipal obligations would be applicable for purposes of any other regulation that includes a definition of high-quality liquid asset.
Community Bank Relief
Capital Simplification for Qualifying Community Banks
Section 201 of the Reform Law simplifies applicable leverage capital requirements and risk-based capital requirements for qualifying community banks (“QCBs”), defined as depository institutions or depository institution holding companies with total consolidated assets of less than $10 billion. The Reform Law requires the Federal Banking Agencies to establish, through notice and comment rulemaking, a “Community Bank Leverage Ratio” (i.e., a ratio of tangible equity capital to average total consolidated assets, as reported on the bank’s applicable regulatory filing with the appropriate Federal Banking Agency) of between eight and ten percent. They must also establish procedures for the treatment of QCBs that fall below the Community Bank Leverage Ratio percentage after having previously exceeded it.
QCBs that exceed the Community Bank Leverage Ratio will be considered to have met the generally applicable leverage capital and the generally applicable risk-based capital requirements of the Federal Banking Agency, as well as, for depository institutions, the capital ratio requirements that are required to be considered well capitalized under Section 38 of the FDIA (the Prompt Corrective Action regime). More generally, QCBs that exceed the Community Bank Leverage Ratio will be considered to have met any other capital or leverage requirements to which the QCB is subject.
The Federal Banking Agencies are required to consult with applicable state bank supervisors when implementing this section, and must notify the applicable state bank supervisor when the QCB it supervises exceeds the Community Bank Leverage Ratio or fails to exceed such ratio after having previously exceeded it.
Short Form Call Reports
The Reform Law also reduces reporting requirements under the FDIA for “covered depository institutions,” defined as insured depository institutions that: (1) have less than $5 billion in total consolidated assets; and (2) satisfy such other criteria as the Federal Banking Agencies deem appropriate. Specifically, Section 205 of the Reform Law requires the Federal Banking Agencies to issue regulations to allow for a reduced reporting requirement for a “covered depository institution” filing the first and third quarterly reports of condition (i.e., call reports) required under Section 7(a) of the FDIA. While this provision would purport to alleviate the regulatory reporting burden on smaller depository institutions or community banks, it leaves discretion to the Agencies to determine what constitutes “reduced” reporting requirements.
Small Bank Holding Company Policy Statement
The Federal Reserve is required under Section 207 to increase the size of bank holding companies (including savings and loan holding companies) permitted to utilize acquisition debt financing under the “Small Bank Holding Company and Savings and Loan Holding Company Policy Statement” (i.e., Appendix C to 12 C.F.R. Part 225) (the “Policy Statement”) for purposes of applications under the Bank Holding Company Act of 1956. The Reform Law raises the threshold for small bank holding companies entitled to utilize such debt financing from those with pro forma consolidated assets of $1 billion to $3 billion (subject to meeting certain conditions currently set forth in the Policy Statement).
Under Section 210 the consolidated asset threshold under which insured depository institutions are permitted to be examined by a Federal Banking Agency every 18 months (as opposed to every 12 months) is increased from $1 billion to $3 billion. The Reform Law does not otherwise alter the FDIA requirements that in order to be subject to the 18-month periodic review, the insured depository institution must be well capitalized and found to be well managed after its most recent examination, with a composite condition of outstanding (or good for insured depository institutions with less than $200 million in assets). The Federal Banking Agencies are currently permitted to increase that $200 million threshold to $1 billion. Under the Reform Law, they are permitted to increase the $200 million threshold to $3 billion if they determine that a greater amount is consistent with principles of safety and soundness. Currently, in order to be subject to the 18-month periodic review, an institution must also not be subject to an enforcement action by the appropriate Federal Banking Agencies, and no person may have acquired control over the institution during the preceding 12-month period. The Reform Law does not change this requirement.
SEC Study on Algorithmic Trading
Section 502 of the Reform Law requires the SEC to submit to the Committee on Banking, Housing, and Urban Affairs (“Senate Banking Committee”) and the HFSC a report detailing the risks and benefits of algorithmic trading in United States capital markets within 18 months of the Reform Law’s enactment. The report is required to include: (1) an assessment of the effect of algorithmic trading on the provision of liquidity in stressed and normal market conditions; (2) an analysis of whether the activity of algorithmic trading and the entities that engage in it are subject to appropriate Federal supervision and regulation; and (3) a recommendation of any changes that need to be made to existing regulations concerning algorithmic trading based on this analysis, and whether the SEC needs additional legal authorities or resources in order to effect such changes.
Annual Review of Government-Business Forum on Capital Formation
Section 503 focuses on the SEC Government-Business Forum on Small Business Capital Formation, which the SEC has hosted annually since 1982. The Small Business Forum serves as a platform for small business executives, venture capitalists, government officials, lawyers, academics and small business advocates to discuss capital formation concerns of small businesses, including regulatory and other challenges faced by small businesses. Each Small Business Forum develops a set of findings and recommendations that are delivered to Congress and the SEC. Section 503 mandates that the SEC assess the findings and recommendations coming from the Small Business Forum and disclose the action, if any, the SEC intends to take.
Exemption for Venture Capital Funds
Section 504 amends Section 3(c)(1) of the Investment Company Act of 1940 (the “Investment Company Act”) to establish a new registration exemption for certain venture capital funds. These funds would be exempt from registration under the Investment Company Act so long as they have no more than 250 investors and no more than $10 million in capital commitments.
Protection for Investors in U.S. Territories
Section 506 revokes Section 6(a)(1) of the Investment Company Act, which currently provides a registration exemption for funds offered solely in Puerto Rico, the U.S. Virgin Islands and other U.S. territories. Funds currently relying on the exemption have at least three years from the date of the Reform Law’s enactment in which they would continue to be exempt, which period the SEC could extend for an additional three years.
Encouraging Employee Ownership
Section 507 amends Rule 701 of the Securities Act of 1933. Rule 701 is an exemption from the registration requirements of the securities laws that allows private companies to grant equity awards, including stock options, to employees, directors and consultants. Private companies overwhelming rely on Rule 701 as it permits them to grant equity awards to employees and others without any filings with the SEC and without paying any fees. Under Rule 701(e), if a private company issues more than $5 million of securities in a 12-month period, it is required to provide financial statements and risk factor disclosures to anyone receiving equity awards. Section 507 increases this threshold to $10 million.
Improving Access to Capital
Section 508 amends Regulation A. Regulation A is an exemption from the registration requirements of the Securities Act that serves as an alternative to a traditional initial public offering or capital raising that is designed to be faster and cheaper for developing and early stage companies. Regulation A is only available to private companies, but Section 508 permits already public companies who are reporting to the SEC to use Regulation A as a means of conducting a public offering without a traditional SEC registration statement.
Parity for Closed-End Companies
Section 509 directs the SEC to establish rules generally treating closed-end funds like other public company issuers under certain offering and proxy rules. The Reform Law requires a rule to be proposed within one year and finalized within two years from the date of the Reform Law’s enactment. This change is a high priority for the Investment Company Institute (the primary trade group representing U.S. registered funds). Should the SEC fail to meet the prescribed timelines, a closed-end fund would be deemed an “eligible issuer.”
Other Reforms and Studies
Home Mortgage Disclosure Act Adjustment and Study
Section 104 amends Section 304 of the Home Mortgage Disclosure Act of 1975 (the “HMDA”) to provide certain insured depository institutions and insured credit unions limited exemptions from certain HMDA reporting requirements. Specifically, institutions that originate fewer than 500 closed-end mortgages and fewer than 500 open-end lines of credit in each of the two preceding years are exempted from subsections (b)(5) and (6) of the HMDA, which require institutions to maintain itemizations of mortgage loan data disclosure that include, respectively: (1) the number and dollar amount of mortgage loans grouped according to certain measurements; and (2) the number and dollar amount of mortgage loans and completed applications grouped according to certain measurements. Consumer advocates have argued that such data is critical for identifying housing discrimination.
However, a bank that has received a “needs to improve record of meeting community credit needs” during its two most recent Community Reinvestment Act (“CRA”) exams, or a rating of “substantial noncompliance in meeting community credit needs” on its most recent CRA exam is not eligible for the exemption. Moreover, Section 104 requires the Comptroller General of the United States to conduct a study to evaluate the impact of these amendments on the amount of data available under the HMDA within two years and issue a report within three years regarding the same.
Study Mandated on the Risk of Cyber Threats
Within a year of the Reform Law’s enactment, Section 216 requires the Secretary of the Treasury to submit to the Senate Banking Committee and the HFSC a report on the risks of cyber threats to financial institutions and capital markets in the United States. The report is required to include:
- An assessment of material risks of cyber threats to, and the impact and potential effects of material cyber attacks on, financial institutions and capital markets in the United States;
- An analysis of how the Federal Banking Agencies and the SEC are addressing such material risks of cyber threats, including how they are assessing those threats, how they are assessing cyber vulnerabilities and preparedness of financial institutions, coordination amongst the named agencies, as well as with other government agencies, including with respect to regulations, examinations, and other regulatory tools, and areas for improvement; and
- A recommendation of whether any of the named agencies requires additional legal authorities or resources in order to adequately assess and address the material risks of cyber threats in light of the analysis by the U.S. Department of the Treasury.
This note provides a brief summary of many, but not all, provisions of the Reform Law. Also, as noted above, additional reforms may be enacted as part of the budget process or otherwise.
While many of the provisions of the Reform Law are self-effectuating, several others require action by the Federal Banking Agencies, and thus the ultimate impact of certain sections of the Reform Law remains to be seen. For example, Section 401 provides that the Federal Reserve should conduct stress tests on bank holding companies with $100 billion to $250 billion in assets on a “periodic basis,” but it does not specifically address the form those stress tests must take. For example, Comprehensive Capital Analysis and Review (“CCAR”), a process created by the Federal Reserve outside of the Dodd-Frank Act, is not addressed. In March, Federal Reserve Chairman Jerome Powell stated that if the Reform Law was passed as is, those banks below the new $250 billion threshold for stricter stress testing but falling within the Federal Reserve’s discretionary stress testing would still face “meaningful, strong, regular periodic stress tests—frequent stress tests”. Chairman Powell explained that stress testing (e.g., CCAR) is the most successful regulatory tool of the post-financial crisis era, and that the Federal Reserve would continue to frequently conduct stress tests of “small community banks.”
Moreover, there are several significant rulemakings that are out for proposal or expected in the near term. For example, on April 11, 2018, the Federal Reserve and the OCC published a joint notice of proposed rulemaking that would make significant changes to the calculation of the enhanced supplementary leverage ratio for U.S. G-SIBs and certain of their insured depository institution subsidiaries regulated by the Federal Reserve and OCC. The FDIC did not join the Federal Reserve and OCC, and the Chairman of the FDIC, Martin Gruenberg, was critical of the proposed rulemaking. In addition, proposed interagency rulemaking to modify and tailor the Volcker Rule (“Volcker Rule 2.0”) is expected to be released the week of May 28. It will be interesting to see if either of these proposals will reflect or otherwise modify the changes to the SLR and the Volcker Rule contained in the Reform Law.