On July 22 and 23, 2009, the Administration proposed specific legislative language to put flesh on the bones of its previously announced financial services reform proposal. These releases include what may be the key elements of the Administration’s financial services reform proposal:

  • The expansion of the role of the Federal Reserve Board (“FRB”) to (i) supervise all financial companies that are systemically significant to the US financial system, (ii) regulate the holding companies of all insured depository institutions on a uniform basis and (iii) oversee a broader range of a holding company’s activities; and
  • The creation of new regulatory authority to place a systemically significant financial company into receivership or conservatorship.

The proposed legislation also includes the establishment of a Financial Services Oversight Council (“FSOC”), new restrictions on transactions between an insured depository institution and its affiliates and the merger of the Office of the Comptroller of the Currency (“OCC”) and the Office of Thrift Supervision (“OTS”). See Administration Releases Its Plan for Strengthening Financial System Stability and Regulation, 21st Century Money, Banking & Commerce Alert® (June 18, 2009). However, the testimony of the federal banking regulators and Secretary of the Treasury Geithner demonstrated that there is little unanimity among them on the allocation of new financial regulatory authority.  

Systemic Supervision  

The Bank Holding Company Modernization Act of 2009 would authorize the FRB, at any time, to designate any US company or any foreign company engaged in activities in the US that are “financial in nature” as a Tier 1 financial holding company (“Tier 1 FHC”) if it meets certain requirements. The FRB would base this designation on a determination that “material financial distress at the company could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress.”  

To identify a Tier 1 FHC, the FRB would consider a company’s financial assets, liabilities (particularly its reliance on short-term funding), off-balance sheet obligations and degree of interconnectedness (in terms of its transactions and relationships with other major financial companies and its importance as a source of credit and liquidity). The FRB also would consider in this regard any recommendation made by the FSOC, discussed below, and “any other factor that the Board deems appropriate.” When it comes to identifying Tier 1 FHCs, this creates a wide net for the government to use to identify and regulate systemically significant companies, but it does not necessarily answer the complex legal, market and timing questions that will be raised by the exercise of this authority. See Treasury Proposes Wide-Ranging Resolution Authority Over Financial Institution Holding Companies; Proposes Other Significant Regulatory Changes, 21st Century Money, Banking & Commerce Alert® (March 30, 2009).  

There is no minimum size requirement for a Tier 1 FHC, but a good practical measure is provided by the authority that would be granted to the FRB to collect information regarding a company for the purpose of making Tier 1 FHC determinations. The FRB would be able to require a US company engaged in any activity that is financial in nature and that has $10 billion or more in assets, $100 billion or more of assets under management or $2 billion or more of gross annual revenue to submit information. A foreign company whose activities or assets in the US met these criteria also could be required to submit information. These are lower numerical thresholds than might have been expected. In particular, the asset size threshold in the legislation is far lower than the threshold of $100 billion of assets that was used earlier this year by the Department of the Treasury and the federal banking regulatory agencies in determining which firms would be subject to a “stress test.” See Reading Between the Lines of the Financial Stability Plan, 21st Century Money, Banking & Commerce Alert® (Feb. 12, 2009).  

Before requesting information directly from a company, the FRB would be expected to seek to obtain any necessary information from the company’s primary federal regulatory agency, if any. Under certain circumstances, the FRB would have the authority to conduct an examination of a company in order to determine whether to designate it as a Tier 1 FHC. It remains to be seen how many Tier 1 FHCs the FRB may ultimately designate.  

Before being designated as a Tier 1 FHC, a company would have an opportunity to contest its designation. If a company was so designated, it would generally have 180 days to register with the FRB.  

A Tier 1 FHC would have five years to bring all its activities into compliance with the restrictions applicable to a financial holding company (“FHC”) under the Bank Holding Company Act (“BHC Act”). There is no provision at this time for an extension of the transition period. During this transition period, a Tier 1 FHC that was engaged predominantly in non-financial activities would be required to conduct all its activities that are financial in nature through a single intermediate holding company that must be established within 90 days after the parent company was notified of its Tier 1 FHC status. Transactions between such an intermediate holding company and its affiliates would be subject to restrictions under Sections 23A and 23B of the Federal Reserve Act as if the intermediate holding company was a bank.  

These provisions leave many practical questions unanswered. For example, a newly designated Tier 1 FHC may be required to reorganize to establish a single intermediate holding company, and creditors and other counterparties of the various companies affected thereby may find their rights or expectations altered as a result of such reorganization and the imposition of FRB supervisory authority in general. The prospect of such an effect could impose a burden on companies that may be candidates for Tier 1 FHC designation as they approached the thresholds for designation, and could put additional pressure on the FRB as it surveys the field. While the restrictions on non-banking activities would not take effect immediately, the supervisory authority of the FRB (including the authority to establish and enforce regulatory capital requirements and institute prompt corrective action) and the restrictions on transactions by an intermediate holding company with affiliates would appear to take effect immediately.  

The regulation of Tier 1 FHCs would include risk-based capital requirements, leverage limits, liquidity requirements and overall risk management requirements (including credit exposure to unaffiliated companies). The FRB would be required to establish standards in these areas that are more stringent than the standards applicable to bank holding companies.  

The FRB would have the authority to examine any financial or non-financial subsidiary of a US Tier 1 FHC and any US branches, agencies or subsidiaries of a foreign Tier 1 FHC. The Federal Deposit Insurance Corporation (“FDIC") would have back-up examination authority. Each Tier 1 FHC would be required to maintain a plan for its rapid and orderly resolution in the event of severe financial distress. Furthermore, the FRB could require a Tier 1 FHC by regulation to make certain public disclosures in order to allow the market to evaluate the company’s risk profile.  

Perhaps of greatest significance to a Tier 1 FHC, its investors and its counterparties is the requirement that such a company must at all times be well capitalized and well managed. The legislation would establish a prompt corrective action (“PCA”) structure for Tier 1 FHCs that would be generally similar to the PCA structure that currently applies to insured depository institutions.  

Under the PCA provisions, a Tier 1 FHC that was not well capitalized would be deemed to be undercapitalized. An undercapitalized Tier 1 FHC would generally be prohibited from making capital distributions, subject to certain exceptions. It would be required to submit an acceptable capital restoration plan to the FRB. It also would be subject to restrictions on its asset growth and on engaging in acquisitions and entering into new lines of business.  

Based on the degree of the Tier 1 FHC’s capital deficiency and the FRB’s evaluation of the company’s circumstances, the FRB also could, among other things, (i) require it to raise additional capital (including voting stock) or enter into a merger or acquisition transaction, (ii) impose stricter restrictions on its asset growth, (iii) restrict certain transactions among its subsidiaries, (iv) require it to hold a new election for its board of directors or dismiss directors or management, (v) require it divest itself or liquidate any subsidiary if the FRB determined that the subsidiary was in danger of becoming insolvent or posed a risk to the Tier 1 FHC, or (vi) limit certain senior management compensation without FRB approval. If the FRB believed that a condition, practice or activity of a foreign Tier 1 FHC did not comply with any rules or orders prescribed by the FRB or otherwise posed a threat to financial stability, the FRB could, after notice and an opportunity for a hearing, order the foreign Tier 1 FHC to terminate any branch, agency or subsidiary that it operated in the US.  

Within 90 days after a Tier 1 FHC became critically undercapitalized, the FRB would be directed either (i) to require the Tier 1 FHC to file a voluntary bankruptcy petition or (ii) to file an involuntary bankruptcy petition against the company. The Bankruptcy Code would be amended to provide that being a critically undercapitalized Tier 1 FHC constituted sufficient grounds for the FRB to commence such an involuntary case.  

Special Resolution Authority  

An additional resolution authority would be created under the Resolution Authority for Large, Interconnected Financial Companies Act of 2009. This authority would be modeled closely on the receivership and conservatorship powers of the FDIC with regard to insured depository institutions. It could be applied to any US bank holding company, any US Tier 1 FHC or any subsidiary of either of them (except an insured depository institution, a broker or dealer registered with the Securities and Exchange Commission (“SEC”) or an insurance company). Unlike the mandatory bankruptcy filing provision described above, it could be applied only upon the recommendation of not less than two-thirds of the members of the FRB and two-thirds of the directors of the FDIC (or two-thirds of the commissioners of the SEC if the largest subsidiary of the company was a broker or dealer registered with the SEC) and a determination of the Secretary of the Treasury in consultation with the President. Among other factors, the Secretary would be required to determine that the failure of the company and its resolution under other authority would have serious adverse effects on financial stability or economic conditions in the US and that resolution under this authority would avoid or mitigate such adverse effects. The appointment of the FDIC or SEC as a conservator or receiver for a company under this provision would automatically terminate any bankruptcy case or state insolvency proceeding filed by or against the company and would prevent any such case or proceeding from being commenced as long as the receiver or conservator remained in place.  

Funding for such a receivership or conservatorship would be provided by the Treasury without need of further appropriation. In addition, the FDIC could, with the approval of the Secretary, provide debt or equity financing to, assume or guarantee obligations of or purchase assets from the company or any of its subsidiaries. This funding authorization suggests that the principal use of the special resolution procedure in preference to a mandatory bankruptcy proceeding may occur when a “bailout” of a company was determined to be necessary and only the government had sufficient resources or willingness to fund it. If that were the case, then the special resolution procedure may not be as much a means of preventing bailouts as a substitute for them when all preventive measures have failed.  

The FDIC would serve as receiver or conservator, unless the largest subsidiary of the company was a broker or dealer, in which case the SEC would serve in such capacity. The receiver or conservator would have powers closely resembling the FDIC’s powers as receiver or conservator for insured depository institutions. The FDIC would be required to take steps to recover any funds that were expended in a special resolution procedure and were not otherwise recouped, by, among other measures, assessing all bank holding companies, Tier 1 FHCs and the subsidiaries of either of them that are not insured depository institutions, SEC-registered brokers or dealers or insurance companies. This assessment would be based on a formula related to the amount of their liabilities and their risk profile.  

The potential for a company to be subject at a given point in time to two alternative resolution regimes, which may differ or conflict in various respects, may create significant issues for the company, its shareholders, creditors and other counterparties.  

Uniform Holding Company Supervision  

The BHC Act would be amended to require the registration as a bank holding company of any company controlling an insured depository institution. Companies that controlled a savings and loan association would no longer be regulated separately as savings and loan holding companies. The exemptions from bank holding company status would be eliminated for companies that controlled certain limited-purpose banks, such as industrial loan companies (“ILCs”), credit card banks and trust companies. As a result, all companies that controlled an FDIC-insured bank or thrift would be subject to an identical regulatory regime under the FRB.  

All affected companies would be required to register with the FRB within 90 days after the date the law is enacted. The FRB would have the authority to grant temporary exemptions or provide other appropriate temporary relief to permit affected companies to implement measures necessary to comply with the BHC Act. An affected company would have two years to bring its activities into compliance with BHC Act limitations (subject to the possibility of the FRB granting up to three one-year extensions). The limited exemptions and grace period for existing non-FHC activities may pose significant challenges for grandfathered unitary savings and loan holding companies and commercial companies that own ILCs or credit card banks.

Expanded Prudential Supervision  

Restrictions on the ability of the FRB to examine, supervise and take enforcement action against the functionally regulated subsidiaries of a bank holding company would be largely eliminated. As a result, the FRB would have increased oversight of those entities and their activities when they are conducted within the organizational framework of a bank holding company.  

For the first time, FHCs would be required to be well capitalized and well managed on a consolidated level. In addition, a bank holding company would need to be well capitalized and well managed, rather than adequately capitalized and adequately managed, in order to be exempt from any state law restrictions on interstate bank acquisitions. In the past, the FRB on a case-by-case basis has generally expected bank holding companies to be well capitalized in order to undertake bank acquisitions, so these amendments are likely to have only an incremental effect.  

Financial Services Oversight Council  

The FSOC would be comprised of the heads of the federal banking regulatory agencies, the SEC, the Commodity Futures Trading Commission, the proposed Consumer Financial Protection Agency, and the Federal Housing Finance Agency, and would be chaired by the Secretary of the Treasury. The FSOC would facilitate information sharing and coordination among its members with regard to domestic financial services policy development, rulemaking, examinations, reporting and enforcement actions and would consult with the FRB in identifying systemically important financial companies and systems and in setting standards for those companies and systems.  

The FSOC would have a permanent full-time staff in the Treasury, but it would have no independent examination or enforcement authority. The FSOC would be able to require periodic and other reports from any US financial firm solely for the purpose of assessing the extent to which a financial activity or financial market in which the firm participates poses a threat to financial stability. Some have proposed providing the FSOC with a more direct and robust role in managing systemic risk.  

Restrictions on Transactions with Affiliates  

The proposal seeks to strengthen firewalls between banks and their affiliates. It would extend the current limitations under Sections 23A and 23B on covered transactions between an insured depository institution and its non-banking affiliates to apply to transactions between an insured depository institution and any investment fund advised by either the institution or any of its non-banking affiliates. In addition, the definition of a “covered transaction” would be expanded to include securities borrowing and lending transactions with an affiliate to the extent those transactions created credit exposure by an insured depository institution to that affiliate, and to include derivative transactions with an affiliate to the extent they created current and potential future credit exposure to that affiliate. The current exception from the quantitative limit on transactions with a single affiliate for covered transactions between a bank and its financial subsidiary would be eliminated. The ability of the FRB to grant exemptions under Section 23A would be limited by requiring the concurrence of the FDIC and, for a national bank, the concurrence of the National Bank Supervisor (“NBS”) as well. Exemptions under Section 23B would require the concurrence of the FDIC. Certain of these restrictions may limit the ability of banks to engage in certain transactions no matter their potential benefit to the bank or the absence of any threat to the bank’s safety and soundness, based apparently on the assumption that these transactions are inherently risky.  

Merger of Federal Banking Agencies and Elimination of Thrift Charter  

The Federal Depository Institutions Supervision and Regulation Improvements Act of 2009 would merge the OCC and the OTS into a newly established NBS. The NBS would assume all functions and responsibilities of the OCC and all functions and responsibilities of the OTS except for those related to the supervision and regulation of state-chartered savings associations, which would be transferred to the FDIC. The transfer of functions would become effective one year after the date of the law’s enactment.  

In addition, the federal thrift charter would be eliminated. Within six months following the date of the law’s enactment, each federal savings association would be required to elect whether to become a national bank, a mutual national bank, a state bank, or a state savings association. Following an election to be a national bank or mutual national bank, the OCC would be able to request certain information and would issue the relevant federal charter within one year of the date of enactment. Any federal savings association that did not make an election within six months or was unable to compete its planned conversion to a state bank or state savings association within the one-year period following enactment would become a national bank or mutual national bank by operation of law.  

The OCC or the appropriate state banking agency would be permitted to impose such conditions in connection with the issuance of a new charter as it determined in its sole discretion to be appropriate to assure the safe and sound operation of the new institution. This provision raises uncertainty for federal savings associations and their parent companies insofar as the permissible conditions are not expressly limited to those that may apply to currently chartered state and national banks.  

The proposal contains provisions for the charter conversion. Among its provisions, a three-year transition period would apply to the non-conforming activities and assets of federal thrifts that converted to a national bank charter, subject to the possibility of receiving up to two one-year extensions. However, even during the transition period, the appropriate federal banking agency could impose certain conditions on those activities. The need to divest these assets and terminate these activities may negatively impact the value of some organizations.