Will the Fed’s Approach to Large BHCs Trickle Down to All?

Authors: Gordon M. Bava | Mick Grasmick

On December 20, 2011, the Federal Reserve Board issued proposed regulations intended to strengthen the regulation and supervision of large bank holding companies (BHCs) and systemically important nonbank financial firms as required by Dodd-Frank Sections 165 and 166. The proposal addresses a wide range of measures addressing issues such as capital, liquidity, credit exposure, stress testing, risk management and early remediation requirements. With notable exceptions, firms subject to the final regulations would need to comply with many of the enhanced standards a year after they are finalized.

Although the proposal generally directly applies only to bank holding companies with consolidated assets of $50 billion or more and to any nonbank financial firms that may be designated by the Financial Stability Oversight Council as systemically important companies (and none have been so far), we believe smaller bank and savings and loan holding companies should take note since new rules and supervisory standards set for larger organizations have a way of becoming “best practices” for smaller institutions in conditions to regulatory approvals and examinations.

Comments on the Fed’s Proposal

1. Capital
There was great anticipation as to what the Fed’s game plan would be for implementing  stricter capital requirements.  However, it is evident the Fed chose to reduce the anxiety related to the timing and implementation of the Dodd-Frank requirements and the imposition of the evolving and sometimes conflicting Basel III and Dodd-Frank capital requirements.

The proposal provides that the Fed will go slow and follow more than lead in layering on U.S. banks and holding companies more capital levels until several Basel III open issues are resolved. A first phase would implement the Board's November capital plan rule, which  requires firms to develop annual capital plans, conduct stress tests, and maintain adequate capital, including a Tier 1 common risk-based capital ratio greater than 5 percent. Then, in a later second phase, the Board would issue a proposal to implement a risk-based capital surcharge based on the final Basel III framework and methodology.

2. Liquidity
The Fed proposes a similar two-phase approach for liquidity following current interagency guidance now, with more proposals to implement quantitative liquidity requirements based on the Basel III liquidity rules coming in the second phase.

3. Stress Testing
Eventually annual or semiannual stress testing will be required for both liquidity and capital for each covered company as well as any state member bank, bank holding company or savings and loan holding company (S&LHC) with more than $10 billion in total consolidated assets. Companies must also publish a summary of the results of the company-run stress tests, and the Fed will also publish results. Stress testing requirements for bank holding companies would take effect shortly after the Fed’s rule is finalized rather than a year later. 

Stress testing is the new normal and we have already seen stress tests become a “must do” examination expectation for even smaller community banks.

4. Single-Counterparty Credit Limits
Holding companies with a portfolio of loans should pay close attention to the Fed’s new credit limits proposal for BHCs. The Fed would limit credit exposure of a covered financial firm to a single unaffiliated company to a percentage of the firm's regulatory capital—25% of the capital stock and surplus of the covered company for $50+ billion asset counterparties and 10% for $500+ billion asset counterparties. The proposal describes the types of collateral, guarantees and derivative hedges that are eligible under the rule and provides valuation rules. 

The definition of credit exposure is expanded to capture derivatives exposure and includes “all extensions of credit to the company; all repurchase and reverse repurchase agreements, and securities borrowing and lending transactions, with the company; all guarantees and letters of credit issued on behalf of the company; all investments in securities issued by the company; counterparty credit exposure to the company in connection with derivative transactions; and any other similar transaction that the Board determines to be a credit exposure.”

We believe these credit limits portend new “safety and soundness” lending limits for all holding companies regardless of size by applying customary bank lending limits to those parent holding companies that are active lenders as well as borrowers.  Reverse repos, liquidity and Fed Funds lines of commercial banks that frequently exceed lending limits could now be the subject of more intense regulatory scrutiny. While these credits have been the subject of comment in examinations, the proposed regulations heighten the scrutiny to which these credits will be subject. 

5. Risk Management
The proposal will implement the Dodd-Frank requirement that each publicly traded bank holding company with $10 billion or more in total consolidated assets must establish a risk committee. Institutions with $50+ billion assets must have a risk committee of the board of directors and a chief risk officer. Adopting enterprise-wide risk management and considering a Chief Risk Officer position have become nearly household words in all bank examinations regardless of size.

6. Early Remediation Requirements
The Fed noted a key lesson learned from the financial crisis:  the condition of large banking organizations can deteriorate rapidly even during periods when their reported regulatory capital ratios were well above required minimums. The Fed proposes a number of triggers for remediation, such as capital levels, stress test results, and risk management weaknesses.  Required actions would vary based on the severity of the situation, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales and limits on transactions with affiliates.

We expect all prompt corrective action sanctions will be imposed much sooner for financial institutions of all sizes going forward as examiners often held back from recommending enforcement action when capital ratios looked adequate only to subsequently impose overly broad and harsh orders when they later observed severe asset quality declines.

In announcing the proposal the Fed stated:
“While this proposal was largely developed with large, complex bank holding companies in mind, some of the standards nonetheless provide sufficient flexibility to be readily implemented by covered companies that are not bank holding companies...

“...in applying the enhanced prudential standards to covered companies, the Board may determine, on its own or in response to a recommendation by the Council, to tailor the application of the enhanced standards to different companies on an individual basis or by category, taking into consideration their capital structure, riskiness, complexity, financial activities, size, and any other risk-related factors that the Board deems appropriate.” 

We believe these statements reinforce our judgment that while these standards if adopted would not immediately apply to smaller institutions, it is very possible that they will become general standards for all institutions. 

The Fed plans to issue a separate proposal later to address the applicability of these enhanced standards to S&LHCs. We expect every standard to be made nearly equally applicable, at least to the financial operation S&LHCs. We further would expect the forthcoming Government Accountability Office study of the industrial loan company charter to contain similar recommendations, if the charter survives. 

A comment period on the Fed’s proposal will run through March, 2012.