Tuesday, December 20, 2011

Fed Proposes Enhanced Standards for Systemically Important Financial Companies, Including Counterparty Credit Limits

As directed by the Dodd-Frank Act, the Federal Reserve Board has proposed enhanced prudential standards for systemically important backs and non-bank financial companies that pose a grave threat to financial stability. The Dodd-Frank Act tags banks and bank holding companies with $50 billion in assets as subject to enhanced oversight. For hedge funds, private equity funds and other non-bank financial firms, the Act entrusts the Financial Stability Oversight Council with the task of designating the firms for enhanced regulation based on a set of factors.

The prudential standards for covered companies must include enhanced risk-based capital and leverage requirements, enhanced liquidity requirements, enhanced risk management and risk committee requirements, a requirement to submit a resolution plan, single-counterparty credit limits, stress tests, and a debt-to-equity limit for covered financial companies that the Council has determined pose a grave threat to financial stability. Dodd-Frank also requires the Fed to establish a regulatory framework for the early remediation of financial weaknesses of covered financial companies in order to minimize the probability that they will become insolvent and the potential harm of such insolvencies to US financial stability.

In addition to the required standards, the Act authorizes but does not require the Board to establish additional enhanced standards for covered financial firms relating to contingent capital; disclosure; short-term debt limits; and such other prudential standards as the Board determines appropriate. But the Fed decided not to propose any of these supplemental standards at this time.

The single-counterparty credit requirements would limit credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit. Credit exposures to sovereign entities would be subject to the credit exposure limits in the same manner as credit exposures to financial companies.

Interconnectivity among major financial companies poses risks to financial stability. The effects of one large financial company’s failure or near collapse may be transmitted and amplified by the bilateral credit exposures between large, systemically important financial companies. Thus, Dodd-Frank directs the Board to establish single-counterparty credit limits for covered financial companies in order to limit the risks that the failure of any individual company could pose to a financial company.

The Fed proposes a two-tier single counterparty credit limit, with a more stringent limit applied to the largest financial companies. The general limit would be 25 percent of capital stock and surplus and the more stringent limit between major covered financial companies and major counterparties would be 10 percent of capital stock and surplus. They both apply to the aggregate net credit exposure between the covered company and the counterparty.

Credit exposure to a company is defined broadly in Section 165(e) of Dodd-Frank to cover all extensions of credit to the company; all repurchase and reverse repurchase agreements, and securities borrowing and lending transactions, with the company as well as all investments in securities issued by the company and counterparty credit exposure to the company in connection with derivative transactions.

The Fed would allow covered financial companies to reduce their credit exposure to a counterparty for purposes of the limit by obtaining credit risk mitigants such as collateral and credit derivative hedges. The proposal describes the types of eligible collateral and derivative hedges and provides valuation rules for reflecting such credit risk mitigants.

The Fed proposed risk-based capital and leverage requirements that would be implemented in two phases. In the first phase, the financial firms and institutions would be subject to the Board's capital plan rule, which was issued in November 2011, requiring them to develop annual capital plans, conduct stress tests, and maintain adequate capital, including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions. In the second phase, the Board would issue a proposal to implement a risk-based capital surcharge based on the framework and methodology developed by the Basel Committee on Banking Supervision.

The Fed also proposed liquidity requirements that would be implemented in multiple phases. First, financial firms and institutions would be subject to qualitative liquidity risk-management standards generally based on the interagency liquidity risk-management guidance issued in March 2010. These standards would require companies to conduct internal liquidity stress tests and set internal quantitative limits to manage liquidity risk. In the second phase, the Board would issue one or more proposals to implement quantitative liquidity requirements based on the Basel III liquidity rules.

Sound, enterprise-wide risk management by financial companies reduces the likelihood of their material distress or failure and thus promotes financial stability. Thus, the Fed would require all covered financial companies to implement robust enterprise-wide risk management practices that are overseen by a risk committee of the board of directors and chief risk officer with appropriate levels of independence, expertise and stature.

Stress tests of the financial companies would be conducted annually by the Board using three economic and financial market scenarios. The stress tests would be under baseline, adverse, and severely adverse scenarios and financial firms subject to company-run stress test requirements would conduct their own capital adequacy stress tests on an annual or semiannual basis. A summary of the results, including company-specific information, would be made public. In addition, the proposal requires financial companies to conduct one or more company-run stress tests each year and make a summary of their results public.

Dodd-Frank says the Board must require a covered financial firm to maintain a debt-to-equity ratio of no more than 15-to-1, upon a determination by the Council that the firm poses a grave threat to US financial stability and the imposition of such a requirement is necessary to mitigate the risk that the firm poses to financial stability. The Fed proposes to notify a financial company that the Council has made a determination that the company must comply with the 15-to-1 debt-to-equity ratio requirement. The proposal defines the terms “debt” and “equity” for purposes of calculating compliance with the ratio, and provides an affected financial firm with a transition period to come into compliance with the ratio.

The early remediation requirements would be put in place for all financial firms subject to the proposal so that financial weaknesses are addressed at an early stage. The Board is proposing a number of triggers for remediation, such as capital levels, stress test results, and risk-management weaknesses. In some cases, the triggers would be calibrated to be forward-looking. Required actions would vary based on the severity of the situation, noted the Fed, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales.