The Federal Reserve’s Proposed Enhanced Prudential Standards for Foreign Banks Explored

Richard Coffman, General Counsel, 
Institute of International Bankers

Barbara R. Mendelson, Partner, 
Morrison & Foerster

Hugh C. Kelly, Principal and National Lead, Bank Regulatory Advisory Group, 
KPMG LLP

Fed Concerns Regarding FBOs Arising from the Financial Crisis

• Shift from “lending branch” to “funding branch” model
• Over reliance on short-term USD wholesale funding with corresponding maturity mismatches
  • Need for US liquidity support

• Fed, as host country regulator, has limited visibility into FBOs’ total risk profiles, risk management capabilities and strategy
• Increased concentration, interconnectedness and complexity
  • Expansion into capital markets – 5 of top 10 broker-dealers are FBO-owned

• Resolution aspects – the location of capital and liquidity is critical as resolution regimes remain nationally based and pre-crisis home/host supervisory arrangements (ie, MOUs) were found to be lacking

The Existing US Regulatory Framework Applicable to FBOs

• Flexibility to operate through multiple structures
  • Branches, agencies, insured depository institution subsidiaries and bank holding companies, broker-dealers and other nonbank financial companies with or without intermediate US holding companies

• Fed with umbrella oversight of all FBO US operations regardless of degree of consolidation
• Fed’s application of SR 08-09 to FBO’s led to inconsistent implementation of the “virtual bank holding company” concept
• Roles and authorities of multiple functional regulators
• Reliance on home country consolidated oversight in accordance with international standards

Statutory Requirements of Section 165 – Enhanced Prudential Standards

• Statutory Purpose (Section 165(a)(1))
  • “prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities of large, interconnected financial institutions”

• The Statutory Solution (Section 165(a)(1))
  • Application by the Fed of prescribed enhanced prudential standards to “bank holding companies with total consolidated assets equal to or greater than $50,000,000” (where “bank holding company” is defined to include FBOs that own US banks as well as FBOs that do not own a US bank but operate US branches/agencies)

• Mandatory requirements (Section 165(b)(1)(A))
  • risk-based capital and leverage limits
  • liquidity requirements
  • overall risk management requirements
  • resolution plan and credit exposure report requirements
  • concentration limits

• Also: stress testing (Section 165(i)) – supervisory and company-run
• debt-to-equity limits (Section 165(j))

• Discretionary requirements (Section 165(b)(1)(B))
  • contingent capital
  • enhanced public disclosures
  • short-term debt limits
  • “such other prudential standards as the [Fed], on its own, or pursuant to a recommendation by [FSOC], determines are appropriate”

The Statutory Approach

• Section 165(a)(1)(B) – degree of stringency of standards to increase based on a variety of factors
• Section 165(a)(2)(A) – “differentiate among [covered] companies on an individual basis or by category, taking into consideration their capital structure, riskiness, complexity, financial activities (including the financial activities of their subsidiaries), size and any other risk-related factor that the [Fed] deems appropriate”
• Specific directives regarding standards for foreign financial companies
  • Section 165(b)(2)(A) – “give due regard to the principle of national treatment and equality of competitive opportunity”
  • Section 165(b)(2)(B) – “take into account the extent to which the foreign financial company is subject on a consolidated basis to home country standards that are comparable to those applied to financial companies in the United States”

Consequences of Failure To Abide by Standards – Early Remediation Requirements of Section 166

• Statutory Purpose (Section 166(b))
  • “establish a series of specific remedial actions to be taken by [a covered company] that is experiencing increasing financial distress, in order to minimize the probability that the company will become insolvent and the potential harm of such insolvency to the financial stability of the United States”

• Remediation Requirements (Section 166(c))
  • Fed to define measures of a company’s financial condition, “including regulatory capital, liquidity measures, and other forward-looking indicators”
  • Remedial actions to increase in stringency as the financial condition of the covered company deteriorates
    • Initial stages – limits on capital distributions, acquisitions and asset growth
    • Later stages – capital restoration plan and capital raising requirements, limits on transactions with affiliates, management changes, asset sales

Proposed Implementation of Sections 165 and 166 for Large FBOs 

• In the interest of time, concentrate on the most significant aspects of the proposal
  • The Intermediate Holding Company (IHC) Requirement
  • Risk-Based Capital and Leverage Limits
    • IHCs
    • FBOs Themselves

• Liquidity Measures
  • IHCs
  • FBOs Themselves

• Risk management requirements for FBOs with larger US footprint (Section 165(h) of the Dodd-Frank Act)
  • Required oversight of enterprise-wide risk management for the combined U.S. operations of the FBO by a Chief Risk Officer and a risk committee
  • Risk committee can be a committee of the global board of directors (stand alone or part of the FBOs enterprise wide risk management) or a committee of the IHC board of directors
  • U.S. Chief Risk Officer must be employed by a U.S. subsidiary or office of the FBO
  • FBOs will have to implement and coordinate the U.S. risk management with its global risk governance, management and control infrastructure

• Single Counterparty Credit Limits
  • IHCs
  • FBOs Themselves

• Early Remediation

Policy Implications

• National treatment/equality of competitive opportunity and home country standards (Section 165(b)(2)(A) and (B) of the Dodd-Frank Act) :
  • Mandate of Dodd-Frank Act to give due regard to national treatment and equality of competitive opportunity and take into account the extent to which the foreign financial institution is subject on a consolidated basis to home country standards that are comparable to U.S. standards

• Tailoring – one size does not fit all (Section 165(a)(2)(A) of the Dodd-Frank Act)
• Proposed rules do not differentiate sufficiently among companies on an individual basis or by category when prescribing more stringent prudential standards under Section 165
• Tailored approach should consider an FBO’s capital structure, risk to the U.S. financial system, complexity, financial activities, size and other risk-related factors
  • Proposed rules would apply to over 100 FBOs, most of them with only a limited footprint in the United States (and without being a risk to the U.S. financial system)
  • Tailored measures should address the specific risks of an FBO to the U.S. financial system and not an FBO’s general risks

• Early remediation triggers (Section 166 of the Dodd-Frank Act)
  • General impact of U.S. regulatory action on home country remediation/resolution – necessity for coordination and cooperation between U.S. regulators and home country regulators
  • Ring-fencing contrary to global development
  • Application of the early remediation triggers as of January 1, 2015, whereas Basel III will not take fully effect until January 1, 2019

Overview of Comments

• Foreign Government and Regulatory Authorities
• Trade Associations
• Individual Banks
• Others