Federal Reserve Unveils Proposal on Dodd-Frank Enhanced Prudential Standards and Early Remediation Requirements

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Contributed by V. Gerard Comizio, Kevin L. Petrasic, Helen Y. Lee, Erica Berg Brennan
  • Evaluations of a covered company's stress plan include both company-run and supervisory stress tests.
  • The Proposal requires each covered company to form a risk committee and name a chief risk officer.
  • Ongoing compliance with stress test requirements under the Proposal are scheduled to coordinate with capital plan reporting requirements.

On December 20, 2011, the Board of Governors of the Federal Reserve System (FRB) approved proposed rules1 (Proposal) to implement Sections 165 and 166 of the Dodd-Frank Wall Street Reform and Consumer Protection Act2 (Dodd-Frank Act). Section 165 requires FRB to develop enhanced prudential standards to strengthen regulation and supervision of large bank holding companies (BHCs) and systemically important nonbank financial firms designated by the Financial Stability Oversight Council (FSOC). Section 166 calls for early remediation requirements to be established for entities covered by Section 165. The enhanced standards set forth in the Proposal would affect a covered company’s enterprise-wide operations and address risk-based capital and leverage requirements, liquidity standards, requirements for overall risk management (including establishing a risk committee), single-counterparty credit limits, stress test requirements, and a debt-to-equity limit. The Proposal sets forth a number of questions posed by FRB for public comments, which are due March 31, 2012.

Scope of Application

The Proposal applies to all U.S. BHCs with consolidated assets of $50 billion or more3 and any U.S. nonbank financial firm designated by the FSOC for supervision by FRB as a systemically important nonbank entity pursuant to the FSOC’s authority and procedures set forth under Section 113 of the Dodd-Frank Act. While Section 165 also includes foreign banking organizations that otherwise meet the asset thresholds for U.S. BHCs and are treated as such for purposes of the Bank Holding Company Act of 1956, as amended (BHCA),4 as well as any foreign nonbank financial firm that otherwise meets the standards for designation by the FSOC as a systemically important nonbank entity, these foreign entities are notably not included in the Proposal.5 The Proposal does apply to a U.S.-based BHC subsidiary of a foreign banking organization that, on its own, has total consolidated assets of $50 billion or more.6 Moreover, the Proposal generally does not apply to savings and loan holding companies (SLHCs), except certain stress test requirements.7 FRB indicated in the Proposal that it intends to issue separate guidance that would apply the enhanced standards to foreign entities that are otherwise covered under sections 165 and 166 of the Dodd-Frank Act and to address the applicability of the enhanced standards to SLHCs.8

Risk-Based Capital Requirements and Leverage Limits

The first set of enhanced prudential standards discussed in the Proposal address risk-based capital and leverage standards. FRB’s proposal implements these standards in two parts. First, all covered BHCs and nonbank financial companies would be subject to FRB’s recently adopted capital plan rule under Regulation Y, which currently requires all BHCs with $50 billion or more in consolidated assets to submit an annual capital plan to FRB for review.9 Covered companies would be required to demonstrate that they have robust, forward-looking capital planning processes that account for their unique risks and that permit continued operations during times of economic and financial stress.10 The Proposal would extend the capital plan rule to nonbank financial companies that the FSOC has determined to be systemically important. Pursuant to the capital plan, covered companies would be required to demonstrate their ability to maintain capital above existing minimum regulatory capital ratios and above a tier 1 common ratio of five percent under both expected and stressed conditions over a minimum nine-quarter planning horizon.11 In addition, covered companies would be expected to integrate the results of their own company-run stress tests.12 Both company-run stress tests as well as the annual supervisory stress tests conducted by FRB would then be considered in FRB’s evaluation of a covered company’s stress plan.13 Covered companies with unsatisfactory capital plans would face restrictions on their ability to make capital distributions under the proposal, consistent with the capital plan rule.14 The second part of FRB’s approach would be implemented through a quantitative risk-based capital surcharge. Rather than craft its own surcharge rule, however, FRB plans to issue a separate, future proposal to implement the surcharge provision derived largely from the Basel III regulatory capital regime for internationally active banks and the Basel Committee on Banking Supervision’s (Basel Committee) separate framework setting forth additional capital requirements for global systemically important banks (G-SIBs).15 What remains unclear from this proposal is whether FRB will apply the capital surcharge component only to those institutions that are deemed to be G-SIBs by the Basel Committee or whether the eventual requirement will apply to all covered companies with consolidated assets exceeding $50 billion. FRB expects to issue final implementing rules on capital surcharges in 2014, following the completion of the Basel Committee’s work, and require G-SIBs to meet the capital surcharge requirement on a phased-in basis from 2016-2019.16

Liquidity Requirements

Under the proposed liquidity requirements, covered companies would be subject to higher liquidity risk management standards than currently in place.17 These would include liquidity stress testing, cash flow projections, a liquidity buffer, planning for contingency funding, liquidity risk limits, and monitoring and documenting compliance. Internal liquidity stress testing would be required at least monthly to measure a covered company’s liquidity needs at 30-day, 90-day, and one-year intervals during times of instability in the financial markets.18 Companies would have to hold liquid assets sufficient to cover 30-day stressed net cash outflows under internal stress scenarios.19 Covered companies would also have to produce comprehensive projections forecasting cash flows over short-term and long-term timeframes appropriate to the covered company’s capital structure, risk profile, complexity, activities, size, and other risk factors.20 In addition, covered companies would have to establish internal limits on certain liquidity metrics, including a “liquidity buffer” of unencumbered and highly liquid assets sufficient to meet projected net cash outflows and projected losses or impairments of existing funding sources for 30 days over a range of liquidity stress scenarios.21 Another set of liquidity metrics would require a covered company to establish and maintain specific limits for three specified sources of liquidity risk: (i) funding concentrations based on instrument and counterparty type, secured and unsecured funding, and other liquidity risk identifiers; (ii) amount of specified liabilities maturing within various time horizons; and (iii) off-balance sheet and similar exposures that could adversely affect funding during liquidity stress events.22 There would also be a requirement to maintain a contingency funding plan (CFP) identifying potential sources of liquidity strain and alternative sources of funding when usual sources of liquidity are unavailable.23 Pursuant to the CFP, covered companies would implement policies, procedures, and action plans for managing liquidity stress events. The CFP would include four components: (i) a quantitative assessment; (ii) an event management process; (iii) monitoring requirements; and (iv) testing requirements.24 These would be designed to enable companies to respond to a liquidity crisis by identifying alternate liquidity sources available during liquidity stress events, and steps to ensure sufficient sources of liquidity to fund operating costs and meet outstanding commitments while minimizing costs and disruption.25 The remaining components of the liquidity requirements would impose monitoring and documentation requirements on covered companies.26

Single-Counterparty Credit Limits

Another important aspect of FRB's proposal involves establishing “single-counterparty” credit limits for covered companies in order to limit the risk that the failure of any one company could pose to a covered company. The Proposal includes a two-tiered single-counterparty credit limit that is applied based on the consolidated assets of a covered company.27 The Proposal would generally prohibit a covered company from having a credit exposure to any unaffiliated company exceeding 25 percent of the covered company’s capital stock and surplus.28 However, the limit would be 10 percent of capital stock and surplus for credit exposures between a “major covered company” and a “major counterparty” where both companies are either BHCs with total consolidated assets greater than $500 billion and/or nonbank covered companies (including a foreign banking organization treated as a BHC).29 A “counterparty” would include a natural person, company, and state, federal or foreign sovereign entity.30 “Credit exposure” is defined broadly under the proposal to include a broad range of transactions with a counterparty, including extensions of credit, securities lending or securities borrowing transactions, repurchase and reverse repurchase agreements, guarantees and letters of credit issued on behalf of a company, counterparty credit exposure in connection with derivative transactions, and any other similar transaction FRB determines to be a credit exposure under the rule.31

Risk Management and Risk Committee Requirements

Pursuant to the Dodd-Frank Act Section 165(h), FRB is required to issue regulations requiring each publicly-traded nonbank covered company and publicly-traded BHC with over $10 billion in assets to establish a risk committee.32 The Proposal mandates the committee must be chaired by an independent director, have at least one member with risk management expertise, and be responsible for oversight of enterprise-wide risk management.33 The requirement would also apply to publicly-traded BHCs with total consolidated assets of over $10 billion that are not covered companies,34 representing an additional regulatory burden for smaller publicly-traded banks (with assets of more than $10 billion but less than $50 billion) that is reflected in certain other aspects of the Proposal.35 Covered companies would also be required to employ a chief risk officer (CRO) who will implement enterprise-wide risk management practices and report to the risk committee and CEO.36 The risk committee would be responsible for overseeing a covered company’s enterprise-wide risk management framework, including: (i) risk limitations appropriate to each business line of the company; (ii) appropriate policies and procedures for risk management governance, practices, and infrastructure; (iii) processes and systems for identifying and reporting risks; (iv) monitoring compliance and implementing timely corrective actions; and (v) integrating risk management and control objectives with management’s goals and the company’s compensation structure.37 CRO oversight would involve: (i) allocating and monitoring compliance with delegated risk limits; (ii) establishing appropriate policies and procedures for risk management governance, practices, and controls; (iii) developing processes and systems for identifying and reporting risks; (iv) monitoring and testing these controls; and (v) ensuring risk management issues are effectively resolved in a timely manner.38

Stress Testing Requirements

Pursuant to the Dodd-Frank Act Section 165(i), the Proposal requires FRB to conduct annual analyses of the financial condition of covered companies to evaluate the potential effect of adverse economic and financial market conditions on the capital of those companies.39 Covered companies would also have to conduct their own internal semi-annual stress tests; and financial companies with total consolidated assets of more than $10 billion and for which FRB is the primary federal financial regulator would have to conduct internal stress tests annually.40 FRB-conducted annual stress tests would be based on a minimum of three different sets of economic and financial conditions, including baseline, adverse, and severely adverse scenarios, under which FRB would conduct its annual analysis.41 Companies would be required to provide data and other information to enable FRB to estimate net income, losses, and pro forma capital levels and ratios for each scenario.42 A company would also be required to take the results of FRB's stress test into account in making changes to the company’s capital structure; its exposures, concentrations, and risk positions; and related areas, including updating its Dodd-Frank Act resolution plan.43 Company-run stress tests would supplement and complement FRB’s supervisory stress tests, utilizing the same three scenarios (baseline, adverse, and severely adverse) as used in the supervisory stress test.44 Each company would be required to calculate, for each quarter end within the planning horizon, potential losses, pre-provision revenues, allowance for loan losses, and future pro forma capital positions over the planning horizon, including the impact on capital levels and ratios.45 FRB expects to collect the company-run stress tests and other information on a confidential basis and analyze each company’s stress test processes and results.46 However, each company subject to the rule would be required to publish a summary of the results.47

Debt-to-Equity Limits for Certain Covered Companies

Under the Dodd-Frank Act Section 165(j), a covered company must maintain a debt-to-equity ratio of no more than 15-to-1 if the FSOC determines—based on various criteria—that (i) the company poses a grave threat to the financial stability of the United States and (ii) that the imposition of such a requirement is necessary to mitigate such risk.48 Pursuant to the Proposal, an identified company would have 180 calendar days to comply upon receipt of notice that it is subject to the 15-to-1 ratio requirement.49 A company could request an extension of time to comply with the requirement for up to two additional periods of 90 days each.50

Early Remediation Framework

In order to address the inability of the existing prompt corrective action framework to deal promptly with emerging problems, Dodd-Frank Act Section 166 requires FRB to (i) define measures regarding a covered company’s financial condition that would trigger remediation; and (ii) mandate requirements that would increase the severity of remedial actions as the financial condition of a company deteriorates.51 The Proposal establishes four levels of remediation and the triggers and remediation actions that are associated with those levels: (i) heighted supervisory review; (ii) initial remediation; (iii) recovery; and (iv) recommended resolution.52 The triggers comprise regulatory and forward-looking triggers based on supervisory stress tests, liquidity requirements, risk management standards and market indicators.53 Market indicators are designed to capture idiosyncratic and systematic risks across covered companies and can serve as effective early warning triggers.54 Market-based indicators, however, have the potential to trigger remediation for companies that have no weaknesses and may not trigger remediation for companies in need of remedial action.55 Thus, FRB is proposing to use these triggers only for level 1 remediation at this time.56 FRB is seeking comment on the types of indicators used, which include equity-based indicators like expected default frequency, marginal expected shortfall, market equity ratios and option-implied volatility; and debt-based indicators, like credit default swap usage and subordinated debt spreads.57

Transition Arrangements and Ongoing Compliance

FRB has proposed a phase-in period for compliance in order to reduce the burdens faced by covered companies.58 For those companies deemed covered companies on the effective date of the final rule, the enhanced standards are applicable beginning on the first day of the fifth quarter following the effective date of the final rule.59 Any company that becomes a covered company after the effective date of the final rule is subject to the enhanced standard beginning on the first day of the fifth quarter following the date it became a covered company.60 For ongoing compliance, FRB has proposed that the stress test requirement for covered companies is timed to coordinate with the reporting requirements associated with the capital plan.61 This timing is designed to minimize overlap with the resolution plan update requirements.62

Reservation of Authority

The Proposal includes a provision that would allow FRB to require any covered company to hold additional capital or be subject to other requirements or restrictions if it determines that existing requirements would not sufficiently mitigate risks to U.S. financial stability posed by the failure or material financial distress of the covered company.63 These further enhanced prudential standards could include liquidity requirements, activity limits, or other requirements or restrictions that FRB may deem necessary to carry out the purposes of the rule or Dodd-Frank Act section 165.64 The proposed reservation of authority provision would also permit FRB to apply one or more of the enhanced prudential standards to a BHC with less than $50 billion in consolidated assets based on risk related factors that FRB deems appropriate, as necessary, to mitigate risks to the stability of the U.S. financial system.65


BHCs and nonbank financial firms covered by the Proposal should undertake a comprehensive review of their programs and operating policies that would be affected to assess the overall impact of the new requirements and, most immediately, the steps that would have to be taken to come into compliance with such requirements. As with any new regulatory compliance requirement, an important challenge is to understand the nature of the underlying vulnerabilities of the existing programs and potential risks to the banking entity’s ongoing operations, policies, and programs. V. Gerard Comizio is the chair of the Global Banking and Payment Systems practice of Paul Hastings and is resident in the Washington, D.C. office. He is a leading authority on banking and financial services matters. He has extensive experience in representing a wide range of both domestic and foreign bank, thrift, mortgage, industrial loan banks, trust and fiduciary, consumer and specialty lenders, and financial services companies.Kevin L. Petrasic is a partner in the Global Banking and Payment Systems practice of Paul Hastings and is resident in the Washington, D.C. office. He advises banks and financial services firms on a wide array of regulatory, legislative, transactional and compliance issues. His practice area includes Dodd-Frank compliance, bank/thrift and holding company regulation, credit card and consumer financial compliance laws, UDAP issues, privacy and data breach, compliance laws impacting payments systems, mergers and acquisitions and other specialized transactions, bank/thrift powers and activities, legislative matters and analysis, mortgage market regulation, and corporate governance.Helen Y. Lee is an associate in the Global Banking and Payment Systems practice of Paul Hastings and is resident in the Washington, D.C. office. Ms. Lee's practice encompasses both securities and bank regulatory matters involving banking institutions. Her experience has included assisting both foreign and domestic banking institutions with a broad range of issues involving federal and state banking laws, as well as the federal securities laws for publicly traded U.S. holding companies of banking institutions.Erica Berg Brennan is an of counsel in the Corporate practice of Paul Hastings and is based in the firm's Washington, DC office. Ms. Brennan focuses her practice on financial service clients, representing such clients in various corporate transactions and consulting clients with respect to corporate governance and regulatory compliance. She also has experience working with financial institutions and other companies in payment system matters involving money transmission, stored value cards and ACH transactions.Michael Hertzberg is an associate in the firm's Global Banking and Payment Systems practice, resident in the Washington, D.C. office. He advises banks, thrifts, and financial holding companies on a broad range of regulatory, transactional, and compliance issues arising under federal and state law.Amanda Jabour is an associate in the firm's Global Banking and Payment Systems practice, resident in the Washington, D.C. office. She advises banks, thrifts, and financial holding companies on a broad range of regulatory, transactional, and compliance issues arising under federal and state law. Her primary practice areas include Dodd-Frank Act compliance and corporate governance and authority, as well as consumer financial protection.DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

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