May 21, 2015

Confronting Systemic Risk: Enhanced Standards for Foreign Banks

Foreign banks have been operating in the United States for more than 100 years, providing international transactional expertise as well as borrowing, investment, and savings opportunities for millions of U.S. businesses and households. The nearly 200 foreign banks currently active in the United States also provide tens of thousands of American jobs. For the last several decades, these institutions – generally known as foreign banking organizations (FBOs) – have been regulated differently than their domestic counterparts, most of which operate within a bank holding company (BHC) structure. Both the regulation of BHCs and FBOs alike were forever changed as a result of the global financial crisis. 

In the aftermath of the crisis, the Dodd-Frank Act and related regulatory reforms addressed the mitigation of systemic risk – that is, the risk that certain institutions and activities impose on the stability of the financial system. Title I of the Dodd-Frank Act, in particular, created a regime of enhanced prudential standards aimed not simply at improving the safety and soundness of individual financial institutions, but also at mitigating the risk such institutions impose on the overall stability of the U.S. financial system. The Board of Governors of the Federal Reserve System (Federal Reserve) and other banking regulators initially focused on formulating such standards for the largest U.S. BHCs. 

During the past year, however, the Federal Reserve also introduced enhanced prudential standards for FBOs – a move that some contend is aggressive and fear may be reciprocated by foreign regulators supervising U.S. banks operating abroad. For its part, the Federal Reserve believes its new standards reflect a measured approach consistent with recent U.S. banking history, including the events of the financial crisis. 

FBOs during the Financial Crisis 

According to the Federal Reserve, the role of FBOs in the U.S. financial system has shifted substantially over the last 15 years or so, from primarily extending credit to U.S. borrowers and holding U.S.-based assets, to issuing short-term obligations and using the funding to finance operations and extend credit outside the United States. In other words, FBOs traditionally used funds raised overseas to lend into the United States, but now are increasingly borrowing from within the United States and sending the funds overseas.

During the financial crisis, many U.S. and non-U.S. financial institutions had difficulty rolling over their short-term obligations. Many FBOs that were unable or unwilling to provide external support to their U.S. operations became substantial borrowers from the Federal Reserve discount window and from other government-supported liquidity facilities. A number of commentators criticized the use of government funds for purposes of “bailing out” these foreign banks. To prevent a recurrence, the Federal Reserve has determined that it is necessary that FBOs hold sufficient capital in the United States and observe other requirements and limitations to ensure that their U.S. operations can withstand a period of financial distress on a stand-alone basis.

The Federal Reserve’s Final Rule

Aimed at reducing systemic risk, Section 165 of the Dodd-Frank Act directs the Federal Reserve to adopt enhanced prudential standards for BHCs that have $50 billion or more of consolidated assets. These standards must be more stringent than those applicable to financial institutions that do not present similar risks to U.S. financial stability, and they must increase in stringency based on the nature of the activities and features (such as the size, scale, and interconnectedness) of each covered institution. 

Section 165 vests similar authority in the Federal Reserve to supervise FBOs with $50 billion or more of globally consolidated assets. To that end, the Federal Reserve recently issued a final rule specifically requiring those FBOs to comply with a host of enhanced prudential standards, including the following:

  • risk-based capital and leverage capital ratios;
  • capital plan submissions;
  • risk-management requirements;
  • liquidity provisioning;
  • supervisory and self-applied stress testing requirements; and
  • debt-to-equity requirements imposed in extreme circumstances. 

In addition, as its centerpiece, the final rule requires each FBO with a substantial presence in the United States – generally an institution with $50 billion or more in non-branch U.S. assets – to establish an intermediate holding company (IHC) to hold its U.S.-based banking and nonbanking subsidiaries. An IHC will be subject to supervision by the Federal Reserve and must comply with risk-based capital, leverage, liquidity, and other requirements and restrictions on substantially the same terms as apply to U.S. BHCs. In taking this controversial step, the Federal Reserve believes that the result will be that FBOs will hold sufficient capital and liquidity to fund their domestic operations without relying on resources outside the United States (or, in a crisis, on the U.S. government). The Federal Reserve has estimated that 15 to 20 FBOs will be required to establish an IHC. The requirements mandated by the final rule are expected to be fully implemented within the next several years. 

Risk-Based Capital and Leverage Ratios 

Capital is vital to ensuring that a bank remains financially solvent. Capital provides a cushion against losses and a debt-free means of funding operations. Hence, enhanced capital requirements were a cornerstone of the Dodd-Frank Act and other recent regulatory developments such as international capital accords, commonly referred to as Basel III.

Not all capital is equal in terms of its resilience and capacity for loss absorption. Historically, regulators have distinguished between higher quality “Tier 1” capital and lower quality “Tier 2” capital, with the highest form of Tier 1 capital being common equity. Furthermore, capital requirements come in two basic forms: (1) risked-based ratios and (2) leverage ratios. The former permits the amount of capital that is held against assets to be adjusted based upon the riskiness of the assets, while the latter generally applies a uniform ratio based on an institution’s total assets regardless of individual assets’ risk profiles. In the wake of the financial crisis, regulators such as the Federal Reserve have favored applying both types of capital requirements simultaneously.

Because FBOs are by definition headquartered outside the United States, the Federal Reserve cannot apply capital and leverage requirements to the entire foreign institution. Nor can it practically apply those requirements to an FBO’s U.S. branches and agencies, which are largely indistinguishable from the parent institution for legal and accounting purposes. Consequently, in order to apply uniform capital requirements to U.S. BHCs and FBOs alike, the Federal Reserve is requiring each FBO with a substantial U.S. presence to establish an IHC, which is a separate legal entity that is controlled by the FBO and is designed to contain most of its non-branch operations in the United States. Once in place, an IHC will be subject to significant capital requirements just as a domestic BHC is.

More specifically, under the final rule and the Federal Reserve’s general risk-based and leverage capital rules incorporated thereby, an IHC is required to maintain the following minimum ratios:

  • Tier 1 common equity to risk-based assets of 4.5%;
  • Tier 1 capital to risk-based assets of 6%;
  • Total (Tier 1 and Tier 2) capital to risk-based assets of 8%; and
  • Tier 1 capital to total assets (leverage ratio) of 4%. 

In order to avoid limitations on capital distributions and discretionary bonus payments to its executive officers, an IHC also must maintain:

  • a capital conservation buffer, consisting of additional Tier 1 common equity in an amount greater than 2.5% of risk-based assets. 

In addition, an IHC that would qualify as an advanced approach financial institution must maintain:

  • a minimum supplementary leverage ratio of 3%, which takes into account off-balance sheet exposures; and
  • a countercyclical capital buffer during periods of excessive credit growth, consisting of Tier 1 common equity in an amount up to 2.5% of risk-based assets.

Capital Plan Submissions 

A related requirement addresses the submission of capital plans. Any FBO required to form an IHC must submit a detailed plan demonstrating the IHC’s ability to meet all applicable minimum risk-based capital requirements under both baseline and stressed conditions over a minimum period of nine calendar quarters. An IHC that does not meet these requirements may not make any capital distributions except as permitted by the Federal Reserve. While the ultimate parent of an FBO is expected to provide capital support to its IHC – such as through guarantees and keepwell agreements – an IHC may not rely on such agreements as sources of capital in demonstrating its ability to meet its minimum capital requirements. 

Risk Management Requirements 

The final rule goes beyond financial ratios and plans and also addresses personnel and risk management processes within FBOs. For the roughly 15–20 FBOs required to establish an IHC, each must establish a risk management committee and appoint a chief risk officer for the IHC, both charged with responsibility to develop a risk management program meeting various specific requirements set forth in the final rule. 

The U.S. risk committee must have:

  • at least one member with experience in identifying, assessing, and managing the risk exposure of a large and complex financial firm; and
  • at least one independent member. 

The U.S. chief risk officer must:

  • serve as a single point of contact for the Federal Reserve; and
  • be located in the United States and employed by a U.S. entity.

Even if an FBO is not required to form an IHC, it must nonetheless satisfy certain risk management criteria of the final rule. Although the FBO need not have a U.S. chief risk officer and may rely on the parent institution’s risk management committee to oversee U.S. operations, it must:

  • certify to the Federal Reserve on an annual basis that it maintains a U.S. risk committee of its board of directors (or equivalent home country governance structure) that oversees the risk management policies of its combined U.S. operations;
  • certify that the U.S. risk committee has at least one member with experience in identifying, assessing, and managing the risk exposures of a large and complex firm; and
  • take measures to ensure that its combined U.S. operations implement the policies of the U.S. risk committee and report sufficient information to enable the committee to discharge its responsibilities.

Liquidity Provisioning 

An important corollary to capital in managing bank operations is liquidity. While the purpose of capital is to ensure that a bank remains solvent and can weather losses, the purpose of liquidity is to ensure that a bank can pay its bills day-to-day and maintain its operations. Liquidity is a measure of the ability of an institution to meet its current obligations; for example, customers withdrawing their deposits. Stated differently, liquidity represents how much cash or cash equivalents a bank has available to it relative to its short-term needs for such assets. Large domestic BHCs are required to maintain sufficient liquidity “buffers” against potential cash needs for a certain period of time in the future. Going forward, FBOs will face similar requirements.

Under the Federal Reserve’s final rule, an FBO must establish a liquidity-management program covering all U.S. operations and must appoint an officer responsible for implementing the program. It must calculate liquidity requirements on a daily basis for its IHC, if one exists, and its U.S. branches and agencies, and maintain the following liquidity buffers:

  • an IHC must maintain a buffer of high quality liquid assets to cover 30 days of net liquidity needs; and
  • U.S. branches and agencies must maintain a buffer to cover 14 days of net liquidity needs. 

An FBO must conduct liquidity stress tests at least monthly for its combined U.S. operations, including its U.S. branches and agencies, and its IHC, if one exists. At least annually, an FBO’s U.S. risk committee must review and approve strategies, policies, and procedures that are designed to determine whether the tolerance of its U.S. operations for liquidity risk is appropriate to the nature of those operations and to their role in the U.S. financial system. And for those FBOs with IHCs, the U.S. chief risk officer must review at least quarterly internal reports describing the liquidity risk profile of the combined U.S. operations.

Stress Testing Requirements

Stress testing has been a key feature of prudential supervision in the aftermath of the financial crisis. As noted above, stress testing can be used for liquidity provisioning, but its more common purpose is to estimate the amount of capital a bank should hold to address certain identified events. At bottom, a stress test is simply a simulation exercise in which a regulator assumes various market conditions as well as events specific to the institution being tested come to pass, and asks how the institution’s financial condition would be affected. If a bank’s assets are assumed or found by the workings of the model to decline sharply in value while its liabilities remain constant or possibly increase, then the bank’s capital base would take a hit. Too large a hit may prompt the regulator to require the bank to maintain capital at levels higher than the compulsory ratios detailed above. 

Under the final rule, any FBO required to establish an IHC is subject to the same annual and semi-annual stress testing and related reporting and disclosure requirements for its IHC as the Federal Reserve adopted in 2012 for large BHCs generally. This includes an annual company-run stress test applying scenarios supplied by the Federal Reserve and a second company-run stress test conducted at mid-cycle applying scenarios developed by the IHC. The IHC must then publicly disclose a summary of the results of the annual stress test under the severely adverse scenario, and must also disclose a summary of the results of the mid-cycle stress test, regardless whether the IHC is publicly traded. In addition, certain stress testing requirements apply to those FBOs not required to establish an IHC.

Debt-to-Equity Limits for “Grave Threats”

As a kind of “nuclear option” aimed at mitigating the systemic risk of one or more specific FBOs, the final rule establishes a process for the Financial Stability Oversight Council – a body comprising the heads of the various U.S. financial regulatory agencies and chaired by the Treasury Secretary – to determine whether a given FBO poses a “grave threat” to U.S. financial stability. If that determination is made, then the Federal Reserve is required to impose a debt-to-equity limit on the designated FBO’s IHC (if any) or its U.S. subsidiaries, consisting of a ratio of total liabilities to total equity capital less goodwill of not more than 15:1. Such a limit is the equivalent of an ultra-conservative version of the leverage ratio, and essentially mirrors the authority available to the Financial Stability Oversight Council vis-à-vis U.S. BHCs.

Potential Impact of the Enhanced Standards

In sum, the final rule requires certain FBOs to maintain substantial financial resources in the United States on a permanent basis, rather than relying on the non-U.S. parents to be the predominant source of financial strength for the U.S. operations. FBOs now face the prospect of increased capital and liquidity requirements, reduced lending capacity, and increased operating and compliance costs in the United States. Some FBOs may also be required to engage in substantial restructuring in order to place all of their U.S. banking and nonbanking subsidiaries under an IHC and may incur significant operating expenses and tax liabilities in the process. Capital held in an IHC may not be available to support other global operations, which may increase an FBO’s overall financing costs. Furthermore, U.S. branches and agencies of FBOs, while remaining outside any IHC structure, will face heightened liquidity standards nonetheless.

To be sure, the Federal Reserve is not blind to the costs and difficulties that the final rule may impose on FBOs. During the rulemaking process, foreign banks were not shy in voicing their opposition to a number of the new requirements and explaining the economic impact on their U.S. operations. Indeed, central banks and supervisory authorities in several countries commented on various proposed requirements, lodging a number of objections which the Federal Reserve took into account in the final rule. In the end, however, the Federal Reserve believes that confronting the purported systemic risk posed by FBOs justifies what can only be described as a fundamental change in the supervision of foreign banks operating in the United States.