ViewPoint: Spotlight: A Dodd-Frank Milestone: Enhanced Prudential Standards Adopted

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On February 18, 2014, the Federal Reserve Board approved a rule requiring enhanced supervisory standards for capital, liquidity, and risk management for U.S. bank holding companies with $50 billion or more in total consolidated assets and for foreign banking organizations with $50 billion or more in non-branch U.S. assets.

This action marks a milestone in the implementation of Dodd-Frank's Section 165 framework for managing and reducing the systemic risk posed by large banking firms. The requirements in the final rule will aid in improving the resiliency of these firms and provide a level playing field for all banking firms operating in the United States. Domestic bank holding companies (BHCs) have until January 1, 2015, to comply with the enhanced standards. Foreign banking organizations have an extended period in which to comply, beginning on July 1, 2016.

Enhanced requirements for U.S. bank holding companies
For U.S. BHCs that are subject to the enhanced standards, the rule incorporates earlier requirements for capital planning and stress testing. These companies must also comply with enhanced liquidity-management and risk-management standards.

Liquidity requirements: The enhanced liquidity risk-management standards cover the responsibilities of the board of directors, including establishing a risk tolerance, reviewing compliance with the risk tolerance and approving and reviewing strategies, policies, and procedures designed to manage liquidity risk. Risk committees are required to approve and review the contingency funding plan and any changes prior to implementation. Senior management is responsible for establishing policies and procedures to insure proper assessment and management of liquidity risk for existing business lines as well as proposed new business. In addition to board of directors, risk committee, and management oversight, an independent review function must also be in place to evaluate the liquidity-risk management function on at least an annual basis.

The rule also requires covered firms to conduct liquidity stress tests to assess the impact on cash flow, liquidity position, profitability, and solvency given its current position. Covered firms must maintain a buffer of highly liquid assets based on projected funding needs during the 30-day stress test. These requirements are designed to allow firms to continue to serve as financial intermediaries for households and businesses in times of financial stress.

Risk-management requirements: All BHCs are expected to maintain risk management frameworks appropriate for their size, structure, risk profile, complexity and activities. The enhanced risk-management standards contained in the Federal Reserve's rule are designed to improve the expertise and independence of the risk assessment function. For firms with $50 billion or more in total consolidated assets, the standards require the establishment of an independent enterprise-wide risk management committee, reporting directly to the board of directors, to oversee the BHC's global risk management framework and the appointment of an experienced enterprise-wide chief risk officer. Additional requirements address governance and risk-committee membership. Risk committees must be chaired by an independent director and include at least one member with experience in identifying, assessing, and managing risk exposures of large, complex financial firms.

In keeping with supervisory expectations, Dodd-Frank extends the risk committee requirement to smaller firms. Publicly traded BHCs with total consolidated assets of $10 billion or more are required to establish risk committees that are chaired by an independent director and include at least one member with expertise in risk management of large, complex firms. In contrast to the requirements for larger firms, the expertise requirement for these firms does not specify that the experience encompass risk management of a financial firm.

Enhanced requirements for foreign banking organizations
Dodd-Frank recognizes the increased scope and complexity of foreign banking activities in the United States and extends the requirements for enhanced prudential standards to foreign banking organizations with $50 billion or more in total consolidated worldwide assets. These requirements are scaled based on the size of U.S. operations.

Intermediate holding company requirement: To provide a consistent framework for supervision, firms with $50 billion or more in non-branch U.S. assets are required to establish an intermediate holding company over their U.S. subsidiaries. These intermediate holding companies will generally be subject to the same enhanced standards for risk-based and leveraged capital, risk management, liquidity, and capital planning and stress testing as their U.S. peers. Foreign banking organizations must be in compliance with the intermediate holding company requirement by July 1, 2017.

Risk-based capital and leverage requirements: A foreign banking organization with combined U.S. assets of $50 billion or more must certify to the Board that it meets capital adequacy standards on a consolidated basis as established by its home country supervisor. The standards must be consistent with the Basel capital framework, including risk-based capital ratios, minimum leverage ratios, and restrictions regarding buffers. If the foreign banking organization does not meet these requirements, the Federal Reserve may impose additional requirements and take action to restrict the U.S. operations of the organization. Application of the leverage ratio requirement for foreign owned U.S. intermediate holding companies has been deferred until 2018.

Capital stress testing requirements: Foreign banking organizations with combined U.S. operations of $50 billion or more and a U.S. branch or agency must be subject to a capital stress testing regime, which meets Federal Reserve requirements, on a consolidated basis established by its home country supervisor. Information on the stress testing regime and results will be reported to the Board annually. Organizations not meeting the Board's standards will be subject to additional requirements at its branches, agencies, and U.S. subsidiaries.

Liquidity requirements: The rule includes liquidity risk management, stress testing, and buffer requirements for foreign banks with U.S. operations of $50 billion or more. These requirements focus on ensuring the viability of U.S. operations. Stress tests must separately assess the impact of potential events on the cash flows, liquidity position, profitability, and solvency of the combined U.S. operations as a whole; U.S. branches and agencies in aggregate; and the intermediate U.S. holding company. Foreign banking organizations with $50 billion or more in total U.S. assets must also maintain a liquidity buffer for their intermediate U.S. holding companies along with a separate buffer for branches and agencies, as directed in the rule.

Risk-management requirements: Foreign owned intermediate holding companies will be required to form U.S. risk committees and appoint chief risk officers to oversee combined U.S. operations in the same way as domestic companies.

Requirements for foreign banking organizations with under $50 billion in U.S. assets: The capital, liquidity, and stress-testing requirements are lessened for firms with under $50 billion in U.S. assets. Foreign banking organizations with $10 billion or more in total consolidated assets are subject to Dodd-Frank requirements for internal stress testing and, if publicly traded, are also required to establish risk committees in the same manner as domestic firms.

"Grave threat" requirements
The rule also includes a 15-to-1 debt-to-equity limit for BHCs that the Financial Stability Oversight Council determines pose a grave threat to the financial stability of the United States. Firms must comply with the limit within 180 days. This standard also applies to the U.S. operations of foreign banks. Branches and agencies of foreign banks identified as a grave threat must maintain a buffer of eligible assets of to cover the aggregate liabilities of all branch and agency offices in the United States.

Still to come
The final rule does not include Dodd-Frank's single-counterparty credit limits or early remediation requirements for U.S. or foreign banking organizations, which are still under consideration. The final rule also does not apply to nonbank systemically important financial institutions designated by the Financial Stability Oversight Council. The Board will develop appropriate standards for those institutions following an evaluation of the business model, capital structure, and risk profile of each designated nonbank financial company.

The Board continues to consider additional standards as directed by Dodd-Frank, including three enumerated standards—a contingent capital requirement, enhanced public disclosures, and short-term debt limits. In addition to the specified requirements in Dodd-Frank, Congress gave the Federal Reserve permission to adopt additional prudential standards as appropriate to limit systemic risk. Rules requiring capital buffers for the largest, most interconnected organizations and scaled quantitative liquidity requirements for firms with $50 billion or more in total assets have already been proposed for comment. The Financial Stability Oversight Committee is charged with assessing risks to the financial system and may also recommend additional supervision by the Federal Reserve if deemed necessary.