Six Takeaways on the Federal Reserve’s New Prudential Rules for Foreign Banks
Nearly a year after releasing extensive proposed prudential rules governing large U.S. banking organizations, the Federal Reserve has issued proposed rules that would overhaul the ways in which it would supervise foreign banks organizations (FBOs) operating in the United States. This is a response to the increased risks posed to U.S. financial stability as large, interconnected FBOs have expanded their U.S. activities – from traditional lending to more complex capital market activities – over the last decade. The new proposed rules, as mandated by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), are intended to lower the risks by requiring FBOs to hold capital and liquidity in the U.S. and comply with many of the same proposed regulations that large U.S. banking organizations must follow, creating parity between the two.
The new proposed rules represent a significant change in the Federal Reserve’s supervisory approach to FBOs with U.S. operations. For the last decade, the Federal Reserve’s regulatory framework with regard to FBOs has essentially remained the same, relying heavily on a home country’s supervisor to regulate the FBOs on a consolidated global basis. Additionally, the Federal Reserve depended on both FBOs to support their U.S. operations during normal periods and in times of stress, and federal and state regulators to supervise individual legal entities. But the economic events of 2007 to 2009, and their aftermath, resulted in a re-visit of the Federal Reserve’s supervisory framework and likely highlighted the need to evolve and strengthen the regulatory and supervisory framework for FBOs.
Under the new proposed rules, FBOs with total global assets of $50 billion or more and at least $10 billion in non-branch U.S. assets would be required to organize their U.S. subsidiaries into a single intermediate holding company (IHC). These IHCs would be subject to enhanced prudential standards and early remediation requirements, an approach which is consistent with the rules proposed for large U.S. banking organizations. This means that IHCs would also be subject to a host of requirements, including risk-based capital and leverage, liquidity, risk management and risk committee, single-counterparty credit limits, and stress testing, among other requirements included in the U.S. proposed rules.
Today, there are 107 FBOs that the Federal Reserve estimates would fall under the scope of these new proposed rules. Of these, 23 FBOs have at least $50 billion in U.S. assets and would face a more stringent set of standards consistent with U.S. banking organizations of similar size because of the greater risk they may pose to the U.S. financial system.
The Federal Reserve recognized that a FBO’s U.S. branches and agencies are still part of the parent organization and would not be included in an IHC. However, they would be subject to some enhanced prudential requirements, particularly around liquidity. The rules would also apply to nonbank foreign financial firms, which have yet to be designated by the Financial Stability Oversight Council.
The Federal Reserve is seeking feedback on the proposed rules during the comment period (through March 31, 2013) on the potential application of these proposed rules.
After conducting an initial review of these new proposed rules, we have identified six observations that may be of primary interest to FBO executives charged with guiding their organizations through this new landscape should these become final rules.
The new proposed rules create a unified structure and impose new governance and risk management requirements
The proposed rules would require that large FBOs consolidate their U.S. operations under a single IHC. Under this unified platform, all applicable prudential rules would apply. As a result, the Federal Reserve is likely to apply a more consistent supervisory program across all large FBOs with large U.S. subsidiaries – which may facilitate the resolution of an IHC under certain circumstances.
With the creation of an IHC, foreign banks must create corporate governance and risk management structures and internal controls for managing risk across their U.S. operations. This means that an IHC must form a board of directors or equivalent body to provide a strong, centralized governance framework in the United States. Some IHCs may have to appoint a chief compliance officer or chief risk officer and be subject to additional risk committee requirements. In previously issued guidance in October 2008 and a recent release in December 2012, the Federal Reserve has further strengthened its consolidated supervision framework outlining its expectations for the largest foreign banks to focus on governance, risk management, and resiliency across the U.S. operations. The new guidance compliments the proposed enhanced standards.
The proposed rules may impose more stringent local capital requirements
Under the proposed rules, all U.S. IHCs would be subjected to the same risk-based and capital standards applicable to U.S. bank holding companies (BHCs) to help increase the resiliency of their U.S. operations. Some FBOs will likely have to raise not only more, but higher quality capital or, at a minimum, downstream capital and hold it captive in the U.S. at the IHC level. The implications for FBOs may be far reaching, changing the flow of capital and liquidity for what was previously more of a borderless capital market business. In this regard, some FBOs may need to re-orient their business strategy to account for the potential impact on their return on equity.
Additionally, the rules would require an IHC to conduct capital and liquidity stress testing, similar to U.S. banking organizations, and demonstrate the ability to maintain sufficient available capital to support its operations through periods of economic and financial stress. If an IHC is unable to satisfy the Federal Reserve’s requirements, it would generally not be permitted to pay dividends (or upstream earnings) to the foreign parent.
The Federal Reserve extends its influence over FBO liquidity requirements
The proposed rules set forth liquidity requirements that don’t just extend to the IHC, but also to the branch and agency networks. They are intended to make an FBO’s U.S. operations more resilient to funding shocks during times of stress.
The rule would require FBOs with U.S. consolidated assets of $50 billion to implement and adhere to specific risk management and liquidity risk practices, which include conducting internal liquidity stress tests and maintaining a 30-day liquidity buffer. The IHC would have to hold all 30-days captive at the U.S. IHC. Notably, the FBO’s U.S. branch and agency network would also have to calculate the stress buffer and hold 14 days of the 30-day liquidity buffer in the United States and demonstrate to the Federal Reserve’s satisfaction that the FBO or an affiliate could provide the residual liquidity assets to the U.S. branch and agency, if needed. FBOs with less than $50 billion in U.S. assets would be required to report the results of internal liquidity stress testing results to the Federal Reserve on an annual basis.
The Federal Reserve would also assess whether the home country supervisor conducts stress testing on the FBO and if it is broadly consistent with the U.S. standard. If the stress testing results highlight potential mismatches in funding or the Federal Reserve’s stress testing standards are not met, the Federal Reserve would require significantly more detailed information on the home country’s stress testing standards. The Federal Reserve may potentially also impose asset maintenance on the U.S. branch and agency network, intragroup funding restrictions, or increased local liquidity requirements.
The combination of captive liquidity buffers at both the IHC and the U.S. branch and agency network levels, the analysis of home country stress testing results, and the emphasis on whether the branch and agency network is in a position of funding the parent on a prolonged basis has the potential to significantly reduce the flexibility of some FBOs to manage liquidity on a centralized basis and to increase costs.
The Federal Reserve may have a more dominant role in supervising broker-dealers
Today, five of the top 10 U.S. broker-dealers are owned by FBOs. With the requirement that FBOs organize their U.S. subsidiaries into an IHC, the Federal Reserve, as the holding company supervisor, would effectively gain oversight and play a more significant role in the supervision of these broker-dealers.
The proposed rules include substantial infrastructure, data, and reporting requirements for FBOs
FBOs with consolidated assets of $50 billion or more would be required to provide significantly more detailed information about their U.S. operations than they have in the past. Under the proposed rules, FBOs would have to provide increased reporting for their U.S. IHC and legal entities for risk management and regulatory compliance, including regulations regarding management, financial, risk, stress testing, and capital issues. This requirement is designed to increase transparency into an FBO’s U.S. operations, and is on par with what is already required of domestic institutions. It will likely strengthen oversight and risk management of an FBO’s U.S. activities.
As a result, FBOs will likely need to significantly alter and enhance their infrastructures, processes, and resourcing to comply with the official reporting requirements and provide the level of data granularity that will be required. While they may capture and report data at the global level, now they must also provide more detailed data at the IHC level or even, in some cases, at the subsidiary level. For many FBOs and their U.S. operations, this may result in significant changes in how they build new data collection and management systems, provide automated reporting, and enforce governance, documentation, and data consistency across risk, regulatory, financial, and management reporting.
FBOs will have to become compliant within an aggressive timeline
While the effective date for compliance is more than two years away (July 1, 2015), the deadline may pose a significant challenge for FBOs as they endeavor to meet all the requirements. For example, they would likely need to build the necessary infrastructure to provide the detailed reporting across their U.S. operations. At the same time, they may need to develop new governance and risk management models and meet new capital and liquidity levels. Those are potentially resource-intensive, time consuming initiatives – on any timeline.
There is much more to know about the impact of the proposed new prudential rules on FBOs in the U.S., which bear a detailed examination – especially for those charged with bringing their organizations into compliance. These high-level takeaways attempt to set the context for leaders before they dive into the full set of rules. Deloitte will soon release a more in-depth look at the proposed rules and their implications for FBOs, so stay tuned.
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4 Federal Reserve Board Supervisory Letter SR12-17 issued December 17, 2012
5 While the regulated U.S. subsidiaries of FBOs are already required to meet applicable U.S. capital standards on a standalone basis, the requirement that the IHC meet consolidated U.S. BHC capital requirements is likely to trap additional capital in the U.S. especially for FBOs with extensive non-bank subsidiaries and those with significant goodwill and other intangibles.
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