On March 4, 2016, the Board of Governors of the Federal Reserve System (the "Fed") issued a Notice of Proposed Rulemaking ("NPRM"), inviting comment on reproposed rules (the "Reproposed Rules") that would establish single counterparty credit limits for U.S. bank holding companies ("BHCs") and foreign banking organizations ("FBOs") with at least $50 billion in total consolidated assets.1 Pursuant to section 165(e) ("section 165(e)") of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), the Fed is required to prescribe rules that limit the amount of credit exposure that U.S. BHCs and FBOs can have to an unaffiliated company to reduce the risks that may arise from such a counterparty's sudden failure. In addition to the NPRM, the Fed also issued a white paper (the "White Paper") that provides the analytical and quantitative reasoning for the Reproposed Rules' more stringent 15% limit for credit exposures between systemically important financial institutions ("SIFIs").
The Fed originally proposed single-counterparty credit limits for U.S. BHCs and FBOs in December 2011 and December 2012, respectively (the "Originally Proposed Rules"),2 the Fed has issued the Reproposed Rules to take into consideration: (1) the extensive comments the Fed received in response to the Originally Proposed Rules; (2) the revised lending limit rules applicable to national banks;3 (3) the Basel Committee on Banking Supervision's introduction of large exposures standards;4 and (4) the results of quantitative impact studies and related analysis conducted by the Fed to gauge the impact of the Originally Proposed Rules.5
The Reproposed Rules represent another effort to reduce interconnectedness in the financial system. While the Fed has sought to gauge counterparty credit risk through annual stress testing of large financial institutions,6 the Reproposed Rules would establish hard limits on these exposures. Comments on the NPRM must be submitted to the Fed by June 3, 2016.
This alert is divided into four parts. Part I provides an overview of the general requirements under section 165(e). Part II highlights the requirements of the Reproposed Rules for both U.S. BHCs and FBOs. Part III provides a brief overview of the White Paper and discusses the Fed's justification for more stringent counterparty risk exposure requirements for SIFIs. Lastly, Part IV provides a chart summarizing several of the key requirements of the Reproposed Rules.
I. Section 165(e) of the Dodd-Frank Act
Under section 165(e), the Fed is required to establish single-counterparty credit limits for U.S. BHCs ("Covered Companies") and FBOs with at least $50 billion in total consolidated assets,78 While investment securities limits and lending limits are already in place for certain depository institutions, such as national banks, state-chartered banks, and state and federally chartered savings associations, pursuant to the National Bank Act of 1863 and the Federal Reserve Act, section 165(e) requires separate and independent enhanced single-counterparty credit limits.
The Dodd-Frank Act defines "credit exposure" to a particular company as:
- all extensions of credit to a company, including loans, deposits, and lines of credit;
- all repurchase agreements ("Repos"), reverse repurchase agreements ("Reverse Repos"), and securities borrowing and lending transactions with a company (to the extent that such transactions create credit exposure for the Covered Company or Covered Entity);
- all guarantees, acceptances, and letters of credit (including endorsement or standby letters of credit) issued on behalf of the company;
- all purchases of, or investments in, securities issued by the company;
- counterparty credit exposure to the company in connection with derivative transactions between the Covered Company, or Covered Entity, and the company; and
- any other similar transaction that the Fed determines, through regulation, to be a credit exposure under section 165(e).9
Covered Companies and Covered Entities are prohibited from maintaining credit exposure to any unaffiliated companies that exceeds 25% of the "capital stock and surplus" of the Covered Company or Covered Entity, or any such amount that the Fed determines may be necessary to mitigate risks to the financial stability of the U.S. economy.10 The Fed may additionally issue any such regulations and orders as it deems necessary to administer and carry out the requirements set forth under section 165(e), as well as exempt from the definition of "credit exposure" certain transactions if it finds that the exemption is in the "public interest and consistent with the purposes of section 165(e)."11 Lastly, the Fed is authorized to establish single-counterparty credit limits for any nonbank financial companies designated as a SIFI by the Financial Stability Oversight Council.12
II. The Reproposed Rules
The Reproposed Rules establish separate requirements for U.S. BHCs (i.e., Covered Companies) and FBOs and IHCs (i.e., Covered Entities), albeit the requirements are largely analogous. Specifically, the Reproposed Rules establish: (1) three levels of increasingly stringent credit exposure limits; (2) the methodology for calculating "aggregate net credit exposures"; (3) exemptions from the credit exposure limits; (4) compliance requirements; and (5) the timing in which Covered Companies and Covered Entities must comply with the Reproposed Rules' requirements.
A. Credit Exposure Limits for U.S. BHCs (Covered Companies)
Overview of Reproposed Rules as Applied to U.S. BHCs. Section 165(e) directs the Fed to impose single-counterparty credit limits on the "capital stock and surplus" of a Covered Company, which is defined under the Reproposed Rules as the "sum of the [Covered Company's] total regulatory capital as calculated under the capital adequacy guidelines applicable to that [Covered Company] under Regulation Q . . . and the balance of the [Covered Company's allowance for loan and lease losses ("ALLL")] not included in tier 2 capital under the capital adequacy guidelines applicable to that [Covered Company] under Regulation Q."13
Under the Reproposed Rules, the "aggregate net credit exposure" of a Covered Company to a single counterparty would be subject to one of three categories of credit exposure limits, each with increasing stringency. The Reproposed Rules define "aggregate net credit exposure" as the sum of all net credit exposures of a Covered Company or Covered Entity to a single counterparty.14 The below credit exposure limits would apply to a Covered Company on a consolidated basis, including any of the Covered Company's subsidiaries, to any unaffiliated counterparty:15
- Category 1. The first category of limits would apply to Covered Companies with less than $250 billion in total consolidated assets and less than $10 billion in on-balance-sheet foreign exposures.16 Such Covered Companies would be prohibited from maintaining aggregate net credit exposure to an unaffiliated counterparty in excess of 25% of the Covered Company's total capital stock and surplus.17
- Category 2. The second category of exposure limits would prohibit any Covered Company with at least $250 billion or more in total consolidated assets or at least $10 billion or more in total on-balance-sheet foreign exposures from maintaining aggregate net credit exposure to an unaffiliated counterparty that exceeds 25% of the Covered Company's tier 1 capital.18
- Category 3. The third category of exposure limits would prohibit any Covered Company that is a globally systemically important banking organization ("G-SIB" or "Major Covered Company") from maintaining aggregate net credit exposure that exceeds (i) 15% of the Major Covered Company's tier 1 capital to any "Major Counterparty"19 and (ii) 25% of the Major Covered Company's tier 1 capital to any other counterparty.20
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1 Board of Governors of the Federal Reserve System, "Single-Counterparty Credit Limits for Large Banking Organizations," Notice of Proposed Rulemaking, Mar. 4, 2016, available at http://www.federalreserve.gov/aboutthefed/boardmeetings/sccl-fr-notice-20160304.pdf, at 1.
2 See Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies; Proposed Rule, 77 Fed. Reg. 594 (Jan. 5, 2012); and Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies, 77 Fed. Reg. 76628 (Dec. 28, 2012).
3 See Lending Limits, 78 Fed. Reg. 37930 (June 25, 2013).
4 See "Final standard for measuring and controlling large exposures published by the Basel Committee," BIS Press Release, Apr. 15, 2014, available at http://www.bis.org/press/p140415.htm.
5 NPRM, supra note 1 at 7.
6 See Remarks by Chair of the Federal Reserve Janet L. Yellen, "Finance and Society" Conference, Washington, D.C., May 6, 2015, available at http://www.federalreserve.gov/newsevents/speech/yellen20150506a.pdf ("We are also employing annual stress tests to gauge large institutions' ability to weather a very severe downturn and distress of counterparties and, importantly, continue lending to households and businesses.").
7 Notwithstanding section 165(a)(2), the Fed has not proposed a threshold higher than $50 billion for applying section 165(e).
8 See 12 U.S.C. § 5365(e)(1).
9 See 12 U.S.C. § 5365(e)(3).
10 See 12 U.S.C. § 5365(e)(2).
11 See 12 U.S.C. § 5365(e)(5)-(6).
12 See NPRM, supra note 1 at 5.
13 See Reproposed Rule § 252.71(d).
14 See Reproposed Rule § 252.71(b).
15 A "subsidiary" of a Covered Company includes any "company that is directly or indirectly controlled by the specified company for purposes of the Bank Holding Company Act of 1956." NPRM, supra note 1 at 13 (citing 12 U.S.C. § 1841). However, the Fed notes that, to the extent an investment fund or vehicle is not controlled by a Covered Company, the exposures of such a fund or vehicle to their counterparties would not be aggregated to the Covered Company for purposes of the Covered Company's single-counterparty credit limits. See NPRM, supra note 1 at 13.
16 NPRM, supra note 1 at 11.
17 The Reproposed Rules defines "total capital stock and surplus" as the Covered Company's total regulatory capital plus ALLL.
18 NPRM, supra note 1 at 11.
19 A "major counterparty" is defined as a G-SIB or a nonbank financial company supervised by the Fed (i.e., a nonbank SIFI). NPRM, supra note 1 at 12.
20 Pursuant to Section 165(a)(1)(B) of the Dodd-Frank Act, the Fed may establish enhanced prudential standards based on factors such as "the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company." See 12 U.S.C. § 5323; and 12 U.S.C. § 5365(e). The establishment of enhanced credit exposure limitations for Major Covered Companies is consistent with section 165(a)(1)(1)(B) of the Dodd-Frank Act and discussed in further detail in Part III below.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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