Wednesday, January 16, 2013

FED Foreign Bank Regulation – Simple and straightforward writing?



The FED intends to change the rules for foreign banks operating in the US. A first draft has been communicated on December 12, 2012.







What is the purpose of the new regulation?

The purpose is twofold: The US operations of foreign banks shall become more resilient and the US financial system and US economy shall be held immune against a failure of a foreign bank.



When will the regulation apply?

For now, the FED has only published a proposal.

Thresholds shall apply, for the first time, on July 1, 2014. The respective regulation will then apply one year after exceeding the threshold. The details vary from stipulation to stipulation, but it is probably a good idea to keep in mind the date of July 1, 2014.



What are the areas of regulation?

  • US intermediate holding company
  • Risk-based capital
  • Leverage
  • Liquidity
  • Single-counterparty limits
  • Risk management
  • Stress tests
  • Early remediation



When do you need to set up a US intermediary holding company?

You ought to set up a US intermediary holding company if you are a foreign banking organization with total consolidated assets of at least 50 BUSD and, cumulatively, dispose of combined US assets of 10 BUSD or more.


Why is a US intermediary holding company required?

This makes it easier for the FED to regulate and control you.


What is the framework for setting up a US intermediary holding company?

The holding can be set up in any US state. It must not be wholly owned by you. In other words, you can engage minority investors. A scheme with multiple holding companies is possible under exceptional circumstances.

The FED will apply specific prudential standards to you; the standards of US bank holding companies will not apply.



When do risk-based capital requirements apply?

They apply if you are a foreign banking organization with total consolidated assets of at least 50 BUSD.


Which risk-based capital requirements exist?

You will be subject to the same capital adequacy standards as they apply to US bank holding companies. There are minimum risk-based capital, leverage, and capital adequacy requirements as well as the capital plan rule.

If you are a global systemically important banking organizations under the Basel III scheme, the FED may implement consolidated capital surcharges.


Why do risk-based capital requirements apply?

Basel III only addresses capital requirements at the consolidated level of internationally active banking organizations. However, it does not handle the capitalization in each country of operations. In addition, the information on the firm’s consolidated capital position may not be available in time.

The foreign banking organization might not be able or willing to support its US operations during a crisis.

Finally, the bank’s home jurisdiction could restrict cross-border intra-group capital flows to the US when the foreign bank faces financial difficulties.



When do leverage limits apply?

You must meet leverage limits if you dispose of consolidated assets of 50 BUSD or more.


Which leverage limits apply?

At US intermediary holding company level and at the level of any US subsidiary not organized under your intermediate holding company, you have to meet a debt-to-equity ratio of no more than 15:1.

In addition, your US branch and agency network must maintain assets at 108 % of third party liabilities.



When do liquidity constraints apply?

Liquidity constraints apply if you hold combined US assets of at least 50 BUSD.

If you hold less, you will only have to report, on an annual basis, the results of an internal liquidity stress test on your combined US operations to the FED.


Which liquidity constraints are put in practice?

  • You must conduct monthly liquidity stress tests, based on a series of time intervals out to one year.
  • Holding a buffer of local liquidity will be obligatory. Your buffer must be of high quality and not carry any pledges. In addition, it should be sufficient to cover the first 30 days of cash flow needs under stressed conditions.
  • You shall establish a contingency funding plan for your combined US operations to counter a liquidity crisis. You have to update the plan at least annually.
  • Internally, you must set up an independent review function to evaluate the liquidity risk management of your combined US operations.
  • On- and off-balance sheet cash flows shall be projected; collateral positions of your US operations be monitored.
  • You need to establish and maintain limits on potential sources of liquidity risk such as concentrations of funding by instrument type, single counter-party limits, and secured vs. unsecured funding.

Liquidity requirements and buffers apply separately to your US branch and agency network on the one hand and your intermediate holding company on the other hand.


Why has the FED put up liquidity constraints?

The intention is not to increase liquidity requirements but to make sure that you hold liquidity locally in the US.



When do single-counterparty limits apply?

They apply when you show consolidated assets of at least 50 BUSD on your balance sheet.


Which single-counterparty limits apply?

Your exposure to a single counterparty, including affiliates, cannot exceed 25 % of your total regulatory capital. This threshold applies separately to both your intermediate holding company and your combined US operations. Moreover, the limit reduces to 10 % if you hold total consolidated assets of minimum 500 BUSD.


Which deductions are made when calculating your exposure?

You deduct the following items:

  • Adjusted market value of eligible collateral
  • Unused credit lines
  • Eligible guarantees
  • Eligible credit or equity derivatives and hedges that limit your exposure
  • Bilateral netting agreements
  • Face amount of a short sale of your counterparty's debt or equity
  • Repurchase transactions with your counterparty


Why are single-counterparty limits put in place?

Single-counterparty limits are meant to track the interconnectedness among large US and foreign financial institutions in the US and globally.



When do risk management requirements apply?

Risk management requirements apply gradually, first, if your stock trades publicly and you hold consolidated assets of 10 BUSD or more and, second, if you hold consolidated assets of at least 50 BUSD, regardless of whether your stock trades publicly or not.


Which risk management requirements exist?

In either case, you need to institute a risk committee to oversee your US operations. The committee must comprise one member independent from your bank.

In addition, meeting the 50 BUSD asset threshold will oblige you to appoint a U.S. chief risk officer.


What are the tasks of your risk committee?

Your risk committee is bound to review and approve the risk management practices of your combined US operations and to oversee your risk management framework.



When are stress tests brought into play?

Stress tests are necessary in three scenarios:

  • 1st scenario: Your US intermediate holding company carries assets between 10 and 50 BUSD.
  • 2nd scenario: Your US intermediate holding company carries assets of more than 50 BUSD.
  • 3rd scenario: You hold combined US assets of at least 50 BUSD.


How are stress tests put in practice?

  • In the first scenario, you must conduct annual company-run stress tests.
  • In the second scenario, you will need to conduct semi-annual company-run stress tests and annual supervisory stress tests.
  • In the third scenario, you must put in place annual capital stress tests on a consolidated level. These tests can be carried out by yourself, if they are reviewed by your home country supervisor. Naturally, a stress test accomplished by your home country supervisor directly would also suffice.


What happens if you fail to meet the stress testing conditions?

Your US branch and agency network will have to maintain eligible assets at a minimum of 108 % of third party liabilities. In addition, the FED can impose intra-group funding restrictions and increased liquidity requirements on you.



When do early remediation standards apply?

Remediation standards apply automatically if you hold combined US assets of 50 BUSD or more. They shall apply on a case by case basis if your combined US assets are less than 50 BUSD.


What triggers early remediation?

The FED proposes four triggers:

  • Level 1 refers to a qualitative analysis of
    Capital: Evidenced signs of deterioration / Capital position not commensurate with the level and nature of the risks you run in the US
    Stress test: Your US intermediate holding company fails to comply with stress testing rules.
    Risk management: Your US operations manifest signs of weakness in meeting risk management requirements.
    Liquidity risk management: Any part of your combined US operations manifests signs of weakness in meeting liquidity risk management standards.
    Market indicators: Expected default frequency / Marginal expected shortfall / Market equity ratio / Option-implied volatility / CDS spread / Subordinated debt spread – Thresholds will be published on an annual basis.

  • Level 2 is a quantitative analysis of
    Capital: Your or your US intermediate holding company's risk-based capital ratio falls below [200-250] basis points above the minimum risk-based capital requirement threshold. / Your or your US intermediate holding company's leverage ratio falls below [75-125] basis points above the minimum leverage requirement.
    Stress test: Under a severely adverse scenario, the results of your US intermediate holding company's supervisory stress test reflect a tier 1 common risk-based capital ratio of less than 5 %.
    Risk management: Your US operations have manifested multiple deficiencies in meeting the risk management requirements.
    Liquidity risk management: Any part of your combined US operations has demonstrated multiple deficiencies in meeting the liquidity risk management standards.

  • Level 3 is a quantitative analysis of
    Capital: For two consecutive quarters, your or your US intermediate holding company's risk-based capital ratio falls below [200-250] basis points above the minimum risk-based capital requirement threshold. / For two consecutive quarters, your or your US intermediate holding company's leverage ratio falls below [75-125] basis points above the minimum leverage requirement.
    Stress tests: Under a severely adverse scenario, the results of your US intermediate holding company's supervisory stress test reflect a tier 1 common risk-based capital ratio of less than 3 %.
    Risk management: Your US operations are in substantial noncompliance with the risk management requirements.
    Liquidity risk management: Any part of your combined US operations is in substantial noncompliance with the liquidity risk management standards.

  • Level 4 is a quantitative analysis of
    Capital: Your or your US intermediate holding company's risk-based capital ratio falls below [100-200] basis points above the minimum applicable risk-based capital requirement threshold. / your or your US intermediate holding company's leverage ratio falls below [50-150] basis points above the minimum leverage requirement.
    Stress tests: None
    Risk management: None
    Liquidity risk management: None


Which early remediation actions exist?

  • Level 1
    Your US operations will be subject to heightened supervisory review.

  • Level 2
    Capital distributions are limited to 50 % of the average net income over the two preceding calendar quarters.
    Your US branch and agency network must remain in a net due position towards your group.
    Your US branch and agency network must maintain a liquid asset buffer in the US sufficient to cover 30 days of stressed cash outflows.
    Average daily total assets and average daily risk-weighted assets of your US operations cannot exceed average daily total assets or average daily risk-weighted assets during the preceding calendar quarter by more than 5 %.

  • Level 3
    You need to put in place a capital restoration plan and, in absence of restoration, effectuate forced asset divestment.
    You cannot grow in the US: Your average daily total assets cannot grow from one calendar year to the next; your average daily risk-weighted assets cannot grow from one quarter to the next. In addition, you are prohibited to open any new branches, agencies, representative offices, or places of business in the US. Finally, you cannot acquire a controlling interest in a new company.
    Your US branch and agency network must remain in a net due position towards your group
    You must maintain eligible assets at least at 108 % of your US branch and agency network's third-party liabilities.
    Additional measures include capital raising requirements, limits on transactions with affiliates, obligatory management changes, prohibition of capital distributions and increased bonus and other compensation.

  • Level 4
    The FED considers to terminate or resolve your combined US operations.



How are assets calculated?

When you calculate the above described thresholds, you take into account the most recent four quarter average.



What else?

“The Board has sought to present the proposed rule in a simple and straightforward manner, and invites comment on the use of plain language.”, writes the FED on page 175 of its proposal. I have two comments:

  • Don't write 300 pages if you want to keep it simple.
  • Why do you repeat yourself several times when presenting the regulatory proposals?