On October 31, 2018, the Board of Governors of the Federal Reserve System (FRB) released two notices of proposed rulemaking to tailor prudential standards for certain banking organizations, the second of which was issued jointly with the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) (together, "Proposal"). The Proposal, in part, implements section 401 of S. 2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA).
Under the Proposal, the FRB would do the following:
- Create a framework with four risk-based categories of banking organizations with more than $100 billion in total consolidated assets
- Tailor enhanced prudential standards in accordance with the risk-profile of the banking organizations in each category
- Extend the full panoply of enhanced prudential standards to savings and loan holding companies (SLHCs) using the same risk-based framework
- Tailor regulatory capital and liquidity requirements consistent with the proposed framework
Notably, the FRB went beyond what EGRRCPA requires for tailoring prudential standards. The Proposal, for example, would remove the liquidity coverage ratio (LCR) for banking organizations with total assets of less than $250 billion and would relax it for banking organizations with total assets between $250 and $700 billion. Banking organizations with total assets of less than $250 billion also would no longer be subject to advanced approaches capital requirements, which are based on internal models.
The Proposal Framework
In an effort to better tailor the application of prudential standards to banking organizations, the Proposal creates a framework with categories of prudential standards that reflect a firm's risk profile. These categories take into account total assets, along with certain risk-based indicators: cross-jurisdictional activity, weighted short-term wholesale funding, nonbank assets, and off-balance sheet exposure. Each of the risk-based indicators (RBIs) has a $75 billion threshold that, when met, can push a banking organization into a higher risk category. Below are the four proposed categories (from lowest to highest risk):
Firms that are not in any other category and that have $100–$250 billion in total assets. These firms would be subject to significantly reduced requirements that reflect their relatively lower risk.
Firms that are not in Category I or II and that have $250–$700 billion in total assets or have $75 billion or more of any RBI. These firms would be subject to enhanced prudential standards that are tailored to their risk profile.
Firms that are not in Category I and that have $700 billion or more in total assets or have $75 billion or more of cross-jurisdictional activities. These firms would be subject to more stringent prudential standards.
Firms that are U.S. global systemically important bank holding Companies (US-GSIBs). These firms would remain subject to the most stringent prudential standards.
It is important to note that the Proposal places significant weight on a firm's cross-jurisdictional activities. Having $75 billion or more in cross-jurisdictional activities puts a firm in Category II, whereas meeting any of the other RBI thresholds would put a firm in Category III. In the memorandum that accompanied the Proposal (FRB Memorandum), FRB staff highlighted that "foreign operations and cross-border positions add operational complexity in normal times and complicate the ability of a firm to undergo an orderly resolution in times of stress, generating both safety and soundness and financial stability risks."
Enhanced Prudential Standards for Each Category
Category IV ($100–$250 billion and no RBIs)
The FRB notes that firms with assets between $100 billion and $250 billion tend to have a regional focus. Although the failure of any such firm is unlikely to impact U.S. financial stability, it could have more negative effects on economic growth and employment than would smaller firms. These types of institutions tend to have a larger geographic presence and more operational complexity than smaller banking institutions.
- Capital and Liquidity
Category IV standards maintain core elements of the existing liquidity and capital standards, but they are tailored to reflect the lower risk profile of the applicable firms. The Proposal would reduce the frequency of required internal liquidity stress testing to quarterly (from monthly) and increase the period for calculating collateral positions to monthly (from weekly). Additionally, institutions in Category IV would not be subject to LCR or net stable funding ratio (NSFR) requirements.
- Stress Testing and Capital Plans
Stress testing for firms subject to Category IV would be more tailored to the company's risk profile. The FRB would reduce the frequency of supervisory stress testing to a two-year cycle, but maintain the current FR Y-14 reporting requirements. The Proposal would eliminate company-run stress tests for Category IV institutions.
Category III ($250–$700 billion or an RBI)
The FRB notes that Category III firms have a lower risk profile than those in Category I or II but that the failure of a Category III institution is likely to have a significant economic impact. Category III firms also tend to focus on select business lines and are less operationally complex than larger banking organizations. As a result, Category III firms would be subject to fewer requirements than those firms that are larger or more internationally active.
- Capital and Liquidity
Under the Proposal, Category III firms would no longer be subject to advanced approaches capital requirements. Although Category III firms would still be subject to LCR and NSFR, the Proposal would reduce them to between 70% and 85% of the full requirement, provided the firm has a weighted short-term wholesale funding level of less than $75 billion. For Category III, the Proposal would leave unchanged the supplementary leverage ratio and the countercyclical capital buffer.
- Stress Testing and Capital Plans
The Proposal maintains the required supervisory stress testing and annual comprehensive capital analysis and review (CCAR) requirements. However, the Proposal would increase the period for conducting and publicizing company-run stress tests to every two years (from every six months).
Category II (more than $700 billion or more than $75 billion cross border)
Under the Proposal, Category II banking companies remain subject to enhanced capital and liquidity requirements that are based on global standards developed by the Basel Committee on Bank Supervision. FRB standards for Category II firms remain largely unchanged, except that the Proposal would increase the period for conducting and publicizing company-run stress tests to every year (from every six months).
Category I (US-GSIBs)
The Proposal would not change the regulation of US-GSIBs. These banks pose significant financial stability risk to the U.S. economy and remain subject to the most stringent regulatory requirements.
More to Come
The Proposal appears to be only a first step toward further tailoring of prudential standards and other regulatory requirements implemented following passage of the Dodd-Frank Act. The FRB intends to issue a separate proposal for each of the following:
- Prudential standards applicable to foreign banking organizations
- Flexibility for large banking organizations in developing their annual CCAR plans
- Further differentiation of resolutions planning requirements for large banking organizations (jointly with the FDIC)
- Community bank leverage ratio changes to ease compliance burdens (proposed on November 21, 2018)
It will be important to watch whether the forthcoming proposals implement only the minimum congressionally mandated changes or, as with this Proposal, extend the scope of burden reduction. It is noteworthy that the FRB's vote on the Proposal was not unanimous. Governor Brainard's "no" vote on this Proposal was based largely on its provisions that modified prudential standards beyond what EGGRCPA required, and she almost certainly will continue to oppose similar deregulatory efforts. It is unclear, however, whether Governor Brainard's position, combined with an incoming Democratic majority in the House, will have any effect on the FRB's current rulemaking trajectory. Regardless, banks need to keep their eyes on the FRB in 2019.