Cheat Sheet: New Details and Questions in the Fed's Dodd-Frank Proposal
The president of the Kansas City Fed sat down with American Banker to talk about a range of topics, including the missed opportunity to eliminate 'too big to fail' in Dodd-Frank.
Three years after the crisis, the rules governing finance haven't changed enough to ward off fear and dread. But a giant reg coming from the Fed should bring enough clarity to prevent panic.
WASHINGTON — Federal regulators on Tuesday disclosed one of the best kept secrets in town: how they planned to regulate the largest U.S. banks and what additional capital and liquidity firms would now need to hold.
Still, the Federal Reserve Board didn't spell out everything.
Industry observers noted that the central bank did not detail whether it would require a risk-based capital surcharge for all banks with more than $50 billion of assets, as well as specify liquidity requirements that are still being ironed out by the Basel Committee on Banking Supervision.
"The Fed withheld its full force on the capital and liquidity rules and did so wisely given how unstable the markets are right now. It's outlined a gradual progression for its very stringent rules rather than seeking to mandate them immediately as the systemic criteria for the banks," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc.
Fed officials said it would be premature to press ahead on certain requirements like liquidity until there was greater consensus internationally on how to move forward given the number of concerns that have been raised. For now, banks will rely on their own internal modeling in their own stress testing to ensure things are in line on the liquidity front.
Although the eight largest U.S. institutions will face a capital surcharge of between 1% to 2.5%, the Fed kept it an open question whether it would institute a surcharge for institutions below that level but above the Dodd-Frank threshold of $50 billion of assets.
Rather, it asked the public to weigh in on what methods would best be used to assess a surcharge for those covered companies.
Still, Fed officials specified that other pieces of the mammoth rule including capital planning, stress testing, and liquidity would apply to all the different types and sizes of institutions above that $50 billion threshold, even if they varied slightly.
To outside observers, at least initially, much of it looked like similar tools used by Fed, but perhaps with a little more bite.
"There aren't any surprises. They're bank regulators, they took the tools they are familiar with and they're ratcheting them up and adjusting them to deal with what they think they learned this time around," said Oliver Ireland, a partner at Morrison & Foerster and a former Fed attorney.
Another crucial piece left untouched in the proposal was how the Fed would regulate the roughly 100 foreign banks that would be subject to the rule — a significant piece given their role in the U.S. market. Instead, officials said it would come out "shortly," but offered no specific timeline.
Fed officials said it was best to defer on the rules for now, until international agreements were in place and the agency could think through how all the rules would apply to the varying foreign banks with presence in the U.S.
The central bank also agreed to postpone releasing a credit exposure reporting requirement as it works alongside the Federal Deposit Insurance Corp. in a separate rulemaking process.
Recognizing the complexity and the breadth of the rule, Fed officials offered to give industry more than 90 days to comment on the proposal. The comment period is set to close on March 31, 2012.
Some observers were most focused -- at least initially -- on the proposed remediation requirements the Fed might use to address any financial weakness at a large institution. Regulators listed a number of triggers for remediation, including capital levels, results of stress tests and risk-management issues. The rule ups the ante on current prompt corrective action regulations in place, observers said.
"This is the real guts of the proposal because it is saying regulators will have to act if a big bank starts to get into trouble," said Jaret Seiberg, senior financial policy analyst for Guggenheim Partners' Washington Research Group, in a research note. "The real issue going forward is how will it apply to some of the bigger banks that have yet to recover from the crisis?
Regulators did shed some light in how and when these rules would begin to apply on firms.
Regulators opted to take a graduated approach in applying both new capital and liquidity requirements largely in order to not to interfere with the Basel III process, assuaging some fears from bankers in the process.
"Until the Fed lays out a clear roadmap on these very complicated rules, they were right not to force immediate compliance with rules that aren't even released as proposals, let alone final dictates," said Shaw Petrou.
In most cases, firms will have to comply with the new requirements within a year of the rule being finalized.
So, for example, firms will have to adhere to the Fed's November guidelines on yearly capital planning, which will require companies to conduct stress tests and maintain adequate capital, including a Tier 1 risk-based ratio of greater than 5%, both under expected and stress conditions.
"This should be seen as positive based on the summary as the requirements do not seem to go beyond what the Fed said in announcing the stress test," said Seiberg.
On capital, the Fed said it will issue further guidance on when any surcharge would be adopted at a later date, but would adhere to the Basel timetable.
The Fed proposal also provided a window into how the Fed plans to supervise systemically important nonbanks, which must first be designated by the Financial Stability Oversight Council. The central bank said any firm designated by the FSOC would have 180 days to comply with the minimum risk-based capital and leverage requirements.
The proposal asked for comment on the appropriateness of requiring nonbank covered companies to have the same capital planning and stress testing requirements as bank holding companies. Fed officials also said they would show some flexibility on how the rules would apply to nonbank financial firms once they are designated.
The Fed largely reiterated its plans announced last month on stress testing. Under the proposal, firms will have to test using three economic and financial market scenarios. Regulators will make those results public. Banks must also complete internal stress tests, which must also be made public.
A bigger, more pressing issue was a step taken by the Fed to address single-party counterparty concentration limits. Such requirements would limit credit exposure of a covered firm to a single counterparty as a percentage of the firm's regulatory capital.
Credit exposure between the biggest banks with assets of more than $500 billion or above would be subject to the toughest limits of 10% in certain situations, according to the Fed. Only four U.S. institutions that meet that threshold. Firms above $50 billion of assets but below the $500 billion mark would face a 25% counterparty limit.
"This will warrant more attention," Seiberg wrote. "We believe the limit on exposure between mega financial firms will get much scrutiny."
The Fed did provide an exception from the requirements for savings and loan holding companies, which must only comply with the stress test mandate. The Fed will issue a separate proposal later to address issues if enhanced standards should be applied to those firms.