Tuesday, January 17, 2012

Federal Reserve Proposes Enhanced Prudential Standards and Early Remediation Requirements

On December 20, 2011, the Federal Reserve Board of Directors published its long awaited proposal on enhanced prudential standards and early remediation requirements.  This proposal, required by the Dodd-Frank Act, would impose greater levels of regulation and supervision on:

  • U.S. bank holding companies with $50 billion or more in consolidated assets; and

  • Non-bank financial companies (U.S. and non-U.S.) designated as “systemically important” by the Financial Stability Oversight Council.
Among the measures in the Fed's proposal are:

Risk-based capital and leverage requirements. These requirements would be implemented in two phases. In the first phase, the institutions would be subject to the FRB's capital plan rule, which was issued in November 2011. That rule requires firms to develop annual capital plans, conduct stress tests, and maintain adequate capital, including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions. In the second phase, the FRB would issue a proposal to implement a risk-based capital surcharge based on the framework and methodology developed by the Basel Committee on Banking Supervision.

Liquidity requirements. These measures would also be implemented in multiple phases. First, institutions would be subject to qualitative liquidity risk-management standards generally based on the interagency liquidity risk-management guidance issued in March 2010. These standards would require companies to conduct internal liquidity stress tests and set internal quantitative limits to manage liquidity risk. In the second phase, the FRB would issue one or more proposals to implement quantitative liquidity requirements based on the Basel III liquidity rules.

Stress tests. Stress tests of the companies would be conducted annually by the FRB using three economic and financial market scenarios. A summary of the results, including company-specific information, would be made public. In addition, the proposal requires companies to conduct one or more company-run stress tests each year and to make a summary of their results public.

Single-counterparty credit limits. These requirements would limit credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit.

Early remediation requirements. These measures would be put in place for all firms subject to the proposal so that financial weaknesses are addressed at an early stage. The FRB is proposing a number of triggers for remediation--such as capital levels, stress test results, and risk-management weaknesses--in some cases calibrated to be forward-looking. Required actions would vary based on the severity of the situation, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales.

Comments on the proposals are due by March 31, 2012.  

The full text of the Fed's proposing release is available at: http://www.gpo.gov/fdsys/pkg/FR-2012-01-05/pdf/2011-33364.pdf

Schulte, Roth & Zable LLP has drafted an excellent memorandum summarizing the release and highlighting some of the most vital areas of potential concern.  The memorandum may be found at: http://www.srz.com/files/News/a2c9b996-deb5-4094-a8ef-f0ee4dbc0401/Presentation/NewsAttachment/5406f6e7-f23f-4382-9dae-007e0762068e/011012_Federal_Reserve_Proposes_Enhanced_Prudential_Standards_.pdf