INTRODUCTION Federal Reserve Board s Final Rule to Implement the Dodd-Frank Act s Enhanced Prudential Standards for Foreign Banking Organizations *

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1 INTRODUCTION Federal Reserve Board s Final Rule to Implement the Dodd-Frank Act s Enhanced Prudential Standards for Foreign Banking Organizations * Luigi L. De Ghenghi** Andrew S. Fei*** The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) directs the Federal Reserve Board, as the U.S. regulator primarily responsible for the overall supervision and regulation of the U.S. operations of foreign banking organizations (FBOs) 1, to promulgate enhanced prudential standards for foreign banking organizations with total global consolidated assets of $50 billion or more (Large FBOs). 2 These enhanced prudential standards include enhanced risk-based and leverage capital requirements, liquidity requirements, risk management requirements, single counterparty credit limits and stress test requirements. * The authors express their gratitude to Jennifer E. Kerslake, whose e orts have been invaluable. ** Partner, Davis Polk & Wardwell. *** Associate, Davis Polk & Wardwell. 1 A foreign banking organization is a foreign bank that has a banking presence in the United States by virtue of operating a U.S. branch, agency or commercial lending company subsidiary or controlling a company organized under Section 25A of the Federal Reserve Board Act (Edge Act) or any company that directly or indirectly controls a foreign bank. It also includes a foreign-based company that controls a U.S. bank that is, a foreign-based bank holding company. 2 The Federal Reserve Board also issued Supervision and Regulation Letter SR regarding the consolidated supervision framework for large nancial institutions, including domestic banking organizations with total consolidated assets of $50 billion or more and Large FBOs. This SR letter focuses on enhancing the resiliency of a rm and reducing the impact of failure on nancial stability. The letter outlines a framework for supervisory review of resolution planning, corporate governance, and capital and liquidity planning. Consolidated Supervision Framework for Large Financial Institutions, SR Letter (Dec. 17, 2012). ix

2 U.S. Reg. Foreign Banks & Affiliates In February 2014, the Federal Reserve Board issued, pursuant to its authority under the Dodd-Frank Act, a nal rule (Final FBO Rule) 3 that applies U.S. capital, liquidity and other enhanced prudential standards to the U.S. operations of Large FBOs, on a tiered basis, depending on various total asset thresholds and other criteria. 4 Fewer requirements apply to Large FBOs with limited U.S. footprints and smaller FBOs. The Final FBO Rule represents one of the most signi cant developments in the regulation of foreign banks in nearly two decades and will fundamentally change the U.S. regulatory landscape for FBOs described throughout this book. 5 Overview of the Final FBO Rule A central aspect of the Final FBO Rule is a requirement applicable to several Large FBOs to designate or form a separately capitalized top-tier U.S. intermediate holding company (IHC) for virtually all of a Large FBO s U.S. bank and nonbank subsidiaries. The IHC will be subject to U.S. capital, liquidity, capital planning and stress testing, risk management and other enhanced prudential standards on a consolidated basis. In addi- 3 Federal Reserve Board, Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking Organizations: Final Rule, 79 Fed. Reg (Mar. 27, 2014). The Federal Reserve Board has also published a series of frequently asked questions regarding implementation of the Final FBO Rule. See Federal Reserve Board, Frequently Asked Questions: Implementation of Regulation YY Enhanced Prudential Standards for Foreign Banking Organizations (June 26, 2014) (FBO Rule FAQs), available at bankinforeg/topics/faq-enhanced-prudential-standards-fbo.htm. 4 The Dodd-Frank Act also directs the Federal Reserve Board to establish prudential standards for foreign nonbank nancial companies supervised by the Federal Reserve Board following a systemic designation by the FSOC (Foreign Nonbank SIFI). The Federal Reserve Board, however, determined not to impose enhanced prudential standards on Foreign Nonbank SIFIs through the Final FBO Rule and stated that it intends separately to issue orders or rules imposing enhanced prudential standards on each Foreign Nonbank SIFI. As of December 31, 2013, no systemic designations have been made with respect to foreign nonbank nancial companies. 5 According to the Federal Reserve Board, the Final FBO Rule and its fundamental revisions to the U.S. regulatory framework for Large FBOs are justi ed by (1) concerns that Large FBOs operating in the United States had grown so large, leveraged and interconnected that their failure could pose a threat to the nancial stability of the United States and (2) the belief that the recent nancial crisis has revealed certain weaknesses in the existing framework for supervising, regulating and constraining the risks of the U.S. operations of FBOs. x

3 Introduction tion, as the umbrella supervisor of IHCs, the Federal Reserve Board will have the authority to examine or inspect any IHC and its subsidiaries and to prepare a report of their operations and activities. 6 Although the U.S. branches and agencies of a foreign bank would not be required to be held underneath the IHC, they too would be subject to liquidity risk management, single counterparty credit limits and, in certain circumstances, asset maintenance requirements. Large FBOs not required to form an IHC would also be subject to many of the new enhanced prudential standards. Implementation Timing For Large FBOs with combined U.S. assets of $50 billion or more as of June 30, 2015, the Final FBO Rule s enhanced prudential standards, other than leverage ratio and stress testing requirements, will apply beginning on July 1, Large FBOs with U.S. non-branch assets of $50 billion or more as of June 30, 2015 must designate or establish an IHC by July 1, FBOs that reach or exceed the relevant asset thresholds for the enhanced prudential standards and for the IHC requirement, respectively, after July 1, 2015 must generally comply with the applicable requirements beginning on the rst day of the ninth quarter following the date they reach the relevant threshold, unless accelerated or extended by the Federal Reserve Board. 9 Requirement to Establish an IHC Under the Final FBO Rule, the requirement to establish or designate a single, 10 top-tier U.S. IHC applies to any Large FBO 6 12 C.F.R (b)(3). Traditionally, in ful lling its role as umbrella supervisor of bank holding companies, the Federal Reserve Board relies, to a signi cant extent, on information and analysis provided by the appropriate supervisory authority of the bank holding company s bank, securities, insurance or other functionally regulated subsidiaries. See 12 U.S.C. 1844(c); Federal Reserve Board, Framework for Financial Holding Company Supervision, SR (SUP) (Aug. 15, 2000) C.F.R (c)(1) C.F.R (c)(2) C.F.R (a) C.F.R (b). The Federal Reserve Board retains the authority to approve alternative organizational structures upon written application by an xi

4 U.S. Reg. Foreign Banks & Affiliates with U.S. non-branch assets 11 of $50 billion or more. The IHC must be a company organized under U.S. law and governed by a board or directors or managers that is elected or appointed by the owners of the IHC. 12 Any ownership interest that an FBO holds in a U.S. subsidiary other than interests in certain U.S. subsidiaries of foreign commercial subsidiaries, known in U.S. banking law as Section 2(h)(2) companies, or DPC Subsidiaries must be held through the IHC. 13 On July 1, 2016, the IHC must hold the FBO s ownership interest in any U.S. bank holding company subsidiary, any depository institution subsidiary, and U.S. subsidiaries representing 90 percent of the FBO s non-branch assets not already held under a U.S. bank holding company or depository institution FBO if applicable home country law would prevent the FBO from controlling its U.S. subsidiaries through a single IHC or where the activities, scope of operations or structure of the U.S. subsidiaries warrant consideration of alternative structures, such as where the FBO controls multiple lower-tier FBOs with separate U.S. operations. If the Federal Reserve Board authorizes the formation of more than one IHC by an FBO, it generally will treat any additional IHC as an IHC with $50 billion or more in total consolidated assets, even if its assets are below that threshold. See 12 C.F.R (c). The preamble to the Final FBO Rule also states that, in the narrow circumstance in which an FBO is permitted to hold its interest in a U.S. subsidiary outside of an IHC, the Federal Reserve Board expects to require passivity commitments or other supervisory agreements to limit the exposure to and transactions between the IHC and the U.S. subsidiary that remains outside the IHC. See Final FBO Rule, 79 Fed. Reg. at Under the Final FBO Rule, U.S. non-branch assets means the sum of the consolidated assets of each top-tier U.S. subsidiary of the FBO (excluding any Section 2(h)(2) company and any subsidiary of a U.S. branch or agency acquired, or formed to hold assets acquired, in the ordinary course of business and for the sole purpose of securing or collecting debt previously contracted in good faith by that branch or agency (DPC Subsidiary). In calculating its U.S. non-branch assets, the FBO must reduce its U.S. non-branch assets by the amount corresponding to any balances and transactions between any top-tier U.S. subsidiaries that would be eliminated in consolidation were an IHC already formed. Balances and transactions between any U.S. subsidiary, on the one hand, and branches or agencies or non-u.s. a liates, on the other hand, would be included. See 12 C.F.R (b)(2) C.F.R (a)(2) C.F.R (b). The term subsidiary is de ned as any company controlled by the FBO, using the de nition of control in the BHC Act. Accordingly, an IHC must house any U.S. company for which the FBO: (1) directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 percent or more of any class of voting securities of the company; (2) controls in any manner the election of a majority of the directors or trustees of the company; or (3) directly or indirectly exercises a controlling in uence over the management or policies of the company. xii

5 Introduction subsidiary. 14 By July 1, 2017, the FBO must transfer its ownership interest in any residual U.S. subsidiaries to the IHC. 15 The Final FBO Rule does not require a Large FBO to be the 100% owner of any U.S. subsidiary; in other words, a Large FBO is not required to buy out other, una liated third-party investors in a U.S. subsidiary. An FBO with total consolidated assets of its U.S. subsidiaries other than an interest in a Section 2(h)(2) company or a DPC Subsidiary of $50 billion or more as of June 30, 2014 must submit to the Federal Reserve Board, by January 1, 2015, an IHC implementation plan outlining its proposed process to come into compliance with the IHC requirement. 16 The Federal Reserve Board will review the IHC implementation plan for reasonableness and achievability. 17 Within 30 days of establishing or designating an IHC, an FBO must provide notice to the Federal Reserve Board that includes a description of the IHC, a certi cation that the IHC satis es the applicable requirements, and any other information requested by the Federal Reserve Board. 18 The IHC will be subject to umbrella supervision by the Federal Reserve Board, including examination and inspection of the IHC and each of its subsidiaries, and will be required to submit periodic reports. 19 In addition, an IHC that is also a BHC will continue to be subject to requirements applicable to U.S. BHCs, except for enhanced prudential standards applicable to Large U.S. BHCs, following the designation or formation of an IHC by the FBO C.F.R (c)(2)(i) C.F.R (c)(2)(ii) C.F.R (d)(1). Mandatory elements of the IHC implementation plan include, among others, a list of the FBO s U.S. subsidiaries setting forth the ownership interest in each subsidiary and an organizational chart showing the ownership hierarchy, quarterly pro forma nancial statements and regulatory capital ratios for the IHC through January 1, 2018, and a compliance plan for the liquidity and risk management requirements of the Final FBO Rule. See 12 C.F.R (d)(2); see also FBO Rule FAQs, FAQ nos (Implementation Plan). 17 See Final FBO Rule, 79 Fed. Reg. at C.F.R (a)(3) C.F.R (b)(2) (3). The Federal Reserve Board will specify the form and content of IHC reporting requirements in a separate rule. See Final FBO Rule, 79 Fed. Reg. at xiii

6 U.S. Reg. Foreign Banks & Affiliates Establishing an IHC involves complex corporate structuring, regulatory, capital, liquidity, tax and corporate governance considerations and signi cant legal analysis. It is critical that the IHC be structured in an e cient and optimal manner from a business, operations, capital, funding liquidity, tax, risk management, compliance and corporate governance perspective. 20 IHC Subject to U.S. BHC Capital Requirements An IHC, regardless of whether it controls a U.S. bank, must generally comply with the same U.S. risk-based and leverage capital standards that apply to a U.S. BHC and on the same implementation schedule. 21 All IHCs will be subject to the U.S. Basel III capital rules (and any successor regulation), including the U.S. Basel III standardized approach for calculating riskweighted assets for credit risk and the U.S. leverage ratio (ratio of Tier 1 capital to average total on-balance sheet assets). 22 The Federal Reserve Board clari ed in the preamble to the Final FBO Rule that capital instruments issued by IHCs must meet the U.S. Basel III eligibility criteria and thus that IHCs may not treat keepwell agreements, senior debt or parent guarantees as capital. 23 Additionally, the IHC will not be required to make U.S. Pillar 3 public disclosures if its Large FBO parent makes comparable disclosures in its home country. 24 An IHC with $250 billion or more in total consolidated assets or $10 billion or more of on-balance sheet foreign exposures will not be subject to the U.S. Basel III advanced internal ratingsbased approach for calculating credit risk-weighted assets and advanced measurement approaches for calculating operational risk-weighted assets (together, the U.S. advanced approaches 20 See Davis Polk & Wardwell LLP, U.S. Intermediate Holding Company: Structuring and Regulatory Considerations for Foreign Banks (April 2, 2014) C.F.R (e)(2)(i). 22 An IHC that was not a BHC prior to its formation or designation as an FBO s IHC is not required to comply with the U.S. leverage ratio requirements until January 1, A prospective IHC that is currently a BHC, however, will continue to be subject to the U.S. leverage ratio. 12 C.F.R (e)(1)(ii)(B). 23 See Final FBO Rule, 79 Fed. Reg. at See Final FBO Rule, 79 Fed. Reg. at xiv

7 Introduction capital rules) unless the IHC expressly opts in. 25 However, an IHC that crosses the applicability threshold for the U.S. advanced approaches capital rules will still be subject to the U.S. Basel III supplementary leverage ratio, 26 the U.S. Basel III countercyclical bu er (if deployed), and unrealized gains and losses owing through to the IHC s Common Equity Tier 1 capital. In addition, an IHC will be subject to the U.S. Basel 2.5 market risk capital rule (and any successor regulation) if it crosses the relevant applicability threshold (i.e., aggregate trading assets and trading liabilities equal to $1 billion or more or 10% or more of total assets). Such an IHC will need to obtain separate approval from the Federal Reserve Board for its internal market risk models. Among other things, the permanent capital oor imposed by the Collins Amendment 27 and the Dodd-Frank Act s prohibition on reliance on external credit ratings in federal regulations have resulted in signi cant departures by the U.S. Basel III regime from the Basel capital framework and the capital regulations in other major jurisdictions. Other key di erences under U.S. Basel III include the eligibility criteria for regulatory capital instruments, the approach to the use of internal models to determine derivatives exposures, and the recognition of minority interests. Imposing uniquely U.S. capital standards on the IHC of a Large FBO that is subject to home country capital standards on a groupwide consolidated basis will likely give rise to challenging operational and compliance issues, such as multiple capital calculations and di erent capital optimization outcomes C.F.R (e)(2)(i). 26 The U.S. banking regulators have proposed a rule to implement the Basel Committee s January 2014 revisions to the Basel III leverage ratio. The compliance date for the supplementary leverage ratio is January 1, As a result of the Collins Amendment capital oor (see Dodd-Frank Act, Pub. L. No , 171 (2010)), a rm that is subject to the U.S. advanced approaches capital rules must calculate its risk-based capital ratios under both the general risk-based capital rules, based on the U.S. standardized approach for credit risk and the advanced approaches capital rules, in each case supplemented by the U.S. market risk capital rules, if applicable. The rm must then use the lower of the two sets of capital ratios to determine whether it meets its minimum risk-based capital requirements. 28 See Davis Polk & Wardwell LLP, U.S. Basel III Rule: Visual Memorandum (July 8, 2013); Davis Polk & Wardwell LLP, U.S. Basel III: Standardized Risk Weights Tool, available at Davis Polk & Wardwell LLP, U.S. Intermediate Holding Company: Structuring and Regulatory Considerations for Foreign Banks (April 2, 2014). xv

8 U.S. Reg. Foreign Banks & Affiliates U.S. Capital Planning and Stress Testing Requirements Under the Final FBO Rule, an IHC must generally comply with the same capital planning and stress testing requirements as large U.S. BHCs. 29 This will require an IHC to conduct semiannual Dodd-Frank company-run stress tests, submit an annual capital plan 30 to the Federal Reserve Board, and be subject to annual supervisory stress tests and capital plan analysis conducted by the Federal Reserve Board. The Federal Reserve Board explained in the preamble to the Final FBO Rule that an IHC should re ect in its capital plan any parent support provided by guarantees and keepwell agreements. The Federal Reserve Board further noted, however, that in demonstrating its ability to maintain capital above minimum requirements under stress scenarios, the IHC will not be permitted to re ect these agreements as sources of capital. 31 Similarly, for stress testing purposes, the IHC must project its regulatory capital ratios without consideration of possible support from its foreign parent. 32 The Federal Reserve Board s stress test rules require rms to publish summaries of their company-run stress test results. In addition, the Federal Reserve Board publishes summaries of supervisory stress test results. An IHC may disclose additional stress testing information beyond what is required by the Federal Reserve Board s Dodd-Frank stress testing rules, including explanations of any di erences between the stress testing methodologies of the IHC and its foreign parent that led to the 29 See 12 C.F.R (e)(2)(ii), (e)(5). The U.S. capital planning and stress testing requirements applicable to IHCs and to BHCs with total consolidated assets of at least $50 billion are codi ed at, respectively, 12 C.F.R and 12 C.F.R. pt. 252, sub. pts. E F. 30 The IHC s capital plan must demonstrate its ability to maintain capital above the Federal Reserve Board s minimum risk-based capital and leverage ratios under both baseline and stressed conditions over a minimum ninequarter, forward-looking planning horizon. An IHC that is unable to satisfy the capital plan rule s requirements, for quantitative or qualitative reasons, generally will not be permitted to make any capital distributions to its foreign parent or other investors until it provides a satisfactory capital plan to the Federal Reserve Board. As is the case with an FBO s U.S. bank subsidiary that is subject to the Federal Reserve Board s capital planning rules, this may make it more di cult for a Large FBO to repatriate excess capital from an IHC. 31 See Final FBO Rule, 79 Fed. Reg. at See Final FBO Rule, 79 Fed. Reg. at xvi

9 Introduction divergent results. 33 IHCs must submit capital plans to the Federal Reserve Board in January 2017 and comply with Dodd-Frank stress testing requirements beginning with the October 1, 2017 stress-test cycle. 34 BHC and IDI subsidiaries of a Large FBO must continue to comply with capital planning and Dodd-Frank stress testing requirements until corresponding requirements applicable to the IHC become e ective. Liquidity Requirements for U.S. Operations of a Large FBO The Final FBO Rule subjects an FBO with $50 billion or more in combined U.S. assets to a qualitative liquidity framework, including liquidity risk management standards and a U.S. liquidity bu er requirement based on the results of internal liquidity stress testing. The Federal Reserve Board also stated that it intends, through future separate rulemakings, to implement a quantitative liquidity framework imposing the Basel III liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) on the U.S. operations of some or all FBOs with $50 billion or more in U.S. assets. 35 A Large FBO with combined U.S. assets of $50 billion or more must maintain separate liquidity bu ers for its U.S. branches and agencies and for its IHC, if any. 36 An IHC must maintain a U.S. liquidity bu er in the United States 37 that is su cient to meet its projected net stressed cash ow needs over a 30-day pe- 33 See Final FBO Rule, 79 Fed. Reg. at C.F.R (e)(2)(ii)(B), (e)(5). Under the Federal Reserve Board s recent proposal to modify the schedule and other regulations with respect to capital planning and stress testing, these dates would be modi ed to April 5, 2017 and January 1, 2018, respectively. See Federal Reserve Board, Amendments to the Capital Plan and Stress Test Rules (June 12, 2014). 35 See Final FBO Rule, 79 Fed. Reg. at The qualitative liquidity framework in the Final FBO Rule will exist alongside, and is designed to complement, the Basel III LCR and NSFR. A key di erence between the LCR and the U.S. liquidity bu er requirement in the Final FBO Rule is that the former is based on prescribed cash in ow and out ow rates and assumptions under the standardized supervisory stress scenario, whereas the latter is based on the results of an FBO s internal liquidity stress testing C.F.R (c)(1). 37 The Federal Reserve Board explained in the preamble to the Final FBO Rule that this U.S. location requirement means that an IHC s liquidity bu er should be re ected on the balance sheet of the IHC. See Final FBO Rule, 79 xvii

10 U.S. Reg. Foreign Banks & Affiliates riod based on results of internal liquidity stress tests. 38 In determining its net stressed cash ow needs, an IHC must separately calculate its net external cash ow needs and its net internal cash ow needs. 39 In addition, intragroup cash ow sources may o set intragroup cash ow needs of an IHC only to the extent that the term of the intragroup cash ow source is the same as or shorter than the term of the intragroup cash ow need. 40 An IHC s liquidity bu er must consist solely of unencumbered 41 highly liquid assets, which include the following: (A) cash; (B) securities issued or guaranteed by the U.S. government, a U.S. government agency, or a U.S. government-sponsored enterprise (GSE) (e.g., Fannie Mae and Freddie Mac) and; (C) any other asset that the FBO demonstrates to the satisfaction of the Federal Reserve Board (1) has low credit risk and low market risks; (2) is traded in an active secondary two-way market that has committed market makers and independent bona de o ers to buy and sell so that a price reasonably related to the last sales price or current bona de competitive bid and o er quotations can be determined within one day and settled at that price within a reasonable time period conforming with trade custom; and (3) is a type of asset that investors historically have purchased in periods of nancial market distress during which market liquidity is impaired. 42 Fed. Reg. at Moreover, any cash that an IHC includes in its liquidity bu er may not be held in an account located at any U.S. branch or agency of its parent FBO or other a liate of the FBO that is not controlled by the IHC. 12 C.F.R (c)(4)(i). See also FBO Rule FAQs, FAQ no. 48 (Can a branch use foreign government debt held in a custody account at the foreign branch of a U.S. bank in its liquidity bu er? For instance, can a branch count non-u.s. government bonds that are held in the branch s name for its liquidity bu er?) C.F.R (c)(2) C.F.R (c)(2). An IHC s total net stressed cash ow needs equal the sum of its net external and internal stressed cash ow needs. An IHC may not net external cash ow needs against internal cash ow sources. 40 See Final FBO Rule, 79 Fed. Reg. at See also Davis Polk & Wardwell LLP, Foreign Banks: U.S. Liquidity Bu er Requirement Visual Memorandum and Interactive Calculator (February 27, 2014). 41 A highly liquid asset will be considered unencumbered for purposes of the Final FBO Rule if the asset is free of legal, regulatory, contractual, or other restrictions on the ability of such company promptly to liquidate, sell or transfer the asset and is either not pledged to secure or provide credit enhancement to any transaction or, in general, pledged to a central bank or a U.S. GSE. 12 C.F.R (c)(7)(ii) C.F.R (c)(7)(i). xviii

11 Introduction The Federal Reserve Board explained in the preamble to the Final FBO Rule that assets that are considered HQLAs under the U.S. LCR proposal would generally be considered highly liquid assets for purposes of the Final FBO Rule. 43 The Federal Reserve Board also noted that highly liquid assets should not include assets required to be pledged or segregated for regulatory requirements, such as the OCC s Capital Equivalency Deposit requirement or state law asset pledge requirements. 44 In addition, cash held in deposit at other banks is considered a loan and may constitute a cash in ow, rather than a highly liquid asset that counts toward the liquidity bu er. 45 On the other hand, if an IHC is able to rehypothecate collateral consisting of highly liquid assets that secures a loan (but has not done so), the IHC may count that collateral as a highly liquid asset, subject to appropriate haircuts. 46 When calculating the value of a highly liquid asset for purposes of its liquidity bu er, an IHC must discount the fair market value of the asset to re ect any credit risk and market price volatility of the asset, but the Final FBO Rule does not prescribe speci c haircuts that an IHC must apply. 47 In addition, an IHC s liquidity bu er must not contain signi cant concentrations of highly liquid assets by issuer, business sector, region, or other factor related to the IHC or its parent FBO s risk, except with respect to cash and securities issued or guaranteed by the United States, a U.S. government agency or a U.S. GSE. 48 The Federal Reserve Board noted that dipping into the liquidity bu er during periods of liquidity stress may, in certain circumstances, be bene cial for the safety and soundness of the institution and potentially for nancial stability. The Federal Reserve Board anticipates that any supervisory decisions in response to a reduction of the liquidity bu er will take into consideration the particular circumstances surrounding the reduction See Final FBO Rule, 79 Fed. Reg. at See Final FBO Rule, 79 Fed. Reg. at See Final FBO Rule, 79 Fed. Reg. at See Final FBO Rule, 79 Fed. Reg. at C.F.R (c)(7)(iii) C.F.R (c)(7)(iv). 49 See Final FBO Rule, 79 Fed. Reg. at xix

12 U.S. Reg. Foreign Banks & Affiliates In addition to the liquidity bu er for its IHC, an FBO is required to maintain a liquidity bu er of unencumbered, high quality liquid assets su cient to meet the projected net stressed cash ow needs of its U.S. branches and agencies over the rst 14 days of a 30-day stress test planning horizon. 50 The types of assets that may make up an FBO s liquidity bu er for its U.S. branches and agencies and the method it must use to calculate the projected net stressed cash ow needs of its U.S. branches and agencies are generally comparable to the requirements described above with respect to the IHC liquidity bu er. The Federal Reserve Board stated that it expects Large FBOs to hold additional liquidity resources, either at the home o ce or in the United States, to protect against longer periods of funding pressure at their U.S. branches and agencies. 51 A Large FBO with combined U.S. assets of $50 billion or more must conduct, at least monthly, separate liquidity stress tests for its combined U.S. operations as a whole, all of its U.S. branches and agencies, and its IHC (if any). 52 The stress test results will be used to determine the size of the liquidity bu ers, discussed above, and to inform the Large FBO s contingency funding plan. The Final FBO Rule imposes general requirements for the stress scenarios, assumptions and time horizons that the Large FBO must incorporate into its liquidity stress tests. 53 Other components of the qualitative liquidity framework for Large FBOs with combined U.S. assets of $50 billion or more include: E An FBO s U.S. risk committee must establish and approve at least annually the acceptable level of liquidity risk that the FBO may assume in connection with its U.S. operations and review compliance with the established liquidity risk tolerance. E Among other duties, an FBO s U.S. chief risk o cer (CRO) must monitor compliance with the FBO s liquidity risk tolerance and review and approve new products and business lines that could have a signi cant liquidity e ect. E An FBO must produce comprehensive cash- ow projections for its U.S. operations over short- and long-term time horizons that must be reviewed by the U.S. CRO C.F.R (c)(3). 51 See Final FBO Rule, 79 Fed. Reg. at C.F.R (a)(1) (2) C.F.R (a). xx

13 Introduction E An FBO must develop a contingency funding plan for its combined U.S. operations that, among other elements, identi es liquidity stresses and describes strategies and sources of funding to address such stresses, including a liquidity event management process. The U.S. risk committee must approve the plan at least annually. E An FBO must establish liquidity risk limits that are approved by the U.S. CRO for (i) concentrations of sources of funding by instrument type, counterparty, secured and unsecured lending and other forms of liquidity risk; (ii) the amount of liabilities maturing within various time horizons; and (iii) o -balance sheet exposures and other exposures that could create funding needs during liquidity stress events. E An FBO must establish and maintain procedures for monitoring liquidity risks relating to (i) assets that have been or are available to be pledged as collateral; (ii) legal entities and business lines; and (iii) intraday exposure. 54 Under the Final FBO Rule, a Large FBO with combined U.S. assets of less than $50 billion is subject to fewer liquidity standards. Speci cally, it is required to report annually to the Federal Reserve Board the results of an internal liquidity stress test, either on a consolidated basis or for its combined U.S. operations. The internal stress test must be conducted in a manner consistent with the Basel Committee on Banking Supervision s (BCBS) principles for liquidity risk management 55 and must incorporate 30-day, 90-day and one-year stress test horizons. 56 If the Large FBO does not satisfy this requirement, it must limit the net aggregate amount owed by its head o ce and its non- U.S. a liates to its combined U.S. operations to 25 percent or less of the third-party liabilities of its combined U.S. operations, on a daily basis. 57 Risk Management and Risk Committee Requirements Under the Final FBO Rule, Large FBOs, as well as publicly traded FBOs with total global consolidated assets of at least $10 54 See generally 12 C.F.R See BCBS, Principles for Sound Liquidity Risk Management and Supervision (Sept. 2008) C.F.R (a) C.F.R (b). xxi

14 U.S. Reg. Foreign Banks & Affiliates billion but less than $50 billion (Public Mid-size FBOs), must maintain a U.S. risk committee, with additional risk management requirements for Large FBOs with a large U.S. footprint. A Large FBO with $50 billion or more in combined U.S. assets that conducts its operations through U.S. branches and agencies (in addition to its IHC, if any) may maintain its U.S. risk committee either as (1) a committee of its global board of directors, on a stand-alone basis or as part of its enterprise-wide risk committee; or (2) a committee of the board of directors of its IHC, on a stand-alone basis or as a joint committee with the risk committee of its IHC. 58 The U.S. risk committee for such a Large FBO must include at least one member with experience in identifying, assessing, and managing risk exposures of large, complex nancial rms and at least one member who meets certain independence requirements. 59 In addition, the U.S. risk committee must approve and periodically review the risk management policies of the FBO s combined U.S. operations as well as adopt and oversee a risk management framework 60 for these operations. 61 For Large FBOs with less than $50 billion in combined U.S. assets and Public Mid-size FBOs, there are less stringent composition requirements for the U.S. risk committee, which is not subject to the independent committee member requirement. In addition, although at least one committee member must have experience in identifying, assessing, and managing risk exposures of large, complex rms, this experience may be acquired in a nonbanking or non nancial eld. Each such FBO must certify annually to the Federal Reserve Board that it maintains a U.S C.F.R (a)(3)(ii) C.F.R (a)(5). 60 Speci cally, the risk management framework must include the following elements: (i) policies and procedures establishing risk management governance, risk management procedures, and risk-control infrastructure for the FBO s combined U.S. operations; and (ii) processes and systems for implementing and monitoring compliance with such policies and procedures, including: (A) processes and systems for identifying and reporting risks and risk management de ciencies, including regarding emerging risks, on a combined U.S. operations basis and ensuring e ective and timely implementation of actions to address emerging risks and risk management de ciencies; (B) processes and systems for establishing managerial and employee responsibility for risk management of the combined U.S. operations; (C) processes and systems for ensuring the independence of the risk management function of the combined U.S. operations; and (D) processes and systems to integrate risk management and associated controls with management goals and the compensation structure of the combined U.S. operations. 12 C.F.R (a)(2) C.F.R (a)(1). xxii

15 Introduction risk committee of its global board of directors, on a stand-alone basis or as part of its enterprise-wide risk committee, that oversees the risk management policies of the FBO s combined U.S. operations and that includes at least one member with the required risk management experience. The Final FBO Rule requires an FBO with combined U.S. assets of $50 billion or more to appoint a U.S. CRO with speci ed risk management expertise who will be responsible for overseeing the (A) measurement, aggregation and monitoring of risks undertaken by an FBO s U.S. operations; (B) implementation of and ongoing compliance with the FBO s risk-management policies and procedures for its U.S. operations; and (C) management of risks and risk controls within the parameters of the FBO s risk management framework for its U.S. operations and monitoring and testing such risk controls. 62 In addition, the U.S. CRO is responsible for reporting risks and risk-management de ciencies of the combined U.S. operations and resolving them in a timely manner. 63 The U.S. CRO is also required to regularly provide information on the risks undertaken by the U.S. operations to the FBO s U.S. risk committee, the global CRO and the Federal Reserve Board. 64 The U.S. CRO must be employed by the FBO s IHC or other U.S. subsidiary and must be located in the United States. 65 In addition, the U.S. CRO must report directly to the U.S. risk committee and the FBO s global CRO, unless the Federal Reserve Board approves an alternative reporting structure. 66 According to the Federal Reserve Board, the individual serving as the U.S. CRO generally should not ful ll other roles within the FBO, such as global CRO. 67 Under the Final FBO Rule, an IHC must establish a risk committee of its board of directors. 68 The IHC s risk committee must include at least one member with experience in identifying, C.F.R (b)(1) (2) C.F.R (b)(2)(ii) C.F.R (b)(3)(iv) C.F.R (b)(3)(ii) C.F.R (b)(3)(iii). 67 See Final FBO Rule, 79 Fed. Reg. at 17289; see also FBO Rule FAQs, FAQ no. 37 (Can the U.S. CRO of an FBO oversee non-u.s. entities such as the Americas region?). The Federal Reserve Board states that a U.S. CRO is expected to be primarily focused on overseeing the risk management of the FBO s combined U.S. operations C.F.R (e)(3). For an FBO that conducts its U.S. operations solely through an IHC (i.e., an FBO that does not have a foreign bank with any xxiii

16 U.S. Reg. Foreign Banks & Affiliates assessing, and managing risk exposures of large, complex nancial rms. 69 Furthermore, the Federal Reserve Board expects all risk committee members generally to have an understanding of risk management principles and practices relevant to the rm, and the appropriate level of risk management expertise for an IHC s risk committee will vary depending on the risks posed by the rm to the stability of the U.S. nancial system. 70 In addition, an IHC s board-level risk committee must include at least one member who meets certain independence requirements. 71 The Federal Reserve Board generally expects an FBO to determine the appropriate proportion of independent directors on the risk committee (beyond the minimum of one) based on its size, scope, and complexity. An IHC s board-level risk committee must periodically review and approve the IHC s risk management policies and oversee the IHC s risk management framework. An IHC s risk management framework must generally include, among other elements, risk management policies, procedures and systems for ensuring compliance with the IHC s risk management policies and procedures and integrating risk management policies and procedures with management goals and compensation structures. 72 Home Country Capital and Stress Testing Requirements Under the Final FBO Rule, a Large FBO must demonstrate to the Federal Reserve Board its compliance with home country capital and stress testing requirements that are comparable to U.S. standards. A Large FBO will be required to certify that it meets capital adequacy standards established by its home-country supervisor that are consistent with the international Basel III capital U.S. branches or agencies), the IHC s risk committee must also serve as the FBO s U.S. risk committee. 12 C.F.R (a)(3)(i) C.F.R (e)(3)(iv)(A). 70 See Final FBO Rule, 79 Fed. Reg. at C.F.R (e)(3)(iv)(B) C.F.R (e)(3)(i) (ii). xxiv

17 Introduction framework. 73 If an FBO is not subject to comparable home-country standards and is not able to show that it could satisfy international Basel III standards if it were subject to them, the Federal Reserve Board may impose requirements, conditions or restrictions on the FBO s U.S. operations and activities. 74 In addition, a Large FBO will be required to be subject to and pass annual home country stress tests that are comparable to U.S. standards. The FBO s home country capital stress testing regime must include: (i) an annual supervisory capital stress test conducted by the FBO s home country supervisor or an annual evaluation and review by the home country supervisor of an internal capital adequacy stress test conducted by the FBO; and (ii) requirements for governance and controls of stress testing practices by the FBO s management and board of directors (or equivalent thereof). 75 The Final FBO Rule does not include a stress testing requirement for a Large FBO s U.S. branches and agencies. By January 5 of each year, a Large FBO with combined U.S. assets of $50 billion or more must report to the Federal Reserve Board certain speci ed quantitative and qualitative information on its stress testing activities and results. 76 An FBO with U.S. branches and agencies that provide funding to the FBO s non- U.S. o ces and a liates, as calculated based on the average daily position over the FBO s stress test cycle for a given year, must report additional information about its stress tests C.F.R (a), (a) C.F.R (c), (c) C.F.R (b), (b) C.F.R (c)(1). Speci cally, the FBO must provide (i) a description of the types of risks included in the stress test; (ii) a description of the conditions or scenarios used in the stress test; (iii) a summary description of the methodologies used in the stress test; (iv) estimates of: (A) aggregate losses; (B) pre-provision net revenue; (C) total loan loss provisions; (D) net income before taxes; and (E) pro forma regulatory capital ratios required to be computed by the home country supervisor of the foreign banking organization and any other relevant capital ratios; and (v) an explanation of the most signi cant causes for any changes in regulatory capital ratios C.F.R (c)(2). Speci cally, the FBO must provide (i) a detailed description of the methodologies used in the stress test, including those employed to estimate losses, revenues, and changes in capital positions; (ii) estimates of realized losses or gains on available-for-sale and held-to-maturity securities, trading and counterparty losses, if applicable; and loan losses (dollar amount and as a percentage of average portfolio balance) in the aggregate and by material sub-portfolio; and (iii) any additional information that the Federal Reserve Board requests. xxv

18 U.S. Reg. Foreign Banks & Affiliates If the Federal Reserve Board determines that a Large FBO with combined U.S. assets of $50 billion or more is not subject to comparable home-country stress testing standards, the FBO will be required to maintain eligible assets in its U.S. branches and agencies that, on a daily basis, are not less than 108 percent of the average value of each day of the previous quarter of the total liabilities of the FBO s U.S. branches and agencies. The FBO may also be subject to intragroup funding restrictions or additional liquidity requirements. 78 A Large FBO with less than $50 billion in combined U.S. assets that the Federal Reserve Board determines is not subject to comparable home-country stress testing standards will be subject to a 105 percent asset maintenance requirement for its U.S. branches and agencies and must conduct an annual stress test of its U.S. subsidiaries and report on the stress test to the Federal Reserve Board. 79 Debt-to-Equity Limitation Under the Final FBO Rule, in the event that the Financial Stability Oversight Council (FSOC) determined that an FBO posed a grave threat to U.S. nancial stability and that the imposition of a debt-to-equity requirement was necessary to mitigate such risk, within 180 days after such a determination, subject to any extension granted by the Federal Reserve Board: (1) the FBO s IHC (or, if the FBO has not established a U.S. IHC, any U.S. subsidiary) must maintain a debt-to-equity ratio of no more than 15-to-1; and (2) the FBO s U.S. Branch and Agency Network must maintain a 108 percent asset maintenance requirement. 80 Single Counterparty Credit Limits The Final FBO Rule did not include single counterparty credit limits (SCCLs), which the Federal Reserve Board continues to develop. The Federal Reserve Board stated that it is conducting a quantitative impact study and will also take into account the C.F.R (d) C.F.R (c) C.F.R xxvi

19 Introduction BCBS s large exposures regime before nalizing SCCLs. 81 The proposed rule to apply enhanced prudential standards to FBOs (Proposed FBO Rule), 82 which addressed SCCLs, would limit the aggregate net credit exposure arising from credit transactions 83 that an IHC and the combined U.S. operations of a Large FBO may have to any una liated counterparty. Speci cally, an IHC, together with its subsidiaries, 84 would be prohibited from having an aggregate net credit exposure 85 to any una liated counterparty, together with its subsidiaries, in excess of 25 percent of the IHC s consolidated capital stock and surplus. 86 In addition, the combined U.S. operations of a Large FBO, together with any subsidiary of an entity within the combined U.S. operations, would be prohibited from having an aggregate net credit exposure to any una liated counterparty, together with its sub- 81 See Final FBO Rule, 79 Fed. Reg. at 17243; Davis Polk & Wardwell LLP Capital and Prudential Standards Blog, Summary of Basel Committee s Final Large Exposures Framework (April 15, 2014), available at blog.usbasel3.com/basel-large-exposures-summary/. 82 Federal Reserve Board, Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies; Proposed Rule, 77 Fed. Reg (Dec. 28, 2012). 83 Credit transactions subject to the single counterparty credit limits include: any extension of credit, including loans, deposits and lines of credit, but excluding advised or other uncommitted lines of credit; any repurchase or reverse repurchase agreement; any securities lending or securities borrowing transaction; any guarantee, acceptance or letter of credit (including any con rmed letter of credit or standby letter of credit) issued on behalf of a counterparty; any purchase of, or investment in, securities issued by a counterparty; in connection with a derivative transaction: (1) any credit exposure to a counterparty, and (2) any credit exposure to the reference entity, where the reference asset is an obligation or equity security of a reference entity; any transaction that is the functional equivalent of the above; and any similar transaction that the Federal Reserve Board determines to be a credit transaction for purposes of the single counterparty credit limits. 84 A subsidiary of a speci ed company means a company that is directly or indirectly controlled by the speci ed company. The proposed de nition of control for purposes of single counterparty credit limits is more limited than under the BHC Act and essentially excludes the controlling in uence and other qualitative elements. Speci cally, a company controls another company if it (1) owns, controls or holds with power to vote 25 percent or more of a class of voting securities of the company; (2) owns or controls 25 percent or more of the total equity of the company; or (3) consolidates the company for nancial reporting purposes. 85 Generally, net credit exposure is determined by adjusting gross credit exposure to take into account, where permissible, bilateral netting agreements, eligible collateral, eligible guarantees, eligible credit and equity derivatives and certain other eligible hedges. 86 An IHC s capital stock and surplus is de ned as the sum of the IHC s total regulatory capital and its excess allowance for loan and lease losses not included in Tier 2 capital under the applicable capital rules. xxvii

20 U.S. Reg. Foreign Banks & Affiliates sidiaries, in excess of 25 percent of the consolidated total regulatory capital of the Large FBO. The Large FBO would have to comply with those requirements on a daily basis and submit monthly compliance reports to the Federal Reserve Board. The Proposed FBO Rule would also impose a more stringent credit exposure limit between a major IHC or the combined U.S. operations of a major FBO, together with their respective subsidiaries, and any una liated major counterparty, together with its subsidiaries. 87 This more stringent limit would be set to be consistent with the stricter limit established for major U.S. BHCs and for nonbank nancial companies supervised by the Federal Reserve Board following a systemic designation by the FSOC. Early Remediation Framework In addition, the Final FBO Rule did not include early remediation requirements, which also remain under development by the Federal Reserve Board. Under the Proposed FBO Rule s early remediation framework, a Large FBO would be subject to four levels of early remediation triggers based on the Large FBO s and any IHC s capital ratios relative to applicable minimum requirements, stress test results, liquidity and risk management weaknesses and market indicators. A Large FBO with combined U.S. assets of $50 billion or more that triggers early remediation would be subject to four levels of nondiscretionary remediation actions imposed on its U.S. operations, including, among other things, restrictions on growth, restrictions on capital distributions and certain corporate governance related restrictions. 88 A Large FBO with combined U.S. assets of less than $50 billion would not be automatically subject to remediation actions. In the event a Large FBO with combined U.S. assets of less than $50 billion breached an early remediation trigger, the Federal Reserve Board would consider the activities, scope of operations, structure and risk to U.S. nancial stability posed by the Large FBO and determine whether any of the remediation actions that would be 87 A major IHC is de ned as an IHC with total consolidated assets of $500 billion or more. A major FBO is de ned as an FBO with total global consolidated assets of $500 billion or more. A major counterparty is de ned to include a BHC or FBO that has total consolidated assets of $500 billion or more and any nonbank nancial company supervised by the Federal Reserve Board following a systemic designation by the FSOC (Nonbank SIFI). 88 The Federal Reserve Board stated that it expects to notify the Large FBO s home country supervisor, the primary regulators of its U.S. o ces and subsidiaries and the FDIC as the Large FBO s U.S. operations enter into or change remediation levels. xxviii