2014 Morrison & Foerster LLP All Rights Reserved mofo.com The Federal Reserve Board s Final Dodd-Frank Enhanced Prudential Regulations for Foreign Banks March 14, 2014 Presented By Henry M. Fields hfields@mofo.com Barbara R. Mendelson bmendelson@mofo.com
Today s Discussion Topics Background Changes from the Proposals and Effective Dates Coverage Intermediate Holding Companies Capital Liquidity Risk Management Stress Testing Debt-to-Equity Limits Issues and Response Strategies This is MoFo. 2
Other Topics Deferred Rulemaking Single-Counterparty Credit Limits Early Remediation Standards Enhanced Prudential Standards for Non-Bank Financial Companies To be addressed on a case-by-case basis This is MoFo. 3
Some Helpful Definitions Board Federal Reserve Board FBO Foreign banking organization as defined in the Board s Regulation K. IHC U.S. intermediate holding company BHCA U.S. Bank Holding Company Act BHC Bank holding company as defined under the BHCA DFA Dodd-Frank Wall Street Reform and Consumer Protection Act DPC subsidiaries Subsidiaries of a U.S. branch/agency formed to hold assets acquired in the ordinary course for debt previously contracted ( DPC ) This is MoFo. 4
Quantitative Thresholds Covered FBO a FBO with $50BB+ of consolidated worldwide assets $10BB FBO FBO with consolidated worldwide assets of between $10BB and $50BB Combined U.S. Assets the sum of the consolidated assets of each toptier U.S. subsidiary of the FBO (excluding any BHCA section 2(h)(2) company) and the total assets of each U.S. branch and agency of the FBO U.S. Non-branch Assets - the sum of the consolidated assets of the toptier U.S. subsidiaries of the FBO (excluding any BHCA section 2(h)(2) company and DPC branch subsidiary) Combined U.S. Operations the U.S. branches and agencies of an FBO and (i) if the FBO has an IHC, the IHC and its subsidiaries; or (ii) if the FBO does not have an IHC, the direct and indirect U.S. subsidiaries of the FBO (excluding any section 2(h)(2) company, if applicable) This is MoFo. 5
Background Proposed in December 2012 under DFA Sections 165,166 and 167 Section 165: Enhanced supervision and prudential standards for systemically important banks and nonbank financial companies Section 166: Early remediation requirements for systemically important banks and nonbank financial companies Section 167: Intermediate holding company requirement for systemically important nonbank financial companies FBO provisions modeled on DFA Section 165/166 rules proposed in December 2011 for domestic bank holding companies This is MoFo. 6
Represents the Board s attempt to create a workable framework for the U.S. regulation of systemically important FBOs under the DFA Board required to take into account national treatment and competitive equality considerations Also reflects other discrete Board concerns Background Increased scope/complexity of FBOs U.S. nonbank operations Availability of home country financial resources for U.S. operations of foreign banks and financial companies Availability of information on U.S. operations of foreign firms Use of U.S. branch/agency operations to fund home country or offshore activities This is MoFo. 7
Changes from Proposals/Effective Dates Final Rule defers action on single-counterparty credit limits and early remediation standards Foreign nonbank financial institutions not covered and to be evaluated by Board on a case-by-case basis Decreases liquidity buffer for U.S. branches and agencies of FBO from 30 days to 14 days Extends initial compliance date for Covered FBOs from July 1, 2015 to July 1, 2016 This is MoFo. 8
Changes from Proposals/Effective Dates Other changes applicable to IHCs Raises the threshold for requiring a Covered FBO to form an IHC Defers application of the leverage capital requirements and stress test requirements to IHCs until January 1, 2018 and October 1, 2017, respectively Transition period to form an IHC extended (discussed below) Requires IHC implementation plan to be submitted by January 1, 2015 This is MoFo. 9
Coverage General Coverage All Covered FBOs $10BB FBOs are subject to stress testing and, if publicly traded, risk committee requirements Tiered applicability based on size and footprint of U.S. operations This is MoFo. 10
Summary of Tiered Applicability Size Requirements Subpart of Final Rule $10BB FBOs Company-run stress tests Subpart L $10BB FBOs that are publicly traded Covered FBO with less than $50BB of Combined U.S. Assets Covered FBO with $50BB+ of Combined U.S. Assets Risk committee Risk-based and leverage capital Risk committee Liquidity Capital stress testing Debt-to-equity limits (upon grave threat determination) Risk-based and leverage capital Risk management framework Risk committee and U.S. chief risk officer Liquidity risk-management, stress-testing and buffers Capital stress testing U.S. IHC requirement (if U.S. Non-branch Assets of $50BB+) Debt-to-equity limits (upon grave threat determination) Subpart M Subpart N Subpart U Subpart O Subpart O Subpart E (IHC Supervisory Stress Test) Subpart F (IHC Company-Run Stress Test) Subpart U This is MoFo. 11
IHCs IHC not required under DFA section 165 but established as an additional prudential standard Board may establish any appropriate additional prudential standard for covered companies Purpose is to prevent or mitigate risks to U.S. financial stability IHC requirement intended to increase the resiliency of the U.S. operations of large FBOs Also provides for a single focus for risk management of operations of U.S. Non-branch Assets Provides single point of entry for resolution of operations of U.S. Nonbranch Assets This is MoFo. 12
IHCs A Covered FBO with $50BB+ of U.S. Non-branch Assets must consolidate those assets under an IHC The IHC requirement applies even if the Covered FBO does not operate a bank or thrift in the U.S. subjects such operations to capital and other BHC-type requirements even though not a BHC U.S. Non-branch Assets are measured for this purpose based on four prior quarters Form FR Y7-Q financial data Must provide notice to the Board within 30 days of establishing or designating an IHC This is MoFo. 13
IHC Compliance dates IHCs FBOs that meet the threshold on July 1, 2015 must form an IHC and transfer their U.S. BHC and bank subsidiaries and substantially all of their other U.S. nonbank subsidiary business to the IHC by July 1, 2016. Full compliance must be achieved by July 1, 2017 FBOs that meet the threshold after July 1, 2015 must comply by the first day of the ninth quarter following the date on which it meets the threshold FBOs meeting the threshold as of June 30, 2014 must submit an implementation plan by January 1, 2015 Timeline for transfer of subsidiaries to IHC List of subsidiaries to be held or excluded from IHC Planned capital actions that will allow IHC capital compliance 3 years of pro forma quarterly financials How IHC will comply with risk management and liquidity stress testing requirements This is MoFo. 14
Structure and Regulation of the IHC IHCs must be organized under U.S. law IHCs All U.S. banking and nonbanking operations must be held under the IHC, except U.S. branches and agencies of the FBO BHCA section 2(h)(2) companies owned by the FBO DPC branch subsidiaries Controlled merchant banking portfolio companies and/or insurance companies must be held under the IHC even though not integral to U.S. operations IHCs must have a full-functioning board of directors or managers Use of BHCA control definition could create uncertainties for companies owned at 10 24.99% level This is MoFo. 15
Structure and Regulation of the IHC (contd.) IHCs IHCs subject to supervision and regulation comparable to U.S. BHCs, including enhanced prudential standards Enhanced prudential standards apply to the consolidated operations of the IHC, including foreign subsidiaries of the IHC Until the IHC becomes subject to the new parallel requirements applicable to IHCs (date varies based on the type of requirement), U.S. BHCs with $50BB+ of consolidated assets controlled by an FBO are subject to enhanced prudential standards applicable to U.S. BHCs beginning on January 1, 2015 This is MoFo. 16
Alternative Organizational Structures Home country law may prohibit FBO from owning U.S. subsidiaries through a single U.S. IHC IHCs Other circumstances may warrant exceptions based on the FBO s activities, scope of operations, structure or similar considerations, e.g. an FBO controls multiple lower-tier FBOs that have separate U.S. operations an FBO cannot transfer its ownership interest in a U.S. subsidiary to an IHC or otherwise restructure its investment (passivity commitment or supervisory agreement may be required) Alternative structures require application to Board Virtual U.S. IHC not permitted Board voices concerns about centralized risk management Exercise of resolution authority through holding company model This is MoFo. 17
Requirements for Covered FBOs: Capital Beginning July 1, 2016, a Covered FBO must certify and demonstrate compliance with capital adequacy standards at the consolidated level consistent with the Basel Committee capital framework Specific reports on applicable Basel capital ratios (including leverage ratio) to be included in FR Y-7Q Must provide reports relating to their compliance with the Basel capital adequacy standards (Board will propose these rules separately as an amendment to the FR Y-7Q) FBO public disclosures must be consistent with the Basel Capital Framework Failure to meet capital adequacy standards may result in Board restrictions on U.S. activities or business operations This is MoFo. 18
IHCs Capital IHCs are subject to U.S. risk-based capital and leverage requirements to the same extent as U.S. BHCs (even if they are not BHCs) Must comply with leverage capital requirements by January 1, 2018 Includes base 4% leverage ratio and, for IHCs with total consolidated assets of $250BB+ or foreign exposures of $10BB+, 3% supplementary leverage ratio Not required to implement advanced internal models based approach to determine capital (even if a BHC) Until the IHC becomes subject to the new parallel requirements applicable to U.S. BHCs, each subsidiary BHC and bank subsidiary of an FBO currently subject to leverage capital requirements must continue to comply IHCs must comply with Board capital plan rule to the same extent as a covered U.S. BHC (first plan would be due in January 2017) Must comply with risk-based capital and capital plan requirements by July 1, 2016 This is MoFo. 19
Liquidity: Covered FBOs with less than $50BB of Combined U.S. Assets Annual Basel Committee-consistent internal liquidity stress test with results reported to the Board Failure to comply with this requirement obliges the Covered FBO to limit the net aggregate amount owed by the FBO parent office and non-u.s. affiliates to its Combined U.S. Operations to 25% or less of the Combined U.S. Operations third-party liabilities on a daily basis This is MoFo. 20
Liquidity: Covered FBOs with $50BB+ of Combined U.S. Assets U.S. risk committee (see Risk Management below) must: Approve the liquidity risk tolerance for the Combined U.S. Operations at least annually Review information provided by senior management of the Combined U.S. Operations at least semi-annually to determine compliance with liquidity risk tolerance Approve the contingency funding plan for Combined U.S. Operations at least annually or upon revision Conduct a liquidity risk review of significant business lines and products of the Combined U.S. Operations at least annually This is MoFo. 21
Liquidity: Covered FBOs with $50BB+ of Combined U.S. Assets U.S. chief risk officer (see Risk Management below) must: Review liquidity risk management strategies, policies and procedures for Combined U.S. Operations Review information provided by senior management of U.S. operations to determine compliance with liquidity risk tolerance Report to the U.S. and enterprise-wide risk committee on U.S. operations liquidity risk profile at least semi-annually (and establish procedures governing the content of such reports) Approve new products and business lines based on liquidity risk At least quarterly: Review cash flow projections for Combined U.S. Operations Establish and determine compliance with liquidity risk limits And upon material revision, approve liquidity stress testing practices, methodologies and assumptions Review liquidity stress testing results Approve liquidity buffer This is MoFo. 22
Liquidity: Covered FBOs with $50BB+ of Combined U.S. Assets Establish and maintain a liquidity risk management review function independent of the management responsible for funding Regular (no less than annual) review of adequacy and effectiveness of liquidity risk management processes within Combined U.S. Operations and compliance with law Report liquidity risk management issues to U.S. risk committee and enterprise-wide risk committee Produce comprehensive cash flow projections Establish and maintain a contingency funding plan Monitor sources of liquidity risk and establish liquidity risk limits consistent with liquidity risk tolerance Establish and maintain procedures for collateral, legal entity, and intraday liquidity risk monitoring This is MoFo. 23
Liquidity: Covered FBOs with $50BB+ of Combined U.S. Assets Conduct monthly (or more frequently as the Board may require) liquidity stress tests that are reported to the Board Separate testing of branch/agency network and IHC Stress testing must also be conducted for the Combined U.S. Operations Policies, procedures and controls for liquidity stress testing are required FBO parent of IHC is required to make available to the Board in a timely manner the results of home-country liquidity stress testing and the establishment of any liquidity buffers This is MoFo. 24
Liquidity: Covered FBOs with $50BB+ of Combined U.S. Assets IHC must maintain in U.S. liquidity buffer of unencumbered highly liquid assets equal to external and internal net stressed cash flow need over a 30-day horizon Liquidity buffer for IHC comprised of cash may not be held in an account at a U.S. branch/agency or other affiliate that is not controlled by the IHC U.S. branch/agency network must maintain in U.S. 14- day liquidity buffer (change from proposal) Liquidity buffer for U.S. branch/agency network comprised of cash may not be held in an account at the IHC or other affiliate This is MoFo. 25
Risk Management $10BB FBOs that are publicly traded and Covered FBOs with less than $50BB of Combined U.S. Assets The FBO must certify annually to the Board that it maintains a risk committee that oversees the risk management policies (formerly practices ) of its Combined U.S. Operations, with at least one member with risk management experience (formerly expertise ) The risk committee may be a committee of the FBO s global board of directors or supervisory board The certification requirement would first apply on the later of July 1, 2016 or the first day of the ninth quarter following the date on which it meets the threshold Certification to be filed concurrently with FR Y-7 Noncompliance with risk management requirements may result in Board-imposed limits on activities or business operations This is MoFo. 26
Risk Management Covered FBOs with $50BB+ of Combined U.S. Assets FBO must also maintain a risk committee with at least one member with risk management experience, and at least one independent member An FBO conducting operations through U.S. branches/agencies may place its risk committee at the FBO s global board of directors or supervisory board, or at the IHC if applicable An FBO that operates in the U.S. solely through an IHC must place its U.S. risk committee at the IHC Risk committee must meet at least quarterly and fully document and maintain records, including risk-management decisions Risk committee s responsibilities include the liquidity riskmanagement responsibilities This is MoFo. 27
Risk Management Covered FBOs with $50BB+ of Combined U.S. Assets (cont.) U.S. risk committee would have a number of specific responsibilities, including the obligation to: Approve and periodically review risk management policies of Combined U.S. Operations or IHC Oversee the risk-management framework that is commensurate with the structure, risk profile, complexity, and size of Combined U.S. Operations or IHC An FBO generally may rely on its parent company s enterprisewide risk management policies for its U.S. operations IHC must have its own risk committee to oversee the risk function of the IHC (but may also fulfill the responsibilities of the U.S. risk committee of the Combined U.S. Operations) This is MoFo. 28
Risk Management Covered FBOs with $50BB+ of Combined U.S. Assets (cont.) The FBO or its IHC must appoint a U.S. chief risk officer, who must: Have risk management experience (formerly expertise ) Be independently compensated Be employed by and located in the U.S. branch/agency, IHC, or another U.S. subsidiary Report directly and regularly provide information to the U.S. risk committee and global risk officer Undertake liquidity risk-management responsibilities This is MoFo. 29
Risk Management Covered FBOs with $50BB+ of Combined U.S. Assets (cont.) The U.S. chief risk officer must oversee: Measurement, aggregation, and monitoring of risks of U.S. combined operations Implementation of and compliance with the policies and procedures for reporting risks and risk-management deficiencies Management, monitoring and testing of risks and risk controls Noncompliance with risk management requirements may result in Board-imposed limits on activities or business operations This is MoFo. 30
Stress Testing $10BB FBOs and Covered FBOs with less than $50BB of Combined U.S. Assets Must be subject to a consolidated home country stress-testing regime that includes either (i) an annual supervisory stress test, or (ii) or a supervisor-reviewed annual internal stress test The home country regime also must include requirements for governance and controls of the stress testing regime The FBO must conduct and pass the home country stress test These requirements also apply to foreign savings and loan holding companies of $10BB+ in assets (DFA requirement) Separate information/reporting requirements of the sort applicable to Covered FBOs with $50BB+ of Combined U.S. Assets (discussed below) would not apply This is MoFo. 31
Stress Testing $10BB FBOs and Covered FBOs with less than $50BB of Combined U.S. Assets (cont.) Failure to comply with these requirements would trigger: An asset maintenance requirement for the FBO s U.S. branch/agency network of eligible assets equal to 105% of third-party liabilities An annual stress test requirement of its U.S. subsidiaries. This test could be conducted separately or as part of an enterprisewide stress test This is MoFo. 32
Stress Testing Covered FBOs with $50BB+ of Combined U.S. Assets FBOs having a U.S. branch/agency must be subject to a consolidated home country stress-testing regime that includes either (i) an annual supervisory stress test, or (ii) or a supervisorreviewed annual internal stress test Home country regime also must include requirements for governance and controls of the stress testing regime FBO must conduct and pass the home country stress test FBO must report summary information about its stress-testing activities and results by January 5 of each year This is MoFo. 33
Stress Testing Covered FBOs with $50BB+ of Combined U.S. Assets (cont.) U.S. branch/agency networks in a net due from position to their foreign parent/affiliates have additional reporting requirements, determined on a case-by-case basis and accounting for the size, complexity, and business activities of the FBO and its U.S. operations Additional information required by January 5 of each year Confidentiality of information would be determined in accordance with existing Board and FOIA requirements This is MoFo. 34
Stress Testing Covered FBOs with $50BB+ of Combined U.S. Assets (cont.) Consequences of failure to comply: An asset maintenance requirement U.S. branch/agency network would have to hold eligible assets equal to 108% of third party liabilities Annual stress test requirement for U.S. subsidiaries (to the extent that an FBO has not established an IHC) The Board would have the authority to impose liquidity buffers or intragroup funding restrictions on noncompliant FBOs This is MoFo. 35
Stress Testing IHCs IHCs are subject to the annual supervisory and semi-annual company-run stress testing requirements applicable to similarlysized U.S. BHCs Must comply by October 1, 2017 Requirements for U.S. subsidiaries of IHCs: Until the IHC becomes subject to the new parallel requirements applicable to IHCs, each subsidiary BHC and insured depository institution of an FBO currently subject to stress test requirements must continue to comply through September 30, 2017 This is MoFo. 36
Debt-to-Equity Limits Covered FBOs: A conditional debt-to-equity limit of not more than 15-to-1, upon a determination by the U.S. Financial Stability Oversight Council that a Covered FBO poses a grave threat to U.S. financial stability, and that the debt-to-equity limit is necessary to mitigate that risk The limits would be applied to any IHC and any U.S. subsidiary (other than a section 2(h)(2) company or DPC branch subsidiary) that is not part of an IHC structure In addition, the FBO s U.S. branch/agency network would be subject to a daily 108% asset maintenance requirement This is MoFo. 37
Issues and Response Strategies The economic and regulatory costs of the Final Rule could be substantial in some cases, and will need to be carefully assessed by affected FBOs (which will essentially include any FBOs with U.S. banking operations) That being said, the impact of the Final Rule on FBOs will be widely disparate, depending on the nature and footprint of an FBO s U.S. operations Possible Strategic Responses Reduce size of U.S. operations, especially capital-intensive operations Move certain U.S. operations into the U.S. branch/agency network Board discusses this possibility and will be monitoring This is MoFo. 38
Issues and Response Strategies Possible FBO response strategies: Review nature and scope of U.S. operations and their role in, and consistency with, the enterprise s strategic planning efforts and outcomes Quantify economic and regulatory costs of the compliance with standards for various thresholds (i.e. total consolidated assets, Combined U.S. Assets, and U.S. Non-branch Assets) Assess impact of the Final Rule on enterprise profitability Critically consider adjustments to U.S. operations based on the foregoing reviews If applicable, consider potential alternative organizational structures in lieu of establishing a single IHC This is MoFo. 39
Deferred Topics Single-counterparty Credit Limits The Board is continuing to develop single-counterparty credit limits required under DFA Section 165 based on the results of a quantitative impact study conducted last summer and the Basel Committee s initiative to develop a regulatory framework governing large credit exposures that would apply to all global banks Early Remediation Requirements (DFA Section 166) The Board is continuing to review comments on early remediation requirements and is integrating the remediation levels with the Basel III capital rules adopted in July 2013 Prudential Requirements for Systemically Important Nonbank Financial Companies (DFA Section 167) Unlike the proposal s one-size-fits-all approach for nonbank financial companies, the Final Rule provides that the Board will apply enhanced prudential standards on a case-by-case basis This is MoFo. 40
About Morrison & Foerster We are Morrison & Foerster a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life sciences companies. We ve been included on The American Lawyer s A-List for 10 straight years, and Fortune named us one of the 100 Best Companies to Work For. Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. 2014 Morrison & Foerster LLP. All rights reserved. This is MoFo. 41