Fed’s Prudential Rule Changes Launch A New Era in Financial Regulation
By Deborah Bailey
Long-awaited regulations implementing wide-ranging enhanced prudential standards and early remediation rules have been proposed by the U.S. Federal Reserve, and many financial companies — both domestic and foreign — should begin preparations for a vastly changed regulatory landscape.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, a direct response to the financial crisis, placed a spotlight on the high degree of interconnectedness of the financial system and the implication that poses to the world economy. Thus, the proposed enhanced prudential supervision rules demonstrate a fundamental shift in financial regulation. They reflect a much more aggressive, granular and hands-on approach; failure to comply with the rules can come with steep civil monetary penalties.
The rules will likely be finalized as law this summer, though they won’t take effect for about a year after enactment.
Those covered by the new rules will include bank holding companies with assets of more than $50 billion, U. S. bank holding company subsidiaries of foreign banks with assets of more than $50 billion and nonbank financial institutions to be designated as systematically important — institutions whose failure could threaten the greater financial system.
Provisions such as stress testing and risk management will relate to bank holding companies and nonbank financial institutions with assets over $10 billion. The Fed intends to release at a later date rules applying to foreign banking organizations with U.S. operations outside of the bank holding company structure.
Implications of the Rules
Once final, the implications of the rules will vary. But, bottom line, they are designed to prevent the largest financial institutions from getting substantially bigger, or even to reduce their size. Compliance around these broad and extensive rules will likely require improved systems and controls to help achieve and monitor compliance with the heightened prudential standards.
For many organizations, this may mean that they will need to collect and analyze data differently than they do currently. The required reporting will be stringent and frequent. Some companies may need to change their information technology infrastructure to improve data aggregation and analysis processes, given that it will be necessary to identify, aggregate, measure, monitor and report on enhanced standards.
In summary, the draft rules address the following:
▪ Counterparty Credit Limits: New caps on the maximum exposure any one bank holding company can have to any other party, including other banks, will be enacted. These limitations could restrict exposures on derivatives, sovereign debt and other transactions. Banking organizations will be required to have enterprise-wide processes in place to identify, measure and control concentrated risk exposures at the legal entity and enterprise levels. Considering the role concentrations played in the financial crisis, supervisors will look closely at compliance in these aspects, possibly on a daily basis.
▪ Stress Testing and Capital: The Fed will require a covered company to conduct stress testing as part of its capital planning exercise and establish risk-based capital requirements, leverage limits and internal liquidity requirements, in line with still-undetermined international rules from the Basel Committee. Once the international rules are applied in the U.S., they will likely be prescriptive for both capital and liquidity requirements and could impact bank growth and even the types of business banks pursue.
▪ Risk Management: Boards of directors at institutions with more than $10 billion in total assets will be required to establish a risk committee to oversee enterprise-wide risk management plans. The committee would be required to have at least one independent director, who would serve as chair, and at least one risk management expert.
These same companies would need to establish the position of an independent, enterprise-wide chief risk officer who would report dually to the CEO and the new risk committee.
▪ Early-warning Remediation Triggers: Based on a “prompt corrective action” regime, these triggers outline predefined actions the Fed must take if a covered company begins to experience specific capital or liquidity challenges. These might include limitations on growth or dividend distributions, a call to raise capital, a sale of assets or even liquidation of the organization. This remediation process is designed to detect and slow an institution’s potential collapse and impacts on the integrity of the greater financial system.
These new prudential rules are far more expansive than past regulations and represent a significant shift in supervisory oversight. If they are eventually made into law, affected companies will experience a momentous change to the way they collect data, monitor compliance, develop internal policies and manage and report on risk taking.
Deborah Bailey (212.436.4279) is a director in Deloitte & Touche’s regulatory, governance and risk strategies practice in New York. She is a former deputy director of the banking supervision and regulation division of the Federal Reserve System, where in 2009 she led the first round of stress testing at the 19 largest financial institutions.