Kathleen A. Scott
Kathleen A. Scott ()

As discussed in previous columns,1 section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 required the Board of Governors of the Federal Reserve System (FRB) to promulgate enhanced prudential standards for large U.S. bank holding companies and large non-U.S. banks with U.S. banking operations (“large” meaning $50 billion or more in consolidated global assets). The FRB also is required to promulgate prudential standards for nonbank financial institutions (both U.S. and non-U.S.) that have been designated as systemic risks to the U.S. banking system by the Financial Stability Oversight Council (FSOC).2

The FRB issued the proposed prudential standards in two parts—in January 2012 for large U.S. bank holding companies and FSOC-designated U.S. systemically important nonbank financial institutions,3 and in December 2012, for large non-U.S. banks and non-U.S. nonbank financial institutions designated by FSOC as posing a systemic risk to the U.S. financial system.4 The non-U.S. bank proposal was intended to be “broadly consistent” with the proposed standards to be imposed on U.S. bank holding companies and FSOC-designated U.S. systemically important nonbank financial institutions.

On Feb. 18, 2014, the FRB approved final prudential standards regulations for both U.S. banking organizations and non-U.S. banks with banking operations in the United States.5 FSOC-designated systemically important nonbank financial institutions, whether U.S. or non-U.S. in origin, were excluded from the scope of the final rule; for this category of companies, the FRB will impose prudential requirements on a company-by-company basis by specific rule or order. This month’s column will provide an overview of the final prudential standards regulations and their impact on non-U.S. banks’ operations in the United States.

The Original Proposals

As proposed, the prudential requirements would be applicable in the first instance to non-U.S. banks with total global consolidated assets of at least $10 billion. More stringent requirements would be imposed as the assets of the non-U.S. bank, both globally and in the United States, increased. The proposals included required risk management committees, stress tests, liquidity tests, and limits on credit exposure to counterparties. One of the most controversial proposals required incorporation of a U.S. holding company for certain U.S. assets of non-U.S. banks.

Final Regulations

As finally adopted, the final regulations generally prescribe the same or similar requirements for similarly situated U.S. and non-U.S. banks. The final rule applies to (i) large companies (including non-U.S. banks) that are bank holding companies for purposes of the Bank Holding Company Act of 1956 (BHC Act), because of their ownership of banks subject to the BHC Act, and (ii) large non-U.S. banks that maintain branches, agencies or commercial lending companies in the United States and thus, pursuant to the International Banking Act of 1978 (IBA), are treated as if they are bank holding companies for purposes of the BHC Act. Substantive changes included an increase in the threshold for establishment of an intermediate holding company, clarification of risk committee operations and member expertise and lengthening the effective dates for compliance.

Two material proposals were not finalized. With respect to non-U.S. banks, the FRB reserved decision on a proposed matrix of remediation actions to be taken by the FRB (from a targeted supervisory review of the non-U.S. bank’s U.S. operations up to and including consideration by the FRB whether to terminate the non-U.S. bank’s U.S. operations) in order to address financial distress in the non-U.S. bank’s U.S. operations if the non-U.S. bank failed to comply with the prudential standards. The FRB also reserved decision on a proposal that would have limited aggregate net credit exposure to a single unaffiliated counterparty to 25 percent of regulatory capital of the non-U.S. bank or any U.S. intermediate holding company subsidiary, with that limit becoming stricter the higher the amount of the non-U.S. bank’s total global or U.S. consolidated assets, except for the non-U.S. bank’s own home country sovereign debt and U.S. federal government debt.

In the final requirements below, it is important to note that a reference to “combined U.S. operations” means a non-U.S. bank’s U.S. branches and agencies and its U.S. subsidiaries, excluding section 2(h)(2) companies.6 “Total consolidated assets” is a reference to the non-U.S. bank’s consolidated assets on a global basis.

The final prudential standards for large non-U.S. banks are as follows:

Category Number 1: A non-U.S. bank with at least $10 billion or more of total consolidated assets is required to:7

• Certify, if it has at least one class of stock (or similar interest such as an American Depository Receipt) that is publicly traded, that it maintains a committee of its global board of directors that oversees the risk management policies of the combined U.S. operations of the non-U.S. bank and that at least one member of the committee has experience in “identifying, assessing, and managing risk exposures of large complex firms”;

• Be subject to, and conduct, home country capital stress tests in accordance with a regime that is broadly consistent with the FRB’s own stress testing requirements for U.S. bank holding companies, or otherwise be subject to additional requirements to help ensure the capital adequacy of its U.S. operations;

The final rule clarified what the FRB meant by requiring that at least one member of the risk management committee possess “risk management experience.” Non-U.S. banks that fall within this category must comply with these requirements by July 1, 2016, if the non-U.S. bank’s total consolidated assets meet the $10 billion to $50 billion threshold as of June 30, 2015.

Category Number 2: A non-U.S. bank with at least $50 billion in total consolidated assets but less than $50 billion in total U.S. assets is required to:8

• Comply with the requirements listed above for non-U.S. banks with $10 billion to $50 billion of total consolidated assets (there is no requirement that the non-U.S. bank be publicly traded);

• Certify to the FRB that it meets the capital adequacy standards established by its home country supervisor on a consolidated basis and that those standards are consistent with the Basel capital accords, or if not subject to Basel capital standards, demonstrate that it would meet them if they were imposed9;

• Annually report to the FRB the results of an internal liquidity stress test (either on a consolidated basis or for its combined U.S. operations) pursuant to a home country stress testing regime that is consistent with Basel Committee principles for liquidity management (the penalty for noncompliance is a limitation on the net aggregate amount owed by the non-U.S. banking organization’s non-U.S. offices and non-U.S. affiliates to the combined U.S. operations).

Non-U.S. banks that fall within this category must comply with the capital, risk management, liquidity and stress test requirements by July 1, 2016, if the non-U.S. bank’s total consolidated assets meet the $50 billion threshold as of June 30, 2015.

Category Number 3: A non-U.S. bank with at least $50 billion of total consolidated assets and $50 billion of total U.S. Assets is required to:10

• Comply with all of the foregoing requirements applicable to non-U.S. banks with less than $50 billion in U.S. assets;

• Form a U.S. intermediate holding company (IHC), or designate an existing entity as the IHC provided that such entity is the non-U.S. bank’s top tier entity in the United States, to hold its U.S. subsidiaries (except for 2(h)(2) companies and DPC branch subsidiaries),11 if the non-U.S. bank has at least $50 billion in U.S. nonbranch assets;

• Submit a proposed IHC implementation plan to the FRB by Jan. 1, 2015, if its U.S. subsidiaries’ assets exceed $50 billion as of June 30, 2014 (excluding 2(h)(2)companies and DPC branch subsidiaries and other exclusions noted in the regulations);

• Have its IHC meet the U.S. bank holding company risk-based capital and leverage requirements (regardless of whether the IHC holds a depository institution subsidiary) and other enhanced prudential requirements applicable to large U.S. bank holding companies;

• Have its IHC comply with the capital planning and FRB and internal stress test requirements applicable to large U.S. bank holding companies;

• Comply with the monthly liquidity stress tests and 30 day liquidity buffer requirements applicable to U.S. bank holding companies for both its IHC and its direct U.S. branches/agencies;

• Appoint a U.S. chief risk officer, whether or not the non-U.S. bank is publicly traded, and maintain a U.S. risk committee with at least one member of such risk committee being independent and one member experienced in identifying, assessing and managing risk exposures of large complex financial firms.

Many of the most substantive changes occurred with banks that fell into this category. The FRB originally had proposed that the IHC requirement apply when the non-U.S. bank had a minimum of $10 billion in U.S. nonbranch assets, excluding only the 2(h)(2) companies. In the final rule, the FRB increased the IHC requirement asset threshold amount to $50 billion in U.S. nonbranch assets, excluded DPC branch subsidiaries from the calculation (in addition to 2(h)(2) companies), and allowed a non-U.S. bank to designate an existing entity as the IHC.

With respect to IHC capital requirements, the final rule clarified that an IHC that meets the threshold for the advanced approaches capital rules may instead comply with the standardized risk-based capital rules, unless it voluntarily chooses to use the advanced approaches capital rules. With the FRB’s prior approval, an IHC that also is a bank holding company may opt out of complying with the advanced approaches capital rules.

In addition, the original proposal would have required branches and agencies to maintain the liquidity buffer assets themselves for the entire 30-day period, unless the FRB allowed the non-U.S. bank to maintain the required assets at its head office after the first 14 days. Under the final rule, U.S. branches and agencies of the non-U.S. bank are required to maintain the highly liquid unencumbered assets only for the first 14 days of a stress test with a 30-day planning horizon. IHCs still will need to maintain liquidity buffer assets in U.S. accounts for the entire 30-day period.

Clarifications in the final rule also were made with respect to the duties of the chief risk officer and the risk management experience of the designated risk management-experienced committee member.

The compliance schedule for non-U.S. banks that fall within this asset category is as follows:

• July 1, 2016, for a non-U.S. bank that, as of June 30, 2015, has combined U.S. assets of at least $50 billion;

• Establishment of an IHC by July 1, 2016, by a non-U.S. bank that, as of June 30, 2015, has U.S. non-branch assets of at least $50 billion; by that date, the non-U.S. bank must have established the IHC and transferred its entire ownership interest in any bank holding company subsidiary (if that is not otherwise the designated IHC), any insured depository institution subsidiary, and U.S. subsidiaries holding at least 90 percent of its U.S. non-branch assets that are not owned by a subsidiary bank holding company or insured depository institution subsidiary (other than section 2(h)(2) companies and DPC branch subsidiaries);

• July 1, 2017, for transfer of any other U.S. subsidiaries (other than section 2(h)(2) companies and DPC branch subsidiaries) to the IHC;

• Jan. 1, 2018, for the leverage ratio requirement at the IHC.12

Debt-to-Equity Limits

Finally, the FRB adopted final regulations requiring bank holding companies (or non-U.S. banks subject to the BHC Act restrictions through the IBA) with total consolidated assets of at least $50 billion to maintain a debt-to-equity ratio of no more than 15-to-1 if the FSOC determines that the non-U.S. bank poses a “grave threat” to the financial stability of the United States and that the imposition of the debt-to-equity ratio is necessary to mitigate such risk.13

Compliance by the bank holding company or non-U.S. bank is required within 180 days after being informed by the FSOC of its “grave threat” determination (or informed by the FRB on the FSOC’s behalf) and continues until it is informed by the FSOC that it no longer poses such a threat.

If this requirement is imposed, the U.S. bank holding company and the non-U.S. bank’s IHC each must comply with the 15-to-1 debt-to-equity ratio requirement; if there is no IHC, then each U.S. subsidiary of a non-U.S. bank, except for 2(h)(2) companies and DPC branch subsidiaries, must comply with the requirement. The non-U.S. bank’s U.S. branches and agencies would be subject to a 108 percent asset maintenance requirement.

Conclusion

Since December 2013, the FRB, and other U.S. regulators, have finalized some of the most substantive and far-reaching of the systemic risk regulations required by Dodd-Frank: these prudential standards and the Volcker Rule.14 As banks gear up for the compliance deadlines noted above, both U.S. and non-U.S. banks should now be in a better position to calculate the true cost of compliance. Non-U.S. banks (as well as U.S. banks) may want to keep their regulators apprised as to the actual costs and consequences of implementation of these regulations.

Kathleen A. Scott is senior counsel in the New York office of Norton Rose Fulbright.

ENDNOTES:

1. “Comments on Proposed Enhanced Standards for Non-U.S. Banks,” New York Law Journal, Volume 249, No. 90, May 10, 2013; “Proposed Enhanced Standards for Non-U.S. Banks,” New York Law Journal, Volume 249, No. 6, Jan. 9, 2013.

2. 12 U.S.C. §5365(b).

3. 77 Fed. Reg. 594 (Jan. 5, 2012).

4. 77 Fed. Reg. 76628 (Dec. 28, 2012).

5. See http://www.federalreserve.gov/newsevents/press/bcreg/20140218a.htm.

6. Section 2(h)(2) of the Bank Holding Company Act of 1956 allows qualifying non-U.S. banking organizations to retain their interests in non-U.S. commercial firms conducting business in the United States.

7. See 12 C.F.R. §§252.131 – 225.132.

8. See 12 C.F.R. §§252.140 – 225.146.

9. See, for example, Basel Committee on Banking Supervision, Basel III: A global framework for more resilient banks and the banking system, December 2010 and revised June 2011.

10. See 12 C.F.R. §§252.150 – 225.158.

11. A DPC branch subsidiary is a subsidiary of a U.S. branch or a U.S. 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. See 12 C.F.R. §252.2(i).

12. A subsidiary bank holding company or insured depository institution prior to the formation of the IHC must continue to comply with its applicable leverage capital requirements until Dec. 31, 2017.

13. See 12 U.S.C. §5365(j); 12 C.F.R. §§252.220, 252.221.

14. In addition to articles listed in endnote 1, please see Kathleen A. Scott, “Dodd-Frank Three Years On: International Bank Consequences,” New York Law Journal, July 10, 2013, and Kathleen A. Scott, “Non-U.S. Banks, ‘Volcker’ And “Solely Outside the United States,” New York Law Journal, May 9, 2012.