Washington regulatory update

June 13, 2011

"Reality is the leading cause of stress among those in touch with it." Lily Tomlin (Actress/Comedian)

"The true measure of a man is how he treats someone who can do him absolutely no good." Samuel Johnson (Brilliant English Author and Lexicographer

Treasury Secretary Geithner Addresses Challenges to Completing Financial Reforms -- Urges International Margin Standard for Uncleared Derivatives

Treasury Secretary Tim Geithner used the occasion of a June 6th Speech to the International Monetary Conference as a bully pulpit to urge completion of financial regulatory reform in the US and ensure a level playing field globally. The Secretary began by noting the many positive developments since the financial crisis:
  • The weakest parts of the US. financial system – the firms that took the most risk – no longer exist or have been significantly restructured. Of the 15 largest financial institutions in the United States before the crisis, only nine remain as independent entities.
  • Those that survived did so because they were able to raise capital from private investors. Regulatory stress tests gave the private market the ability – through unprecedented disclosure requirements and clear targets for how much capital these institutions needed – to distinguish between those institutions that needed to strengthen their capital base and those that did not. The 19 firms put through that process have together increased common equity by more than $300 billion since 2008. The average level of common equity to risk weighted assets across these institutions is now 10 percent and the average total leverage in these institutions has fallen from $16 of assets for every dollar of common equity to $11.
  • The risk in the so-called “shadow banking system” – the financial firms that operated outside of the protections and constraints imposed on banks – has fallen substantially. Assets in the “shadow banking system” are roughly half the level seen in 2007.

Open Questions under Basel III

Secretary Geithner noted that foremost among the many challenges of reform ahead are those that relate "to capital or leverage requirements and derivatives. It is on these two pillars that the prospect of a truly level global playing field most squarely rests." Commenting on Basel III, he said decisions remained in three important areas:
  • The question of the size of the additional requirements to be imposed on the largest institutions, which is commonly referred to as the systemic surcharge. In deciding on the amount, Secretary Geithner noted the need to consider the impact of other reforms that reduce both the probability of failure of large institutions and the ability of the rest of the financial system to absorb or contain or diffuse those losses.
  • Secondly is to distinguish between what all countries commit to require as a minimum, and what measures some countries may choose to have the discretion to impose on top of the systemic surcharge. In the United States, the Secretary stated the largest US firms will hold an additional surcharge of common equity. Given the other protections available in the US, including the orderly resolution authority, "we do not need to impose on top of that requirement any of the three other proposed forms of additional capital – convertible, bail in, contingent capital instruments, or counter cyclical capital requirements." (This contrasts somewhat with the view recently taken by FRB Governor Tarullo, who does not see capital and an orderly resolution authority as substitutes, but rather as complementary.)
  • And third the US needs to make sure that it provides a much stronger set of protections to ensure a level playing field in the application of the new Basel III requirements and the additional systemic surcharge.

Derivatives Regulation -- Where Work Remains

On derivatives regulation, the Secretary indicated that "alignment with Europe and Asia is essential." The Secretary noted that the focus of remaining work with European counterparts "lies in a few key areas: scope of standardized derivatives contracts, central clearing and mandatory trading of standardized derivatives contracts, fair and open access to qualified participants for central counterparties of swaps, electronic trading platforms, reporting to data repositories, the scope of any exceptions or exemptions – for example, end-user exemptions and intra-group exemptions – and, finally, capital and margin requirements."

In working with international counterparts on this range of issues, the Secretary said there is a need to develop "a global margin standard." Just as there is a global minimum standard for bank capital – expressed in a tangible international agreement –"we need global minimum standards for margins on uncleared derivatives trades. Without international consensus, the broader cause of central clearing will be undermined." In the Secretary's view, a global approach to margin will help prevent regulatory arbitrage and a race to the bottom. It will make the global financial system safer and stronger.

EU Commissioner Michel Barnier Urges Coordination and Consistency in Financial Regulatory Reform

In a somewhat provocative speech before the Brookings Institute in Washington on June 3rd, Michel Barnier, EU Commissioner with responsibility for the Internal Market and Services, emphasized that in financial services regulation "technical details matter." Which is why he views it as so important that dialogue continue between the US and EU on a "technical level." Commissioner Barnier focused his remarks on four financial regulatory issues:

Derivatives

According to Commissioner Barnier, the first area for consistency is regulation of derivatives. In his words, "[I]ncoherence and inconsistency between our rules will have negative consequences for our markets. The financial system is by nature global. Differences could lead to global arbitrage. Trades may move where rules are laxer. This would put us all at risk." He emphasized that consistency must be sought on important issues ­- scope and conditions for clearing collateral and capital requirements and the recognition of each other's central counterparties and trade repositories. He rejected calls for delay in implementing derivatives reforms and noted EU concerns about extraterritorial impact, all the while stressing that "[e]quality and reciprocity are not only justified. They are also necessary."

Basel

Mr. Barnier said the EU Commission will shortly adopt a Basel III proposal for all EU banks, regardless of their size. To be precise, the EU will apply Basel to 8232 banks compared to less than 20 in the USA. He noted with some fervor that "[We] must have a global level playing field. I can assure you that EU regulators will not accept a global regulatory race to the bottom."

Accounting standards

Although expressing confidence that the United States "will deliver on its promise to bring true convergence in the area of financial reporting,"he noted that the US and EU "have been working on this issue for a long time. And the patience of Europe is reaching its limits."

Managing failing banks

Mr. Barnier said that this autumn, he will put forward a proposal to create a European framework to manage banking crises, which he viewed as perhaps the most important reform during his mandate as a European Commissioner.

Compensation

As a "small final point," he expressed the hope to see change in the United States' remuneration for bankers, noting that "we in Europe are the only ones that have put binding rules on bonuses in place." [C]ertain [US] remuneration packages and bonuses are simply beyond our citizen’s comprehension. And mine."

Banking Agencies Propose Guidance on Stress Testing for Banking Organizations with more than $10 Billion in Total Consolidated Assets

On June 9, 2011, the Federal Reserve Board (FRB), the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) (collectively, the “agencies”) issued proposed joint guidance to emphasize the importance of stress testing as an "ongoing risk management practice" that supports banking organizations forward-looking assessment of risks and better equips them to address a range of adverse outcomes.

The proposed guidance is applicable to all banking institutions supervised by the agencies that have more than $10 billion in total consolidated assets. This includes national banks, state chartered insured banks, branches and agencies of foreign banks and bank holding companies. The guidance does not explicitly address the stress-testing requirements in the Dodd-Frank Act for SIFIs, but the agencies indicate that they expect to implement the SIFI provisions in a future rulemaking that "would be consistent with the principles in the proposed guidance."

For purposes of the guidance, stress testing refers to exercises used to conduct a forward-looking assessment of the potential impact of various adverse events and circumstances on a banking organization. Stress testing occurs at various levels of aggregation, including on an enterprise-wide basis.

The guidance establishes four general principles for stress-testing, describes several common approaches and applications, underlines the importance of stress-testing for capital adequacy and liquidity, and concludes with expectations for corporate governance.

General stress testing principles

Under the guidance, a banking organization is expected to develop and implement "an effective stress testing framework as part of its broader risk management and governance processes." The uses of a banking organization’s stress testing framework is expected to include, but not be limited to: (i) augmenting risk identification and measurement; (ii) estimating business line revenues and losses and informing business line strategies; (iii) identifying vulnerabilities and assessing their potential impact; (iv) assessing capital adequacy and enhancing capital planning; (v) assessing liquidity adequacy and informing contingency funding plans; (vi) contributing to strategic planning; (vii) enabling senior management to better integrate strategy, risk management, and capital and liquidity planning decisions; and (viii) assisting with recovery planning.
  • Principle 1: A banking organization’s stress testing framework should include activities and exercises that are tailored to and sufficiently capture the banking organization’s full set of material activities, exposures, and risks, whether on or off the balance sheet.
  • Principle 2: An effective stress testing framework employs multiple conceptually sound stress testing activities and approaches and relies on high-quality input data and information to produce credible outcomes.
  • Principle 3: An effective stress testing framework is forward-looking and should be sufficiently dynamic and flexible to incorporate changes in a banking organization’s (i) on- and off-balance-sheet activities, (ii) portfolio composition, (iii) asset quality, (iv) operating environment, (v) business strategy, and (vi) other risks that may arise over time from firm-specific events, macroeconomic and financial market developments, or (vii) some combination of these events.
  • Principle 4: Stress test results should be clear, actionable, well supported, and inform decision-making. Stress testing should incorporate measures that adequately and effectively convey results of the impact of adverse outcomes, such as changes to asset values, accounting and economic profit and loss, revenue streams, liquidity levels, cash flows, regulatory capital, risk weighted assets, loan loss provisions, internal capital estimates, levels of problem assets, breaches in covenants or key trigger levels, or other relevant measures.

Stress-Testing Approaches and Applications

The proposed guidance includes descriptions of four approaches to stress-testing -- scenario analysis, sensitivity analysis, enterprise-wide stress-testing and reverse stress testing. The proposed guidance notes that while enterprise-wide stress tests can help a banking organization in its efforts to assess the impact of its full set of risks under adverse events and circumstances, it should nonetheless be supplemented with other stress tests and other risk measurement tools given inherent limitations in capturing all risks and all adverse outcomes in one test. Reverse stress testing is viewed as a tool that allows a banking organization to assume a known adverse outcome, such as suffering a credit loss that breaches regulatory capital ratios or suffering severe liquidity constraints making it unable to meet its obligations, and then deduce the types of events that could lead to such an outcome.

Stress-Testing for Evaluating Adequacy of Capital and Liquidity

Given the importance of capital and liquidity to a banking organization’s viability, the guidance says that stress-testing should be applied in these two areas in particular, including an evaluation of the interaction between capital and liquidity and the potential for both to become impaired at the same time. Stress testing for capital and liquidity adequacy should be conducted in coordination with a banking organization’s overall strategy and annual planning cycles. Results should be refreshed in the event of major strategic decisions, or other decisions that can materially impact capital or liquidity.

Governance of a Stress-Testing Framework

Governance over a banking organization’s stress testing framework rests with the banking organization’s board of directors and senior management. As part of their overall responsibilities, a banking organization’s board and senior management should establish a comprehensive, integrated and effective stress testing framework that fits into the broader risk management of the institution. A banking organization should have written policies, approved and annually reviewed by the board, that direct and govern the implementation of the stress testing framework in a comprehensive manner.

SEC Announces Steps to Address One-year Effective Date of the Derivatives Title of the Dodd-Frank Act

The SEC announced on June 10th that it is taking a series of actions in the coming weeks to clarify the requirements that will apply to security-based swap transactions as of July 16 – the effective date of Title VII of the Dodd-Frank Act – and to provide appropriate temporary relief.

Title VII establishes a comprehensive regulatory regime for regulating over-the-counter derivatives. The portion of Title VII referred to as Subsection B, which deals with the new regulatory regime for security-based swaps, will take effect on July 16, 360 days after the date of the Dodd-Frank Act’s enactment.

According to its press release, the SEC will take the following steps:
  1. Provide guidance regarding which provisions of Subsection B of Title VII will become operable as of July 16, and, where appropriate, provide temporary relief from several of these provisions.
  2. Provide guidance regarding – and where appropriate, temporary relief from – the various pre-Dodd-Frank provisions of the Securities Exchange Act that would otherwise apply to security-based swaps on July 16. Under Dodd-Frank, security-based swaps would be included in the definition of “security” under the Exchange Act. While such swaps will be subject to provisions addressing fraud and manipulation, the Commission intends to provide temporary relief from certain other provisions of the Exchange Act so that the industry will have time to seek, and the SEC can consider, what if any further guidance or action is required.
  3. Take other actions such as extending existing temporary rules under the Securities Act, the Exchange Act, and the Trust Indenture Act, and extending existing temporary relief from exchange registration under the Exchange Act. This will help to continue facilitating the clearing of certain credit default swaps by clearing agencies functioning as central counterparties.
The SEC further stated it has been focusing more generally on how Title VII and the rules there under will be implemented. The SEC and CFTC staffs held a joint public roundtable in April, and Commissioners and staff have had extensive discussions with market participants on the appropriate sequence for implementing the security-based swap regulations.

Finally, the SEC stated that once it has proposed all the key rules under Title VII, it plans to consider publishing a detailed implementation plan in order to enable the SEC to move forward expeditiously with the roll-out of the new securities-based swap requirements in the most efficient manner, while minimizing unnecessary disruption and costs to the markets.

SEC to Hold Open Meeting on to Consider Proposed Rules on Advisers to Private Funds and Other Provisions under Title IV of Dodd-Frank

The SEC will hold an open meeting on June 22, 2011 at 10:00 a.m. to consider whether to adopt new rules and rule amendments under the Investment Advisers Act of 1940 (Advisers Act) to implement provisions of the Dodd-Frank Act.

Specifically, the SEC will consider whether to adopt the following:
  1. New rules and rule amendments designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration of investment advisers with the SEC, require advisers to hedge funds and other private funds to register with the SEC, and address reporting by certain investment advisers that are exempt from registration.
  2. Rules that would implement new exemptions from the registration requirements of the Advisers Act for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States. The new rules also would clarify the meaning of certain terms included in a new exemption for foreign private advisers.
  3. A rule defining “family offices” that will be excluded from the definition of an investment adviser under the Advisers Act.

FDIC Establishes Advisory Committee on Systemic Resolutions

On June 3, The Board of Directors of the FDIC approved the creation of the FDIC Advisory Committee on Systemic Resolutions to "provide advice and guidance on a wide range of issues regarding the resolution of large, systemically important institutions." The Committee was established in accordance with Title II of Dodd-Frank.

According to the Committee's charter, issues to be considered include:
  • Effects on financial stability and economic conditions from a covered company's failure and how they arise;
  • The effects on markets and stakeholders of a covered company;
  • Market understanding of the structures and tools available to the FDIC to facilitate an orderly resolution of a covered company;
  • The application of such tools to nonbank financial entities;
  • International coordination of planning and preparation for the resolution of internationally active companies; and
  • Harmonization of resolution regime across international boundaries.
This Committee will only provide advice and recommendation and is not charged with any formal decision making authority. The Committee will not have access to non-public or confidential supervisory information and will report to the FDIC Chairman. According to the charter, the Committee will meet as necessary (estimated to be at least twice a year) with the first meeting taking place on June 21, 2011.

Members of the Committee will include representatives from various financial, audit, accounting, credit rating, legal, and academic backgrounds. The number of members on the committee will not exceed 20 and members will serve terms not exceeding two years. The committee chairperson will be selected by the Board Chairman.

The initial members are an august group led by former Fed Chairman Paul Volcker, former SEC Chairman William Donaldson, former Citi CEO John Reed, and a number of prominent academics, banking lawyers, and bankruptcy and payment system experts among others.

Stop and Study Interchange Amendment Stops in the Senate

An amendment to stop and study the FRB's Regulation II "Debit-Card Interchange Fees and Routing" proposed rule failed to pass the Senate on June 8. The Regulation II proposal was issued on December 16, 2010 by the FRB in response to section 1075 of Dodd-Frank. This section requires the FRB to establish standards for assessing whether the amount of any debit interchange fee received or charged by an issuer with respect to an electronic debit transaction is reasonable and proportional to the transactions' cost of the issuer. The final interchange fee standards were originally set to be released by April 21, 2011; however, due to the rules significant impact on the financial services industry and number of comment letters the Board received in response to the proposal, final rules were postponed. Final standards are currently set to be released by July 21, 2011.