Financial Regulatory Reform Update

Welcome to PwC's Financial Regulatory Reform Update where we update you on the latest developments relating to financial services regulatory reform.

October 24, 2011

I have always been afraid of banks.
- Andrew Jackson

Weather forecast for tonight: dark.
- George Carlin

The Volcker Rule -- A Closer Look at Proprietary Trading

Since its release (both leaked and official), the joint Volcker Rule Proposal by the Federal Reserve Board (FRB), Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC) and US Securities and Exchange Commission (SEC) has engendered equal parts incredulity and concern among those institutions that would be impacted by its prohibition of proprietary trading by banking entities. With the shock and awe period over, institutions are now settling down to determine practical ways to respond and ask "What should I do now?" PwC has just published "A Closer Look" document focused on answering that very question.

Entitled the "Volcker Rule Proposal: A focus on proprietary trading - What now?" the Closer Look document recommends that every affected banking entity should focus on three things:

  • First, -- get organized around your response to the proposal by making sure your voice is heard before the rule is finalized. The Agencies have sought comment on 1300 questions -- individually or through collective efforts answer those questions that would most impact your organization's activities.
  • Second -- conduct a detailed assessment of your trading businesses -- desk by desk -though the lens of the Proposed Rule. In particular, a granular understanding of unbundled trading activities and related revenues and expenses is essential -- the results can be surprising. Granular comments are needed in commenting on a highly granular rule.
  • Third -- don't ignore the effective date. Make sure your institution understands what it will take to implement the compliance and reporting requirements by July 2012. The Agencies ask and want to know whether their expectations for compliance are not realistic and whether some additional transition time may be needed.

Click here to read the "A Closer Look", where each of these three recommendations is explored in much greater and practical detail.

Is Your Firm a Nonbank SIFI -- Inside the Black Box of the Financial Services Oversight Council

One of the many defining features of the Dodd-Frank Act is its attempt to bring nonbank financial companies into the world of banking type regulation. At one end of the spectrum, are the thousands of nonbank financial companies that will be brought within the ambit of the Consumer Financial Protection Bureau (CFPB) based on their engagement in consumer financial activities. While the largest nonbank financial companies will be the primary focus of the CFPB, thousands of much smaller companies will also be covered. Activities-based regulation in the nonbank financial area has the widest impact.

On the other end of the spectrum is the proposed regulation of nonbank financial companies that are Systemically Important Financial Institutions (SIFIs). Designation as a SIFI will be limited to relatively few institutions, but the impact for such institutions will be more pronounced because Dodd-Frank adds a new dimension of federal prudential regulation to these nonbank financial institutions, including perhaps most importantly, the development of resolution plans.

The Financial Services Oversight Council's (Council's) initial efforts to communicate which types of firms might be designated as nonbank SIFIs was the subject of adverse comment as not being forthcoming enough to guide firms as to their probability of selection. Insurance companies, hedge funds, asset management companies and specialized lenders, among others, were all viewed as fair game for designation creating a certain amount of general anxiety.

On October 18, 2011, the Council published in the Federal Register a second notice of proposed rule-making accompanied by proposed interpretive guidance which explains in far greater detail not only the determination process but also the role of certain quantitative thresholds in that process. The proposal provides that the Council will rely on a three-stage process of determination:

  • Stage One -- The Council will use this Stage to identify nonbank financial companies that merit company-specific evaluation in Stage 2. The Council will utilize several quantitative thresholds as a screen to select candidates for Stage 2 analysis. Specifically, if a US nonbank financial company has total global consolidated assets of $50 billion or more (or a foreign nonbank financial company has $50 billion or more in US total consolidated assets), it will be selected for Stage 2 analysis if it also meets one or more of the following thresholds:
    • Credit Default Swaps Outstanding. The Council intends to apply a threshold of $30 billion in gross notional credit default swaps (“CDS”) outstanding for which a nonbank financial company is the reference entity. This threshold was selected based on an analysis of the distribution of outstanding CDS data for nonbank financial companies included in a list of the top 1,000 CDS reference entities.
    • Derivative Liabilities. The Council intends to apply a threshold of $3.5 billion of derivative liabilities. In accordance with Accounting Standards Codification 815, derivative liabilities equals the fair value of any derivatives contracts in a negative position after taking into account the effects of master netting agreements and cash collateral held with the same counterparty on a net basis, if elected.
    • Loans and Bonds Outstanding. The Council intends to apply a threshold of $20 billion of outstanding loans borrowed and bonds issued.
    • Leverage Ratio. The Council intends to apply a minimum leverage ratio of total consolidated assets (excluding separate accounts) to total equity of 15 to 1. Historical testing of this threshold demonstrated that it would have captured the major nonbank financial companies that encountered material financial distress and posed a threat to U.S. financial stability during the recent financial crisis, including Bear Stearns, Countrywide, Indymac Bancorp, and Lehman Brothers.
    • Short-Term Debt Ratio. The Council intends to apply a threshold ratio of debt with a maturity of less than 12 months to total consolidated assets (excluding separate accounts) of 10 percent. Historical testing of this threshold demonstrated that it would have captured a number of the nonbank financial companies that faced short-term funding issues during the recent financial crisis, including Bear Stearns and Lehman Brothers
  • Stage Two -- After identifying its Stage 2 "Pool", the Council intends to evaluate the risk profile and characteristics of each individual nonbank financial company in the Pool based on a wide range of quantitative and qualitative industry specific and company specific factors. In addition, the Stage 2 evaluation will include a review, based on available data, of qualitative factors, including whether the resolution of a nonbank financial company could pose a threat to U.S. financial stability, and the extent to which the nonbank financial company is subject to regulation
  • Stage Three -- The Council, working with the Office of Financial Research (OFR), will conduct a review of each nonbank financial company in the Stage 3 Pool using information collected directly from the nonbank financial company, as well as the information used in the first two stages. The Stage 3 analysis will also include an evaluation of a nonbank financial company’s resolvability.
    • The Council may, by a vote of two-thirds of its members (including the Council Chairperson), make a Proposed Determination with respect to the nonbank financial company, after which the Council intends to issue a written notice of the Proposed Determination to the nonbank financial company, which will include an explanation of the basis of the Proposed Determination.
    • The Council expects to notify any nonbank financial company in the Stage 3 Pool if the nonbank financial company, either before or after a Proposed Determination of such nonbank financial company, ceases to be considered for determination.
    • Any nonbank financial company that ceases to be considered at any time in the Council’s determination process may be considered for Proposed Determination in the future at the Council’s discretion.
    • A nonbank financial company that is subject to a Proposed Determination may request a hearing to contest the Proposed Determination. The Council will (after a hearing, if a hearing is requested), determine by a vote of two-thirds of the voting members of the Council (including the affirmative vote of the Chairperson) whether to subject such company to supervision by the FRB and prudential standards. A nonbank financial company that is subject to a final determination may bring an action in U.S. district court for an order requiring that the determination be rescinded.

In the Preamble to the Proposed Rule, the Council notes that in applying the Stage One thresholds to hedge funds and private equity firms, less data is available for these institutions' However, increased reporting by advisers to such funds will be required by the SEC in 2012. Using this new data, the Council may consider whether to establish an additional set of metrics or thresholds more tailored to evaluating these funds. The Council while considering potential threats to financial stability presented by asset management companies will also consider whether any threats to financial stability that may exist would be better addressed through other regulatory measures.

CFPB Issues Supervision Manual 1.0

The first edition of the CFPB Supervision and Examination Manual was released on October 13, 2011 as a guide to how the CFPB will supervise and examine consumer financial service providers under its jurisdiction for compliance with Federal consumer financial law. The Manual is divided into three parts. The first part describes the supervision and examination process. The second part contains examination procedures, including both general instructions and procedures for determining compliance with specific regulations. The third part presents templates for documenting information about supervised entities and the examination process, including examination reports.
The CFPB stated that the procedures in this manual are designed to be used by examiners to examine supervised entities that offer similar types of consumer financial products or services, or conduct similar activities. The CFPB indicated that it will tailor its expectations of how that is accomplished to fit particular entity profiles.

The first edition includes examination procedures developed under the auspices of the Federal Financial Institutions Examination Council (FFIEC) for many of the laws now generally enforced by the CFPB, including the Truth in Lending Act, Real Estate Settlement Procedures Act, and the Fair Credit Reporting Act. The CFPB will also use the Uniform Consumer Compliance Rating System established by the FFIEC. The Manual will also include examination procedures organized by product and line of business, beginning with procedures for reviewing mortgage servicing.

Noting that a dynamic supervision program depends on continual enhancement, the CFPB stated that contributions from all stakeholders are critical in the accomplishment of this goal. The CFPB welcomes feedback and suggestions for improvements from examiners, the banking industry, nonbank financial services companies, federal and state agencies, consumer and community groups, and the general public.

Federal Insurance Office Requests Public Input on How to Modernize and Improve the System of Insurance Regulation in the United States

The Dodd-Frank Act requires the Federal Insurance Office ( FIO) to conduct a study on how to modernize and improve the system of insurance regulation in the United States ).The study must be submitted to Congress not later than January 21, 2012. To assist the FIO in conducting the study and formulating its recommendations, the FIO issued a request for comment. This study will be based on and guided by the considerations and factors listed in the statute. Commenters are invited to submit views on:

  1. Systemic risk regulation with respect to insurance;
  2. Capital standards and the relationship between capital allocation and liabilities, including standards relating to liquidity and duration risk;
  3. Consumer protection for insurance products and practices, including gaps in State regulation and access by traditionally underserved communities and consumers, minorities, and low and moderate-income persons to affordable insurance products;
  4. The degree of national uniformity of State insurance regulation, including the identification of, and methods for assessing, excessive, duplicative or outdated insurance regulation or regulatory licensing process;
  5. The regulation of insurance companies and affiliates on a consolidated basis;
  6. International coordination of insurance regulation;
  7. The costs and benefits of potential Federal regulation of insurance across various lines of insurance (except health insurance);
  8. The feasibility of regulating only certain lines of insurance at the Federal level, while leaving other lines of insurance to be regulated at the State level;
  9. The ability of any potential Federal regulation or Federal regulators to eliminate or minimize regulatory arbitrage;
  10. The impact that developments in the regulation of insurance in foreign jurisdictions might have on the potential Federal regulation of insurance;
  11. The ability of any potential Federal regulation or Federal regulator to provide robust consumer protection for policyholders; and
  12. The potential consequences of subjecting insurance companies to a Federal resolution authority, including the effects of any Federal resolution authority:
    • On the operation of State insurance guaranty fund systems, including the loss of guaranty fund coverage if an insurance company is subject to a Federal resolution authority;
    • On policyholder protection, including the loss of the priority status of policyholder claims over other unsecured general creditor claims;
    • In the case of life insurance companies, on the loss of the special status of separate account assets and separate account liabilities; and
    • On the international competitiveness of insurance companies.