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.

September 19, 2011

"It will be of little avail to the people that the laws are made by men of their own choice if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood." -James Madison

"There are worse things in life than death. Have you ever spent an evening with an insurance salesman?" -Woody Allen

FDIC Approves Final Rule on SIFI Resolution Plans: Federal Reserve Expected to Also Approve in Near Future

FDIC also Approves Interim Final Rule on Resolution Plans for Large Insured Depository Institutions

At its meeting on September 13, 2011, the FDIC Board approved a Final Rule on Resolution Plans required by the Dodd-Frank Act (DFA) for Systemically Important Financial Institutions (SIFIs). The Federal Reserve Board (FRB) is expected to approve the Final Rule in the near future (DFA requires the rule be jointly approved by the Agencies). The Agencies issued a proposed rule that was published in the Federal Register on April 22, 2011 and the comment period ended on June 10, 2011. The Final Rule reflects a number of changes from the Proposal in response to comments.

The DFA Final Rule requires each "Covered Company" to produce a Resolution Plan or "living will" for the rapid and orderly resolution of such company under the US Bankruptcy Code in the event of material financial distress or failure. A Covered Company under the DFA Final Rule includes a Bank Holding Company that has $50 Billion or more in consolidated assets, any Foreign Banking Organization (FBO) that is a Bank Holding Company (BHC) or that has US branches or agencies and which FBO has assets of $50 Billion or more on a worldwide basis, and any Nonbank Financial Company Designated as a SIFI to be supervised by the FRB. While the Agencies did not agree with FBO comments that the $50 Billion threshold should be calculated on the basis of US assets only, the Agencies did make some important changes intended to limit the scope and complexity of Resolution Plans for Covered Companies with limited nonbank assets or operations in the United States, which should be of particular benefit to FBOs.

The FDIC also approved a separate Interim Final Rule requiring Insured Depository Institutions with $50 Billion or more in total assets (Covered Insured Depository Institutions or CIDIs) to submit a Resolution Plan that should enable the FDIC as receiver to resolve the CIDI under the Federal Deposit Insurance Act. The FDIC had published an earlier proposal on May 17, 2010 before enactment of the DFA. The FDIC rule is based on the FDIC's authorities under the FDIC Act, not the DFA, and also includes a number of changes from the 2010 proposal.

Final Rule on DFA Resolution Plans

Submission Requirements for DFA Resolution Plans

For a number of reasons, including a desire to align with forthcoming Enhanced SIFI Prudential Standards as well as with Financial Stability Board and other international developments, the Final DFA Rule on Resolution Plans staggers the filing date for initial Resolution Plans for Covered Companies such that only:
  • Covered Companies with $250 Billion or more in nonbank assets (US nonbank assets for FBOs) will have to file plans by July 1, 2012
  • Covered Companies with $100 Billion or more in US nonbank assets (US nonbank assets for FBOs) will have to file by July 1, 2013
  • Remaining Covered Companies will not have to file until December 31, 2013
Note, however, that the Agencies may jointly determine that a Covered Company must file its initial plan on a different date.

Annual updates are due on or before the anniversary of the initial plan filing and covered companies must give notice to the Agencies of events that could have a material effect on the Resolution Plan. The notice must be filed within 45 days of the event unless the event is within 90 days of an annual update. The notice requirement replaces a proposed requirement for automatic interim updates which are now required on a discretionary basis only.

Information Requirements for Resolution Plans

Covered Companies with less than $100 Billion in total nonbank assets (US nonbank assets for FBOs) and predominantly engaged in banking in the US -- meaning 85% of more of their US total assets are in US depository institution subsidiaries (including for FBOs US branches and agencies) will be able to submit "Tailored Resolution Plans" that are more limited in scope and complexity.

For foreign-based companies, the rule provides that the information specified for the subsidiaries, branches and agencies, and critical operations and core business lines, as applicable, are those that are domiciled in the United States or conducted in whole or material part in the United States.

The DFA Final Rule designates a subsidiary or foreign office that is significant to the conduct of core business lines or critical operations of the covered company as a "material entity." When a Covered Company has a material entity that is subject to the Bankruptcy Code, then a Resolution Plan should assume the failure or discontinuation of such material entity and provide both the Covered Company’s and the material entity’s strategy, and the actions that will be taken by the Covered Company to prevent or mitigate any adverse effects of such failure or discontinuation of the material entity on the financial stability of the United States.

A new provision in the Final Rule recognizes that a material entity of a Covered Company may be subject to insolvency regimes other than the Bankruptcy Code, such as a national bank subject to resolution under the FDI Act. When such a material entity has greater than $50 billion in US assets or conducts a critical operation, the preamble to the Final Rule indicates that a Covered Company in its strategic analysis should assume, for example, that a national bank subsidiary would be put into FDIC receivership and set forth the Covered Company's strategy and actions to be taken to prevent or mitigate any adverse effects of such receivership on the financial stability of the US.

Recovery Plans

While the DFA Final Rule does not require the preparation of Recovery Plans, it is clear that a strong regulatory recommendation to commence such a process may be anticipated. The discussion of Resolution Plan requirements for the second group of filers (i.e. those with nonbank assets between $100B and $250B) contains the following language: "A recovery planning process, such as that proposed by the Financial Stability Board in its recently published consultative document [footnote deleted], can be useful towards developing a robust Resolution Plan. Therefore, the Board and Corporation encourages covered companies to fully consider the recommendations of the Financial Stability Board regarding effective recovery planning.[Emphasis added]"

DFA Resolution Plan Reviews

The Agencies went to great pains to allay industry concerns regarding a draconian approach to the acceptability of Resolution Plans and to convey a desire for more of an "iterative" process. The Preamble to the Final Rule states that the regulators desire to "work closely with covered companies…in the development of Resolution Plans and are dedicating staff for that purpose." They "expect the review process to evolve as covered companies gain more experience in preparing" Resolution Plans. The Agencies recognize that Resolution Plans will "vary by company and, in their evaluation of plans, will take into account variances among companies in their core business lines, critical operations, domestic and foreign operations, capital structure, risk, complexity, financial activities (including the financial activities of their subsidiaries), size and other relevant factors…There is no expectation by the Board and the Corporation that initial Resolution Plan iterations submitted after this rule takes effect will be found to be deficient, but rather the initial Resolution Plans will provide the foundation for developing more robust annual Resolution Plans over the next few years following that initial period."

Confidentiality of DFA Resolution Plans

The DFA Final Rule provides that Resolution Plans should be divided into two parts: a public section and a confidential section. The public section would consist of an executive summary that would detail a high level description of the firm, its core businesses, critical operations and a summary of the firm's resolution strategy. A Covered Company may submit a "properly substantiated request" for confidential treatment of any details in the confidential section that it believes are subject to withholding under exemption 4 of the Freedom of Information Act (trade secrets and privileged or confidential commercial or financial information). The Agencies note that they "expect" large portions of the information to be confidential under Exemption 4 or Exemption 8 for examination and other reports prepared for a financial regulatory agency.

Resolution Plans for Large US Insured Depository Institutions

Timing of Submission of CIDI Resolution Plans
The FDIC has adopted an Interim Final Rule on Resolution Plans for any CIDI with $50 Billion or more in total assets -- a total of 37 such institutions according to the Preamble. For those CIDIs, the FDIC Rule provides that their Resolution Plans should be filed on the same schedule as for their parent Covered Company under the Final DFA Rule. Thus, if the parent Covered Company does not have to file until December 31, 2013, the same date would apply for the CIDI subsidiary to file its plan.

CIDI Resolution Plan vs. DFA Resolution Plan
The FDIC has sought to make the DFA and CIDI Resolution Plan rules complementary and avoid duplication of costs, efforts and burdens on the covered CIDIs. In that regard, the Resolution Plan required by the CIDI Rule is different from the DFA Resolution Plan the CIDI's parent is required to prepare under the DFA. The CIDI Rule requires a plan to resolve the insured depository institution under the FDI Act with the FDIC acting as receiver. The DFA rule requires the covered company to submit a plan for it to be resolved in an orderly manner under the Bankruptcy Code. The CIDI Rule is focused on ensuring depositors receive access to their insured deposits rapidly, minimizing the costs to the Deposit Insurance Fund and maximizing recovery for creditors in the resolution of insured depository institutions. The DFA rule is focused on minimizing systemic risk in the resolution of the covered company in order to protect the financial stability of the United States while maximizing recovery for creditors. To avoid duplication in the production of information, the CIDI Rule specifically provides that the CIDI may incorporate data and other information from its Parent's DFA Resolution Plan.

CFTC Proposes Timing for Final Swap Regulation and Phase-In of Clearing/Execution Mandates, Swap Documentation Requirements and Margin for Uncleared Swaps

The CFTC turned its focus to scheduling the finalization and phase in of swap regulation at its open meeting on September 8. Two topics dominated an at times contentious discussion among the commissioners - scheduling the consideration of 40-odd final rules remaining in proposed form, and predicting the sequencing and timing for compliance with three core requirements of derivatives reform -- central clearing, swap documentation and margin for uncleared swaps.

Categories of Rules for Approval in 2011 or First Quarter 2012
Chairman Gensler identified the categories of final rules he hopes to bring before the full Commission for approval by year end 2011 and in the first quarter of 2012. Adoption of final rules in these categories -- listed in the table below -- will provide for implementation of most swap regulation provided in the Dodd-Frank Act. Key matters such as swap dealer registration, definitions of "swap" and "swap dealer" and additional rules needed to implement the clearing mandate are scheduled for finalization by year end 2011. Other controversial topics, such as margin requirements and investment of customer funds, are planned for consideration in Q1 2012. The Chairman noted that although the Commission may deviate from this schedule, particularly regarding the key definitions which must be jointly finalized with the SEC, he hopes they will act to put in place final rules that permit swap regulation to phase in throughout 2012.

Implementation and Compliance Phase-In Approaches
The CFTC's plans for implementation and phase-in of compliance for clearing, trade documentation and margin for uncleared swaps were discussed in two regulatory proposals approved at the meeting. The approach to implementation of these regimes was similar. For clearing, the proposal listed specific regulations that must also become final and effective before phased-in compliance schedules begin. Compliance phase in for trade documentation and margin for uncleared swaps would simply begin after these largely stand-alone rules become final.

The Commission proposed a 3, 6 and 9 month compliance phase-in with the identified rules that would be based on classifying swap market participants into three categories depending on how active they are in the swap market. This approach follows the often mentioned view of the CFTC that compliance would be required first by the most sophisticated swap market players and last for those that are not financial institutions and are not major swap market players.
  • Category 1 entities would consist of swap dealers, major swap participants and a new class of entity -- "active funds". These category 1 entities would be given three months after the applicable final rules become effective to comply with the particular mandate -- whether it be clearing, swap documentation or margin for uncleared swaps. An "active fund" would be any private fund as defined in section 202(a) of the Investment Advisers Act of 1940 (private fund) that is not a third-party subaccount and that executes 20 or more swaps per month based on a monthly average over the 12 months preceding the Commission issuing a mandatory clearing determination under 2(h)(2) of the" Commodity Exchange Act.
  • Category 2 entities also are financial entities and include a commodity pool, a private fund that is not an active fund, an employee benefit plan under ERISA, or a person predominantly engaged in activities that are the business of banking or financial in nature under the Bank Holding Company Act. Category 2 entities cannot include a third-party subaccount, however. Category 2 entities would have six months or 180 days to comply with final, effective regulations for clearing, trade documentation or uncleared swap margin.
  • Category 3 entities -- which consist of any entities not otherwise found in the first two categories -- will have 9 months or 270 days to comply with applicable regulations.
The Commissioners shared projections on when this scheme for compliance might lead to a regulatory requirement, such as a swap subject to mandatory clearing. Based on a number of factors related to how the regulatory process for declaring a swap subject to mandatory clearing might work, both Chairman Gensler and Commissioner O'Malia projected that swaps in any asset class might not face a clearing mandate before the third quarter of 2012. This projection, they noted, is inexact however and is based on factors that are not entirely within the CFTC's control. One factor that could impact this timing is the timing of final effective rules for defining key terms with the SEC. Another is when derivatives clearing organizations choose to submit swaps for a clearing mandate.

The proposals for implementation and compliance will be open for comment for 45 days after appearing in the Federal Register, which is pending. As the Commissioners noted, these proposals will be viewed positively or negatively depending on the perspective of the affected parties. The important factor to note is that the CFTC has provided insight into its preferred approach to compliance with the myriad rules waiting in the pipeline. While this category and entity based view of compliance may not apply to every type of rule, it lends itself to application across a many of the rulemaking topics. Short of a comprehensive or definitive time frame for phase in of swap regulation as preferred by Commissioner O'Malia, the proposals do offer new ability to project regulatory action and plan a business or compliance response.

Outline of Final Dodd-Frank Act Title VII Rules the CFTC May Consider in 2011 or the First Quarter of 2012

Remainder of 2011

  • Clearinghouse Rules
  • Data Recordkeeping and Reporting
  • End-User Exception
  • Entity Definitions/Registration
  • External Business Conduct
  • Internal Business Conduct (Duties, Recordkeeping and Chief Compliance Officers)
  • Position Limits
  • Product Definitions/Commodity Options
  • Real-Time Reporting
  • Segregation for Cleared Swaps
  • Trading – Designated Contract Markets and Foreign Boards of Trade

First Quarter 2012

  • Capital and Margin
  • Client Clearing Documentation and Risk Management
  • Conforming Rules
  • Disruptive Trading Practices
  • Governance and Conflict of Interest
  • Internal Business Conduct (Documentation)
  • Investment of Customer Funds
  • Swap Execution Facilities
  • Segregation for Uncleared Swaps
  • Straight-Through Trade Processing

UK Independent Banking Commission Recommends Reform of UK Banking Sector

The Independent Banking Commission (Commission) in the United Kingdom has released its final report to the UK authorities recommending a number of significant banking sector reform measures. Chief among these recommendations are the ring-fencing of retail banking in the UK and a substantial increase in capital and loss absorbing debt requirements for large ring-fenced banks and globally systemically important banks headquartered in the UK.

The Commission was established by the UK Government in June 2010 to consider structural and other reforms to the UK banking sector to promote financial stability and competition. The Commission, on September 12, 2011, submitted its Report to the Cabinet Committee on Banking Reform. The Commission is chaired by Sir John Vickers.

The Retail Ring-Fence Recommendation
According to the Commission Report, the purpose of the retail ring-fence is to isolate those activities whose "continuous provision" to customers is "vital" to the economy and to ensure such continuous provision is not threatened by other activities (such as investment banking) and can be maintained even if the bank fails without government support. In this connection, the Report takes the view that ring-fenced banks would have more straightforward structures and be easier to manage, monitor, regulate and recover or resolve successfully.

The Commission has developed a set of five "ring-fence principles" that should govern the organization and operations of a ring-fenced bank -- noting however that such principles are not in a format appropriate for legislation or regulatory rule. These principles involve (i) which services must be provided by ring-fenced banks (mandatory services), (ii) which services must not be provided by ring-fenced banks (prohibited services), (iii) which ancillary services should be permitted for the efficient provision of services that are not prohibited, (iv) what types of legal and operational links should be allowed for a ring-fenced bank within a corporate group, and (v) what types of economic links should be permitted for a ring-fenced bank within a corporate group.

From a US standpoint, the ring-fence proposal has certain elements in common with past or present structural policies or proposals in the US, though in each case the ring-fence proposal stands on its own. For example, like Glass-Steagall, the ring-fence proposal prohibits the mixing of retail/commercial banking and investment banking within the same banking entity, but like the Gramm-Leach-Bliley Act, allows for the common ownership of a retail/commercial bank and an investment bank within the same corporate structure.

Recommendations on Capital and Loss-Absorbency
The Commission recommends higher equity capital requirements combined with loss-absorbing debt to minimize the odds of failure of a ring-fenced bank and, if so, any need for Government support. Specifically:
  • The Commission recommends that large ring-fenced banks have a "ring-fence buffer" of at least 3% of Risk-Weighted-Assets (RWAs) above the Basel II baseline of 7%, e.g. an equity to RWA ratio of 10%
  • The Commission supports the use of leverage ratios which should be implemented in the form of a sliding scale based on bank size from 3% to 4.06% of total assets
  • The Commission recommends that UK authorities should have "primary bail-in" power to impose losses in resolution on a set of pre-determined liabilities that are most readily loss-absorbing that being all unsecured debt with a term of at least 12 months at time of issue (would exclude debt governed by foreign law and other debt that may not be within the scope of the primary bail-in power). The Commission also recommends that UK authorities have a "secondary bail-in power" that would allow them to impose losses on all unsecured liabilities and secured liabilities with a floating charge
  • The Commission recommends "depositor preference" such that insured deposits in the UK should be moved above other unsecured creditors and above floating charge holders in the creditors' hierarchy. (In the US. depositor preference extends to all deposits except those in foreign branches of US banks)
  • Based on its analysis of cumulative losses suffered by UK and Non-UK "loss-making banks" over the period 2007-2009 as a percentage of RWAs, the Commission concluded that a loss-absorbing capacity within the range of 16% to 24% would have been sufficient to absorb fully the losses suffered by "nearly all" of those banks. Taking into account several other factors favoring a more modest approach, the Commission recommended a minimum loss-absorbing capacity of 17% of RWA apply to all of the largest ring-fenced banks
The Commission also recommends that G-SIB banks that have a 2,5% G-SIB surcharge under Basel should also be required to have capital and bail-in bonds equal to at least 17% of RWAs. In addition, the Commission recommends that any supervisor of a G-SIB bank headquartered in the UK or ring-fenced Bank with an RWA to GDP of 1% or more also have additional loss-absorbing capacity of up to 3% of RWAs if the supervisor has concerns about its ability to be resolved at minimum risk to the public purse. While US authorities have authority to impose additional capital or other prudential standards to SIFIs that fail to come up with a credible resolution plan after several tries, no specific resolution surcharge has been proposed or discussed.

Treatment of Non-UK Banks
The Commission believes that the requirement to comply with the ring-fence principles should apply to anyone carrying on a banking business as a "distinct legal entity with permission from the UK regulator." This would include any UK bank which is a subsidiary of a wider banking group headquartered outside the UK.

Mandated services could also be provided in the UK by branches of foreign banks, although the Commission takes the view that any significant banks based outside the European Economic Area (EEA) wishing to carry out mandated services in the UK should generally be required to establish a UK subsidiary.

The Commission notes any bank established in the EEA can "in principle" branch into the UK and remain primarily regulated in its home country. In fact, the Commission further notes that a UK bank could relocate its headquarters to another EEA jurisdiction and branch into the UK without having to comply with the ring fence and loss-absorbency proposals. However, the Commission discounts that option as being fraught with practical and other difficulties.

House Hearings on Legislative Proposals to Reform SEC Structure and Operations

On September 15, 2011, the House Financial Services Committee held a hearing on two legislative proposals to "Improve and Enhance the Securities and Exchange Commission". In the opening part of her testimony, Chairman Schapiro noted that:

"We (the SEC) are responsible for examining more than 11,000 investment advisers whose assets under management total $43 trillion, over 5,000 broker-dealers with in excess of 160,000 branch offices, and 7,500 mutual funds. We also are responsible for the review of the disclosures and financial statements of nearly 10,000 public companies, including tens of thousands of disclosure documents each year, plus initial public offering and other public capital markets transaction filings of corporate issuers, public asset-backed securities offering documents, proxy statements, and filings related to public mergers, acquisitions and tender offers. The SEC also oversees approximately 500 transfer agents, 15 national securities exchanges, 10 nationally recognized statistical ratings organizations (NRSROs), 9 clearing agencies, as well as the Public Company Accounting Oversight Board (PCAOB), Financial Industry Regulatory Authority (FINRA), Municipal Securities Rulemaking Board (MSRB), and other SROs.

In addition to these existing responsibilities, the Dodd-Frank Act significantly expanded the SEC’s mission to include new duties with respect to regulation of over-the-counter derivatives and advisers to hedge funds, expanded oversight of credit rating agencies, greater disclosure regarding asset-backed securities, and strengthened corporate governance."

The SEC Modernization Act
The first piece of legislation, the SEC Modernization Act of 2011, would significantly restructure the SEC by, among other things, reducing the number of the SEC’s divisions, restructuring the Office of the Chairman, and modifying certain new offices created by the Dodd-Frank Act. SEC Chairman Mary Schapiro testified that the agency is actively reviewing some similar recommendations from a Boston Consulting Group study to evaluate improvements in the structure, operations and processes of the agency.

In that regard, Section 967 of the Dodd-Frank Act required the SEC to hire an independent consultant to examine the internal operations, funding, structure and the need for comprehensive reform of the SEC, including its relationship and reliance on self-regulatory organizations. On March 10, 2011, the Boston Consulting Group delivered the results of its assessment to the SEC and to Congress in a 263-page final report titled U.S. Securities and Exchange Commission: Organizational Study and Reform. Recently, the SEC provided to Congress its first Report on the Implementation of SEC Organization Reform Recommendations. While noting agreement with several of the approaches proposed by the legislation, Chairman Schapiro said the SEC had a " number of concerns, first and foremost, I would be very concerned about the overarching loss of the agency’s flexibility in the future to change with our dynamic capital markets if its structure is rigidly established by statute. I would welcome an opportunity to work with the Committee on this legislation."

The SEC Regulatory Accountability Act

The second bill -- H.R. 2308, the “SEC Regulatory Accountability Act" -- would establish a significant number of additional specific standards for cost-benefit analyses for SEC rules and orders. Chairman Schapiro said statutory requirements already explicitly require the SEC to consider the economic effects of its rules, and economic and cost-benefit analyses are fundamental components of its rulemaking and an essential part of its work.

H.R. 2308 enumerates eleven new factors for the SEC to consider in its economic analysis, each of which in the SEC's view "would create a new potential challenge to future rules." The SEC Chairman noted as well that a number of these new factors are potentially in conflict with the SEC’s mission, duplicative of existing requirements, unrelated to SEC rulemaking, or unclear in scope. "For example, the bill’s direction to “assess the best ways of protecting market participants” could conflict with the SEC’s mission. The SEC’s mission is to protect investors which in some cases means protecting them from certain market participants."

A particular concern noted by Chairman Schapiro is that the bill would apply not only to rules, but also to orders, which could significantly impede the SEC’s ability to administer the securities laws. Chairman Schapiro said that requiring "cost-benefit analyses for orders could undermine our ability to issue enforcement orders against wrongdoers, delay exemptive orders needed to facilitate the introduction of new investment products to the market, and impede the capital formation process by delaying orders to registrants that accelerate the registration of their securities."

FDIC Finalizes Guidelines for Adjusting Large and Highly Complex Bank Assessments

On September 14, the FDIC adopted guidelines that it will use to determine how adjustments may be made to an institution’s total [risk] score when calculating the deposit insurance assessment rates of large and highly complex insured institutions. Total scores are determined according to the "Final Rule on Assessments and Large Bank Pricing" that was approved by the FDIC Board on February 7, 2011.

The Amended Assessment Regulations allow the FDIC to make a limited adjustment to an institution’s total score up or down by no more than 15 points (the large bank adjustment). Adjustments are made to ensure that the total score produced by an institution’s scorecard appropriately reflects the institution’s overall risk relative to other large institutions.

The FDIC explained that there are two general guidelines that govern the adjustment process; analytical and procedural.

Analytical Guidelines
The FDIC will focus on identifying institutions for which a combination of risk measures and other information suggests either materially higher or lower risk than their total scores indicate (an adjustment of at least five points). Two types of information will primarily be considered in determining whether to make an adjustment:
  • A scorecard ratio or measure that is an outlier to a minimum or maximum cutoff value; and
  • Information not directly captured in the scorecard, including complementary quantitative risk measures and qualitative risk considerations.
Adjustments to an institution’s total score will be made only if the comprehensive analysis of an institution’s risk generally based on the two types of information listed above, and the institution’s relative risk ranking warrant a material adjustment of the institution’s score.

Procedural Guidelines
The processes for communicating to affected institutions and implementing a large bank adjustment remain largely unchanged from the 2007 Guidelines, except that the revised guidelines provide for an adjustment made as a result of a request by the institution (an institution initiated adjustment).The guidelines further indicate that while the FDIC is not precluded from making an adjustment immediately, the FDIC intends to initially make few, if any, adjustments until it develops a thorough understanding of the impact of the new pricing system.