Our take: The changing regulatory landscape

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Current topics - June 26, 2020

Fed releases results of CCAR and crisis sensitivity analysis

Yesterday, the Federal Reserve (Fed) released the results of its 2020 Comprehensive Capital Analysis and Review (CCAR). Given the economic turbulence of the last several months, it also conducted additional sensitivity analyses of how banks would fare under three different recession and recovery scenarios from least to most severe: V-shaped, U-shaped, and a W-shaped double-dip.1

The Fed did not report firm-specific results under these additional scenarios but showed that aggregate loan losses ranged from $560b to $700b and aggregate capital ratios fell from 12% in Q4 2019 to between 9.5% and 7.7% under the recovery scenarios. It also reported that several banks would approach their capital minimums under the U- and W-shaped scenarios.

Due to uncertainty about the actual path of economic recovery and the risk of approaching capital minimums, the Fed is requiring the 34 banks that participated in CCAR to (1) suspend share repurchases in Q3 and (2) cap Q3 dividends at Q2 levels or at the average level of the last four quarters. It is also requiring the banks to resubmit their capital plans later this year and stated that it will conduct additional analysis each quarter which may result in extended repurchase and dividend limitations as needed.

The Fed also did not release individual banks’ stress capital buffers (SCBs). The SCB, which was finalized in March and will take effect in Q4, replaces the static 2.5% capital conservation buffer and formally incorporates Fed-modeled start-to-trough stressed capital depletions into ongoing capital requirements. In implementing the SCB, it stated that it would no longer object to capital plans on quantitative grounds and would instead require a firm to adjust its planned distributions if the firm’s own baseline scenario results as submitted in its capital plan indicate that it will not maintain capital ratios that meet capital requirements inclusive of the SCB. In addition, no firm received a qualitative objection this year, effectively ending that aspect of the CCAR process.

1The Fed emphasized that these scenarios “are not predictions or forecasts” and noted that they do not include potential effects of government stimulus payments and expanded unemployment insurance.

Our take

The Fed’s response to an unprecedented situation reflects a balance between recognizing that banks are well-capitalized enough to weather the immediate crisis while maintaining dividends and that the current substantial economic uncertainty warrants caution. The decision to limit distributions is notable given that among the objectives of the SCB were to re-empower boards as the arbiters of capital actions and to eliminate the supervisory quantitative objection. Although the SCB will still take effect this year, the Fed has reasserted itself in the capital planning process by mandating limits on capital distributions. However, it has stayed true to moving the qualitative assessment behind the scenes by clearing the five remaining firms subject to the qualitative objection. That said, based on the Fed’s observation that some banks did not navigate the current economic situation as nimbly and thoughtfully as it would have expected, those that fall into this category should expect continued scrutiny from examiners.

Given the uncertainty around the economic outlook and the Fed’s observation that some firms’ capital planning processes are “more optimistic than appropriate,” it is not surprising that it is requiring banks to resubmit capital plans later this year. Moreover, because the sensitivity analyses reflected plausible scenarios rather than specific forecasts, we expect the Fed to increase scrutiny as the economic outlook becomes more clear. All tools are on the table to preserve capital levels, including resizing SCBs and limiting distributions.

Stay tuned for our First take on CCAR results next week.

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Agencies offer relief and flexibility for crisis management

This week, the financial services regulatory agencies have continued to take actions to support the economy and markets in response to heightened volatility and uncertainty. Specifically:

6-26 – FRBB - The Federal Reserve Bank of Boston (FRBB) updated the FAQs for the Main Street Lending Program (MSLP) including new questions on how eligible borrowers should calculate “total compensation” for purposes of complying with limits on compensation under the CARES Act direct loan restrictions and on the financial information borrowers are required to submit to lenders and lenders are required to submit to the Main Street Portal.

6/26-6/23 – FRBNY - The Federal Reserve Bank of New York (FRBNY) made several announcements regarding the Term Asset-Backed Securities Loan Facility (TALF) including: the total value of the loans settled for the 6/17/20 subscription date, how benchmarks for fixed and floating rates will be established for loans made on the 7/15/20 loan closing date, and a list of eligible and ineligible collateral for the 6/17/20 subscription date for TALF.

6/25 – SBA & Treasury - The Small Business Administration (SBA) and Treasury Department pledged to give Congressional committees full access to all Paycheck Protection Program (PPP) loan-level information by the end of next week. The committees will get all borrower names and loan amounts while SBA will publish on its website names of borrowers with loans greater than $150k. The agencies also updated PPP FAQs.

6/23 - Multiple Agencies - The Fed, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), National Credit Union Administration (NCUA), and Conference of State Bank Supervisors (CSBS) issued examiner guidance for assessing safety and soundness considering the effect of the pandemic on financial institutions.

6/23 – CFPB - The Consumer Financial Protection Bureau (CFPB) issued an interim final rule clarifying that mortgage servicers do not violate requirements to collect a complete loss mitigation application by offering certain crisis-related loss mitigation options based on an evaluation of limited application information. The rule also stipulates that the loss mitigation option must allow the borrower to delay paying all principal and interest that became delinquent as a result of the crisis and cannot come with any fees.

6/23 – SEC - The Securities and Exchange Commission (SEC) issued guidance regarding operations, liquidity, and capital resources disclosures companies should consider with respect to business and market disruptions related to the crisis.

6/22 - SBA & Treasury - SBA and Treasury Department issued a new interim final rule on PPP loan forgiveness and review procedures reflecting the changes made by Congress. The agencies also released the latest report on approved loans through 6/20/20.

6/22 – FDIC - The FDIC finalized a rule that mitigates the deposit insurance assessment effects of participating in the PPP, the PPP Liquidity Facility (PPPLF) and the Money Market Mutual Fund Liquidity Facility (MMLF).

6/22 – OCC - The OCC issued an interim final rule to reduce assessments due to be paid to the OCC on 9/30/20 by making their calculation based on lower of the banks’ 12/31/19 or 6/30/20 call reports.

Our take

The interagency examiner guidance provides welcome reassurances that firms making a good faith effort to withstand the impacts of the crisis will not be unduly criticized or otherwise penalized. However, it is clear that the regulators will expect to see that this effort is taking place and firms should have a well-documented story in advance of exams. In particular, firms that have experienced operational difficulties, such as a business continuity program that did not plan for a long term disruption and the transition to working from home, should be prepared to show how they have adapted to the crisis and adjusted going forward. One area not addressed by the guidance is how US regulators will treat foreign banks that have experienced tensions between their home office requirements and local regulatory expectations, including restrictions on remote work set by home office policies or even foreign laws.

Ahead of next Tuesday’s deadline for PPP approvals, the pace of demand increased for the fourth straight week with 105k new loans (up from 83k) totalling over $3.2b (up from $2b). However, it appears that the program is likely to close with over $120b available to lend - a far cry from concerns that the $310b expansion at the end of April would be depleted in a matter of weeks. While additional PPP funding is therefore unlikely, there are ongoing discussions about further stimulus for individuals as expanded unemployment benefits are set to expire on July 31. Extending them at the same level approved in the CARES Act is controversial, but there is broad acknowledgment that individuals will need more assistance as new unemployment claims remain high. Given the bipartisan desire for the economic recovery to continue, we expect compromise to emerge around another round of stimulus checks (which President Trump has said he supports), a lower level of expanded unemployment benefits, and business tax credits.

Register here for a replay of our webcast on the CARES Act, PPP, MSLP and return to work for banks.

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Agencies finalize amendments to Volcker covered funds rules

Yesterday, the five agencies charged with overseeing the Volcker Rule (the Fed, FDIC, OCC, SEC, and CFTC) approved final amendments to the rule’s restrictions on investing in or controlling certain “covered” funds. The agencies finalized a number of other revisions to the rule in October 2019 and proposed the covered funds amendments in January 2020.

Acknowledging that the definition of a covered fund was broad in the original rule, the agencies will exclude four types of funds from the definition: credit, venture capital, customer exposure facilitation and single-family wealth management. The amendments also formally exempt certain foreign funds, essentially codifying what the agencies have already done through policy statements. Under the amendments, banks will be able to engage in certain transactions with covered funds that they were not previously able to such as payment, clearing, settlement and intraday extensions of credit. The original rule had a number of exclusions that the amendments modify; for example, they now allow loan securitizations to hold up to five percent of non-loan assets and would treat foreign public funds similarly to US registered investment companies.

The final rule also makes a number of adjustments to the proposal in response to feedback. Regarding newly permitted transactions between banks and covered funds, it adds riskless principal transactions. It also adds an exemption for the purchase or sale of a financial instrument by a qualifying foreign excluded fund. In addition, it further aligns the treatment of foreign public funds with the treatment of US registered investment companies by stipulating the same permitted ownership threshold of 24.9%. It also clarifies that the seeding period for foreign public funds can exceed three years and that the exclusion for public welfare investments includes investments that qualify for Community Reinvestment Act credit.

The final changes will take effect on October 1, 2020.

Our take

With these amendments finalized, the long awaited Volcker Rule reforms are finally complete. Much like last year’s revisions, the industry will welcome this rule as a common sense reversal of overly broad restrictions on activity that does not run contrary to the rule’s prohibition on proprietary trading. The changes will provide banks with more flexibility around investing in areas such as foreign public funds and venture capital - currently a grey area for banks - and providing limited banking services to affiliated funds which banks currently have to delegate to third parties. That said, the rule should be viewed more as a moderate pull back of the pendulum rather than a complete swing in the opposite direction. For some banks, these changes may be too little too late as many have already spun off or restructured their legacy funds to adhere to the original rule’s requirements. Banks will also be unlikely to revert to pre-crisis levels of fund investments as they remain less attractive due to post-crisis capital and liquidity requirements.

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Agencies finalize inter-affiliate margin amendments

Yesterday, the Fed, OCC, FDIC, Farm Credit Administration and Federal Housing Finance Agency voted to finalize amendments to swaps rules that eliminate the requirement that financial institutions post initial margin (IM) for non-cleared swap transactions among their own affiliates, subject to certain concentration limitations. They are still required to post variation margin, collateral intended to account for fluctuations in the market value of a trade. The industry has long pushed for this move, arguing that while requiring IM is sound policy for reducing risk of losses if a third party defaults, it simply does not apply to inter-affiliate transactions and, as a result, needlessly ties up large amounts of funds. Currently, only US bank regulators require IM for inter affiliate trades.

The final rule adds a measure not included in the proposal to ensure that insured depository institutions’ (IDIs’) inter-affiliate swap exposures do not get too high. IDIs will be required to monitor and aggregate information on affiliate swap transactions and to collect IM from affiliates if their aggregate inter-affiliate IM exposures exceed 15% of their tier 1 capital. It also adds the requirement for covered swap entities to collect IM from an affiliate if they determine it is necessary to address credit risk posed by the affiliate.

Out take

The industry, particularly banks with a number of swap dealers, welcomed the finalization of this long-sought relief that is estimated to free up approximately $40b in IM. The original rule put US banks with multiple swap dealers on an uneven playing field with foreign firms, nonbanks, and single-dealer banks by making booking significantly more complicated and expensive. The final rule also responds to critics of the proposal who argued that eliminating the IM requirement would put the Deposit Insurance Fund at risk, in particular with the new 15% limit and collection of IM when this threshold is exceeded. However, this mandate will require IDIs to maintain daily calculations of their exposures, reducing the operational relief that they would have gained from the proposal. Looking ahead, the rule may require regulatory interpretation to address the alignment of the final rule with Regulation W requirements that mandate market terms comparable with non-affiliated counterparties.

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UK legislature and regulators make statements on ‘tough legacy’ LIBOR contracts and transition timing

On Tuesday, UK finance minister Rishi Sunak released a statement announcing the Government’s intention to expand the Financial Conduct Authority’s (FCA) powers to deal with legacy LIBOR-based contracts that cannot be transitioned or amended prior to LIBOR’s cessation. Under the proposed legislation, the FCA would be granted the authority to require a change in LIBOR’s methodology in the case that the benchmark was found to be no longer representative. While the proposal does not include a specific methodology, the FCA notes that a market consensus has emerged to use “the risk-free rates (RFRs) chosen by each LIBOR currency area, adjusted for the relevant term of the contract, and with a fixed credit spread adjustment added.” Such a methodology change would end the reliance on panel bank submissions and allow for a “synthetic LIBOR” to continue to exist for use in legacy contracts. The end result would be similar to that of the Alternative Reference Rates Committee’s (ARRC) proposal submitted to the New York State legislature, which would provide a mechanism to replace LIBOR with a spread adjusted form of the Secured Overnight Financing Rate (SOFR), the recommended alternative to USD LIBOR, in legacy contracts.

The FCA welcomed the announcement and provided additional detail on the proposal, cautioning market participants that a methodology change to extend the publication of a synthetic LIBOR might not be possible, or even preferred, for all currencies and tenors. Over the coming months, the FCA will look for market input on what the specifics of such a methodology change should look like.

The statement came only a day after the FCA’s head of markets and wholesale policy disclosed that an announcement on the timing of LIBOR’s cessation could come as early as November or December of this year. With LIBOR expected to continue through the end of 2021, the announcement would provide market participants at least one year's notice to prepare for its end.

Our take

The FCA’s foreshadowing of a definitive cessation date announcement (at least for some currency tenor pairs) as early as this year should provide banks with more certainty and reduce the risk of large value transfers and market disruption. As the calculation of fallback spread adjustment is expected to occur at the time of such an announcement, markets have already begun to price in expectations about the value of the fallback rate. However, neither the foreshadowing of a formal announcement nor the prospect of a synthetic LIBOR solve firms’ operational challenges associated with the transition. In fact, firms are likely to feel even greater urgency to to develop new alternative reference rate products, update systems and risk management capabilities and remediate legacy contracts.

Going forward, firms should think carefully before relying on the continued publication of a synthetic LIBOR as a solution for legacy products. The uncertainties associated with the potential rate, including how it is calculated, which currencies and tenors would be in scope and the potential for litigation in certain regions outside the UK and eurozone make it difficult to predict where it would apply and what exactly the economic impacts would be. Further, they would be giving up any control over the terms of such a solution. Transitioning contracts away from LIBOR on terms that a firm can agree on with their counterparties should remain the preferred approach to the greatest extent possible.

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On our radar

These notable developments hit our radar this week:

  1. FDIC finalizes “valid-when-made” rule. Yesterday, the FDIC voted to issue a final rule to codify the “valid-when-made” concept, which provides that interest on a loan is determined at the time the loan is made and is not affected by subsequent events such as a change in state law or the transfer of the loan across state lines to other banks and nonbanks such as fintechs. The FDIC’s finalization of the rule follows a similar action by the OCC earlier this month. For more information on the OCC’s rule and “valid-when-made” generally, see our previous Our take.
  2. CFTC moves forward on four rules, withdraws one. In addition to finalizing its version of the interagency inter-affiliate margin amendments, the CFTC finalized a rule to prohibit post-trade name give-up for swaps arranged or executed on a swap execution facility (SEF). The agency also proposed two new rules: 1) principles to address the risk of an electronic trading-related disruption on a designated contract market’s (DCM’s) trading platform and 2) an extension of the compliance date for margin requirements for uncleared swaps. It withdrew the Regulation Automated Trading Proposal, which was first proposed in November 2015.
  3. NYDFS advances crypto initiatives. On Wednesday, the New York Department of Financial Services (NYDFS) announced several cryptocurrency initiatives including a new conditional licensing framework, final guidance regarding licensees’ ability to self-certify the use of new coins, a notice of virtual currency license application practices, and new virtual currency-related FAQs.
  4. Supreme Court releases SEC disgorgement decision. On Monday, the Supreme Court decided that the SEC retains the ability to seek “disgorgement,” a broad remedy that allows the agency to recoup unlawful gains from wrongdoers. The decision notes that disgorgement is lawful if a) it does not exceed the net unlawful profits and b) returns such profits to the victims. However, it did not explain when disgorgement that does not follow those conditions becomes unlawful.
  5. CFPB releases GSE Patch proposals. On Monday, the CFPB issued two notices of proposed rulemaking (NPR) to address the January 2021 expiration of the Government-Sponsored Enterprises (GSE) Patch, which exempts GSE-backed mortgages from the 43% debt-to-income (DTI) cap under the Ability to Repay/Qualified Mortgage (ATR/QM) rule. The first NPR would amend the QM definition to replace the current DTI limit with a price-based approach for all loans and calls for lenders to take into account and verify consumer income and debts. The second NPR would extend the GSE Patch expiration until the changes in the first NPR take effect.

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Julien Courbe

Financial Services Advisory Leader, PwC US

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