Our take: financial services regulatory update - October 23, 2020

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Change remains a constant in financial services regulation. Read "our take" on the latest developments and what they mean.

Current topics – October 23, 2020

Agencies finalize Net Stable Funding Ratio rule

On Wednesday, the Fed, OCC and FDIC approved the long-awaited Net Stable Funding Funding Ratio (NSFR) rule. The NSFR, which was proposed in May 2016, is intended to promote greater resiliency of banks’ funding of business activities by requiring that banks maintain available stable funding (ASF) that is at least equal to their required stable funding (RSF) for assets, commitments, and derivatives exposures over a one year time horizon. It serves as a complement to the Liquidity Coverage Ratio (LCR), which promotes shorter-term resilience by requiring that banks maintain liquidity sufficient to withstand a 30-day stress event.

The proposed rule met with considerable industry criticism that challenged RSF for derivatives and secured funding transactions and ASF factors assigned to brokered and operational deposits (i.e., how stable they are considered to be for the purposes of the calculation), among other concerns. The final rule addresses many of these issues, assigning zero RSF to Treasury securities (including related secured funding transactions), providing more favorable treatment of affiliate sweep deposits, and reducing the amount of gross derivative position requiring stable funding from 20% to 5%. The final rule also includes technical changes to the LCR rule to bring it in full alignment with the NSFR.

Consistent with the tailoring framework finalized last year, banks with more than $250b in assets (Categories I, II, and III) will be subject to the NSFR requirement along with banks with between $100b and 200b (Category IV) that have more than $50b in weighted short-term wholesale funding. The rule provides relief for Category III and IV banks, which will be required to maintain ratios of 85% and 75%, respectively. Banks must begin reporting NSFR for the second quarter of 2021.

Our take

The NSFR rule represents the final chapter of the Basel III liquidity reforms, and its final form represents a victory for the industry by addressing most of its concerns. In particular, the removal of the RSF requirement for Treasury-secured funding transactions will be welcome given the turbulence experienced from both the current crisis and the Treasury repo market stress last September. The banking industry has had an extended period of time to prepare structurally and operationally for NSFR, and we do not expect widespread challenges for implementation. Now that the rule is finalized, covered banks will likely begin to reach beyond meeting baseline reporting requirements to incorporate the NSFR into broader balance sheet decisions, including folding it into risk limits and early warning indicators, which in turn will impact asset optimization models, funding decisions, and funds transfer pricing methodologies.

Agencies finalize large bank debt interconnectedness rule

On Wednesday, the Fed, FDIC and OCC finalized a rule designed to limit the interconnectedness of the largest US banks. The rule requires institutions from Categories I and II of the Fed’s tailoring framework – US global systemically important banks (GSIBs) and one bank with over $75b in cross-jurisdictional activity – to deduct holdings of certain Total Loss Absorbing Capacity (TLAC) debt issued by other large banks from their regulatory capital. TLAC, which includes a minimum amount of regulatory capital and long term unsecured debt, is meant to ensure that the largest banks have the loss absorbing and recapitalization capacity so that, in and immediately following resolution, critical functions can continue without requiring taxpayer support or threatening financial stability. Although the interconnectedness rule only applies to the nine Category I and II banks because of the risk that the failure of one of these banks could affect the others, the agencies noted that they are considering how to address similar risks with respect to other banks.

The rule is substantially similar to the agencies’ April 2019 proposal and takes effect on April 1, 2021.

Our take

Interconnectedness among large financial institutions was a primary reason for public sector intervention during the 2008 financial crisis, and the banking regulators have been determined to reduce it ever since. This rule refines the interaction of resolution planning and regulatory capital reforms consistent with that objective, aligning the treatment of TLAC debt with current rules that reduce regulatory capital. While the agencies believe that the rule will have a relatively small impact on overall capital and market liquidity for TLAC debt, there certainly will be operational costs associated with its implementation as affected banks will have to monitor their holdings and deduct concentrations of direct, indirect and synthetic holdings of TLAC debt.

Agencies propose limiting the role of supervisory guidance

On Tuesday, the Fed, FDIC, OCC, CFPB, and NCUA proposed a rule that would codify a 2018 statement clarifying that supervisory guidance does not create binding legal obligations and will not be cited in enforcement actions or criticism such as Matters Requiring Attention. Instead, such actions will only be taken as a result of laws enacted by Congress or agency regulations that have gone through the formal rulemaking process, which includes notice and comment periods as well as potential reversal under the Congressional Review Act (CRA). The proposal notes that while enforcement actions and criticism will directly reference violations of law or regulation, the agencies may reference guidance to provide examples of safe and sound conduct or appropriate risk management practices. It also provides that the agencies will limit the use of bright-line numerical thresholds in guidance, and where such thresholds are used they will serve as examples rather than prescriptive requirements. The agencies issued the proposal in response to a petition from industry groups asking that they codify the 2018 statement into law in order to bind future agency leadership and staff to its terms. Comments on the proposal will be due 60 days following publication in the Federal Register.

The proposal continues the direction from both Congress and the agencies of limiting the role of guidance. In 2018, the Government Accountability Office (GAO) determined that existing interagency leveraged lending guidance and CFPB auto lending guidance were both “rules” as opposed to “guidance” because they contained prescriptive requirements, and therefore they were subject to the Congressional Review Act (CRA). The CRA allows Congress to reverse rules issued by federal agencies within 60 legislative days of issuance and forbids agencies from issuing “substantially similar” rules in the future absent a new law from Congress permitting their issuance.

Our take

By codifying the 2018 statement, the agencies would not only continue their policies of being more transparent and avoiding back door regulation, but they would also cement this approach for future Administrations. As the election approaches and the industry faces the prospect of an eventual guard change, this formalized policy will provide some insurance against new requirements without a formal comment period and opportunity for Congressional review. However, the proposal does not mean that firms are now free to disregard supervisory guidance. The agencies will still enforce the underlying rules, and supervisory guidance can inform examiner judgment that practices are not safe and sound, which can then - under law - lead to enforcement action.

LIBOR transition milestones reached in derivative markets

Earlier today, ISDA publicly launched its much-awaited IBOR Fallbacks Protocol, which provides market participants with a mechanism to amend derivatives master contracts with provisions to facilitate the transition of LIBOR-indexed contracts to alternative reference rates upon LIBOR’s cessation. It had been made available for adherence “in escrow” to major market participants about two weeks ago, with the intent to demonstrate broad usage of the protocol prior to its official launch. At the point of its formal launch, over 250 entities had already joined. All remaining market participants are now able to adhere to the protocol, which will take effect on January 25, 2021.

This move by ISDA follows actions taken by major central counterparty clearing houses (CCPs) such as the London Clearing House (LCH) and Chicago Mercantile Exchange (CME) over the course of last weekend to complete the switch from the Effective Federal Funds Rate (EFFR) to SOFR as the rate used for calculating price alignment interest (PAI, the interest paid on variation margin) for cleared USD interest rate derivatives. The change is considered important to further entrench SOFR, the recommended alternative to USD LIBOR, in the derivatives markets and drive liquidity in SOFR derivatives. In fact, SOFR swap trading activity has already seen a significant increase. Beginning last Friday, daily trading volumes and traded notional amounts have already more than quadrupled compared to levels observed since the beginning of the year.

Our take

It is difficult to overstate the importance of the ISDA IBOR Fallbacks Protocol as a facilitator of the transition from LIBOR given that the vast majority of USD LIBOR exposures are concentrated in derivatives. Amid endorsements from the various alternative reference groups – and at times strongly worded recommendations from regulators around the globe – we expect that many more market participants will take advantage of the protocol now that it is available. However, the protocol does not represent a universal fix for any and all LIBOR-based derivatives. There will remain a number of legacy contracts requiring bilateral remediation, as a) some organizations will inevitably choose not to adhere to the protocol, and b) the protocol may not be a solution for derivatives that require the benchmark fixing to be known in advance of the interest period. Even for those transactions that can be managed via the protocol, we nevertheless expect to see firms proactively transitioning contracts on terms they can agree with their counterparties in advance of LIBOR’s cessation.

Both the fallbacks protocol and CCP discounting switch represent the culmination of a plethora of working group deliberations, industry consultations and diligent preparation by market participants. The passing of these milestones continues the ongoing shift from theoretical planning and preparation to embedding and executing transactions in SOFR as a replacement rate. The immediate increase in SOFR trading liquidity following the discounting switch is a promising indicator that its derivative volumes will continue to increase, now that market participants have SOFR discounting risks to manage. Increased volumes and liquidity should in turn lead to broader understanding across market participants and further increased adoption of SOFR derivatives.

For more information read PwC’s Understanding ISDA’s IBOR Fallback Protocol: What’s next for financial institutions? Subscribe to PwC’s LIBOR Transition Market Update here to read more about these and other developments. Also, register here to join PwC and leading LIBOR transition practitioners for our upcoming webcast on Navigating operational risk during the LIBOR transition.

On our radar

These notable developments hit our radar over the past week:

  1. Crisis response continues. Over the past week, the federal regulatory agencies continued to take steps to support the economy while Congress remained deadlocked on relief. Specifically:
    • Yesterday, the New York Fed released updated FAQs on the Term Asset-Backed Securities Loan Facility.
    • On Wednesday, Fed Governor Lael Brainard gave a speech explaining that despite an overall recovery in GDP and consumer spending, minority communities remain hard hit, especially regarding unemployment and small business closure. She urged further targeted support and fiscal stimulus to help the recovery become “broader based, stronger, and faster.”
    • On Tuesday, Fed Vice Chair for Supervision Randal Quarles gave a speech detailing how money market funds and certain other nonbanks experienced stress during the crisis. He also explained that next month, the Financial Stability Board will produce a report at the G20 Summit that will provide an analysis of the shock to the nonbank sector during the crisis and a list of areas that may warrant policy consideration.
    • On Tuesday, the Treasury Department sent a letter to the CARES Act Congressional Oversight Commission answering questions regarding the Municipal Liquidity Facility.
    • On Monday, the Federal Housing Finance Agency announced that Fannie Mae and Freddie Mac will extend certain flexibilities around alternative appraisals as well as alternative methods for income and employment verification until November 30, 2020.
  2. CFPB requests feedback on data aggregation standards. Yesterday, the CFPB released an advance notice of proposed rulemaking seeking input on data aggregation standards. It requests feedback on a number of issues including data privacy concerns and whether banks should be able to restrict the frequency that data aggregators can access customer data.
  3. Fed and FinCEN propose AML recordkeeping changes. Earlier today, the Fed and the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) proposed a rule that would lower the recordkeeping threshold for international transactions from $3,000 to $250. It also would clarify that the thresholds apply to convertible virtual currencies and digital assets.
  4. US and UK regulators sign clearing supervision agreement. On Tuesday, the CFTC and the Bank of England signed a memorandum of understanding that the agencies will work together to promote supervisory coordination and reliance upon the other authority’s supervision and regulatory framework.

Contact us

Julien Courbe

Financial Services Leader, PwC US

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