Regulating Systemically Important Financial Companies
Federal Reserve Issues Proposed Rule on Enhanced Prudential Standards
and Early Remediation Framework for Systemically Important Financial
Organizations
January 10, 2012
The Board of Governors of the Federal Reserve System (the “Federal Reserve”) has released amuch-awaited proposal (the “Proposed Rule”) on the enhanced prudential standards and early
remediation framework that will apply to (i) large bank holding companies with $50 billion ormore in total consolidated assets and (ii) nonbank financial companies designated by the new
Financial Stability Oversight Council (the “FSOC”) as systemically important (collectively,“Covered Companies”). The Proposed Rule would implement Sections 165 and 166 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) and,
together with other rulemakings, form the heart of systemic risk regulation under Dodd-Frank.
Comments on the Proposed Rule, which was published last week in the Federal Register, aredue by March 31, 2012.
As described below, the Proposed Rule sets forth:
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risk-based capital requirements and leverage limits;liquidity requirements;
single-counterparty exposure limits;risk management and risk committee requirements;
stress testing requirements;
debt-to-equity limits for certain Covered Companies; andan early remediation framework.

The requirements under the Proposed Rule generally become effective on the first day of thefifth calendar quarter after the date on which the Proposed Rule becomes effective (or the dateon which a company becomes a Covered Company), although certain requirements are subject
to delayed effectiveness and transition periods.
In addition to the requirements contained in the Proposed Rule, Dodd-Frank requires theFederal Reserve to implement resolution plan and credit exposure report requirements withrespect to Covered Companies. These requirements are not part of the Proposed Rule because
the Federal Reserve and the Federal Deposit Insurance Corporation (the “FDIC”) have already
implemented the resolution plan requirement, effective November 30, 2011, and are expected to
implement the periodic reporting of credit exposures in a separate rulemaking. The Proposed
Rule also does not cover various supplemental prudential standards listed in Dodd-Frank that
the Federal Reserve is authorized, but not required, to impose on Covered Companies. TheseMemorandum – January 10, 2012

standards relate to contingent capital, public disclosures, short-term debt limits and such otherprudential standards the Federal Reserve determines are appropriate. In the backgroundmaterial accompanying the Proposed Rule, the Federal Reserve indicated that it continues toconsider whether it should adopt any of these standards.
A.

BACKGROUND AND SCOPE OF APPLICATIONThe Proposed Rule would create an “integrated set of requirements” to “meaningfully reduce”
the probability of a systemically important financial company failing and to minimize damage
to the U.S. financial system in the event such a company does fail. The requirements set forth
by the Federal Reserve are designed to increase in stringency with the level of systemic risk
posed by a particular Covered Company. Notably, the Federal Reserve characterizes the
Proposed Rule as providing “incentives” for Covered Companies to “reduce their systemic
footprint.”
As noted above, the Proposed Rule would apply to Covered Companies, which are those bankholding companies that have $50 billion or more in total consolidated assets and those nonbank
financial companies that have been designated by the FSOC as systemically important. Certain
requirements, such as the risk committee and annual stress testing requirements, would also
apply to bank holding companies with $10 billion or more in total consolidated assets. As
proposed, the Federal Reserve would generally apply the same set of enhanced prudential
standards to Covered Companies that are bank holding companies and Covered Companies
that are nonbank financial companies; however, the Federal Reserve will have the discretion to“tailor” the application of the standards to different companies, on an individual basis or by
category, taking into consideration such things as capital structure, riskiness, complexity,
financial activities, size and any other risk-related factors that the Federal Reserve deems
appropriate.
Although Sections 165 and 166 of Dodd-Frank also apply to foreign banking organizations(“FBOs”) that have $50 billion or more in total consolidated assets or are treated as bankholding companies pursuant to Section 8(a) of the International Banking Act, the Proposed Ruledoes not cover FBOs. The Federal Reserve is expected to issue a separate rulemaking regarding
the application of the enhanced prudential standards and early remediation requirements tothese organizations. With regard to U.S. bank holding company subsidiaries of FBOs that haverelied on the Federal Reserve’s Supervision and Regulation Letter SR 01-01, the Proposed Rulegenerally does not apply to these companies until July 21, 2015, with the exception of the
proposed liquidity and risk management requirements and the debt-to-equity limit, which aredescribed below.
Sections 165 and 166 of Dodd-Frank do not generally apply to savings and loan holding
companies unless they are otherwise designated as systemically important by the FSOC or, inthe case of the annual stress testing requirement, have $10 billion or more in total consolidated
assets. However, the Federal Reserve, as the new primary regulator of such companies, intends
to issue a separate proposal to initially apply the enhanced prudential standards and early
remediation requirements to savings and loan holding companies that have $50 billion or morein total consolidated assets and “substantial banking activities” (i.e., where thrift subsidiaries
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Memorandum – January 10, 2012

comprise 25% or more of such company’s assets or themselves have $50 billion or more in
assets).
B.

RISK-BASED CAPITAL REQUIREMENTS AND LEVERAGE LIMITS

Both Dodd-Frank and the new Basel III capital framework reflect the view that the amount of
capital held by many large, complex banking companies prior to the recent financial crisis wasinadequate for the risk. Dodd-Frank directs the Federal Reserve to establish enhanced riskbased capital and leverage standards for Covered Companies to address these weaknesses.
Consistent with this mandate, the Federal Reserve proposes a two-part effort. First, the Federal
Reserve would subject all Covered Companies to enhanced risk-based capital and leverage
requirements by means of the Federal Reserve’s capital plan rule, which was introduced in
November 2011. And second, through implementation of guidance issued by the BaselCommittee on Banking Supervision (“BCBS”), the Federal Reserve proposes to implement aquantitative risk-based capital surcharge for Covered Companies (or a subset thereof).
1.

Enhanced Risk-Based Capital and Leverage Requirements

Under the capital plan rule, Covered Companies will have to demonstrate to the Federal
Reserve that they have robust, forward-looking capital planning processes, including stresstesting, that account for their unique risks and that permit continued operations during times of
economic and financial stress. In particular, Covered Companies will be required todemonstrate to the Federal Reserve their ability to maintain capital above existing minimum
regulatory capital ratios1 and above a Tier 1 common ratio of 5% under both expected andstressed conditions over a minimum nine-quarter planning horizon.2 Covered Companies with
unsatisfactory capital plans will face limits on their abilities to make capital distributions.
The Proposed Rule contemplates that nonbank Covered Companies will be subject to the same
minimum risk-based and leverage capital (and regulatory reporting) requirements applicable to
Covered Companies that are bank holding companies, although the Proposed Ruleacknowledges that some aspects of these capital requirements may not take into account thecharacteristics of activities and assets of nonbank Covered Companies that are impermissible
for banks and bank holding companies. The Federal Reserve may consider whether any
1

At present, the Federal Reserve’s rules for calculating minimum capital requirements are foundat 12 C.F.R. Part 225, App. A (general risk-based capital rule), 12 C.F.R. Part 225, App. D (leveragerule), 12 C.F.R. Part 225, App. E (market risk rule), and 12 C.F.R. Part 225, App. G (advanced
approaches risk-based capital rule). As a consequence of the so-called “Collins Amendment” of
Dodd-Frank, a firm that meets the applicability thresholds under the market risk rule or theadvanced approaches risk-based capital rule is required to use those rules to calculate its
minimum risk-based capital requirements, in addition to the general risk-based capitalrequirements and the leverage rule.

2

Under the capital plan rule, Tier 1 common is defined as Tier 1 capital less non-common elements
in Tier 1 capital, including perpetual preferred stock and related surplus, minority interest in
subsidiaries, trust preferred securities and mandatory convertible preferred securities.

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Memorandum – January 10, 2012adjustments to the minimum capital requirements applicable to a nonbank Covered Company
may be appropriate, within the limits of its statutory authority. The Federal Reserve is seeking
comments on the appropriateness of requiring nonbank Covered Companies to have the same
capital planning, stress testing and regulatory capital requirements as bank holding companies.
2.

Capital Surcharge for Certain Covered Financial Companies

Over the past few years, the Federal Reserve and other U.S. federal banking agencies haveworked together with the BCBS to strengthen the regulatory capital regime for internationallyactive banks.3 The Federal Reserve is working with the other U.S. banking regulators to
implement the resulting Basel III capital reforms in the United States.
Building on the Basel III reforms, the BCBS published a document in November 2011 that
establishes an additional capital requirement for approximately 30 global systemicallyimportant banks (“G-SIBs”). The BCBS would require G-SIBs to hold an additional amount ofcommon equity above the regulatory minimums to enhance their resiliency and ability toabsorb losses under difficult economic conditions. The recently finalized framework establishesa special capital surcharge, ranging from 100 to 350 basis points, based on a twelve-factor
formula for measuring systemic risk.
The Federal Reserve’s Proposed Rule embraces this surcharge concept, noting that “[a] capitalsurcharge would help require that these companies account for the costs they impose on the
broader financial system and would reduce the implicit subsidy they enjoy due to market
perceptions of their systemic importance.” The Federal Reserve intends to adopt implementing
rules in 2014 for a quantitative risk-based capital surcharge for Covered Companies, withcapital surcharges becoming effective on a phased-in basis from 2016-2019.
C.

LIQUIDITY REQUIREMENTS

Dodd-Frank and Basel III also reflect the view that significant weaknesses in liquidity buffers
and liquidity risk management practices throughout the financial system contributed to thefailure or near failure of a number of companies and exacerbated the crisis. Dodd-Frankaddresses inadequacies in the existing regulatory liquidity requirements by directing theFederal Reserve to establish liquidity standards for Covered Companies. Similar to enhanced
risk-based capital and leverage requirements, the Federal Reserve intends to implement thisstatutory requirement through a multi-stage approach. First, the Proposed Rule would subject
Covered Companies to a set of enhanced liquidity risk management standards, including
liquidity stress testing, which build on guidance previously adopted by the Federal Reserve andother U.S. federal banking agencies. Higher liquidity risk management standards would apply
3

The new regime for internationally active banks, known as Basel III, seeks to improve the qualityof regulatory capital and introduces a new minimum common equity requirement. Basel III also
raises the numerical minimum capital requirements and introduces capital conservation andcountercyclical buffers to induce banking organizations to hold capital in excess of regulatory
minimums. In addition, Basel III establishes for the first time an international leverage standard
for internationally active banks.

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Memorandum – January 10, 2012

to Covered Companies. Second, the Federal Reserve proposes, at a later date, to issue
regulations establishing quantitative liquidity requirements for Covered Companies that areconsistent with those currently being tested by the BCBS.
1.

Enhanced Liquidity Risk Management Standards

In the first stage, Covered Companies would be subject to enhanced liquidity risk management
standards that build upon existing supervisory guidance. The Proposed Rule would require a
Covered Company to take a number of prudential steps to manage liquidity risk, including
requirements to:
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establish effective corporate governance, consisting of oversight of the
Covered Company’s liquidity risk management by its board of directors,
senior management and an independent review function;
produce specific liquidity management processes, cushions andmeasures, including detailed cash flow projections, liquidity stress testing
and liquidity buffer;conduct independent validation of liquidity stress tests; andestablish and maintain a contingency funding plan that sets out the
Covered Company’s strategies for addressing liquidity needs forcircumstances in which normal sources of funding may not be available.

In particular, each contingency funding plan would require:a quantitative assessment of future liquidity needs and funding sources;
an event management process that sets out the procedures for managing
liquidity during identified liquidity stress events;
procedures for monitoring emerging liquidity stress events; andperiodic testing of the components of the contingency funding plan toassess its reliability during liquidity stress events.

To enhance management of liquidity risk, the Proposed Rule also would require a Covered
Company to establish and maintain limits on potential sources of liquidity risk, including three
specified sources of liquidity risk:

concentrations of funding by instrument type, single counterparty,
counterparty type, secured and unsecured funding, and other liquidity
risk identifiers;
the amount of specified liabilities that mature within various time
horizons; andoff-balance sheet exposures and other exposures that could create
funding needs during liquidity stress events.

Liquidity and collateral positions must be monitored on a daily and intra-day basis. The
Proposed Rule would require a Covered Company to monitor liquidity risk related to collateralpositions, liquidity risks across the enterprise and intraday liquidity positions. A Covered
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Memorandum – January 10, 2012

Company would be required to establish and maintain procedures for monitoring assets it has
pledged as collateral for an obligation or position and assets that are available to be pledged.
All procedures for managing liquidity risk also must be monitored and documented. To
promote effective monitoring across the enterprise, the Proposed Rule would require a Covered
Company to establish and maintain procedures for monitoring and controlling liquidity risk
exposures and funding needs within and across significant legal entities, currencies andbusiness lines. In addition, the Proposed Rule would require the Covered Company tomaintain sufficient liquidity with respect to each significant legal entity in light of legal andregulatory restrictions on the transfer of liquidity between legal entities. The Proposed Rulewould require a Covered Company to adequately document all material aspects of its liquidity
risk management processes and its compliance with the requirements of the Proposed Rule, andsubmit such documentation to the risk committee.
Liquidity requirements imposed on an individual institution are not expected to be “one size
fits all.” Rather, the requirements of the Proposed Rule are designed to increase in stringency
based on the systemic footprint of a company. For example, a Covered Company’s capital
structure, risk profile, complexity, activities, size and other appropriate risk related factors
would be considered in: (i) setting the liquidity risk tolerance of the Covered Company; (ii)determining the amount of detail provided in cash flow projections; (iii) tailoring liquidity
stress testing to the Covered Company; (iv) setting the size of the liquidity buffer; (v)formulating the contingency funding plan; and (vi) setting the size of the specific limits on
potential sources of liquidity risk. In addition, the Federal Reserve would reserve its authority
to require a Covered Company to be subject to additional or further enhanced prudential
standards if it determines that compliance with the rule does not sufficiently mitigate the risks
to U.S. financial stability posed by the failure or material financial distress of the Covered
Company.
2.

Future Proposal as to Quantitative Liquidity Measures

In addition to the enhanced liquidity risk management standards included in the Proposed
Rule, the Federal Reserve and other U.S. federal banking agencies have been working with the
BCBS over the past few years to develop quantitative liquidity requirements to increase thecapacity of internationally active banking firms to absorb funding shocks relative to theliquidity risks they face. The BCBS approved two new liquidity rules as part of the Basel III
reforms in December 2010:a Liquidity Coverage Ratio (“LCR”), which would require banks to holdan amount of high-quality liquid assets sufficient to meet expected net
cash outflows over a 30-day time horizon under a supervisory stressscenario; anda Net Stable Funding Ratio (“NSFR”), which would require banks toenhance their liquidity risk resiliency out to one year.

These metrics are currently undergoing observation by the BCBS and may be modified
depending on the results of that observation.
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Memorandum – January 10, 2012

The Federal Reserve intends, in conjunction with other federal banking agencies, to implement
these standards in the United States through one or more separate rulemakings. Throughimplementation of these standards in the United States, the Federal Reserve anticipates that theBasel III liquidity rules would then become a central component of the enhanced liquidity
requirements for Covered Companies, or a subset of Covered Companies, in compliance with
Dodd-Frank. Under the terms of Basel III, global banks are required to comply with the LCR by
2015 and with the NSFR by 2018.
D.

SINGLE-COUNTERPARTY EXPOSURE LIMITS

Section 165(e) of Dodd-Frank requires the Federal Reserve to prescribe, by regulation, standards
that prohibit a Covered Company from having credit exposure to any unaffiliated company
that exceeds 25% of the Covered Company’s capital stock and surplus (or such lower threshold
if necessary to mitigate risks to U.S. financial stability). As explained in the backgroundmaterial accompanying the Proposed Rule, the recent financial crisis highlighted how “[t]heeffect of one large financial institution’s failure or near collapse was amplified by theinterconnectedness of large, systemically important firms” and “the degree to which theyextended each other credit and served as over-the-counter counterparties to each other.” In
addition, the financial crisis exposed deficiencies in the existing U.S. supervisory approach to
single-counterparty credit concentration limits, “which failed to limit the interconnectedness
among and concentration of similar risks within large financial companies that contributed to a
rapid escalation of the crisis.”
The Proposed Rule introduces a two-tier single-counterparty credit limit: (i) a general limit on a
Covered Company’s aggregate net credit exposure to any single unaffiliated counterparty and(ii) a more stringent limit applicable to aggregate net credit exposures of the largest Covered
Companies. Both limits would be measured in terms of a Covered Company’s capital stock andsurplus (defined as the Covered Company’s total regulatory capital and the balance of its
allowance for loan and lease losses not included in Tier 2 capital in the capital adequacy
guidelines applicable to the Covered Company) and, importantly, apply on a consolidated
basis.
1.

General 25% Limit on Aggregate Net Credit Exposure for Covered Companies

A Covered Company, together with its subsidiaries, would be prohibited from having an
aggregate net credit exposure to any unaffiliated counterparty, together with its subsidiaries,that exceeds 25% of the consolidated capital stock and surplus of the Covered Company.
2.

10% Limit on Aggregate Net Credit Exposures Between Major Covered
Companies and Major Counterparties

The Proposed Rule also targets the mutual interconnectedness of financial companies that havea larger systemic footprint, with a stricter quantitative limit applying for credit exposures
between so-called “Major Covered Companies” and “Major Counterparties.” Specifically, a
Major Covered Company, together with its subsidiaries, would be prohibited from having an
aggregate net credit exposure to an unaffiliated Major Counterparty that exceeds 10% of the

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Memorandum – January 10, 2012

Major Covered Company’s consolidated capital stock and surplus. For this purpose, a Major
Covered Company includes (i) a bank holding company that has $500 billion or more in total
consolidated assets and (ii) any nonbank Covered Company. A Major Counterparty includes (i)any Major Covered Company (and all of its subsidiaries) and (ii) any foreign banking
organization (and all of its subsidiaries) that has $500 billion or more in total consolidated
assets.
3.

Key Terms and Calculations(i)

Subsidiaries

The credit exposure limits under the Proposed Rule apply to both a Covered Company and its
subsidiaries, on the one hand, and an unaffiliated counterparty and its subsidiaries, on the otherhand. A “subsidiary” is a company that is directly or indirectly controlled by another company.
For this purpose, a company controls another company if it (i) owns or controls 25% or more ofa class of a company’s voting securities, (ii) owns or controls 25% or more of a company’s total
equity or (iii) consolidates the company for financial reporting purposes. Significantly, thisstandard of control would exclude the more subjective “controlling influence” test contained in
the Bank Holding Company Act and the Federal Reserve’s Regulation Y.
Under the Proposed Rule, a fund or vehicle that is sponsored or advised by a Covered
Company would not be considered a subsidiary of the Covered Company (and, thus, exposures
to such fund or vehicle would not be aggregated with those of the Covered Company) unless it
falls within the voting/equity ownership or financial reporting “control” tests above. The
Federal Reserve has requested comment on whether the exclusion of a non-controlledsponsored or advised fund or vehicle is appropriate, particularly given the support that many
money market fund sponsors, including banking organizations, gave to their funds during thefinancial crisis “in order to enable those funds to meet investor redemption requests without
having to sell assets into then-fragile and illiquid markets.”(ii)

Counterparties

The Proposed Rule would establish limits on the credit exposure of a Covered Company to asingle unaffiliated “counterparty,” which is defined to include:
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with respect to a natural person, the person and members of the person’s
immediate family, collectively;
with respect to a company, the company and all of its subsidiaries,
collectively;
with respect to the United States, the United States and all of its agencies
and instrumentalities (excluding states and their political subdivisions),
collectively;
with respect a U.S. state, the state and all of its agencies, instrumentalities,
and political subdivisions (including any municipalities), collectively; andPage 8

Memorandum – January 10, 2012

with respect to a foreign sovereign entity, the foreign sovereign entityand all of its agencies, instrumentalities, and political subdivisions,collectively.

Significantly, the Federal Reserve included foreign sovereign entities in the counterparty
definition because it believes that credit exposures of a Covered Company to suchgovernmental entities create risks that are comparable to those created by large exposures toother types of entities, such as financial firms. With regard to the U.S. government, as discussed
below, the Proposed Rule specifically exempts certain exposures to the U.S. government fromthe limits.
(iii)

Credit Transactions

Consistent with the definition of “credit exposure” in Section 165(e)(3) of Dodd-Frank, the limits
under the Proposed Rule apply broadly to the following “credit transactions” with acounterparty:
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any extension of credit, including loans, deposits and lines of credit, but
excluding advised or other uncommitted lines of credit;
any repurchase or reverse purchase agreement;
any securities lending or securities borrowing transaction;
any guarantee, acceptance or letter of credit (including any confirmed
letter of credit or standby letter of credit) issued on behalf of thecounterparty;
any purchase of, or investment in, securities issued by the counterparty;
any credit exposure to the counterparty in connection with a derivativetransaction with the counterparty;
any credit exposure to the counterparty in connection with a credit
derivative or equity derivative transaction between the Covered
Company and a third party where the reference asset is an obligation orequity security of the counterparty; andany transaction that is the functional equivalent of the transactions listed
above or any similar transaction that the Federal Reserve determines tobe a credit transaction.
(iv)

Calculation of Credit Exposures

Generally, a Covered Company will first calculate its “gross credit exposure” and then calculate
its “net credit exposure” after taking into account and adjusting for certain credit risk mitigants
such as netting agreements for certain types of transactions, most forms of collateral (subject tohaircuts), guarantees and other forms of credit protection.
(A)

Calculation of Gross Credit Exposure

The Proposed Rule outlines how the gross credit exposure of a Covered Company to a
counterparty would be calculated with respect to the following types of credit transactions:Page 9Memorandum – January 10, 2012

Type of Credit Transaction
Loans and leases to a counterparty
Debt securities issued by the counterparty

Equity securities issued by the counterparty
Repurchase agreements

Reverse repurchase agreements
Securities borrowing transactions

Securities lending transactions

Committed credit lines to a counterparty
Guarantees and letters of credit issued on behalf ofa counterparty
Derivative transactions that are not subject to aqualifying master netting agreement

Derivative transactions that are subject to aqualifying master netting agreement
Credit or equity derivative transactions with athird party where the Covered Company is theprotection provider and the reference assets is an
obligation or equity security of the counterparty

Gross Credit Exposure
The amount owed by the counterparty to the
Covered Company
The greater of the amortized purchase price ormarket value, for trading and available for salesecurities, and the amortized purchase price, forsecurities held to maturity
The greater of the purchase price or market value
The market value of the securities transferred by
the Covered Company to the counterparty plus
such market value amount multiplied by theapplicable collateral haircut to the securities
transferred by the Covered Company to thecounterparty
The amount of cash transferred by the Covered
Company to the counterparty
The amount of cash collateral plus the market
value of securities collateral transferred by the
Covered Company to the counterparty
The market value of securities lent by the
Covered Company to the counterparty plus suchmarket value amount multiplied by theapplicable collateral haircut to the securities lentby the Covered Company to the counterparty
The face amount of the credit line
The lesser of the face amount or the maximum
potential loss to the Covered Company on thetransaction
The sum of (i) the current exposure of thederivatives contract equal to the greater of themark-to-market value of the derivative contract orzero and (ii) the potential future exposure of thederivatives contract, calculated by multiplying
the notional principal amount of the derivative
contract by the appropriate conversion factor
The exposure at default amount calculated under
the Federal Reserve’s existing methodology(see 12 C.F.R. Part 225, App. G, § 32(g)(6))
The lesser of the face amount of the transaction or
the maximum potential loss to the Covered
Company on the transaction

With respect to derivative transactions, a “qualifying master netting agreement” is defined in
the Proposed Rule as a legally enforceable bilateral agreement such that: (i) the agreement
creates a legal obligation for all individual transactions covered by the agreement upon an eventof default (including bankruptcy, insolvency, or similar proceeding of the counterparty); (ii) the
agreement provides that the Covered Company has the right to accelerate, terminate and closeout on a net basis all transactions under the agreement and to liquidate or set off collateral
Page 10Memorandum – January 10, 2012

promptly upon an event of default, and that, in such case, any exercise of rights under theagreement will not be stayed or avoided under applicable law in the relevant jurisdiction; (iii)the Covered Company has conducted sufficient legal review to conclude that the agreement
meets the requirements in the immediately preceding clause and that in the event of a legal
challenge the relevant court and administrative authorities would find the agreement to bevalid, binding and enforceable under the law of the relevant jurisdiction; (iv) the Covered
Company establishes and maintains procedures to monitor possible changes in relevant law
and to ensure the agreement continues to satisfy the requirements of this definition; and (v) the
agreement does not contain a walk-away clause (i.e., a clause that permits a non-defaulting
counterparty to make lower payments than it would make otherwise under the agreement, orno payment at all, to a defaulter or the estate of a defaulter, even if the defaulter is a net creditor
under the agreement).
(B)

Calculation of Net Credit Exposure

In calculating net credit exposure, the Proposed Rule would permit exposures from repurchaseand reverse repurchase transactions and securities lending and borrowing transactions that are
subject to a bilateral netting agreement (as defined above) with the relevant counterparty to be
calculated on a net basis under such agreement.
Importantly, the Proposed Rule provides that gross credit exposure amounts can be converted
into net credit exposure amounts by taking into account eligible collateral, unused credit lines,
eligible guarantees, eligible credit and equity derivatives and other eligible hedges. If a
Covered Party has eligible collateral, then it would have the choice to reduce its gross credit
exposure to a counterparty by the adjusted market value of that collateral, subject to theapplicable regulatory haircut for that type of collateral and to other limitations. If a Covered
Company chooses to reduce its gross credit exposure by the adjusted market value of eligible
collateral, however, it would be required to include the adjusted market value of the eligible
collateral when calculating its gross credit exposure to the issuer of the collateral (in effect, theCovered Company would shift its credit exposure from the original counterparty to the issuerof the eligible collateral). The term “eligible collateral” means collateral in which the Covered
Company has a perfected, first priority security interest (or the legal equivalent, if outside theUnited States), with the exception of cash on deposit and notwithstanding the prior security
interest of any custodial agent, and which is in the form of (i) cash on deposit with the Covered
Company (including cash held for the Covered Company by a third party custodian or trustee),(ii) debt securities (other than mortgage- or asset-backed securities) that are bank eligible
investments, (iii) equity securities that are publicly traded or (iv) convertible bonds that are
publicly traded. Because tracking the market movements of a diverse pool of collateral can be
operationally burdensome, Covered Companies would not be required to reduce their credit
exposure in respect of any eligible collateral based on changes in market prices.
Covered Companies would also be able, but not required, to reduce their gross credit exposure
by the amount of certain unused extensions of credit, provided generally that the Covered
Company does not have a legal obligation to advance additional funds under the relevant
extension of credit and that the relevant credit contract specifies that any unused portion of the

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Memorandum – January 10, 2012

credit extension be fully secured by certain high quality collateral, such as cash and U.S.
government obligations.
In contrast to eligible collateral and unused credit lines, Covered Companies that have “eligible
guarantees,” “eligible credit and equity derivatives” or “other eligible hedges,” each as definedin the Proposed Rule, would be required to reduce their gross credit exposures to the relevant
counterparties by the amount of the eligible guarantees, the notional amount of such eligible
credit and equity derivatives or the face amount of a short sale of the counterparty’s debt orequity securities, as applicable.
4.

Attribution Rule

Consistent with Section 165(e)(4) of Dodd-Frank, the Proposed Rule provides that a Covered
Company must treat a transaction with any person as a credit exposure to a counterparty to theextent the proceeds of the transaction are used for the benefit of, or transferred to, thatcounterparty. Because an overly broad application of this so-called attribution rule “would leadto inappropriate results and would create a daunting tracking exercise” for Covered
Companies, the Federal Reserve is expected to limit application of the attribution rule to thosesituations where it is necessary to prevent evasion of the limits.
5.

Effectiveness; Compliance

Initially, any company that is a Covered Company on the effective date or that became a
Covered Company before September 30, 2012 will be subject to the credit exposure limits
beginning on October 1, 2013. Once the Proposed Rule becomes effective, a company that
becomes a Covered Company will have until the first day of the fifth quarter following the dateon which it became a Covered Company to comply with the limits.
Covered Companies will need to comply with the limits on a daily basis, measured as of theend of each business day. Covered Companies will also need to submit monthly compliancereports. In the event of noncompliance, a Covered Company will have a 90-day cure period
during which time it will not be subject to enforcement actions if it uses reasonable efforts toreturn to compliance. During the 90-day cure period, a Covered Company is prohibited fromengaging in any additional credit transactions with the counterparty, unless the Federal Reserve
determines such transactions are “necessary or appropriate to preserve the safety andsoundness” of the Covered Company or U.S. financial stability. In granting approval for such a
special temporary credit exposure limit, the Federal Reserve will consider the extent to which
noncompliance with respect to a counterparty was due to (i) a decrease in the Covered
Company’s capital stock and surplus, (ii) the merger of the Covered Company with another
Covered Company, (iii) the merger of two unaffiliated counterparties, or (iii) any othercircumstance the Federal Reserve determines is appropriate.
6.

Exemptions

Certain categories of credit transactions are exempt from the credit exposure limits, including
claims that are directly and fully guaranteed as to principal and interest by the United States

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Memorandum – January 10, 2012

and its agencies, Fannie Mae and Freddie Mac (only while operating under U.S.
conservatorship), and any additional obligations issued by a U.S. government sponsored entity
as determined by the Federal Reserve.
7.

Relationship to Other Exposure Limits

The Proposed Rule makes clear that the single-counterparty exposure limits for Covered
Companies are similar to, but also broader than, existing limits that have applied only at thebank level of banking organizations. Traditionally, depository institutions (i) are limited to 10%of their capital stock and surplus when purchasing investment securities from any one obligor;
and (ii) face a total loan-to-one borrower limit that cannot exceed 15% of their capital stock or
surplus (or 25% if the amount that exceeds the general limit is fully secured by readilymarketable collateral). These investment securities and lending limits are separate and distinct
from the single-counterparty exposure limits and, accordingly, are unaffected by the Proposed
Rule.
E.

RISK MANAGEMENT AND RISK COMMITTEE REQUIREMENTS

Section 165(b) of Dodd-Frank requires the Federal Reserve to establish overall risk management
requirements for Covered Companies, while Section 165(h) requires the Federal Reserve to issue
regulations requiring publicly traded (i) nonbank Covered Companies and (ii) bank holding
companies with total consolidated assets of $10 billion or more to establish risk committees.
Dodd-Frank also authorizes, but does not require, the Federal Reserve to impose the risk
committee requirement on all publicly traded bank holding companies, regardless of their asset
size. Under Dodd-Frank, a risk committee would be responsible for the oversight of risk
management practices on an enterprise-wide basis.
Significantly, the Proposed Rule goes farther than what is required by Dodd-Frank in that it
would extend the risk committee requirement to all Covered Companies, regardless of whether
they are publicly traded. Bank holding companies that have between $10 billion and $50 billion
in total consolidated assets would not be subject to the risk committee requirement under the
Proposed Rule if they are not designated as Covered Companies and are not publicly traded.
In the background material accompanying the Proposed Rule, the Federal Reserve emphasizes
that the risk committee and overall risk management requirements would supplement, and not
replace, existing risk management guidance and supervisory expectations, including under theFederal Reserve’s Supervision and Regulation Letter SR 08-8.
1.

Risk Committee Requirements

Under the Proposed Rule, each Covered Company (publicly traded or not) and each publicly
traded bank holding company with $10 billion or more in total consolidated assets would be
required to establish and maintain an enterprise-wide risk committee consisting of members of
its board of directors.

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Memorandum – January 10, 2012

Such a risk committee would be required to:






have a formal, written charter, approved by the company’s board of
directors;
have at least one member with “risk management expertise” that iscommensurate with the company’s capital structure, risk profile,complexity, activities, size and other appropriate risk related factors;
be chaired by an independent director4; andmeet regularly and as needed, and fully document and maintain recordsof such proceedings, including risk management decisions.

As for responsibilities, the Proposed Rule would require each committee to oversee theoperation of, on an enterprise-wide basis, an appropriate risk management framework that
includes:











2.

risk limitations appropriate to each business line of the company;
appropriate policies and procedures relating to risk management
governance, risk management practices and risk control infrastructure forthe enterprise as a whole;
processes and systems for indentifying and reporting risks and riskmanagement deficiencies, including emerging risks, on an enterprisewide basis;monitoring of compliance with the company’s risk limit structure andpolicies and procedures relating to risk management governance,
practices and risk controls across the enterprise;effective and timely implementation of corrective actions to address
management deficiencies;
specification of management and employees’ authority and independence
to carry out risk management responsibilities; andintegration of risk management and control objectives in management
goals and the company’s compensation structure.
Additional Risk Management Requirements for Covered Companies

The risk committees of Covered Companies would have to satisfy additional requirements.
Specifically, a Covered Company’s risk committee would have to be a stand-alone committee,
4

For publicly traded companies, the Federal Reserve will generally not consider a director to be
independent unless the company indicates in its securities filings, pursuant to Regulation S-K ofthe Securities and Exchange Commission, that the director satisfies the applicable independence
requirements of the national securities exchange on which the company’s securities are listed. In
the case of a director of a non-publicly traded company, the Federal Reserve will expect, among
other things, that the company demonstrate that such director would qualify as an independent
director under the listing standards of a national securities exchange if the company were
publicly traded on such an exchange.

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Memorandum – January 10, 2012

in that it could not be housed within another committee or be part of a joint committee, and it
would have to report directly to the Covered Company’s board of directors and receive andreview regular reports from the chief risk officer (“CRO”), who a Covered Company would be
required to employ to oversee risk management practices on an enterprise-wide basis. The
CRO would have to report directly to both the risk committee and the chief executive officer
and be “appropriately compensated and incentivized to provide an objective assessment” of therisks taken by the Covered Company. The CRO must also have risk management expertise thatis commensurate with the Covered Company’s structure, risk profile, complexity, activities, sizeand other risk-related factors. The Federal Reserve is soliciting comments on whether the
Proposed Rule should specify any minimum qualifications, such as educational attainment andprofessional experience, for the CRO of a Covered Company.
F.

STRESS TESTING REQUIREMENTS

During the height of the crisis, the Federal Reserve began stress testing the capital adequacy oflarge, complex bank holding companies as a forward-looking exercise designed to estimate
losses, revenues, regulatory capital ratios, and reserve needs under various macroeconomic
scenarios. These stress tests provided valuable information to market participants and had an
overall stabilizing effect. Dodd-Frank directs the Federal Reserve to implement rules requiring
the Federal Reserve, in coordination with the appropriate primary federal financial regulatory
agencies and the Federal Insurance Office, to conduct an annual supervisory stress tests ofCovered Companies and to publish a summary of those results. In addition, Dodd-Frankrequires each Covered Company to conduct its own semi-annual stress tests and any state
member bank, bank holding company or savings and loan holding company with more than
$10 billion in total consolidated assets (that is not a Covered Company) to conduct its own
annual stress tests (company-run stress tests). Covered Companies must also publish asummary of the results of the company-run stress tests.
The Proposed Rule would implement these statutory provisions by requiring the Federal
Reserve to conduct annual supervisory stress tests of Covered Companies under baseline,
adverse and severely adverse scenarios, as well as by requiring companies that are subject tocompany-run stress test requirements to conduct their own capital adequacy stress tests on anannual or semi-annual basis, as applicable. Under the Proposed Rule, the Federal Reserve
would publicly disclose information on the company-specific results of the supervisory stresstests.
G.

DEBT-TO-EQUITY LIMIT FOR CERTAIN COVERED COMPANIES

Under Section 165(j) of Dodd-Frank, if the FSOC determines that a Covered Company (i) posesa “grave threat” to U.S. financial stability and (ii) that the imposition of a leverage limitation is“necessary to mitigate” that threat, then the Federal Reserve must require the company tomaintain a debt-to-equity ratio of no more than 15-to-1. Absent these two findings by the
FSOC, the leverage limitation does not apply automatically.
The Proposed Rule defines “debt” and “equity” as having the same meaning as “total
liabilities” and “total equity capital,” respectively, as calculated in a company’s reports ofPage 15

Memorandum – January 10, 2012financial condition (i.e., in the case of a bank holding company, on the Federal Reserve’s FormFR Y-9C). The 15-to-1 debt-to-equity ratio would be calculated as the ratio of total liabilities tototal equity capital minus goodwill.
A Covered Company that is subject to a “grave threat” determination by the FSOC will receive
written notice from the FSOC.5 After receiving such notice, the Covered Company will have180 calendar days to come into compliance with the prescribed debt-to-equity ratio
requirement, although it may seek up to two extensions of 90 days each. The debt-to-equity
ratio requirement would remain in effect until the FSOC determines that a particular Covered
Company no longer poses a grave threat to U.S. financial stability and that the imposition of theleverage limitation is no longer necessary.
Although the Proposed Rule does not outline a specific set of actions that must be taken inorder to comply with the debt-to-equity ratio requirement, the Federal Reserve would expect a
Covered Company to comply in a manner that is consistent with its “safe and sound operationand preservation of financial stability.” As an example of what is expected in this regard, theFederal Reserve would look to whether a Covered Company has made a “good faith effort toincrease equity capital through limits on distributions, share offerings, or other capital raisingefforts prior to liquidating margined assets in order to achieve the required ratio.”
As with the liquidity and risk management requirements discussed above, the leverage
limitation can be applied to U.S. bank holding company subsidiaries of foreign banking
organizations that are currently relying on the Federal Reserve’s Supervision and Regulation
Letter SR 01-01.
H.

EARLY REMEDIATION REQUIREMENTS

To minimize the probability that a Covered Company will become insolvent and the potential
harm of such insolvency to U.S. financial stability, Section 166 of Dodd-Frank requires theFederal Reserve to issue regulations providing for the early remediation of financial distress of
Covered Companies. The regulations must define measures of the financial condition of thecompany (including regulatory capital, liquidity measures and other forward-looking
indicators) and establish requirements that increase in stringency as the financial condition of
the company declines. The Proposed Rule establishes this early remediation framework, setting
forth a matrix of five remedial triggering events, including several forward-looking triggers,and four levels of remediation actions that Covered Companies are required to take when therelevant triggering event occurs.
1.

Early Remediation Requirements

The Proposed Rule lays out four levels of remediation requirements and several forwardlooking triggers designed to identify emerging or potential issues before they develop into
5

The background information accompanying the Proposed Rule provides that the notice would
come from the Federal Reserve. See 77 Fed. Reg. 594, 633 (Jan. 5, 2012). However, the Proposed
Rule itself states that such notice would come from the FSOC.

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Memorandum – January 10, 2012

larger problems. Most of the remediation actions under each level are non-discretionary andapply automatically once a triggering event subjects a Covered Company to that level.
(i)

Level 1 – Heightened Supervisory Review

Under Level 1 remediation, the Federal Reserve would conduct, within 30 days of a Level 1
triggering event, a targeted supervisory review of the Covered Company to determine whether
a Covered Company is experiencing financial distress or material risk management weakness,such that further decline of the Covered Company is probable and that the Covered Company
should be subject to the next level of remediation (initial remediation).
(ii)

Level 2 – Initial Remediation

Under Level 2 remediation, a Covered Company would be subject to, among other things:
restrictions on capital distributions and asset growth; a restriction on acquiring any controllinginterest in any company (including an insured depository institution), establishing or acquiring
any office or other place of business or engaging in any new business line, in each case, without
the Federal Reserve’s prior approval; a requirement to enter into a non-public memorandum of
understanding or other acceptable enforcement action; and additional limitations or conditions
on the conduct or activities of the Covered Company (or any of its affiliates) as the Federal
Reserve deems appropriate and consistent with Title I of Dodd-Frank.
(iii)

Level 3 – Recovery

Under Level 3 remediation, a Covered Company would be subject to, among other things: flatprohibitions on capital distributions, asset growth, acquiring any interest in any company(including a depository institution), establishing or acquiring any office or other place ofbusiness or engaging in any new business line; a requirement to raise additional capital; and alimitation on executive compensation. In addition, the Federal Reserve could require theCovered Company to (i) conduct a new election of the institution’s board of directors, (ii)dismiss senior executive officers who had held office for more than 180 days prior to the
Covered Company’s notification that it is subject to Level 3 remediation or (iii) employ qualified
senior executive officers approved by the Federal Reserve. The Federal Reserve may also place
restrictions on the Covered Company engaging in transactions with its affiliates.
(iv)

Level 4 – Resolution Assessment

Under Level 4 remediation, the Federal Reserve must consider whether a Covered Company
poses a risk to the stability of the U.S. financial system. If the Federal Reserve determines,
based on the Covered Company’s financial decline and the risk posed to U.S. financial stability,that the Covered Company should be placed into receivership under the orderly liquidation
authority provided for in Title II of Dodd-Frank, the Federal Reserve must make a written
recommendation to the Treasury Department and the FDIC to that effect.

Page 17

Memorandum – January 10, 20122.

Early Remediation Triggering Events

A number of triggering events will determine whether a Covered Company falls within one of
the four levels of remediation requirements. These events would be based on the Federal
Reserve’s existing definitions of minimum risk-based capital and leverage ratios, the results ofsupervisory stress tests under the Proposed Rule, weaknesses in complying with enhanced risk
management and liquidity standards and other market indicators.
Once the Federal Reserve ascertains that a remediation event under the Proposed Rule has
occurred with respect to a Covered Company, it must notify the Covered Company of the eventand the applicable remediation action to be taken. Also, a Covered Company would be
required to notify the Federal Reserve if it becomes aware of a triggering event or a change inthe remediation level to which it is subject.
(i)

Risk-Based Capital and Leverage

While a change in regulatory capital levels may be a lagging, rather than forward-looking,indicator of distress, the Federal Reserve intends to differentiate the early remediation regime
from the existing prompt corrective action regime. In this regard, the Federal Reserve would
impose non-discretionary restrictions on growth and capital distributions by a Covered
Company if its capital levels fall below the “well capitalized” threshold (in contrast, similaractions are not imposed under the prompt corrective action regime until a depository institution
becomes less than “adequately capitalized”). In addition, Level 1 remediation would betriggered if the Federal Reserve determines that a Covered Company’s capital structure orplanning process is not commensurate with the level and nature of the risks to which thecompany is exposed, even if the company’s capital ratios exceed the minimum levels thatwould trigger Level 2 remediation. Levels 2, 3 and 4 remediation actions would be triggered if
any of the Covered Company’s capital ratios fall below the minimum required level in the tablebelow. Level 3 remediation would also be triggered if any of the capital ratios remain at theLevel 2 levels for two consecutive quarters.
Total risk-based capital ratio
Tier 1 risk-based capital ratio
Tier 1 leverage ratio

Level 2
< 10.0% and ≥ 8.0%
< 6.0% and ≥ 4.0%
< 5.0% and ≥ 4.0%

Level 3< 8.0% and ≥ 6.0%
< 4.0% and ≥ 3.0%
< 4.0% and ≥ 3.0%

Level 4
< 6.0%< 3.0%< 3.0%The Federal Reserve intends to make changes to the regulatory capital triggers to conform to the
new capital requirements to be implemented under Basel III.
(ii)

Stress Tests

To integrate the enhanced prudential standards under the Proposed Rule with the early
remediation regime, the Federal Reserve proposes to use the results of the supervisory stresstest under the “severely adverse scenario” as a trigger for early remediation action. Level 1
remediation would be triggered when a Covered Company is not in compliance with any of theFederal Reserve’s capital plan and stress test requirements. Levels 2 and 3 would be triggered
depending on the level of a Covered Company’s Tier 1 common risk-based capital ratio under
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Memorandum – January 10, 2012

the severely adverse scenario, with Level 2 remediation required when the ratio is less than
5.0% and greater than or equal to 3.0% and Level 3 remediation required when the ratio is lessthan 3.0%.
(iii)

Risk Management/Liquidity

Under the Proposed Rule, a Covered Company’s failure to comply with the enhanced risk
management provisions or liquidity risk management requirements of the Proposed Rulewould trigger Level 1, 2 or 3 remediation depending on the severity of noncompliance. The
standards for determining the severity of noncompliance are as follows: “manifested signs of
weakness” for Level 1, demonstration of “multiple deficiencies” for Level 2 and “substantial
noncompliance” for Level 3. The Federal Reserve has not provided any guidance as to how
these standards differ from each other.
(iv)

Market Indicators

The Federal Reserve also proposes to use various market indicators designed to capture both
emerging idiosyncratic and systemic risk across Covered Companies. Rather than setting forthsuch indicators in the Proposed Rule, the Federal Reserve proposes to publish for comments
annually (or less frequently as deemed appropriate) the market-based triggers and thresholds.
For now, Level 1 remediation would be required if the Federal Reserve determines that any
single market indicator has exceeded the market indicator threshold with respect to the
Covered Company for the applicable breach period.
The Federal Reserve has proposed an initial list of market-based indictors, including various
equity-based and debt-based indicators.


Equity-Based Indicators—The proposed equity-based indicators include: (i) an“expected default frequency,” which measures the expected probability of default in thenext 365 days based on a model developed by Moody’s; (ii) a “marginal expectedshortfall,” which would look at the expected loss in a company’s equity based on its
stock price and volatility; (iii) a “market equity ratio,” which is the ratio of market valueof equity to market value of equity plus book value of debt; and (iv) “option-implied
volatility,” which would use a standard option pricing model.

Debt-Based Indicators—The proposed debt-based indicators would be based on credit
default swaps (CDS) and subordinated debt (bond) spreads.
**

Page 19*

Memorandum – January 10, 2012

For more information regarding the Proposed Rule or how comments may be submitted to theFederal Reserve, please contact a member of Simpson Thacher’s Financial Institutions Group.
Lee Meyerson(212) 455-3675
lmeyerson@stblaw.com

Gary Rice(212) 455-7345
grice@stblaw.com

Stacie McGinn(212) 455-2250
smcginn@stblaw.com

Maripat Alpuche(212) 455-3971
malpuche@stblaw.com

Ellen Patterson(212) 455-2499
epatterson@stblaw.com

Elizabeth Cooper(212) 455-3407
ecooper@stblaw.com

Mark Chorazak(212) 455-7613
mchorazak@stblaw.com

This memorandum is for general informational purposes and should not be regarded as legal advice. The
information contained herein does not represent, and should not be regarded as, the view of any particular client ofSimpson Thacher & Bartlett LLP. Distribution does not constitute the establishment of an attorney-client
relationship, and Simpson Thacher & Bartlett LLP assumes no liability in connection with the use of thismemorandum.

The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

Page 20

Memorandum – January 10, 2012

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