Megabanks Bear Brunt in Revised Fed Counterparty Plan

WASHINGTON — The Federal Reserve Board unanimously voted to release a proposal Friday to limit the exposures between systemically risky bank holding companies in a move that reflects not only an evolution in the agency's finesse but a change in the pressures it is facing.

The plan replaces a similar proposal issued in 2011 that featured a two-tiered standard with one affecting all banks with more than $50 billion in assets and another for banks with $500 billion or more in assets.

The revised proposal features three tiers of regulation with a softer standard for banks between $50 billion and $250 billion, the same requirements for those between $250 billion and $500 billion, and a harsher standard for banks with more than $500 billion in assets (though not as harsh as the 2011 proposal).

The Fed will take comment on the new proposal through June 3.

Karen Shaw Petrou, managing partner at Federal Financial Analytics, said the change between the 2011 proposal and Friday's reflects in part increasing pressure from the industry and Congress to tailor regulations to reflect the systemic risk an institution poses — a philosophy that the Fed has repeatedly said it embraces. The proposal also shows the agency's fixation on reducing the risks posed by the biggest of the big banks, she said.

"The new proposal shows clearly the Fed's recognition of the political pressures to tailor its rules for smaller bank holding companies, but also its determination to shrink any systemic footprint it thinks may still be left from the biggest U.S. banks," Petrou said.

Questions from Fed board members during meeting also suggested the Fed was taking extra steps to make sure that it has analyzed the potential costs of its rules and the effects on the market.

In comments prepared for delivery at an afternoon board meeting, Fed Gov. Daniel Tarullo noted that Fed staff had undergone an extensive analysis of the costs to the covered banks and found that "almost all of the roughly $100 billion in current exposures among domestic firms" would be borne by the largest banks.

Sean Campbell, associate director in banking supervision and regulation division, also pointed out that much of the $100 billion in exposures identified with respect to the proposal could be resolved by the globally systemically important banks with the adoption of sound business practices.

"The principal effect of the proposal would be to reduce concentrations of credit risk between SIFIs," Campbell said. "Staff anticipates that U.S. firms would be able to limit excess exposure amounts by compressing derivatives trades, collecting more collateral from their counterparties, increasing their use of central clearing with qualified central counterparties, and rebalancing their portfolios."

Fed Chair Janet Yellen asked staff what, if any, effect the proposal might have on market liquidity. The central bank has faced heavy criticism over the past year from Congress and industry, who allege that the post-crisis regulatory framework is reducing banks' ability to serve as market-makers and therefore drying up liquidity.

Campbell replied that the proposal would limit only banks' ability to serve one counterparty to an excessive degree, and should not therefore have an effect on a bank's ability to participate in a market in a diversified way.

"This rule, in principle, constrains the banks' ability to take a single concentrated exposure to a single counterparty. It does in no way limit a bank's ability to face an entire market," Campbell said. "So we do not, as a general matter, think of this rule as having significant consequences for market liquidity."

Tarullo also sought comment from staff during the meeting on whether the reduction in interconnectedness between SIFI banks since the crisis has changed qualitatively, quantitatively, or both. In other words, are the largest banks exhibiting the same connections to one another, but just by half the pre-crisis rate, or are the connections themselves changing from one form to another?

Campbell answered that in general, the interconnections have changed in response to various regulatory changes that have shaped the marketplace since 2008. For example, the move toward central clearing of what had previously been bilateral derivatives has increased exposures between counterparties and clearinghouses — exposures that are collateralized and for which margin is collected.

"In some of the data that we've looked at, my initial reaction is that we see more of a compression in the exposure to derivatives transactions than from other kinds of credit that may be provided," Campbell said. "There has been a larger decline that we've seen in … some transactions."

The revised proposal differs from the 2011 proposal in significant ways. The December 2011 proposal called for a two-tiered structure. Under that plan, no bank with more than $50 billion in assets would be allowed to have an exposure to a single counterparty, either a bank or nonbank, that amounts to more than 25% of their Tier 1 capital. The 2011 plan also contemplated a secondary limit for the largest global systemically important banks, keeping those with $500 billion of assets or more from holding more than 10% exposure to any other megabank.

The March 4 proposal, by contrast, calls for a three-tiered structure. Banks between $50 billion and $250 billion of assets would face a single counterparty exposure limit of 25% of total capital (as opposed to Tier 1 capital). Banks with between $250 billion and $500 billion of assets, meanwhile, would still face a proposed limit of 25% of Tier 1 capital.

Megabanks, however, face a slightly more stringent limit under the new plan. Both foreign banks with more than $500 billion of assets and U.S. banks regulated as GSIBs would be required to limit their exposures to one another and to nonbanks designated as systemically important financial institutions to 15% of Tier 1 capital (as opposed to 10% of overall capital in the 2011 plan).

But industry said the proposal still includes some aspects of the rule that remain troublesome. Greg Lyons, partner with Debevoise & Plimpton, said the revised plan did not adopt an approach to collateralized haircuts that had been adopted by the Basel Committee in December, though they said they may consider it in the final rule.

He added that the proposal's definition of what counts as a counterparty includes any subsidiary in which a parent company has at least a 25% stake, which is problematic because under existing accounting rules, banks may not know or easily be able to discover whether a company is 25% owned by another large counterparty or another SIFI bank.

"They took pieces of the Basel Committee rules — for instance the exemption of foreign exposures," Lyons said. "The Fed had a good template to work off of, and I think what they did is looked at that template and … adopted the pieces they liked and didn't adopt the pieces they don't like."

But Petrou said the pervasive emphasis on risk sensitivity in the revised proposal — as opposed to the 2011 proposal — demonstrates an evolution in the Fed's approach to risk management and regulation.

"One of the big differences between 2011 and 2016 … is that in the course of five years the agencies have learned an awful lot in how to measure credit exposures," Petrou said. "That I think it the principal takeaway of the five year silent period" between 2011 and today.