Fed Finalizes Contentious Capital Surcharge, Nonbank Rules

WASHINGTON — The Federal Reserve Board unanimously agreed on Monday to finalize two of its most significant unfinished rules, setting out a graduated surcharge for globally risky banks and establishing capital requirements for GE Capital, the first such regulation for a systemically important nonbank.

During a board meeting, Fed Chair Janet Yellen said that the final risk-based capital surcharge rule for so-called global systemically important banks, or G-SIBs, is designed to reduce the potential for large institutions to fail, or, alternately, to encourage them the reduce their risk profile.

"In practice, this final rule will confront these firms with a choice: they must either hold substantially more capital, reducing the likelihood that they will fail, or else they must shrink their systemic footprint, reducing the harm that their failure would do to our financial system," Yellen said. "Either outcome would enhance financial stability."

Fed Gov. Daniel Tarullo said that the final rule is virtually identical to the proposal released by the Fed in December. The plan built on the Basel Committee's recommendations for a graduated scale of systemic risk, where the G-SIBs would hold between 1% and 2.5% additional capital based on their size and complexity.

The Fed's proposal went a step further by including a second method for calculating the surcharge that takes into account a bank's reliance on short-term wholesale funding. In practice, JPMorgan Chase is the only firm that would have to accrue additional capital to meet the new rule's standards — a fact that was inadvertently revealed by Fed Gov. Stanley Fischer during the board hearing in December.

Fed officials said Monday that based on current estimates, JPMorgan Chase would still be the only bank facing a capital shortfall under the new rules, but that shortfall would now be around $12.5 billion.

Still, Tarullo said there were some important changes between the proposal and the final rule. The most important one is that, rather than having the eight U.S. banks' systemic risk be judged relative to one another, they will be assessed on a fixed metric based on each bank's global systemic risk.

"As commenters pointed out, the Basel approach makes each firm's surcharge a somewhat unpredictable function of changes that a group of large firms have, or have not, made in their own systemic profile," Tarullo said.

One issue that remains unresolved is whether banks will have to include the G-SIB capital standards as part of their annual Comprehensive Capital Assessment and Review stress tests. Banks strongly oppose such an inclusion, arguing it would require them to hold extremely high levels of capital in order to pass. The final rule does not include the G-SIB surcharge as part of the CCAR stress test, however, so any possible inclusion would have to come at a later date.

Tarullo said that staff are considering other changes to the CCAR program and would make recommendations on whether and to what extent to include the surcharge in the CCAR tests.

"We anticipate that later this year staff will develop a series of recommendations for consideration by the board, including changes that would make the supervisory stress test and CCAR better address systemic risks arising from correlations in the exposures and activities of financial institutions," Tarullo said. "While incorporation of some or all of the capital surcharges would be one way to account for those risks, it is only one among a number of possibilities, all of which we want to evaluate."

The Clearing House, a trade group that represents many of the largest banks subject to the G-SIB surcharge, said it was disappointed with the Fed's passage of the final rule, though it appreciated some of the changes that made the methodology more transparent. Jim Aramanda, the CEO of The Clearing House, said the final rule would have "meaningful and negative consequences" and is simply added on to the various other liquidity and capital rules to which large banks are already subject.

"We are disappointed that, like the proposal, the final rule does not properly take into account the dramatic reduction in systemic risk that has come from enhanced liquidity, increased use of clearing, stricter margining, resolution and recovery rules, and other post-crisis changes that significantly reduce the probability of a GSIB failure and the potential systemic impact in the event of a failure," Aramanda said.

Karen Shaw Petrou, managing principal of Federal Financial Analytics, said the purpose of the rule is clear — to break up the banks and incentivize other SIFIs to downsize as well.

"The [Federal Reserve Board] clearly intends the very largest U.S. banks to buckle under this new capital regime, restructuring quickly and dramatically," Petrou said. "It is no coincidence that the big banks are put under a break-em-up rule at the same time GE Capital is rewarded for self-amputation."

Separately, the board also approved final prudential standards for GE Capital Corp., one of only four nonbanks to be designated a systemically important financial institution by the Financial Stability Oversight Council. The final rule effectively applies many of the prudential standards required of bank holding companies but takes into account the firm's announced plan to divest itself of many of its riskiest assets, with the ultimate goal of becoming de-designated by FSOC sometime in the future.

Tarullo said that while GE Capital should be commended for its intention to divest and spin off its financial assets and cease to be a nonbank SIFI, that process has not yet taken place. Having a regulatory framework in place for the firm is an important backstop until that de-designation occurs, he said.

"While GE has put forward a plan for substantial divestitures by GECC and has already begin to execute that plan, no one can know with complete assurance if or when it will be fully executed or how GE's stated intention to seek de-designation of GECC will proceed," Tarullo said. "Thus it is possible that GECC will remain a designated institution for some time to come, and we should have a regulatory framework in place to take account of that possibility."

The GE Capital rules will be implemented in two phases. The first would require the firm to adopt risk-based and leverage capital ratios similar to those applicable to a large bank holding company, as well as the liquidity coverage ratio and certain reporting requirements. Those requirements will have to be met by Jan. 1, 2016, but Fed officials said GE already meets the liquidity and risk-based.

The remaining set of rules will not go into effect until Jan. 1, 2018, and include CCAR stress testing, capital planning requirements, liquidity risk management, compliance with the supplementary leverage ratio in a regulatory capital framework and a 4% enhanced supplementary leverage ratio, as well as requirements for the firm's board of directors and risk committee to be independent of GE or GECC. Certain transactions between GECC and its affiliates would also be forbidden under the second phase of the rules.

The Fed's broad application of bank holding company prudential standards to GE Capital has little direct effect for other firms — all three of the remaining nonbank SIFIs, including American International Group, Prudential and MetLife, are insurance companies. Bu the rule suggests that the agency does not intend to take a soft touch with nonbank SIFIs, giving some credence to some of those firms' fears that the SIFI designation is to be avoided.

Tarullo said that the process of soliciting and considering public comment on prudential rules for nonbank SIFIs is one aspect of the GE Capital regulation process that will likely be applied to the other nonbanks as their rules are further developed.

"I think the notice and comment process that we went through here to tailor the nature of the standards that would be applicable to GECC is one that I think we're going to have to pursue in the future for the other nonbank SIFIs as well," Tarullo said. "Obviously the set of considerations will be different because they are different institutions, but the notice and comment, opportunity for public comment, is something that we will adhere to in the future."

MetLife, the most recent firm to be designated by FSOC, has challenged its designation in court, arguing that the designation is harmful to its business and that the council acted arbitrarily in reaching its conclusion to designate the firm. Yellen told Congress last week that, while there was no specific timetable for the agency to issue its rules for insurance companies, it was working diligently to develop its rules and that it intended to tailor those rules to meet the risks of the industry.