A small proposed change to the Federal Reserve's risk-reporting requirements could have a significant impact on large foreign banks.
If adopted, a
The Fed estimates that the entities most impacted would be shifted from either Category III or Category IV under the Fed's regulatory tiering framework into Category II, a change that would come with enhanced liquidity-reporting obligations, more frequent stress testing and greater resolution-planning obligations.
"It's a pretty sweeping change tucked into an unexpected place," said David Sewell, partner at the law firm Freshfields Bruckhaus Deringer.
The proposal calls for modifications to the systemic-risk reporting form known as FR Y-15, through which banks with $100 billion of assets or more must disclose information about their systemic footprints, including their size, interconnectedness, substitutability, complexity, short-term wholesale funding and cross-jurisdictional activity.
Under the proposed changes, banks would have to include cross-border derivatives — financial contracts typically used to hedge exposure in which one counterparty is based in another country — in their calculations of their total cross-jurisdictional activity, instead of just direct assets and liabilities as had been the rule before.
Banks and their allies — many of whom are
Those who support the modified standards say the change merely remedies the Trump-era push to ease financial regulation. Alexa Philo, a senior bank policy analyst at the consumer advocacy group Americans for Financial Reform and a former examiner with the Federal Reserve Bank of New York, said the shift would restore needed guardrails that should have never been removed.
"If the Fed says seven banks and two IHCs are going to be impacted, my reaction to that is that they should have been in those higher categories to begin with and their current categorizations are an understatement of the systemic risk they present," Philo said.
The suggested change is part of a set of proposals for the capital surcharge on global systemically important banks, or GSIBs. Most of the changes included in the notice would be low-impact, granular modifications meant to eliminate steep jumps between surcharge categories, a phenomenon referred to as the "cliff effect."
Fed officials — including Vice Chair for Supervision Michael Barr — previewed the changes as being minor in public remarks during the weeks leading up to the proposal. Because of this, some in and around the banking industry feel blindsided by the altered treatment of cross-border derivatives.
"The expectations were that changes to the GSIB surcharge would be only technical refinements, rather than changes that moved numerous institutions into higher prudential regulatory categories," said Andrew Olmem, a Washington-based partner at the law firm Mayer Brown. "That change appears arbitrary."
The requirement would have no impact on domestic banks, and it would not alter the capital surcharge applied to any GSIB. But, for nine or so entities, the new reporting methodology would push their cross-jurisdictional exposure levels to more than $75 billion, thus elevating them into the second-highest tier in the Fed's regulatory examination framework.
"This is a significant change," Sewell said. "It's so significant that it may cause some banks to rethink their businesses and maybe even engage in some balance-sheet reforms or optimization to avoid the category change if they can. But some may just not be able to."
The exact impact of the change is hard to quantify for a few reasons. First, the Fed itself is unsure of exactly how many institutions would cross the $75 billion threshold as a result of the change — ultimately, that figure would depend on how banks fill out their reports. Also, because the amendment would not result in higher capital costs, but rather new operational requirements, the price tag of the changes could vary significantly from bank to bank.
"My sense is that some banks are concerned and considering how significant the impact would be," Alison Hashmall, a lawyer with the firm Debevoise & Plimpton, said. "Without putting numbers on it or cost, on its face it is a meaningful distinction between Categories IV or III and Category II."
Some banks could go from reporting on their liquidity positions monthly — or, in some cases, not at all — to having to report daily. Similarly, the category change could see banks going from quarterly to monthly internal stress-testing requirements. Both those shifts would require banks to build out new compliance infrastructures, regulatory lawyers say.
Likewise, some of these banks would also see their resolution-planning requirements change. Under the 2019 tailoring reforms, foreign firms with limited cross-border exposures were allowed to file reduced resolution plans. Under the proposed change, they could be required to submit full plans, which are costlier and more time-consuming to compile.
Certain details of the proposal frustrate foreign banks and their representatives, including the fact that derivatives contracts between U.S. banking operations and their foreign parent companies are counted toward their cross-jurisdictional totals. Also, the framework would treat contracts collateralized by cash or cash-like securities the same as those backed by riskier assets, an approach that some feel does not accurately reflect underlying risk.
"I question, for positions collateralized with cash or equivalents, whether that measurement is warranted," Hashmall said. "So the questions are twofold: whether derivatives should be included at all, and if they should be measured on a gross basis."
The proposal also comes with logistical issues, including the fact that the changes would be phased in over two quarters, giving affected banks a relatively small window to adjust their business models or prepare for enhanced regulatory treatment. Further complicating the matter are the proposed Basel III endgame capital changes, which would have a longer phase-in period, meaning banks could have to make one set of changes based on the GSIB surcharge reform and then quickly make another set of reforms to comply with Basel.
The Fed Board of Governors introduced the GSIB reform proposal alongside the Basel III endgame package — a joint proposal with the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency — at the end of last month. But while the Basel reforms were a
Fed Govs. Michelle Bowman and Christopher Waller, who both voted against the Basel III endgame package, supported putting the GSIB rule change out for public comment. They made no mention of the impact on foreign banks in their remarks at the meeting.
Philo, who was a supervising examiner at the New York Fed during the subprime lending crisis, said derivatives played a large role in the distress in the banking sector during that episode. She noted that Lehman Brothers, in particular, suffered because of its large derivatives portfolio.
Leaving derivatives out of cross-jurisdictional asset calculations represented both a gap in the U.S. regulatory framework and an opportunity for regulatory arbitrage, Philo said.
"Leaving derivatives out presents the risk of materially understating the complexity and transmission channels for financial distress, as the Fed proposal indicates and as the Lehman Brothers bankruptcy exemplified well in the 2008 financial crisis," she said. "This is concerning, particularly considering that derivatives have the potential to amplify the impacts of a financial firm's failure more than other cross-border assets and liabilities."
The proposal will be open to public comment until Nov. 30.
