Fed Proposal to Strengthen Banks

by Weiss Ratings | December 21, 2011

The Board of Governors of the Federal Reserve System just issued a proposal to strengthen regulation and supervision of large bank holding companies and nonbank financial firms such as large insurers.  The proposed rules are an attempt to reduce the risks of financial crises and reduce the interdependence between large institutions that have had a destabilizing effect on the economy in the past. 

The proposal establishes requirements for capital, liquidity, credit exposure, stress testing, risk management and early remediation mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Fed proposal applies to all U.S. bank holding companies with assets of $50 billion or more and any nonbank financial firms designated by the Financial Stability Oversight Council as being important to the soundness of the U.S. financial system. 

Savings and loan holding companies (SLHCs) would be subject to the stress test requirements.  But, the Board plans to issue separate proposals to address additional standards for SLHCs and foreign banking organizations.

The Fed proposal includes:

  • Risk-based capital and leverage requirements to be implemented in phases.  First, institutions would be required to develop annual capital plans, conduct stress tests, and maintain adequate capital.  One feature requires tier one, risk-based capital ratios to be greater than 5 percent under normal as well as stress conditions.  The idea is for institutions to maintain sufficient capital reserves to cushion against severe economic stress.  In the next phase, banks would follow the international bank standards set by the Basel III agreement requiring a 7 percent capital reserve cushion, and up to 2.5 percent surcharges based on “risk-weighted assets.” 

  • Liquidity requirements would also be implemented in phases.  Institutions would be required to conduct internal liquidity stress tests and set qualitative limits for risk management.  For the next phase, the Board wants to set quantitative liquidity requirements based on the Basel III rules.

  • Stress tests would be conducted annually by the Board using economic and financial market scenarios.  The company would also be required to conduct at least one internal stress test each year. Some of the results would be made public. 

  • Single-counterparty credit would be limited to a percentage of each firm’s regulatory capital. Credit exposure between the largest financial companies would be tightened to prevent the collapse of one big company triggering a larger crisis.  Credit exposure between the nation’s six largest firms including J.P. Morgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley would be limited to 10 percent, while most other firms would be subject to a 25 percent limit.   

  • Early remediation requirements are intended to identify and address financial weaknesses at an early stage.  Triggers for remediation include capital levels, stress test results and risk-management weaknesses.  In some cases, these tests would include forward-looking criteria.  Depending on the severity of the situation, institutions could be required to restrict growth, capital distributions and executive compensation, as well as raise capital or sell assets.      

There are some concerns that the new rules would increase costs for U.S. banks while they are already dealing with reduced revenue associated with new regulations, the struggling housing market and stiff competition at home and abroad. 

The Fed would like these enhanced standards implemented within a year after they are finalized.  But, stress testing for holding companies would take effect as early as possible after the rule is in place. 

Comments on the proposal are requested by March 31, 2012.

You may submit comments, identified by Docket No. 1438 and RIN 7100-AD-86 by any of the following methods:

All public comments are available from the Board’s website at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, unless modified for technical reasons. That means your comments will not be edited to remove any identifying or contact information.