Enhanced Supervision for U.S. Operations of Foreign Banking Organizations: The FRB Proposal and Its Implications

BEIJING BRUSSELS CHICAGO DALLAS FRANKFURT GENEVA HONG KONG HOUSTON LONDON LOS ANGELES NEW YORK PALO ALTO SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C.

Enhanced Supervision for U.S. Operations

of Foreign Banking Organizations: The FRB

Proposal and Its ImplicationsConnie M. FriesenDavid M. Katz

March 13, 2013

I. Introduction

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Background• On December 14, 2012, the Federal Reserve Board

(the “FRB”) released a significant new proposal (the “Proposal”) to strengthen oversight of the U.S. operations of foreign banking organizations (“FBOs”).

• The Proposal applies to any FBO with total global consolidated assets of $50 billion or more, but its application to a particular FBO depends on the size and composition of the FBO’s U.S. operations.

• If adopted substantially as proposed, the Proposal would be the most significant change in U.S. regulation of FBOs since the adoption of the International Banking Act of 1978.

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A Paradigm Shift for Bank Regulation

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• The Proposal represents a paradigm shift and indicates that the FRB has lost confidence in traditional methods of bank supervision and regulation.

• The Proposal represents a transition away from the old qualitative and judgmental supervisory approach to a more quantitative approach and requirements.

• The Proposal also represents a movement away from principles of reliance on home country supervision to a greater focus on host country supervision and U.S. ring-fencing of the U.S. operations of FBOs.

Introduction of the New Approach: Governor Tarullo’s Speech

• FRB Governor Daniel Tarullo explained the need for a new approach to regulation of foreign banks in the United States in an important speech on November 28, 2012.

• Regulation of foreign banks in the United States has changed little over the past decade or two, despite a significant and rapid transformation of foreign bank operations.

• Foreign banks have moved beyond traditional lending functions to engage in substantial, complex trading and capital markets activities.

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“Lending Branches” and “Funding Branches”

• The traditional model of U.S. branches as “lending branches” well-funded by the home country Head Office changed dramatically in the period preceding the financial crisis.

• Reliance on less stable, short-term wholesale funding increased significantly and many foreign banks shifted to a “funding branch” model in which U.S. branches of foreign banks were borrowing large amounts of U.S. dollars to upstream to their home country operations.

• According to Governor Tarullo, assets of such “funding branches” grew from 40 percent to 75 percent of foreign bank branch assets between the mid-1990s and 2009.

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Rapidly Changing Transactions and Objectives

• Short-term U.S. dollar funding raised in the United States was used to provide long-term U.S. dollar-denominated project and trade finance around the world and to finance non-U.S. affiliates’ investments in U.S. dollar-denominated asset-backed securities.

• Commercial and industrial lending originated by U.S. branches and agencies as a share of third-party liabilities declined significantly after 2003.

• U.S. broker-dealer assets of the top ten foreign banks increased rapidly during the past 15 years, rising from 13% of all foreign bank third-party U.S. assets to 50% in 2011.

• Five of the top ten U.S. broker-dealers are currently owned by FBOs.

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New Structures to Support Supervisory Objectives

• Governor Tarullo suggested that a more uniform structure should be required for the U.S. operations of foreign banks. FBOs with significant U.S. operations should be required to establish a top-tier U.S. intermediate holding company (“IHC”) over all U.S. bank and nonbank subsidiaries.

• Capital requirements that apply to U.S. bank holding companies should be applied to IHCs.

• While IHCs would be subject to special requirements, Governor Tarullo also indicated that there would be enhanced supervision of U.S. branches and agencies of FBOs.

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II. Overview of Proposal

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Proposal Implements Dodd-Frank Act Provisions

• Sections 165 and 166 of the Dodd-Frank Act direct the FRB to impose enhanced prudential standards on FBOs with total global consolidated assets of $50 billion or more.

• Section 166 of the Dodd-Frank Act requires the FRB to establish a regulatory framework for the early remediation of financial weaknesses of FBOs in order to minimize the possibility that they will become insolvent.

• The FRB notes in its introduction to the Proposal that its proposal for IHCs is a “supplemental enhanced standard”.

• The FRB also cites the so-called Collins Amendment to the Dodd-Frank Act, which directs the FRB to strengthen capital standards applied to U.S. bank holding company subsidiaries of FBOs.

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Some Important Dates

• Proposal would be effective on July 1, 2014 and FBOs would be required to meet new standards as ofJuly 1, 2015.

• Proposal includes numerous requests for comments or responses to questions on specific items. Comment period ends April 30, 2013.

• Proposal requires careful study and pre-planning to assess and adapt to its capital and leverage, liquidity, risk management, corporate governance, tax, accounting, cost allocation and restructuring implications.

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Types of Requirements Included in the Proposal

• Enhanced FRB supervision of all U.S. operations of FBOs.• Imposition of IHC requirement for FBOs with more than

$10 billion in U.S. non-branch and non-agency assets.• Risk-based capital and leverage requirements.• Liquidity requirements.• Single-counterparty credit limits.• Risk management requirements.• Stress testing requirements.• Debt-to-equity limitations.• Early remediation requirements.

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Tailored Requirements for Different Structures and Activities

• Different requirements for:– FBOs with total global consolidated assets of greater

than $10 billion but less than $50 billion.– FBOs with total global consolidated assets of $50 billion

or more but less than $50 billion in combined U.S. assets.

– FBOs with total global consolidated assets of $50 billion or more and more than $50 billion in combined U.S. assets.

– Note: The term “combined U.S. assets” is defined in the Proposal to mean all U.S. assets (banking and non-banking) unless otherwise qualified for certain purposes to exclude U.S. branch and agency assets.

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Application of the Proposal to U.S. Operations

• The Proposal’s focus on IHCs sometimes seems to obscure the fact that it will also apply to U.S. branches and agencies and to nonbank operations whether or not included in an IHC.

• Some of the Proposal’s requirements are directed specifically to IHCs or to U.S. branches and agencies.

• Other requirements are applied to the “combined U.S. operations,” a term which generally means (i) any IHC and its consolidated subsidiaries; (ii) any U.S. branch or agency; and (iii) any other U.S. subsidiary of an FBO that is not a section 2(h)(2) company.

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III. Specific Provisions of the Proposal

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IHC Requirement• One of the most controversial aspects of the Proposal is the

IHC requirement.• IHC requirement would apply to an FBO that meets the

asset thresholds and other criteria for establishment of an IHC regardless of whether the FBO has a bank subsidiary.

• An IHC would be subject to the same U.S. requirements on capital, liquidity and leverage that would apply to a U.S. domestic bank holding company.

• Imposition of IHC requirement for FBOs with more than $50 billion in total global consolidated assets and more than $10 billion in U.S. non-branch and non-agency assets.

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IHC Formation Requirements

• An FBO that establishes an IHC would be required to hold its interest in any U.S. subsidiary, other than a Section 2(h)(2) company, through the IHC.

• An FBO that forms an IHC would be required to transfer to such IHC any controlling interest in U.S. companies acquired pursuant to the merchant banking authority.

• An IHC would be required to have a board of directors.• There would be an after-the-fact notice procedure for the

formation of an IHC.• The FRB may, on a case by case basis, permit an FBO to

establish multiple IHCs or alternative organizational structures if foreign laws or other circumstances warrant an exception.

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Risk-Based Capital and Leverage Requirements for IHCs

• An IHC of an FBO would be subject to the same capital adequacy standards, including minimum risk-based capital and leverage requirements and restrictions associated with applicable capital buffers, that are applicable to U.S. bank holding companies.

• The FRB anticipates that the capital adequacy standards for U.S. bank holding companies will incorporate Basel III standards on the July 1, 2015 effective date.

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New Capital Requirements and Broker-Dealers

• The capital requirements for IHCs would seem to present a particular challenge for IHCs that do not include a bank subsidiary.

• Broker-dealers, investment advisers and other nonbank subsidiaries that are currently subject only to capital requirements that might be imposed by the SEC or other functional regulators would, under the terms of the Proposal, be subject to bank capital requirements that were not developed or designed for broker-dealers or other nonbank subsidiaries.

• SEC Commissioner Dan Gallagher noted in a speech on February 22, 2013 that a U.S. broker-dealer subsidiary of an FBO could be required to hold more capital than would be necessary to satisfy the SEC’s net capital rule to maintain the same positions.

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New Capital Requirements and Broker-Dealers (continued)

• SEC-registered broker-dealers, as an example of nonbank subsidiaries that might be included in an IHC, are already subject to separate capital requirements.

• The SEC has a robust and extensive capital regulatory structure for SEC- registered broker-dealers via SEC Rule 15c3-1.

• However, the SEC’s capital regime has a fundamentally different focus than the FRB’s capital requirements. SEC Rule 15c3-1 is a net liquid assets test that is designed to require a broker-dealer to maintain sufficient liquid assets to meet all of its obligations to customers and counterparties, and then have adequate additional resources to wind-down its business in an orderly manner without the need for a formal proceeding it fails financially (that is, via a self-liquidation) and, thus, without the need to tap into the SIPC insurance fund established under Securities Investor Protection Act of 1970.20


• U.S. bank capital requirements on the other hand are focused on ensuring the safety and soundness of bank operations; that is, to ensure that banks operate in a manner to minimize risk and avoid liquidation. Thus, bank capital requirements are not designed to ensure that banks maintain sufficient net liquid assets to satisfy all creditors because banks have access to federal liquidity facilities that can be accessed in the event the bank cannot otherwise obtain private funding, but bank capital requirements are designed to minimize the need to tap into those federal liquidity facilities.

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• Pursuant thereto, there are four fundamental capital regimes for SEC-registered broker-dealers (current and proposed) and all of these regimes are quite distinct from bank capital requirements: – “Standard” broker-dealers

i. SEC Rule 15c3-1(a)(1)(i) sets forth the “basic” standard for computing net capital and is often used by smaller broker-dealers. A broker-dealer operating under this requirement must maintain minimum net capital equal to the greater of some specified amount (which varies depending on the type of business in which the broker-dealer is engaged) and 6⅔% of “aggregate indebtedness” (“AI”; that is, the total money liabilities of a broker-dealer arising in connection with any securities transaction whatsoever, subject to certain exceptions). Alternatively, the broker-dealer’s aggregate indebtedness cannot exceed fifteen times its net capital (where 1/15 equals 6-2/3%).

ii. SEC Rule 15c3-1(a)(1)(ii) sets forth an “alternative” standard for computing net capital and is generally used by larger broker-dealers. A broker-dealer operating under this requirement must maintain net capital equal to the greater of $250,000 and 2% of specified aggregate “debit” items, subject to certain adjustments. Broker-dealers operating under the alternative standard, however, are not subject to any specific AI or debt limits.

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OTC Derivative Dealers (“OTCDDs”)i. OTCDDs are allowed to engage in dealer activities involving certain

OTC derivative instruments, such as swaps and OTC options, and must maintain minimum net capital of $20 million and minimum tentative net capital of $100 million (subject to adjustments and deductions).

– Alternative Net Capital Broker-Dealers (“ANCBDs”)i. ANCBDs are the largest broker-dealers and they have been approved

by the SEC, on a firm-by-firm basis, to use internal value-at-risk (VaR) models to determine market risk charges for proprietary securities and derivatives positions and to take a credit risk charge in lieu of a 100% charge of unsecured receivables related to OTC derivatives transactions. VaR models are also available for OTCDDs.

ii. ANCBDs are required to maintain minimum net capital of $500 million and minimum tentative net capital of $1 billion, although under an SEC rule proposal an ANCBD would be required to maintain minimum net capital of $1 billion and minimum tentative net capital of $5 billion.

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– Proposed Net Capital Rules for Security-Based Swap Dealers (“SBSDs”)i. Under an SEC proposal, a non-bank SBSD (stand-alone and

not otherwise registered as a broker-dealer) without a prudential regulator would be required to maintain minimum net capital of $20 million if such SBSD does not use internal VaR models. SBSDs that use internal VaR models would be required, in addition to the $20 million requirement, to maintain minimum tentative net capital of $100 million.

• Broker-dealers are also subject to higher “minimum” amounts by reason of various SEC “early warning” requirements (including a proposal to raise the early warning amount to $6 billion for ANCBDs).

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• In addition, FINRA can impose additional capital requirements on certain member firms. Pursuant to Section 15(i)(1) of the Securities Exchange Act of 1934 (the “Exchange Act”), the States are preeempted from imposing, among other things, capital requirements that differ from or are in addition to the capital requirements under the Exchange Act, although such preemption does not, technically, prohibit the States from imposing capital requirements on stand-alone SBSDs.

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– Proposed Net Capital Rules for Security-Based Swap Dealers (“SBSDs”)i. Under an SEC proposal, a non-bank SBSD (stand-alone and

not otherwise registered as a broker-dealer) without a prudential regulator would be required to maintain minimum net capital of $20 million if such SBSD does not use internal VaR models. SBSDs that use internal VaR models would be required, in addition to the $20 million requirement, to maintain minimum tentative net capital of $100 million.

• Broker-dealers are also subject to higher “minimum” amounts by reason of various SEC “early warning” requirements (including a proposal to raise the early warning amount to $6 billion for ANCBDs).

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• In addition, FINRA can impose additional capital requirements on certain member firms. Pursuant to Section 15(i)(1) of the Securities Exchange Act of 1934 (the “Exchange Act”), the States are preeempted from imposing, among other things, capital requirements that differ from or are in addition to the capital requirements under the Exchange Act, although such preemption does not, technically, prohibit the States from imposing capital requirements on stand-alone SBSDs.

• Also, registered broker-dealers are permitted to finance themselves using satisfactory subordinated debt under Appendix D to SEC Rule 15c3-1. Generally, a broker-dealer may borrow funds on a subordinated basis and treat the borrowing as “good capital” for the purposes of SEC Rule 15c3-1 (an addition to assets and an exclusion from liabilities in the computation of net capital), although in most cases, a broker-dealer is limited in the amount of subordinated debt financing that it may incur (generally, not more than 70% of its debt-equity total).

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• To require a broker-dealer to adhere to a capital framework for banks may be unworkable; nonetheless, to date, the FRB seems committed to imposing bank capital requirements on IHCs.

• FRB states in the Proposal that it will consult with the SEC and other relevant regulators before it adopts a final rule, but the Proposal seems quite prescriptive in its approach.

• FBOs with significant broker-dealer or other nonbank subsidiaries might want to take advantage of the opportunity to comment on or respond to the FRB’s questions included in the Proposal before the April 30 deadline.

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Capital and Leverage Requirements for FBOs with Total Global Consolidated Assets of $50 Billion or

More• FBOs with total global consolidated assets of $50 billion or more

must certify to FRB that they meet, at the consolidated level, capital adequacy standards established by home country supervisor that are consistent with the Basel Capital Framework (Basel III) or are otherwise consistent with Basel III.

• The Proposal would not apply the U.S. minimum leverage ratio to an FBO. However, when the Basel III leverage ratio is implemented internationally in 2018, FBOs with total global consolidated assets of $50 billion or more would need to demonstrate compliance with the international leverage ratio.

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Liquidity Requirements

• Generally, the Proposal imposes detailed and complex liquidity requirements on FBOs with combined U.S. assets of $50 billion or more.

• Such requirements are broadly consistent with those set forth in the FRB’s December 2011 Proposal for large U.S. bank holding companies and are based on standards set forth in the Interagency Liquidity Risk Policy Statement (March 2010).

• FBOs with combined U.S. assets of less than $50 billion would be subject to a more limited set of requirements.

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Liquidity Requirements for FBOs with Combined U.S. Assets of Less than $50

Billion • An FBO with combined U.S. assets of less than $50 billion

would be required to:– Report to the FRB the results of an internal liquidity stress test

(either on a consolidated basis or for its combined U.S. operations) on an annual basis.

– Internal stress test would need to be consistent with Basel Committee principles for liquidity risk management and incorporate 30-day, 90-day and one-year stress test horizons.

– An FBO that does not comply with this requirement must limit the net aggregate amount owed by the FBO’s head office and non-U.S. affiliates to its combined U.S. operations to 25% or less of the 3rd party liabilities of its combined U.S. operations, on a daily basis.

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Liquidity Requirements for FBOs withCombined U.S. Assets of $50 Billion or More• More burdensome liquidity requirements for FBOs with

larger U.S. operations:– U.S. risk committee and U.S. risk officer– Independent review– Cash flow projections– Liquidity stress tests– Liquidity buffers– Contingency funding plan– Specific limits– Monitoring

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Liquidity Requirements for FBOs withCombined U.S. Assets of $50 Billion or More• Requirements include:A. U.S. Risk Committee and U.S. Risk Officer Responsibilities.• U.S. Risk Committee would review and approve the liquidity risk

tolerance for the FBO’s combined U.S. operations at least annually.

• U.S. Risk Officer would be responsible for:- Reviewing and pre-approving the liquidity costs,

benefits and risks of each significant new U.S. business line and each significant new product offered.

- Reviewing approved significant business lines and products for compliance with established liquidity risk tolerance for combined U.S. operations at least annually.

- Many other review, reporting and approval responsibilities.

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Liquidity Requirements for FBOs with Combined U.S. Assets of $50 Billion or More

(continued)B. Independent Review

● FBO would be required to maintain an independent review function to evaluate the liquidity risk management of combined U.S. operations.

C. Cash Flow Projections● FBO would be required to provide cash flow projections for

combined U.S. operations that project cash flows arising from assets, liabilities and off-balance sheet exposures over short-term and long term time horizons.

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(continued)D. Liquidity Stress Tests• FBO would be required to conduct monthly liquidity stress

tests of its cash flow projections separately for its IHC and its U.S. branch and agency network.

• FBO must establish and maintain policies and procedures outlining its liquidity stress testing practices, methodologies and assumptions.

• FBO must maintain an effective system of controls and oversight over stress test function.

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(continued)E. Liquidity Buffers

● FBO must maintain separate liquidity buffers for its U.S. branch and agency network and its IHC, comprised of highly liquid assets that are sufficient to meet net stressed cash flow needs over a 30-day stressed horizon.

i. U.S. branch and agency network would be required to maintain the first 14 days of its 30-day buffer in the United States. The remainder of the buffer could be maintained at the parent consolidated level.

ii. IHC would be required to maintain the full 30-day buffer in the United States.

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(continued)F. Contingency Funding Plan• The FBO must maintain and update (at least

annually) a contingency funding plan for its combined U.S. operations that describes strategies for addressing liquidity needs during liquidity stress events.

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(continued)G. Specific Limits

The FBO must establish limits on potential sources of liquidity risk, including:

i. Concentrations of funding sources, by instrument type, counterparty type, etc;

ii. The amount of specified liabilities that mature within various time horizons; and

iii. Off-balance sheet exposures and other exposures that could create funding needs during liquidity stress events.

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(continued)H. Monitoring

FBO must have procedures for:i. Monitoring assets pledged or available to be pledged

as collateral;ii. Monitoring liquidity risk and funding needs within and

across significant legal entities, business lines and currencies;

iii. Monitoring intraday liquidity risk exposure; andiv. Monitoring specific limits on potential sources of

liquidity risk.

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Single-Counterparty Credit Limits• The Proposal would establish a 25 percent net credit

exposure limit between an IHC or the combined U.S. operations of an FBO with total global consolidated assets of $50 billion or more and a single unaffiliated counterparty.*

– The IHC would be prohibited from having aggregate net exposure to any single unaffiliated counterparty in excess of 25 percent of the IHC’s capital stock and surplus.

– Combined U.S. operations of an FBO would be prohibited from having aggregate net credit exposure to any single unaffiliated counterparty in excess of 25 percent of the consolidated capital stock and surplus of the FBO.

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Single-Counterparty Credit Limits (continued)

• Compliance– An FBO must submit a monthly compliance report

demonstrating its daily compliance with the single-counterparty credit limits.

– Noncompliance by either the IHC or the combined U.S. operations could result in the IHC and/or the combined U.S. operations being prohibited from engaging in any additional credit transactions with the particular counterparty.

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Risk Management and Risk Committee Requirements

• FBOs that are publicly-traded with global consolidated assets of $10 billion or more and all FBOs with total global consolidated assets of $50 billion or more would be required to certify annually to the FRB that they maintain a U.S. risk committee to oversee risk management practices of the U.S. operations.– Risk committee must have at least one member with

appropriate risk management expertise.– An FBO’s enterprise-wide risk committee may serve as the

U.S. risk committee. However, if the FBO has combined U.S. assets of $50 billion or more and operates in the U.S. solely through an IHC, it must maintain the risk committee at the IHC.

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Risk Management and Risk Committee Requirements (continued)

• FBOs with combined U.S. assets of $50 billion or more are subject to additional risk committee requirements.

– U.S. risk committee would be responsible for reviewing and approving the risk management practices of the combined U.S. operations and for overseeing the operations of an appropriate risk management framework.

– At least one member of the U.S. risk committee must be independent.

– Risk management framework must be comprehensive and consistent with the FBO’s enterprise-wide risk management framework.

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Risk Management and Risk Committee Requirements (continued)

• U.S. Chief Risk Officer– FBOs with combined U.S. assets of $50 billion or more or its

IHC must appoint a U.S. chief risk officer to be in charge of the risk management framework and practices for the FBO’s combined U.S. operations.

– U.S. chief risk officer would report directly to the U.S. risk committee and the FBO’s chief risk officer and must be employed by a U.S. branch or agency, an IHC or another U.S. subsidiary.

– U.S. chief risk officer would have direct oversight responsibilities for implementation of and ongoing compliance with appropriate policies and procedures.

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Stress Test Requirements

• Stress tests requirements would vary depending on the size of the FBO and the scope of its U.S. operations.

• Smaller FBOs with total global consolidated assets of more than $10 billion, but combined U.S. assets of less than $50 billion, must be subject to a home country stress testing regime that meets certain standards. Otherwise, it must meet certain U.S. requirements, including a 105% asset maintenance requirement for the FBO’s U.S. branch and agency network and annual stress tests for U.S. subsidiaries not held under an IHC.

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Stress Test Requirements (continued)• FBOs with combined U.S. assets of $50 billion or more

that have a U.S. branch and agency network must meet certain stress test requirements or be subject to additional standards imposed by the FRB:– The FBO must be subject to and meet the minimum

standards of a consolidated home country capital stress testing regime that is broadly consistent with U.S. standards and includes:i. either an annual supervisory capital stress test conducted by the

home country supervisor or an annual review by the home country supervisor of an internal capital adequacy stress test conducted by the FBO; and

ii. requirements for governance and controls of the stress testing practices by relevant FBO management and the board of directors.

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Stress Test Requirements (continued)– FBOs that meet the above requirements would submit to

the FRB summary information regarding the home country stress test activities and results.

i. If the FBO’s U.S. branch and agency network provides, on a net basis, funding to its parent or non-U.S. affiliates, FBO must provide additional information regarding annual stress test results.

– FBOs that do not meet these requirements must comply with the following additional standards imposed by the FRB:

i. Asset maintenance requirement for U.S. branches and agencies of not less than 108% of the preceding quarter’s average value of third party liabilities.

ii. Separate internal stress tests for any U.S. subsidiary not held under an IHC.

iii. Intragroup funding restrictions as determined by the FRB.

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Debt-to-Equity Limits

• If the Financial Stability Oversight Council (the “FSOC”) has determined that an FBO (with total global consolidated assets of $50 billion or more) poses a grave threat to U.S. financial stability and determines that a debt-to-equity limit is necessary to mitigate that risk, the Proposal would require such an FBO to maintain: – a debt-to-equity ratio of not more than 15-to-1 for its

IHC and any U.S. subsidiary not organized under an IHC; and

– a 108% asset maintenance requirement for its U.S. branch and agency network.

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Early Remediation• The Proposal would establish a regime for the early

remediation of the combined U.S. operations of an FBO with total global consolidated assets of $50 billion or more, in a manner generally consistent with the December 2011 Proposal for U.S. bank holding companies.

• The regime is divided into four levels of remediation that increase in stringency with respect to remediation requirements.

• Early remediation triggers for each level are based on one or more of the following: risk-based capital and leverage ratios, stress test results, liquidity risk and risk management deficiencies and market indicators.

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IV. Implications of the Proposal

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Major Implications• Like the International Banking Act, the Foreign Bank

Supervision Enhancement Act and the Gramm-Leach-Bliley Act, the Proposal would likely result in fundamental changes in the U.S. operations of many FBOs.

• The Proposal would require enhanced attention to compliance, risk management and corporate governance.

• The Proposal would require many FBOs to dedicate more capital to U.S. operations and would subject FBOs to new liquidity and leverage requirements.

• New activities of FBOs would be subject to greater supervisory scrutiny.

• U.S. nonbank operations of FBOs would be subject to greater scrutiny by the FRB.

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Effects on Funding Arrangements

• Many international banks issue commercial paper, certificates of deposit and medium-term notes in the United States and then send some of the proceeds back to the home country to fund operations there.

• The Proposal aims to limit such transfers; FBOs will need to assess the effects of potential limitations and adjust their funding programs accordingly.

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Special Implications for Broker-Dealers• Capital requirements for IHCs are to be calculated with

reference to requirements typically applied to domestic U.S. bank holding companies. As noted earlier, the FRB’s “safety and soundness” approach to bank regulation is fundamentally different from the SEC’s financial responsibility regulation of broker-dealers (where the latter focuses on customer protection and orderly liquidation).

• Such calculations may present significant issues for IHCs where the primary subsidiary is a broker-dealer. As noted above, broker-dealers are subject to capital requirements established by the SEC, which rule establishes a liquid assets test or approach.

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Special Implications for Broker-Dealers• It is unclear how the differing capital requirements of

the SEC and FRB might be coordinated or how capital required by the SEC will be counted towards IHC capital requirements. It is possible that such SEC and FRB requirements may conflict in certain respects.

• As noted earlier, for larger broker-dealers, there are no specific debt limits/ratios under the SEC’s capital requirements, although there are for smaller broker-dealers that are subject to AI requirements.

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Special Implications for Broker-Dealers• Broker-dealers are already subject to oversight by

multiple regulators, including the SEC and at least one self-regulatory organization (SRO) that is the designated examining authority for the broker-dealer. SEC Rule 17d-1 requires coordination among such multiple SRO regulators.

• Adding the FRB to the mix of regulators runs the risk of having too many “cooks in the kitchen” that can result in duplicative or contradictory regulatory regimes absent careful coordination between the FRB and the SEC.

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Special Implications for Broker-Dealers• Proposed U.S. Risk Officer Requirement: might subject to

such person to FINRA registration as a FINOP (Financial and Operations Principal), if such person can approve/manage financial funding for a broker-dealer or review and approve contingency plans or conduct quarterly reviews of liquidity stress test results, cash flow projections, and size and composition of its liquidity buffer as well as review strategies, policies and procedures for managing liquidity risk – all least for a broker-dealer which is a significant subsidiary.

• U.S. Risk Committee responsible for overall risk monitoring: should not necessarily trigger principal registration with FINRA under NASD Notice to Members 99-49.

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Special Implications for Broker-Dealers• The SEC requires that broker-dealers be subject to the SEC’s

capital requirements on a “moment to moment” basis. FINRA also imposes capital requirements on broker-dealers, requires that a broker-dealer appoint a chief financial officer/FINOP and that such FINOP be responsible for preparing detailed monthly or quarterly unaudited financial reports.

• Subjecting broker-dealers to a different capital regime with a fundamentally different policy/purpose could require broker-dealers to hire additional/multiple financial principals who are responsible for potential conflicting requirements, and could subject broker-dealers to substantial/additional capital compliance costs, including the need to build-out of new compliance procedures and financial control systems.

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Special Implications for Broker-Dealers (continued)

• One principle affirmed in 1994 by the Gramm-Leach-Bliley Act and generally respected by federal banking and securities regulators has been the principle of “functional” regulation which requires federal banking regulators to respect the primary supervisory authority of the functional regulator, i.e., the SEC in the case of a broker-dealer.

• The Proposal assigns supervisory responsibility for IHC capital, liquidity and leverage requirements to the FRB and it is not clear whether the FRB would also be allowed to inspect the books and records, generally examine or initiate supervisory actions directly against a broker-dealer subsidiary of an IHC.

• The Proposal notes that the FRB intends to consult with each primary or functional regulator of a bank or non-bank subsidiary before imposing specific prudential standards.

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Special Implications for Broker-Dealers• The imposition of an IHC could trigger FINRA and other

SRO approvals. For example, NASD Rule 1017(a)(4), (b) and (c) requires the filing of a formal application with, and approval by, FINRA in respect of any change in the equity ownership or partnership capital of a FINRA member (broker-dealer) that results in one person or entity directly or indirectly owning or controlling 25% or more of the equity or partnership capital thereof. FINRA takes the position that NASD Rule 1017(a)(4) applies to the imposition of a new intermediate holding company for a FINRA member, even if the foregoing does not result in a change in the beneficial ownership or control of the broker-dealer. Other SROs have similar filing and approval requirements.

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Special Implications for Broker-Dealers

• Pursuant to FINRA Rule 8210, FINRA may have jurisdiction to examine the books and records of an IHC.

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Regulation of Other Non-Bank Subsidiaries of IHC

• The FRB notes in its explanation of the Proposal that an IHC would provide a more uniform platform for oversight of the U.S. operations of FBOs.

• It is unclear how the Proposal would affect the traditional application of Regulation Y and Regulation K to non-banking subsidiaries of FBOs.

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V. Actions to be Taken

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Assessing Impact of Proposal’s Requirements

• An FBO will need to identify all of the specific provisions of the Proposal that might be applicable to its U.S. operations.

• An FBO will need to conduct a “gap analysis” by assessing its current capital and leverage, liquidity, risk management, counterparty credit limit positions against the new requirements of the Proposal.

• Comparison of capital requirements on a cross-border basis and including Basel III requirements as well may prove to be a challenging but necessary exercise.

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Rethinking U.S. Strategy● In addition to the specific gap analysis noted above, every FBO

should be conducting an analysis of the Proposal’s effects on its U.S. strategy and structure.

● Questions to be considered would include:– How will enhanced supervision affect U.S. operations generally?– What changes in business model will be needed as a result of

the Proposal?– What new compliance, risk management and corporate

governance policies and procedures will be needed if the Proposal is adopted as issued?

● While the Proposal has not yet been adopted, the changes it will introduce are significant and an FBO should begin now to consider how it will meet the challenges of the new regulatory regime contemplated by the Proposal.

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Contact Information

Connie M. Friesen(212) 839-5507

[email protected]

David M. Katz(212) 839-7386

[email protected]

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This presentation has been prepared by Sidley Austin LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers.

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World Offices

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Documents

Enhanced Supervision for U.S. Operations of Foreign Banking Organizations: The FRB Proposal and Its Implications