In three separate letters, SIFMA and six other financial industry associations filed comments with the Office of the Comptroller of the Currency (“OCC”), the Board of Governors of the Federal Reserve System (“FRB”) and the Federal Deposit Insurance Corporation (“FDIC”) (collectively, the “Federal Agencies”) on the proposed rules regarding the liquidity coverage ratio (“LCR”).  The letters contained comments on the LCR proposal in connection with international standards, securitization and municipal securities. 

In the first letter (linked below), SIFMA, the Structured Finance Industry Group (“SFIG”), the Clearing House Association, the American Bankers Association (“ABA”), the Financial Services Roundtable (“FSR”), the Institute of International Bankers (“IIB”) and the International Association of Credit Portfolio Managers (collectively, the “Associations”) commented on the LCR proposal in connection with the international liquidity standards published by the Basel Committee on Banking Supervision (“Basel LCR”).  The Associations believe that the Basel LCR “strikes an appropriate balance” between capturing liquidity risk and the concerns raised by banks with respect to the measurement of that risk and the scope of oversight and related compliance regulations.  The Associations share concerns that the U.S. LCR Proposal deviates so significantly from the Basel LCR that it detracts from “the goals of clarity and transparency across markets, competitive equality, and minimizing opportunities for regulatory arbitrage and the potential balkanization of national markets.” 

Regarding securitization, SIFMA and the SFIG also submitted comments to the Federal Agencies stating their support for the effort to implement an LCR requirement that is generally consistent with the Basel LCR.  However, SIFMA and the SFIG also stated that they believe LCR regulations should recognize that traditional securitization activities are (i) an essential source of core funding to the real economy, and (ii) an important part of a bank’s liquidity management strategy.  SIFMA and the SFIG proposed adjustments to the proposal, which they stated could allow the Federal Agencies to “sufficiently recognize these realities while still meeting their stated goals and objectives for enhanced liquidity standards.”

Additionally, the SIFMA Municipal Securities Division provided comments to the Federal Agencies on issues in the proposal related to municipal securities, municipal securities financing, and state and local government finance.  More specifically, the comments focus on three areas:

1. the exclusion of municipal securities from the definition of High-Quality Liquid Assets (“HQLA”),
2. outflow rate assumptions applied to bank liquidity facilities extended to certain special purpose entities (municipal Tender Option Bond financing vehicles), and
3. the outflow rate assumptions assigned to public sector entity deposits that are collateralized with municipal bonds.

See:  SIFMA Letter on LCR and Securitization; SIFMA Letter on LCR and International Standards; SIFMA Letter on LCR and Munis.
See also:  SIFMA Press Release.

The Office of the Comptroller of the Currency (“OCC”) released a proposal setting forth new standards for large national banks and federal savings associations that would be enforceable under Part 30 of its regulations.  The guidelines set forth the minimum standards for the design and implementation of an institution’s risk governance framework and provide minimum standards for oversight of that framework by the board of directors. 

The new standards are based on the OCC’s heightened expectations program, which was developed by the agency following the financial crisis to strengthen the governance and risk management practices of large national banks and federal savings associations, as well as to enhance the OCC’s supervision of those institutions.

The proposed guidelines would apply to any insured national bank, insured federal savings association or insured federal branch of a foreign bank, with average total consolidated assets of $50 billion or more. The proposal would reserve the OCC’s authority to apply the guidelines to an institution with less than $50 billion in assets if the OCC determines that it is highly complex or otherwise presents a heightened risk.

See: Notice of Proposed Rulemaking; OCC Press Release. 

SEC Commissioner Daniel M. Gallagher delivered a speech on the theories behind capital requirements for both banks and non-bank financial institutions. 

According to Commissioner Gallagher, policymakers often advance the mistaken view that there is a one-size-fits-all approach to capital.  Rather, he explained, there are several models of capital requirements.

Commissioner Gallagher stated that, in the banking sector, capital requirements are designed with the goal of enhancing safety and soundness, serving as a cushion against unexpected losses.  By placing bank owners’ equity at risk in the event of a failure, capital requirements reduce risk and the possibility that taxpayers would be required to backstop banks in times of stress. 

Gallagher also stated that capital requirements for broker-dealers are predicated on risk and focus on managing failure rather than avoiding it.  Therefore, Gallagher said, applying bank-based capital requirements to non-bank financial entities is “like trying to manage an orange grove using apple orchard techniques.”

To highlight the danger of imposing a bank capital regime on broker-dealers, Gallagher pointed to 2008, when the Fed “became the investor of last resort” and went beyond offering access to the discount window to depository institutions in its capacity as the lender of last resort.  According to Gallagher, the extension of the Fed’s regulatory paradigm to non-bank institutions had an adverse effect on these institutions, such as broker-dealers who had their own regulatory capital regime that was “designed to manage, rather than prevent, failure in order to ensure the return of customer assets.” 

Citing the Financial Stability Oversight Council’s (“FSOC”) proposal of capital requirements for money market funds which, contrary to the intention behind the proposal, would not mitigate the risk of investor panic leading to a run on a fund, Gallagher concluded that the situation is “terribly muddled.”  He questioned whether the goal is to expand the Fed’s role by making it the lender of last resort to non-bank entities, or to use the Fed’s Bank Holding Company Act authority and its role in FSOC to dictate capital requirements to non-bank entities in order to prevent them from gaining access to the discount window.  Gallagher stated that it is his hope in the coming year to work with the SEC and FINRA to review whether it is appropriate to establish separate capital rules for bank-affiliated broker-dealers. 

Lofchie Comment:  It is always gratifying to see senior level financial regulators addressing the important big-picture regulatory issues in a serious manner.   SEC Commissioner Gallagher’s thoughtful commentary shows his willingness to take on the complexities of the situation publicly, and, more specifically, to provide support for the role of the Fed as the lender of last resort in a liquidity crisis.

One should carefully consider a scenario, however, where liquidity really dries up.   If that were to happen, it is likely that the Fed might be forced to (and should) provide liquidity support to broker-dealers as well as to banks, since, like banks, broker-dealers are vulnerable to runs.   Where there is a general market confidence crisis, the markets stop settling trades, which has the potential to cause every firm to fail.

See:  Commissioner Gallagher’s Speech.

The Board of Governors of the Federal Reserve System (“FRB”) issued a final rule to align certain of its capital rules with the Basel III capital framework, which was adopted by the FRB earlier this year.  The changes to the rule reflect modifications by the Organization for Economic Cooperation and Development regarding country risk classifications. The final rule also clarifies criteria for determining whether underlying assets are delinquent for certain traded securitization positions. Additionally, it clarifies disclosure deadlines, and modifies the definition of a covered position.

FRB also made minor modifications to the Basel III revised capital framework to clarify the criteria for subordinated debt instruments that may be counted as Tier 2 capital. 

See: Regulatory Capital Final Rule Change; Risk-Based Capital Guidelines Final Rule Change; FRB Press Release.

The GAO released the first of a two-part report examining the various aspects of government support in bank holding companies since the financial crisis.  This report focused on the progress that the government has made (limited progress) towards preventing itself from providing special help to banks in the event of another financial or liquidity crisis.  In this report, the GAO examines (i) actual government support for banks and bank holding companies during the financial crisis, and (ii) recent statutory and regulatory changes related to government support for banks and bank holding companies. The GAO reviewed relevant statutes, regulations, and agency documents, in addition to bank program transaction data. Also, the GAO interviewed regulators, financial institution representatives, and academics in order to compile a comprehensive foundation to inform the report.

The GAO found that relevant provisions of Dodd-Frank remain at best partially implemented and the effectiveness of those provisions remains uncertain. The report stated that agencies have finalized certain changes to traditional safety nets for insured banks, yet the impact of the provisions to limit the scope of transactions that benefit from these safety nets depends on how they are implemented. The GAO recommends that agencies (specifically, the Federal Reserve) establish timelines for completing their processes for drafting procedures related to emergency lending authority to ensure “timely compliance” with Dodd-Frank requirements. 

Lofchie Comment:  There are a number of incidental aspects of the GAO report that are more interesting than the main topic of the report, which is the direct costs to the government of providing liquidity to the financial system at the time of the financial crisis. 

Here is the GAO’s explanation of the principal cause of the financial crisis crisis (at page 11):

“The 2007-2009 financial crisis was the most severe that the United States has experienced since the Great Depression.  The dramatic decline in the U.S. housing market that began in 2006 precipitated a decline in the price of financial assets that were associated with housing, particularly mortgage-related assets based on subprime loans (emphasis added).  Some institutions found themselves so exposed to declines in the values of these assets that they were threatened with failure-and some failed-because they were unable to raise the necessary capital as the value of their lending and securities portfolios declined.  Uncertainty about the financial condition and solvency of financial entities led banks to dramatically raise the interest rates they charged each other for funds and, in late 2008, interbank lending effectively came to a halt.  The same uncertainty also led money market funds, pension funds, hedge funds, and other entities that provide funds to financial institutions to raise their interest rates, shorten their terms, and tighten credit standards.”

This seems rather at odds with the justification for much of Dodd-Frank:  that hedge funds and swaps were to blame. But, the GAO report does not address why it should be a good idea to prevent the Federal Reserve from bailing out financial institutions at the time of a massive liquidity crisis. According to the GAO report (at page 1), “government interventions helped to avert a more severe crisis. . . ” Query, Should Congress, which in the past was not able to prevent a financial crisis, prevent a future Federal Reserve from responding in a way that seems most prudent at the time. If the market is absolutely convinced that the Federal Reserve will not provide liquidity in a financial crisis, doesn’t that make a crisis far more likely to occur because the market will panic faster if it believes that the government will simply let the banks fail?

See: Full GAO Report.
See also: GAO Report Highlights.

The Board of Governors of the Federal Reserve System (“FRB”) issued a final policy statement describing the processes it will use to develop scenarios for future capital planning and stress testing exercises.  The policy statement will be used to develop scenarios for both annual supervisory and company-run stress tests, and describes the characteristics of the stress test scenarios and procedures for formulating the scenarios.  Although the policy statement is not effective until January 1, 2014, the macroeconomic scenarios released last week for the 2014 stress testing exercise are consistent with the policy statement.

The FRB also issued revised macroeconomic scenarios for the 2014 capital planning and stress testing program to correct a minor computational error for the projections of the five-year Treasury yield in the baseline and adverse scenarios.

See: FRB Final Policy Statement on Scenario Design Framework; FRB Press Release.
Related news: Federal Reserve Board Releases Supervisory Scenarios and Instructions for 2014 Capital Planning and Stress Testing (November 4, 2013); OCC Releases Dodd-Frank Stress Testing Scenarios for 2014 and the Final Policy Statement (November 4, 2013).