A more gradualist approach to US banking regulation

On 10 October 2019, US banking regulators increased the application thresholds for the capital and liquidity requirements imposed on large banks.

Whilst the new rules do not change the prudential requirements for the eight biggest banking groups, they do reduce the burden for large regional banks.

The number of banks subject to the Basel Liquidity Coverage Ratio (LCR) requirement will be reduced and the definition of core equity relaxed to some degree.

In general terms, the rules as finalised over the past two months will significantly narrow the scope of application of Basel 3 in the USA.

Given concern over lending trends in certain segments and the continued economic slowdown in the US, this relaxation of regulations catches attention.

The Dodd-Frank Act, implemented under the Obama presidency in July 2010, aimed to set risk-weighted capital requirements for all US banks, irrespective of the size of their balance sheets. However, it created the ability for regulators to impose Enhanced Prudential Standards (EPS) on financial institutions likely to represent a systemic risk[1]. The regulators have therefore adopted a differentiated application, varying according to the size of the institution, of certain prudential rules (risk measurement using internal models, the Basel leverage and liquidity ratios, and so on).

The Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA), passed into law by President Trump in May 2018, watered down two aspects of the 2010 law. First, it gave regulators responsibility for setting a new leverage requirement, within a range from 8% to 10%, in order to allow the smallest depository institutions (those with consolidated assets of less than USD 10 bn, or 97% of the banking sector by number of institutions and 16% in terms of assets at June 2019), with low leverage, to be completely free of the Basel 3 requirements (section 201 of EGRRCPA). On 17 September 2019, the regulators set this requirement at 9%[2].

Secondly, the law in 2018 raised the threshold for designating banks as systemically important, and therefore subject to enhanced prudential requirements – from USD 50 bn of assets to USD 250 bn for US Bank Holding Companies (BHCs) and, breaking with the principle of equality of treatment, from USD 50 bn to USD 100 bn for foreign banks’ Intermediate Holding Companies (IHCs)[3] (section 401 of EGRRCPA) – whilst also giving the Federal Reserve (Fed) considerable latitude to adjust these thresholds.

On 10 October 2019, this opportunity was used to the full. In accordance with the proposals set out in October 2018 and April 2019, the three US banking regulators (the Fed, FDIC and OCC) have introduced a more gradualist approach to the application of enhanced requirements[4]. The new framework is no longer based solely on the size of institutions but also takes account of other criteria for the assessment of their risk profile (cross-juridictional activities, weighted short-term wholesale funding, nonbank assets and off-balance sheet exposure)[5].

Regarding the details of the calculation of these risk criteria, the regulators have however moved from the proposal set out in April, which was particularly unfavourable for US subsidiaries of foreign banks (IHCs). Liquidity constraints for IHCs will depend on the risk profile of the IHC rather than, as initially proposed, on the risk profile of the foreign banking organization’s combined US operations (US subsidiaries’ and US branches and agencies’ operations). By harmonising the risk calculation methods and the thresholds for application of liquidity requirements between foreign and US banks, the regulators returned, in part, to the principle of equality of treatment contained in the Dodd-Frank Act, something that the May 2018 law had broken with.

Whilst the new rules do not change the capital and liquidity requirements for the eight biggest US banking groups (although they do reduce the frequency of required updates to resolution plans[6]), they do reduce the burden for large regional banks.

Requirements adjusted as a function of banks’ risk profiles

Banks with total assets of USD 100 bn or more will now be split into four categories according to their risk profile. The more a bank is likely to create systemic risk, the greater the requirements imposed upon it (Tables 1 and 2):

- Category IV: banks with assets of between USD 100 bn and USD 250 bn. These banks remain subject to risk-weighted capital requirements (standardized approach) and a simple leverage standard[7]. They will be required to take part in the Fed’s stress tests every two years. Banks in Category IV with USD 50 bn or more in weighted short-term wholesale funding will be subject to a looser version of the short-term LCR (see box) and the long-term net stable funding ratio (NSFR, once this has been included in the regulatory corpus); other banks in this category will be exempt from these constraints.

- Category III: banks with total assets of between USD 250 bn and USD 700 bn or at least USD 75 bn in nonbank assets, weighted short-term wholesale funding or off-balance sheet exposure. These banks will also be subject to the countercyclical capital buffer[8] (currently set at 0%) and to the Basel supplementary leverage ratio (SLR)[9]. However, they will not be required to apply the Basel 3 advanced approaches capital requirements. Also, they will not be subject to the mandatory recognition of accumulated other comprehensive income (AOCI) in their regulatory capital. They will also benefit from the ‘simplifications’ to the capital rule finalised on 9 July 2019[10] which reduces the deductions applied to common equity[11]. They will be required to take part in the Fed’s stress tests every year; however, the results of internal stress tests will only be published every two years. Banks in Category III with USD75 bn or more in weighted short-term wholesale funding will be subject to the LCR and NSFR requirements; other banks will be subject to a looser version of these requirements (see Box).

- Category II: over and above USD 700 bn of total assets or USD 75 bn of cross-juridictional assets, liquidity requirements will be applied in full (irrespective of the scale of weighted short-term wholesale funding).

- Category I: the specific framework for Global Systemically Important Banks (G-SIBs) remains unchanged. In addition to the constraints placed on Category II banks, they will be subject to enhanced capital requirements (the G-SIB surcharge and the Basel SLR leverage standard raised to 5%).

The impact of the new thresholds

Overall, the relaxations and waivers announced could increase banks’ net interest income (substitution of more profitable assets for high-quality liquid assets, which generate low returns, see below) and reduce their operating costs (notably for those with a waiver from developing internal models to calculate their risk-weighted assets and/or with a waiver from Basel liquidity requirements).

According to the Federal Reserve, the final rule will reduce the capital requirements of BHCs and IHCs in Category III and IV[12] by only USD 8 bn and USD 3.5 bn respectively (the equivalent of 60 basis points of their risk-weighted assets).

Greater savings in capital could, however, be obtained following the forthcoming finalisation of the rule introducing the Stress Capital Buffer (SCB). This rule, proposed by the Federal Reserve in April 2018[13], aims to simplify the regulatory framework by reducing the number of capital requirements that need to be satisfied[14]. The Fed suggests that this can be achieved by the creation of this Stress Capital Buffer, the size of which, for each bank, will be fixed each year following CCAR stress tests[15]. Although the Fed’s initial proposal promised a reduction in capital requirements for banks not identified as G-SIBs, the announcement at the beginning of September[16] of revisions to the definition of the SCB opens the way for a possible reduction for G-SIBs as well.

The raising of thresholds, in contrast, could significantly reduce the scope of application of the Basel LCR requirement.

At present 37 resident US banks (25 BHCs and 12 IHCs), representing 80% of total banking assets, are subject to the LCR requirements. In the absence of detailed information on the main criterion (scale of weighted short-term wholesale funding) it is hard to indicate with any accuracy which LCR rule will now apply to certain banks (Table 3).

In all, between 19 and 36 banks will continue to be subject to the Basel liquidity requirement or one of its relaxed versions (see box): between 10 and 14 by the full LCR requirement (from 18 at present), and between 5 and 26 by one of the two relaxed versions of LCR (from 19 at present). Between 1 and 13 banks would be exempt.

Category I and II banks (the 8 G-SIBs and Northern Trust) and one US subsidiary of a British bank (Barclays US) will continue to apply the full LCR requirement. Amongst the Category III banks, 3 IHCs (TD Group US, HSBC NA and Deutsche Bank USA) will benefit from a relaxation of the rules; 4 BHCs (US Bancorp, PNC Financial, Capital One and Charles Schwab) could do likewise. However, LCR requirements for two subsidiaries of major Swiss banks (UBS Americas and Credit Suisse Holdings) will be tightened. Of the banks with total assets of less than USD 250 bn (12 BHCs and 6 IHCs) only those with less than USD 50 bn in weighted short-term wholesale funding will enjoy a waiver; the others will see their LCR requirement tightened slightly (calibrated at 70% of the full requirement but with an add-on taken into account, see box). The US subsidiary of a Spanish bank (BBVA Compass) will no longer be subject to LCR.

The Fed has estimated, on the basis of LCRs for Q1 2019, that the introduction of new thresholds will reduce the required volume of high-quality liquid assets (HQLA) by USD 48 bn for the BHCs and by USD 5 bn for the IHCs (the reduction coming particularly at Category III banks). In order to flesh out these aggregate figures, we have estimated the probable HQLA saving for each bank (Table 4). Our estimates have a fairly large range due to uncertainty over the level of requirements for some banks. Thus, in the extreme case that the 4 Category III BHCs have their requirements reduced and the 12 Category IV BHCs receive a waiver from LCR, the required volume of HQLA would be reduced by USD 201 bn; under the opposing extreme case, where only one BHC (American Express) enjoys a relaxation, the HQLA saving would be just USD 7 bn. Similarly, in the extreme case that the LCR requirement is relaxed for all IHCs (other than Barclays US, UBS Americas and Credit Suisse Holdings, whose requirements will be unchanged or increased), the required volume of HQLA would be reduced by USD 86 bn. Under the opposing extreme case, where only 4 IHCs benefit from a relaxation (TD Group US, HSBC NA, Deutsche Bank USA, and BBVA Compass), we estimate that the HQLA saving would be USD 25 bn.

[1] These banks are not necessarily considered as G-SIBs (global systemically important banks) or D-SIBs (domestic systemically important banks).

[2] Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Capital simplification for Qualifying Community Banking Organizations, September 2019. The agencies estimate approximately 85% of community banks will qualify for the community bank leverage ratio.

[3] Since July 2016, foreign banks active in the USA have been required to bring together all US subsidiaries within a single holding company when total consolidated assets of all subsidiaries exceed USD 50 bn.

[4] The final rules Changes to applicability thresholds for regulatory capital and liquidity requirements and Prudential Standards for Large Bank Holding Companies, Savings and Loan Holding Companies, and Foreign Banking Organizations of 10 October 2019 will come into force 60 days after their publication in the Federal Register.

[5] The final classification of banks will depend on the average of these criteria over four quarters.

[6] Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Resolution plans required, October 2019.

[7] This standard compares Tier 1 capital to average balance sheet assets (with a minimum of 4%).

[8] This capital requirement can be applied at the regulators’ discretion if they believe that credit growth is excessive and threatens a build-up of risk across the financial system.

[9] The Basel leverage ratio compares Tier 1 capital to the leverage exposure, which includes balance sheet assets and off balance sheet items. The denominator of the ratio is calculated on the basis of gross values of exposures to derivatives and securities financing transactions (netting of certain lines is allowed only under restricted conditions).

[10] Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Simplifications to the Capital Rule, July 2019.

[11] The inclusion of certain balance sheet items in banks’ Common Equity Tier 1 (CET1) is capped (significant investments in the common shares of unconsolidated financial institutions, mortgage servicing rights, deferred tax assets). Amounts above this cap must be deducted from CET1. The 9 July rule raised the ceiling: each of these elements can be included in CET1 provided that they do not represent more than 25% (from 10% previously) of CET1.

[12] Among BHC in Category IV, the expected capital savings are likely to concern primarily American Express. To date this bank has been included in the list of banks designated as “of international scope” (banks using the advanced risk measurement approaches) and thus subject to enhanced prudential requirements.

[13] Board of Governors of the Federal Reserve System, Amendments to the Regulatory Capital, Capital Plan, and Stress Test Rules, April 2018.

[14] From 18 to 8 for the biggest banks subject to the advanced approaches for risk measurement (from 24 to 14 if one takes account of Total Loss Absorbing Capital and Long-Term Debt requirements) and from 14 to 4 for banks subject solely to the standardized approach (from 20 to 10).

[15]This buffer will replace the capital conservation buffer (CCB) and will complement the requirements set independently of stress tests. The introduction of the SCB will merge ‘non-stressed’ requirements (for instance the minimum CET1 requirement of 4.5% of risk-weighted assets + the CCB of 2.5% + the countercyclical capital buffer and the possible G-SIB surcharge) and ‘stressed’ requirements (minimum CET1 requirement of 4.5% + estimated losses in the stress scenario + 9 months of dividend distributions) into a new requirement (minimum CET1 requirement of 4.5% + SCB + countercyclical capital buffer and possible G-SIB surcharge). The Fed initially proposed that the SCB would be defined as estimated losses in the severely adverse stress test scenario plus the equivalent of 4 quarters of dividend distributions (with a floor of 2.5%). On 5 September, Randal Quarles, Fed Vice Chairman for Supervision, indicated that removal of the requirement that 4 quarters of dividend distribution be pre-funded was under consideration. In return for this relaxation, he suggests setting a higher floor level for the SCB, or increasing the countercyclical capital buffer.

[16] Randal Quarles, Refining the Stress Capital Buffer, Speech, September 2019

The different versions of the LCR in the USA

This Basel standard requires banks to hold sufficient unencumbered high-quality liquid assets (HQLA, the numerator of the LCR) to cover the net cash outflows over 30 days in the event of a liquidity crisis (denominator of the LCR). In the USA, this requirement was finalised in September 2014 and phased in between January 2015 and January 2017.

The assets considered as the most liquid (those that can be converted into cash on private markets with very little or no loss of value) include reserves with the central bank and claims on, or guaranteed by, public issuers such as Treasury securities or agency securities. For the denominator of the LCR, the valuation of cumulative net outflows over 30 days is based on a cash flow scenario defined by the regulator. Net cash outflows correspond to the difference between cumulative inflows and outflows over 30 days increased by an add-on. This last item is calculated as the difference (if greater than zero) between the highest daily value of net cash outflows under the stress exercise and the value of cumulative net outflows on the thirtieth day of the stress period. The introduction of the peak-day maturity mismatch add-on (over and above the Basel recommendations) aims to prevent any potential maturity mismatch between cash inflows and outflows (for example the risk of substantial outflows at the beginning of the exercise, with inflows coming later).

Banking regulators adopted a differentiated application of the LCR requirement as early as September 2014ⁱ. Currently only 18 banks are subject to the full LCR requirement: the 14 US Bank Holding Companies (BHC) using the advanced approaches for risk measurementⁱⁱ, and 4 US Intermediate Holding Companies (IHC) of foreign banksⁱⁱⁱ (Table 3). For these banks, the LCR must be calculated on a daily basis; it must be met both on a consolidated basis and by each of their depository subsidiaries with consolidated assets of more than USD 10 bn^iv. 19 other banks (with more than USD100 bn in assets^v) are subject to a looser version of the LCR requirement (modified LCR): 11 BHCs and 8 IHCs. The ratio is calculated on the last business day of each month. Under this modified version of LCR, the list of HQLA and stress assumptions are identical. However, the denominator does not include the peak-day maturity mismatch add-on and is multiplied by 0.7, which reduces the net cash outflows to be covered and so the required volume of liquid assets.

The regulations of October 2019 replaced modified LCR with two new relaxed versions of the requirement (reduced LCR): one multiplied the denominator of the ratio by 0.85 (for Category III); the other by 0.7 (for Category IV). Category III banks must calculate their ratios daily, Category IV banks on the last business day of each month. However, all banks, irrespective of category, must include the maturity mismatch add-on in their denominatorvi. For Categories I, II and III, the requirement must be met on both a consolidated basis and by each of their depository subsidiaries with assets of more than USD 10 bn.

ⁱ In the European Union regulators have applied them to all credit institutions.

ⁱⁱ Banks with consolidated assets of more than USD 250 bn, with international exposure that exceeds USD 10 bn or which have requested this approach.

ⁱⁱⁱ These 4 IHCs are subject to certain constraints imposed on banks applying the advance approaches for risk measurement. They do not apply internal models for the calculation of risk-weighted assets, but they are subject to the tighter leverage requirement and to LCR in particular.

^iv The banking group’s total HQLA excludes the amount of HQLA in excess of each subsidiary’s standalone LCR requirement that is transferable to non-bank affiliates within the group.

^v The final rule of September 2014 introducing LCR requirements in the USA (in their complete or modified version) would have affected all banks with more than USD 50 bn in assets. The EGRRCPA of May 2018 then gave a waiver from modified LCR to BHCs with assets of less than USD 100 bn. By contrast, IHCs with less than USD 100 bn in assets (such as BBVA Compass Bancshares) but which were subsidiaries of foreign groups with consolidated assets of more than USD 100 bn did not benefit from this waiver.

^vi The calculation method for the add-on at banks subject to the monthly (rather than daily) LCR requirement is not provided.