Key Takeaways

• In early March, the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) issued proposed resolution planning guidance for firms captured by a new proposed methodology (Specified Foreign Banking Organizations ).
• The proposed guidance contains new, extraterritorial expectations that are designed to align with resolution planning guidance for the US G-SIBs. However, this ignores the growing divergence in size and risk profile of these two sets of institutions, much of it driven by the super equivalent regulatory requirements that the Foreign Banking Organizations (FBOs) are subject to. It also discounts the progress that the Specified FBOs have made in ensuring they are resolvable in the event of failure.
• The proposed guidance also fails to recognize that the U.S. resolution plan is a back-up plan to the global single-point-of-entry (SPOE) plan, the success of which is ultimately premised on cooperation with the FBO’s home country regulator.
• The Agencies should reconsider the proposed guidance as currently written. Specifically, they should:
  1. adopt a different scoping mechanism that more accurately captures the systemic risk posed by these institutions and
  2. tailor the expectations in the proposed guidance to reflect the divergent profile of these institutions relative to the US GSIBs.

Earlier this year, the Federal Reserve and the FDIC issued proposed guidance updating their resolution planning expectations Specified FBOs captured by a new scoping methodology.[1]  As the Agencies look to finalize the guidance, we have included a series of recommendations for them to consider. These recommendations reflect the fact that the Specified FBOs have, in response to substantial new regulatory requirements, significantly reduced their size and risk profile over the past decade, have put in place mature resolution and recovery processes satisfying requirements in the US and their home country, and have established a significant pool of “bail-inable” resources to mitigate against public losses that exceed home and host country requirements.

The Specified FBOs No Longer Present a Significant Systemic Risk to the US Financial System

The Specified FBOs have significantly shrunk in both size and risk profile over the past decade, largely due to changes in the regulatory regime that have subjected them to a dual regime of super equivalent home country and U.S. requirements. This decline has only accelerated in recent years, with much of it occurring in their capital markets business (a pattern demonstrated in SIFMA’s 2019 study[2] on the importance of FBOs to the US capital markets).[3] This decline is concerning for the health of the U.S. capital markets and the real economy. Seventy-five percent of all lending in the United States occurs through the capital markets, and FBOs have traditionally played an outsized role, particularly in the primary dealer and swap dealer markets.

In a recognition of the changing size and risk profile of the Specified FBOs, the banking Agencies placed their IHCs into “Category III” under the final rules tailoring Enhanced Prudential Standards (EPS) last year. By contrast, the U.S. Global Systemically Important Banks (GSIBs) were placed into the “Category I” group subject to the most stringent regulatory regime, an acknowledgment of the distinct profiles of the two different sets of institutions. Federal Reserve Vice Chair for Supervision Randy Quarles acknowledged this in remarks earlier this year[4], in which he stated that the Specified FBOs ought to be de-designated from the Large Institution Supervision Coordinating Committee (LISCC) portfolio and that supervisory expectations more generally should be tailored to match the regulatory tailoring categories.[5] However, the proposed guidance runs counter to both the tailoring exercise and Quarles’ remarks. Rather than tailoring expectations for the Specified FBOs to reflect their reduced size and risk profile, the proposed  guidance adds new extraterritorial expectations that are designed to align with those contained in the 2019 US GSIB Resolution Plan Guidance (see below) [6]. Given the acknowledged divergence in profiles between these two sets of institutions (see figures 1 and 2 below for further illustration of these differences), this seems to be an odd decision.

The Specified FBOs have also made significant progress enhancing their resolution and recovery capabilities and have sizeable “bail-inable” resources to mitigate against the need for public assistance. The jurisdictions in which the Specified FBOs are domiciled have strengthened both going- and gone-concern resources since the financial crisis. For example, they have raised additional Total Loss Absorbing Capacity (TLAC), supporting the credibility of home-country SPOE strategies, and they have provided cash-collateralized support for their US operations in the form of Internal TLAC long-term debt.  Together these changes have raised the TLAC of these firms well north of 25% of their assets and many multiples of such capacity in the last crisis.  These advances are augmented by improved local risk systems, including the creation of robust stress testing capabilities, simplified organizational structures and streamlined business mixes, and affiliate and third-party service arrangements that ensure the continuation of critical business operations under both stressed conditions and resolution.

In short, the likelihood of one of these institutions failing is much lower today than it was even a few years ago and the consequences to the U.S. of failure have been mitigated by the declining systemic risk of the Specified FBOs and the progress that has been made in resolution and recovery planning. The Agencies should therefore reconsider both the scoping mechanism and the substantive expectations included in the proposed guidance.

The Method 2 Scoping Mechanism Exaggerates the Systemic Riskiness of the FBOs

In the proposed guidance, the Agencies adopt the GSIB Method 2 framework as a scoping mechanism. The Method 2 framework was developed by the Federal Reserve as an alternative method to establish a capital surcharge for U.S. GSIBs, replacing the substitutability indicator included in the internationally agreed Method 1 framework with a measure of short-term wholesale funding (STWF). Of note, Method 2 has never been used as a scoping tool in any rulemaking or guidance (including the determination of whether a firm qualifies as a U.S. GSIB[7]), nor has it even been applied to other types of institutions outside of the U.S. GSIBs.

For a variety of reasons, when Method 2 is applied to the Specified FBOs, the STWF indicator overwhelms the other components, comprising an average of 92% of the total Method 2 score relative to approximately one-fifth of the Method 2 score for the U.S. GSIBs.[8]  As can be seen in Figure 3, the STWF factor is the sole reason that any of the IHCs of the Specified FBOs breach the 250 Method 2 scoping threshold. By contrast, the four other metrics used in the method 2 calculation show that the systemic risk for the IHCs of the Specified FBOs is quite low[9].

Thus, when applied to the Specified FBOs, the Method 2 framework falls well short of the “comprehensive, integrated assessment of a large bank holding company’s systemic footprint” described in the preamble of the proposed guidance, and is instead the product of a single factor – STWF.

Figure 3: Method 2 GSIB Score Components for US GSIBs and the Specified FBOs

The high STWF for the Specified FBOs also obscures the underlying risk involved; although the STWF score for the Specified FBOs is 2.3x greater on average than the U.S. GSIBs, their absolute STWF figure is 84% smaller. In fact, the primary reason for the high STWF scores is due to the declining risk of these institutions, as measured by risk-weighted assets (RWA). The STWF score is based on a ratio with RWA as the denominator, meaning that a declining RWA pushes the overall score higher. The result is that a single unit of STWF risk at one of the FBO’s IHCs is given 16.7x greater weight than the equivalent unit of STWF risk at one of the non-processing U.S. GSIBs. This methodological anomaly therefore ironically punishes the FBOs for their reduced size and risk profile.

Given these methodological flaws, neither Method 2 nor the STWF score as currently calculated should be used as a scoping mechanism: they grossly exaggerate the systemic risk posed by the Specified FBOs (this is backed up by other measures of liquidity risk, which show that the Specified FBOs have adopted a relatively conservative funding model[10]). A variety of other alternatives would more appropriately capture the systemic riskiness of the Specified FBOs. An obvious approach would be to adopt the tailoring categories, which are based on size and a series of risk-based indicators developed by the Federal Reserve. This approach would have the benefit of aligning the resolution planning guidance with other EPS regulatory requirements and avoid adding unnecessary complexity to the regulatory and supervisory regimes for FBOs. Given that the highest categorization levels for domestic BHCs and FBO IHCs were Categories 1 and 2 respectively, it would seem appropriate to use those categories as the scoping mechanism for application of the proposed guidance.

Although the most logical alternative, the Agencies could look to other metrics to fix the methodological flaws with the proposed scoping framework. This could include adopting the internationally agreed GSIB Method 1 framework or making changes to the Method 2 approach to mitigate against its flaws (e.g., capping the STWF component as a share of the total Method 2 score, or using absolute STWF values).

The Expectations in the Proposed Guidance Ought to be Tailored

As discussed, the Specified FBOs pose a vastly reduced systemic risk, a fact that should be reflected not only in the scoping mechanism adopted, but also in the substance of the proposed guidance. Instead of tailoring expectations from the 2018 FBO Guidance to reflect the reduced risk profile of these firms, the proposed guidance adds new extraterritorial expectations related to non-U.S. entities and activities in the areas of derivatives and trading and payments, clearing, and settlement. These new provisions would impose duplicative information and analytical burdens on the firms and are wholly unnecessary given that such information is already provided to the firms’ home country regulators as part of their parent firm’s SPOE plans. These provisions also appear to be outside the scope of the Agencies’ Dodd-Frank Title I authorities, which extend only to the resolution of U.S. material entities.

A better approach would be to recognize the U.S. resolution plan for FBOs is ultimately a back-up to the home country SPOE plan, not a replacement for it. The new extraterritorial provisions in the proposed guidance would create inefficiencies in global resolution planning, which could complicate the SPOE process. It would also create a precedent that may prompt other jurisdictions to impose similar requirements on U.S. headquartered firms, which would undermine resolvability globally.

The Agencies should instead engage in information sharing and cooperation with each firm’s home country supervisor to obtain data on non-U.S. entities and activities, rather than placing those expectations on the Specified FBOs. This outcome would clearly be in the interests of both home and host jurisdictions and would be more consistent with the approach to resolution laid out by Fed Vice Chairman Quarles in his “Brand Your Cattle” speech in 2018.[11]

However, the Fed and FDIC should go further and look for opportunities to tailor the 2018 FBO Guidance to reflect the reduced risk profile of the firms and the progress made in improving resolution capabilities. For example, the Agencies should remove standalone Resolution Liquidity Adequacy and Positioning (RLAP) and Resolution Capital Adequacy and Positioning (RCAP) expectations and instead integrate them into business-as-usual (BAU) capital and liquidity requirements. RLAP and RCAP are duplicative of other requirements such as internal liquidity stress testing and TLAC and have thus often added to the overall level of capital and liquidity firms are required to maintain. They may also have other unintended negative effects. As one recent study published by economists from the Federal Reserve Board and the University of Chicago noted, RLAP can become the binding constraint at the material entity level, limiting intra-firm movement of liquidity and potentially constraining firms’ ability to be liquidity providers during periods of market stress.[12]

As the resolution planning process continues to mature, the Agencies should consider other ways to streamline the scope of submissions to include only ongoing resolvability concerns. For example, resolution playbooks concerning Financial Market Utilities (FMUs) could be streamlined to include only the key information required to facilitate an orderly resolution. Individual firms should not be required to include information in their playbooks related to FMU membership rules or expected behavior; this information is consistent across financial institutions and available through the supervisory process. Discussion and documentation of the expected behavior of FMUs in a stress or resolution scenario should also be facilitated and managed directly with the FMUs through the supervisory process.

Similarly, the Agencies should also leverage to the maximum extent possible information provided through existing supervisory processes or financial regulatory reporting to reduce duplicative requirements. Not only would this help firms streamline their resolution plan submissions, but it would reduce the amount of time it would take the Agencies to review and (if necessary) challenge the plans.

Tailoring the Expectations in the Proposed Guidance: Key Recommendations

1. Remove the new extraterritorial derivatives and trading, and payments, clearing and settlements expectations in the proposed guidance. This information is already included in each firm’s SPOE home country plan and should be obtained through information exchange with the firms’ home country supervisors. These extraterritorial information request also exceed the scope of Regulation QQ (which implements the Dodd-Frank Title I authorities).
2. Remove standalone RLAP and RCAP expectations and integrate these capabilities into capital and liquidity requirements established through formal rulemakings (e.g., “BAU rules” such as LCR for liquidity).
3. Streamline playbooks to include only key information required to facilitate an orderly resolution (e.g., firms should not be required to include information regarding FMU membership rules or expectations). We also encourage further tailoring as the resolution planning process continues to mature, including limiting the scope of submissions to the agencies’ ongoing resolvability concerns.
4. Leverage information provided through existing US supervisory processes to reduce duplicative requirements/expectations.

Conclusion

The Specified FBOs have evolved radically since the original Title I resolution planning rules were put in place, and indeed have changed significantly in size and risk profile since the Federal Reserve and FDIC finalized their last set of heightened resolution guidelines for FBOs in 2017 (i.e. the 2018 FBO Guidance). Their resolution planning capabilities have also expanded and matured, and they have put in place bail-inable resources in the form of Internal TLAC. Put simply, the likelihood of these institutions failing is lower today than at any point in recent history, and the impact of any failure on the US financial system is low. Given these facts, it is no longer justifiable to apply the same set of heightened supervisory expectations to these firms as those that are applied to the U.S. GSIBs. Rather, the Agencies should look for ways to sensibly tailor their resolution planning expectations for the firms and cooperate with their home country supervisors to ensure that their parent SPOE plan is successful.

Peter Ryan is Managing Director and Head of International Capital Markets & Prudential Policy at SIFMA

[1] 85 Federal Reserve. Reg. 15449, “Notice of Proposed Rulemaking, Guidance for Resolution Plan Submissions of Certain Foreign-Based Covered Companies.” Available at: https://www.govinfo.gov/content/pkg/FR-2020-03-18/pdf/2020-05513.pdf. The Specified FBOs are Barclays, PLC; Credit Suisse AG; and Deutsche Bank AG.

[2] SIFMA. “SIFMA Insights: The Importance of FBOs to US Capital Markets,” April 2019. Available at: https://www.sifma.org/wp-content/uploads/2019/04/SIFMA-Insights-The-Importance-of-FBOs-to-US-Capital-Markets.pdf.

[3] The Specified FBOs reduced the aggregate size of their Intermediate Holding Companies (IHCs) by 38% (from $605 billion to $374 billion) between 2016 and 2019, and reduced their aggregate broker-dealer assets by 45% (from $475 billion to $262 billion). Meanwhile, broker-dealers affiliated with US bank holding companies (BHCs) have grown, albeit not by margins that compensate for the loss of market capacity previously provided by the FBOs.

[4] Vice Chair for Supervision Randal K. Quarles, “Spontaneity and Order: Transparency, Accountability, and Fairness in Bank Supervision,” January 17, 2020. Available at: https://www.federalreserve.gov/newsevents/speech/quarles20200117a.htm. Vice Chair Quarles commented that “Since 2010, [the Large Institution Supervision Coordinating Committee or LISCC FBOs] have significantly shrunk their U.S. footprint, and their U.S. operations are much less risky than they used to be. Since 2008, the size of the LISCC FBOs’ combined U.S. assets has shrunk by about 50 percent, and they have reduced the assets at their broker-dealers from a peak of $1.9 trillion in 2008 to $340 billion today, a reduction of over 80%. In addition, the estimated systemic impact of the LISCC FBOs today is much smaller than the U.S. GSIBs. The average method 1 GSIB score of the combined U.S. operations of the LISCC FBOs is less than a quarter of the average GSIB score of the six non-processing U.S. GSIBs.

[5] Note that UBS was de-designated from the LISCC portfolio in early March.

[6] Proposed Guidance, p. 8.

[7] The determination of whether a U.S. BHC qualifies as a GSIB is based solely on the internationally agreed method 1 framework as a scoping tool. See 12 CFR Section 217.402.

[8] All of the U.S. GSIBs first had to clear a threshold established by method 1 before method 2 was applied.  Method 2 STWF was then calibrated to produce a balanced score for this group, based on an average RWA for the US GSIBs that is far larger than the Specified FBOs.

[9] Under method 1, the surcharge score of a GSIB is calculated based on the following five categories of the Basel Committee’s assessment methodology:  size, interconnectedness, substitutability, complexity and cross-jurisdictional activity.  Method 2 is similar, except that it replaces substitutability with STWF.

[10] For example, the Liquidity Coverage Ratio (LCR), perhaps the most widely used liquidity metric, shows that the IHCs of the Specified FBOs have an LCR of 160 percent[10], well above the average of 121 percent for the non-processing US GSIBs. This indicates that the modest amounts of wholesale funding issued by these FBOs are well covered by high quality liquid assets and do not pose any special systemic threat.

[11] Vice Chair for Supervision Randal K. Quarles, “Trust Everyone—But Brand Your Cattle: Finding the Right Balance in Cross-Border Resolution” (May 16, 2018).

[12] Ricardo Correa, Wenxin Du, and Gordon Liao, “US Banks and Global Liquidity,” Board of Governors of the Federal Reserveeral Reserve System, International Finance Discussion Papers, Number 1289, July 2020, p. 41. Available at: https://www.Federal Reserveeralreserve.gov/econres/ifdp/files/ifdp1289.pdf.