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Recent U.S. Banking Developments

Moderation in all things: the Federal Reserve introduces single counterparty credit limits. The Board of Governors of the Federal Reserve System has proposed a rule that would establish limits on the amount of credit that a large U.S. bank holding company (BHC) or foreign banking organization (FBO) with operations in the United States may extend to a single unaffiliated counterparty. The proposed rule would implement Section 165 of the Dodd-Frank Act, which directs the Federal Reserve to impose such limits on banking organizations with USD 50 billion or more of total consolidated assets and authorizes the Federal Reserve to adopt more stringent limits for those organizations that pose a heightened risk to the financial stability of the United States.

In general, any covered company would be subject to a basic limit on its credit exposure to any single counterparty equal to 25% of such covered company's capital stock and surplus. Larger and more interconnected covered companies would be subject to a more stringent limit, equal to 25% of Tier 1 capital, based on the concern that the financial distress or failure of such institutions would have substantially greater systemic effects.

Global systemically important banking organizations (G-SIBs) would be subjected to a yet more stringent limit on their credit exposure to other G-SIBs. Based on evidence that these organizations are often engaged in common business lines with common counterparties and rely significantly on common funding sources – thus increasing the correlation of their risks – a G-SIB's credit exposure to another G-SIB would be limited to 15% of Tier 1 capital.

The single counterparty credit limits for FBOs, including separate credit limits for any intermediate holding company (IHC) that an FBO may organize to hold its non-branch and non-agency U.S. operations, are similar to the limits for BHCs but combine U.S. and non-U.S. factors. Thus, the single counterparty credit limits for FBOs apply only to the credit exposures of their combined U.S. operations (ie bank and non-bank subsidiaries), but are calculated with reference to their global assets.

Capital rules modified to measure credit exposure

The measurement of a covered company's gross and net credit exposures would be based largely on the Federal Reserve's standardized risk-weighted capital rules. The proposed rule takes into account any available credit risk mitigants recognized under the capital rules, including eligible collateral, eligible guarantees, credit or equity derivatives, other hedges, and bilateral netting agreements. It also applies the same risk-shifting approach, whereby a credit exposure to one counterparty and its corresponding risk weight may be replaced in whole or in part by a credit exposure to another counterparty at its risk weight. Covered companies with USD 250 billion or more in total consolidated assets or USD 10 billion or more in on-balance-sheet foreign exposures would apply special rules with respect to their credit exposures to investment funds, securitizations, and other special purpose vehicles. First, unless such covered company could demonstrate that its credit exposure to the issuer of each underlying asset of the fund or vehicle constituted less than 0.25% of the company's Tier 1 capital, the company would be required to "look through" the fund or vehicle and recognize its exposure to each underlying issuer. Second, such covered company would be required to identify all third parties, such as originators, fund managers, and providers of credit support or liquidity, whose failure or distress would be likely to result in a loss in the value of its investment.

Covered companies with less than USD 250 billion in total consolidated assets and less than USD 10 billion in on-balance-sheet foreign exposures would be required to demonstrate compliance with the applicable credit exposure limits on a quarterly basis, but also to have the ability to calculate compliance on a daily basis. Larger covered companies would be required to demonstrate compliance as at the close of business on each business day.

Credit exposure limits: a new paradigm?

The proposed rule is generally consistent with similar non-U.S. standards. The European Union, in its Capital Requirements Regulation, has set a limit on credit exposure by an institution to a client or group of connected clients equal to 25% of an institution's eligible capital and authorizes Member States to set lower limits of not less than 10% of eligible capital. The higher limit is the same as the general limit on credit exposure in the Dodd-Frank Act and the Federal Reserve's proposal. The Basel Committee on Banking Supervision, in its Supervisory Framework for Measuring and Controlling Large Exposures, has set a credit exposure limit for all internationally active banks equal to 25% of Tier 1 capital and a limit for the credit exposure of one G-SIB to another G-SIB equal to 15% of Tier 1 capital. The proposed rule's more stringent credit exposure limits for larger and more interconnected covered companies correspond to these limits.

The relationship of the proposed rule to prior U.S. law setting credit exposure limits is ambiguous. Under the National Bank Act and regulations of the Office of the Comptroller of the Currency, national banks are subject to limits on the total "loans and extensions of credit" they may have outstanding to any person, including loans to a common enterprise or a corporate group. The statute was amended by the Dodd-Frank Act to include any "credit exposure" arising from a derivative transaction, repurchase agreement, reverse repurchase agreement, or securities lending or borrowing transaction, but the limits on "loans and extensions of credit" remain, resulting in lending limits that are based on a combination of traditional, on balance-sheet fully weighted assets and more abstract on- and off-balance-sheet risk-weighted "credit exposures."1 Similarly, Section 22(h) of the Federal Reserve Act (FRA), which restricts the ability of banks and savings associations to extend credit to insiders, and Section 23A of the FRA, which restricts the ability of banks and savings associations to engage in "covered transactions" with affiliates, were amended by the Dodd-Frank Act to include credit exposures, but they retain traditional restrictions on fully weighted assets.2 The proposed single counterparty credit limits, and the Basel III capital rules on which they are based, represent a more sophisticated treatment of credit risk and may portend further statutory or regulatory changes in the design or implementation of the older lending limits.

Footnotes

1.Pub. L. No 111-203, § 610(a) (July 21, 2010), amending 12 U.S.C. § 84(b)(1).
2.
Pub. L. No 111-203, § 608(a)(1)-(3), amending 12 U.S.C. § 371c(b), (c), and (d)(4); Pub. L. No 111-203, § 614, amending 12 U.S.C. § 375b(9)(D)(i).

Legal and Regulatory Risk Note
United States