Federal Reserve on Proposed Single Counterparty Credit Limits
Federal Reserve Board of Governors
Proposed Rules on Single Counterparty Credit Limits
Friday, March 4, 2016
Key Topics & Takeaways
- Unanimous Approval: The Federal Reserve Board (Fed) unanimously agreed to release for public comment the proposed rules imposing single counterparty credit limits on large U.S. bank holding companies and foreign banking organizations.
- Three Key Elements: Governor Tarullo highlighted that the proposal would: 1) only apply to financial firms covered by Section 165 of the Dodd-Frank Act (that is, to bank holding companies above the $50 billion threshold); 2) impose increasingly tighter limits in line with the systemic importance of a bank; and 3) impose an additional limit of 15% on Tier 1 capital (rather than total regulatory capital) on the eight domestic G-SIBs and foreign banks with more than $500 billion in assets in their U.S. holding companies.
- Market Liquidity: Yellen noted market participants’ concern about a “possible deterioration in market liquidity,” and asked whether reducing these credit limits would further exacerbate market liquidity. Campbell assured her that the proposal does not limit a bank’s ability to “face an entire market” and thus should not have a “first-order effect on market liquidity” since it only would limit exposure to a single entity. Still, Campbell acknowledged that the proposal could bind a counterparty which could affect a bank’s ability to provide liquidity to that specific entity.
Speakers
- Janet Yellen, Chair
- Daniel Tarullo, Governor
- Lael Brainard, Governor
- Michael Gibson, Director, Division of Banking Supervision and Regulation
- Jordan Bleicher, Supervisory Financial Analyst
- Sean Campbell, Deputy Associate Director, Division of Research and Statistics
Opening Remarks
In her remarks, Yellen claimed that the single counterparty credit limit “sets a bright line” on credit exposures between one large bank holding company and another large bank (or a major counterparty). She explained that the exposure limit for global systemically important banks (G-SIBs) will be set at 15% of Tier 1 capital, a more stringent requirement than for smaller banks. Yellen added that the Fed is “determined to do as much as [it] can to reduce or eliminate the threat that trouble at one big bank will bring down other big banks.”
In his remarks, Tarullo argued that the proposal is a “fundamental and long standing element of prudential regulation” necessary to limit the “combined exposures to a single counterparty within all parts of large bank holding companies.” Tarullo highlighted that the proposal would: 1) only apply to financial firms covered by Section 165 of the Dodd-Frank Act (that is, to bank holding companies above the $50 billion threshold); 2) impose increasingly tighter limits in line with the systemic importance of a bank; and 3) impose an additional limit of 15% on Tier 1 capital (rather than total regulatory capital) on the eight domestic G-SIBs and foreign banks with more than $500 billion in assets in their U.S. holding companies.
Tarullo explained that the staff examined potential effects of the rule through a quantitative impact study (QIS), which he claimed estimated that almost $150 billion in exposures stems from exposures among G-SIBs. While he recognized that regulatory reforms and firms’ improved risk management have reduced these exposures, he suggested that large counterparty exposures should still be considered for the Fed’s annual stress tests and supervisory assessments.
Staff Proposal
Michael Gibson, Director, Division of Banking Supervision and Regulation
Gibson stated that the current proposal is “more risk sensitive and effective” than the 2011 proposal. In addition, he explained that the Fed aligned its re-proposal with the Basel Committee’s large exposure framework, to maintain a level playing field.
Jordan Bleicher, Supervisory Financial Analyst
Bleicher explained that the proposal is designed to make the financial system more resilient by eliminating risk that a failure of one large financial institution would result in failure of another. He added that the staff made some modifications to increase the risk sensitivity and effectiveness of the framework. He noted that there is a tighter exposure limit applied to U.S. G-SIBs on their exposures to other systemically important financial firms. Specifically, bank holding companies with more than $250 billion in assets would be subject to more stringent limits based on Tier 1 capital (instead of total regulatory capital), to reduce the likelihood that failure of one large financial institution will result in failure of other large banking companies.
Bleicher also explained that, based on the QIS results, the two main drivers of credit exposure stemmed from derivatives transactions, in general, and credit derivative hedges, in particular. As such, the proposed rule would seek comment on the appropriate measurement methodology of credit exposures, such as the standardized approach for measuring counterparty credit risk (SA-CCR).
Bleicher maintained that the derivatives measurement component of rule is designed to the risk that the near failure of a firm could threaten to destabilize the system as a whole. For instance, firms using credit derivatives would be required to recognize credit exposure equal to the whole notional amount (for financial firms exposures), or less than the full notional amount of derivatives exposures for non-financial firms. He added that securities financing transactions (SFTs) comprise much of banks’ credit exposures, so the proposed framework aims to make SFTs more “risk sensitive” by requiring firms to model exposures based on a five-day liquidation period (as opposed to a 10 day liquidation period in the earlier proposal). Bleicher closed by stating that the proposal provides an exemption for exposures to the U.S. government debt, which he explained is consistent with the standardized risk-based capital rules.
Sean Campbell, Deputy Associate Director, Division of Research and Statistics
Campbell explained that the proposed rule enhances risk sensitivity by imposing more stringent credit limits on exposures to systemically important financial institutions (SIFIs) than non-SIFIs.
Question and Answer
In response to Yellen’s question about the proposal’s treatment of derivatives, Bleicher explained that the proposal has two components for addressing exposure to derivatives. First, firms are permitted to use the CEM that is currently used under the risk-based capital rules. However, since CEM is “not a particularly risk sensitive tool” but a “fairly blunt tool,” he encouraged the Board to consider incorporating the Basel Committee’s revised SA-CCR that is designed to be more risk sensitive. Second, the proposal would require firms using credit derivatives to recognize the exposure equal to the full notional amount of the hedge.
Yellen noted market participants’ concern about a “possible deterioration in market liquidity,” and asked whether these reducing these limits would further exacerbate market liquidity. Campbell assured her that the proposal does not limit a bank’s ability to “face an entire market” and thus should not have a “first-order effect on market liquidity” since it only would limit exposure to a single entity. Still, Campbell acknowledged that the proposal could bind a counterparty which could affect a bank’s ability to provide liquidity to that specific entity.
Interconnections
Tarullo noted that interconnections among the largest banks have been reduced “by about half” since 2008, and asked whether the pattern of exposures has changed since the crisis, or whether the interconnections have remained proportionate to the total amount. Campbell explained that there has been a larger decline in exposures in some transaction types, such as in the derivatives market since the adoption of central clearing.
Brainard expressed her support for imposing substantially tighter limits on credit exposures on the largest and most interconnected banks because of the high degree of correlation in their exposures.
The Board unanimously agreed to release for public comment the proposed rules imposing single counterparty credit limits for large U.S. bank holding companies and foreign banking organizations.
Additional information about this event can be accessed here.
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Federal Reserve Board of Governors
Proposed Rules on Single Counterparty Credit Limits
Friday, March 4, 2016
Key Topics & Takeaways
- Unanimous Approval: The Federal Reserve Board (Fed) unanimously agreed to release for public comment the proposed rules imposing single counterparty credit limits on large U.S. bank holding companies and foreign banking organizations.
- Three Key Elements: Governor Tarullo highlighted that the proposal would: 1) only apply to financial firms covered by Section 165 of the Dodd-Frank Act (that is, to bank holding companies above the $50 billion threshold); 2) impose increasingly tighter limits in line with the systemic importance of a bank; and 3) impose an additional limit of 15% on Tier 1 capital (rather than total regulatory capital) on the eight domestic G-SIBs and foreign banks with more than $500 billion in assets in their U.S. holding companies.
- Market Liquidity: Yellen noted market participants’ concern about a “possible deterioration in market liquidity,” and asked whether reducing these credit limits would further exacerbate market liquidity. Campbell assured her that the proposal does not limit a bank’s ability to “face an entire market” and thus should not have a “first-order effect on market liquidity” since it only would limit exposure to a single entity. Still, Campbell acknowledged that the proposal could bind a counterparty which could affect a bank’s ability to provide liquidity to that specific entity.
Speakers
- Janet Yellen, Chair
- Daniel Tarullo, Governor
- Lael Brainard, Governor
- Michael Gibson, Director, Division of Banking Supervision and Regulation
- Jordan Bleicher, Supervisory Financial Analyst
- Sean Campbell, Deputy Associate Director, Division of Research and Statistics
Opening Remarks
In her remarks, Yellen claimed that the single counterparty credit limit “sets a bright line” on credit exposures between one large bank holding company and another large bank (or a major counterparty). She explained that the exposure limit for global systemically important banks (G-SIBs) will be set at 15% of Tier 1 capital, a more stringent requirement than for smaller banks. Yellen added that the Fed is “determined to do as much as [it] can to reduce or eliminate the threat that trouble at one big bank will bring down other big banks.”
In his remarks, Tarullo argued that the proposal is a “fundamental and long standing element of prudential regulation” necessary to limit the “combined exposures to a single counterparty within all parts of large bank holding companies.” Tarullo highlighted that the proposal would: 1) only apply to financial firms covered by Section 165 of the Dodd-Frank Act (that is, to bank holding companies above the $50 billion threshold); 2) impose increasingly tighter limits in line with the systemic importance of a bank; and 3) impose an additional limit of 15% on Tier 1 capital (rather than total regulatory capital) on the eight domestic G-SIBs and foreign banks with more than $500 billion in assets in their U.S. holding companies.
Tarullo explained that the staff examined potential effects of the rule through a quantitative impact study (QIS), which he claimed estimated that almost $150 billion in exposures stems from exposures among G-SIBs. While he recognized that regulatory reforms and firms’ improved risk management have reduced these exposures, he suggested that large counterparty exposures should still be considered for the Fed’s annual stress tests and supervisory assessments.
Staff Proposal
Michael Gibson, Director, Division of Banking Supervision and Regulation
Gibson stated that the current proposal is “more risk sensitive and effective” than the 2011 proposal. In addition, he explained that the Fed aligned its re-proposal with the Basel Committee’s large exposure framework, to maintain a level playing field.
Jordan Bleicher, Supervisory Financial Analyst
Bleicher explained that the proposal is designed to make the financial system more resilient by eliminating risk that a failure of one large financial institution would result in failure of another. He added that the staff made some modifications to increase the risk sensitivity and effectiveness of the framework. He noted that there is a tighter exposure limit applied to U.S. G-SIBs on their exposures to other systemically important financial firms. Specifically, bank holding companies with more than $250 billion in assets would be subject to more stringent limits based on Tier 1 capital (instead of total regulatory capital), to reduce the likelihood that failure of one large financial institution will result in failure of other large banking companies.
Bleicher also explained that, based on the QIS results, the two main drivers of credit exposure stemmed from derivatives transactions, in general, and credit derivative hedges, in particular. As such, the proposed rule would seek comment on the appropriate measurement methodology of credit exposures, such as the standardized approach for measuring counterparty credit risk (SA-CCR).
Bleicher maintained that the derivatives measurement component of rule is designed to the risk that the near failure of a firm could threaten to destabilize the system as a whole. For instance, firms using credit derivatives would be required to recognize credit exposure equal to the whole notional amount (for financial firms exposures), or less than the full notional amount of derivatives exposures for non-financial firms. He added that securities financing transactions (SFTs) comprise much of banks’ credit exposures, so the proposed framework aims to make SFTs more “risk sensitive” by requiring firms to model exposures based on a five-day liquidation period (as opposed to a 10 day liquidation period in the earlier proposal). Bleicher closed by stating that the proposal provides an exemption for exposures to the U.S. government debt, which he explained is consistent with the standardized risk-based capital rules.
Sean Campbell, Deputy Associate Director, Division of Research and Statistics
Campbell explained that the proposed rule enhances risk sensitivity by imposing more stringent credit limits on exposures to systemically important financial institutions (SIFIs) than non-SIFIs.
Question and Answer
In response to Yellen’s question about the proposal’s treatment of derivatives, Bleicher explained that the proposal has two components for addressing exposure to derivatives. First, firms are permitted to use the CEM that is currently used under the risk-based capital rules. However, since CEM is “not a particularly risk sensitive tool” but a “fairly blunt tool,” he encouraged the Board to consider incorporating the Basel Committee’s revised SA-CCR that is designed to be more risk sensitive. Second, the proposal would require firms using credit derivatives to recognize the exposure equal to the full notional amount of the hedge.
Yellen noted market participants’ concern about a “possible deterioration in market liquidity,” and asked whether these reducing these limits would further exacerbate market liquidity. Campbell assured her that the proposal does not limit a bank’s ability to “face an entire market” and thus should not have a “first-order effect on market liquidity” since it only would limit exposure to a single entity. Still, Campbell acknowledged that the proposal could bind a counterparty which could affect a bank’s ability to provide liquidity to that specific entity.
Interconnections
Tarullo noted that interconnections among the largest banks have been reduced “by about half” since 2008, and asked whether the pattern of exposures has changed since the crisis, or whether the interconnections have remained proportionate to the total amount. Campbell explained that there has been a larger decline in exposures in some transaction types, such as in the derivatives market since the adoption of central clearing.
Brainard expressed her support for imposing substantially tighter limits on credit exposures on the largest and most interconnected banks because of the high degree of correlation in their exposures.
The Board unanimously agreed to release for public comment the proposed rules imposing single counterparty credit limits for large U.S. bank holding companies and foreign banking organizations.
Additional information about this event can be accessed here.