Federal Reserve Board, OCC, and FDIC Propose New Rules and Guidance for Bank Resolutions
On August 29, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (FDIC) (the “agencies”) issued proposals and guidance aimed at strengthening the regulatory oversight of large and regional banking organizations and better managing bank resolution. Collectively, the notices of proposed rulemaking (NPRs) and proposed guidance would:
- Require certain large banking organizations with total assets of US$100 billion or more to maintain long-term debt (LTD) that could be used, after failure, to absorb losses and increase the agencies’ resolution options
- Establish “clean holding company” requirements that would restrict a holding company issuing LTD from certain actions that could impede an orderly resolution
- Amend and restate the FDIC’s current resolution planning rule for FDIC-insured depository institutions with total assets of US$50 billion or more, including eliminating the current moratorium for such institutions with total assets of US$50 billion to US$100 billion; requiring FDIC-insured depository institutions with total assets of US$100 billion or more to provide an identified strategy for resolution, for which the proposed default is the establishment of a bridge depository institution (BDI) rather than a purchase and assumption transaction; and significantly expand informational reporting and engagement expectations
- Establish guidance for the Dodd-Frank Act Title I resolution plans of banking organizations with total assets of US$250 billion or more that are not global systemically important banking organizations (GSIBs)
These proposals are the agencies’ attempt to put themselves in a better position to handle the failure of large banking organizations by requiring more financial resources and more resolution planning from the organizations. For subject institutions, the proposal would mean higher funding costs and potentially substantial investments in resolution planning capability.
The proposals aim to continue to update and implement a more structured supervisory program for large banking organizations, with an enhanced focus on resolution tools and planning. In October 2022, the agencies issued an advance NPR seeking comments on whether an extra layer of loss-absorbing capital could improve the options for resolving large banking organizations, the costs and benefits of the requirement, how the requirement might be structured, what other requirements might be appropriate, and the scope of the requirement.
The proposals are consistent with remarks made by FDIC Chair Martin Gruenberg this summer at the Brookings Institution outlining elements of the forthcoming proposal, which we discussed in our August 22 Advisory. The proposals also come in the wake of the federal banking agencies’ proposed implementation of the Basel III accords, referred to as the Basel III Endgame, which we discussed in our August 3 Advisory.
Long-Term Debt Proposal
Under the NPR, the federal banking agencies jointly propose to apply LTD requirements, which currently apply to U.S. GSIBs, to all Category II, III, and IV bank holding companies (BHCs), traditional savings and loan holding companies, and intermediate holding companies of foreign banking organizations that are not GSIBs, as well as to insured depository institutions (IDIs) that are not consolidated subsidiaries of U.S. GSIBS and that (1) have at least US$100 billion in consolidated assets or (2) are affiliated with IDIs that have at least US$100 billion in consolidated assets.1
The LTD requirements are meant to allow regulators to use LTD to resolve banks and holding companies in a way that reduces costs and the risk of disruption to the banking system. For example, the LTD requirements may give the FDIC more flexibility to use a BDI, potentially preserving the IDIs franchise value and providing additional time to pursue resolution options. Upon failure, the debt could be converted to equity or otherwise used to assist in recapitalizing the stricken entity. The agencies also believe that the LTD will reduce the chances of failure by improving the funding profile of the banking organizations.
The proposal would generally require large banking organizations that are not GSIBs to comply with an LTD requirement at each of the holding company and IDI levels. The proposal would also generally require that IDIs with US$100 billion or more in consolidated assets and any affiliated IDIs issue minimum amounts of LTD to their parents to ensure loss-absorbing resources are available at the IDI level if the covered entity fails. Covered IDIs without a parent covered by the rule could issue LTD externally to the market or, when applicable, internally to their noncovered entity parent.
Large banks would be required to maintain a minimum amount of eligible LTD equal to the greater of 6% of the risk-weighted assets, 3.5% of the average total consolidated assets, and for banks subject to the supplementary leverage ratio, 2.5% of the total leverage exposure under the supplementary leverage ratio. When calculating the LTD requirement, the amount of eligible LTD that is due to be paid between one and two years would be subject to a 50% haircut, and any eligible LTD that is due to be paid in less than one year would not count toward the LTD requirement. Under the proposal, a large bank with total assets of US$100 billion or more that is not one of the largest and most complex banks would not be subject to the Federal Reserve’s total loss-absorbing capacity (TLAC) requirements, including minimum capital and buffer requirements, which currently apply to only GSIBs.
The proposal would require that debt instruments issued to satisfy the minimum LTD requirement meet certain criteria designed to ensure that the LTD can readily absorb losses in resolution. The eligibility criteria in the proposal would require that the LTD be paid in and issued directly by a covered entity or covered IDI; have a remaining maturity of more than one year from the date of issuance; be unsecured; not contain exotic features, such as embedded derivatives; be governed by U.S. law; and have a minimum principal denomination of at least $400,000.2 The proposal would also apply a stringent capital deduction treatment to large banking organizations’ holdings of eligible LTD issued by other large banking organizations to discourage cross-holdings of LTD by other banking organizations.
Under the proposal, banking organizations would get credit for existing outstanding LTD that meets certain criteria and would have three years to comply with the new requirements. The requirements would be phased in over a three-year period. The phase-in component of the proposed rule would follow a 25-50-100 structure. Covered entities would be required to have 25% of the LTD requirement by one year after the date they become subject to the proposed rule; 50% of the LTD requirement by two years after that date; and 100% of the LTD requirement by the end of the third year of the phase-in period.
Clean Holding Company Requirements
As part of the LTD NPR, the Federal Reserve Board proposes to impose clean holding company requirements similar to those imposed on U.S. GSIBs and U.S. intermediary holding companies subject to TLAC. These clean holding company requirements are designed to ensure that the covered entity’s losses are largely imposed upon the LTD holders by limiting liabilities that are not LTD and to avoid the potential domino effects of the failure of a covered entity on its counterparties and the financial system as a whole.
The proposal would prohibit covered entities from having the following categories of outstanding liabilities: (1) third-party short-term (original maturities of less than one year) debt instruments; (2) instruments with the right to offset debt owed by the holder or an affiliate; (3) certain third-party qualified financial contracts; (4) guarantees of a subsidiary’s liabilities if cross-default rights are created; and (5) liabilities with upstream guarantees from a subsidiary. The proposal would also limit the amount of certain debt owed to non-affiliates at the same or junior priority to eligible LTD.
FDIC Resolution Planning Proposal
The FDIC’s existing IDI resolution plan rule requires banks with over US$50 billion in total assets to periodically submit to the FDIC a resolution plan demonstrating how they could be resolved in an orderly and timely manner in the event of receivership. Banks with US$50 billion to US$100 billion in assets have not had to submit such plans since 2018 because of a moratorium adopted by the FDIC. Under the FDIC’s NPR, the moratorium would be lifted, and the FDIC would make several modifications to the rule designed to support the FDIC’s resolution readiness for material distress and the failure of large IDIs.
The NPR creates two groups of covered IDIs (CIDIs) with different submission content requirements. IDIs with US$100 billion or more in total assets would be the Group A CIDIs, while IDIs with at least US$50 billion but less than US$100 billion in total assets would be the Group B CIDIs. Under the proposal, Group A CIDIs would be required to submit complete resolution plans containing all content elements described in the NPR, including a comprehensive resolution strategy appropriate for the CIDI’s orderly and efficient resolution and a demonstration of the capabilities necessary to produce valuations that the FDIC could use to conduct the statutorily required least-cost analysis at the time of an actual failure. Group B CIDIs would be required to submit an informational filing, which would not require a resolution strategy and demonstration of valuation capabilities but would require substantially all of the informational elements otherwise required for inclusion in a Group A CIDI resolution plan.
The proposal would require Group A CIDIs to include in their resolution plans an “identified strategy,” from point of failure through sale or disposition of the CIDI’s franchise, on how the FDIC could establish and stabilize a BDI and exit from the BDI. Notably, the NPR would make this the default strategy for resolution of Group A CIDIs, with exits from the BDI that could be accomplished by such means as a multiple acquirer exit, an orderly wind-down of certain business lines and asset sales, or an exit via restructuring. While the BDI strategy is the default identified strategy under the proposal, the proposal would permit CIDIs to use an alternative strategy so long as the alternative strategy meets certain specified criteria and that the strategy includes meaningful options for execution across a range of scenarios. A CIDI, however, would not be permitted to use as its identified strategy a closing weekend sale of the franchise to one or more acquirers.
The NPR revises the standards that will be used to assess the credibility of resolution plans.
The first prong, which only applies to resolution plans submitted by Group A CIDIs, provides that a submission is not credible if its identified strategy would not provide timely access to insured deposits; maximize value from the sale or disposition of assets; minimize any losses realized by creditors of the CIDI in resolution; and address potential risks of adverse effects on U.S. economic conditions or financial stability.
The second prong, which applies to submissions of both Group A CIDIs and Group B CIDIs, provides that a submission is not credible if the information and analysis in it are not supported with observable and verifiable capabilities and data and reasonable projections or if the CIDI fails to comply in any material respect with the requirements of the proposal.
Further, the NPR amends requirements of the resolution plan rule to outline the FDIC’s expectations for engagement between the CIDIs and the FDIC and for capabilities testing. For engagement, the NPR requires a CIDI to provide the FDIC the information and access to CIDI personnel that the FDIC determines are relevant to any provision of the rule. Unlike the current requirement, this requirement provides that the information and personnel access would be at the discretion of the FDIC and would not be limited as it currently is to information and personnel access “necessary to assess the credibility of the resolution plan and the ability of the CIDI to implement the resolution plan.”3 For capabilities testing, under the NPR, the FDIC could require a CIDI to demonstrate that it can perform the capabilities described, or required to be described, in a submission, including the CIDI’s ability to provide the information, data, and analysis underlying the submission.
Lastly, the NPR adjusts the frequency of submissions from the current rule’s annual cycle to a two-year cycle and requires the submission of a comprehensive submission — a resolution plan for Group A CIDIs or an informational filing for Group B CIDIs — and an interim supplement on the one-year anniversary of a CIDI’s most recent comprehensive submission. The interim supplement would contain updates to key information and would be composed of a limited subset of the content items required in a comprehensive submission.
Interagency Dodd-Frank Resolution Guidance Proposal
The Federal Reserve Board and FDIC have proposed guidance on the federal banking agencies’ expectations of how certain large BHCs should address key challenges in resolution. The guidance would generally apply to BHCs and foreign banking organizations (FBOs) with more than US$250 billion in total assets but that are not the largest and most complex companies, which are already subject to guidance on resolution planning. The guidance is organized by key areas of potential vulnerability to resolution: capital; liquidity; governance mechanisms for decisions associated with entering bankruptcy; operational capabilities; legal entity rationalization and separability; and IDI resolution, if applicable.
The guidance also addresses the management information system capabilities banking organizations should have to perform a detailed analysis of the specific types of financial and risk data that would be required to execute the preferred resolution strategy.
Banking organizations should have the capabilities to produce information appropriate for its resolution strategy, including (1) financial statements for each material entity (at least monthly); (2) external and inter-affiliate credit exposures; (3) gross and net risk positions with internal and external counterparties; (4) guarantees, cross holdings, financial commitments, and other transactions between material entities; (5) data to facilitate third-party valuation of assets and businesses, including risk metrics; (6) key third-party contracts, including legal agreement information, service level agreements, and updated legal records for domestic and foreign entities; (7) licenses and memberships to all exchanges and value transfer networks; and (8) key management and support personnel.
A separate guidance on FBOs would contain additional topics related to home country, groupwide resolution plans, and branches, and, if approved, would replace the 2020 FBO guidance for FBOs that were subject to that guidance. The proposed guidance is bifurcated, with separate proposed guidance for single-point-of-entry and multiple-point-of-entry strategy needs, which are different strategies companies may adopt.
The proposals represent the continuation of an effort by the federal banking regulators to substantially strengthen the regulatory oversight of large regional banks in the wake of a string of bank collapses earlier this year.
Below are several key takeaways from the proposals:
- The agencies were not satisfied with how the resolution processes unfolded for the three failed banks, with two requiring the invocation of a systemic risk exception to a least-cost resolution and one involving the acquisition by a GSIB. These proposals are all aimed at increasing the agencies’ flexibility in the event of a failure of a banking organization of a similar size or smaller. The FDIC, notably, intends to establish a bridge bank strategy that can achieve multiple sales of key segments and portfolios over time to resolve an organization rather than a single purchase and assumption transaction with a single bidder over the weekend following failure. The bridge structure default is due to the sheer size of the CIDIs and the few (if any) sufficiently large institutions that could achieve a single purchase, and the FDIC is expecting additional planning from banking organizations to facilitate such a strategy.
- While it may have benefits in the form of increased resilience, the LTD requirement will almost definitely increase the funding costs of the institutions to which it applies as institutions pay more to extend the maturities of their debt and increase their outstanding debt over time. The NPR states that the LTD requirement would increase funding costs by US$1.5 billion to US$5.6 billion. The transition period will help mitigate these effects, but institutions will need to start planning sooner rather than later.
- For banks with total assets of US$100 billion and over, the proposed resolution rule provides a substantial increase in what the agencies will expect to see in resolution plans. For banks with total assets of US$50 billion and over that have been subject to a moratorium for several years, these requirements will create new expectations. For banks that crossed the US$50 billion in total assets threshold in the past five years, the proposed resolution rule will significantly increase the initial and ongoing compliance costs. Banking organizations that are under the thresholds established by the proposal should also be aware of the new expectations. Growth may bring them into these categories, or the proposals may be indicative of the approach the agencies plan to take for smaller institutions through the supervisory process.
- Firms will need to staff appropriately to meet these new standards and to prepare for more frequent and vigorous engagement with the FDIC. This is underlined by the fact that certain expectations that were formerly in the form of guidance will now be in the form of a rule. The FDIC reiterated its enforcement authority in the proposals over untimely and inadequate resolution plans as violations of the resolution planning rule and, at the FDIC’s discretion, Section 8 of the Federal Deposit Insurance Act.
It is quite possible that the agencies will act on the proposals quickly, both because of the urgency created by the bank turmoil of this past spring and because the agencies may have the Congressional Review Act in mind, which provides a limited period to repeal agency action. Once adopted, midsize and large banking organizations will have to make substantial efforts to meet the new requirements.
Financial institutions interested in how the agencies’ proposed changes to resolution and capital requirements may impact their businesses may contact any of the authors of this Advisory or their usual Arnold & Porter contact. The firm’s Financial Services team would be pleased to assist with any questions about the NPR, submitting a comment to the agencies, or banking regulation in general.
© Arnold & Porter Kaye Scholer LLP 2023 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
IDIs that are consolidated subsidiaries of U.S. GSIBs would not be subject to the proposed LTD requirement because their parent holding companies are subject to the LTD requirement under the Federal Reserve Board’s total loss-absorbing capacity rule.
Although covered entities and covered IDIs are not subject to the TLAC rule, the NPR makes some technical adjustments to the current TLAC rule, including the requirement that LTD have a minimum principal denomination.