Federal Reserve Board Issues Proposed New Regulation YY to Regulate Certain “Covered Companies” as Required by Dodd-Frank

by Edmund D. Harllee

On Thursday, January 5, the Federal Reserve Board (the "Board") issued proposed new Regulation YY, in order to implement changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act").

Sections 165 and 166 of the Act require the Board to impose various "enhanced prudential standards" on so-called "covered companies."  Two types of covered companies would be regulated under new Regulation YY, domestic bank holding companies having total consolidated assets of $50 billion or more and domestic non-bank financial companies that the new Financial Stability Oversight Counsel (the "Counsel") has designated as requiring such regulation by the Board.  The Board intends to issue proposed additional regulations in the future with respect to the other types of covered companies.

The Board's proposed rule would generally regulate domestic covered companies in the following seven main areas, as required under the Act:

1.         Risk-Based Capital Requirements and Leverage Limits.

            The Board proposes to comply with the Act's requirements in two ways:

• To subject all covered companies to the Board's existing "capital plan rule," which requires all bank holding companies with $50 billion or more in consolidated assets to submit an annual capital plan to the Board.  The plan must demonstrate a "robust, forward-looking" capital planning process that permits the company to continue operations during times of economic stress.
• To implement a quantitative risk-based capital surcharge for some or all covered companies, based on the approach taken by the Basel Committee on Banking Supervision with respect to internationally active banks ("Basel III"). 

2.         Liquidity.

The Board is proposing a multi-stage approach to implementing this requirement.  Initially, covered companies would be required to conduct internal stress tests at least monthly to measure liquidity needs at 30-day, 90-day and one-year intervals during times of financial instability in the market, and to hold liquid assets sufficient to cover 30-day stressed net cash outflows under these scenarios.  Other initial requirements would be specific governance requirements, cash flow projections, internal limits on certain liquidity metrics and the maintenance of a "contingency funding plan."

In the future, the Board intends to implement, along with other federal banking agencies, standard liquidity rules currently implemented under Basel III and under review by U.S. federal banking agencies.     

3.         Single-Counterparty Credit Limits.

            The Act prohibits covered companies from having credit exposure to any unaffiliated company that exceeds 25% of the capital stock and surplus of the covered company, but permits the Board by regulation to lower this threshold.  The proposed rule would lower this threshold to 10% where either the covered company or the counterparty has more than $500 billion in total consolidated assets, or is a non-bank covered company.  The proposal also contains rules for measuring the amount of credit exposure associated with various types of credit transactions.

4.         Risk Management and Risk Committees.         

            The proposal requires enhanced risk management standards for covered companies.  Publicly traded covered companies and publicly traded bank holding companies having $10 billion or more in total consolidated assets will be required to establish a risk committee of the board of directors, the composition of which is set forth in the proposed regulation.  All covered companies would have to implement "robust" enterprise-wide risk management policies overseen by a risk committee and a "chief risk officer."  All publicly traded bank holding companies having $10 billion or more in total consolidated assets would have to establish a risk committee.

5.         Stress Testing.

            The proposal requires two types of capital adequacy stress testing:

• Supervisory stress tests, conducted annually by the Board and the covered company's primary federal regulator
• Company-run stress tests, conducted semi-annually by covered companies, and annually by state member banks, bank holding companies and savings and loan holding companies having $10 billion or more in total consolidated assets 

The results of the above stress tests are to be made public.

6.         Debt-to-Equity Limits.

            Under the Act, upon the determination by the Counsel that a covered company poses a grave threat to the financial stability of the United States and that such threat will be mitigated by such action by the Counsel, the Board must require such company to maintain a debt-to-equity ratio of no more than 15-to-1.  The proposed regulation defines these terms and establishes procedures for notice to the company of the Counsel's determination.

7.         Early Remediation Framework.

            The proposed regulation establishes a procedure for the early warning of financial distress at covered companies and requirements for the remediation process.  This procedure includes various triggers to alert the company to potential problems, including triggers based on regulatory capital, supervisory stress test results, market indicators and weaknesses in enterprise-wide and liquidity risk management.  

The proposed rule is 70 pages long in the Federal Register and contains many specific requests for comments, in addition to the general request.

Covered companies and others may comment, and should do so if they think that the proposed new regulation, or the specifics of the implementation of the regulation as published in the notice, will have an adverse effect on their businesses.  According to the notice of proposed rulemaking, comment letters should refer to Docket No. R-1438 and RIN No. 7100-AD-86 and may be mailed electronically to regs.comments@federalreserve.gov.  There are other methods of submitting comments, as set forth in the notice.  The comment period ends March 31, 2012.

If you have any questions about the information in this Alert, please contact Ed Harllee at eharllee@williamsmullen.com.