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From Banking and Finance Law Daily, July 20, 2015

Fed adopts capital surcharge for GSIBs

By John M. Pachkowski, J.D.

As part of its July 20, 2015, open meeting, the Federal Reserve Board has approved a final rule that imposes a capital surcharge on the largest, most systemically important U.S. bank holding companies pursuant to Section 165 of the Dodd-Frank Act. Under the final rule, a firm that is identified as a global systemically important bank holding company, or GSIB, will have to hold additional capital to increase its resiliency in light of the greater threat it poses to the financial stability of the United States.

The final rule is the result of a December 2014 proposed rule that was based upon the international standard adopted by the Basel Committee on Banking Supervision and is augmented to address risks to U.S. financial stability (see Banking and Finance Law Daily, Dec. 9, 2014).

Identification of a GSIB. As in the proposal, the Fed’s final rule would use five broad categories correlated with systemic importance—size, interconnectedness, cross-jurisdictional activity, substitutability, and complexity—to calculate a numerical score that would be used to determine whether a U.S. bank holding company would be identified as a GSIB. Using year-end 2014 data, eight bank holding companies would be identified as GSIBs under the final rule. The eight holding companies are: JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp., Wells Fargo & Co., Goldman Sachs Group Inc., Morgan Stanley, Bank of New York Mellon Corp., and State Street Corp.

GSIB surcharge amount: A firm identified as a GSIB will need to calculate its GSIB surcharge under two methods and will be subject to the higher surcharge.

Method 1 is the same method used to identify whether the firm is a GSIB. Under the final rule, advanced approaches bank holding companies—those with $250 billion or more in consolidated total assets or $10 billion or more in consolidated total on-balance-sheet foreign exposures—will be required to calculate their method 1 score on an annual basis. Under the proposed surcharge rule, each U.S.-based top-tier bank holding company with total consolidated assets of $50 billion or more was required to perform a calculation on an annual basis to determine whether it was a GSIB. The change was made in recognition of the fact that firms not meeting the definition of an advanced approaches bank holding company are likely to pose less systemic risk to U.S. financial stability than firms that meet the advanced approaches threshold.

Method 2 uses similar inputs but differs in two key respects. First, substitutability is replaced with the use of short-term wholesale funding. Second, method 2 is calibrated in a manner that generally will result in surcharge levels for GSIBs that are higher than those calculated under method 1. The higher calibration of method 2 is based on an assessment of the capital necessary to equalize the expected impact from the failure of a GSIB as compared to the expected systemic impact from the failure of a large, non-GSIB.

The final rule made a couple of changes to the method 2 calculations that were in the proposed rule. First, a GSIB’s method 2 score is calculated as relative to fixed measures of systemic importance, rather than as relative to annually updated measures of systemic importance of global firms, and incorporates an average exchange rate over a three-year period, rather than using a daily spot rate. The second change adjusts several elements of the short-term wholesale funding calculation.

Calibration explained. To better explain the calibration of the capital surcharges based on the measures of each GSIB’s systemic footprint derived from the two methods, the Fed released a white paper focusing on the expected impact from the failure of a GSIB. The white paper explains the expected impact framework in detail; provides surcharge calibrations resulting from that framework under a range of plausible assumptions, incorporating the uncertainty that is inherent in the study of rare events such as systemic banking failures; and offers a high level discussion of two alternative calibration frameworks that explains why neither of the alternatives appeared to be as useful as a framework for the calibration of the GSIB surcharge.

Implementation. The capital surcharge will be phased in beginning on Jan. 1, 2016, and would become fully effective on Jan. 1, 2019, on the same implementation timeline as the Fed’s capital conservation buffer. Using the most recent available data, it is estimated that surcharges for the eight GSIBs will range from 1.0 to 4.5 percent of each firm's total risk-weighted assets. However, a staff memorandum to the Fed cautioned that since the final rule relies on individual GSIB data that will change over time, the currently estimated surcharges may not reflect the surcharges that would apply to a GSIB when the rule becomes effective.

The staff memorandum also indicated that seven of the eight firms currently identified as GSIBs under the draft final rule already meet their GSIB surcharges on a fully phased-in basis, and all such firms are on their way to meeting their surcharges over the three-year phase-in period.

Fed comments. Commenting on the final rule, Fed Chair Janet Yellen stated, "A key purpose of the capital surcharge is to require the firms themselves to bear the costs that their failure would impose on others. In practice, this final rule will confront these firms with a choice: they must either hold substantially more capital, reducing the likelihood that they will fail, or else they must shrink their systemic footprint, reducing the harm that their failure would do to our financial system. Either outcome would enhance financial stability."

Fed Governor Daniel K. Tarullo noted, “A set of graduated capital surcharges for the nation's most systemically important financial institutions will be an especially important part of the strengthened regulatory framework we have constructed since the financial crisis. Like the higher leverage ratio requirements we will apply to these firms, they reflect the relatively new, but very significant, principle that the stringency of prudential standards should vary with the systemic importance of regulated firms."

Finally, Fed Governor Lael Brainard said the final rule “represents important progress in strengthening the capital positions of the largest, most systemic U.S. bank holding companies.” She added, “The crisis taught us that the distress of large complex banking institutions can pose risks to financial stability” and that the “first line of defense is to require that systemic banking institutions maintain a very substantial stack of common equity to provide loss absorbency and compel them to internalize the risks to the system posed by their activities.” Brainard concluded her comments noting that the “crisis also provided a stark reminder that what may seem like thick capital cushions in good times may prove uncomfortably thin at moments of stress.”

Industry reaction. The Financial Services Roundtable issued a statement on the final rule. FSR President & CEO Tim Pawlenty acknowledged that regulators should reasonably address risk, but that the final rule “will keep billions of dollars out of the economy, reduce lending to small businesses and families, and put American companies at a competitive disadvantage compared to foreign competitors.” Pawlenty’s statement added, “The Fed has also not been transparent regarding how they calculated the new capital requirement and provided only limited information to the firms covered by it.”

Companies: Bank of America Corp.; Bank of New York Mellon Corp.; Citigroup Inc.; Financial Services Roundtable; Goldman Sachs Group Inc.; JPMorgan Chase & Co.; Morgan Stanley; State Street Corp.; Wells Fargo & Co.

MainStory: TopStory BankHolding BankingOperations CapitalBaselAccords DoddFrankAct FederalReserveSystem FinancialStability

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