Dodd Frank: Enhanced prudential standards explained

Enhanced Prudential Standards Explained

Just over a year ago the Federal Reserve approved a final rule strengthening the supervision and regulation of large US bank holding companies and foreign banking organisations (FBOs) under section 165 of the Dodd-Frank Act.

It establishes a number of enhanced prudential standards (EPS) to help increase the resiliency of these institutions’ operations. Standards include liquidity, risk management, and capital.

"As the financial crisis demonstrated, the sudden failure or near failure of large financial institutions can have destabilising effects on the financial system and harm the broader economy," Federal Reserve chair Janet Yellen said a year ago. "And, as the crisis also highlighted, the traditional framework for supervising and regulating major financial institutions and assessing risks contained material weaknesses. The final rule addresses these sources of vulnerability."

US bank holding companies

From this year on US banks with consolidated assets of $50 billion or more will have to comply with enhanced risk-management and liquidity risk-management standards, and conduct liquidity stress tests. They will need to hold a “buffer” of highly liquid assets based around the Fed’s so-called stress tests. Virtually every bank past this annual examination this year.

The rule also requires US bank holding companies with total consolidated assets of $10 billion or more to establish enterprise-wide risk committees.

However, EPS will not apply to non-bank financial companies that are designated by the Financial Stability Oversight Council for Federal Reserve supervision. Instead, the Fed says it will apply enhanced prudential standards on a case-by-case basis for these firms.

Foreign Banking Organisations

The largest foreign banks, or FBOs in Fed-speak, that have non-branch assets of $50 billion or more will be required to establish a US intermediate holding company (IHC) over their subsidiaries, set up a US risk committee and employ a dedicated chief risk officer for US operations.

IHCs will be subject to the same risk-based and leverage capital standards applicable to US bank holding companies. The intermediate holding companies also will be subject to the Federal Reserve's rules requiring regular capital plans and stress tests.

FBOs will have to meet enhanced liquidity risk-management standards, conduct liquidity stress tests, and hold a buffer of highly liquid assets based on Fed stress tests.

Large foreign banks with $50 billion or more, but where their combined US assets are less than $50 billion, are also subject to enhanced prudential standards.

However, the capital, liquidity, risk-management, and stress testing requirements applicable to these FBOs are “substantially less” than those who have a bigger presence in the US.

In addition, there are stress testing requirements for smaller FBOs with total consolidated assets of more than $10 billion.

However smaller FBOs - those with less than $50 billion in US non-branch assets - are no longer required to form an Intermediate Holding Company (IHC).

For FBOs, the key July 2015 compliance date has been pushed to July 2016.

Large FBOs will benefit from not being subject to Advance Approaches methodology for calculating their risk-based capital at the holding company level. Additionally, these large foreign banks do not need to implement the US leverage ratio until 2018.