United States: Section 165 Revisited - Rethinking Enhanced Prudential Regulations

In a recent speech, Federal Reserve Governor Daniel Tarullo proposed a "rethinking" of the aims of prudential regulation for bank holding companies.¹ With his remarks, Governor Tarullo has sought to initiate a debate on how a "more precise specification of prudential regulatory aims" could provide a basis for recalibrating regulation.² This debate is especially timely and much needed with respect to the Federal Reserve's new enhanced prudential standards issued under Section 165 of the Dodd-Frank Act, which have transformed the nature and scope of bank regulation.

Yet as important as it is to reconsider the aims of Section 165, it is equally important to reconsider its means. Congress was very specific in prescribing how it intended the Federal Reserve to implement Section 165's enhanced prudential standards. Therefore, any debate on how to recalibrate them must be grounded in an understanding of the parameters imposed by the statute.

There also is a more fundamental reason to reexamine Section 165's requirements: the current approach differs sharply from the approach set out in the statute. This divergence has resulted in bank holding companies being subject to enhanced prudential standards based primarily on whether they satisfy an arbitrary asset threshold rather than on the risks they present. Accordingly, the implementation of Section 165's enhanced prudential standards deserves a second look.

This article examines the legislative history of Section 165, with the purpose of showing how the statute envisions the implementation of enhanced prudential standards. This legislative history has important implications for how enhanced prudential standards could be recalibrated to be not only more effective but also more consistent with the provisions of Section 165.

Overview of Section 165

Section 165 of Dodd-Frank requires the Federal Reserve to establish enhanced prudential standards for bank holding companies with $50 billion or more in consolidated assets.³ The Federal Reserve must promulgate enhanced prudential standards for: (1) risk-based capital requirements and leverage limits; (2) liquidity requirements; (3) overall risk management requirements; (4) resolution plans and credit exposure reports; (5) concentration limits; (6) risk committees; and (7) company stress tests.⁴ On a discretionary basis, the Federal Reserve may establish additional enhanced prudential standards.⁵

To implement Section 165, the Federal Reserve has issued a series of rules that mostly apply uniformly to bank holding companies that satisfy the $50 billion threshold. These rules have implemented not only the mandatory enhanced prudential standards under Section 165 but also the Federal Reserve's annual Comprehensive Capital Analysis and Review, or CCAR.⁶ Additional enhanced prudential standards also apply at other asset thresholds, including at the $250 billion (or $10 billion in foreign exposures), $700 billion (or $10 trillion in assets under custody), and, for foreign banking organizations, $50 billion in U.S. assets levels.⁷ The Federal Reserve is expected to issue additional rules using similar asset thresholds.⁸ This reliance on asset thresholds, however, is not the approach set forth in Section 165.

The Legislative History

The legislative history of Section 165 begins in the U.S. Senate Committee on Banking, Housing, and Urban Affairs ("Senate Banking Committee"). The provision originated as Section 165 of legislation, S. 3217, the Restoring American Financial Stability Act of 2010 ("RAFSA"), passed by the Senate Banking Committee on March 22, 2010.⁹ The provision was amended several times by Congress, but ultimately became Section 165 of Dodd-Frank. The key legislative history lies in how Section 165 was incorporated into RAFSA, but, to fully understand this history, it is first necessary to understand the influence of Senate Banking Committee Chairman Christopher Dodd's discussion draft proposal of November 2009 ("Dodd Discussion Draft").

Dodd Discussion Draft

As Congress began considering financial regulatory reform during the 111th Congress, Chairman Dodd's initial proposal was the Dodd Discussion Draft.¹⁰ Its central reform was consolidation of all prudential regulation into a single regulator, the Financial Institutions Regulatory Administration ("FIRA").¹¹ This restructuring of financial regulation was designed to streamline financial regulation, as well as to discipline federal banking regulators for their perceived regulatory failures in the lead-up to the financial crisis of 2008.

The Dodd Discussion Draft also would have created the Agency for Financial Stability ("AFS"), which would have been responsible for designating any financial company (whether a bank holding company or nonbank financial company) whose "material financial distress" would "pose a threat to the financial stability of the United States or the United States economy during times of economic stress."¹² Any designated company would have been subject to enhanced prudential standards set by the AFS. These enhanced prudential standards would have been required to be "more stringent than [the standards] applicable to financial companies that do not present similar risks to United States financial system stability and economic growth" and to "increase in stringency with the size and complexity" of the designated financial company.¹³

In devising enhanced prudential standards, the AFS also would have had to take into account a long list of specific factors, including "the amount and types of the liabilities of the company"; "the amount and nature of the financial assets of the company"; "the extent and type of the off-balance-sheet exposures of the company"; the company's relationships with other major financial companies; and its ownership of any clearing, settlement, or payment businesses.¹⁴ As this list demonstrates, these enhanced prudential standards were supposed to reflect a variety of factors, rather than just the amount of assets held by a designated company.

Although the Dodd Discussion Draft failed to garner sufficient support and was never voted on by the Senate Banking Committee, its provisions for streamlining financial regulation under FIRA and its approach to enhanced prudential standards laid the foundation for Section 165.

RAFSA

After abandoning the Dodd Discussion Draft, Chairman Dodd scaled back his reforms and proposed RAFSA in March 2010. Nevertheless, Section 165 of RAFSA reflects many of the same approaches and goals of the Dodd Discussion Draft.

Under Section 165 of RAFSA, the Federal Reserve, like the AFS under the Dodd Discussion Draft, was required to establish enhanced prudential standards for certain financial companies. Section 165 explicitly sets forth the aim of these enhanced prudential standards: "to prevent or mitigate risks to the financial stability of the United States that could arise from the material distress or failure of large, interconnected financial institutions."¹⁵

RAFSA also established the Financial Stability Oversight Council ("FSOC") and made it responsible for designating the nonbank financial companies that would be subject to Section 165's enhanced prudential standards.¹⁶ Unlike the AFS under the Dodd Discussion Draft, however, the FSOC was authorized to designate only nonbank financial companies because RAFSA explicitly provided that Section 165 applied to all "large, interconnected" bank holding companies with consolidated assets of $50 billion or more.¹⁷

The $50 Billion Threshold

What was the rationale for the $50 billion threshold? In isolation, it seems very arbitrary and over-inclusive. The reason is that the $50 billion threshold was not designed to identify companies that pose risks to financial stability but rather to advance two other objectives of RAFSA.

First, RAFSA sought to continue the Dodd Discussion Draft's goal of streamlining prudential supervision. However, unlike the Dodd Discussion Draft, which would have eliminated entirely the Federal Reserve's jurisdiction over bank holding companies, RAFSA instead would have reduced the Federal Reserve's jurisdiction to only bank holding companies with consolidated assets of $50 billion or more.¹⁸ All other bank holding companies were to be regulated by the primary regulator of their depositories, either the OCC or the FDIC.¹⁹

According to the Senate Banking Committee Report on RAFSA, the Federal Reserve's jurisdiction over bank holding companies was set at the $50 billion threshold because data demonstrated that "in almost all instances of banking organizations with less than $50 billion in assets, the vast majority of assets are in the depository institution."²⁰ The aim was to have the Federal Reserve regulate bank holding companies that had securities, insurance, and other nonbank activities and to consolidate the regulation of bank holding companies that had few or no nonbank assets under the OCC or the FDIC. By doing so, RAFSA sought to "enhance the accountability of individual regulators," "reduce the regulatory arbitrage in the financial regulatory system," "reduce regulatory gaps in supervision," and limit the regulatory burden on industry.²¹ As this report language reveals, the $50 billion threshold was not intended to separate companies based on whether they presented risks to financial stability. Indeed, the Committee Report states that the Federal Reserve's jurisdiction would "include, but not be limited to, those companies whose failures potentially pose risk to U.S. financial stability."²²

Because the $50 billion threshold included companies that do not pose risks to financial stability, its use in Section 165 also served a second objective of RAFSA: blunting criticism that any company subject to enhanced prudential standards would be considered systemically significant. Borrowing the $50 billion threshold established for allocating bank holding company regulation advanced this objective because, as noted above, the threshold was not established to determine whether a company presents risks to financial stability. In other words, Section 165 could apply to any "large, interconnected" bank holding company regulated by the Federal Reserve. As a result, it covered companies with a range of risk profiles. By then requiring that the Federal Reserve employ a "graduated approach" in implementing Section 165's enhanced prudential standards to this broad group (see below), RAFSA "intended to avoid identification of any bank holding company as systemically significant."²³

These rationales for the $50 billion threshold have been obscured because, during the full Senate's consideration of RAFSA, an amendment (the Hutchison- Klobuchar Amendment) was adopted that restored the Federal Reserve's jurisdiction over all bank holding companies.²⁴ As a result, the $50 billion threshold in Section 165 was no longer congruent with the Federal Reserve's holding company jurisdiction. Because Section 165 was not amended to reflect this change, it has permitted an inference, not supported by the record, that Dodd-Frank deemed any bank holding company with consolidated assets above $50 billion to be systemically significant.

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Originally published by The Clearing House's Banking Perspective.

Footnotes

1. Daniel k. tarullo, Member, Board of Governors of the Federal reserve System, Rethinking the Aims of Prudential Regulation, remarks to the Federal reserve Bank of Chicago Bank Structure Conference, Chicago, IL (May 8, 2014) (Hereinafter tarullo (2014)).

2. Id. (He suggested that these aims should include protecting the deposit insurance fund, macroprudential aims and financial stability.)

3. Section 165 also applies to designated nonbank financial companies. Because the designation of, and application of enhanced prudential standards to, nonbank financial institutions raises numerous and complex issues unrelated to bank holding company regulation, this article focuses solely on the application of Section 165 to bank holding companies.

4. Dodd-Frank Act § 165(a), (h)(2), and (i)(2)(C).

5. Section 165(b)(1)(B) explicitly provides for discretionary standards on contingent capital requirements, enhanced public disclosures, and short-term debt limits.

6. See Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking Organizations, 79 Fed. Reg. 17,240 (Mar. 27, 2014).

7. See id. and Regulatory Capital Rules, 79 FR 24528 (May 1, 2014).

8. See Daniel K. Tarullo, Member, Board of Governors of the Fed. Reserve System, Dodd-Frank Implementation, Testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate (Feb. 6, 2014).

9. Available at http://www.gpo.gov/fdsys/pkg/BILLS-111s3217pcs/pdf/BILLS-111s3217pcs.pdf. Restoring American Financial Stability Act of 2010, S. 3217, 111th Cong. (2010) (Hereinafter "RAFSA").

10. Available at http://www.llsdc.org/assets/DoddFrankdocs/bill-111th-s3217-discussion-draft.pdf (Hereinafter "Dodd Discussion Draft"). The formal title of the Dodd Discussion Draft was the "Restoring American Financial Stability Act of 2009."

11. Dodd Discussion Draft, Title III.

12. Dodd Discussion Draft §105.

13. Dodd Discussion Draft §107(a).

14. Dodd Discussion Draft §107(b)(3).

15. RA FSA § 165(a)(1) (this language was revised by the conference committee to also cover such risks arising from "ongoing activities" of these institutions). This language also largely mirrors the aim of enhanced prudential standards under the Dodd Discussion Draft § 107.

16. RA FSA § 111; § 113.

17. RA FSA § 312(a).

18. RA FSA § 312.

19. RA FSA § 313 eliminated the Office of Thrift Supervision.

20. T he Restoring American Financial Stability Act of 2010, S. Rep. No. 111-76, at 25 (2010) (Hereinafter "Committee Report").

21. Id. at 23, 25.

22. Id. at. 23.

23. Id. at 2.

24. Senate Amendment No. 3759, 111th Congress.

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