Capital and Liquidity Regulations – Risk Based Indicators

The Board of Governors of the Federal Reserve System (Board), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) (together, the agencies) published a proposal to revise the criteria for determining the applicability of capital and liquidity requirements for U.S. banking organizations and U.S. operations of foreign banking organizations. The agencies regularly review their regulatory framework, including liquidity and capital requirements. The final rule, which was published in October 2019, comes from such reviews, which includes assessing the impact of regulations as well as exploring alternatives that achieve regulatory objectives while improving the simplicity, transparency, and efficiency of the regulatory structure. The objective is to “develop a regulatory framework that more closely ties regulatory requirements to underlying risk” according to Vice Chair for Supervision, Randal K. Quarles. The final rule enhances the risk sensitivity and efficiency of capital and liquidity requirements, as well as supports banking organization’s resilience and intended functionality during both times of economic stress and turbulence, and on a regular basis.

The final rule revises the criteria for determining the applicability of regulatory capital and liquidity requirements for large U.S. banks and U.S. IHC’s (Intermediate Holding Companies) of certain foreign banking organizations. The rule establishes four categories which are built on risk-based indicators such as size, cross-jurisdictional activity, reliance on short term wholesale funding, nonbank assets, and off-balance sheet exposure.

These five indicators have proven to be important in assessing the potential risks to U.S. financial stability:

A banking organizations size provides a measure of the extent to which stress at its operations could spill over and be disruptive to U.S. markets and overall U.S. financial stability. Size is defined as the amount of total consolidated assets, or combined U.S. assets. A larger bank has more customers and counterparties that would be affected if the bank goes through a period of distress; therefore, the larger the size of a banking organization, the more likely that a period of distress would affect more market participants and affect the economy.

Cross-jurisdictional activity provides a measure of the global footprint of the bank, which is a proxy for the international impact from a bank’s distress. Cross-jurisdictional activity is defined as the sum of cross-jurisdictional claims and liabilities. The BCBS (Basel Committee on Banking Supervision) concluded that the greater the global reach of a bank, the more difficult it is to coordinate its resolution and the more widespread the effects of its failure. Significant cross jurisdictional activity can indicate heightened interconnectivity and operational complexity. There are additional legal and regulatory complexities for banks with a higher amount of cross-jurisdictional activity, which require more sophisticated risk management systems to manage.

A banking organization’s activities conducted through nonbank assets may involve a broader range of risks than those associated with activities that are permissible for a depository institution to conduct directly. Nonbank assets refer to the amount of activities conducted through nonbank subsidiaries. These activities also lead to higher complexity and requirement of more sophisticated risk management systems. Therefore, nonbank assets provide a measure of the organizations business and operational complexity.

A bank’s off-balance sheet exposure complements the measure of size. Off-balance sheet exposure is defined as the difference between total exposure, calculated in accordance with the instructions to the FR Y-15 (a Federal Reserve report form that collects systemic risk data from large banking organizations), and total assets. Off-balance sheet exposure can lead to significant future draws on liquidity, particularly in times of stress. During times of stress, vulnerabilities at individual banking organizations may be exacerbated by calls on commitments and the need to post collateral on derivatives exposure.

Weighted short-term wholesale funding measures the amount of a banking organization’s short-term funding obtained generally from wholesale counterparties, certain brokered deposits, and certain sweep deposits with remaining maturity of one year or less. Short-term wholesale funding is typically less stable than funding of a longer term fully insured retail deposits, long term debt, and equity. Reliance on short-term, generally uninsured funding can make a banking organization more vulnerable to large scale funding runs, creating safety and soundness risks.

These five indicators are used to determine the four categories for applying capital and liquidity requirements. These factors serve as a basis for assessing a banking organization’s financial stability and safety and soundness risks. Along with improving transparency and efficiency, these factors enhance the risk sensitivity of the agencies rules and provide a simple and transparent measure of size, complexity, and potential systemic risks of the banking organization.

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