PwC on Counterparty Credit Limits: Do You Know Where Your Exposures Are?

Over the summer, the Federal Reserve Board (Fed) concluded the comment period on its reproposed single counterparty credit limits (SCCL) rule issued in March 2016.[1] SCCL is intended to reduce systemic risk by limiting a banking organization’s credit exposure to any single unaffiliated counterparty as a percentage of the organization’s capital. The rulemaking applies to organizations with over $50 billion in total consolidated assets, including US bank holding companies (BHCs), intermediate holding companies (IHCs), and foreign banking organizations’ (FBOs)[2] US operations (collectively, “Covered Banks”).

The comments put forth by the industry mainly focus on the reproposed rule’s criteria for determining which affiliates of Covered Banks, as well as those of their counterparties, must be deemed to be one entity for limit setting purposes. Under the reproposal, affiliate consolidation is based on the Bank Holding Company Act’s (BHCA) broad “control test,”[3] a threshold that will combine more affiliates into one single entity than did prior proposals, thereby significantly increasing the likelihood of breaching the rule’s limits. In response, commenters have suggested that affiliate consolidation should instead be based on US GAAP’s higher threshold which is also used by the US’s risk-based capital rules.[4]

Further complicating matters, if a Covered Bank’s exposure to a counterparty exceeds 5% of the Covered Bank’s capital base, the Covered Bank is also required to aggregate its exposures with its other counterparties that are “economically interdependent” with that counterparty, based on an additional set of subjective criteria. Commenters uniformly objected to this requirement, citing the lack of an objective standard for determining economic interdependence. In addition, such a determination would require access to information that is not easily obtainable, as many of the counterparties that would have to be aggregated are not required to report data publicly (and would likely also face legal or competitive impediments by revealing such data).

Commenters also lamented certain other heightened requirements of the reproposal, including daily monitoring of SCCL limits and monthly attestation by the Chief Risk Officer (CRO) that such limits have not been breached. Most Covered Banks’ current processes and systems are not capable of satisfying this monitoring obligation.

We believe the Fed will finalize the reproposal late this year, but we expect it to push back the effective date in order to give Covered Banks more time to be able to comply.[5]

This post analyzes the SCCL reproposal and the most significant issues raised by the industry in comment letters.

SCCL reproposal

The SCCL reproposal was issued after two earlier versions in 2011 and 2012,[6] and almost two years after the related large exposures framework issued by the Basel Committee on Banking Supervision (BCBS).[7] The reproposal defines three tiers of Covered Banks, based on balance sheet assets or foreign exposures, which then determines: (1) limits on credit exposures to unaffiliated counterparties, and (2) types of capital needed to be held against such exposures.

Most restrictively, global systemically important banks (G-SIBs) would have exposures to another G-SIB capped at 15% of Tier 1 capital (T1C) and exposures to any other unaffiliated counterparty capped at 25% of T1C. The table below details these limits, compliance dates, and reporting frequency for exposures of the three tiers of Covered Banks (i.e., G-SIBs, Large Banks, and Small Banks) to unaffiliated counterparties.

Covered Bank Exposure to Exposure limit Compliance & reporting schedule
G-SIBs:

·   > $500Bn in Total Assets

G-SIB 15% of T1C 1 year from effective date:

·   Daily compliance

·   Monthly reporting

 

Non G-SIB 25% of T1C
Large Banks:

·   > $250Bn and < $500Bn in Total Assets or

·   > $10Bn in foreign on-balance-sheet exposures

G-SIB

or

Non G-SIB

25% of T1C
Small Banks:

·   >$50Bn and <$250Bn in Total Assets and

·   < $10Bn in foreign on-balance-sheet exposures

G-SIB

or

Non G-SIB

25% of total capital, plus ALLL[8] 2 years from effective date:

·   Quarterly compliance

·   Quarterly reporting

Analysis

The SCCL reproposal hit a nerve in the banking industry despite making several concessions from earlier proposals. Twenty-five comment letters were submitted, representing a broad array of the industry including industry groups, US BHCs, FBOs, insurance companies, custodians, foreign central banks, and central counterparties (CCPs).

The topics that received the most comments were:
(a) consolidation thresholds, (b) counterparty exposures (economic interdependence, sovereigns, and special purpose vehicles (SPVs)), and (c) other issues:

Consolidation thresholds

Under the reproposal, both Covered Banks and their counterparties are required to consolidate affiliates under their respective controls based on the Bank Holding Company Act’s (BHCA) broad control test.[9]
This consolidation results in an aggregation of the affiliates’ exposures into one larger exposure, for both the Covered Bank and the counterparty.

This BHCA standard for consolidation is broader and more complex than consolidation criteria under US risk-based capital rules and the BCBS’s large exposure framework, both of which are based on a 50% ownership threshold (consistent with US GAAP). As a result, commenters argued that affiliates should only be consolidated based on US GAAP because the BHCA definition would lead to significant operational challenges. Most notably, Covered Banks generally do not monitor exposures of their unconsolidated affiliates (under US GAAP), and often lack enough operational control over such entities to do so. We expect, however, that the Fed will keep the BHCA consolidation criteria in place for both Covered Banks and counterparties when it ultimately finalizes the rule.

In addition, commenters noted that the BHCA’s broad control test would exacerbate the issue of Covered Banks having to monitor counterparties that will not come close to approaching SCCL exposure limits (because Covered Banks and counterparties will have more affiliates to consider under the BHCA’s test). This is particularly true for those affiliates with exposures primarily to individual retail customers (e.g., credit cards, overdrafts) and small businesses (e.g., loans, revolving lines of credit).

Finally, commenters voiced concerns regarding the implications of having to determine control of affiliates under the BHCA’s broad control test. Non-bank counterparties will likely reject requests for information by Covered Banks, including on voting rights, joint venture terms and conditions, and personal family member connection information. This type of information would be needed to determine whether affiliates should be aggregated, but has the potential to lead to privacy or non-disclosure lawsuits. Accordingly, commenters suggested that exposures to small business and individual retail counterparties be exempted.

Counterparty exposures

Economic interdependence

In addition to the consolidation of affiliates based on the BHCA’s broad control test, a Covered Bank is required to aggregate its exposures to its counterparties that are “economically interdependent” with each other, if the Covered Bank’s exposures to one of the counterparties exceeds 5% of the Covered Bank’s capital. These counterparties might be customers of each other, suppliers, or connected in other ways. The review and qualitative determination to establish economic interdependence will be challenging as Covered Banks will have to acquire information about their counterparties that is not easily discernible or readily available from public sources.

Two counterparties are economically interdependent if the answer is “yes” to any of the following seven questions:

  1. Are 50% or more of one counterparty’s gross receipts or gross expenditures derived from transactions with the other counterparty?
  2. Has one counterparty fully or partly guaranteed the credit exposure of the other counterparty (or is liable by other means), and is the exposure so significant that the guarantor is likely to default if a claim occurs?
  3. Is 25% or more of one counterparty’s output/production sold to the other counterparty, and unable to be easily sold to other customers?
  4. Is the expected source of funds to repay loans between the counterparties the same? If so, does at least one of the counterparties have another source of income from which the loan may be fully repaid?
  5. Would financial problems of one counterparty cause difficulties for the other counterparty to fully and timely repay its liabilities?
  6. Would financial insolvency or default of one counterparty be associated with the insolvency or default of the other?
  7. Do the counterparties rely on the same source for the majority of their funding and, in the event of the source’s default, would they be unable to find an alternate provider?

In applying this qualitative determination of economic interdependence, commenters were particularly concerned about finding interdependence between private sector counterparties and public sector counterparties (e.g., states, municipalities, state owned enterprises, public-private enterprises), which would lead to outsized exposures. Furthermore, commenters thought it highly problematic to force Covered Banks, when calculating exposures to public entities, to aggregate exposures for all municipalities within a state with exposures to the state (the reproposal presumes economic interdependent between various public entities). As such, commenters suggested that economic interdependent analysis be limited to private sector counterparties, but that if public sector counterparties remain in scope, that municipal revenue bonds be exempted since they are supported by a specific stream of revenue.

Upon finalization of the reproposal, our view is that the Fed is unlikely to give ground on the BHCA’s consolidation criteria and on requiring aggregation of economically interdependent exposures. However, the Fed could adopt the somewhat more lenient approach proposed by the European Banking Authority (EBA).
The EBA calls for consolidation of affiliates of counterparties consistent with BCBS’s large exposure framework (i.e., a 50% consolidation threshold, thereby consolidating fewer affiliates), but reduces the economic interdependence threshold from 5% to 2% (thereby bringing in some more counterparties).

Sovereigns

The reproposal exempts exposures to sovereign entities from SCCL calculations, as long as the sovereign entities are assigned a zero risk weight under the US risk-based capital rules. This is a considerable easing from prior proposals, which only exempted a Covered Bank’s exposures to the US government (and to Government Sponsored Enterprises while in conservatorship) and FBOs’ exposures to their home country sovereign entities. G-SIBs with a global footprint will benefit the most from this change due to their exposure to non-US sovereign entities. This modification was welcomed by commenters, but commenters further suggested that exposures to sovereigns that are non-zero risk-weighted should not be presumed to be economically interdependent with public entities associated with the sovereign (e.g., government agencies and government-owned corporations), which the reproposal currently presumes. Rather, commenters suggested that exposures to these associated public entities should only be aggregated with the sovereign for public entities whose individual exposures exceed 5% of the Covered Bank’s capital.

Special Purpose Vehicles

Under the reproposal, G-SIBs and Large Covered Banks are generally required to recognize an exposure to an SPV in an amount equal to the value of its investment in the SPV, which is consistent with the BCBS’s large exposure framework. However, under the reproposal, if such a Covered Bank cannot demonstrate that its exposure to each underlying investment in an SPV is less than 0.25% of its T1C, the Covered Bank must “look-through” the SPV – i.e., recognize (and aggregate) exposures to the issuer of each individual asset held by the SPV.[10]

Commenters believe a better approach would be to limit the SCCL’s scope to SPVs that are under control of the Covered Bank, based on US GAAP thresholds. We don’t expect the Fed to agree, however, given the large number of SPVs that are effectively under a Covered Bank’s control where ownership is often much less than 50%. Commenters also suggested narrowing the scope of the “look-through” to only those investments (or equity-like exposure) of an SPV where access to daily updated information may be attainable. Again, we expect the Fed to hold firm in this regard.

Remaining issues

Securities Finance Transactions

The calculation methodology for Securities Finance Transactions (SFTs) under the reproposal excludes internal model approaches, which will cause exposure amounts to increase dramatically for securities lending and repo products. As such, commenters expressed their desire to allow firms to measure SFTs using any methodology permitted under the US risk-based capital framework, as is the case under the reproposal for measuring over-the-counter (OTC) derivatives exposure. However, it would be an uphill battle to get the Fed to concede this point as global regulators are moving away from internal models and towards standardized approaches for the risk-weighting of exposures.[11]

On the positive side for Covered Banks, the reproposal allows them to use risk mitigants to reduce net credit exposures by transferring risk to an unaffiliated counterparty. While the reproposal permits a range of risk mitigants (including eligible collateral, guarantees, credit and equity derivatives, other hedges, and bilateral netting agreements), the transferred exposure counts toward total exposure to the provider of the risk mitigant.

FBOs’ combined US operations

For FBOs, commenters requested excluding combined US operations (CUSO) for SCCL purposes as they will be subject to comparable home country regimes (CUSO would include the FBO’s IHC, branches in the US, and any subsidiaries in the US outside of the IHC). However, the Fed is likely to stand firm on including CUSO as this is consistent with its Enhanced Prudential Standards and its desire to improve the risk governance of FBOs’ US operations.[12] FBOs also requested the elimination of the cross-trigger mechanism between the IHC and the rest of the CUSO, which mandates that neither the IHC nor the rest of the CUSO be permitted to increase counterparty exposure if either breaches the SCCL limit.

Cost and Compliance Period Burden

In order to comply with SCCL , we believe a minimum of twelve months is needed for Covered Banks to perform a gap analysis, develop a system design, and implement standardized technology solutions that span legal entities and replace siloed systems,. In addition, user-acceptance testing of SCCL data integration solutions will require at least three months.

Commenters argued that that the compliance start date should be changed to coincide with BCBS’s large exposure standard compliance date of January 2019 in order to give G-SIBs and Large Banks the necessary time for process and technology re-engineering across functions, and to reduce the likelihood of market disruptions. FBOs also noted that although the compliance period for IHCs was extended to two years from the final SCCL rule’s effective date, FBOs with assets greater than $250 billion are offered no relief as they will still need to comply with the rule for CUSO (of which the IHC is the key component) within the shorter one year compliance period. We expect the Fed to give Covered Banks extra time to comply with the rule by delaying its effective date, even if the SCCL reproposal is finalized by the end of this year as we anticipate.

ENDNOTES

[1] See PwC’s First take: Ten key points from the Fed’s single-counterparty credit limits proposal (March 2016).

[2] The $50 billion asset threshold would be measured globally in the case of FBOs. Notably, the reproposal leaves out non-banks that are designated as systemically important by the Financial Stability Oversight Council, but indicates that similar requirements will be applied in the future.

[3] Based on this control test, an affiliate should be consolidated with its “parent” if the parent (a) directly or indirectly, controls, or has power to vote at least 25% of any class of voting securities of the entity, (b) controls the election of a majority of the directors or trustees of the entity, or (c) exercises a controlling influence over the management or policies of the entity.

[4] Consolidation under US GAAP is based on a 50% ownership threshold.

[5] Compliance will be required one year after the rule’s effective date for Covered Banks with greater than $250 billion in total consolidated assets (or greater than $10 billion in on-balance sheet foreign exposures), and two years after the effective date for Covered Banks with less than $250 billion in total assets.

[6] See PwC’s First take, Enhanced Prudential Standards (February 2014).

[7] See PwC’s First take, Ten key points from Basel’s new large exposure framework (April 2014).

[8] Allowance for Loan and Lease Losses (“ALLL”)

[9] See note 3.

[10] Separately, Covered Banks must also recognize exposures to collateral or credit protection issuers (e.g., credit enhancement providers) whose failure or distress would result in a reduction in the value of the Covered Bank’s investment in the SPV.

[11] See PwC’s First take, Five key points from Basel’s proposed restrictions on internal models for credit risk (April 2016).

[12] See PwC’s Regulatory brief, Foreign Banks: Resolution plans meet IHCs (February 2016).

This post comes to us from PwC. It is based on the firm’s A Closer Look, “Counterparty credit limits: do you know where your exposures are?”, dated October 2016 and available here.