As has been widely reported, FDIC Vice Chairman Thomas Hoenig put forward in remarks to the Institute of International Bankers on Monday, March 13, a “Market-Based Proposal for Regulatory Relief and Accountability” (the “Hoenig Proposal” or the “Proposal”).  If adopted, the Hoenig Proposal would substantially change the regulation of large and complex banking organizations doing business in the United States.

The Hoenig Proposal advances ideas that the Vice Chairman has long advocated concerning a new framework for bank regulation.  In 2015 and 2016, Mr. Hoenig proposed various types of regulatory relief for what he described as traditional commercial banks that maintained an equity-to-assets ratio (i.e., a leverage ratio) of at least 10 percent and met certain additional criteria.  The Proposal put forward earlier this week would apply to banking firms engaged in what are described as nontraditional activities—i.e., it would apply to financial holding companies (“FHCs”).  While the Proposal has no asset size threshold, embedded in it is a new systemic risk framework that would replace much of the approach of the Dodd-Frank Act applicable to the largest and most interconnected banking organizations.  The Proposal is of particular salience in light of statements from the White House that favor a reinstatement of Glass-Steagall-like restrictions of a sort set out in the Proposal, as well as speculation that Vice Chairman Hoenig is a contender to become the Federal Reserve’s Vice Chair for Supervision.

Covered Firms.  The Hoenig Proposal would apply to banking organizations (in practice, principally FHCs) that engage in specified securities market activities, futures market activities, merchant banking activities and insurance underwriting activities (referred to as “Nontraditional Activities”).  These include, for example, any FHC that owns a registered broker-dealer, investment adviser, swaps dealer, major swaps or securities-based swaps participant, futures commission merchant, commodity pool operator, or merchant banking entity.  Any banking organization that holds an Edge Act or Agreement Corporation would also be covered, as would any organization that operates in the insurance underwriting or reinsurance business.   An FHC with an entity that manages hedge funds or private equity funds (an activity not prohibited by the Volcker Rule) is covered, as is any FHC with an entity that sponsors such a fund (although the Volcker Rule prohibits such sponsorship, subject to certain exemptions).  Finally, a banking organization that operates any entity that provides services similar to the categories of entities specifically listed in the Proposal is also covered.

The Proposal would not apply to any banking organization that does not engage in Nontraditional Activities or that does so primarily to provide custodial banking services.  Traditional commercial banks eligible for relief under Vice Chairman Hoenig’s 2015 and 2016 proposals also are exempt from the more recent Proposal.

Separation of “Traditional” and “Nontraditional” Activities at Covered Firms.  FHCs engaged in Nontraditional Activities would be required to create two separately capitalized intermediate holding companies, one for their Traditional Activities (a bank intermediate holding company or “BIHC”) and one for their Nontraditional Activities (a nontraditional intermediate holding company or “NIHC”).  Operations housed in the NIHC would include underwriting, market making, broker-dealer, futures commissions merchant, investment advisory, asset management, investment company, hedge fund or private equity investment, or swap dealing activities.

Limited NIHC Recourse to the “Federal Safety Net”.  NIHCs would not have recourse to “the current federal safety net” (i.e., deposit insurance and Federal Reserve credit, including discount window access) and an FHC’s exposures to its NIHC would be limited.

Capitalization and Organization of the NIHC.  An FHC would be required to capitalize the NIHC by issuing tracking shares that would give investors all of the economic gains and losses of the NIHC (but that would not necessarily give investors claims to any of the assets of the FHC or the NIHC).  The NIHC could issue debt directly or take on other liabilities but its parent FHC could not hold more than 20% of the NIHC’s liabilities and debt.

The Hoenig Proposal would obligate an FHC’s board of directors to organize the NIHC as a “resolvable entity,” one that could be resolved through the bankruptcy process.  Although this obligation is not further discussed (and would apply to an FHC of any size), it would, for those FHCs with assets of $50 billion or more, supersede both the current resolution planning requirements and the orderly liquidation authority in Title II of the Dodd-Frank Act.

Regulation of the NIHC.  NIHCs would be supervised by the Federal Reserve and their subsidiaries by either the Securities and Exchange Commission or the Commodity Futures Trading Commission.  NIHCs would be subject to standalone liquidity requirements (as yet unspecified) to limit or eliminate access to the federal safety net and to ensure that if the NIHC were separated from the FHC, the NIHC could continue to function.   NIHCs would be prohibited from engaging in “speculative proprietary trading,” but the Proposal would do so through trader mandates, rather than through the current Volcker Rule requirements.  The affiliate transaction restrictions in section 23A (and section 23B) would continue to apply and would be modified in a way that would apply the quantitative limits to the capital stock and surplus of both the NIHC and the banks under the BIHC.  The Proposal does not further discuss the mechanics.

BIHCs.  BIHCs would be separately capitalized and managed.  Capitalization would not require the use of tracking shares.  The Hoenig Proposal does not discuss separate management in detail, but we would assume that a BIHC and its sister NIHC could not share senior managers or directors.  The Proposal also provides that the risk-mitigating hedging requirements and the prohibitions on investments in hedge funds or private equity in the Volcker Rule would continue to apply.

Corporate Governance.  FHCs would be subject to new corporate governance requirements.  No member of management would be allowed to serve on an FHC’s board of directors.  Taken literally, this requirement would prevent the same individual from serving as both Chairman (or as any other board member) and Chief Executive Officer of an FHC.

An FHC would also be required to create a General Internal Auditor position to report directly and exclusively to the board of directors.   An FHC’s external auditors would be required to be rotated every five years and would be prohibited from providing any service other than “traditional auditing services” to the FHC.

Capital Requirements.  The Hoenig Proposal would make the leverage ratio the primary measure of capital adequacy for FHCs, NIHCs, BIHCs and insured depository institution subsidiaries (IDIs) of BIHCs.  Each BIHC and its subsidiary IDIs would be required to maintain a 10% leverage ratio.  The Proposal does not firmly commit to a specific leverage requirement for FHCs and NIHCs but suggests that 10% would be the appropriate level there as well.   The Proposal also discusses the design of the leverage ratio: the ratio should capture all credit, operational, market, concentration, liquidity, interest rate, off-balance sheet  and other risks.  According to the Proposal, the leverage ratio also should take into account the credit, counterparty, and payment liquidity risks presented by derivatives and other level 2 and level 3 assets.  The Proposal suggests two options for doing so: an enhanced supplemental leverage ratio or recognition only of payment netting.

Regulatory Capital Relief.  For all FHCs (together with their NIHCs, BIHC, and BIHC subsidiary IDIs) that meet the leverage ratio requirements, risk-based capital requirements would no longer be the “primary” measure of capital adequacy.  Specifically, the risk-based capital requirements in the prompt corrective action (“PCA”) regime would be eliminated.  However, other standards to address deterioration in asset quality (such as the Texas ratio) would be added to PCA.

Systemic Risk Regulation.  The Hoenig Proposal intends that the establishment of separate NIHCs and BIHCs and the leverage capital standards would eliminate the need for many of the systemic risk regulations and programs developed under the Dodd-Frank Act.  Among the items that the Proposal would replace are the comprehensive capital analysis and review (CCAR) exercise, stress tests required by the Dodd-Frank Act, the Liquidity Coverage Ratio and the Net Stable Funding Ratio, resolution planning and enhanced prudential standards under section 165 of the Dodd-Frank Act, and the Title II Orderly Liquidation Authority.

Supervision.  Under the Hoenig Proposal, prudential supervision would include certain specific elements.  As part of an examination, an entity would make internal calculations of risk-based capital and liquidity, but these calculations would not be disclosed publicly. Internal stress testing would remain a supervisory tool, notwithstanding the possible elimination of the current testing programs.  An entity would develop its own testing scenarios and assumptions (subject to the approval of its board and its supervisor) commensurate with its own business model and risks.  The regulators would not have authority to set across-the-board scenarios or assumptions.  Regulators would, however, continue to assess the adequacy and soundness of planned capital distributions.  Finally, FHCs would be expected to demonstrate that they had allocated capital internally in a way that would absorb losses that could “emanate from” any risks.

Transition.  The Hoenig Proposal suggests a three-year transition period for any necessary restructuring by an FHC and a five-year transition period for capital requirements.

Prospects for Implementation.  The Hoenig Proposal contemplates significant changes in the current regulation of FHCs that would require new legislation.  While the underlying concept behind the proposal—requiring banks to restructure their activities and increase their leverage capital levels in exchange for regulatory relief—is one that has found some favor both on the Hill and in the White House, how the Hoenig Proposal may inform any forthcoming legislation is uncertain.  There has been no reaction yet from Congress or from the Administration.

This post comes to us from Covington & Burling LLP. It is based on a post on their Financial Services blog, “FDIC Vice Chairman Hoenig’s Proposal for Regulation of Financial Holding Companies,” dated March 15, 2017, and available here.