Counterparty Credit Risk Roundtable April 6, 2011

Transcription

1 Updated 4/16/11 Table of Contents Counterparty Credit Risk Roundtable April 6, 2011 Detailed Outline of Regulatory Framework I. Introduction...1 A. Financial crisis brought new focus on U.S. and international capital and liquidity regimes, and perceived systemic risks posed by large institutions and activities with the potential to substantially disrupt financial markets...1 B. Result...1 II. The Orderly Liquidation Authority and Counterparty Credit Risk...1 A. Overview...1 B. Implementation...2 C. Coverage...3 D. Treatment of QFCs...4 E. Bridge Financial Companies...6 F. Treatment of Creditors of Similar Priority...10 G. Haircut Study...12 H. Use of CCPs...12 III. New Capital Burdens...13 A. General Capital and Liquidity Burdens...13 B. Potential Capital Burdens Specific to Counterparty Risk...16 C. Practical Implications...20 IV. Limits on the Counterparty Exposure of Banking Institutions...21 A. At the Consolidated Entity Level...21 B. At the Bank Level...21 C. Affiliate Transactions...22 V. Dodd-Frank Act and Swap Counterparty Risk...22 A. Overview...22 B. Capital and Margin Requirements...22 C. Clearing of Swaps...25 D. Proposed Rule on Financial Resources Requirements for DCOs and SIDCOs...26 E. Other Dodd-Frank Act Related Swap Counterparty Issues...27 F. Absence of International Coordination...27 Appendix A: Collins Amendment Phase-in Timeline Appendix B: Basel III Capital Component and Phase-in Timeline Authors: Gregory Lyons ; Emilie Hsu ; i Debevoise & Plimpton LLP

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3 I. Introduction A. Financial crisis brought new focus on U.S. and international capital and liquidity regimes, and perceived systemic risks posed by large institutions and activities with the potential to substantially disrupt financial markets. B. Result: The most significant change in banking law since the Great Depression 1. Dodd-Frank, which calls for 240 rule-making processes and nearly 70 studies by 11 different regulators, and 2. The Basel III framework, with higher minimum capital requirements and new conservation and countercyclical buffers, revised risk-based capital measures, a new leverage ratio, and two new global liquidity standards. 3. Some provisions of Dodd-Frank are already effective, but many provisions will become effective on July 11, 2011, or after rules are written. 4. It is impossible now to know the full repercussions of the Dodd- Frank Act and Basel III framework, or their cumulative effect, but some things are (unfortunately) clear. II. The Orderly Liquidation Authority and Counterparty Credit Risk A. Overview: Title II of Dodd-Frank provides a framework for the liquidation of certain large financial institutions, the failure of which it is determined would pose systemic risk to U.S. financial stability. 1. In response to the market disarray surrounding Bear Stearns, Lehman Brothers and AIG, the Orderly Liquidation Authority is meant to provide an infrequent alternative to bankruptcy or bailout, allowing for the quick wind-down of large, interconnected financial companies in an orderly manner. 2. The resolution process would ensure that there is the necessary liquidity to complete transactions that are in process at the time of failure, thus addressing the potential for systemic risk without creating the expectation of a bailout. (Testimony of FDIC Chair Sheila Bair, Senate Banking Committee, July 23, 2009) 1 Debevoise & Plimpton LLP

4 3. Section 214 of Dodd-Frank provides that all financial companies put into receivership under the Orderly Liquidation Authority must be liquidated; there will be no bail-out. However, the FDIC may create a bridge financial company to continue any or all of the operations of the covered financial institution. B. Implementation: The Orderly Liquidation Authority is intended to be used rarely, only with firms that are thought to be too big to fail and if bankruptcy is deemed to present too much of a threat to the U.S. economy; bankruptcy remains the preferred regime for resolving failed financial institutions. 1. Per Section 203 of Dodd-Frank, triggering the Orderly Liquidation Authority requires: a. A recommendation by a two-thirds vote of the FRB; b. A recommendation by a two-thirds vote of the FDIC (or the SEC if the largest subsidiary is a registered broker-dealer; or the FIO if the largest subsidiary is an insurance company); c. A determination by the Treasury Secretary after consulting with the President; and d. A review by a federal district court (unless the company consents). 2. Section 209 of Dodd-Frank requires the FDIC (in consultation with the Financial Stability Oversight Council) to make rules and regulations necessary or appropriate to implement Title II; such rules should be harmonized with existing insolvency laws wherever possible. a. Dodd-Frank gives no time frame for this rule-making; but the first Notice of Proposed Rulemaking was issued October 12. Additional interim and proposed rulemakings were issued on January 25, 2011 and March 23, Debevoise & Plimpton LLP

5 C. Coverage: The Orderly Liquidation Authority may only be applied to nonbank financial companies. 1. This is a broad category, extending possibly to broker-dealers, investment advisers, investment banks, and other asset management firms. 2. Financial company means: a. A bank holding company. b. A non-bank financial company supervised by the FRB (because it has been determined systemically significant ). c. Any company that is predominately engaged in financial activities, 1 that is, under the FDIC s March 23 Notice of Proposed Rulemaking, if: i. At least 85 percent of the total consolidated revenues of such company (determined in accordance with applicable accounting standards) for either of its two most recent fiscal years were derived, directly or indirectly, from financial activities, or ii. Based upon all the relevant facts and circumstances, the FDIC determines that the total consolidated revenues of the company from financial activities constitute 85 percent or more of the total consolidated revenues of the company. d. Any subsidiary of any of the above (other than a bank or insurance company) that is predominantly engaged in BHC Act Section 4(k) financial activities. (Dodd-Frank Section 201(a)(11)) 1 Financial activities include: (i) any activity, wherever conducted, described in 12 CFR or any successor regulation, (ii) ownership or control of one or more depository institutions, or (iii) any other activity, wherever conducted, determined by the FRB, in consultation with the Secretary of the Treasury, under section 4(k)(1)(A) of the BHC Act, to be financial in nature or incidental to a financial activity. 3 Debevoise & Plimpton LLP

6 3. Liquidation of covered financial companies administered by: a. FDIC All covered financial companies other than brokerdealers and insurance companies. b. SIPC (to be appointed liquidation trustee by FDIC) registered broker dealers. i. SIPC must conduct a liquidation in accordance with SIPA; but the rights and obligations of any counterparty to a qualified financial contract ( QFC ) (discussed below) will be governed exclusively as provided by Section 210 of Dodd- Frank, notwithstanding any contrary SIPA provision. c. If an insurance company is a covered financial company (or subsidiary or affiliate of a covered financial company), its liquidation will be conducted under state law. 4. Insured depository institutions are not covered financial companies; liquidation of insured depository institutions is governed as provided under the Federal Deposit Insurance Act. 5. A registered mutual fund is not deemed a subsidiary of a covered financial institution unless the institution (together with its affiliates) owns 25% or more of the interests in the fund. D. Treatment of QFCs: Dodd-Frank prescribes the rights of counterparties to certain QFCs with the covered financial company. 1. Any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement, and any similar agreement that the FDIC determines is a QFC under Section 210(c)(8)(D) of Dodd-Frank. 2. Ipso Facto Termination Rights Limited Stay (Dodd-Frank Section 210(c)(10)(B)) a. Once the FDIC has been appointed receiver: i. parties to QFCs may not exercise termination rights triggered by the appointment or the insolvency or financial condition of the covered financial company so-called ipso facto clauses: 4 Debevoise & Plimpton LLP

7 (1) until 5:00 p.m., Eastern time, on the business day after appointment; or (2) if earlier, after receipt from the FDIC of notice of transfer of the QFC to a bridge financial company or other financial institution that is not the subject of an insolvency proceeding. b. Similarly, contracts entered with subsidiaries of the covered financial institution that are guaranteed by the covered financial institution may not be terminated based on the insolvency or receivership of the covered financial institution, provided the guarantee is transferred to a bridge financial company or other entity. (Dodd-Frank Section 210(c)(16)) c. The exercise of other termination rights not triggered by ipso facto clauses are not stayed. d. Drafting has left some ambiguity in the scope of the stay, which applies to termination rights exercisable solely by reason of or incidental to the appointment of the FDIC as receiver or insolvency or financial condition of the covered financial company. i. For example, would a termination right triggered by a failure to post additional collateral upon a ratings downgrade be stayed as incidental to the financial condition of the covered financial company? 3. Limited Suspension of Obligations (Dodd-Frank Section 210(c)(8)(F)) a. Payment and delivery obligations of the non-covered financial company under a QFC are suspended until the earlier of: i. 5:00 p.m., Eastern time, on the business day after the appointment of the FDIC as receiver, or 5 Debevoise & Plimpton LLP

8 ii. Receipt from the FDIC of notice of transfer of the QFC to a bridge financial company or other financial institution that is not the subject of an insolvency proceeding. b. Any walkaway clause a provision suspending or excusing performance by the non-covered financial company as the non-defaulting party under a QFC triggered by the appointment of the FDIC as receiver or insolvency of the covered financial company is unenforceable. 4. Section 210(c)(1) of Dodd-Frank provides that the FDIC may repudiate contracts if it determines that: a. Performance under the contract would be burdensome, and b. Repudiation would promote the orderly administration of the company s affairs. c. In exercising its right to repudiate QFCs, the FDIC shall either repudiate all or none of the QFCs between any person (or such person s affiliate) and the covered financial company. (Section 210(c)(11)) d. Compensatory damages for repudiation of QFCs will be determined as of the date of the contract s repudiation; they include normal and reasonable costs of cover, but not damages for lost profits. (Section 210(c)(3)(C)) E. Bridge Financial Companies 1. Section 210(h) of Dodd-Frank authorizes the FDIC to organize a bridge financial company (a Bridge ) to continue to operate potentially systemic operations of the failing firm, to prevent a disorderly collapse. 2. As a general matter, the Bridge may assume liabilities and purchase assets of the covered financial company at its discretion. 3. The FDIC may transfer to the Bridge (or to another financial institution that is not itself under receivership; if such other institution is a foreign entity, rights with respect to QFCs must be substantially the same as under Dodd-Frank) either all or none of: 6 Debevoise & Plimpton LLP

9 a. The QFCs between any person (or such person s affiliate) and the covered financial company; b. All claims of the person or the covered financial company under such QFCs (other than claims that are subordinated under the terms of the contract to the claims of unsecured creditors); and c. The property securing or any other credit enhancement with respect to such QFCs. (Dodd-Frank Sections 210(a)(1)(g); 210(c)(9)(A)) d. Note: per informal discussions with FDIC staff, all QFCs are likely to be transferred to the bridge as a practical matter. 4. Although the FDIC must treat similarly situated creditors similarly in exercising its authority to transfer assets and liabilities to a Bridge, it may do otherwise if necessary to maximize the value of the assets of the covered financial company or maximize the value or minimize the loss from the sale or other disposition of assets. 5. If the FDIC establishes a Bridge with respect to a covered broker dealer, it must transfer all customer accounts of the broker dealer and all associated customer name securities and customer property, unless such accounts and property are likely to be promptly transferred to another registered broker dealer, or the transfer would materially interfere with the FDIC s ability to avoid or mitigate serious adverse effects on the U.S. economy. (Section 210(a)(1)(O)) 6. Financial institutions are being encouraged and in the case of systemically significant institutions and bank holding companies over $50 billion, required to design Living Wills to guide the FDIC in its exercise of its Orderly Liquidation Authority in the event the institution fails; Living Wills could help to determine which operations are appropriate for transfer and eventual sale, rather than liquidation. a. By July 21, 2012, the primary federal bank regulators must prescribe regulations requiring that financial companies maintain records with respect to QFCs that would assist the FDIC as receiver in the performance of its obligations with respect to QFCs. 7 Debevoise & Plimpton LLP

10 b. FDIC proposed Living Wills rules on March 29, 2011; comments due 60 days after published in Federal Register. c. For those required to comply, Living Wills due July 21, i. 134 estimated covered entities. ii. Resolution Plan and Credit Exposure Report. 7. Creditors that are counterparties to agreements that have been transferred to a Bridge will be able to enforce and terminate the contracts in accordance with their terms, except that, as noted in II.D.3.b above, walkaway termination rights for QFCs based on the insolvency of the covered financial company will be unenforceable at the FDIC s discretion. a. SIPC, as liquidation trustee of a broker-dealer that is a covered financial institution, will not have any powers or duties with respect to assets and liabilities transferred by the FDIC to a Bridge. b. The FDIC s March 23 Notice of Proposed Rulemaking (Section ) suggests that contracts purchased or assumed by the Bridge cannot later be rejected by the Bridge. 8. Creditors that are counterparties to agreements that have not been transferred to the Bridge will be at greater risk. a. The FDIC s March 23 Notice of Proposed Rulemaking provides that if the FDIC as receiver sells or transfers an asset free and clear of a setoff right that would otherwise be recognized under section 210(a)(12)(A), the party with the setoff right will have a claim in the amount of the value of the setoff established as of the date of the sale or transfer of the asset and the claim will be paid prior to any other general or senior liability of the covered financial company. In the event that the setoff amount is less than the claim, the balance of the claim will be paid at the otherwise applicable level of priority for the claim. 8 Debevoise & Plimpton LLP

11 b. The FDIC could determine to repudiate any contract to which the failing firm is a party within a reasonable time ; repudiation would not permit the avoidance of a perfected security interest in the assets of the failed company (such as collateral received in a securities lending transaction). i. Section 210(c)(1) of Dodd-Frank provides that the FDIC may repudiate contracts if it determines that: (1) performance under the contract would be burdensome, and (2) repudiation would promote the orderly administration of the company s affairs. ii. iii. The FDIC s liability for repudiated contracts generally is limited to actual compensatory damages, determined as of the date of the appointment of the FDIC as receiver. The FDIC s January 25 Interim Final Rule (Section 380.4(b)) provides that damages for repudiation of a covered financial company s contingent obligation shall be no less than the estimated value of the claim as of the date the FDIC was appointed receiver, as measured based on the likelihood that the claim would become fixed and the probable magnitude thereof. 9. Thus, e.g., if a borrower were put in liquidation and securities loans repudiated, the indemnity for counterparty credit risk provided by agent lenders for counterparty credit risk would apply, and if this were to occur in the context of a broader market crisis, agent lenders could be saddled with illiquid collateral, insufficient to cover the indemnification. a. To the extent a borrower posts securities as collateral in a securities lending transaction, the securities lending agent, unable to close out a securities lending transaction with a defaulting borrower, would bear any liquidity risk associated with illiquid collateral. b. An agent lender would be an unsecured creditor of the borrower to the extent of a collateral shortfall. 9 Debevoise & Plimpton LLP

12 F. Treatment of Creditors of Similar Priority 1. Section 210(b)(5) of Dodd-Frank provides that the priority structure will not affect secured claims, except to the extent a creditor is under-secured. a. The FDIC s March 23 Notice of Proposed Rulemaking provides that in the case of a claim secured by property of the covered financial company, the FDIC as receiver shall determine the amount of the claim, whether the claimant s security interest is legally enforceable and perfected; the priority of the claimant s security interest, and the fair market value of the security interest. The portion of the claim that exceeds an amount equal to the fair market value of the property will be treated as an unsecured claim. b. The FDIC s January 25 Interim Final Rule provides that collateral for secured claims will be valued at fair market value as of the date the FDIC was appointed receiver of the covered financial company. c. The FDIC s March 23 Notice of Proposed Rulemaking provides that the FDIC as receiver may sell property of the covered financial company that is subject to a security interest. In the event that the FDIC sells collateral, the purchaser of the property would take free and clear of the security interest, and the security interest would attach to the proceeds of the sale, up to the allowed amount of the secured claim. d. The FDIC s March 23 Notice of Proposed Rulemaking provides that the FDIC as receiver may pay the secured creditor the fair market value of the property subject to a security interest up to the amount of the secured claim in full, and retain the property free and clear of the security interest. 2. Under Section of the FDIC s March 23 Notice of Proposed Rulemaking, unsecured claims have priority in the following order: a. Repayment of debt incurred by or credit obtained by the FDIC as receiver for the covered financial company, provided that the FDIC as receiver has determined that it is 10 Debevoise & Plimpton LLP

13 otherwise unable to obtained unsecured credit for the covered financial company from commercial sources; b. Administrative expenses of the receiver; 2 c. Amounts owed to the United States; 3 d. Wages, salaries and commissions to the extent of $11,275 earned not later than 180 days before the date of appointment of the receiver; e. Contributions owed to employee benefit plans arising from services rendered not later than 180 days before the date of appointment of the receiver; f. Any amounts due to creditors who have an allowed claim for loss of setoff rights; g. Other general or senior liabilities of the covered financial company; h. Obligations subordinated to general creditors; i. Wages, salaries or commissions, including vacation owed to senior executives and directors of the covered financial company; j. Post-insolvency interest on allowed claims; and k. Shareholder, member, general partner, limited partner or other equity interests in the covered financial company; 3. Generally, all similarly-situated creditors will be treated alike, and payments may not be less than the amount that would have been 2 3 Administrative expenses of the receiver include those actual and necessary pre- and post-failure costs and expenses incurred by the FDIC as receiver in liquidating the covered financial company, together with any obligations that the FDIC as receiver for the covered financial company determines to be necessary and appropriate to facilitate the smooth and orderly liquidation of the covered financial company. Amounts owed to the United States includes all amounts due to the United States or any department, agency or instrumentality of the United States government, without regard for whether such amount is included as debt or capital on the books and records of the covered financial company. Such amounts shall include obligations incurred before and after the appointment of the receiver. 11 Debevoise & Plimpton LLP

14 received under Chapter 7 liquidation. (Sections 210(b)(4)(B) and 210(d)(2) and (3)) 4. However, the FDIC does have the ability to make additional payments to certain creditors if necessary to: a. Maximize the value of the assets; b. Initiate and continue essential operations; or c. Maximize the return (or minimize the loss) realized upon the sale or disposition of the assets. The FDIC s interim final rule absolutely bars additional payments to holders of long-term senior debt, subordinated debt, or equity interests that would result in those creditors recovering more than others of the same priority (see January 25 Interim Final Rule, Section 380.2(b)). 5. Section 210(o) of Dodd-Frank requires the FDIC to impose assessments as soon as practicable on any claimant that received any such additional payments, except for payments necessary to initiate and continue operations essential to the receivership or any Bridge (up to the amount of the additional payments). G. Haircut Study: Section 215(a) of Dodd-Frank calls for a study (and report by July 21, 2011) on the possible use of secured creditor haircuts to promote market discipline and protect taxpayers (the House version of the bill had called for haircuts of up to 10% on QFCs with original terms of 30 days or less secured by collateral other than U.S. government and agency paper in the event of a shortfall in the amount owed to the U.S. Treasury in connection with a liquidation). H. Use of CCPs: However unlikely the Treasury Secretary is to use this special liquidation procedure, management of associated risks will impose additional operational burdens on counterparties to a covered institution, and may result in additional capital charges (based on operational risk or otherwise). 1. To the extent the Orderly Liquidation Authority leads to additional capital charges based on counterparty credit risk, it may encourage more widespread use of Central Counterparty (CCP) services in counterparty transactions the Basel Committee has proposed that 12 Debevoise & Plimpton LLP

15 market exposures to CPSS/IOSCO-compliant CCPs should be subject to a 2% risk weight. III. New Capital Burdens A. General Capital and Liquidity Burdens 1. Dodd-Frank Provisions a. Section 165 of Dodd-Frank requires the FRB to develop prudential standards for systemically significant nonbank financial institutions supervised by the FRB and bank holding companies with assets of at least $50 billion. i. Will require both risk-based capital and leverage requirements that are more stringent than those applicable to smaller institutions. ii. iii. iv. Must take into consideration off-balance sheet activities (potentially including indemnities). Must include liquidity requirements. Timing: Section 165 prudential standards have yet to be implemented; the FRB must submit an annual report to Congress regarding their implementation. v. FRB Governor Tarullo Mar. 31, Still in the midst of developing these requirements as well as related international initiatives. Focus on enough capital to absorb stress. b. Section 171 of Dodd-Frank (the Collins Amendment ) requires banking agencies to establish minimum leverage and risk-based capital requirements for the largest US bank holding companies. i. May not be less stringent nor quantitatively lower than for US community banks as of July 21, Debevoise & Plimpton LLP

16 ii. iii. iv. Will reduce the types of capital (such as trust preferred securities and cumulative perpetual preferred securities) that qualify as Tier 1 Capital. Must address the particular risks posed by such institutions to the economy as a whole, including those arising from securities borrowing and lending. Timing: On February 28, 2011, the comment period closed on a notice of proposed rulemaking jointly issued by the OCC, FRB, and FDIC that would require bank holding companies and thrift holding companies to calculate capital charges using both the general risk-based capital rules and the Basel II advanced approaches rules. v. Phase-in varies depending upon institution. See Appendix A. c. Additional well-managed and well-capitalized requirements (all effective July 21, 2011). i. Section 606 of Dodd-Frank requires that all financial holding companies be well-capitalized and well-managed. ii. iii. Section 607(a) of Dodd-Frank requires bank holding companies undertaking interstate acquisitions of banks to be well-capitalized and well-managed. Section 607(b) of Dodd-Frank requires banks resulting from interstate mergers to be wellcapitalized and well-managed. d. The Financial Stability Oversight Council, by a two-thirds vote, determines whether a systemically significant nonbank financial company could pose a threat to US financial stability and will therefore be supervised by the FRB and subject to heightened prudential standards, including higher capital requirements and other restrictions. (Dodd-Frank Section 113) 14 Debevoise & Plimpton LLP

17 i. Timing: On February 11, 2011, the FRB released a notice of proposed rulemaking establishing criteria for determining whether a nonbank financial company was predominately engaged in financial activities, and defining the terms significant nonbank financial company and significant bank holding company for purposes of the FSOC designation. The comment period closed March 30, Basel III Numerator/Ratios (See also Appendix B) a. Reduces the types of capital that qualify as Tier 1 capital, with the deductions phased in over the period from 2013 through i. Note: Generally longer than permissible under the Collins Amendment. b. Creates a new minimum common equity capital ratio, with a numerator consisting exclusively of common stock and equivalents, of 3.5%, beginning January 1, 2013, growing to 4.5% by c. Requires a minimum Tier 1 capital ratio of 4.5% as of January 1, 2013, growing to 6% by d. Requires a minimum total capital ratio of 8% as of January 1, e. Requires a capital conservation buffer of 2.5% which while not part of the minimum requirements a bank will have to maintain or have its ability to pay dividends and discretionary bonuses and engage in stock repurchases restricted; to be phased in beginning January 1, 2016, growing in 0.625% yearly increments to 2.5% by f. Another countercyclical buffer, which will be left to individual country discretion, could, if implemented, add up to another 2.5% to the minimum capital ratios. g. The Basel Committee will test a minimum Tier 1 leverage ratio of 3% during the parallel run period from 1/2013 to 1/2017, including off-balance sheet items; securities 15 Debevoise & Plimpton LLP

18 finance transactions are included as a source of leverage and should be calculated by applying the accounting measure of exposure and the Basel II regulatory netting rules. h. The Basel Committee has stated that systemically important banks should have loss absorbing capacity beyond the minimum standards of the Basel III framework. (See the FSB s February 2011 Report to the G20.) Final regime due by end of i. Reportedly up to a 3% surcharge on largest banks. ii. FRB reportedly prefers graduated approach. i. In January, 2011 the Basel Committee published nonviability contingent capital provision requirements for all internationally active banks that require a write down of Additional Tier 1 or Tier 2 instruments or their conversion upon specified non-viability events or determinations. These low-trigger provisions are required after January 1, 2013 and non-conforming outstanding instruments must be phased out. Canadian OSFI published detailed guidance in February, B. Potential Capital Burdens Specific to Counterparty Risk 1. Dodd-Frank/Market Risk Provisions Denominator a. As noted above, Section 165 of Dodd-Frank requires regulators to take into account off-balance sheet activities (potentially including securities finance, securities contracts and direct credit substitutes). b. Section 171 of Dodd-Frank requires the development of capital regulations for the largest banking institutions that address the risks of certain activities to the economy as a whole, expressly including derivatives and securities finance. c. As a general matter, it is likely that certain non-core activities will be assigned higher risk weights. 16 Debevoise & Plimpton LLP

19 d. Federal agencies are required by Section 939A of Dodd- Frank to modify regulations to remove any reference to or requirement of reliance on credit ratings and to substitute them with an alternative standard of credit-worthiness. i. Decreased reliance on credit ratings agencies could make it more difficult to calculate counterparty credit risk. ii. On February 16, the SEC proposed a rule that would replace rule and form requirements under the Securities Act and the Exchange Act for securities offering or issuer disclosure rules that relied on or made accommodations for security ratings. The comment period for the proposal closes on March 28, e. Separately from Dodd-Frank, the US banking agencies published a proposed market risk rule to implement Basel 2005 and 2009 market risk publications. i. Applies to banks with trading assets/liabilities equal to at least 10% of total assets or $1B. ii. iii. iv. Covered positions modified to include positions held for short-term resale/price movement; hedges of such positions, F/X, commodity positions. Risks captured expanded to include VAR-based, stressed (weekly) VAR-based, specific (non-general market-based) and incremental (default) risk addons, comprehensive risk and de minimis exposures. Securitizations treatment hampered by Dodd-Frank section 939A. (See III.B.1.d above) v. Proposal estimates that average market risk measure up 300%, increasing minimum required capital by $57.7B. vi. Comments due by April 11, Debevoise & Plimpton LLP

20 2. Basel III Final Capital Provisions Denominator a. Higher risk weights, particularly for non-core activities like securities finance and similar counterparty credit risk activities (focus on Internal Models Method ( IMM ) Exposure). b. To determine default risk capital charge for CCR, banks must use higher of portfolio-level capital charge based on Effective EPE, and the charge based on Effective EPE using a stress calibration. i. Meant to capture general wrong-way risk. ii. Stress calibration uses three years of data, including period of stress to credit default spreads. c. Banks will be subject to a capital charge for potential markto-market losses (i.e., credit valuation adjustment risk) associated with deterioration in the credit-worthiness of a counterparty. i. Creates a bond equivalent approach intended to cover risk of mark-to-market losses on expected counterparty risk to OTC derivatives (in addition to default risk capital requirements). ii. iii. Transactions with CCPs, and securities finance transactions, generally excluded. Certain types of CDSs provide only effective hedge. d. Basel III applies a 1.25x correlation capital charge multiplier to the asset value correlation of regulated FIs with assets of at least $100B, and unregulated FIs, regardless of size. e. Basel III increases the minimum margin period (a component of the IMM under Basel II) from 5/10 to 20 days for netting sets if the number of trades during a quarter exceeds 5,000, or if illiquid or bespoke collateral is used. 18 Debevoise & Plimpton LLP

21 f. The leverage ratio includes off balance sheet items (applying a uniform 100% credit conversion factor), including commitments (including liquidity facilities), unconditionally cancelable commitments, direct credit substitutes, acceptances, standby and trade letters of credit, failed transactions and unsettled securities. Note special treatment of securities finance. Allowed to do Basel II netting. Per Norah Barger (FRB), exposure is current exposure where master netting agreement in place (no PFE). Typically results in zero exposure for leverage purpose. (2/27/11 ) g. The Basel Committee is undertaking what it calls a fundamental review of the trading book framework (targeted for completion by year-end 2011) to determine whether or not the distinction between the banking and the trading book should be maintained, how trading activities are defined and how risks in trading books (and possibly market risk more generally) should be captured by regulatory capital. (See the Basel Committee s October 2010 Report to the G20) h. In addition to numerical enhancements, Basel III also dictates more specific requirements than Basel II for collateral departments, as well as model validation and backtesting. 3. Basel III Liquidity Proposals a. Basel III replaces the policy of regulatory discretion regarding bank liquidity requirements with new short- and long-term liquidity ratios. b. The requirement to maintain high quality, highly liquid assets in an amount correlated with the perceived potential for liquidity outflows will likely have an adverse effect on the overall net interest margin of a bank. c. National regulators have discretion to determine the liquidity risk impact of and appropriate run-off rates for contingent funding liabilities and non-contractual obligations (such as cash collateral pools). 19 Debevoise & Plimpton LLP

22 d. Basel III calls for a liquidity coverage ratio and a net stable funding ratio to be introduced as minimum standards in 2015 and 2018, respectively. C. Practical Implications: 1. Capital numerator limitations and increases in risk capital charges will put pressure on bank operators. Liquidity issues may force holding of lower-earning assets to support perceived risky activities; there is a danger that these requirements will be more severe than is warranted, particularly if the implementation of Dodd-Frank and Basel III is not coordinated. a. For instance, a Swiss proposal calls for its largest banks (UBS; Credit Suisse) to hold minimum capital well above Basel III levels around 40% more common equity and 80% more total capital than Basel III alone would require. - Final legislation due in fall b. Standard Chartered Plc announced a 3.3 billion-pound rights offer on October 13. Market analysts have suggested that may induce a race to the top, forcing other European banks to raise capital in excess of the Basel III minimum. c. An example of the mounting market pressure to meet and even exceed new capital requirements can be found in Italian banks, which in part because they are among the lowest capitalized in Europe are trading at a 20 percent discount to tangible book value. (Financial Times, October 24, 2010, Italian Banks on the Ropes After Basel III ) d. Credit Suisse announced a US $2B offering of Tier 2 Buffer Capital Notes. One of the first successful high trigger CoCo issuances. (See March 2011 FIR) 2. As capital constraints applicable to large regulated institutions become more onerous, they are likely to push more activity into the unregulated shadow banking sector; Dodd-Frank and Basel III focus mainly on large regulated institutions, but the FRB is aware of the implications of recent reforms for regulatory arbitrage, and has begun to explore ways of regulating the shadow banking system. (See FRB Governor Daniel K. Tarullo, 20 Debevoise & Plimpton LLP

23 September 17, 2010, Comments on Regulating the Shadow Banking System ) FSB Report to be released in autumn IV. Limits on the Counterparty Exposure of Banking Institutions A. At the Consolidated Entity Level: 1. Section 165 of Dodd-Frank limits the aggregate exposure, expressly including exposures from guarantees, securities finance and derivatives, of a systemically significant nonbank or bank holding company to any unaffiliated company to 25% of the banking institution s capital and surplus (or such lower amount as the FRB may determine appropriate by regulation). 2. Although the FRB has the authority to issue regulations or interpretations with respect to the manner in which netting agreements may be taken into account in determining the credit exposure to an affiliate of a member bank for purposes of the affiliate transaction rules (see Section 608(a)(4)(B) of Dodd- Frank), the Dodd-Frank Act does not similarly address how netting might be taken into account for purposes of determining credit exposure of systemically significant institutions to unaffiliated companies. 3. These concentration limits will not take effect until July 21, The FRB is permitted (but not required) to limit short-term debt, which would presumably include securities finance and other transactions. B. At the Bank Level: 1. Section 610 of Dodd-Frank amends the lending limits provisions applicable to national banks to expressly include exposures from securities finance arrangements, as well as derivatives; thus, a national bank s indemnification exposure with respect to a borrower cannot exceed 25% of its capital and surplus. 2. Historically, limitations on national banks have been viewed as a model for states when regulating state banks. Section 611 of Dodd-Frank amends the FDIA to prohibit insured state banks from engaging in derivatives transactions unless the state s lending limit 21 Debevoise & Plimpton LLP

24 laws take into consideration credit exposure to derivatives transactions. C. Affiliate Transactions 1. Section 608 of Dodd-Frank defines affiliate to now include any investment fund (whether or not a registered mutual fund and whether or not an investment is made) where an FRB member bank or an affiliate serves as investment adviser. 2. Section 608 of Dodd-Frank requires the FDIC, in addition to a bank s primary regulator, to assent before any decision is made to grant a waiver from the affiliate transaction restrictions. 3. Potential Implications: The affiliate transactions rules are not new, but now include investment funds, and it will be tougher to get an exemption because exemptive authority for 23A will be shared by the OCC and the FDIC. V. Dodd-Frank Act and Swap Counterparty Risk A. Overview The financial crisis in 2008 brought to light how interconnected financial institutions are with each other and the important role played by derivatives transactions in our financial system. The current administration believes that the lack of regulation over the derivatives market exacerbated the crisis and created the situation, in which the demise of one financial institution could result in the collapse of the entire financial system. To prevent this domino effect in the future, the Dodd-Frank Act sought to impose capital, margin and various risk management requirements on financial institutions and parties that hold large positions in derivatives. In addition, the CFTC and the SEC will require all derivatives transactions to be reported to appropriate regulators. A number of the regulations prescribed by the Dodd-Frank Act will have an impact on counterparty risk analysis. B. Capital and Margin Requirements Section 731 of Dodd-Frank will impose new capital and margin requirements on Swap Dealers ( SD ) and Major Swap Participants ( MSP ). 22 Debevoise & Plimpton LLP

25 1. Swap dealer means any person who: a. holds itself out as a dealer in swaps; b. makes a market in swaps; c. regularly enters into swaps in the ordinary course of business for its own account; or d. engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps. 2. A swap dealer does not include an entity that engages in a de minimis amount of swap dealing in connection with transactions with or on behalf of customers. 3. Major swap participant generally means any person who is not a swap dealer, and: a. maintains a substantial position in any major category of swaps, excluding (a) positions held for hedging or mitigating commercial risk and (b) positions maintained by any ERISA plan for the purpose of hedging or mitigating risk directly associated with the operation of the plan; b. whose swaps create substantial counterparty exposure that may have serious adverse effects on the stability of the U.S. financial system; or c. (a) is a financial entity that is highly leveraged relative to the amount of capital it holds and not subject to capital requirements established by a federal banking agency; and (b) maintains a substantial position in any major swap category. 4. SDs and MSPs that are banks ( Bank Swap Entities ) will have to meet minimum capital, initial and variation margin requirements to be determined by the appropriate prudential regulators (e.g., the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation), in consultation with the CFTC and the SEC. 23 Debevoise & Plimpton LLP

26 5. SDs and MSPs that are not banks will have to meet minimum capital, initial and variation margin requirements to be determined by the CFTC or the SEC (for SDs and MSPs of security-based swaps). 6. While the uncleared swaps will be subject to regulatory margin requirements, swaps that are cleared will be subject to margin requirements of the clearing organizations. 7. On April 12, 2011, the banking prudential regulators issued proposed rules for the margin and capital requirements on Bank Swap Entities, and the CFTC also issued proposed rules for margin requirements for SDs and MSPs that are not Bank Swap Entities and that are subject to the CFTC s regulation. The SEC has not issued corresponding rules for security-based swaps yet. 8. With respect to capital requirements for Bank Swap Entities, the prudential regulators proposed that such entities shall continue to comply with the existing applicable regulatory capital rules. However, the regulators also note that there will soon be new changes to the regulatory capital regime to implement the Basel III regulatory framework. 9. With respect to margin requirements, Bank Swap Entities will be required to collect initial and variation margins, depending on the status of the counterparties. The margin requirements will apply to swaps entered into after the effectiveness of the margin rules. 10. The prudential regulators proposed four scenarios for margin collection depending on the status of the Bank Swap Entities counterparties: a. Counterparties are also Bank Swap Entities the Bank Swap Entity must collect initial and variation margins without any threshold of permitted credit exposure, and the initial margin must be held at an independent, third-party custodian. Variation margin must be collected at least daily. b. Counterparties are high-risk financial end users the Bank Swap Entity must collect initial and variation margins without any threshold of permitted credit exposure. A high-risk financial end user is a financial entity (as otherwise defined in Title VII of Dodd-Frank, which is 24 Debevoise & Plimpton LLP

27 C. Clearing of Swaps essentially an entity that engages in financial activities) that is not a low-risk financial end user (as defined below). Variation margin must be collected at least daily. c. Counterparties are low-risk financial end users the Bank Swap Entity must collect initial and variation margins, but the low-risk financial end users can benefit from a threshold of permitted credit exposure for either type of margin, which is capped at the lesser of (i) an amount equal to $15 to $45 million and (ii) a percentage of the Bank Swap Entity s capital equal to 0.1 to 0.3% (both numbers to be finalized in the final rules). Variation margin must be collected at least daily. i. A low-risk financial end user is defined as a financial entity that: (1) does not have a significant swap exposure, (2) predominantly uses swaps to hedge or mitigate the risks of its business activities, including balance sheet, interest rate, or other risk arising from its business, and (3) is subject to capital requirements established by a prudential regulator or state insurance regulator. d. Counterparties are nonfinancial end users the Bank Swap Entity is not obligated to collect initial or variation margin unless the Bank Swap Entity s credit exposure to a nonfinancial end user exceeds the limits established under appropriate credit processes and standards established by the Bank Swap Entity. If the Bank Swap Entity collects margin, it must do so at least weekly. All swaps will have to be cleared unless an exception or an exemption applies. The rationale for clearing requirements is to minimize counterparty risk that financial institutions and large swap-holders have to each other. Further, to manage the risk of centralized counterparty risk, once swaps are cleared through clearing houses, the CFTC and the SEC will impose certain capital requirements and on-going risk management 25 Debevoise & Plimpton LLP

28 procedures on derivatives clearing organizations ( DCO ) to minimize the risk of a DCO failure. Generally, there are two ways swaps can be cleared through a DCO, and either situation presents slightly different counterparty risk analysis. 1. Two types of clearing arrangements: (i) clearing members acting as agents and (ii) clearing members acting as principals. When the clearing member is acting as an agent, the customer s credit exposure is ultimately to the DCO. When the clearing member is acting as the principal, the customer is exposed to the credit risk of the clearing member, and the clearing member is exposed to the credit risk of the DCO. The credit risk is different in either situation the customer is exposed to different counterparty risk. 2. Consider that while a DCO guarantees the performance of the swaps to the customer, a clearing member does not guarantee the performance of a DCO to the customer. In case a DCO fails, the customer cannot look to the clearing member for performance. However, when a clearing member acts as the agent of a customer, the clearing member guarantees the performance of the customer to the DCO, so will need to collect sufficient margin from the customer to make payments to the DCO; therefore, the margin required by the clearing member from the customer typically exceeds what the DCO actually requires the clearing member to post with respect to the customer s transactions. 3. What will margin/collateral maintenance requirements be for cleared swaps? The DCO is not likely to post collateral to the customer (through the clearing member). 4. Gross vs. net margin posting: will a clearing organization permit the netting of margin posting for all transactions of a customer? Does the clearing member itself post margin on a gross or net basis with the clearing organization? 5. If a customer uses multiple clearing members or multiple DCOs to manage credit exposure to any one clearing member or DCO, the customer will not be able to net margin posting so may end up with potentially greater amounts at risk. D. Proposed Rule on Financial Resources Requirements for DCOs and SIDCOs 26 Debevoise & Plimpton LLP

29 1. Requirement for swaps to be cleared through DCOs does not completely eliminate counterparty risk, so to manage the risk of a DCO failure, the CFTC has issued proposed rules that impose minimum financial resource requirements (to meet obligations to its clearing members and to cover operating expenses) on each DCO and systemically important DCO ( SIDCO ). 2. Through regulation on DCOs and SIDCOs, the CFTC will try to mitigate the new counterparty risk that every swap participant will have with respect to the cleared swaps. E. Other Dodd-Frank Act Related Swap Counterparty Issues 1. OLA and Swaps: The CFTC has proposed a rule requiring parties to insert in swap documentation language acknowledging that OLA may apply to one s counterparty; consequently, one s contractual right to terminate may be limited or one s swaps (and associated collateral) may be transferred. 2. Swap Push-Out and Limitation on Set-Off: For banks that will need to push out some of their swap business to a different entity, consider enforceability risks of triangular set-off in case of the bankruptcy of the counterparty. 3. Segregation of Independent Amount: Counterparties to an SD and an MSP can require the segregation of initial margin at an independent custodian. This new regulatory requirement highlights the need for negotiating good tri-party custodial agreements, and each SD and MSP should evaluate its new exposure to custodian s default/insolvency risks with respect to initial margin. 4. Business Conduct Rules and Potential Litigation Risks: The additional burdens imposed on swap dealers (e.g., KYC due diligence, reasonable basis to believe representations received, disclosure of material risks of swaps, disclosure of material characteristics of swaps, disclosure of conflicts of interest, providing daily marks, suitability requirement for recommendations, etc.) may open swap dealers to potential litigation risks by counterparties. F. Absence of International Coordination 27 Debevoise & Plimpton LLP