By R. Christian Bruce

The Federal Reserve Board Dec. 20 asked for comment by March 31 on a tougher set of regulatory standards for financial firms critical to the well-being of the financial system, leaving some specific items, such as a special risk-based surcharge, to be addressed in follow-up proposals.

The 173-page proposal, which implements Sections 165 and 166 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, mandates new capital, liquidity, stress testing, risk management, and other requirements for banking firms with $50 billion or more in assets.

It also sets the basic ground rules for a class of nonbank financial firms that the Financial Stability Oversight Council (FSOC) may later determine to be, in the words of the proposal, “a grave threat to financial stability.”

Broad Impact Certain

Experts said the importance of the Dec. 20 proposal is almost impossible to exaggerate. Joseph Engelhard, senior vice president of Capital Alpha Partners, a Washington, D.C., area firm that provides research and analysis for institutional investors, called Section 165 “the single most important section of Dodd-Frank” for banks.

Michael E. Bleier, a partner in the Pittsburgh offices of Reed Smith, Dec. 20 called the Fed’s rules the most significant since 1971, when the Fed reshaped bank holding company regulation with the release of Regulation Y.

“They will likely have a major impact on investors and how these companies’ share price is impacted, and what steps they must take to meet the higher capital requirements that will surely be an outcome of the rulemaking process,” Bleier told BNA…

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By Thecla Fabian

The Federal Deposit Insurance Corporation (FDIC) Sept. 13 cleared a final rule on so-called living wills mandated for certain large banks and critical nonbank financial firms, along with some extra time to put those plans in place.

The rule, mandated under the Dodd-Frank Wall Street Reform and Consumer Protection Act, affects three classes of institutions:

• Bank holding companies with $50 billion or more in assets;

• Foreign bank holding companies regulated by the Federal Reserve Board with $50 billion or more in assets, and;

• Nonbank systemically important financial institutions (non-bank SIFIs) designated as risks to U.S. financial stability by a new council of regulators and made subject to bank-like regulation by the Fed.

No one yet knows which companies make up that last group. The Financial Stability Oversight Council (FSOC), which Dodd-Frank created to monitor and respond to systemic risks, is working on rules that will govern how it designates certain firms that might cause wider damage should they collapse.

The FSOC has not yet put any firm in that category, but once it does, any firm designated as systemically important would have to submit to regulators its own so-called living will, which would be a detailed plan showing how the firm would unwind itself under the Bankruptcy Code.

The rule approved by the FDIC Sept. 13 sets out the requirements for those plans.

Fed Must Approve

The Federal Reserve Board also must approve the joint rule, which will come into effect 30 days after it is published in the Federal Register. The Fed is expected to act soon.

The final rule currently applies to some 124 bank holding companies, most of which are foreign-owned, an FDIC official said. In the future, it also will apply to companies designated by FSOC as systemically significant, he added.

A Sept. 9 FDIC staff memo to the board stressed that the final rule did not focus on simple disclosure of additional information about business operations, but rather required a strategic analysis by the company of how it can be resolved in a way that does not pose systemic risk to the financial system.

This strategic analysis will require a number of key analytical elements, including a description of the company’s critical thinking detailing how, in practice, it could be resolved under the Bankruptcy Code, as well as analytical support for the plan, its key assumptions, and how it would be implemented under different stress scenarios.

If the company cannot be resolved under the Bankruptcy Code and resolution goes to the FDIC under Title II of the Dodd-Frank Act, the living will give the FDIC access to enhanced understanding of the company’s foreign operations if the U.S. regulator and its foreign counterparts must develop a comprehensive and coordinated resolution strategy for a cross-border firm.

Rules Crafted with Lehman In Mind

A Treasury Department official recently said the FSOC is working on a revised set of rules for designating which firms should be considered as nonbank SIFIs (97 BBR 289, 8/23/11).

However, the Dodd-Frank Act also gives the FDIC new authority to resolve those firms under separate procedures if a traditional bankruptcy filing would cause wider damage.

The new procedures are designed to avoid a replay of financial stress that came in the wake of the September 2008 Lehman Brothers bankruptcy.

The FDIC rule takes effect 30 days following publication in the Federal Register. The Fed is expected soon to approve its version of the regulation.

The rule could affect money market funds, insurance companies, hedge funds, and other non-bank financial firms that might be designated as nonbank SIFIs by the FSOC.

However, the final rule will apply right away to 124 bank holding companies, most of which are foreign-owned, an FDIC official said…

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Commercial banks and thrifts reported an aggregate profit of $29 billion in the first quarter of 2011, the highest quarterly net income since the 2007 onset of the financial crisis, according to the latest Federal Deposit Insurance Corporation Quarterly Banking Profile, released May 24.

FDIC Chairman Sheila Bair also predicted that the deposit insurance fund would be back in positive territory by the end of the current quarter (June 30).

Bank profits were up $11.6 billion, or 66.5 percent, in the first quarter compared to the first quarter of 2010. The first quarter of 2011 was the seventh consecutive year-over-year quarterly increase for insured institutions, according to the latest QBP.

Reduced loan loss provisions drove the improvement in earnings, FDIC said.

The industry as a whole is showing continuing signs of improvement, Bair said at a briefing to roll out the latest QBP. However, she added that there is a limit to how far reductions in loan loss provisions can go to boost industry earnings.

More Than Half of Banks See Better Income

More than half of all insured institutions (56 percent) reported better quarterly net income than in the first quarter of 2010, FDIC said, and added that only 15 percent had a net loss for the quarter. The average return on assets (ROA)—considered a basic yardstick of profitability—rose to 0.87 percent from 0.53 percent a year ago.

First-quarter loss provisions totalled $20.7 billion, less than half of the $51.6 billion that insured institutions had set aside in the first quarter of 2010. However, the FDIC pointed out that reduced revenues offset some of the benefits from the lower loss provisions.

Net operating revenue (net interest income plus total non-interest income) was $5.5 billion (3.2 percent) lower than in the first quarter of 2010, and realized gains on securities fell by $1.7 billion.

The latest QBP found that bank asset quality continued to improve as noncurrent loans and leases (those 90 days or more past due or in non-accrual status) fell for the fourth consecutive quarter. Insured institutions charged off $33.3 billion in uncollectible loans during the first quarter of the year, down $19.9 billion (37.5 percent) from the same quarter in 2010.

Balance Sheets Look Better

Bair said the process of repairing bank balance sheets was “well along,” but not yet complete. In addition, she said that the housing markets remained weak, in part because of continued questions about mortgage servicing problems. The economic recovery, along with borrower demand, remained sluggish, she said.

In the longer term, banks could be exposed to interest rate risk when the economy emerges from this prolonged stretch of unusually low interest rates, she said. In response to a question, she said the FDIC was not seeing any near-term indicators of increased interest rate risk. One of the reasons, she said, is that the dollar has remained strong, maintaining needed investor confidence.

The three-year high in net income was the best in the industry since the $36.8 billion earned in the second quarter of 2007, according to the QBP.

Loan Balances Continue to Drop

The QBP noted that total loans and leases fell for the 10th time in the past 11 quarters. The only exception was the first quarter of 2010, and the increase then resulted from changes in reporting rules, not actual loan growth, FDIC said (94 BBR 1011, 5/25/10).

In the first quarter of 2011, more than 70 percent of all insured institutions reported declines in loan balances. The net decline in loan balances in the first quarter totalled $126.6 billion, or 1.7 percent.

The largest drop in loan portfolios occurred in one-to-four family residential mortgages, which were down $63.8 billion, or 3.4 percent; and credit card balances, down $38.9 billion, or 5.5 percent.

Real estate construction and development loans were down $25.9 billion, or 8.1 percent. Small loans to businesses and farms dropped 2.8 percent during the quarter.

Balances in loans to commercial and industrial borrowers, however, were up for the third consecutive quarter, rising by $18.1 billion or 1.5 percent, but almost half of this growth represented loans to foreign borrowers, according to the QBP.

Revenue Losses Concentrated in Big Banks

Net interest income dropped year over year for the first time since the fourth quarter of 1989, falling by $3.2 billion, or 3 percent, the QBP said. Non-interest income was down $2.2 billion, or 3.7 percent, compared to the first quarter in 2010.

The QBP said that the reduction in net interest income was caused by narrower net interest margins and weak growth in interest earning assets. The drop in non-interest income reflected lower revenues from service charges on deposit accounts, down $1.7 billion, or 17.3 percent, according to the latest call reports, the QBP said. In response to a question, Bair said recent changes in permissible overdraft fees likely were a factor in the drop.

Much of the reduction in net operating revenue was concentrated at the larger institutions, the QBP said, and added that more than half of all institutions (59.5 percent) reported year-over- year increases in net operating revenue: 57.6 percent reported higher net interest income and 52.1 percent reported increased non-interest income.

However, of the 10 largest institutions, which collectively hold more than half of all insured institution assets, six reported year-over-year drops in net operating revenue. Six reported drops in non-interest income and eight reported drops in net interest income.

Asked about higher prudential standards for systemically significant financial institutions, Bair said that was a question for the Federal Reserve, but that surcharges for such institutions also were being discussed as part of the Basel process.

Regulators Must Remain Vigilant

Bair cautioned that regulators must remain vigilant, given the industry’s penchant for going too far, and particularly with the potential for downstream interest rate risk. Now is the time to think about raising prudential standards and reserve rates.

The system is awash with liquidity, and some of the same conditions that led to the last financial crisis have returned, she said. She added that lenders needed to be very firm on lending and capital standards.

Asked about the impact of the Fed’s proposed interchange rules, Bair said they certainly would result in a decline in fee income. However, she said that while interchange caps certainly would hurt community banks, she did not think they alone would send any banks “over the precipice.” But they are another area of stress for small banks, and the reality is that these banks will have to push the costs onto their customers, she said.

Asked about the prospects for the securitization markets, Bair said it would be good for securitization to come back, but only if it were “solid, safe and sustainable.” She said two things will factor into this: risk retention and loan level disclosures. With these mechanisms, “we can get investor confidence back,” she said, adding that securitization needed to be fixed, and it would not come back unless it is fixed.

When asked about a possible extension of the comment period on the interagency risk retention rules, Bair said the agencies were discussing it but had not made a decision yet.

On the topic of “living wills” for the largest, systemically significant institutions, Bair said that she definitely thought these were possible, but that some companies would find them more difficult than others. Some institutions, she said, have evolved into thousands of legal entities but have never bothered to rationalize these entities. The living wills would force them to take a closer look at them…

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