Bank Capital Requirements: Federal Reserve Board Proposes Rule Establishing Common Equity Surcharge on U.S. Global Systemically Important Banks

Sullivan & Cromwell LLP - December 14, 2014

On December 9, the Board of Governors of the Federal Reserve System (the “FRB”) issued a Notice of Proposed Rulemaking (the “Proposed Rule”) to establish risk-based capital surcharges for systemically important U.S. bank holding companies (“BHCs”).  The Proposed Rule implements for these U.S. BHCs the framework developed by the Basel Committee on Banking Supervision (“BCBS”) and published by the Financial Stability Board (the “FSB”) (the “Basel G-SIB Framework”) for assessing a common equity surcharge on certain global systemically important banks (“G-SIBs”).  Like the Basel G-SIB Framework, the Proposed Rule establishes an indicator-based approach for determining which BHCs are U.S. G-SIBs and the amount of the risk-based capital surcharge that will be applied to each G-SIB.  The Proposed Rule, however, would result in higher surcharges than under the Basel G-SIB Framework, with expected surcharges ranging from 1.0% to 4.5%, as compared to 1% to 2.5% under the Basel G-SIB Framework, and includes a new indicator to address the perceived risks of short-term wholesale funding (the “STWF Score”).  The Proposed Rule generally follows the Basel G-SIB Framework in approach by implementing the charge as an extension of the capital conservation buffer that can only be satisfied with Common Equity Tier 1 (“CET1”) capital.
The Proposed Rule also retains the surcharge calculation from the Basel G-SIB Framework (referred to as “Method 1”), but uses it as a floor. Under the alternative calculation approach in the Proposed Rule (referred to as “Method 2”), the STWF Score replaces the “substitutability” systemic indicator in the Basel G-SIB Framework.  The Preamble to the Proposed Rule notes that this change is designed to “address the G-SIB’s susceptibility to failure” by increasing the surcharge based on a G-SIB’s short-term wholesale funding use rather than its substitutability, as a “more effective means of requiring a G-SIB to internalize the externalities it imposes on the broader financial system and reduce its probability of failure.”  Short-term wholesale funding sources would include secured funding transactions, unsecured wholesale funding transactions (excluding operational deposits), certain asset exchanges, short positions in securities, and retail brokered deposits and brokered sweep deposits (each as defined in the U.S. Liquidity Coverage Ratio Rule, the “LCR Rule”), risk-weighting the sources of short-term wholesale funding by type and maturity in a grid approach.

Based on year-end 2013 data, the FRB estimates that G-SIB surcharges under the Proposed Rule would apply to eight U.S. top-tier BHCs, presumably those that were previously identified by the BCBS.  The surcharge under the Proposed Rule would be phased in beginning on January 1, 2016, to become fully effective on January 1, 2019, consistent with the implementation time frame for the capital conservation buffer.

The Proposed Rule has substantial potential consequences beyond its four corners.  In particular, the surcharge will, in effect, be added to the Total Loss Absorbency Capacity requirement for G-SIBs recently proposed by the Financial Stability Board and expected to be the subject of FRB rulemaking in the near future.  In addition, the adverse impact of certain overly broad definitions in the LCR Rule will now be even greater.  It also remains to be seen how the surcharge will relate to the CCAR process.