The Federal Reserve Board (Board) recently adopted final rules representing the most significant change in U.S. regulation of foreign banking organizations (FBOs) since the International Banking Act of 1978. Perhaps most significantly, the rules require that many large FBOs establish a U.S. intermediate holding company (IHC) that will become the focal point of the regulation and supervision of their U.S. banking and non-banking subsidiaries. An IHC generally must comply with the same capital, liquidity and other enhanced prudential requirements applicable to large domestic bank holding companies (BHCs), regardless of whether the IHC actually controls a bank.

This OnPoint summarizes the significant aspects of the final rules and highlights some of the practical implications and challenges facing FBOs. Please refer to the Appendix for a chart summarizing the key requirements based on the size of the FBO and the extent of its U.S. operations.

Practical Implications of the Final Rules

• The final rules substantially restructure the Board’s supervision of FBOs to a more U.S.-centric approach, requiring the establishment of separately capitalized IHCs which will be subject to the same capital requirements as U.S.-based BHCs, even if the IHC has no U.S. bank or thrift subsidiaries.
• With substantial increases in the level of supervision and oversight of an FBO’s U.S. operations, its costs of doing business in the United States could substantially increase. 
• FBOs with at least $50 billion in U.S. assets beyond their U.S. branches and agencies may be required to reorganize their U.S. activities to comply with the new IHC requirement, which may have significant tax and other implications.
• Functionally regulated U.S. non-banking subsidiaries of an FBO, such as investment advisers, broker-dealers and insurance companies, would be placed under the IHC umbrella and the direct supervision of the Board, possibly resulting in conflicts between the requirements of their functional regulator and those of the Board.
• The broad scope of the term “subsidiary” (which would include, for example, any company in which an FBO, directly or indirectly, controlled 25% or more of the voting securities) means that while a company may be a subsidiary for bank regulatory purposes, it may be difficult, if not impossible, for the parent to compel that company to become part of the IHC or otherwise conform to these new regulatory requirements.
• FBOs will generally be required to comply with the rules, including the new IHC requirement, on July 1, 2016, subject to certain exceptions noted below.
• A U.S. bank holding company with total consolidated assets of $50 billion or more that is a subsidiary of an FBO must comply with the enhanced prudential standards applicable to large domestic BHCs beginning on January 1, 2015, and will continue to be subject to the domestic rules until such time as the IHC rules are phased in.
   

General Overview of the Rules

In general, the rules impose a series of enhanced prudential requirements including capital, liquidity, risk management, stress tests and debt-to-equity limits, based on the size of an FBO’s U.S. and global operations. An FBO with global total consolidated assets of $50 billion or more (Large FBO) is generally subject to more stringent requirements under the rules than are smaller institutions. Some requirements apply primarily to an FBO’s U.S.-based banking and non-banking subsidiaries, whereas others apply to an FBO’s U.S. operations generally, including its branches and agencies. If an IHC is required to be established, the IHC will independently be subject to the enhanced prudential requirements of the rules.

The final rules are substantially similar to the proposed rules with several significant modifications related to the IHC requirement. In the proposal, the Board would have required all Large FBOs with at least $10 billion in U.S. non-branch assets to create an IHC to house all its U.S. bank and non-bank subsidiaries, except for subsidiaries held under Section 2(h)(2) of the Bank Holding Company Act (Section 2(h)(2) subsidiaries).¹ In the final rule, the Board raised the threshold for the required formation of an IHC from $10 billion to $50 billion of U.S. non-branch assets.² In addition, the Board extended by one year – until July 1, 2016 – the date by which an FBO must establish an IHC, and extended until July 1, 2018 the date by which an IHC must comply with leverage capital requirements.

The Board did not adopt two of the significant requirements of the proposal – single counterparty credit limits and early remediation requirements. With respect to single counterparty credit limits, the Board noted that the Basel Committee on Banking Supervision (BCBS) is developing a similar large exposure regime for global banks and that the Board intends to take that effort into consideration in implementing single counterparty credit limits under the Dodd-Frank Act for large domestic BHCs and Large FBOs. The Board also noted that it is still reviewing the comments with respect to the establishment of an early remediation regime that would be triggered by non-compliance with the various enhanced prudential requirements.

The Board decided not to impose enhanced prudential standards on nonbank financial companies designated as systemically significant (SIFIs) by the Financial Stability Oversight Council. Instead, the Board noted that it intends separately to issue orders and rules imposing such standards on each SIFI, based on an assessment of the institution’s business model, capital structure and risk profile.

Concurrently with the adoption of the final rules for FBOs, the Board adopted final rules on enhanced prudential standards for domestic BHCs with consolidated assets of at least $50 billion. Consistent with the principle of national treatment, the enhanced prudential standards that apply to the U.S. operations of FBOs are broadly consistent with those that apply to domestic BHCs, with certain adaptations to account for the unique structure and home country supervision of FBOs.

Intermediate Holding Companies

Perhaps the most significant aspect of the final rule is the requirement that all Large FBOs with $50 billion or more of assets in U.S.-based banking and non-banking subsidiaries place all their interests in those subsidiaries (with limited exceptions) under a single, independently capitalized, U.S.-based IHC.

An IHC would be the parent entity for all of an FBO’s functionally regulated subsidiaries, such as broker-dealers and investment advisers registered with the Securities and Exchange Commission, commodity pool operators registered with the Commodity Futures Trading Commission, and insurance companies regulated by state insurance commissioners, as well as all of an FBO’s national and state bank and thrift subsidiaries. Any other U.S. subsidiaries of an FBO, whether or not subject to supervision at the federal or state level, also would be required to be held through an IHC, except for Section 2(h)(2) subsidiaries and subsidiaries of branch or agency offices formed for the sole purpose of collecting or securing debts previously contracted (DPC subsidiaries). The U.S. branches and agencies of an FBO would continue to be operated by the FBO outside of the IHC framework.

An IHC and its subsidiaries would be subject to examination by the Board, and the IHC would be required to file reports with the Board to the same extent as if the IHC were a BHC. In the final rule, the Board declined to exclude a number of categories of subsidiaries from the requirement to become part of the IHC; thus, for example, subsidiaries of U.S. branches (except for DPC subsidiaries), merchant banking subsidiaries, subsidiaries that are conduits for funding, and, in some cases, joint ventures with third parties, all must be transferred to the IHC. Assets held through branches or agencies generally will not need to be transferred to the IHC. The Board also clarified in the final rule that the FBO must transfer all of its interest in any U.S. subsidiary to the IHC, and that it may not retain any minority ownership interest in the subsidiary directly or through other subsidiaries of the FBO (except through the IHC).

The final rule provides that an FBO could request the Board’s approval to establish alternate or multiple IHC structures for its U.S. operations. FBOs may also designate an existing entity as the IHC, provided that the entity is the top-tier entity in the United States. If multiple IHCs are authorized, any additional IHC will be treated for regulatory purposes as though it had $50 billion or more in consolidated assets, even if its balance sheet assets are less than $50 billion. Furthermore, in the narrow circumstance where the Board permits an FBO to hold its interest in a U.S. subsidiary outside of an IHC (such as when the FBO demonstrates that it cannot transfer its ownership interest in the subsidiary to the IHC or otherwise restructure its investment), the Board expects to require passivity commitments or other supervisory agreements to limit the exposure to and transactions between the IHC and the subsidiary.

The amount of an FBO’s combined U.S. assets would be determined by reference to the financial reports it files with the Board. Generally, all balance sheet assets would be counted and off-balance sheet exposures would not. Consequently, assets under management by a U.S.-based investment adviser subsidiary of an FBO generally would not be included among the combined U.S. assets of the FBO, except to the extent they were reflected on the balance sheet of the investment adviser. For purposes of determining combined U.S. assets, the FBO would be permitted to net intra-group transactions that would have been eliminated in consolidation were an IHC already formed. Netting of transactions with U.S. branches and agencies of the FBO, however, would not be permitted, since branches and agencies will not be consolidated under the IHC.

As indicated above, the Board initially proposed that all FBOs with at least $10 billion in U.S. non-branch assets would be subject to the IHC requirement, but it raised the threshold to $50 billion in the final rule. The Board also extended the transition period for forming an IHC by one year, to July 1, 2016. Furthermore, in recognition of the fact that it may be challenging for an FBO to arrange for the transfer of certain non-bank subsidiaries to an IHC, the final rule provides that by the July 1, 2016 deadline, FBOs need only transfer to the IHC those subsidiaries that represent 90% of the FBO’s U.S. assets not held through any BHCs or depository institutions. Any residual subsidiaries must be transferred to the IHC by July 1, 2017.

The final rule requires FBOs to prepare and submit to the Board an implementation plan by January 1, 2015, outlining the FBO’s proposed process to come into compliance with the IHC requirement. The plan must contain:

• a list of U.S. subsidiaries to be transferred to the IHC;
• detailed information regarding those subsidiaries that the FBO is not required to hold through the IHC or for which it intends to seek an exemption from the IHC requirement;
• a projected timeline for transfers of subsidiaries to the IHC and quarterly pro forma financial statements for the IHC, including pro forma capital ratios, for the period from December 31, 2015 to January 1, 2018;
• a projected timeline for, and description of, planned actions to facilitate compliance with IHC capital requirements; and
• a description of the risk management and liquidity stress testing practices of the U.S. operations of the FBO, and how the FBO and its IHC intend to come into compliance with those requirements.
   

Enhanced Prudential Standards

As discussed above, the rule will generally have the greatest effect on Large FBOs with significant U.S. operations (i.e., those with more than $50 billion of assets in U.S. subsidiaries, excluding any Section 2(h)(2) subsidiaries and DPC subsidiaries.). Certain requirements will also be imposed on smaller FBOs. Following is a brief overview of the impact of the prudential requirements on FBOs of varying sizes, both globally and within the United States.

Risk-Based Capital and Leverage

Large FBOs

• A Large FBO would be required to certify to the Board that it meets capital adequacy standards established by its home country supervisor and applied on a consolidated basis that are consistent with standards recommended by the BCBS. Separate capital requirements would not be imposed on a Large FBO’s U.S. branches and agencies. A Large FBO would also be required to provide reports to the Board relating to its compliance with risk-based capital ratios and other capital metrics. If a Large FBO did not satisfy those requirements, the Board could impose conditions or restrictions on the Large FBO’s U.S. operations.
   

Intermediate Holding Companies

• If an IHC is required to be established by a Large FBO, the IHC would be subject to the same risk-based capital and leverage requirements that would apply to a BHC, regardless of whether the IHC controls a bank. These would include the capital planning requirements set forth in the Board’s Regulation Y, which would require an IHC to demonstrate its ability to maintain capital above minimum risk-based requirements under both baseline and stressed scenarios over a minimum nine-quarter planning horizon. Capital distributions by an IHC would generally be prohibited unless a satisfactory capital plan was submitted to and accepted by the Board. An IHC created by the July 1, 2016 deadline would be required to submit its first capital plan in January of 2017.
• The final rule extended the deadline for IHCs to comply with leverage ratio requirements to January 1, 2018.
   

Liquidity Requirements

Large FBOs with Combined U.S. Assets of $50 Billion or More

• A Large FBO with combined U.S. assets of $50 billion or more would be required to meet enhanced liquidity requirements, including liquidity risk management standards, monthly liquidity stress testing, the maintenance of a liquidity buffer consisting of highly liquid assets and the establishment of a contingency funding plan. These requirements are similar to the Board’s requirements for large domestic BHCs.
• Liquidity stress testing must incorporate overnight, 30-day, 90-day, and one-year time horizons, and must be conducted separately for: (i) the FBO’s combined U.S. operations; (ii) each IHC (if any); and (iii) the FBO’s U.S. branches and agencies on an aggregate basis.
• The liquidity buffer requirement would apply separately to a Large FBO’s IHC and its U.S. branches and agencies. An IHC would be required to hold a 30-day liquidity buffer in the United States and may not hold it at a U.S. branch or agency of the FBO or any affiliate not controlled by the IHC. For its U.S. branches and agencies, a Large FBO would be required to hold highly liquid assets in the United States sufficient to meet the first 14 days’ liquidity requirements. The Board clarified in the final release that cash held in deposits at other banks is not counted as part of the buffer.
• The Board has separately proposed an implementation of the Basel III liquidity coverage ratio (LCR) that would apply quantitative liquidity standards to U.S.-domiciled BHCs with at least $50 billion in consolidated assets, with more extensive LCR requirements applicable to domestic BHCs with greater than $250 billion in consolidated assets. It is unclear how the Board will apply the LCR requirements to the U.S. operations of FBOs.
   

Large FBOs with Combined U.S. Assets of Less than $50 billion

• A Large FBO with combined U.S. assets of less than $50 billion would be required to conduct an internal liquidity stress test, either on a consolidated basis or separately for its U.S. operations, and to report the results to the Board on an annual basis.
• The stress test must incorporate 30-day, 90-day, and one-year time horizons consistent with Basel liquidity risk management principles.
   

Risk Management

General

• The enhanced risk management requirements that would apply to the U.S. operations of an FBO are comparable to the requirements proposed by the Board for domestic BHCs.
• Large FBOs with combined U.S. assets of $50 billion or more would be subject to substantially greater risk management responsibilities than would FBOs with a smaller U.S. footprint.
   

Publicly Traded FBOs with Total Consolidated Assets of More than $10 Billion (but Less than $50 Billion) and Large FBOs with Combined U.S. Assets of Less than $50 Billion

• Publicly traded FBOs with total consolidated assets of more than $10 billion, and Large FBOs (regardless of whether their stock is publicly traded) with combined U.S. assets of less than $50 billion, would be required to certify to the Board on an annual basis that they maintain a U.S. risk committee to oversee the risk management practices of the combined U.S. operations of the company. The U.S. risk committee must have at least one member with risk management expertise.
• The final rule clarifies that an FBO with publicly traded ADRs (American Depositary Receipts) will be deemed to be publicly traded.
• From a governance perspective, the U.S. risk committee must be a committee of the global board of directors of the FBO.
   

Large FBOs with Combined U.S. Assets of $50 Billion or More

• The U.S. risk committee of a Large FBO with $50 billion or more of combined U.S. assets would be subject to additional responsibilities and must have at least one independent member in addition to a member with risk management expertise.
• A Large FBO with combined U.S. assets of $50 billion or more also would be required to have a qualified U.S. chief risk officer employed by an IHC, another U.S.-based subsidiary or a U.S. branch or agency of the FBO. The U.S. chief risk officer would be responsible for, among other things, measuring, aggregating and monitoring risks undertaken by the combined U.S. operations, and reporting to the U.S. risk committee, the global chief risk officer and the Board about such risks, including how they relate to the global operations of the FBO. The U.S. chief risk officer may not also serve as the FBO’s global chief risk officer.
• From a governance perspective, the U.S. risk committee for the combined U.S. operations of a Large FBO may be a committee of the global board of directors of the FBO or a committee of the board of directors of the FBO’s U.S. IHC, if an IHC has been established. However, if an FBO operates in the United States solely through an IHC, then the U.S. risk committee must be placed at the IHC.
   

Capital Stress Tests

Large FBOs with Combined U.S. Assets of $50 Billion or More

• A Large FBO with combined U.S. assets of $50 billion or more (and that also has a U.S. branch or agency) will be subject to an annual capital stress testing regime administered by its home country supervisor. The FBO will be required to submit a summary of its stress testing activities and results to the Board.
• If the U.S. branches and agencies of a Large FBO, on a net basis, provide funding to the FBO’s non-U.S. offices and non-U.S. affiliates, then the Large FBO will be required to provide additional information to the Board regarding the FBO’s annual home country capital stress test. In the preamble to the final rule, the Board reiterates that additional information is necessary in this circumstance, as a result of greater risk to U.S. creditors and U.S. financial stability posed by U.S. branches and agencies that serve as funding sources to their foreign parent.
• If an FBO does not satisfy home country stress testing and related requirements, then the FBO’s U.S. branches and agencies must maintain eligible assets at least equal to 108% of U.S. branch and agency liabilities and may also be required to maintain a liquidity buffer or be subject to intra-group funding restrictions.
   

FBOs with Total Consolidated Assets of More than $10 Billion (but Less than $50 Billion) and Large FBOs with Combined U.S. Assets of Less than $50 Billion

• An FBO in this category will also be subject to an annual stress testing regime administered by its home country supervisor. However, these FBOs will not be required to report their stress testing activities and results to the Board.
• If an FBO in this category does not satisfy the home country stress testing requirements, then the FBO’s U.S. branches and agencies will be required to maintain eligible assets at least equal to 105% of U.S. branch and agency liabilities. The FBO would also need to conduct an annual stress test of its U.S. subsidiaries and report stress test activities and results to the Board.
   

Intermediate Holding Companies

•  An IHC will be subject to the same capital stress test requirements that would apply to a large domestic BHC. The final rule delays the application of stress test requirements to the IHC until October 1, 2017.
• IHCs will be subject to an annual “supervisory” capital stress test conducted by the Board. They will also be required to conduct their own annual “company-run” capital stress test based on baseline and stressed economic scenarios established by the Board, as well as a second mid-cycle “company-run” capital stress test based on scenarios established by the IHC.
• The Board will publicly disclose summary results of the annual supervisory stress test and IHCs must publicly disclose summary results of their company-run stress tests.
   

Debt-to-Equity Limits

Large FBOs

• If the Financial Stability Oversight Council determines that a Large FBO poses a “grave threat” to the financial stability of the United States, then the Large FBO’s IHC or, if an IHC has not been established, any U.S. subsidiary, would be required to maintain a debt-to-equity ratio of not more than 15-to-1 and its U.S. branches and agencies would be required to maintain eligible assets at least equal to 108% of U.S. branch and agency liabilities. The FBO must comply within 180 days of receiving notice of such determination, unless the time period for compliance is extended by the Board.
   

Conclusion

The IHC requirement and other enhanced prudential requirements will substantially alter the regulation and oversight of the U.S. operations of many FBOs, particularly those with substantial U.S. operations. On the immediate horizon, FBOs required to establish an IHC must submit an implementation plan to the Board by January 1, 2015, well in advance of the July 1, 2016 compliance date. Additional regulation will also be forthcoming in the form of single counterparty credit limits and early remediation requirements. The early remediation regime will be of particular interest to FBOs, as the proposal contemplates the imposition of various penalties (mandatory in some cases) for failure to comply with enhanced prudential standards. FBOs should carefully evaluate the costs of the new regulatory regime against the benefits of maintaining their U.S. banking presence or expanding their business in the United States.