Recent Developments in Bank Regulation and Policy

Scott Anenberg David SahrScott AnenbergPartner

+1 202 263 [email protected]

David SahrPartner


Thomas DelaneyPartner

+1 202 263 3216

Donald WaackPartner

+1 202 263 3165+1 202 263 [email protected]


Bank Regulatory Capital andBank Regulatory Capital andLiquidity DevelopmentsLiquidity Developments

Scott AnenbergPartner

+1 202 263 3303+1 202 263 [email protected]

2015 – 2016 US Highlights

• Finalization of G-SIB capital surcharge rule

• Proposal of:

– Total Loss-Absorbing Capacity (TLAC) rule

– Net Stable Funding Ratio (NSFR) rule

– Countercyclical Capital Buffer (CCyB) policy statement

– Capital requirements of savings and loan holding companies that contain– Capital requirements of savings and loan holding companies that containinsurance companies and enhanced prudential standards for SIIs

– LCR disclosure rule

• Modification of Liquidity Coverage Ratio (LCR) for municipal securities

• CCAR and Parallel Run Developments

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2015 – 2016 Global Highlights

• Finalization of

– FSB TLAC standard

– Changes to market risk capital rules

– NSFR disclosure standard– NSFR disclosure standard

• Proposals:

– Revisions to the standardized approach for credit risk in the banking book– Revisions to the standardized approach for credit risk in the banking book

– Basel III Leverage Ratio changes for denominator

– Limitations on use of internal ratings-based models to calculate credit risk

– Standardized approach for calculating operational risk– Standardized approach for calculating operational risk

• Ongoing:

– G-SIFI designations– G-SIFI designations

– Basel III implementation progress

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US CAPITAL ANDLIQUIDITYLIQUIDITYDEVELOPMENTSDEVELOPMENTS

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US: G-SIB Capital Surcharge Rule

• FRB finalized risk-based capital surcharge for 8 US G-SIBs in July 2015

– US G-SIBS are: Bank of America; Bank of New York-Mellon; Citigroup; Goldman Sachs;JPMorgan Chase; Morgan Stanley; State Street; and Wells Fargo

– Subject to 1% - 4.5% CET1 surcharge, depending on size (compared to 1% -– Subject to 1% - 4.5% CET1 surcharge, depending on size (compared to 1% -2.5% under BCBS standard)

– Part of capital conservation buffer (dividends/bonus limits)

– Surcharge bucket based on stricter of 2 methodologies– Surcharge bucket based on stricter of 2 methodologies

• Aggregate systemic indictor score relative to other G-SIBs applying 5 FSB/BCBS measures ofsystemic importance (size, interconnectiveness, subsitutability, complexity, cross-jurisdictionalactivity)activity)

• Unique US objective methodology focused on reliance on short-term wholesale funding

– Operates in conjunction with 2014 US supplementary leverage ratiosurcharges for same 8 G-SIBs (5% for holding companies and 6% for IDIs v.surcharges for same 8 G-SIBs (5% for holding companies and 6% for IDIs v.BCBS 3%)

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US: G-SIB Capital Surcharge Rule

• Took effect January 2016, increases by 25% each year• Took effect January 2016, increases by 25% each yearto 100% on January 1, 2019; most US G-SIBs alreadyin compliance with fully phased-in requirements

• All AA banks must calculate annually if they are G-SIBsbased on FSB/BCBS factors (proposal was $50B)based on FSB/BCBS factors (proposal was $50B)

• Governor Tarullo recently indicated G-SIB surchargeslikely to be incorporated into CCAR (with possiblelikely to be incorporated into CCAR (with possibleoffsets)

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US: Total Loss Absorbing-Capacity Proposal

• FRB-version of FSB standard (finalized in November 2015) to improveresiliency and resolvability of largest banking organizations (Oct. 2015):resiliency and resolvability of largest banking organizations (Oct. 2015):

– Minimum long-term debt (LTD)

– Minimum loss-absorbing capacity (Tier 1 capital plus LTD)– Minimum loss-absorbing capacity (Tier 1 capital plus LTD)

– Clean holding company

– Disclosure of financial consequences– Disclosure of financial consequences

• Will apply to US G-SIBs and US intermediate holding companies (IHCs) ofnon-US G-SIBs

– Capital deduction for investments in unsecured debt of US G-SIBs applies to– Capital deduction for investments in unsecured debt of US G-SIBs applies toUS banking organizations with at least $1B in total consolidated assets

• Proposed phase-in from January 1, 2017 to January 1, 2022Proposed phase-in from January 1, 2017 to January 1, 2022

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US TLAC Proposal: Long-term Debt

• Top-tier holding company of US G-SIBs would serve as single• Top-tier holding company of US G-SIBs would serve as singlepoint-of-entry (SPOE) in a resolution proceeding

– Depository institution subsidiary and nonbank subsidiaries would notenter into resolution proceedingsenter into resolution proceedings

– LTD would be exchanged for equity in a new bridge bank, and equityinterests in old bank would be eliminated

• LTD would be limited to debt:

– Issued by holdco, unsecured, and not guaranteed by G-SIB;

– With a remaining maturity of at least one or two years;

– Governed by US law; and

– That is “plain vanilla” (e.g., no structured notes or CoCos)

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US TLAC: Minimum Loss-Absorbing Capacity

• US G-SIBs would be required to meet minimum:• US G-SIBs would be required to meet minimum:

– Risk-based TLAC ratio of 18% (comprised of CET1, additional Tier 1capital, Tier 2 capital, and LTD)

Risk-based LTD ratio of 7% - 10.5% (comprised of LTD)– Risk-based LTD ratio of 7% - 10.5% (comprised of LTD)

– Risk-based TLAC buffer of 3.5% - 5% (comprised of CET1, additionalTier 1 capital, Tier 2 capital, or LTD)Tier 1 capital, Tier 2 capital, or LTD)

– Leverage-based TLAC ratio of 9.5% (from supplementary leverageratio rule)

– Leverage-based LTD ratio of 4.5% (from supplementary leverage ratiorule)

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US TLAC: Clean HoldingCompany Requirement

• Top-tier holdco of US G-SIB would be subject to• Top-tier holdco of US G-SIB would be subject tolimitations on the type and size of liabilities it could issue

– Would reduce risk of “runs” by holders of short-term debt

– Would facilitate SPOE resolution strategy

• Liability limitations would include:• Liability limitations would include:

– Prohibition from issuing short-term debt, entering into QFCs,and entering into other similar senior-credit arrangements

– 5% of TLAC holdings cap on aggregate non-contingent liabilitiesto third-parties

– Subordination of other permissible debt that is not LTD– Subordination of other permissible debt that is not LTD

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US TLAC: Disclosure and Capital Deduction

• US G-SIBs would be required to disclose to unsecured• US G-SIBs would be required to disclose to unsecureddebtholders the consequences of the US G-SIB entering aresolution proceeding

• FRB proposal would amend Basel III to require all banking• FRB proposal would amend Basel III to require all bankingorganizations to deduct unsecured debt issued by US G-SIBsfrom regulatory capital if the debt does not qualify as Tier 2from regulatory capital if the debt does not qualify as Tier 2capital

– Certain otherwise ineligible G-SIB debt may remain as regulatorycapital if the total amount of ineligible G-SIB debt is less than 10% ofcapital if the total amount of ineligible G-SIB debt is less than 10% ofthe banking organization’s regulatory capital

– FDIC and OCC expected to follow FRB’s lead on amending Basel IIIFDIC and OCC expected to follow FRB’s lead on amending Basel III

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US TLAC: Application to IHC

• US IHCs of G-SIBs generally subject to same TLAC requirements• US IHCs of G-SIBs generally subject to same TLAC requirementsas US G-SIBs, with the following exceptions

– LTD for IHC would be an “internal” rather than “external” requirement(i.e., LTD would be issued by IHC to a parent FBO to permit “push-up”(i.e., LTD would be issued by IHC to a parent FBO to permit “push-up”of losses

– Stricter limitation on the types of debt that qualify as “plain vanilla”

– Regulator will “push” losses to parent FBO to keep US IHC out of aresolution proceeding

– Different TLAC ratios would apply and would vary depending on– Different TLAC ratios would apply and would vary depending onwhether the parent FBO would be resolved under an SPOE strategy ora multiple-point-of-entry strategy

– Clean holding company requirement would restrict guarantees toaffiliates and would not contain a 5% cap on unrelated liabilities

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US: Net Stable Funding Ratio Proposal

• US NSFR proposal released April 2016; comments due• US NSFR proposal released April 2016; comments dueAugust 5, 2016

• Closely tracks October 2014 final BCBS NSFR• Closely tracks October 2014 final BCBS NSFR

• Complements LCR

– LCR focused on short-term liquidity by requiring sufficient– LCR focused on short-term liquidity by requiring sufficienthigh quality liquid assets to meet liquidity needs overstressed 30-day periodstressed 30-day period

– NSFR focuses on ensuring adequate longer-term stablefunding

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US NSFR: Applicability

• NSFR would apply in full to same US banking organizations• NSFR would apply in full to same US banking organizationssubject to LCR (i.e., about 15 that have consolidated assets ofat least $250B) and their IDI subsidiaries with at least $10B inassetsassets

– Modified NSFR would apply to US banking organizations with at least$50B of consolidated assets

– Would not apply to FBOs, but a separate proposal will be developedfor US operations of FBOs with at least $50B in combined US assets

• NSFR would take effect January 1, 2018• NSFR would take effect January 1, 2018

– US holding companies with at least $50B of consolidated assets wouldbe required to publicly disclose their NSFR on a quarterly basisbe required to publicly disclose their NSFR on a quarterly basis

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US NSFR: Calculation

• NSFR would require covered companies to maintain an amount of availablestable funding (ASF) that is not less than the amount of its required stablestable funding (ASF) that is not less than the amount of its required stablefunding (RSF) on an ongoing basis

– Covered companies subject to the modified NSFR would be required to– Covered companies subject to the modified NSFR would be required tomaintain an ASF of at least 70 percent of RSF

• ASF would include regulatory capital and balance sheet liability and equityitemsitems

– Each ASF item (see following slides) would be adjusted by a stability factorbased on (i) funding tenor, (ii) funding type, and (iii) counterparty type

• RSF would include assets, derivative exposures, and commitments• RSF would include assets, derivative exposures, and commitments

– Each RSF item (see following slides) would be adjusted by a liquidity factorbased on (i) credit quality, (ii) tenor, (iii) type of counterparty, (iv) marketbased on (i) credit quality, (ii) tenor, (iii) type of counterparty, (iv) marketcharacteristics, and (v) encumbrance

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Table 1: Summary of ASF Factors

100% • Regulatory capital elements and liabilities with a remaining maturity of one year or more.

95% • Fully insured stable retail deposits.`

ASF FACTOR EQUITY AND LIABILITIES ASSIGNED THE ASF FACTOR

95% • Fully insured stable retail deposits.`

90% • Retail deposits that are neither stable retail deposits nor retail brokered deposits.• Certain more stable retail brokered deposits.

50% • Unsecured wholesale funding and secured funding transactions with a remaining maturity of less than one year thatare provided byare provided by

wholesale customers that are not financial sector entities or central banks.8

• Unsecured wholesale funding and secured funding transactions with a remaining maturity of six months or more, butless than one year and that are provided by financial sector entities or central banks.

• Securities issued by a covered company with a remaining maturity of six months or more but less than one year.

• Operational deposits received by a covered company.• Operational deposits received by a covered company.

• Certain retail brokered deposits with intermediate stability.

0% • All other funding not described above, including:• Funding (other than operational deposits) where the counterparty is a financial sector entity or a central bank, and the

transaction matures within six months.transaction matures within six months.• Retail funding that is not a deposit.• Retail brokered deposits that are not stable.• Derivatives liabilities.• Trade date payables.

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8Wholesale customers or counterparties that are not financial sector entities or central banks include sovereigns, certain multilateraldevelopment banks, public sector entities, and US government-sponsored entities.

0% • Reserve Bank balances or other claims on a Reserve Bank that mature within six months.

Table 2: Summary of RSF Factors9

RSF Factor RSF Factor

0% • Reserve Bank balances or other claims on a Reserve Bank that mature within six months.

• Claims on a foreign central bank that mature within six months.

• Currency, coin, and items in the process of collection.

• Trade date receivables.

5% • Level 1 liquid assets (excluding level 1 liquid assets assigned a zero percent RSF factor), including US Treasury securities.5% • Level 1 liquid assets (excluding level 1 liquid assets assigned a zero percent RSF factor), including US Treasury securities.

• The undrawn amount of committed credit and liquidity facilities.

10% • Secured lending transactions (e.g., reverse repurchase transactions) where the counterparty is a financial sector entity and thetransactions mature within six months and are secured by level 1 liquid assets.

15% • Level 2A liquid assets, including certain obligations issued or guaranteed by a US government-sponsored enterprise.

• Secured lending transactions where the counterparty is a financial sector entity and the transactions mature within six months• Secured lending transactions where the counterparty is a financial sector entity and the transactions mature within six monthsand are secured by assets other than level 1 liquid assets.

• Unsecured wholesale lending that matures within six months and the counterparty is a financial sector entity.

50% • Level 2B liquid assets, including certain publicly traded corporate equity and debt securities and US general obligation municipalsecurities.

• Secured lending transactions and unsecured wholesale lending that mature in six months or more, but less than one year,• Secured lending transactions and unsecured wholesale lending that mature in six months or more, but less than one year,where the counterparty is a financial sector entity or central bank.

• Secured lending transactions and unsecured wholesale lending that mature in less than one year, where the counterparty is nota financial sector entity or central bank.

• Lending to retail customers or counterparties that matures in less than one year.

• Operational deposits placed by a covered company at financial sector entities.

• All other assets that mature in less than one year.

9Table 2 does not include calculation of the derivatives RSF amount.

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9Table 2 does not include calculation of the derivatives RSF amount.

65% • Retail mortgages with a remaining maturity of one year or more that are assigned a risk weight of no greater than 50 percentunder the Board’s capital regulations.

• Other lending that has a remaining maturity of one year or more, is assigned a risk weight of no greater than 20 percent under theBoard’s capital regulations, and where the borrower is not a financial sector entity.

85% • Retail mortgages with a remaining maturity of one year or more that are assigned a risk weight of greater than 50 percent underthe Board’s capital regulations.

• Other lending that has a remaining maturity of one year or more and is assigned a risk weight greater than 20 percent under theBoard’s capital regulations, where the borrower is not a financial sector entity.Board’s capital regulations, where the borrower is not a financial sector entity.

• Publicly traded common equity shares that are not HQLA.• Other securities that are not HQLA and have a remaining maturity of one year or more.

• Traded commodities for which derivative transactions are traded on a US designated contract100% All other assets not described above, including:

• Lending that has a remaining maturity of one year or more, where the borrower is a financial sector entity.• Lending that has a remaining maturity of one year or more, where the borrower is a financial sector entity.• Nonperforming assets.• Equity securities that are not publicly traded.• Commodities that do not qualify to be assigned an 85% RSF factor.

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US: Countercyclical Capital Buffer Proposal

• CCyB is an “add-on” to the risk-based regulatory capital ratio per US and BCBSBasel III regimeBasel III regime

– CCyB would be increased during periods of increased risk (e.g., bull markets) andreduced during periods of reduced risk (e.g., bear markets)

• In December 2015 FRB proposed a policy statement for how it will set the CCyB:

– A set of principles for translating judgmental assessments of financial-systemvulnerabilities into specific levels of the CCyB,vulnerabilities into specific levels of the CCyB,

– A set of empirical models used to “distill” indicators of financial and economicperformance into potential settings for the CCyB, and

– How FRB will assess whether the CCyB is the most appropriate policy tool to address– How FRB will assess whether the CCyB is the most appropriate policy tool to addressidentified financial system vulnerabilities

• CCyB applies only to advanced approaches banking organizations and depositorysubsidiaries of such organizations (regardless of parallel run exit status)subsidiaries of such organizations (regardless of parallel run exit status)

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US CCyB: Calculation

• FRB would set the CCyB annually at 0% - 2.5% depending on the risk of financialsystem vulnerabilitiessystem vulnerabilities

– Currently set at 0%

– Subject to phase-in through 2019 (only if FRB were to increase the CCyB during that– Subject to phase-in through 2019 (only if FRB were to increase the CCyB during thatperiod)

• CCyB would:

– Consist of CET1 capital– Consist of CET1 capital

– Be added to Basel III minimum CET1 ratio

– Be additional Basel III capital conservation buffer

• FRB would give covered banking organizations 12 months to comply withchanges to the CCyB amount

– Changes would likely be done jointly with OCC and FDIC– Changes would likely be done jointly with OCC and FDIC

• Comment period expired March 21, 201621

US: Modification of LCR for MunicipalSecurities

• FRB amended LCR rules to expand the definition of HQLA (April 1,• FRB amended LCR rules to expand the definition of HQLA (April 1,2016)

– State and municipal securities previously could not be counted as HQLA

– FDIC and OCC did not amend LCR for state non-member banks and national– FDIC and OCC did not amend LCR for state non-member banks and nationalbanks

• Allows investment grade, general obligation US state and municipal• Allows investment grade, general obligation US state and municipalbonds to be included as Level 2B HQLA up to certain levels (2Xaverage daily trading volume per single issuer; 5% of HQLA) if theymeet the same liquidity criteria that currently apply to corporatemeet the same liquidity criteria that currently apply to corporatedebt securities

– Did not adopt 25% CUSIP-based limitation

– Abandoned blanket exclusion of insured municipal bonds– Abandoned blanket exclusion of insured municipal bonds

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US: Liquidity Coverage RatioDisclosure Proposal

• November 2015 proposal would require quarterly disclosure of• November 2015 proposal would require quarterly disclosure ofa banking organization’s liquidity profile per LCR

– Would apply to US holding companies with at least $50B ofconsolidated assetsconsolidated assets

– Proposed reporting format is consistent with BCBS reporting template

– Expected phase-in beginning July 1, 2016 to January 1, 2018– Expected phase-in beginning July 1, 2016 to January 1, 2018

• LCR disclosures would include over 2 dozen quantitative valuesthat feed into the LCR calculationthat feed into the LCR calculation

– Covered companies would also need to include a qualitativediscussion of LCR results

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Capital Requirements for InsuranceCompanies

• Congress amended DFA in 2014 to permit FRB to tailor its• Congress amended DFA in 2014 to permit FRB to tailor itscapital rules for insurance companies regulated as SLHCs

– General capital rules under FRB Reg Q apply to BHCs and SLHCswithout significant insurance activitieswithout significant insurance activities

• FRB issued ANPR in June 2016 to apply capital requirements toinsurance depository institution holding companies regulatedinsurance depository institution holding companies regulatedas SLHCs (currently 12) and to SIIs (currently AIG andPrudential)

– Two proposed approaches to capital regulation:

• Building Block Approach (BBA)

• Consolidated Approach (CA)• Consolidated Approach (CA)

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Capital Requirements for InsuranceCompanies

• BBA: Aggregate capital on a legal entity basis, using insurance• BBA: Aggregate capital on a legal entity basis, using insuranceregulator capital rules for insurance entities and Basel III for IDIs andnonbank subsidiaries

– Unclear how top-tier holding companies that are generally regulated as– Unclear how top-tier holding companies that are generally regulated asinsurers would be treated

– Unclear how intercompany transactions would be treated

– FRB would apply unspecified “scalars” to insurance capital requirements– FRB would apply unspecified “scalars” to insurance capital requirements

• CA: Apply the general consolidation approach from the Reg Q capitalrules, with adjustments to risk weights for insurance liabilitycharacteristicscharacteristics

– Unclear how it would apply to insurers using statutory accounting principles

• BBA likely to apply to non-SII SLHCs and the CA to SIIs, but FRB• BBA likely to apply to non-SII SLHCs and the CA to SIIs, but FRBrequested comment

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Enhanced Prudential Standards forAIG and Prudential

• Financial Stability Oversight Council designated AIG and Prudential assystemically important nonbank financial companies in 2013; FRB regulatessystemically important nonbank financial companies in 2013; FRB regulatessuch entities (MetLife successfully challenged its designation)

• FRB issued proposed regulations in June 2016 to apply enhanced prudential• FRB issued proposed regulations in June 2016 to apply enhanced prudentialstandards to SIIs such as AIG and Prudential

– Corporate governance and risk-management (e.g., risk committee, CRO, andchief actuary), and liquidity risk-managementchief actuary), and liquidity risk-management

– Tailored for the insurance industry (e.g., 90-day planning horizon for liquiditystress-testing)

• AIG and Prudential will also be subject to the capital rules discussed on the• AIG and Prudential will also be subject to the capital rules discussed on theprior slide (likely under the Consolidated Approach)

– Required to comply one year after effective date– Required to comply one year after effective date

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US: Other Developments

• 2016 CCAR cycle: 33 banks subject to CCAR (up 2 from 2015; BancWest and TD)

– Due date moved from January to April; public releases on June 23 (D-FAST) andJune 29 (CCAR)

– FRB has indicated it is likely to (i) exempt non-AA banks from qualitative– FRB has indicated it is likely to (i) exempt non-AA banks from qualitativecomponent of CCAR and (ii) include the G-SIB surcharge in the stress tests

• BofA exited its parallel run under Basel III in September 2015

– Joins BNY Mellon, Citi, Goldman Sachs, JPMC, Morgan Stanley, Northern Trust,– Joins BNY Mellon, Citi, Goldman Sachs, JPMC, Morgan Stanley, Northern Trust,State Street, US Bank, and Wells Fargo

– Amex, CapOne, and PNC remain in their parallel runs

• US regulators’ December 10, 2015 statement that BCBS revisions to thestandardized approach “would apply primarily to large, internationally activebanking organizations and not to community banking organizations”

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GLOBAL CAPITALAND LIQUIDITYAND LIQUIDITYDEVELOPMENTSDEVELOPMENTS

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FSB/BCBS: Finalization of TLAC Standard

• FSB finalized the global TLAC standard in November 2015

– Consists of 13 broad principles that national TLAC implementations shouldmeet

– Includes a “term sheet” of 21 specific items that national TLAC– Includes a “term sheet” of 21 specific items that national TLACimplementations should reflect

• Applies to G-SIBs

• Sets risk-based TLAC at 18% and leverage-based TLAC at 6.75%• Sets risk-based TLAC at 18% and leverage-based TLAC at 6.75%

• Permits SPOE or MPOE resolution strategies

• Defines TLAC-eligible regulatory capital instruments

• Requires G-SIBs to deduct exposure to other G-SIBs’ TLAC instruments from TLAC andregulatory capital holdings

– General phase-in from 2019 to 2022

• Delayed phase-in for G-SIBs in emerging markets (i.e., China) from 2025 to 2028

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BCBS: Market Risk Capital Rule Revisions

• BCBS finalized revisions to market risk framework in January 2016 (effective2019); revisions are extensive and expected to sharply increase related2019); revisions are extensive and expected to sharply increase relatedcapital charges

– Changed the boundary between the banking book and trading book to discourageregulatory arbitrageregulatory arbitrage

– Enhanced the internal models approach for market risk for:

• A shift from value-at-risk to expected shortfall to better capture “tail risk”, and calibrationbased on period of significant financial stressbased on period of significant financial stress

• Incorporation of market illiquidity risk, through the introduction of “liquidity horizons”;

• A more granular model approval process whereby internal models are approved for use at thetrading desk level; andtrading desk level; and

• Constraints on the capital-reducing effects of hedging and portfolio diversification

– Modified the standardized approach to serve as a “fallback” or floor to the internalmodels approachmodels approach

• Greater reliance on risk sensitivities as inputs into capital charge calculations

• Relevant if supervisors find a bank’s models are inadequate30

BCBS: Finalization ofNSFR Disclosure Standard

• BCBS finalized substantive NSFR in October 2014• BCBS finalized substantive NSFR in October 2014

– US proposal pending (see earlier slides)

• BCBS finalized NSFR disclosure standard in June 2015• BCBS finalized NSFR disclosure standard in June 2015

– Should be adopted by national regulators with 2018 effectivedate

– Similar to LCR disclosure standards

• Approximately 3 dozen quantitative values

• Qualitative discussion of drivers of NSFR results

• Quarterly publication

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BCBS: Standardized Approach forCredit Risk Revisions

• BCBS re-proposed changes to the Standardized Approach for credit risk inDecember 2015; comments were due March 11, 2016December 2015; comments were due March 11, 2016

– Keeps ratings-based (+ due diligence) approach for various exposures, butadds non-ratings based alternatives for jurisdictions like US

– Includes significant changes to treatment of exposures to securities firms,certain commercial loans, real estate loans, certain commitments, and SFTs;sovereign, central bank, and PSE exposures being addressed separately

• US regulators have stated that they would apply any changes “primarily tolarge, internationally active banking organizations and not to communitybanking organizations”banking organizations”

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BCBS Standardized Approach forCredit Risk Revisions: Highlights

• Banks (includes securities firms/other financial• Banks (includes securities firms/other financialinstitutions subject to prudential regulation)

– Ratings-based: 20/50/100/150% RWs depending on rating(preferential RWs for those with original maturities of 3 months(preferential RWs for those with original maturities of 3 monthsor less)

– Unrated/Non-ratings-based:– Unrated/Non-ratings-based:

• 50% for Grade A (exceeds required regulatory capital and liquidity ratios,including buffers)

• 100% for Grade B (fails to meet required capital or liquidity buffers)

• 150% for Grade C (fails to meet required capital/liquidity minimums)

– Current US: 20% for US banks; 20% - 150% for non-US banks– Current US: 20% for US banks; 20% - 150% for non-US banksbased on OECD CRC ratings

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• Corporate exposures• Corporate exposures

– Ratings-based: 20/50/100/150% (unrated at 100%) (based on issuerratings)

– Non-ratings-based– Non-ratings-based

• 100%, but 75% if investment grade

• 85% for SMEs (less than $50MM annual revenues)• 85% for SMEs (less than $50MM annual revenues)

– Special rules for “specialized lending exposures”

– Ratings-based: same as non-specialized, but based on issue-specific ratings

– Non-ratings-based: 120% for object and commodity finance; 100%(operational phase)/150% (pre-operational) for project finance

– 250% equity/150% sub debt instruments (corporate and financial– 250% equity/150% sub debt instruments (corporate and financialinstitutions)

– US: 100% 34


• Retail• Retail

– 75% for “regulatory retail” (various conditions, includingindividual/SME, less than €1MM, highly granular (no individualexposure exceeded .2% of regulatory retail portfolio)exposure exceeded .2% of regulatory retail portfolio)

– 100% for other retail

– US: 100%US: 100%

• Real Estate: varies based on residential v. commercial, LTV, andreliance on property cash flows

– Residential: 25/30/35/45/55% RWs based on LTV– Residential: 25/30/35/45/55% RWs based on LTV

• 100% if certain criteria, including ability to repay and collateralquality/effectiveness, are not met)

• 70/90/120/150% if repayment depends primarily on lease or rental payments

• US: 50%/100% (abandoned LTV-based RWs)35


• Real Estate (cont.)• Real Estate (cont.)

– Commercial: 60% if LTV does not exceed 60%; otherwise RW ofborrower (generally 100%)

• 80/100/130/150% based on LTV and other factors if repayment materially• 80/100/130/150% based on LTV and other factors if repayment materiallydepends on cash flows generated by property

• US: 100%

– ADC loans: 150%

• US: 150% for HVCRE

Off balance sheet• Off balance sheet

– Favorable CCF of [10-20%, rather than 0%] for unconditionallycancellable commitments available only for retail commitments thatcancellable commitments available only for retail commitments thatare unconditionally cancellable in practice

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BCBS: Basel III Leverage Ratio Revisions

• BCBS proposed changes to the Basel III leverage ratio• BCBS proposed changes to the Basel III leverage ratioframework in April 2016 that would revise the:

– Measurement of derivative exposures;

– Treatment of regular-way purchases and sales of financial assets;

– Treatment of provisions, traditional securitizations, and SFTs; and

– Credit conversion factors for off-balance sheet items– Credit conversion factors for off-balance sheet items

• BCBS would also impose a higher leverage ratio on G-SIBs,either as a higher minimum or a buffereither as a higher minimum or a buffer

• Banks seek to make it more risk-based; critics like FDIC ViceChair Hoenig criticize it for already introducing too many risk-Chair Hoenig criticize it for already introducing too many risk-based principles

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BCBS: Standardized Approach forOperational Risk Proposal

• BCBS currently provides 3 methods for incorporating operational risk into calculation of RWA:

– Advanced Measurement Approach (AMA): based on institution’s internal operational riskmanagement system, including models

– Standardized Approach (TSA): apply specified supervisory multiplier to 3-year average gross incomefor each of 8 business linesfor each of 8 business lines

– Basic Indicator Approach: apply uniform multiplier (15%) to 3-year average of aggregate positivegross income

– Since only AA banks in US are subject to operational risk requirement, only AMA used in US– Since only AA banks in US are subject to operational risk requirement, only AMA used in US

• BCBS March 2016 proposal would replace current 3 methods with single method consisting ofmodified version of existing TSA (Standardized Measurement Approach (SMA))

– Based on October 2014 consultative document– Based on October 2014 consultative document

– Prior AMA was found to be:

• Too complex

• Too reliant on internal modeling• Too reliant on internal modeling

• Lacking in comparability across institutions

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BCBS: Standardized Approach forOperational Risk Proposal

• Proposed new SMA• Proposed new SMA

– Must hold capital relative to “Business Indicator” exposure

– Business Indicator is generated from financial statements, adjusted forbank’s own operational loss data (the “Loss Component”)bank’s own operational loss data (the “Loss Component”)

• Business Indicator is based on gross income figures that are multiplied by a factorthat differs depending on the size of the bank’s gross income

• Loss Component uses 10 years of institution’s own loss data to calculate averageannual loss values for all losses, major losses, and minor losses (these are summedin the overall Loss Component calculation)

• BCBS proposal would apply to all internationally active bankingorganizations

– FRB will consider changes to US advanced approaches risk-based– FRB will consider changes to US advanced approaches risk-basedcapital rules

39

BCBS: Limitations on InternalRatings-Based Models

• BCBS proposed changes to the advanced and foundation• BCBS proposed changes to the advanced and foundationinternal ratings-based (IRB) approaches in March 2016that would:

– Remove the option to use the IRB approaches for certain typesof exposures (e.g., banks, large corporates, equities);

– Adopt exposure-level, model-parameter floors for portfolios– Adopt exposure-level, model-parameter floors for portfolioswhere the IRB approaches remain available; and

– Provide greater specification of parameter estimation practices– Provide greater specification of parameter estimation practicesto reduce variability in risk-weighted assets

• Reflects continuing concerns with risks originating from“unwarranted” model variability“unwarranted” model variability

40

Global: G-SIFI Designations

• FSB progress report and designations• FSB progress report and designations

– Annual G-SIB designations updated: China Construction Bankadded; BBVA removed; so currently 30

• US G-SIBs are: JP Morgan Chase, Citigroup, Bank of America, GoldmanSachs, Morgan Stanley, Bank of New York Mellon, State Street, and WellsFargo

• Each G-SIB assigned to a capital surcharge bucket (1% - 2.5%) (3.5% emptybucket; US buckets go up to 4.5%)

• Surcharge phased in over 3 years beginning January 2016 (same as USphase-in)Surcharge phased in over 3 years beginning January 2016 (same as USphase-in)

– Annual G-SII designations updated: Aegon added; Generaliremoved; so currently 9removed; so currently 9

• US G-SIIs are: AIG, MetLife, and Prudential (FSB designation not affectedby FSOC litigation) 41

BCBS: Basel III Implementation Progress

• All 27 members have implemented Basel III risk-based capital rules, LCRrules, and the capital conservation bufferrules, and the capital conservation buffer

– 24 have adopted final rules for the countercyclical capital buffer

– 23 have adopted or proposed rules for the regulation of domestic SIBs– 23 have adopted or proposed rules for the regulation of domestic SIBs

• Final assessments of risk-based capital rules found compliance by 24members

– LCR assessments completed in Hong Kong, India, Mexico, Russia, Saudi Arabia,Turkey and South Africa

– LCR and risk-based capital rule assessments are underway in South Korea,– LCR and risk-based capital rule assessments are underway in South Korea,Argentina, and Indonesia

– G-SIB standards will be assessed in five G-SIB jurisdictions

• Thematic assessments of cross-jurisdiction consistency of risk-weighted• Thematic assessments of cross-jurisdiction consistency of risk-weightedassets published for counterparty credit risk and the banking book

42

BCBS Implementation Progress: ThematicAssessments

• BCBS has issued several reports on the consistency of risk-weighted assetsin the banking and trading booksin the banking and trading books

• October 2015 report of risk-weighted assets for counterparty credit riskfocused on modeling of derivativesfocused on modeling of derivatives

– Found considerable variability in models due to bank and national supervisorchoices

• April 2016 report of use of IRB models to calculate credit risk capital• April 2016 report of use of IRB models to calculate credit risk capitalrequirements in banking book focused on variability in:

– Retail and small and medium-sized enterprise (SME) banking book portfolios– Retail and small and medium-sized enterprise (SME) banking book portfoliosand

– Estimates of exposure at default (EAD) across the entire banking book

– Found that variations in SME portfolios could move risk-based capital ratio by– Found that variations in SME portfolios could move risk-based capital ratio byup to 3% and wide variations in estimation practices for EAD

43

BCBS Implementation Progress:Individual Banks

• Reviewed “Tier 1” banks (internationally active) and Tier 2• Reviewed “Tier 1” banks (internationally active) and Tier 2banks (all other) on a fully phased-in basis

– 100% of Tier 1 and Tier 2 banks met a 4.5% CET1 risk-based capitalratioratio

– 100% of Tier 1 banks met 7.0% CET1 risk-based (i.e., with capitalconservation buffer), 6.0% Tier 1 risk-based, 8.0% Total risk-based,and 3% leverage ratiosand 3% leverage ratios

• Most Tier 2 banks met these requirements

– Most Tier 1 and Tier 2 banks met the 8.5% Tier 1 and 10.5% total risk-– Most Tier 1 and Tier 2 banks met the 8.5% Tier 1 and 10.5% total risk-based capital ratios (i.e., with capital conservation buffer)

– 84% of Tier 1 and Tier 2 banks met the 100% LCR requirement

– 79% of Tier 1 banks and 83% of Tier 2 banks met the 100% NSFRrequirement

44

Still to Come

• Finalization of US TLAC, CCyB policy statement, US NSFR, and• Finalization of US TLAC, CCyB policy statement, US NSFR, andinsurance company capital requirements

• Finalization of BCBS credit and operational risk standardizedapproaches, denominator changes for leverage ratio, and USapproaches, denominator changes for leverage ratio, and USimplementation

• BCBS review of treatment of sovereign risk• BCBS review of treatment of sovereign risk

45

Single Counterparty CreditSingle Counterparty CreditLimits/Regulation YY UpdateLimits/Regulation YY Update

David SahrPartner

+44 20 3130 3496+44 20 3130 [email protected]

Topics to be Addressed

• Single Counterparty Credit Limits Re-proposal

– Limits

– Covered company definition

– Counterparty definition and aggregation

– Credit exposure definition

– Calculating gross and net credit exposure

– Issues for structured finance vehicles

– Other credit exposure consideration

– Compliance requirements

• Regulation YY Implementation

– Compliance date

– Frequently asked questions

– Variances granted or denied

Other implementation issues– Other implementation issues

47

SINGLECOUNTERPARTYCOUNTERPARTYCREDIT LIMITSCREDIT LIMITS

48

Single Counterparty Credit Limits Re-proposal

• Section 165(e) of Dodd-Frank requires that the Federal Reserve (FRB)establish concentration limits for credit exposures by covered companiesestablish concentration limits for credit exposures by covered companies(known as “single counterparty credit limits” or “SCCL”)

– Limit the aggregate credit exposure a covered company may have to a– Limit the aggregate credit exposure a covered company may have to acounterparty

– Similar to existing lending and investment limits for banks

– Covered companies include bank holding companies (BHCs), foreign banking– Covered companies include bank holding companies (BHCs), foreign bankingorganizations (FBOs), and intermediate holding companies (IHCs)

• FRB re-proposed SCCL in March 2016

– FRB had initially proposed SCCL in 2011 for domestic covered companies and2012 for foreign covered companies as part of enhanced prudential standardsrulemaking

• Final rule possible later in 2016, with phase-in during 2017 and 2018

49

SCCL: Limits

• Covered companies’ credit exposure to counterparties would• Covered companies’ credit exposure to counterparties wouldbe calculated as aggregate net credit exposure divided byeligible capital base

Counterparties MajorCounterparties

Smaller Covered 25 percent of capital 25 percent of capitalSmaller CoveredCompany

25 percent of capitalstock and surplus

25 percent of capitalstock and surplus

Larger CoveredCompany

25 percent of Tier 1capital

25 percent of Tier 1capitalCompany capital capital

Major CoveredCompany



50

SCCL: Covered Company Definition

• Covered companies are divided into several categories:

– Smaller covered companies: Any BHC, FBO, or IHC with at least $50 billion intotal consolidated assets, but less than $250 billion in total consolidatedassets and less than $10 billion in total on-balance sheet foreign exposure

Larger covered companies: Any BHC, FBO, or IHC with at least $250 billion in– Larger covered companies: Any BHC, FBO, or IHC with at least $250 billion intotal consolidated assets or at least $10 billion in total on-balance sheetforeign exposure

– Major covered companies: Any globally systemically important BHC (G-SIB)– Major covered companies: Any globally systemically important BHC (G-SIB)under Method 1 of FRB’s G-SIB surcharge rule and any FBO or IHC with totalconsolidated assets of $500 billion or more

• Covered companies include the top-tier entity in a group and any company• Covered companies include the top-tier entity in a group and any companycontrolled directly or indirectly by that entity

• Nonbank financial companies supervised by FRB are not subject to theproposed rule, although FRB intends to apply a similar rule to them in theproposed rule, although FRB intends to apply a similar rule to them in thefuture

51

SCCL: Counterparty Definition

• Covered companies’ counterparties include all unaffiliated:

– Companies (including 25 percent owned companies and consolidated companies)

– Natural persons (including immediate family members)

– US state and municipal governments and instrumentalities– US state and municipal governments and instrumentalities

– Foreign national governments and their instrumentalities and political subdivisions except thatforeign governments that are assigned a 0 percent risk weight under the regulatory capital rules andtheir instrumentalities are not covered (political subdivisions are not eligible for this exemption)

– “Counterparty” would not include the US federal government, foreign national governments subjectto a 0 percent risk weight (except for their political subdivisions), and the foreign nationalgovernment of an FBO’s home country

• Major counterparties are a subset of counterparties that consists of:• Major counterparties are a subset of counterparties that consists of:

– BHCs designated by FRB as G-SIBs

– FBOs that have the characteristics of G-SIBs under the BCBS’s methodology or that FRB determineswould be globally systemically important at an IHC or FBO levelwould be globally systemically important at an IHC or FBO level

– Nonbank financial companies supervised by FRB

52

SCCL: Counterparty Aggregation

• Covered company would be required to aggregate its credit• Covered company would be required to aggregate its creditexposure to a given counterparty with its exposure to anyother person:

– Under certain control relationships (such as voting agreements,– Under certain control relationships (such as voting agreements,control over management) with the counterparty

– That is “economically interdependent” with the counterparty (if the– That is “economically interdependent” with the counterparty (if thecredit exposure to the counterparty exceeds 5 percent of the coveredcompany’s total capital)

• The rule lays out various factors to determine economic interdependence• The rule lays out various factors to determine economic interdependence

53

SCCL: Credit Exposure Definition

• Definition of credit exposure would include:• Definition of credit exposure would include:

– Extensions of credit (i.e., loans, deposits, and lines of credit, butexcluding uncommitted lines of credit)

Repurchase and reverse repurchase transactions and securities– Repurchase and reverse repurchase transactions and securitieslending and borrowing arrangements

– Guarantees, acceptances, and letters of credit– Guarantees, acceptances, and letters of credit

– Purchases of, or investments in, counterparty securities

– Derivative transactions– Derivative transactions

– Functionally equivalent transactions

54

SCCL: Credit Exposure Definition

• Exempt exposures would be:• Exempt exposures would be:

– US government exposures

– A foreign government (including its instrumentalities, but not itspolitical subdivisions) exposure subject to a 0 percent risk-weightpolitical subdivisions) exposure subject to a 0 percent risk-weight

– Fannie Mae and Freddie Mac exposures (only during conservatorship)

– Intraday credit exposures– Intraday credit exposures

– Trade exposures to a qualified central counterparty

– Foreign government, home-country sovereign exposure for an FBO or– Foreign government, home-country sovereign exposure for an FBO orIHC

55

SCCL: Calculating Gross Credit Exposure

• Loans and leases – amount owed by counterparty

• Debt securities – market value for trading and available-for-sale

• Equity securities – market value

• Repos/reverse repos/securities lending/borrowing – adjusted market value of• Repos/reverse repos/securities lending/borrowing – adjusted market value ofsecurities/cash

• Guarantees/letters of credit – maximum potential loss

• Committed credit lines – face amount of line• Committed credit lines – face amount of line

• Credit/equity derivatives – protection provider exposure to issuer of reference assetdefined as maximum potential loss on the transaction

• Derivatives transactions

– Transactions subject to a QMNA may use any method from Reg Q that the coveredcompany is eligible to use, adjusted for the SCCL’s collateral recognition rules

– Transactions not subject to a QMNA use the current exposure method from Reg Q

56

SCCL: Calculating Net Credit Exposure

• Repos/reverse repos/securities lending/borrowing – “repo-styletransaction” subject to netting agreement calculated under Reg Qtransaction” subject to netting agreement calculated under Reg Q

• For other credit transactions, reduce gross credit exposure by appropriateadjusted market value of eligible collateraladjusted market value of eligible collateral

• For any credit transaction, reduce gross credit exposure by amount ofeligible guarantee issued by eligible protection provider

• In certain circumstances may reduce gross credit exposure by face amountof short sale of counterparty’s debt or equity security

57

SCCL: Treatment for Structured FinanceVehicles

• Larger covered companies are required to “look-through” to• Larger covered companies are required to “look-through” tocredit exposures of structured finance vehicles (e.g., SPVs) ifthe exposure to any issuer of any underlying assets is at least0.25 percent of the covered company’s Tier 1 capital0.25 percent of the covered company’s Tier 1 capital

– Covered companies must aggregate underlying exposures to unknownissuers as a single unknown counterparty

– Must track exposure to SPV and to underlying issuers, as well as tothird-parties whose failure could cause a loss in value of the coveredcompany’s exposure to the SPV (e.g., fund managers, liquiditycompany’s exposure to the SPV (e.g., fund managers, liquidityproviders)

58

SCCL: Other Credit Exposure Considerations

• Attribution rule – if proceeds used for benefit of third party,• Attribution rule – if proceeds used for benefit of third party,deemed to be credit exposure to third party

• If a covered company uses eligible guarantee or eligiblecollateral to reduce the value of an exposure, then the coveredcollateral to reduce the value of an exposure, then the coveredcompany must recognize an exposure to the protectionprovider (risk-shifting)provider (risk-shifting)

– Even if initial exposure is not subject to SCCL, exposure to protectionprovider must be recognized

59

SCCL: Compliance Requirements

• Compliance would involve calculation of limits and reporting to FRB:

Compliance Reporting to FRB

Smaller Covered Company Generally quarterlybasis

Quarterlybasis

Larger Covered Company Daily basis Monthly

Major Covered Company Daily basis Monthly

• 90-day safe harbor for covered companies to correct SCCL non-compliancedue to changes in capital or mergerdue to changes in capital or merger

• Covered companies would be required to comply within one (larger andmajor covered companies) or two (smaller covered companies) years of thefinal rule’s effective datefinal rule’s effective date

60

REGULATION YYIMPLEMENTATIONIMPLEMENTATION

61

Regulation YY: Implementation andCompliance Date

• FRB released final enhanced prudential standards for large BHCs and FBOsin February 2014 (known as “Regulation YY”)in February 2014 (known as “Regulation YY”)

– Implements the IHC requirement for FBOs with large US operations

– Implements capital, liquidity, risk management, and stress testing requirements for– Implements capital, liquidity, risk management, and stress testing requirements forlarge BHCs, FBOs and IHCs

– Graduated application of requirements based on amount of consolidated assets and incase of FBOs with $50 billion or more in consolidated assets depending on amount ofcase of FBOs with $50 billion or more in consolidated assets depending on amount ofthe US non-branch or US combined assets

• Phased implementation from January 1, 2015 to January 1, 2018

– Most requirements effective July 1, 2016– Most requirements effective July 1, 2016

• Many FBOs have faced significant hurdles to:

– Reorganize corporate structures to implement the IHC requirement– Reorganize corporate structures to implement the IHC requirement

– Restructure the risk function to implement the US risk committee and US chief riskofficer requirements

62

Regulation YY: Frequently Asked Questions

• FRB released answers to 55 “frequently asked questions”• FRB released answers to 55 “frequently asked questions”in June 2014; addressed major topics related to:

– Implementation plan requirement

– US structure of FBO operations

– Regulatory reporting

– Capital stress testing

– Risk management

– Liquidity

• FRB may issue additional guidance tailored to institution-• FRB may issue additional guidance tailored to institution-specific concerns

63

Regulation YY: Variances Granted or Denied

• Many FBOs have submitted requests to FRB for “variances”• Many FBOs have submitted requests to FRB for “variances”from Regulation YY requirements

– FRB has thus far approved 12 requests and rejected or substantiallymodified 5 requestsmodified 5 requests

• Requests generally addressed compliance with the IHCrequirementrequirement

– FRB appears more receptive to requests where compliance withRegulation YY is impossible under local law or would impose a grosslydisproportionate burden on the FBO relative to the risk mitigateddisproportionate burden on the FBO relative to the risk mitigated

– Mere difficulties or inconvenience in restructuring does not appear tobe a sufficient basis for FRB to grant a variance

– Some requests were pending for up to 19 months prior to an FRBdetermination being issued

64

Implementation Issues:US Risk Committee

• Structural/governance

– Supervisory Board

– Standalone committee vs. part of enterprise-wide committee

– Full committee vs. subcommittee

• Meeting frequency: no guidance

– FBOs with over $50B in US must do so quarterly, so presumably less– FBOs with over $50B in US must do so quarterly, so presumably lessfrequently than quarterly would be permissible for FBOs with smaller USfootprints

• Annual certification• Annual certification

– Per December 2015 FRB Y-7 proposal, new Report Item 5 beginning with 2016report due April 30, 2017

– Unclear when non-calendar year FBOs are expected to report

65

Implementation Issues:Capital and Liquidity Stress Testing

• Capital stress testing

– Requirement to certify that FBO is subject to annual consolidated capitalstress test; FBO must pass the test

– Per December 2015 FRB proposed amendments to FR Y-7, new Report Item– Per December 2015 FRB proposed amendments to FR Y-7, new Report Item5(d) provides for certification

– Reg YY also imposes governance standards (e.g., oversight by board andsenior management, model validation)senior management, model validation)

• Liquidity stress testing

– Must “report results” annually to FRB

– No guidance or format yet

– Open item as to reporting date (December 31, 2016 year-end vs. July 1, 2016effective date)effective date)

66

Implementation Issues:Home-Country Capital Compliance

• Form FR Y-7Q already requires certification as to whether• Form FR Y-7Q already requires certification as to whetherFBO is subject to home-country Basel III capital regime

• April 2016 proposed amendments to FR Y-7Q:• April 2016 proposed amendments to FR Y-7Q:

– Beginning September 30, 2016: 14 new report items for homecountry capital ratios/numbers; and

– Beginning March 31, 2018: 3 additional items for leverage ratio

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Incentive-Based CompensationIncentive-Based CompensationNEW PROVISIONS IN THE 2016 PROPOSED RULE

Tom DelaneyPartner

+1 202 263 3216+1 202 263 [email protected]

Topics to be Discussed

1. Background and Purpose1. Background and Purpose

2. Covered Institutions

3. Covered Persons

4. General Requirements and Prohibitions4. General Requirements and Prohibitionsfor all Covered Institutions

5. Additional Requirements and Prohibitions5. Additional Requirements and Prohibitionsfor Level 1 and Level 2 Covered Institutions

6. Compliance Date and Enforcement6. Compliance Date and Enforcement

69

Background

• Sec. 956 of the Dodd Frank Act requires enhanced disclosure andreporting of incentive-based compensation (IBC) arrangements forreporting of incentive-based compensation (IBC) arrangements forcertain financial institutions with at least $1 billion in assets.

• 2011 Proposed Rule was issued but never finalized• 2011 Proposed Rule was issued but never finalized

– Issued jointly by Board of Governors of the Federal Reserve System (FRB),Federal Deposit Insurance Corporation (FDIC), Federal Housing FinanceAgency (FHFA), National Credit Union Association (NCUA), Office of theAgency (FHFA), National Credit Union Association (NCUA), Office of theComptroller of the Currency (OCC) and the Securities and ExchangeCommission (SEC) (collectively, the regulators)

– Most of its provisions are retained in the 2016 Proposed Rule (e.g.,– Most of its provisions are retained in the 2016 Proposed Rule (e.g.,deferral of certain compensation, balancing risk and financial rewards)

• Other concepts are expanded or more precisely defined in the 2016 Proposed Rule

• Some new additions were included in the 2016 Proposed Rule (e.g., clawback)

Background

• Concurrently, the regulators focused on IBC in other ways:

– Horizontal Review (2009)

• FRB, with OCC and FDIC cooperation, began a horizontal review of IBC at 25 large,complex banking organizations (both US and foreign). A second, cross-firm review of 12additional banking organizations began in 2012.additional banking organizations began in 2012.

– Federal Banking Agency Guidance on IBC (2010)

• US regulators issued guidance concerning IBC programs in 2010 that is applicable to allbanking organizations, regardless of asset size

• Uses a principles-based approach to tie compensation awards to longer-termperformance and avoid undermining safety and soundness or undue risks to the financialsystem

– OCC’s Heightened Standards (2014)– OCC’s Heightened Standards (2014)

• Requires compensation programs that prohibit IBC arrangements that encourageinappropriate risks by providing excessive compensation or that could lead to materialfinancial loss for the institution

• Applies to insured national banks, federal savings associations, and federal branches with• Applies to insured national banks, federal savings associations, and federal branches withat least $50 billion in average total consolidated assets

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Purpose

• Policy aim: to avoid compensation arrangements that• Policy aim: to avoid compensation arrangements thatencourage inappropriate risks or that could lead to materialfinancial loss to a financial institution or the financial system

• Regulators view the 2016 Proposed Rule as:

– Building on the 2011 Proposed Rule with some modifications– Building on the 2011 Proposed Rule with some modifications

– Extending industry standards and practices developed at the largestinstitutions to all Covered Institutions with at least $1 billion inaverage total consolidated assetsaverage total consolidated assets

– Bringing standards in line with those that have already been adoptedby financial regulators in other leading jurisdictionsby financial regulators in other leading jurisdictions

72

Covered Institutions

• Covered Institutions were defined in the 2011 Proposed Rule, toinclude:include:

– Depository institutions or depository institution holding companies (includes state-licensed insured branches of a foreign bank)

– Registered broker-dealers– Registered broker-dealers

– Investment advisers (whether registered or not)

– Credit unions

– Federal branches (insured or uninsured) of a foreign bank– Federal branches (insured or uninsured) of a foreign bank

– State-licensed uninsured branches and agencies of foreign banks, Edge andAgreement Corporations, and other US operations of foreign banking organizations(FBOs) treated as bank holding companies (BHCs) under section 8(a) of theInternational Banking Act of 1978(FBOs) treated as bank holding companies (BHCs) under section 8(a) of theInternational Banking Act of 1978

• 2016 Proposed Rule also includes:

– State-chartered non-depository trust companies that are members of the FederalReserve System (OCC licensed trust banks are included in the depository

– State-chartered non-depository trust companies that are members of the FederalReserve System (OCC licensed trust banks are included in the depositoryinstitution definition)

Covered InstitutionsAsset Levels

• The 2016 Proposed Rule generally distinguishes among Covered Institutionsbased on their average total consolidated assets, grouping them into threebased on their average total consolidated assets, grouping them into threeasset levels:

Level 1 At least $250 billionMost prescriptive

requirements and prohibitionsLevel 1 At least $250 billion

requirements and prohibitions

Level 2At least $50 billion,

but less than $250 billion

• 2011 Proposed Rule only had two asset levels: $1 billion and $50 billion

Level 3At least $1 billion,

but less than $50 billionLeast prescriptive requirements

and prohibitions (but still covered)

• 2011 Proposed Rule only had two asset levels: $1 billion and $50 billion

• 2016 Proposed Rule would:

• Add the $250 billion asset level

• Include a reservation of authority such that a Level 3 institution can be• Include a reservation of authority such that a Level 3 institution can bedeemed a higher level if assets are at least $10 billion and its operationsare complex enough

Covered Institutions: Subsidiaries -Special Considerations

• A subsidiary may comply with any part of the rule through its parent

• Asset level generally determined by top-tier parent CoveredInstitution’s average total consolidated assets

– Subsidiaries are subject to the same requirements as the parent–even if a subsidiary’s asset on an individual basis could qualify for a lower

– Subsidiaries are subject to the same requirements as the parent–even if a subsidiary’s asset on an individual basis could qualify for a lowertier

• However, there are two considerations for a subsidiary of adepository institution holding company:depository institution holding company:

– The subsidiary’s average total consolidated assets determineswhether that subsidiary is a Covered Institution (i.e., does it have atleast $1 billion in average total consolidated assets)least $1 billion in average total consolidated assets)

• If the subsidiary has less than $1 billion, it is not covered, regardless if theaverage total consolidated assets of the holding company are above $1 billion

– The subsidiary’s designation as Level 1, 2 or 3 is based on the top-tier– The subsidiary’s designation as Level 1, 2 or 3 is based on the top-tierdepository institution holding company’s average total consolidatedassets

Covered Institutions: Foreign BankingOrganizations (FBOs) - Special Considerations

• US operations of FBOs, generally:

– The subsidiary’s asset level would be determined by the totalconsolidated US assets of the FBO, including the assets of:

any US branches or agencies of the FBO;• any US branches or agencies of the FBO;

• any US subsidiaries of the FBO; and

• any US operations held pursuant to section 2(h)(2) of the Bank Holding• any US operations held pursuant to section 2(h)(2) of the Bank HoldingCompany Act (i.e., nonbanking activities principally engaged in bankingactivities outside of the United States).

• However, the asset level of an OCC-regulated Federal branch or agency of a• However, the asset level of an OCC-regulated Federal branch or agency of aforeign bank is determined by the assets of the Federal branch or agency,not the FBO

– Thus if the assets of an OCC licensed branch are less than $1 billion, it– Thus if the assets of an OCC licensed branch are less than $1 billion, itis not covered

Covered Persons

• Covered Person: any employee, executive officer, director• Covered Person: any employee, executive officer, directoror principal shareholder who receives IBC at a CoveredInstitution

• 2016 Proposed Rule would extend IBC regulation to• 2016 Proposed Rule would extend IBC regulation to“Significant Risk-Takers”

– 2011 Proposed Rule applied only to Senior Executive Officers– 2011 Proposed Rule applied only to Senior Executive Officers

– Significant Risk-Taker is a Covered Person, other than a SeniorExecutive Officer, who has the ability to create a risk of materialfinancial lossfinancial loss

• Two tests determine if a Covered Person could be a Significant Risk-Taker; if one of those tests is satisfied, then a third test categorizesindividuals based on the extent to which IBC is a percentage of theirindividuals based on the extent to which IBC is a percentage of theirtotal compensation

77

Covered PersonsSignificant Risk-Taker – 3 Tests

• Relative Compensation Test

– Is the Covered Person among the highest compensated Covered Persons in the entire– Is the Covered Person among the highest compensated Covered Persons in the entireconsolidated organization, including affiliated Covered Institutions?

• Top 5% of Covered Persons for Covered Institutions with at least $250 billion inaverage total consolidated assets

• Top 2% of Covered Persons for Covered Institutions with at least $50 billion inaverage total consolidated assets

• Exposure Test

– Does the Covered Person have authority to commit or expose 0.5% of the common– Does the Covered Person have authority to commit or expose 0.5% of the commonequity tier 1 capital of the Covered Institution or an affiliate that is also a CoveredInstitution?

• IBC Threshold Test

– Is the Covered Person’s IBC at least one-third of his/her total annual base salary and IBCcombined?

If either the Relative Compensation Test or the Exposure Test is met and the IBCThreshold Test is satisfied, and the Covered Person is not a Senior ExecutiveThreshold Test is satisfied, and the Covered Person is not a Senior ExecutiveOfficer, then he/she is a Significant Risk-Taker

General Requirements and Prohibitionsfor all Covered Institutions(regardless of asset level, applies to all Covered Persons)

• Specifically provides that an IBC arrangement would not meet itsrequirement to balance risk and reward unless it:

(regardless of asset level, applies to all Covered Persons)

requirement to balance risk and reward unless it:

– Includes financial and non-financial measures of performance

– Is designed to allow non-financial measures of performance to override– Is designed to allow non-financial measures of performance to overridefinancial measures of performance

– Is subject to adjustment to reflect actual losses, inappropriate risks taken,compliance deficiencies, or other measures or aspects of financial andcompliance deficiencies, or other measures or aspects of financial andnon- financial performance

• Replaces the annual reporting requirement of the 2011 ProposedRule with an annual recordkeeping requirementRule with an annual recordkeeping requirement

– Covered Institutions must create annual records documenting IBCarrangements and demonstrating compliance with the Proposed Rule

– Must maintain such records for 7 years– Must maintain such records for 7 years

Additional Requirements and Prohibitionsfor Level 1 and Level 2 Covered Institutions

• Deferral: delayed vesting of IBC to account for risks taken by a Covered Person

– Accelerating unvested deferred amounts is not permitted (unless death or injury)– Accelerating unvested deferred amounts is not permitted (unless death or injury)

– For Covered Institutions that issue equity as part of compensation, deferred amounts must consistof substantial amounts of cash and equity-like instruments (i.e., any form of payment where thefinal value is linked to the price of the Covered Institution’s equity, even if such compensation settlesin the form of cash). Options cannot form more than 15% of the deferred amount.in the form of cash). Options cannot form more than 15% of the deferred amount.

– Qualifying IBC = the amount of IBC awarded to a Covered Person for a particular performanceperiod, excluding amounts awarded for that particular performance period under any Long-termIncentive Plans

Level 1 Level 2

Senior ExecutiveOfficers

SignificantRisk-Takers

Senior ExecutiveOfficers

SignificantRisk-Takers

Qualifying IBC(Short-Term)

60% deferralfor four years

50% deferralfor four years

50% deferralfor three years

40% deferralFor three years

Long-Term 60% deferral 50% deferral 50% deferral 40% deferralLong-TermIncentive Plans

60% deferralfor two years

50% deferralfor two years

50% deferralfor one year

40% deferralfor one year

Deferred amounts must vest on a pro rata annual basis


• Forfeiture reduces the amount of deferred IBC that has not yet vested

Level 1 and Level 2 Covered Institutions would be required to subject to Forfeiture all– Level 1 and Level 2 Covered Institutions would be required to subject to Forfeiture allunvested, deferred IBC of any Senior Executive Officer or Significant Risk-Taker

– Includes unvested deferred amounts awarded under Long-Term Incentive Plans and anydeferred amounts not required by the Proposed Rule

• Downward Adjustment reduces a Covered Person’s IBC amount not yet awardedfor any performance period that is underway (including amounts payable underLong-term Incentive Plans)

• Events requiring consideration of Forfeiture or Downward Adjustment include:• Events requiring consideration of Forfeiture or Downward Adjustment include:

– Poor financial performance due to a significant deviation from the Covered Institution’srisk parameters set forth in its policies and procedures

– Inappropriate risk-taking (even if positive financial impact)– Inappropriate risk-taking (even if positive financial impact)

– Material failures of risk management or controls

– Enforcement or legal action brought by a federal or state regulator/agency or a requiredrestatement of a financial statement to correct a material error

• Reviews/Consideration of Forfeiture or Downward Adjustment must be part of theIBC arrangements for Senior Executive Officers and Significant Risk-Takers


• Clawback: a mechanism to recover vested IBC from a• Clawback: a mechanism to recover vested IBC from aSenior Executive Officer or Significant Risk-Taker due tocertain events or conduct

– Applies to both current and former Senior Executives and– Applies to both current and former Senior Executives andSignificant Risk-Takers

– 7 year Clawback period: following the date on which IBC vests(i.e., after any deferral periods)

– 7 year Clawback period: following the date on which IBC vests(i.e., after any deferral periods)

– Triggered if Senior Executive Officer or Significant Risk-Takerengaged in:engaged in:

• Misconduct resulting in significant financial or reputational harm to theCovered Institution

• Fraud or intentional misrepresentation of information used to determine• Fraud or intentional misrepresentation of information used to determinethe Senior Executive Officer or Significant Risk-Taker’s IBC


• More detailed recordkeeping requirements apply to Level 1and Level 2 Covered Institutions. They must also document:

• More detailed recordkeeping requirements apply to Level 1and Level 2 Covered Institutions. They must also document:

– Senior Executive Officers and Significant Risk-Takers, listed by legalentity, job function, organizational hierarchy, and line of businessentity, job function, organizational hierarchy, and line of business

– IBC arrangements for Senior Executive Officers and Significant Risk-Takers, including information on the percentage deferred and form ofawardaward

– Any Forfeiture and Downward Adjustment or Clawback reviews anddecisions for Senior Executive Officers and Significant Risk-Takers

– Any material changes to the covered institution’s IBC arrangements– Any material changes to the covered institution’s IBC arrangementsand policies

• Records must be maintained in a manner that allows for anindependent auditindependent audit

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• Risk management and controls for IBC programs are moreextensive than the 2011 Proposed Ruleextensive than the 2011 Proposed Rule

– Risk management framework required for Level 1 and Level2 CoveredInstitutions

• Must be independent from the business lines

• Must include independent compliance program with internal controls, testing,monitoring and training, and written policies and procedures

• Control function personnel would be required to have appropriate authority to• Control function personnel would be required to have appropriate authority toinfluence risk-taking of business areas; must have compensation determinedindependently from the performance of the business area they monitor

– Must have independent monitoring of compliance with rule’s– Must have independent monitoring of compliance with rule’srequirements and prohibitions

– In many respects these requirements are not substantially differentthan those that apply to financial institutions in other contexts


• Governance and internal assessments

– Compensation Committee of board of directors cannot include Senior ExecutiveOfficers and would be required to:

• Seek input from Risk and Audit Committees and risk management functionregarding effectiveness of risk measures and adjustments to balance IBCregarding effectiveness of risk measures and adjustments to balance IBCagreements

• Obtain an independent written assessment from Internal Audit

– Management would be required to submit an annual (or more frequent) writtenassessment to the Compensation Committee documenting the effectiveness of the IBCassessment to the Compensation Committee documenting the effectiveness of the IBCprogram’s compliance. In doing so, it must seek input from the Risk and AuditCommittees

• Written policies and procedures must comply with the 2016 Proposed Rule

– The 2016 Proposed Rule specifies minimum requirements for written policies andprocedures (e.g., must specify the substantive and procedural criteria forForfeiture and Clawback; provide for the documentation of final Forfeiture,Downward Adjustment, and Clawback decisions)


• No hedging for any Covered Persons—not only Senior Executive Officers andSignificant Risk-TakersSignificant Risk-Takers

– Does not limit a Covered Institution’s ability to hedge its own exposure in deferred compensationobligations, which the Board, the OCC, and the FDIC continue to view as a prudent practice

• Cannot exclusively use relative performance measures• Cannot exclusively use relative performance measures

– Applies to any Covered Person; but may combine relative performance measures with absoluteperformance measures (e.g., total shareholder return)

• IBC decisions cannot be based exclusively on transaction revenue or volume

– Applies to any Covered Person

– Must consider the transaction quality and compliance of the Covered Person with sound riskmanagement practice

• Limit on maximum IBC opportunity/leverage• Limit on maximum IBC opportunity/leverage

– If an IBC plan allows a Senior Executive Officer or Significant Risk-Taker to receiveamounts in excess of their target amounts due to performance that exceeds thosetargets, that leverage may not exceed:

• 125% of the target amount for a Senior Executive Officer

• 150% of the target amount for a Significant Risk-Taker

Compliance Date and Enforcement

• Compliance Date• Compliance Date

– No later than the first calendar quarter at least 540 days (about1.5 years) after the final rule is published

– Proposed Rule would not apply to IBC plans that haveperformance periods that begin before the compliance date

• Enforcement• Enforcement

– Besides the FHFA, the regulators will enforce the provisions ofthe Proposed Rule under section 505 of the Gramm-Leach-the Proposed Rule under section 505 of the Gramm-Leach-Bliley Act, as specified in section 956 of the Dodd-Frank Act

Current Issues Under theCurrent Issues Under theVolcker Rule

Donald WaackPartner

+1 202 263 3165+1 202 263 [email protected]

Topics to be Addressed

• Industry Interpretive Issues & Trends• Industry Interpretive Issues & Trends

– Foreign Excluded Funds Update

– Conformance Period Extensions for Legacy Funds– Conformance Period Extensions for Legacy Funds

• Select Practice Points• Select Practice Points

– SOTUS Conformance for Legacy Covered Fund Investments

– Structuring New Equity Investments under the Volcker Rule– Structuring New Equity Investments under the Volcker Rule

– Volcker and BHCA Compliance Issues

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INDUSTRYINTERPRETIVEINTERPRETIVEISSUES &ISSUES &TRENDS

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Foreign Excluded Funds Update

• Status of “foreign excluded funds” controlled by a non-US banking entityremains a key unresolved issueremains a key unresolved issue

– Refresher: Non-US funds controlled by a non-US banking entity that are notoffered/sold to US persons may themselves be “banking entities” subject tooffered/sold to US persons may themselves be “banking entities” subject tothe Volcker Rule proprietary trading and covered fund investment restrictions

• Dialogue with the US regulators continues, industry groups have met withregulators in recent weeksregulators in recent weeks

• Key unresolved issues/regulator concerns:

– Federal Reserve Board continues to have a supervisory concern about foreignexcluded funds controlled by non-US banking entities engaging in proprietaryexcluded funds controlled by non-US banking entities engaging in proprietarytrading into the US without complying with TOTUS

– Certain non-US stakeholders continue to press for relief that extends to non-US private funds in which a foreign banking entity owns a greater than 25%US private funds in which a foreign banking entity owns a greater than 25%ownership interest (largely driven by fund-linked note activities)

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Foreign Excluded Funds Update

• Some indications of progress toward formal relief:

– Regulators have signaled they may be getting comfortable with exemptionfrom banking entity status for foreign excluded funds in which the non-USbank owns less than 25% (after seeding period)

• Approach could parallel relief for foreign public funds under FAQs 14 and 16

• Would permit non-US fund structures where the fund is “controlled” for BHCApurposes as a result of governance (e.g., foreign bank acting as manager, trustee,purposes as a result of governance (e.g., foreign bank acting as manager, trustee,GP, etc.) subject to the 25% proprietary ownership limit

– On a related issue, staff has informally indicated that it would not seek toapply Super 23A prohibition outside the US to SOTUS fundsapply Super 23A prohibition outside the US to SOTUS funds

• Among other things, this eliminates one of the primary impediments to SOTUS “optin” approach for foreign excluded funds

– Progress is slow, but trajectory suggests a reining in some of the more– Progress is slow, but trajectory suggests a reining in some of the moreegregious extraterritorial impacts of the Rule

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Conformance PeriodExtensions for Legacy Funds

• Federal Reserve Board’s December 2014 order extended the Volcker Ruleconformance period for “legacy” funds until July 21, 2016conformance period for “legacy” funds until July 21, 2016

– Scope: Investments in and relationships with (i) covered funds and (ii) foreignfunds that may be treated as banking entities that were in place as offunds that may be treated as banking entities that were in place as ofDecember 31, 2013

• December 2014 order promised a further extension:

The Board also intends next year to exercise the authority granted byThe Board also intends next year to exercise the authority granted bysection 13 of the BHC Act to grant the final one-year extension in order topermit banking entities until July 21, 2017, to conform ownershipinterests in and relationships with legacy covered funds.interests in and relationships with legacy covered funds.

• Question: Where is the further extension order, and what does the delaymean for your business?

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• Board staff silent regarding the delay, has acknowledged receiving inquiriesfrom the industry with increasing frequency as deadline approachesfrom the industry with increasing frequency as deadline approaches

• Nothing to suggest any intention of rescinding the previously announcedfurther extension for legacy fundsfurther extension for legacy funds

• Political Climate: significant incentive for regulators to avoid/minimizeaction that would be viewed as granting further “relief” to banking industry

– Likely to impact timing of announcement

• Technical Issue: BHCA § 13(c) permits the Board to extend the conformanceperiod by rule or order “for not more than one year at a time”period by rule or order “for not more than one year at a time”

– Likely basis for approach taken in the initial order of announcing “intention” to grant afurther extension, without actually granting the extension

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• Practical Implications of the Delay• Practical Implications of the Delay

– Provides banking entities with positions in legacy covered funds withadditional leverage, based on legal/regulatory requirement, to seek orforce redemptions of their investments prior to July 21, 2016force redemptions of their investments prior to July 21, 2016

• Performance-based or other concerns about specific legacy funds

• Avoid potential “fire sale” environment with respect to secondary market• Avoid potential “fire sale” environment with respect to secondary markettransactions in private equity and hedge fund interests in the run up toJuly 21, 2017

• Open-end funds with extended timeline for full redemption (e.g., 25%• Open-end funds with extended timeline for full redemption (e.g., 25%over four successive quarters); acting now may allow bank investor to getahead of other redemption requests

– While looming July 2016 “deadline” provides additional leverage,– While looming July 2016 “deadline” provides additional leverage,these incentives will not disappear even if/when extension is granted

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SELECTPRACTICEPRACTICEPOINTSPOINTS

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SOTUS Conformance forLegacy Covered Fund Investments

• Volcker Rule SOTUS exemption, as interpreted in FAQ 13, broadly permitsforeign banking entities to hold covered fund investments outside the US,foreign banking entities to hold covered fund investments outside the US,subject to conditions (checklist assumes QFBO status):

Banking entity is not organized in the US or directly or indirectly controlled by US-organized bankingentityentity

Banking entity and its affiliates do not act as sponsor, investment adviser, investment manager tothe fund, and are not otherwise involved in offering or selling any ownership interests in thecovered fund to US personscovered fund to US persons

Banking entity (including relevant personnel) that makes the decision to acquire or retain theownership interest in the covered fund is not located in the US or organized under US law

Ownership interest in the covered fund, including any related hedging transaction, is not accountedfor as principal (including a consolidated basis) by any US branch or US affiliatefor as principal (including a consolidated basis) by any US branch or US affiliate

No financing for the banking entity’s ownership interest is provided, directly or indirectly, by any USbranch or US affiliate

• Significant win for FBOs as well as US fund managers that can continue to• Significant win for FBOs as well as US fund managers that can continue toattract foreign bank capital even for US-organized private funds

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SOTUS Conformance forLegacy Covered Fund Investments

• In addition to relying on SOTUS for new investments, FBOs may conformexisting legacy covered fund investments that are held in the US to theexisting legacy covered fund investments that are held in the US to therequirements of the SOTUS exemption

• Several important interpretive issues and structuring mechanics to consider• Several important interpretive issues and structuring mechanics to considerwhen executing an internal transfer of a covered fund investment to a non-US affiliate in order to rely on SOTUS:

– Identity of the acquirer: ensure that the acquiring non-US affiliate is not “controlled” for– Identity of the acquirer: ensure that the acquiring non-US affiliate is not “controlled” forBHCA purposes by any US banking entity; not sufficient to drop investments into asubsidiary of the current US entity that holds the legacy fund investment(s)

– Decision-making authority: non-US acquirer and its personnel will need to make the– Decision-making authority: non-US acquirer and its personnel will need to make thedecision to acquire and retain the covered fund investment(s); requires coordination onstructuring across affiliates and geographies while at the same time ensuring that finaldecision-making authority resides with non-US personnel

– Prohibition on US financing: transaction needs to be executed in a way that ensures US– Prohibition on US financing: transaction needs to be executed in a way that ensures USholder of the legacy fund investment(s) is not viewed as “financing” the acquisition byits non-US affiliate

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Structuring New Equity Investmentsunder the Volcker Rule

• Many creative ways to structure transactions to avoid holding an ownershipinterest in a covered fund, while also achieving business objectives tointerest in a covered fund, while also achieving business objectives toleverage expertise of particular managers and achieve exposure toparticular assets

• A number of common, relatively straightforward examples:

– Exemptions and exclusions under the final regulation itself

– Alternative exceptions and exemptions under the Investment Company Act to avoid– Alternative exceptions and exemptions under the Investment Company Act to avoidrelying on sections 3(c)(1) and 3(c)(7)

– Analyze whether the vehicle is a threshold “investment company” in the first place (orcan be structured to avoid that result)can be structured to avoid that result)

• Deals also may involve more “structured” approaches to achievingeconomics analogous to those associated with a particular fund investmentwithout giving rise to a covered fund ownership interestwithout giving rise to a covered fund ownership interest

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• Example: “side-by-side” investments in portfolio companies held by aprivate fund that relies on 3(c)(1) or 3(c)(7)private fund that relies on 3(c)(1) or 3(c)(7)

• General concept is for banking entity investor to enter into an agreementwith fund manager to invest on a pro rata or other formulaic basis in thewith fund manager to invest on a pro rata or other formulaic basis in thesame (or similar) portfolio of underlying companies

– May allow banking entity investor to rely on its fund manager’s expertise and achievesimilar economics to a fund investment, without involving a covered fund ownershipsimilar economics to a fund investment, without involving a covered fund ownershipinterest

• Regulatory risk (and bank investor’s risk tolerance) are critical elements ofany such proposalany such proposal

– Expansive and vague anti-evasion provisions under section _.20 of the final Volckerregulation could result in regulatory scrutiny or even termination/divestiture order

– On the other hand, banking entities have multiple investment authorities available to– On the other hand, banking entities have multiple investment authorities available tothem under the BHCA, which under certain circumstances permit (and have longpermitted) investments in portfolio companies

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• Elements of side-by-side investment structure that provide banking entityinvestor with discretion and/or those that result in some degree ofinvestor with discretion and/or those that result in some degree of“misalignment” between investor and fund should help mitigate VolckerRule evasion risk:

– Discretion on investor’s part with respect to individual portfolio companies (e.g., limitedopt out rights)

– Optionality with respect to investment amount in particular portfolio companies (e.g.,avoid blanket pro rata investment requirement)avoid blanket pro rata investment requirement)

– Avoid compulsory alignment with respect to timing/circumstances of exiting individualportfolio company investments

– Avoid voting agreements with respect to underlying securities (i.e., banking entityinvestor votes its shares independently of fund)

• Thorough risk assessment and reasoned analysis regarding permissibility ofThorough risk assessment and reasoned analysis regarding permissibility ofthe transaction/structure will be critical part of internal approval process

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Volcker and BHCA Compliance Issues

• Mapping “banking entities” on a global basis has been a key element ofVolcker Rule conformance process for most large banking organizationsVolcker Rule conformance process for most large banking organizations

• Fundamental task is applying BHCA/Reg. Y definition of “control” to non-UScompanies, funds, SPEs, other legal entities:companies, funds, SPEs, other legal entities:

– Ownership, control, or power to vote 25% or more of any class of voting securities

– Control election of a majority of the directors, trustees, general partners (or similar)

– Power to exercise a “controlling influence” over management or policies

• Consequences of banking entity status:

– Subject to Volcker Rule proprietary trading and covered fund restrictions– Subject to Volcker Rule proprietary trading and covered fund restrictions

– Also subject to the nonbanking restrictions of section 4 of the BHCA

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• Banking entity mapping process under Volcker may have identified gaps inunderstanding/management of entities that are deemed to be “controlled”understanding/management of entities that are deemed to be “controlled”for BHCA purposes

– Particular problem for non-US funds controlled by FBOs– Particular problem for non-US funds controlled by FBOs

– If controlled funds and other subsidiaries have not previously been subject togeneral BHCA compliance policies and procedures, they may have attendantcompliance and/or reporting lapsescompliance and/or reporting lapses

– Primary concern are non-US funds, SPEs, JVs, other companies that investdirectly or indirectly in the US (i.e., investing in US-organized companies ornon-US companies with extensive US operations and/or large US subsidiaries)non-US companies with extensive US operations and/or large US subsidiaries)

• For foreign excluded funds, achieving Volcker Rule compliance (e.g., long-sought “banking entity” relief) at the fund level is really only part of thesolution; if the fund is a controlled subsidiary it must also comply withsolution; if the fund is a controlled subsidiary it must also comply withsection 4 of the BHCA

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• Range of exemptions that controlled non-US funds and other subsidiariessubject to section 4 of the BHCA might rely on for their investments:subject to section 4 of the BHCA might rely on for their investments:

– 4(c)(9)/2(h)(2) and Regulation K for qualifying investments in non-US companies

– 4(c)(6) for passive investments involving less than 5% of an issuer’s voting shares (“BHC– 4(c)(6) for passive investments involving less than 5% of an issuer’s voting shares (“BHCPartner” style investments)

– 4(k) and Merchant Banking authority for financial holding companies (FHCs)

• Key point is that these broader BHCA compliance issues must be taken into• Key point is that these broader BHCA compliance issues must be taken intoconsideration and exemptions documented/monitored

• Increasing Federal Reserve Board scrutiny in the wake of Volcker; mapping• Increasing Federal Reserve Board scrutiny in the wake of Volcker; mappingprocess providing staff with new window on non-US activities/investments

• BHCA compliance remediation processes underway or recently completedat a number of non-US banking organizations; may be internally driven orat a number of non-US banking organizations; may be internally driven ordriven by Board staff

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