Fed Compels Banks to Follow Tougher Risk Management Rules

Fed Bolsters Tools for Averting Collapse of Big Financial
Federal Reserve building stands in Washington. Photographer: Andrew Harrer/Bloomberg

The Federal Reserve sought to curb the threat of financial turmoil by compelling the biggest banks to follow a tougher standard for risk management and demanding stricter oversight by companies’ boards of directors.

The proposed rules would set triggers for regulatory enforcement for weak firms and require boards of directors to oversee and approve plans for limiting liquidity risk. The Fed delayed releasing rules for supervision of foreign firms and for risk-based capital and leverage requirements.

The draft standards aim at averting a recurrence of instability following the collapse of U.S. mortgage finance, targeting banks with assets totaling $50 billion or more and financial firms deemed “systemically important.” The Dodd-Frank law passed in July 2010 mandates a supervisory crackdown.

“You do see a sense of regulatory forbearance that continues with the Fed in that they understand that to help these banks earn their way back to financial health, you just can’t slap an increased capital requirement overnight,” said Mark T. Williams, executive-in-residence at Boston University and a former bank examiner.

The 24-company KBW Bank Index, which had dropped 30 percent in 2011 through yesterday, rose 4.1 percent today. The Standard & Poor’s 500 Index increased today by 3 percent to 1,241.30 in New York.

“The proposal would create an integrated set of requirements that seeks to meaningfully reduce the probability of failure of systemically important companies and minimize damage to the financial system and the broader economy in the event such a company fails,” the Fed said today. Comments on the proposal are due by March 31.

Revenue Pinched

“The rules are really going to be quite different for the largest institutions,” Gary Townsend, a founder of Hill-Townsend LLC in Chevy Chase, Maryland, said on Bloomberg Television. “It seems foolish to me to be basing this on size” rather than on business model and complexity, he said.

Under the proposal banks’ boards of directors would be required to review regular reports from senior management on capital adequacy and sign off on plans to fund institutions in times of liquidity stress and economic strain.

The boards would annually need to approve internal liquidity proposals and set levels of risk gauged to companies’ “financial condition and funding capacity on an ongoing basis,” the central bank said.

‘Dramatic Change’

The emphasis on the board of directors is a new regulatory trend and “a dramatic change in the level of care that boards need to take in these regulatory areas,” said Karen Shaw Petrou, a managing partner at Federal Financial Analytics in Washington D.C.

The Fed hasn’t specified capital and leverage requirements and industry representatives have an opportunity to comment on the 95 questions contained in the 173-page proposal. The strength of the rules hinge on how the Fed reacts to public comment, former Fed Governor Randall S. Kroszner said.

“The motivation is to try and reduce fragility of the system and reduce interconnectedness,” among firms, Kroszner said.

“But if the rules are not properly implemented or the definitions don’t properly capture the relevant risks, then you could actually increase interconnections rather than decrease it,” Kroszner said. He is currently a professor at the University of Chicago Booth School of Business.

Failure of a Company

The Fed would curb a larger firm’s exposure to a single counterparty “in order to limit the risks that the failure of any individual company could pose to a covered company,” according to the proposal.

The central bank would set a limit of 10 percent for credit risk between a company considered systemically important and a counterparty when each have more than $500 billion in total assets. This is tougher than the Dodd-Frank act, which allowed for a 25 percent limit.

Goldman Sachs Group Inc., the fifth-biggest U.S. bank by assets, said in a regulatory filing that its credit risk to any single counterparty didn’t exceed 2 percent of the firm’s $949 billion in total assets as of Sept. 30.

The Fed would require “early remediation” for large firms that show weakness in capital, stress test results and risk management. Regulators would be allowed to impose restrictions on a company’s growth, capital distributions, executive compensation and asset sales.

Not Quick Enough

“It’s trying to take some of the judgment out of the hands of regulators, who some believe did not act as quickly as they should have,” said Deborah Bailey, a director at Deloitte & Touche LLP and a former deputy director of supervision at the Fed.

Designing the early remediation procedures was one of the toughest tasks for regulators, a Fed official said today in a conference call with reporters. The central bank sought to design remedial steps that didn’t hasten a firm’s demise, the official said on condition of anonymity.

Regulators already could pursue such supervisory steps toward banks through prompt corrective action, mandated by a law in 1991. Today’s proposal increases that authority to holding companies.

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