Enhanced Prudential Standards for Foreign Banks: What’s after the compliance deadline?

Posted by Irena Gecas-McCarthy, Advisory Principal, Deloitte & Touche LLP, David Wright, Advisory Managing Director, Deloitte & Touche LLP, Richard Rosenthal, Advisory Senior Manager, Deloitte & Touche LLP, and Alex LePore, Advisory Senior Consultant, Deloitte & Touche LLP on July 13, 2016


Although the July 1, 2016 compliance deadline for foreign banking organizations (FBOs) to establish Intermediate Holding Companies (IHCs) has passed, the long road to operationalizing run-the-bank (RtB) functions has just begun. Rather than viewing July 1, 2016 as the “finish line,” FBOs and their IHCs should see it as Mile 13 of a marathon.  These large FBOs must demonstrate that they can govern and manage risk for their Combined US Operations (CUSO) on a self-sufficient and sustainable basis. It will come down to how the US Management and the US IHC Board of Directors (BoD) work through key issues and decisions such as budget approvals, capital planning, and crisis management, as well as navigate their shareholders, their parent organizations, and the parameters between global consolidated efficiency and a regional, legal entity focus.

On an annual basis, FBOs are now subject to increased capital, liquidity, regulatory reporting, and resolution planning assessments, among other requirements that will bring the largest FBOs to be compared to their domestic counterparts.  Although FBOs have been subject to resolution planning requirements prior to the establishment of their IHCs, the new legal entity structures will play a crucial role under this exercise going forward, including the July 2017 plan submission for the largest IHCs.  The stakes will get even higher around November 2016, when some of the core regulatory reports (extensive financials, off-balance sheet, and capital information) are publicly disclosed, which will show how the IHCs can be compared to the US bank holding companies (BHCs). Given the marketplace, these reports will provide a much deeper view into the financial health of the large FBOs operating in the US.

Similarly, although some FBOs have previously participated in the Federal Reserve Board’s (FRB) annual stress testing and Comprehensive Capital Analysis and Review (CCAR) programs, both assessments will include their IHCs in April 2017, presenting an additional layer of complexity. With the United Kingdom’s recent referendum to leave the European Union (the so-called “Brexit”), additional rulemakings being finalized (e.g., single counterparty credit limits, total loss-absorbing capacity and long-term debt requirements, and restrictions on incentive-based compensation), and additional forthcoming supervisory guidance, the pressure on regulatory change, strategic thinking and implementation capabilities does not lessen.

We also expect a heavy increase in the local supervisory teams’ reviews of IHC/Regulation YY implementations, and a focus on how Compliance, Audit and the Three Lines of Defense (3LoD) operating model is actually working.  FBOs should clearly define their business strategies and business models in the US.

In addition, we expect close regulatory scrutiny in the following areas:  vendor management, internal audit, cybersecurity, regulatory reporting, internal MIS, liquidity risk management practices, model governance, and leveraged lending/energy lending.  Demonstrating substantive progress in each of these areas will be a key component of meeting regulatory expectations and remaining competitive with US BHC peers.

Five key focus areas for preparing for post-July 1 readiness

Through a five-part blog series, we will identify the most pressing issues for FBOs in operationalizing their IHCs and demonstrating continued compliance with the FRB’s enhanced prudential standards.

Below is a brief overview of the five issues we plan to cover, each of which will include actionable recommendations for institutions.

1. Brexit and FBOs’ booking model

In light of the recent United Kingdom referendum to leave the European Union, strategic decisions about FBOs’ business models are as critical as ever.  In a sense, these institutions must think about their US business models and answer the question “who they want to be when they grow up”—that is, they must identify markets and business lines that will continue to be profitable and allow them to return capital to their shareholders.  Much of this strategic thinking was put on hold during the IHC implementation and the rush to build infrastructure capabilities.  The United Kingdom decision to leave the European Union may challenge how London is leveraged as a booking center for many FBOs, and will likely force even more transparency on cross-border flows (revenue, cost, and risk management) across jurisdictions.  Conversely, they must consider how to exit certain markets and geographies that they see as unsustainable going forward.   These issues present arguably the most existential questions for FBOs regarding their future of their institutions.

2. Marketplace transparency and reporting readiness

FRB officials have made clear in communications with the industry that they expect IHCs to submit accurate, credible internal reporting/MIS and regulatory reporting data immediately.1 They simply point out that FBOs have had more than three years to come into compliance with enhanced prudential standards (after the initial version of the rule was proposed) and believe that internal MIS and regulatory reporting processes should be fully operationalized now.  This expectation—coupled with increased transparency provided by the public disclosure of regulatory reporting filings—is expected to put increased pressure on FBOs to demonstrate that their front-to-back report production processes and control frameworks produce accurate and complete reporting.  Preparing for regulatory reporting examination processes, and building in quality assurance procedures will become critical to demonstrating credible regulatory reporting implementations, and play a key factor in building confidence in April 2017 CCAR submissions (which rely upon the same date).  The concept of accountability, data quality, controls and attestation will be front and center.

3. Regulatory change and portfolio management

Importantly, regulators continue to propose and finalize key rules that will affect IHCs.  Over the past year, regulations governing long-term debt and single counterparty credit limits have been proposed,2 both of which are expected to be finalized before the end of 2016.  In addition, rules on short- and long-term liquidity standards for IHCs—which may resemble similar rules for their US BHC peers—are expected to be proposed before the end of the year.  Proposals on early remediation and affiliate transactions are also forthcoming.  Further, many of the key regulations that have been implemented have ongoing/annual expectations (e.g., Volcker Rule, resolution planning, CCAR, and the FRB’s annual Comprehensive Liquidity Assessment and Review) and will need ongoing care and monitoring.  IHCs must be careful not to take a siloed approach to any of these or other regulations, but should instead develop strategic approaches to regulatory change and management of these key projects.   A more holistic and sustainable response enabled by technology is in order to increase efficiency and reduce compliance/regulatory risks.

4. Modernization of 3LoD

Three Lines of Defense, and in particular the usage of the term “defense,” gives the impression that functions need to react or prepare for the inevitable. We would suggest that a much more aggressive approach to Compliance, Internal Audit, Operational Risk, and other control and validation functions that are designed to ensure ongoing and sustainable processes becomes critical.  Are these functions equipped with the right and sufficient resources to address the challenge?  The baton will now be passed from large change programs put in place to implement the IHC/Regulation YY requirements to the control functions.  The governance framework, outlining and documenting escalation protocols up to the IHC BoD becomes the key process in which regulators will expect transparent, clear and decisive action.  It is critical that IHCs operationalize their RtB functions and processes, and establish and re-inforce the 3LoD model.  FBOs must emphasize the roles of compliance and internal audit as they stand up their IHCs; the ability of these functions to do their job will be a critical point for bank examiners over the course of the next year.

5. Passing the use text

At a basic level, FBOs must document and demonstrate their compliance with the new regulatory framework in the US.  First and most importantly, FBOs are required to certify, by July 31, 2016, that they comply with the FRB’s enhanced prudential standards.  Although this certification itself may take a simple form—that is, a short statement affirming that IHCs comply with the numerous provisions of the enhanced prudential standards final rule—the process of ensuring ongoing compliance with the regulations becomes a much larger challenge.  In addition, FBOs are required to certify their compliance with specific requirements, including compliance with home country capital adequacy and home country stress testing.  A system of documents, from frameworks to procedures will need to be cohesively organized and prepared to demonstrate that across each line of defense, processes designed to sustain compliance with the IHC requirements are adhered to.

1Federal Reserve System, “Agency Information Collection Activities: Announcement of Board Approval Under Delegated Authority and Submission to OMB,” 81. Fed. Reg. 35016 (June 1, 2016), available at https://www.gpo.gov/fdsys/pkg/FR-2016-06-01/pdf/2016-12867.pdf.
2Federal Reserve System, “Federal Reserve proposes new rule to strengthen the ability of the largest domestic and foreign banks operating in the United States to be resolved without extraordinary government support or taxpayer assistance,” (October 30, 2015), available at http://www.federalreserve.gov/newsevents/press/bcreg/20151030a.htm and Federal Reserve System, “Federal Reserve Board proposes rule to address risk associated with excessive credit exposures of large banking organizations to a single counterparty,” (March 4, 2016), available at http://www.federalreserve.gov/newsevents/press/bcreg/20160304b.htm.

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