A new ratings framework aligned to regulatory reform priorities

On August 3, 2017, the Federal Reserve Board (Fed) released a notice of proposed rulemaking that would establish a new rating system for large financial institutions (LFIs). Specifically, the new rating system would apply to bank holding companies (BHCs) and non-insurance, non-commercial savings and loan holding companies (SLHCs) with more than $50 billion in total assets, as well as intermediate holding companies (IHCs) of foreign banking organizations.

The proposal includes a new rating scale under which component ratings would be assigned for:

  1. Capital planning and positions,
  2. Liquidity risk management and positions, and
  3. Governance and controls.

In essence, the Fed is revamping its rating system for LFIs to catch up with the Fed’s post-crisis heightened supervisory expectations and approach to LFI supervision.  The Fed proposes to assign initial ratings under the new rating system during 2018.

Rather than the current approach of assigning numerical ratings from 1 (e.g., strong) through 5 (e.g., unsatisfactory), the new framework takes a four tier approach and does not contain a tier that would be analogous to the current 1 or “strong” rating.  The proposed rating tiers are as follows:

  • A “Satisfactory” rating indicates that the firm is considered safe and sound and broadly meets supervisory expectations.
  • A “Satisfactory Watch” rating is a conditional “Satisfactory” rating (generally safe and sound; however, certain issues are sufficiently material that if not resolved in the normal course of business, would put the firm’s safe and sound condition at risk (consistent with indication that a rating downgrade is a strong possibility) – timeframe would generally be 18 months for resolution
  • A “Deficient-1” rating indicates that, although the firm’s current condition is not considered to be materially threatened, there are financial and/or operational deficiencies that put its prospects for remaining safe and sound through a range of conditions at significant risk
  • A “Deficient-2” rating indicates that financial and/or operational deficiencies materially threaten the firm’s safety and soundness, or have already put the firm in an unsafe and unsound condition.

No composite rating under “weakest link” approach

Notably, in a departure from the current rating system, institutions would not be assigned a standalone composite rating under the new system.  The Fed believes that the 3 component ratings are fundamental and sufficiently convey the status of an institution’s safety and soundness without attempting to weight one of the components as more important than another in order to produce an aggregate overall rating.  Significantly, the lowest rating of any of the three components would affect whether a firm is considered “well managed,” a key definition in several regulations that is necessary to avoid various restrictions on operations.

All three components would need to be at least a Satisfactory Watch rating to achieve a “well managed” status.  In the current RFI/C (D) rating system (outlined below), only the composite rating affects the definition of well managed and firms could have a less than satisfactory rating in one area without losing that status.  In effect, the Fed is proposing a “weakest link” rating system that indicates a firm’s overall safety and soundness is only as strong as its weakest rating of the three critical pillars.

Re-calibration from RFI/C (D) rating

Since 2005, the Fed has used the “RFI/C (D)” rating system for US BHCs, which focuses on:

  • Risk management practices
  • Financial condition of the consolidated organization
  • Impact of a BHC’s nondepository entities on its subsidiary insured depository institutions (IDIs)
  • Composite assessment of the BHC as reflects by the R, F, and I ratings
  • Depository institutions (i.e., composite CAMELS ratings assigned by primary supervisor of IDIs

Composite, component, and subcomponent ratings are assigned based on a 1 to 5 numeric scale, with a “1” indicating the highest rating and a “5” indicating the lowest rating.

The new rating system would fully align with the Fed’s existing supervisory programs and is reflective of the systemic risks posed by LFIs and changes to supervisory expectations and processes for these firms.  The three components of the proposed rating system—capital planning and positions, liquidity risk management and positions, and governance and controls—are the key examination areas for firms in the Fed’s Large Institution Supervision Coordinating Committee (LISCC) portfolio, as well as for non-LISCC LFIs.

Capital planning and positions

  • Effectiveness of the governance and planning processes used to determine the amount of capital necessary to cover risks and exposures, and to support activities through a range of conditions
  • Sufficiency of capital positions to comply with applicable regulatory requirements and to support the ability to continue to serve as a financial intermediary through a range of conditions

The Fed supervisory activities associated with CCAR for LISCCs and some LFIs will provide input to determine this component rating.  In addition, the Fed has outlined its supervisory expectations through SR 15-18 (Federal Reserve Supervisory Assessment of capital Planning and Positions for LISCC firms and Large and Complex Firms) and SR 15-19 (Federal Reserve Supervisory Assessment of Capital Planning for Positions for Large and Noncomplex Firms).

Liquidity planning and positions

  • Effectiveness of the governance and risk management processes used to determine the amount of liquidity necessary to cover risks and exposures, and to support activities through a range of conditions
  • Sufficiency of liquidity positions to comply with applicable regulatory requirements and to support ongoing obligations through a range of conditions

The Fed supervisory activities associated with Comprehensive Liquidity Analysis and Review (CLAR) for LISCC firms will provide input to determine this rating.  LFI firms are subject to more narrow horizontal examinations depending on their risk profile.  Other requirements also include Regulation WW (Liquidity Risk Measurement /liquidity coverage ratio and Regulation YY (Enhanced Prudential Standards) liquidity risk management and stress testing requirements.

Governance and controls

  • Effectiveness of (a) board of directors, (b) management of core business lines and independent risk management and controls, and (c) recovery planning (only for US firms in the Large Institution Supervision Coordinating Committee (LISCC) portfolio)

This component expressly covers the board of directors, senior management, management of core business lines, independent risk management and controls, and recovery planning (for US LISCC firms only).  This guidance provides greater differentiation between senior management and management of core business lines in a governance context and expectations.

This component provides a refreshed look at the effectiveness of risk management and control activities across the three lines of defense and more deliberately with expectations for alignment of a firm’s strategy with its risk tolerances and risk management capabilities.  A number of previous SR letters have highlighted these expectations include SR 12-17, (Consolidated Supervision Framework for Large Financial Institutions), SR 15-18/SR15-19 (outlined above) and other related risk management SR Letters.

Notably, while the new rating system will no longer explicitly have  the 1 rating (i.e., strong), the Fed still refers to  institutions maintaining strong, effective, and independent risk management and control functions.

Supporting guidance is proposed and forthcoming

In a companion release, the Fed issued proposed guidance on board effectiveness that would apply to US bank to US BHCs, SLHCs, and nonbank financial companies designated by the Financial Stability Oversight Council (FSOC) as systemically important.  The proposed guidance for corporate governance would not apply to IHCs of foreign banking organizations or state member banks, but the Fed noted that it anticipates proposing guidance on board effectiveness for IHCs at a later date, and requested feedback on how the guidance should be adapted to apply to IHCs and state member banks. However, the proposed guidance links back to descriptions to the rating system proposal as part of the Fed’s supervisory assessment of board effectiveness outlined in the proposed LFI rating system.

The Fed also expects to propose additional guidance on supervisory expectations relating to a firm’s management of core business lines and independent risk management and controls in the “near future.” In a preview of the forthcoming guidance, the Fed explains how it would differentiate responsibilities for the board, senior management, management of core business lines, and the independent risk management function.

Know your SR letters

Across all three components, the Fed reinforces how the Supervision and Regulation (SR) Letters have linked supervisory expectations to the underpinning for ratings, serving as a reminder that appropriate awareness, training, and knowing how these expectations align to institution practices, processes and controls is important to demonstrate alignment with guidance.   The new rating system will necessitate reinforced and additional awareness to the expectations and the bar the regulators have set.

Potential rating for resolution planning

One key element missing from the proposed rating components but a key post-crisis priority of the Fed is resolution planning.  However, the Fed asked for public comment on whether the LFI rating system should be revised in the future to assess the sufficiency of a firm’s resolution planning efforts undertaken to reduce the impact on the financial system in the event of the firm’s failure.

Conclusion

The new rating system for LFIs would fully align with the Fed’s supervisory programs, processes and priorities, as well as proposed and existing SR Letters, across the three key pillars.  By reframing the rating system and providing more guidance, there should be greater transparency into how the results of various exams, horizontals and other activities translate into safety and soundness ratings.  This in turn presents LFI boards and senior management with further opportunities to self-identify issues, hold responsible parties accountable and proactively initiate improvement in areas that are less than satisfactory prior to regulatory mandates.

Contacts

Irena Gecas-McCarthy
Principal | Deloitte Risk and Financial Advisory
Deloitte & Touche LLP

David Wright
Managing Director | Deloitte Risk and Financial Advisory
Deloitte & Touche LLP

Chris Spoth
Managing Director | Deloitte Risk and Financial Advisory
Deloitte & Touche LLP

Henrik Sandin
Senior Manager| Deloitte Risk and Financial Advisory
Deloitte & Touche LLP

Alex LePore
Senior Consultant | Deloitte Risk and Financial Advisory
Deloitte & Touche LLP

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor.

Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

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