The nation’s largest banks will be forced to hold far more capital and step up their risk management under a proposed new rule issued Wednesday by the Federal Reserve, addressing one of the main causes of the 2008 financial crisis.
The long-anticipated rule affects banks both domestic and international with assets above $50 billion. It was required as part of the sweeping revamp of financial regulation back in 2010, which sought to right the wrongs that brought the most devastating financial crisis since the Great Depression.
Chief among these ills was the fact that large interconnected financial institutions, many of them global in scale, were spottily supervised or had portions of their businesses supervised by varied regulators. No one regulator was seeing the complete picture of the financial institution’s activities.
The Fed released the proposed rule minutes before the full Federal Reserve Board met in an open session to presumably approve the measure and make it a final rule.
“As the financial crisis demonstrated, the sudden failure or near failure of large financial institutions can have destabilizing effects on the financial system and harm the broader economy,” Janet Yellen, the new Fed chair, said in a written opening statement. “And as the crisis also highlighted, the traditional framework for supervising and regulating major financial institutions and assessing risks contained material weaknesses.”
The final rule, she said, would “help address these sources of vulnerability.”
For giant foreign banks operating in the United States, they would have to create U.S.-based intermediate holding companies that’d be regulated by the Fed and would be subject to stricter capital requirements and enhanced risk-management efforts.
In a nod to pressure over the part of the rule that caused the most friction, the Fed gave overseas banks an extra year to comply, said a senior Fed official, briefing the media under the condition of anonymity because the rule was not yet public.
The rule doesn’t specify a number for how much capital must be kept in reserve, instead each bank will develop a capital plan annually that must pass the Fed’s stress tests, which try to determine what would happen to assets in a crisis scenario. This testing will determine how much they need to have on hand. Foreign banks will have to pass an equivalent stress test in their home country.
The Fed thinks the cost impact will vary significantly across industry, said another Fed official briefer, adding that banks that don’t hold capital today face a larger impact.
Back in 2008, when giant investment banks were toppling like dominoes, regulators were shocked to find that many were highly leveraged, meaning they had invested far more than they had on hand. They were also highly dependent on short-term lending to stay afloat. When banks suddenly stopped lending to each other, it quickly became a game-over situation, and the U.S. taxpayer was forced to inject capital on the largest banks to ensure their solvency.
To address this, the new rule also requires more holdings that can be sold off quickly in a crisis, lowering the reliance on short-term dollar loans that amplified the crisis in 2008.
Going down another tier, the Fed also planned regulatory changes for publicly traded domestic banks and foreign banks with assets above $10 billion. They’ll be required to create special risk committees, and be subjected to stress testing to determine how much capital they need to keep on hand to fend off emergencies and prevent the need for government bailouts like the controversial ones that marked the financial crisis.
Federal Reserve staffers expect that 24 large U.S. bank holding companies and 100 foreign banks would fall under the new rules. Of the 100 foreign banks, about 15 to 20 of them would be required to form a U.S. intermediate holding company if they wanted to continue operating in the U.S. marketplace. The rule would take effect on Jan. 1, 2015, for giant U.S. banks and a year later for large foreign banks.
The rule does not cover non-bank lenders, but the Fed said any giant non-bank lenders would be subjected to similar enhanced supervision by an individual rule or order.