In a recent speech, Federal Reserve Governor Daniel Tarullo proposed a “rethinking” of the aims of prudential regulation for bank holding companies.1 With his remarks, Governor Tarullo has sought to initiate a debate on how a “more precise specification of prudential regulatory aims” could provide a basis for recalibrating regulation.2 This debate is especially timely and much needed with respect to the Federal Reserve’s new enhanced prudential standards issued under Section 165 of the Dodd-Frank Act, which have transformed the nature and scope of bank regulation.
Yet as important as it is to reconsider the aims of Section 165, it is equally important to reconsider its means. Congress was very specific in prescribing how it intended the Federal Reserve to implement Section 165’s enhanced prudential standards. Therefore, any debate on how to recalibrate them must be grounded in an understanding of the parameters imposed by the statute.
There also is a more fundamental reason to reexamine Section 165’s requirements: the current approach differs sharply from the approach set out in the statute. This divergence has resulted in bank holding companies being subject to enhanced prudential standards based primarily on whether they satisfy an arbitrary asset threshold rather than on the risks they present. Accordingly, the implementation of Section 165’s enhanced prudential standards deserves a second look.
This article examines the legislative history of Section 165, with the purpose of showing how the statute envisions the implementation of enhanced prudential standards. This legislative history has important implications for how enhanced prudential standards could be recalibrated to be not only more effective but also more consistent with the provisions of Section 165.
Overview of Section 165
Section 165 of Dodd-Frank requires the Federal Reserve to establish enhanced prudential standards for bank holding companies with $50 billion or more in consolidated assets.3 The Federal Reserve must promulgate enhanced prudential standards for: (1) risk-based capital requirements and leverage limits; (2) liquidity requirements; (3) overall risk management requirements; (4) resolution plans and credit exposure reports; (5) concentration limits; (6) risk committees; and (7) company stress tests.4 On a discretionary basis, the Federal Reserve may establish additional enhanced prudential standards.5
To implement Section 165, the Federal Reserve has issued a series of rules that mostly apply uniformly to bank holding companies that satisfy the $50 billion threshold. These rules have implemented not only the mandatory enhanced prudential standards under Section 165 but also the Federal Reserve’s annual Comprehensive Capital Analysis and Review, or CCAR.6 Additional enhanced prudential standards also apply at other asset thresholds, including at the $250 billion (or $10 billion in foreign exposures), $700 billion (or $10 trillion in assets under custody), and, for foreign banking organizations, $50 billion in U.S. assets levels.7 The Federal Reserve is expected to issue additional rules using similar asset thresholds.8 This reliance on asset thresholds, however, is not the approach set forth in Section 165.
The Legislative History
The legislative history of Section 165 begins in the U.S. Senate Committee on Banking, Housing, and Urban Affairs (“Senate Banking Committee”). The provision originated as Section 165 of legislation, S. 3217, the Restoring American Financial Stability Act of 2010 (“RAFSA”), passed by the Senate Banking Committee on March 22, 2010.9 The provision was amended several times by Congress, but ultimately became Section 165 of Dodd-Frank. The key legislative history lies in how Section 165 was incorporated into RAFSA, but, to fully understand this history, it is first necessary to understand the influence of Senate Banking Committee Chairman Christopher Dodd’s discussion draft proposal of November 2009 (“Dodd Discussion Draft”).
Dodd Discussion Draft
As Congress began considering financial regulatory reform during the 111th Congress, Chairman Dodd’s initial proposal was the Dodd Discussion Draft.10 Its central reform was consolidation of all prudential regulation into a single regulator, the Financial Institutions Regulatory Administration (“FIRA”).11 This restructuring of financial regulation was designed to streamline financial regulation, as well as to discipline federal banking regulators for their perceived regulatory failures in the lead-up to the financial crisis of 2008.
The Dodd Discussion Draft also would have created the Agency for Financial Stability (“AFS”), which would have been responsible for designating any financial company (whether a bank holding company or nonbank financial company) whose “material financial distress” would “pose a threat to the financial stability of the United States or the United States economy during times of economic stress.”12 Any designated company would have been subject to enhanced prudential standards set by the AFS. These enhanced prudential standards would have been required to be “more stringent than [the standards] applicable to financial companies that do not present similar risks to United States financial system stability and economic growth” and to “increase in stringency with the size and complexity” of the designated financial company.13
In devising enhanced prudential standards, the AFS also would have had to take into account a long list of specific factors, including “the amount and types of the liabilities of the company”; “the amount and nature of the financial assets of the company”; “the extent and type of the off-balance-sheet exposures of the company”; the company’s relationships with other major financial companies; and its ownership of any clearing, settlement, or payment businesses.14 As this list demonstrates, these enhanced prudential standards were supposed to reflect a variety of factors, rather than just the amount of assets held by a designated company.
Although the Dodd Discussion Draft failed to garner sufficient support and was never voted on by the Senate Banking Committee, its provisions for streamlining financial regulation under FIRA and its approach to enhanced prudential standards laid the foundation for Section 165.
After abandoning the Dodd Discussion Draft, Chairman Dodd scaled back his reforms and proposed RAFSA in March 2010. Nevertheless, Section 165 of RAFSA reflects many of the same approaches and goals of the Dodd Discussion Draft.
Under Section 165 of RAFSA, the Federal Reserve, like the AFS under the Dodd Discussion Draft, was required to establish enhanced prudential standards for certain financial companies. Section 165 explicitly sets forth the aim of these enhanced prudential standards: “to prevent or mitigate risks to the financial stability of the United States that could arise from the material distress or failure of large, interconnected financial institutions.”15
RAFSA also established the Financial Stability Oversight Council (“FSOC”) and made it responsible for designating the nonbank financial companies that would be subject to Section 165’s enhanced prudential standards.16 Unlike the AFS under the Dodd Discussion Draft, however, the FSOC was authorized to designate only nonbank financial companies because RAFSA explicitly provided that Section 165 applied to all “large, interconnected” bank holding companies with consolidated assets of $50 billion or more.17
The $50 Billion Threshold
What was the rationale for the $50 billion threshold? In isolation, it seems very arbitrary and over-inclusive. The reason is that the $50 billion threshold was not designed to identify companies that pose risks to financial stability but rather to advance two other objectives of RAFSA.
First, RAFSA sought to continue the Dodd Discussion Draft’s goal of streamlining prudential supervision. However, unlike the Dodd Discussion Draft, which would have eliminated entirely the Federal Reserve’s jurisdiction over bank holding companies, RAFSA instead would have reduced the Federal Reserve’s jurisdiction to only bank holding companies with consolidated assets of $50 billion or more.18 All other bank holding companies were to be regulated by the primary regulator of their depositories, either the OCC or the FDIC.19
According to the Senate Banking Committee Report on RAFSA, the Federal Reserve’s jurisdiction over bank holding companies was set at the $50 billion threshold because data demonstrated that “in almost all instances of banking organizations with less than $50 billion in assets, the vast majority of assets are in the depository institution.”20 The aim was to have the Federal Reserve regulate bank holding companies that had securities, insurance, and other nonbank activities and to consolidate the regulation of bank holding companies that had few or no nonbank assets under the OCC or the FDIC. By doing so, RAFSA sought to “enhance the accountability of individual regulators,” “reduce the regulatory arbitrage in the financial regulatory system,” “reduce regulatory gaps in supervision,” and limit the regulatory burden on industry.21 As this report language reveals, the $50 billion threshold was not intended to separate companies based on whether they presented risks to financial stability. Indeed, the Committee Report states that the Federal Reserve’s jurisdiction would “include, but not be limited to, those companies whose failures potentially pose risk to U.S. financial stability.”22
Because the $50 billion threshold included companies that do not pose risks to financial stability, its use in Section 165 also served a second objective of RAFSA: blunting criticism that any company subject to enhanced prudential standards would be considered systemically significant. Borrowing the $50 billion threshold established for allocating bank holding company regulation advanced this objective because, as noted above, the threshold was not established to determine whether a company presents risks to financial stability. In other words, Section 165 could apply to any “large, interconnected” bank holding company regulated by the Federal Reserve. As a result, it covered companies with a range of risk profiles. By then requiring that the Federal Reserve employ a “graduated approach” in implementing Section 165’s enhanced prudential standards to this broad group (see below), RAFSA “intended to avoid identification of any bank holding company as systemically significant.”23
These rationales for the $50 billion threshold have been obscured because, during the full Senate’s consideration of RAFSA, an amendment (the Hutchison-Klobuchar Amendment) was adopted that restored the Federal Reserve’s jurisdiction over all bank holding companies.24 As a result, the $50 billion threshold in Section 165 was no longer congruent with the Federal Reserve’s holding company jurisdiction. Because Section 165 was not amended to reflect this change, it has permitted an inference, not supported by the record, that Dodd-Frank deemed any bank holding company with consolidated assets above $50 billion to be systemically significant.
Section 165 of RAFSA also imposed specific requirements on the implementation of enhanced prudential standards, whether mandatory or discretionary, for bank holding companies.
First, enhanced prudential standards must be “more stringent than the standards and requirements applicable to nonbank financial companies and bank holding companies that do not present similar risks to the financial stability of the United States.”25
Second, enhanced prudential standards must “increase in stringency,” “tak[ing] into account differences among” designated financial companies and bank holding companies subject to Section 165 [emphasis added], based on a series of factors, including: the company’s leverage; “the amount and types of the liabilities of the company”; “the amount and nature of the financial assets of the company”; extent of “off-balance sheet exposures of the company”; the “relationships of the company” with other significant financial companies; “the extent to which assets are managed rather than owned by the company”; and any other factors the Federal Reserve deems appropriate.26 Note that this language refers to “the company” rather than “companies,” indicating an individualized approach. The Federal Reserve was also required, to the extent possible, to ensure that small changes in any of these factors do not “result in sharp, discontinuous changes in prudential standards.” In addition, the Federal Reserve has to consider any recommendations made by the FSOC.27
Third, with respect to foreign-based companies, enhanced prudential standards must give due regard to the principle of national treatment and competitive equity.28
Together, these requirements were designed to make enhanced prudential standards reflect the different risks presented by each of the companies subject to Section 165. They also sought to have enhanced prudential standards apply in a linear manner, rather than uniformly.
The Committee Report for RAFSA confirms this view. The Committee Report states: “With respect to bank holding companies, the heightened prudential standards would increase in stringency gradually as appropriate in relation to the company’s size, leverage, and other measures of risk” [emphasis added].29
It is important to recognize that because the $50 billion threshold caused bank holding companies that do not pose risks to financial stability to fall under Section 165, RAFSA had to ensure that its enhanced prudential standards did not apply uniformly. Otherwise, non-systemic (or even modestly systemic) bank holding companies would be subject to regulations designed for companies that present material risks to financial stability. To avoid this result, Section 165 had to mandate that the Federal Reserve implement enhanced prudential standards in a graduated fashion based on a variety of risk factors. RAFSA also permitted the Federal Reserve to increase the $50 billion threshold to prevent enhanced prudential standards from being applied to companies that do not pose risks to financial stability.
Senate Floor and Conference Committee
After being approved by the Senate Banking Committee, RAFSA was considered on the floor of the U.S. Senate during April and May of 2010. During this debate, the Hutchison-Klobuchar Amendment was adopted. Also as part of the Senate’s consideration of the bill, RAFSA was incorporated as a full substitute amendment into H.R. 4173, the Wall Street Reform and Consumer Protection Act, which had passed the House of Representatives in December of 2009. The Senate passed H.R. 4173, as amended, on May 20, and the bill then proceeded to the conference committee.
During the conference on H.R. 4173, the conference committee agreed to use the Senate passed version of H.R. 4173 (which now consisted of the RAFSA language) as the base text for its compromise legislation. The conference committee also made several changes to Section 165.30 These changes included:
- Requiring the Federal Reserve to appropriately “adapt” Section 165’s enhanced prudential standards to “any predominant lines of business” of a company.31
- Authorizing the Federal Reserve, in a subparagraph titled “Tailored Application,” to “differentiate among companies on an individual basis or by category, taking into consideration their capital structure, riskiness, complexity, financial activities (including the financial activities of subsidiaries), size and any other risk-related factor the [Federal Reserve] deems appropriate.”32
- Granting the Federal Reserve the authority to prescribe alternative enhanced capital and leverage requirements for a company that are more appropriate because of a company’s structure or activities, including “investment company activities or assets under management.”33
- Requiring the Federal Reserve to take into account the extent to which a foreign financial company is subject to home country consolidated supervision.34
- Clarifying that the Federal Reserve must take into account any “risk-related” factors it deemed appropriate.35
These changes further demonstrate that Section 165’s enhanced prudential standards were not intended to be applied on a uniform basis, but instead were to reflect the unique risk profiles of companies. Anticipating this tailoring, the conference committee also required the Federal Reserve to consult with any FSOC member before it impose any standards that could significantly impact any subsidiary of a bank holding company regulated by the FSOC member.36 This provision shows that Congress expected the Federal Reserve to modify enhanced prudential standards to reflect the risk profiles and regulatory regimes of functionally regulated subsidiaries.
The conference committee also sought to further respond to criticism that companies subject to enhanced prudential standards would be deemed systemically significant by broadening the applicability of Section 165. Instead of covering only “large, interconnected” bank holding companies with at least $50 billion in consolidated assets, Section 165 was modified to cover any bank holding company satisfying the $50 billion threshold. In addition, the Federal Reserve’s authority to increase the $50 billion threshold for certain enhanced prudential standards was eliminated.37 These changes ensured that Section 165 would technically apply to a broad range of bank holding companies (including companies that are not “large, interconnected” and do not pose risks to financial stability), presumably making it easier for a gradual application of enhanced prudential standards to avoid “identifying any bank holding company as systemically significant.”38
It should be noted, however, that even though the conference committee technically expanded the applicability of Section 165, it simultaneously expanded the Federal Reserve’s authority to provide “tailored application” of standards so that they have little, if any, applicability to bank holding companies that do not pose risks to financial stability.
After the conference report for H.R. 4173 was passed by the Congress, the legislation (renamed as the “Dodd-Frank Act” by the conference committee) was signed into law on July 21, 2010.
Implications of the Legislative History
The above legislative history shows that Congress consistently sought to ensure that Section 165’s enhanced prudential standards would be implemented in a “graduated” and “tailored” manner, reflecting the unique risks and business lines of bank holding companies. This was the approach that was contained in the Dodd Discussion Draft, adopted by the Senate Banking Committee and the full Senate, reinforced with additional amendments by the conference committee, and contained in the final bill passed by Congress.
This history has several important implications for rethinking the implementation of enhanced prudential standards for bank holding companies.
- The use of strict asset thresholds should be reviewed. Asset thresholds certainly provide a simple and convenient means to implement Section 165. They provide clear lines for determining which enhanced prudential standards apply to which companies. This reliance on asset thresholds, however, strays from the text and intent of Dodd-Frank, which envisioned a far more tailored and risk-based approach.
The $50 billion threshold is especially problematic. The uniform application of most enhanced prudential standards to any bank holding company with $50 billion or more in assets neglects the fact that, by design, that threshold captures bank holding companies that do not pose risks to financial stability. As a result, the current enhanced prudential standards apply, contrary to the statutory requirements, “more stringent” standards to companies that do not pose risks to financial stability, do not take account of “difference among companies” subject to Section 165, and cause “sharp, discontinuous changes” in standards based on which side of the threshold a company falls.39
In his speech, Governor Tarullo properly recognized these problems and suggested raising the $50 billion threshold. As noted already, such a change with respect to certain standards would require congressional action. However, the same result could largely be achieved simply through a recalibration of enhanced prudential standards to reflect the differences in risks presented by covered bank holding companies as Section 165 envisioned.
There are other important policy reasons for reviewing strict asset thresholds. A more graduated and tailored approach would help prevent enhanced prudential standards from serving as either unfair competitive burdens or barriers to entry. Bank holding companies with similar risk profiles should not be subject to vastly different regulatory regimes simply because they are on opposite sides of an arbitrary threshold. Conversely, enhanced prudential standards should not impose costs that deter smaller bank holding companies, especially those just below the $50 billion asset threshold, from entering markets simply to avoid triggering new regulatory requirements (unless, in doing so, they create risks to financial stability).
- Enhanced prudential standards should be more tailored and transparent. The overreliance on asset thresholds also threatens to dilute the effectiveness of enhanced prudential standards with one-size-fits-all regulation that neglects the diverse and often unique risk profiles presented by bank holding companies. Assets thresholds may make regulation easier to implement, but easy implementation does not necessarily lead to effective regulation.
Under Section 165, enhanced prudential standards are intended to address risks to financial stability through the clear identification of those risks and the development of specific standards to address them. From a policy perspective, this focus is important because it recognizes the resource constraints faced by regulators and companies. As Governor Tarullo noted in his speech, if regulation is more focused, regulatory costs can be reduced and “supervisory resources can be deployed where their payoff in achieving well-specified regulatory aims will be the highest.”40 A tailored approach also helps ensure that regulators focus on risks to financial stability and do not use Section 165 to pursue other, non-statutory aims.
Although the Federal Reserve has sought to employ a more tailored approach when exercising its supervisory authorities, this effort, while helpful, neglects the statutory requirements for Section 165 rulemakings and creates a far less transparent regulatory regime.41 Moreover, companies can play a far more active part in addressing risks if regulatory concerns and expectations are specifically identified in transparent rules. For these reasons, recalibrating enhanced prudential standards to better target specific and identified risks should help improve their effectiveness.
- Enhanced prudential standards should seek to better accommodate different business models. The Federal Reserve has indicated that it is considering devising unique enhanced prudential standards for insurance companies and other nonbank financial companies designated by the FSOC, but it has not, with a few exceptions, taken a similar approach with respect to bank holding companies.42 Section 165, however, provides that enhanced prudential standards must be appropriately “adapted” to each company’s “predominant line of business.” Indeed, the statute expressly granted the Federal Reserve additional authority to achieve this objective by allowing it to tailor enhanced prudential standards to a company’s own unique “individual” business model or to a “category” of business models (e.g., bank holding companies whose operations include significant insurance, custody, or broker-dealer activities).
Strong policy arguments also support this intent of Section 165. Each of the bank holding companies above the $50 billion threshold has its own unique business plan, operations, and funding strategy. This diversity helps companies serve consumers and fosters a more dynamic marketplace. Section 165 recognizes these benefits and seeks to minimize the chances that enhanced prudential standards will undermine the viability of a particular business model.
Most importantly, taking business models into consideration can promote financial stability. Such an approach allows for a diversity of business strategies, especially with regard to risk management, that can help reduce correlations among institutions and improve the resiliency of the financial system to a systemic shock. If, however, uniform and prescriptive enhanced prudential standards cause companies to conform their business models and risk management strategies to satisfy regulatory requirements, it could increase the risk of a systemic shock producing a domino effect.
Rethinking Section 165
It has been four years since the passage of Dodd-Frank, making this an appropriate time to step back and rethink its implementation, as well as its aims. Such a rethinking is especially appropriate for Section 165’s enhanced prudential standards, which have been implemented in a broader and more uniform manner than the statute envisioned. Hence, more thought should be given to how Section 165’s enhanced prudential standards could be tailored as envisioned by the statute so that they are more focused on achieving its sole statutory aim – preventing and mitigating risks to financial stability. And to the extent that Section 165’s implementation requirements, or statutory aim, need refinement or prove unworkable, Dodd-Frank should be amended. Lest we forget, it is ultimately Congress’s prerogative to determine both the aims and the means of prudential regulation. bull;
1 Daniel K. Tarullo, Member, Board of Governors of the Federal Reserve System, Rethinking the Aims of Prudential Regulation, Remarks to the Federal Reserve Bank of Chicago Bank Structure Conference, Chicago, IL (May 8, 2014) (Hereinafter Tarullo (2014)).
2 Id. (He suggested that these aims should include protecting the deposit insurance fund, macroprudential aims and financial stability.)
3 Section 165 also applies to designated nonbank financial companies. Because the designation of, and application of enhanced prudential standards to, nonbank financial institutions raises numerous and complex issues unrelated to bank holding company regulation, this article focuses solely on the application of Section 165 to bank holding companies.
4 Dodd-Frank Act § 165(a), (h)(2), and (i)(2)(C).
5 Section 165(b)(1)(B) explicitly provides for discretionary standards on contingent capital requirements, enhanced public disclosures, and short-term debt limits.
6 See Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking Organizations, 79 Fed. Reg. 17,240 (Mar. 27, 2014).
7 See id. and Regulatory Capital Rules, 79 FR 24528 (May 1, 2014).
8 See Daniel K. Tarullo, Member, Board of Governors of the Fed. Reserve System, Dodd-Frank Implementation, Testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate (Feb. 6, 2014).
9 Available at http://www.gpo.gov/fdsys/pkg/BILLS-111s3217pcs/pdf/BILLS-111s3217pcs.pdf. Restoring American Financial Stability Act of 2010, S. 3217, 111th Cong. (2010) (Hereinafter “RAFSA”).
10 Available at http://www.llsdc.org/assets/DoddFrankdocs/bill-111th-s3217-discussion-draft.pdf (Hereinafter “Dodd Discussion Draft”). The formal title of the Dodd Discussion Draft was the “Restoring American Financial Stability Act of 2009.”
11 Dodd Discussion Draft, Title III.
12 Dodd Discussion Draft §105.
13 Dodd Discussion Draft §107(a).
14 Dodd Discussion Draft §107(b)(3).
15 RAFSA § 165(a)(1) (this language was revised by the conference committee to also cover such risks arising from “ongoing activities” of these institutions). This language also largely mirrors the aim of enhanced prudential standards under the Dodd Discussion Draft § 107.
16 RAFSA § 111; § 113.
17 RAFSA § 312(a).
18 RAFSA § 312.
19 RAFSA § 313 eliminated the Office of Thrift Supervision.
20 The Restoring American Financial Stability Act of 2010, S. Rep. No. 111-76, at 25 (2010) (Hereinafter “Committee Report”).
21 Id. at 23, 25.
22 Id. at. 23.
23 Id. at 2.
24 Senate Amendment No. 3759, 111th Congress.
25 RAFSA, § 165(a)(1)(A).
26 RAFSA § 113; § 165(a)(1)(B), (b)(3).
27 RAFSA § 165(a)(1)(C). The factors the FSOC has to consider in making such recommendations largely mirror the factors Section 165 requires the Federal Reserve to consider when devising enhanced prudential standards. RAFSA § 115.
28 RAFSA § 165(b)(2) (this provision originally required consideration of “competitive equity,” which was later modified by the conference committee to “equality of competitive opportunity”).
29 Committee Report at 2.
30 The conference committee also clarified and modified several of the factors the Federal Reserve had to consider in prescribing enhanced prudential standards, imposed several new mandates (stress tests; inclusion of off-balance sheet activities in capital requirements) and provided additional authorities (short-term debt limits; leverage limits). Dodd-Frank § 113; §165(g), (i), (j), and (k).
31 Dodd-Frank Act § 165(b)(3)(D).
32 Dodd-Frank Act § 165(a)(2)(A).
33 Dodd-Frank Act § 165(b)(1)(A)(i).
34 Dodd-Frank Act § 165(b)(2)(B).
35 Dodd-Frank Act § 165(b)(3)(A)(iv).
36 Dodd-Frank Act § 165(b)(4).
37 Dodd-Frank Act § 165(a)(2)(B). The standards covered are those for capital requirements, leverage limits, liquidity requirements, and risk management requirements.
38 Committee Report at 2.
39 Dodd-Frank Act § 165(a) and (b). See also Smith, Deron, Treasurer, Regions Bank; On Behalf of The Regional Bank Coalition, testimony May 20, 2014, before the Committee on Financial Services, United States House of Representatives; BBVA Compass Bancshares, Inc. et al., Comment Letter Re: Notice, Request for Comments – Resolution of Systemically Important Financial Institutions: The Single Point of Entry (FR Docket No. 2013-30057) (March 20, 2014).
40 Tarullo (2014).
41 See The Board of Governors of the Federal Reserve System, Comprehensive Capital Analysis and Review 2014: Assessment Framework and Results 5 (Mar. 2014).
42 79 Fed. Reg. at 17244-45.