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May 3, 2016 Open Board Meeting
Transcript of Open Board Meeting
May 3, 2016
CHAIR YELLEN. Good afternoon and welcome to our guests who are attending or
watching our meeting. The proposed rules we are considering today are important elements of
the Board’s strategy to ensure that our financial system remains strong and stable enough to
support the economy through both good times and bad.
The first proposal we will consider today is crafted to strengthen the resiliency of large
banking organizations and thereby reduce the chance that they might fail. The financial crisis
proved that an overreliance on unstable funding sources, particularly short-term wholesale
funding, leaves firms vulnerable to liquidity risk and poses serious threats to financial stability.
This proposal would establish the Net Stable Funding Ratio--or NSFR. This ratio would require
large banking organizations to maintain a minimum amount of stable funding tailored to the
different risk profiles of these firms and based on a one-year time horizon. By requiring our
largest institutions to maintain an amount of stable funding that is appropriate given the liquidity
of their assets, the NSFR would strengthen the financial system, making it more resilient to
market stress.
The second proposal supports our strategy to reduce the potential systemic impact of the
failure of a large, interconnected banking organization. The crisis underscored that when a large
financial institution gets into trouble, its failure can destabilize other firms. This is because large
banking organizations are connected with each other by the business they do together and
through the contracts that result from that business. Indeed, in the 21st century, a run on a failing
banking organization may begin with the mass cancellation of the derivatives and repo contracts
that govern the everyday course of financial transactions. When these contracts, known
collectively as Qualified Financial Contracts or QFCs, unravel all at once at a failed large
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banking organization, an orderly resolution of the bank may become far more difficult, sparking
asset firesales that may consume many firms.
That is why we are considering a proposal that would require very large banking
organizations to use contracts that allow for a limited stay in resolution so that there is time to
transfer QFCs from a failed firm to a solvent one. This stay-and-transfer requirement will help
manage the risk when a very large firm fails, and will thus strengthen the resiliency of the
financial system as a whole.
Let me now turn to Governor Tarullo who led the effort to develop these two proposals.
GOVERNOR TARULLO. So, Madam Chair, we're going to go one after the other here,
so I should just do the introduction to the NSFR?
CHAIR YELLEN. Yes, we’re going to start with the NSFR.
GOVERNOR TARULLO. OK. So thank you, Madam Chair.
The financial crisis, which at least in the first instance was a liquidity crisis, drew
attention to the need for quantitative liquidity regulation, which had been essentially non-
existent. The proposed Net Stable Funding Ratio (NSFR) has been developed as a complement
to the Liquidity Coverage Ratio (LCR), which we have already adopted and is now applicable to
large U.S. banking organizations.
The LCR’s thirty-day scope addresses the most immediate and acute liquidity problems
that large firms could encounter in a period of stress. The NSFR, as the Chair has already noted,
requires these firms to maintain a stable funding profile over a one-year time horizon, thereby
mitigating the potential effects of a firm’s loss of funding and creating strong incentives for firms
to extend the maturity of their funding arrangements. In addition, because of the impact that a
withdrawal of funding from the customers of large firms can have on the financial system during
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periods of stress, the proposal requires more stable funding for short-term loans to other financial
firms.
As with all liquidity regulation, the proposal must require firms to maintain sustainable
funding profiles and to avoid inappropriate reliance on central bank liquidity access. At the same
time it should not incentivize firms to horde liquidity in periods of stress, rather than to use it to
keep the financial system operating. I look forward to comments from the public both on how
successfully the proposal balances these objectives and on what other regulatory and supervisory
measures might help achieve these regulatory aims.
And let me now turn to Mike Gibson to introduce the staff presentation.
MICHAEL GIBSON. Thank you, Governor Tarullo.
The Federal Reserve has been comprehensively strengthening its regulatory and
supervisory framework for large banking organizations since the financial crisis. The proposed
NSFR the Board is considering today is another important and significant step forward.
As Governor Tarullo noted, the NSFR would be the second quantitative liquidity
requirement issued by the Board, the first being the liquidity coverage ratio, or LCR. The LCR
focuses on resilience to short-term liquidity stress. The NSFR compliments the LCR by requiring
large financial firms to maintain stable funding based on a longer one-year time horizon. These
quantitative requirements augment other aspects of the Federal Reserve's liquidity risk oversight
framework, including our liquidity stress testing and other supervisory standards.
Under our supervisory framework, the Federal Reserve conducts regular horizontal
examinations of both qualitative and quantitative aspects of liquidity risk at our largest and most
complex firms. The comprehensive liquidity analysis and review, known as CLAR, provides a
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comprehensive view of liquidity risk management and stress testing practices of firms that are
overseen by our Large Institution Supervision Coordinating Committee, or LISCC.
The Federal Reserve also conducts different and tailored horizontal assessments of
liquidity risk at other firms with $50 billion or more in total assets. These horizontal reviews
allow our supervisors to benchmark across supervisory portfolios, identify outliers, and help
form a more complete view of liquidity vulnerabilities and funding concentrations in the system
as a whole. The NSFR would be an important addition to this framework by establishing a
standardized quantitative minimum stable funding requirement.
In terms of implementation, banking organizations that would be subject to the proposed
rule have already made significant gains since the financial crisis in strengthening the resilience
to funding disruptions. A number of factors have contributed to these gains, including
regulations that indirectly improve the stability of firm funding profiles, the Federal Reserve
supervisory oversight and stress testing efforts, anticipation by firms of U.S. implementation of
the NSFR, and market discipline since the financial crisis. The NSFR proposal would require
firms to maintain these gains going forward, reinforcing the safely and soundness of the firms,
and improving the resilience of our financial system to liquidity stress.
Staff estimates that nearly all subject firms would meet the proposed NSFR requirement
if it were in effect today. The estimated stable funding shortfall across all firms is approximately
$40 billion or about one half of 1 percent of the aggregate requirement. Based on these current
shortfall estimates, we do not expect firms to incur a significant cost to come into compliance by
the proposed January 2018 effective date and do not expect significant cost to maintain
compliance going forward.
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I will now turn to Adam Trost for a more detailed description of the proposed net stable
funding ratio.
ADAM TROST. Thank you, Director Gibson.
The proposal the Board is considering today is a result of a team effort across divisions
here at the Board and the U.S. federal banking agencies. The proposed NSFR would be issued
jointly with the FDIC and the OCC. My colleagues, including Kevin Littler, Adam Cohen, and
Brian Chernoff, will help you answer your questions following my prepared remarks.
The 2007-2009 financial crisis exposed the vulnerability of large financial institutions to
liquidity shocks. During the crisis, these firms experienced severe contractions in their supply of
funding. As access to funding became limited and asset prices fell, many firms faced the
possibility of failure. This threat caused governments and central banks around the world to
provide significant levels of support to the financial system to maintain global financial stability.
The experience of the financial crisis demonstrated a need to address this vulnerability to
liquidity shocks by implementing a more rigorous approach to measuring, monitoring, and
limiting of firm's reliance on the less stable sources of funding.
The proposal would establish a quantitative liquidity requirement, the net stable funding
ratio, which is designed to strengthen the ability of a firm to withstand disruptions to its regular
sources of funding without compromising its liquidity position or contributing to instability in
the financial system. Whereas the liquidity coverage ratio is a stress metric that requires a firm to
hold a sufficient amount of high-quality liquid assets to survive a 30-day period of significant
stress, the NSFR is a structural balance sheet metric that requires a firm to maintain a stable
funding profile based on the liquidity of its assets over a one-year time horizon. In effect, the
NSFR would limit the ability of a firm to fund illiquid assets with short-term unstable funding.
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Under the requirement, a firm's available stable funding would be the numerator of the
net stable funding ratio. A firm would calculate its available stable funding using standardized
weighting referred to as ASF factors. These ASF factors represent the extent to which an equity
instrument or liability is considered stable based on the likelihood a firm would need to repay or
replace the funding over a one-year time horizon. ASF factor would be scaled from 0 to 100
percent, with a high ASF factor indicating more stability and a low ASF factor indicating less
stability. For example, the proposed rule would assign fully insured retail deposits an ASF factor
of 95 percent compared to an ASF factor of 0 percent for short-term funding from financial
firms.
A firm's required stable funding would be the denominator of its net stable funding ratio.
It would be the sum of two parts, one based on a firm's assets and funding commitments other
than derivatives and the other based on a firm's derivatives. A firm would calculate the required
stable funding for its non-derivative assets and funding commitments using standardized
weightings referred to as RSF factors. Like the ASF factors, the RSF factors will be scaled from
zero to 100 percent. A low RSF factor would indicate an asset is more liquid and would require
less stable funding, and a high RSF factor would indicate an asset is less liquid and would
require a more stable funding. For example, the proposed rule would assign U.S. treasury
securities an RSF factor of 5 percent compared to an RSF factor of 85 percent for most long-term
corporate and commercial real-estate loans.
A firm would separately calculate its required stable funding relating to its derivatives
and portfolio, taking into account margin requirements and potential future changes in the value
of the portfolio. The proposed rule would require a firm's net stable funding ratio to meet or
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exceed 100 percent, meaning that it's the firm's available stable funding would need to meet or
exceed its required stable funding.
The proposed rule would address the risk of trap liquidity within a consolidated banking
firm. Trap liquidity exists when a firm appears to have a stable funding profile on a consolidated
basis when in fact liquidity in one part of the firm is not available throughout the organization
due to transfer restrictions. To address this risk and prevent an overstatement of a firm's NSFR,
the proposed rule would allow a consolidated NSFR to include a subsidiary's excess available
stable funding only if the subsidiary can transfer liquidity throughout the holding company
without restriction. This approach to addressing trap liquidity is similar to the approach taken in
the U.S. LCR.
The proposed rule would apply to the same large and internationally active firms that are
subject to the LCR. Specifically the full NSFR would apply to U.S. bank holding companies and
certain savings and loan holding companies that have total consolidated assets of $250 billion or
more or $10 billion or more in on-balance sheet foreign exposure. The full NSFR requirement
would also apply separately to banks with $10 billion or more in total consolidated assets that are
subsidiaries of these holding companies.
Like the LCR, the proposed rule would include a tailored modified NSFR that would
apply to U.S. bank holding companies and certain savings loan holding companies with $50
billion or more in total consolidated assets, but are not subject to the full NSFR requirement. The
modified NSFR would apply to firms that are smaller, less systemically risky and generally less
complex in structure than firms that would be subject to the full NSFR. Because of this lower
level of risk, the proposed rule would require a modified NSFR firm to maintain an amount of
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stable funding equivalent to 70 percent of the amount that would be required if the firm were
subject to the full NSFR.
The proposed rule would not apply to holding companies with less than $50 billion in
total consolidated assets and would not apply to community banks. The proposed rule would also
not apply to non-bank financial companies designated by the Financial Stability Oversight
Council for Board supervision. However, the Board would retain flexibility to apply the
proposed rule in the future to these non-bank financial companies by a separate rule or order
after assessing their business models and risk profile.
In addition, the proposed rule would not apply to the combined U.S. operations of foreign
banking organizations. Staff intends to prepare a separate proposal for the Board's consideration
in the future that will apply an NSFR and LCR to foreign banking organizations with significant
U.S. operations.
As I noted earlier in my remarks, the NSFR requirement is designed to strengthen the
ability of a firm to withstand disruptions to its regular sources of funding without compromising
its liquidity position or contributing to instability in the financial system. However, it is of course
possible that a firm could breach the minimum requirements. The proposal would retain
flexibility for the Board to determine an appropriate supervisory response to a violation based on
the particular facts and circumstances. Though the proposal provides for a flexible supervisory
response to NSFR shortfalls, it would require a firm to give timely notice of a shortfall to the
Board, and develop and submit to the Board a plan for remedying the firm's shortfall.
Lastly, the proposal would require a holding company subject to the rule to publicly
disclose its NSFR and certain components of its NSFR in a standardized format on a quarterly
basis. The proposed rule would also require a holding company to include a qualitative
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discussion of its NSFR, which is meant to facilitate a better understanding of the firm's NSFR
results. These standardized disclosures would promote market discipline by enabling market
participants to compare U.S. firms subject to the proposed rule and firms subject to similar stable
funding requirements and other jurisdictions. The proposed NSFR would become effective on
January 1, 2018, which should provide firms a sufficient time to make adjustments to their
funding structures and to their systems.
This concludes my prepared remarks. My colleagues and I would be pleased to answer
any questions you may have.
CHAIR YELLEN. Thank you very much.
I just have one question for you. I wanted to ask you about two separate sources of
liquidity risks for GSIBs. The first you mentioned in your presentation, derivatives; the second is
matched book repo transactions. And I guess my question is, can you explain in a little bit more
detail how the NSFR would address these liquidity risks? And then also, in light of that answer,
do you think these rules will have significant impacts on activity or pricing in those markets?
ADAM TROST. So I can start by discussing derivatives. Due to complexity of
derivatives, the proposed rule has a separate framework to address the funding risks associated
with these transactions. The NSFR would have--deal with three distinct risks. The first aspect
would require a firm to maintain stable funding based on the aggregate current value of a firm's
derivatives portfolio. The second aspect would require a firm to maintain stable funding based on
the collateral and future payments based on future--potential future declines in the derivatives--a
firm's derivatives portfolio. The third aspect would require a firm to maintain stable funding
based on initial margin the firm has posted based on its derivative transactions, and then also
default fund contributions to central counterparties based on its clear derivatives. You know, we
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look forward to public comment on whether we've captured all the risks with derivatives and the
complexity of derivatives. And we also look forward to public comment on whether we've
calibrated them appropriately.
MARK VAN DER WEIDE. And I'll address your matched book repo question. One of
the ways in which the NSFR is a very useful supplement to the LCR, and this was referred to by
Governor Tarullo in his opening remarks, is that it does have a charge for matched-book repo.
We felt like this was one of the missing elements of the LCR. The LCR generally assumes that a
very large book of matched book repo can be unwound pretty seamlessly in a very short period
of time. We don't think that's a reasonable assumption. We think there are pretty good
microprudential and macroprudential reasons for thinking there ought to be some kind of a
regulatory charge for these matched-repo books.
So what the NSFR does is it deals with these risks by imposing a 10 to 15% stable
funding charge on those transactions. We think that's a pretty appropriate level of charge to deal
with both the funding risk to the firm and the financial stability risk. The funding risk is
primarily one where firms often have very strong reputational incentives to maintain their
lending to many of their clients, even if they're losing funding on the repo side. They will have
incentives, naturally, to keep some of those reverse repos funding their clients. So I think there
are those microprudential reasons to think there should be a charge. And we also think there are
financial stability concerns. Just if the firm does come under stress, you know, the unwind of that
repo book, if it's large, it's going to be something that's fairly disruptive for the financial markets.
So we feel like there ought to be something around it, a 10 to 15 percent charge for these
matched repo books.
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We’ve tried to calibrate it in a way that was appropriate. We think by calibrating it
relatively low, in the 10 to 15 percent range, we've calibrated it reasonably well. We try to create
a little bit of gradation--not a lot, but a little bit of gradation between Treasury repos, which get
the lower 10 percent RSF, and other repo, which get the higher 15% RSF. But in light of the
relatively low levels of the RSF requirements here--which, by the way, can be met with more
equity funding, more long-term debt funding, and even more insured deposit funding at a
relatively cheaper form of funding--that we struck the balance right. We do see comment,
though, in the proposal as to whether we had struck that balance right and we look forward to
comment on the proposal going forward. We don't think it's going to be terribly impactful on the
repo markets as they exist today. As Mike indicated earlier, the firms have more or less adapted
to the NSFR already and you know, marginal adaptations that we don't think will have any
severe impact, material impact.
CHAIR YELLEN. Thank you very much. Governor Tarullo?
GOVERNOR TARULLO. No questions, thank you.
CHAIR YELLEN. Governor Powell?
GOVERNOR POWELL. So, Adam, you mentioned the effect on liquidity, I think, in
your presentation, and we hear quite a bit about liquidity and regulations and the impact of our
regulations on liquidity, and we're very mindful of that. Can you say anything about what we
expect the possible effect of the NSFR would be on market liquidity?
MICHAEL GIBSON. Sure, I can get that question. So, we observed that currently, the
firms that would be subject to the proposed NSFR have very small shortfalls, so the marginal
impact of closing those shortfalls and market liquidity should be minimal. Now, we would also
want to look at how the regulation would affect market liquidity across the cycle and we believe
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that, because the NSFR has a moderating effect across the cycle--that is, in boom times, having
required stable funding will tend to moderate the boom, and in bad times, the stable funding will
be available to support liquidity.
So, the impact on market liquidity similarly ought to be to smooth out the peaks and
troughs of the cycle, and by removing or reducing the risk that a firm will find itself in a liquidity
squeeze in a downturn, market liquidity and stress should be more available. But as we've
answered in response to the other questions, we are seeking public comment on the different
ways that the NSFR could affect market liquidity, including for different products, so we look
forward to that feedback.
GOVERNOR POWELL. Great, thanks.
CHAIR YELLEN. Thank you. Governor Brainard?
GOVERNOR BRAINARD. So, you talked a little bit about how the NSFR would
interact with our other liquidity requirements and supervisory practices. And I'm just wondering
on the CLAR, which is a very powerful framework, which goes out to various time horizons
beyond the 30 days of the LCR, how does this NSFR add to our ability to help ensure stability of
funding at these institutions?
MICHAEL GIBSON. So I think the LCR and NSFR are complements in the regulatory
space, and as I said in my opening remarks, in the supervisory area with CLAR, we're able to go
in more detail and in different directions and maybe test for things that the regulations capture
only in a broad way. But maybe in specific circumstances, we need to do a little bit more testing
on the supervisory side. So, I think the NSFR just builds on to that, another leg--it's a similar sort
of argument around complementarity of regulations that we've made in other contexts. I don't
know if anyone else?
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MARK VAN DER WEIDE. Yes, I think one of the ways that, one of the reasons that we
like NSFR is that it does provide a fully standardized and fully comparable metric across firms,
both domestically and globally, so we can do better comparisons across different firms using the
same metric to assess their funding stability.
KEVIN LITTLER. I would add that--it adds this quantitative minimum flow, specifically
links a firm's funding structure, the liquidity characteristics of these assets and commitments. So
that's something that's baked into the structure.
GOVERNOR BRAINARD. I look forward to the public comments. Thank you, Madam
Chair.
CHAIR YELLEN. There are no further questions. Before I ask for motions, I'd like to
call on each of you to state your positions on the net stable funding ratio proposal. Vice Chair?
VICE CHAIRMAN FISCHER. In favor.
CHAIR YELLEN. Governor Tarullo?
GOVERNOR TARULLO. In favor. I look forward to the public comment.
CHAIR YELLEN. Governor Powell?
GOVERNOR POWELL. In favor. I look forward to the public comments.
CHAIR YELLEN. Governor Brainard?
GOVENOR BRAINARD. I'll go in favor. I look forward to the comments.
CHAIR YELLEN. I join my colleagues with the same view. Let me now call--we need
two separate motions. First, I need a motion to approve publishing for comment the proposed
rule to establish a minimum net stable funding ratio requirement for large banking organizations.
VICE CHAIRMAN FISCHER. Moved.
CHAIR YELLEN. Thank you.
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GOVERNOR TARULLO. Second.
CHAIR YELLEN. Thank you. All in favor?
ALL GOVERNORS. Aye.
CHAIR YELLEN. Any opposed? No? Now I need motion to authorize staff to make
technical changes and minor changes to prepare the related Federal Register documents for
publication.
VICE CHAIRMAN FISCHER. So moved.
GOVERNOR TARULLO. Second.
CHAIR YELLEN. All in favor?
ALL GOVERNORS. Aye.
CHAIR YELLEN. I never assumed that no one would oppose. So thank you very much.
Thanks for all the good work on this and we all look forward to the comments we'll receive. And
I guess we can now move along to our second item. Governor Tarullo?
GOVERNOR TARULLO. Thank you, Madam Chair. The proposed regulation before us
today represents another step forward in our efforts to make financial firms resolvable without
either injecting public capital or endangering the overall stability of the financial system.
An important difference between large financial firms and most non-financial firms is
that the former usually are party to large numbers of qualified financial contracts, or QFCs,
which are by statute exempted from the automatic stay provisions of bankruptcy law that govern
most other kinds of contracts and that allow firms entering bankruptcy to continue operations
even as creditors' rights are determined in judicial proceedings. A financial firm entering
bankruptcy is thus subject to an immediate and potentially destabilizing unwinding of
derivatives, repo, and other instruments included within the definition of QFCs even if the firm
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or its affiliates continue to perform on the contracts. The consequences can include loss of
important funding sources and firesales of the collateral underlying these contracts.
The FDIC's bank resolution authority under the Federal Deposit Insurance Act and the
orderly liquidation authority included in Title II of the Dodd-Frank Act provide for a one-
business-day stay on the unwinding of QFCs, during which the resolution authority can choose
which QFCs to have transferred to a solvent affiliate of the firm or a third party. However, there
could be some question as to whether a foreign jurisdiction would recognize the exercise of this
authority with respect to QFCs previously executed by a now insolvent U.S. financial firm or its
subsidiaries in that jurisdiction.
To address both of these impediments to orderly resolution of large financial firms, the
Federal Reserve joined a number of its international counterparts in working with the
International Swaps and Derivatives Association (ISDA) to develop a protocol that allows the
QFCs of the most systemically important firms to include provisions effectively extending the
Title II QFC stay-and-transfer provisions to a range of resolution scenarios initiated under
insolvency proceedings involving these firms. The eight U.S. firms that we have identified as
carrying global systemic importance have already adhered to this protocol as part of their
resolution planning process.
The regulation proposed by staff today would follow through on this work first by
completing the regulatory process contemplated in the ISDA protocol and, second, by extending
its requirements beyond transactions among systemically important banking organizations to
transactions of these firms with all counterparties. In approving this proposal for comment and,
eventually, adopting a final regulation, we have the opportunity to consolidate the substantial
progress made in containing the risks to financial stability that can arise from QFCs.
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Nonetheless, if Congress at some point addresses bankruptcy provisions applicable to financial
firms, it could be useful to reconsider the breadth of collateral types that currently are eligible for
QFC treatment.
And so now, Mike, again, I turn to you for the introduction to the staff presentation on
this role.
MICHAEL GIBSON. Thank you, Governor Tarullo. This proposal pertains to financial
transactions that are collectively known as QFCs. QFCs include derivatives contracts, repurchase
agreements, also known as repos, and securities lending and borrowing agreements. Financial
firms enter into QFCs for a variety of purposes, including to borrow money, to finance
investments, to lend money, to manage risk, to enable clients and counterparties to hedge risks,
to make markets in securities and derivatives, and to take positions in financial investments.
QFCs play a role in economically valuable financial intermediation when markets are
functioning normally. But they are also a major source of interconnectedness among financial
firms, and this interconnectedness can pose a threat to financial stability in times of market
stress.
As Governor Tarullo said, the failure of one financial entity can lead to the unwind of the
QFCs of its affiliates, which could cause the affiliates to fail as well, and QFC unwinds can also
lead to fire sales of large volumes of financial assets, pushing down the prices of similar assets
held by other firms. This proposal focuses on a context in which the threat posed to financial
stability by QFC unwinds is especially great, the failure of a global systemically important
banking organization, or GSIB, that is party to large volumes of QFCs. The draft proposed rule is
intended to mitigate this threat and facilitate the orderly resolution of a failed GSIB. I'll now turn
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the presentation over to Felton Booker and Mark Savignac, who will describe the key features of
the proposal.
FELTON BOOKER. Thank you, Mike. Today's proposal focuses on central prerequisite
for the orderly resolution of any major financial firm, and that is the ability to place an entity
within that firm into a resolution proceeding without immediately leading to the unwind of its
vast quantities of QFCs. You know, as mentioned previously, through large volumes of QFCs,
GSIBs are deeply interconnected with each other, with other major financial firms, and with the
markets in which they all participate. The destabilization following the failure of the Lehman
Brothers is a vivid illustration of the risk posed to--I'm sorry, posed by financial connectivity
created through derivatives and other forms of QFCs. Early termination rights are an important
element of the systemic risk presented by QFCs. Often, a non-defaulting party to a QFC, upon
the failure of its counterparty or its counterparty's affiliate, can exercise early termination rights
that it may have under that contract. Under the U.S. bankruptcy code for instance, a counterparty
can exercise its contractual default rights immediately upon initiation of the bankruptcy
proceeding against its direct counterparty. Statutory special resolution regimes like Title II of the
Dodd-Frank Act or the special resolution powers of the Federal Deposit Insurance Act usually
stay the right to termination of closeout for a brief period of time, as Governor Tarullo
mentioned, to give the resolution authorities the opportunity to enforce those contracts if certain
conditions are satisfied. These QFC stay provisions are important to the effectiveness of the U.S.
special resolution regimes for financial firms. However, where it is not clear that those contracts
are governed by U.S. law, there is a risk that a court in a foreign jurisdiction may decline to
enforce the stays provided under Title II in the FDI Act. And that's the first obstacle.
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Second and separately, the resolution strategies preferred by most U.S. GSIBs under the
bankruptcy code involve some form of a single point of entry approach in which a U.S. parent
entity would enter into an insolvency proceeding while its operating subsidiaries would remain
solvent and continue to meet their obligations. However, the direct counterparties to QFCs with
performing subsidiaries may nevertheless have determination rights that are exercisable upon the
bankruptcy of its parent. A non-interrupted contractual right to terminate QFCs, retain and
liquidate collateral under these circumstances can materially obstruct a plan resolution under the
bankruptcy code by hastening the indiscriminate unwind of the firm's operating subsidiaries
worldwide. That's the second obstacle.
Consequently, in 2014, the Board and the FDIC identified the exercise of certain default
rights as an obstacle to the credibility of resolution plans required under the Dodd-Frank Act and
directed the largest resolution plan filers, including U.S. GSIBs, to take action to correct this
problem. It's important to note that this particular obstacle to an orderly resolution is one that's
developed over time as a result of industry practice, rather than as a matter of a legal or statutory
impediment. The bankruptcy code, for example, does not itself confer early termination rights
upon QFC counterparties. It merely commits QFC counterparties to exercise such rights if they
are provided under the contractual terms of the QFC. Therefore, a solution to this problem has
and is largely in the control of the firms in their counterparties.
So, in response to the 2014 guidance provided by the Board and the FDIC, the resolution
plan filers of this first wave group participated in an industry-wide effort to ensure that all
financial contracts with counterparties to US GSIBs into the US operations of foreign GSIBs
were subject to an appropriate stay on early termination. This effort which ultimately resulted in
the launch of a resolution stay protocol was led by ISDA in coordination with the Board, the
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FDIC, the OCC, and foreign regulators. The industry participants in this effort included ISDA
members that represented asset management firms, pension firms, funds, and banking
institutions, as well as other securities trades associations.
In fact, the ISDA resolution stay protocol provides a market-wide mechanism for GSIBs
and their counterparties to adopt standardized amendments to OTC swap agreements, securities
financing agreements and other forms of QFCs that address both the enforcement of resolution
stays for contracts not governed by US law and the lack of an appropriate stay for contracts in
certain resolution scenarios that are initiated under the bankruptcy code.
The US GSIBs and many of the foreign GSIBs as mentioned previously have already
adhered to the ISDA protocol to modify the QFC transactions among that group of large dealer
banks. And as a practical matter, one of the reasons today's proposal is needed is to implement
ISDA's protocol provisions regarding the orderly resolution initiated under the bankruptcy code.
Those provisions do not become effective until implemented by US regulation. But this proposal
is also needed to help create greater consistency and transparency regarding the treatment of all
financial counterparties during a GSIB resolution. That objective is a key consideration for
extending the proposed restrictions beyond dealer banks and to all counterparties covered by the
firm. This proposal, together with the ISDA protocol, will allow us to achieve the consistency
and transparency that we've attempted through other resolution planning processes in a manner
that imposes only modest cost on the system and requires those cost to be borne by GSIBs and
their counterparties. I'll now turn to my colleague Mark Savignac to discuss further the details of
the proposal.
MARK SAVIGNAC. Thank you, Felton. I will quickly walk through the main provisions
of the draft proposed rule and explain how they address the two obstacles that Felton discussed.
May 3, 2016 Open Board Meeting
This proposal is intended to improve the prospects for the orderly resolution of a GSIB
and it would pursue that goal by prohibiting US GSIBs and the US operations of foreign GSIBs
from entering into non-cleared QFCs that do not comply with the following restrictions. First, as
Governor Tarullo discussed, the special resolution frameworks that Congress has created for
failed financial firms under Title II of the Dodd-Frank Act and under the Federal Deposit
Insurance Act, temporarily block a failed firm's QFC counterparties from exercising default
rights and provide for the transfer of the failed firm's QFCs to a bridge company or another
solvent firm. This proposal will build on this congressional action by requiring GSIBs to add
contractual provisions to their QFCs to effectively opt into the treatment applied by those
resolution laws, which should reduce the risk that a foreign court would disregard that treatment.
And financial regulators and other jurisdictions are imposing similar requirements to ensure the
cross-border application of their own resolution laws.
The second portion of the proposal should make it easier to resolve a GSIB in an orderly
way by preventing the failure of one entity within a GSIB group from leading to the disorderly
unwind of its affiliate's QFCs. To achieve this goal, the proposal would generally prohibit GSIB
QFCs from allowing a counterparty to exercise default rights against a GSIB entity based on the
entry into resolution of another entity within the GSIB group. This general prohibition would
have exceptions for a number of creditor protections that would not be expected to interfere with
an orderly resolution. And GSIBs could choose to comply with this portion of the proposal by
signing up to the ISDA protocol and doing QFCs with counterparties that have themselves
signed up.
Finally, the proposal would establish a procedure for the Board to review and approve
QFCs with a different set of creditor protections, so long as those creditor protections are
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consistent with the purposes of the proposal. This would give the Board the flexibility to approve
slightly different contractual or arrangements without the need for a new rulemaking.
Under the proposal, the rule would take effect about a year after the Board issues a final
rule. A GSIB would be required to conform preexisting QFCs to the rule only if it enters into a
new QFC with the same counterparty or its affiliate after the rule's effective date. There are a
couple of exceptions that I should describe. First, this proposal would not apply to subsidiary
national banks of GSIBs or to federal branches of foreign GSIBs. The Office of the Comptroller
of the Currency is expected to propose a similar set of restrictions to cover those entities’ QFCs.
Also, the current proposal would not apply to GSIB QFCs that are cleared through a central
counterparty and we are continuing to consider how best to address impediments to GSIB
resolution associated with cleared QFCs.
We believe that the proposal would yield substantial benefits for the economy of the
United States by protecting US financial stability from the disorderly failure of a GSIB and that
these benefits would greatly outweigh any associated costs. The most obvious cost for covered
firms would be the cost associated with drafting and negotiating compliant contracts with their
QFC counterparties and these costs would likely amount to only a very small fraction of the
overall cost of conducting these firm's capital markets businesses. Covered firms may also need
to offer better contractual terms to their QFC counterparties to compensate them for the loss of
the default rights that would be restricted by the proposal.
We believe that the proposal would be unlikely to cause material reduction and QFC
related economic activity. The proposed restrictions are relatively narrow and would generally
not have a large effect on a counterparty's ability to prudently manage its risk and firms that are
not GSIBs would not be subject to the proposed rule, so those firms could substitute for GSIBs to
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some extent which could allow potential QFC counterparties with a strong demand for the
prohibited default rights to transact with those firms and keep the default rights.
As for benefits, by increasing the likelihood that a failed GSIB could be resolved in an
orderly way, the proposal would reduce the likelihood that GSIB failures will cause or deepen
financial crises in the future. Financial crisis impose enormous costs on the economy, so even
small reductions in the probability or severity of financial crises can do a lot of good. The
proposal would also be likely to benefit the counterparties of a subsidiary of a failed GSIB by
helping to prevent the disorderly failure of the subsidiary and allowing it to continue to meet its
obligations. While it may be in the individual interest of any given counterparty to exercise
available rights to run on a subsidiary, the mass exercise of those rights could harm the
counterparties electively by causing an otherwise solvent subsidiary to fail. Thus, like the
bankruptcy code's automatic stay, which also serves to maximize creditor's ultimate recoveries
by preventing a disorderly liquidation of the debtor, the proposal would mitigate a collective
action problem to the benefit of the failed firms, creditors, and counterparties. And because many
creditors and counterparties of GSIBs are themselves systematically important financial firms
including other GSIBs, improving outcomes for those creditors and counterparties would further
protect the financial stability of the United States.
That concludes our prepared remarks and we would be happy to answer any questions
you may have.
CHAIR YELLEN. Thank you very much. Let me just ask you one question. The
restrictions that you're proposing here as you said only apply to GSIBs, and you mentioned in
your presentation that counterparties who really want these protections now have the ability to
transact with non-GSIBs but won't be covered. I wonder if you considered the possibility of
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expanding the scope of the proposal so that it would cover large banking organizations arguably
some of the same benefits that are approved to improving the resolvability of GSIBs might also
apply to those not quite so systemic but nevertheless still large banking organizations. And are
you concerned or do you think there will be a substantial amount of migration with activity
within GSIBs toward institutions that aren't covered?
MARK VAN DER WEIDE. Madam Chair, staff grappled quite a bit with this question of
the right scope of application for the QFC rule should be. In the end we decided the better
proposal was one that limited the scope to the GSIBs significantly because those firms are the
firms that we determined would pose the greatest threat to financial stability if they came under
stress or were to fail. The proposal doesn't apply to other smaller bank holding companies in
significant part because their derivatives books, their repo books, their aggregate QFC books are
substantially smaller than those of the US GSIBs. So we felt like the protections were of less
value for those firms. And given our statutory mandate to target our regulatory efforts towards
those firms that pose the most threat of financial stability, we thought that was the right bargain
to strike.
We don't expect the proposals can have a meaningful impact on the rights of
counterparties so I think our expectations would be that the migration from GSIBs to non-GSIBs
would be relatively small. We'll look forward to comments on that during the comment period.
We expect a relatively small migration. To the extent there is migration, it's the movement of
derivatives portfolios from our most systematically important firms to less systemically
important firms. So there may be some financial stability benefit from that as the GSIB see
smaller systemic footprints. But the trend that we'll need to monitor, we do have now a GSIB
identification algorithm so that if we do see a very large volume of derivatives going to any
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particular non-GSIBs, that will increase their systemic footprints quite rapidly under our formula
so at some point they would become a GSIB themselves, become subject to our GSIB
regulations including this QFC rule, so we do have that protective device but even with that
protective device in place, we need to keep a watch I think on the migration that might occur.
We did grapple with this issue quite a bit. We do see competing considerations on both
sides and so we included a question, the preamble that would explicitly see comment in whether
we should broaden scope out to cover additional set of bank holding companies.
CHAIR YELLEN. Thank you very much. Vice chair?
VICE CHAIRMAN FISCHER. It's not clear from the--from the papers that we've seen
whether a QFC is naturally defined and everybody knows ex-ante whether something is a QFC
or not. In some places it seems to result from bargaining between the two sides as to whether it's
a QFC. So how--how are they defined?
FELTON BOOKER. So, in the--What we've done is that we've used a defined term that
is we believe well understood by the market and that is the QFC as defined under Title II of
Dodd-Frank Act which effectively repeats QFC as defined under the FDI Act. So it is--We've not
introduced any new confusion as to what the scope of QFC, so.
VICE CHAIRMAN FISCHER. But what's the answer to the--the question? These are
well, well defined and everybody knows what they are. So I think the—
FELTON BOOKER. So I think the answer is largely yes. If there doesn't seem to be a
meaningful confusion about what's in the bucket and what's not in the bucket, and to make sure
that we weren't introducing again any confusion, we've used terms that the market seems to
understand.
VICE CHAIRMAN FISCHER. Thank you.
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CHAIR YELLEN. Governor Tarullo?
GOVERNOR TARULLO. Thank you, Madam Chair. I think it might be useful if one of
you, one of the Marks maybe or Felton could explain the reasoning behind the transition
provision that you've included in the proposal which would not in and of itself require that
existing QFCs be modified to conform to the new requirements, but would require that existing
QFCs with a particular counterparty be modified to come into conformity with requirement
before any new QFC was entered into. And so I guess, if you could explain that a little bit more
and maybe in the process of doing so address, you know, why not just require all existing
contracts to be modified on the one hand or on the other hand, why not just wait for contracts
naturally to run their course and to lapse and have a only new contract rule.
MARK VAN DER WEIDE. And I'll start and turn to you guys for follow-up. So this is
another question that we spent quite a bit of time at the staff level grappling with. There are two
competing considerations here from a public policy perspective. On the one hand, our GSIBs
today, although they might have somewhat smaller QFC portfolios than they did and lead up to
the crisis still have very large QFC portfolios, derivatives books in particular. And although
some of them have been modified consistent with the ISDA protocol, the interdealer books,
many of them remain, they continue to have the same really termination provisions that they've
always had.
Given the high volumes of the QFC businesses of our GSIBs, given the long tenure of
some of those agreements and particular on the derivative side, and that the early termination
problems continues to be there, this is a pretty significant impediment to a GSIB orderly
resolution for the foreseeable future. So, to the extent that we leave the existing portfolios in
place, we are delaying by potentially a considerable period of time or confidence that we can do
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an orderly resolution of the firm. So the more rapidly that we can fix this problem, the more
rapidly we can have greater confidence about GSIB resolvability.
On the other hand, it is important I think to allow those counterparties that don't want to
do business with GSIBs on the terms that our proposal would require to have some flexibility to
opt out of the regime. And so, we've tried to strike the right balance in this proposal of these two
competing considerations so that a counterparty that really doesn't want to do business with a
GSIB without these contractual rights can leave their existing transactions in place untouched
and go do business with a non-GSIB. Whether we struck the right balance or not is again
something that we're going to hear from in the comment period and we look forward to those
comments. But there are competing considerations here that need to be balanced.
GOVENOR TARULLO. So, Mark, part of that--part of your answer implicitly suggests
that a lot of the existing QFCs are somewhat long duration.
MARK VAN DER WEIDE. Yes.
GOVENOR TARULLO. And thus would not actually lapse.
MARK VAN DER WEIDE. Yes, that's correct.
GOVERNOR TARULLO. Any set of--can you give a sense of a distribution there?
FELTON BOOKER. So I think that where you're going to see the largest duration is in
the--in the swaps books, for example. If you would think about the US GSIBs and their
interdealer transactions, which are covered by the current ISDA protocol, you would expect on a
notional basis for that to be roughly in the area of 70 percent of those transactions. However--so
that, of course, leaves again on the notional basis the 30 percent for non-dealers and other types
of clients. On a mark-to-market basis, right, that number drops meaningfully to probably 40
percent, the transactions with the--among dealers are going to be shorter term even though larger
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volumes of smaller number of longer term is going to get the mark-to-market coverage lower.
And, of those--of that remaining group you have in a meaningful amount which has tenures of
remaining maturities of greater than, you know, 10 years. So, I think that, you know, Mark is
correct in thinking about the meaningful amount of the book that would be left untouched if we
didn't cover existing.
CHAIR YELLEN. Thank you. Governor Powell? Governor Brainard? OK, let me, again,
before we go to motions and call for round of position taking on the motion.
VICE CHAIRMAN FISCHER. In favor, Madam Chair.
GOVERNOR TARULLO. As am I.
GOVENOR POWELL. As am I.
GOVERNOR BRAINARD. And I think the crisis showed how damaging it is to have
early termination provisions. I think the staff put a lot of time and effort into carefully crafting
this, so I'm strongly in favor.
CHAIR YELLEN. Thank you and likewise. So, now, we ask for two motions again. First,
I need a motion to approve publishing for comment the proposed rule to establish restrictions on
qualified financial contracts of systemically important US banking organizations in the US
operations with systemically important foreign banking organization. Do we have a motion?
VICE CHAIRMAN FISCHER. So moved.
CHAIR YELLEN. Thank you.
GOVERNOR TARULLO. Second.
CHAIR YELLEN. All in favor?
GOVERNOR TARULLO. Aye.
GOVERNOR POWELL. Aye.
May 3, 2016 Open Board Meeting
GOVERNOR BRAINARD. Aye.
CHAIR YELLEN. And now, I need a motion to authorize staff to make technical changes
and minor changes to prepare the related Federal Register document for publication.
VICE CHAIRMAN FISCHER. So moved.
CHAIR YELLEN. Thank you.
GOVERNOR TARULLO. Second.
CHAIR YELLEN. All in favor?
GOVERNOR TARULLO. Aye.
GOVERNOR POWELL. Aye.
GOVERNOR BRAINARD. Aye.
CHAIR YELLEN. Thank you. And thanks to the staff and Governor Tarullo and your
committee for all the good work in preparing these to put out for comment and look forward to
hearing the comments from the public. Thank you.