January 20, 2023

By: Abhik Kar, Director Consulting, LTIMindtree

The financial industry has interpreted that Large Financial Organizations cannot fail at any given circumstances. The 2008 financial crisis proved it otherwise, which brought a very severe financial crisis to the world’s financial system. Governments of various countries had to announce bailouts to bring some of the banks and financial institutions out of the crisis. Many countries have introduced their native financial regulations post the recession to enable the FIs to withstand the economic pressure arising out of such a crisis. The Federal Government, while introducing multiple measures and regulations to save the banks and FIs, has also brought in stringent guidelines for Large Banks and Financial Institutions with respect to capital adequacy, liquidity, corporate governance, critical operations, and certain other regulatory aspects and classified them as Large Financial Institutions. When the world thought that the banking sector has recovered from the financial crisis which hit the ground a decade back, another major problem struck in the form of the COVID-19 pandemic in late 2019, which exerted huge pressure on the regulators and governments to reduce the bank’s interest rates, provide customers with relaxation in their loan repayments, introduce welfare schemes to bring back the businesses and the individual customers from the financial crisis caused by the pandemic. This started a serious alarm for the LFIs to relook at their business resiliency and ring-fence them from any such unprecedented event or economic crisis.

Who Are These LFIs

Federal Reserve classified the Financial Institutions that have $100Bn or more in Assets as large financial institutions. Be it by organic growth or by merger and acquisition, if the combined assets exceed $100Bn threshold, those entities will fall under the LFI category. It further divided these LFIs into four different categories based on their asset size as Category I, II, III, and IV to exercise additional and concentrated controls on these Financial institutions, which are given in the below table:

Key Regulations Applicable to LFIs

Federal Reserve has established multiple supervisory programs like the LISSC (Large Institution Supervisory Coordinating Committee) supervisory program, LFBO (Large and Foreign Banking Organization) supervisory program, OCC (The Office of the Comptroller of Currency) supervision to effectively monitor the LFIs. These supervisory programs focus on establishing resiliency and reducing the impact of failures for the LFIs. Fed also replaced their existing rating system and re-labeled it as the LFI rating system, which is explained below:

LFI Rating System:

The LFI rating system is based on three components and a four-level rating scale. Capital Planning and Positions, Liquidity Risk Management & Positions, and Governance & Controls are the four components and Broadly Meets Expectations, Conditionally Meets Expectations, Deficient-1, and Deficient-2 are the four rating scales used to rate a firm.
This LFI rating system provides a supervisory evaluation of whether a firm is resilient both in financial and operational aspects. It intends to provide the below:

• Meet the expectations of Federal Reserve’s current supervisory programs and practices
• Provide adequate clarity on the supervisory assessments and effectively communicate supervisory findings and their implications to the LFIs
• Give clear insights on the supervisory consequences of the firm’s rating

Key Regulations:

While the LFIs are required to comply with all the regulations laid out by the Federal Reserve, there are certain key regulations that are more intended towards these large institutions. Below are the key ones that every LFIs has to comply with:

Regulation QQ: Annual Resolution Plans submission

Reg QQ is applicable to each of the LFIs, primarily the ones falling under Category I, II & III. This regulation provides LFIs with the rules and requirements with respect to submission and what should be the content of a resolution plan and also the procedures to be followed by the board on how to review the resolution plan. It also mandates the LFIs to identify their critical operations and create a methodology considering the nature, size, complexity, and scope of the firm’s operations. It identifies and assesses:

• The markets and activities in which the firm is participating in or has operations
• The significance of those markets and activities in accordance with the financial stability of the US
• The importance of LFI as a provider or a participant in the markets and activities

Regulation WW: Liquidity Risk Measurement Standards

This regulation applies to LFIs under Category I, II, III, and IV. It covers various aspects under Liquidity risk whereby the LFIs are required to maintain, validate, and report at regular intervals their liquidity risk measurements to the Federal Reserve:

• Liquidity Coverage ratio – This covers Minimum liquidity coverage ratio requirement, transition from monthly calculation to the daily calculation when a firm moves up the category ladder, and the Calculation of the liquidity coverage ratio
• High Quality Liquid Assets – This covers requirements on high quality liquidity asset criteria, high quality liquid asset amount, requirements for eligible high quality liquid assets
• Total Net Cash Flow – Represents calculation of total net cash outflow amount, determining the maturity of an asset or a transaction, determine various outflow amounts (retail funding, structured transaction, net derivative cash outflow, mortgage commitment, commitment, collateral, and other contractual outflows). It also covers cash flows related to Covered Federal Reserve facility funding and its treatment.
• Liquidity Coverage Shortfall – It covers the notification requirements, liquidity plan, and the supervisory and enforcement actions
• Transitions – This covers the processes that an LFI has to adopt when moving from one category to another and also if it reaches below the LFI threshold as well

Regulation YY: Enhanced Prudential Standards

These regulations are applicable to all the categories of LFIs. It establishes the below regulatory requirements for the LFIs:

• Company-Run Stress Test Requirements for State Member Banks With Total Consolidated Assets Over $250 Billion
• Risk Committee Requirement for Bank Holding Companies With Total Consolidated Assets of $50 Billion or More and Less Than $100 Billion
• Enhanced Prudential Standards for Bank Holding Companies With Total Consolidated Assets of $100 Billion or More
• Supervisory Stress Test Requirements for Certain U.S. Banking Organizations With $100 Billion or More in Total Consolidated Assets and Nonbank Financial Companies Supervised by the Board
• Company-Run Stress Test Requirements for Certain U.S. Bank Holding Companies and Nonbank Financial Companies Supervised by the Board
• External Long-term Debt Requirement, External Total Loss-absorbing Capacity Requirement and Buffer, and Restrictions on Corporate Practices for the US Global Systemically Important Banking Organizations
• Single-Counterparty Credit Limits
• Requirements for Qualified Financial Contracts of Global Systemically Important Banking Organizations
• Risk Committee Requirement for Foreign Banking Organizations With Total Consolidated Assets of at least $50 Billion, but Less Than $100 Billion
• Enhanced Prudential Standards for Foreign Banking Organizations With Total Consolidated Assets of $100 Billion or More and Combined US Assets of Less Than $100 Billion
• Enhanced Prudential Standards for Foreign Banking Organizations With Total Consolidated Assets of $100 Billion or More and Combined US Assets of $100 Billion or More
• Covered IHC Long-Term Debt Requirement, Covered IHC Total Loss absorbing Capacity Requirement and Buffer, and Restrictions on Corporate Practices for Intermediate Holding Companies of Global Systemically Important Foreign Banking Organizations
• Debt-to-Equity Limits for the US Bank Holding Companies and Foreign Banking Organizations

Conclusion

The financial industry is moving faster towards delivering higher and higher value. Differentiate the products and services with innovative offerings. In this journey, there are threats and opportunities crossing the paths constantly. Smaller players in the market are getting merged or acquired by the large, there are plenty of consolidations and M&As are changing the dynamics. Along with organic growth, many midsize banks and financial institutes are moving towards the LFI category crossing the $100 Billion consolidated assets. This not only increases the responsibilities towards adhering to the regulatory requirements but also enforces the LFI to have better control over risk exposure, data management, controls, and governance. That’s a lot on the banks to update their underlying systems, applications, and technology without impacting current business. However, this is an opportunity for the banks to also redefine and rationalize their application landscape, re-engineer business processes, restructure data platforms, and most importantly, sharpen their internal plus external reporting. LFIs should take a pragmatic approach and start thinking ahead in engaging technology changes, modernizing platforms, and adopting new age technologies to acquaint themselves with the changing paradigm.

References

1. The Fed – Supervisory Letter SR 12-17 / CA 12-14 on Consolidated Supervision Framework for Large Financial Institutions — December 17, 2012 (federalreserve.gov)
2. The Fed – SR 19-3 / CA 19-2: Large Financial Institution (LFI) Rating System (federalreserve.gov)