Fed Lays Bank Risk Management Egg

WASHINGTON ( TheStreet) -- Some very stupid questions included in the Federal Reserve's proposed rules to strengthen oversight of large banks show that the regulator just doesn't have any guts.

The regulator on Tuesday released its proposed rules to strengthen oversight of large banks as required under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law by President Obama in July of last year. Most of the new rules cover bank holding companies with total assets exceeding $50 billion, and the Fed posed a host of questions to be answered by the industry or the public, by March 31.

A typical wishy-washy question from the Federal Reserve, in the section of the 173-page rule on improved risk management is:

"Should the Board consider specifying by regulation the minimum qualifications, including educational attainment and professional experience, for risk management expertise on a risk committee?"

That laugher follows the actual proposal, that large bank holding companies establish risk committees chaired by independent directors, with "at least one member of a company's risk committee to have risk management expertise that is commensurate with the company's capital structure, risk profile, complexity, activities, size, and other appropriate risk-related factors."

So, after saying that only one member of the risk committee needs to be qualified to serve on the committee, the Fed asks if it should stipulate what those qualifications should be.

Well, we can save the Fed some time: After seeing hundreds of bank failures over the past several years, with most preceded by regulatory orders requiring an institution's board of directors to begin doing its job, the answer is "yes, all of the members of a board of directors risk committee should be qualified for the task."

The fact that the Fed even needs to make a rule requiring one member of the risk committee to display competence speaks for itself. We might even add that all members of a bank's board of directors should meet some minimal qualification for the job.

Among the risk-management questions posed in its proposed rule, the Fed asks if it would be "should the Board consider specifying by regulation the minimum qualifications, including educational attainment and professional experience, for risk management expertise on a risk committee?"

Of course, the risk-management section of the Fed's proposed rule is one of the shorter sections. Most of the new rules are limited to bank holding companies with total assets of $50 billion or more, and other financial firms designated as "systemically important companies" by the Financial Stability Oversight Council, which was created under Dodd-Frank and includes of the heads of various federal regulatory agencies.

A few of the proposals include:

Capital

The proposed rules cover risk-based capital and leverage requirements, liquidity, stress tests, single-counterparty credit limits and "early remediation," to make sure that "financial weaknesses are addressed at an early stage." The "triggers" for early remediation would include capital measurements, stress test results and "risk-management weaknesses," which in some cases would be "calibrated to be forward-looking." Remediation steps would include "restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales."

As we have already seen with the Federal Reserve's rejection of Bank of America's ( BAC) capital plan earlier this year, which would have included an increased return of capital to shareholders through dividend increases and share buybacks, U.S. regulators are already using stress tests to great effect and requiring remediation steps. The Fed's action with Bank of America was prophetic, coming before Bank of America's $8.5 billion mortgage putback settlement with institutional investors in the second quarter, and subsequent $8.8 billion second-quarter loss.

In its expanded third round of stress tests that will take place in January, the Fed is using a very severe set of economic assumptions, in order to test banks' capital strength in the event of a difficult economic recession, before signing off on large banks plans to return capital to investors.

JPMorgan Chase ( JPM) is expected to make a very strong case to regulators, for an expanded return of capital to investors during 2012.

The company is currently among the most generous among the largest U.S. banks, with a 25-cent quarterly payout translating to a 3.26% dividend yield, based on Monday's closing price of 30.70.

KBW analyst Frederick Cannon expects JPMorgan to increase its dividend to 35 cents during the second quarter, which would represent a 29% dividend payout ratio. It is generally accepted that regulators will be seeking to limit most large banks to a payout ratio of 30% of operating earnings.

In the proposed rules, bank holding companies with total assets of $50 billion or more will continue to be required to undergo annual stress tests, demonstrating to the Federal Reserve that they have "robust, forward-looking capital planning processes that account for their unique risks and that permit continued operations during times of economic and financial stress."

In their capital plans, the holding companies will be required to demonstrate "their ability to maintain capital above existing minimum regulatory capital ratios and above a tier 1 common ratio of 5 percent under both expected and stressed conditions over a minimum nine-quarter planning horizon."

The Federal Reserve didn't specifically say what its enhanced capital requirements would be for the largest systemically important bank holding companies, but did say it was "working with the other U.S. banking regulators to implement the Basel III capital reforms in the United States," and was planning to make a "a subsequent proposal to implement a quantitative risk-based capital surcharge for covered companies or a subset of covered companies," which is expected to follow the lead of the Basel Committee, which seeks to require banks to maintain Tier 1 common equity ratios of at least 7%, while requiring "global systemically important financial institutions" to hold extra capital buffers ranging from 1% to 2.5%.

In the proposed rules, the Fed indicates that the "quantitative risk-based capital surcharges" for the largest global systemically important banks could be as high as 3.5%.

The Wall Street Journal reported on Monday that Citigroup ( C) and JPMorgan would both be required to hold the full 2.5% enhanced capital cushion.

Under Basel 1 rules, Citigroup had the highest Tier 1 common equity ratio of 10.75% as of Sept. 30, among the "big four" U.S. banks, according to SNL Financial. The second highest among the group was JPMorgan Chase, with a Tier 1 common equity ratio of 9.77%, followed by Bank of America, at 8.60%, and Wells Fargo ( WFC), at 8.30%.

Bank of America has said that its recent issuance of new common shares and retirement of preferred shares and senior debt, would increase its Tier 1 common equity by roughly $3.9 billion.

Among the questions the Federal Reserve posed in its proposal, was "What factors should the Board consider in deciding whether to impose different capital planning or stress testing requirements on nonbank covered companies?"

Liquidity

As we saw with bankruptcy of Lehman Brothers and the failure of Washington Mutual in September 2008, a run on a bank's liquidity is its quickest route to failure, regardless of how much excess capital an institution has.

The Federal Reserve proposes to follow the Basel III Liquidity Framework in proposing to measure large banks' liquidity through a liquidity coverage ratio (LCR), "designed to promote the short-term resiliency of a banking organization's liquidity risk profile by ensuring that it has sufficient high quality liquid resources to survive an acute stress scenario lasting for one month," and a net stable funding ratio (NSFR), which "is designed to promote liquidity risk resilience over a longer time period and to create incentives for a banking organization to fund its activities with medium- and longer-term funding sources."

The NSFR has a one-year time frame, and is "to provide a sustainable maturity structure of assets and liabilities."

The Fed also said that companies would be required to conduct liquidity stress tests and that required liquidity levels would be based on the complexity of their businesses. The Fed plans to issue additional liquidity rules proposals "that would implement the Basel Liquidity Framework in the United States."

The proposed rule also requires large banks to establish and maintain contingency liquidity plans, which, of course, every single financial institution should already be doing.

Among the questions posed by the Fed in the liquidity section is whether or not there are "other approaches that would effectively enhance liquidity standards for covered companies."

Single-Counterparty Exposure Limits

Pointing out the obvious in saying that the collapse or near-collapse of some of the world's largest financial companies (AIG, for example) demonstrated "the risk that the failure of large financial companies poses to the financial stability of the United States and the global financial system," the Federal Reserve, as required by Dodd-Frank, as proposed to prohibit "prohibit covered companies from having credit exposure to any unaffiliated company that exceeds 25 percent of the capital stock and surplus of the covered company," while reserving the right "to lower the 25 percent threshold if necessary to mitigate the risks to the financial stability of the United States."

For "major covered companies and major counterparties," the general limit of 25% exposure will be lowered to 10% of capital stock and surplus.

Under Dodd-Frank, "credit exposure" includes any extension of credit, including loans, deposits, credit lines, repurchase agreements, reverse repos, securities borrowing and lending, and essentially any other counterparty relationship, including derivative trades and "all guarantees."

In the proposal, the Federal Reserve asks the "can of worms" question of "what transactions, if any, should be exempt from the definition of credit transaction?"

Another interesting question by the Fed in the counterparty section -- keeping in mind that entire asset classes can crash and burn together, the way the U.S. housing sector did in 2008 -- is "should the Board introduce more granular categories of covered companies to determine to appropriate net credit exposure limit?"

-- Written by Philip van Doorn in Jupiter, Fla.

To contact the writer, click here: Philip van Doorn.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.