The hits just keep on coming.

Even as the aftershocks of the Financial Crisis fade and the Dodd-Frank Act inches closer to completion, large banks continue to face a steady stream of regulatory demands. Recent days have been no exception, with new and pending demands regarding liquidity, swaps contracts, efforts to limit incentive-based pay, and a long-in-the-works plan to undo the United States’ “see no evil” approach to beneficial ownership data.

To start with the most recent development, on May 6, in an admitted response to the “Panama Papers” scandal—a law firm breach that revealed a global web of shell companies, offshore tax shelters, and secret trusts—Treasury Department officials outlined actions intended “to strengthen financial transparency and combat the misuse of companies to engage in illicit activities.”

Among those steps: the announcement of a customer due diligence final rule; proposed beneficial ownership legislation; and proposed regulations related to foreign-owned, single-member limited liability companies.

The customer due diligence final rule adds a new requirement that financial institutions—including banks, brokers or dealers in securities, mutual funds, futures commission merchants, and introducing brokers in commodities—collect and verify the personal information of beneficial owners, the real people who own, control, and profit from companies when those companies open accounts.

Financial institutions will need to identify and verify the identity of any individual who owns 25 percent or more of a legal entity, and an individual who controls the legal entity.

“It is going to create a bubble in activity for banks, and they are going to need to scale up quickly,” says Alan Morley, regulatory compliance practice Lead for GFT, a business and technology consultancy.

“One of the most difficult things in correspondent banking is knowing your banking customers’ customer,” he explains. Not only will post-scandal regulations change how institutions onboard new customers, they can expect to face a “look-back” of historical transactions based on data culled from the leaked documents.

“There is an effective date at least a year after the issuance of the final rule. That gives people, one would think, a fair amount of time to prepare. Lead-time matters and you have what appears to be a reasonable phase-in period for new contracts.”
James Schwartz, Of Counsel, Morrison Foerster

The good news: All that data from the Panama Papers may ultimately assist banks in their due diligence efforts. “With this information, we are going to be better able to make determinations as to what an entity is and the people who are associated with owning it,” Morley says.

On the same day as the Treasury Department announcement, the Securities and Exchange Commission became the latest regulator to join a regulatory effort intended to curb incentive-based executive pay that encourages inappropriate risks at banks and credit unions.

That effort began earlier this month when the National Credit Union Administration re-proposed a stalled 2011 rule proposal.

The proposed rules—which also apply to investment advisors, broker-dealers, and mortgage-finance companies Fannie Mae and Freddie Mac—would impose new clawback provisions, enhance compensation-related disclosures, and require executives and “significant risk takers (individuals receiving at least one-third of their pay in incentive-based compensation)” to defer as much as 60 percent of their incentive-based pay for up to four years

The rulemaking will be a multi-agency effort, as the SEC joined the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Board of Governors of the Federal Reserve System, and the Office of the Comptroller of the Currency.

The proposal also calls upon institutions to claw back bonuses, as far back as seven years, if inappropriate risks caused a material loss or led to an enforcement action. The largest institutions will be required to have a risk management framework in place for their incentive-based compensation programs and an independent compliance program responsible for internal controls, testing, monitoring, and training.

As regulators see things, an antidote to risk is liquidity, and having the assets needed to weather unexpected economic sucker punches. In April, with the release of annual “stress tests” by the Federal Reserve and Federal Deposit Insurance Corporation, five of the nation’s largest banks—JPMorgan Chase, Bank of America, State Street, Bank of New York Mellon, and Wells Fargo—were determined to have significant deficiencies that must be resolved by October. Many of those issues involved insufficient liquidity.


The following is from a statement by Federal Reserve Governor Daniel Tarullo regarding a proposed rule to restrict Qualified Financial 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 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.
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. 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.
Source: Federal Reserve

Last month, a “net stable funding” rule was proposed by the OCC and FDIC. It would require big banks to hold sufficient liquid assets to endure a yearlong funding crisis.

By requiring institutions “to maintain an amount of stable funding that is appropriate given the liquidity of their assets,” the ratio will “strengthen the financial system, making it more resilient to market stress,” Federal Reserve Chairman Janet Yellen said prior to a vote advancing the proposal.

Should any systemically important financial entity collapse, another proposed rule that seeks to improve the resolution process is demanded by Title II of the Dodd-Frank Act.

When a large financial institution gets into trouble, its failure can destabilize other firms because they are connected by the business they do together and through the contracts that result from that business. A run on a failing banking organizations may begin with the mass cancellation of derivatives and repo contracts (known collectively as Qualified Financial Contracts, or QFCs) that govern the everyday course of financial transactions.

“When these contracts, unravel all at once at a failed large banking organization, an orderly resolution of the bank may become far more difficult, sparking asset fire sales that may consume many firms,” Yellen said.

The proposal would require U.S. global systemically important banking institutions (there are currently eight designated GSIBs) and the U.S. operations of foreign GSIBs to amend contracts and prevent the immediate cancellation of QFCs for derivatives, securities lending, and short-term funding transactions. To prevent a run, those contracts cannot be cancelled for at least 48 hours after the bank’s holding company files for bankruptcy or begins resolution proceedings.

The proposal is intended so that all QFC counterparties—domestic and foreign—would be treated in the same way in an orderly resolution. GSIBs may also comply by using QFCs that are modified by the International Swaps and Derivatives Association (ISDA) 2015 Resolution Stay Protocol, which was developed by the association’s members with a similar goal in mind.

Industry coordination may be a key to the rule’s success. “The regulations say pretty plainly that, to the extent your contracts are covered by the ISDA 2015 Universal Resolution Stay Protocol, you will be deemed to comply with the regulation,” says James Schwartz, of counsel at law firm Morrison Foerster. “That was a pretty good indication that what they are trying to do is pretty well coordinated with ISDA, although most market participants will likely be more interested in adhering to the new ISDA Resolution Stay Jurisdictional Modular Protocol.”

“We will have to see, but my feeling is that they have done this in a fairly elegant way,” he adds. “There is an effective date at least a year after the issuance of the final rule. That gives people, one would think, a fair amount of time to prepare. Lead-time matters and you have what appears to be a reasonable phase-in period for new contracts.”

Schwartz isn’t very concerned about the retroactive effect on existing contracts. “If there is a preexisting QFC, one prior to the effective date, you need to confirm that one of you enter into another QFC with the same counterparty on or after the effective date,” he explains. “What that means is that if you just have pre-existing one-off contracts or a transaction with a particular counterparty and you have no intention of doing another transaction with them, you don’t need to go back and amend the contract.”

One side effect of the rulemaking is the potential for parties to bail on a financial institution at the first indications of insolvency, lest they become mired in the resolution process.

“That’s a very difficult issue,” Schwartz says. “The authorities obviously want the power to resolve institutions in accordance with Title II of Dodd-Frank, which they say is expected to be a fairly rare occurrence. By the same token, it is true that derivatives have historically had a somewhat preferred status under the bankruptcy code. It’s a very difficult to know how regulations such as these will affect the derivatives market.”

“This doesn’t totally undo the safe harbors, but it does tend to undermine them in relation to certain transactions,” he adds. “If the market has grown up with one set of assumptions and then has to live with another set of assumptions, how will it respond?”