Among the catalysts of the financial crisis, was the contagion and falling-domino effect caused by interconnectivity and excessive exposure among large financial institutions.
That interconnection, and the lessons learned from what went wrong, were the motivation for a new rule, approved by the Federal Reserve Board on Thursday, that is intended to prevent concentrations of risk between large banking organizations and their counterparties from undermining financial stability.
The final rule, which implements a mandate of the Dodd-Frank Act, applies credit limits that increase in stringency as the systemic footprint of a firm increases. A global systemically important bank holding company (GSIB) would be limited to a credit exposure of no more than 15 percent of the GSIB's tier 1 capital to another systemically important financial firm.
That threshold reflects the Fed’s analysis of the increased systemic risk posed when the largest firms have significant exposure to one another.
“The financial crisis showed that financial interconnections between our largest and most complex institutions—for example, lending and borrowing between such firms—can threaten the stability of the financial system,” said Chairman Jerome H. Powell. The final rule will “limit these exposures and their associated risks. The limit for the very largest banks is tougher than required by statute and is supported by a careful analysis showing that the financial system, as a whole, faces increasing risks when these firms have too much exposure to each other.”
A bank holding company with $250 billion or more in total consolidated assets would be restricted to a credit exposure of no more than 25 percent of its tier 1 capital to a counterparty. Foreign banks operating in the U.S. with $250 billion or more in total global consolidated assets, and their intermediate holding companies (IHCs) with $50 billion or more in total U.S. consolidated assets, would be subject to similar limits.
The limits in the final rule will apply only to GSIBs and bank holding companies with at least $250 billion in total consolidated assets. The Board will consider the extent to which additional standards, including credit exposure limits, should apply to holding companies with total consolidated assets between $100 billion and $250 billion at a later date.
A foreign bank's combined U.S. operations, though not its U.S. intermediate holding company, will be considered in compliance with the final rule if a comparable rule is in effect in the foreign bank's home country.
GSIBs will be required to comply by January 1, 2020, and all other firms are required to comply by July 1, 2020.
“This final rule is another step in sustaining an effective and efficient regulatory regime that keeps our financial system strong and protects our economy while imposing no more burden than is necessary to get the job done,” Powell said.
“The single-counterparty credit limit rule implements common sense guardrails,” said Fed Governor Lael Brainard. “It is also important that we have tailored the rule to adopt more stringent credit limits on the very largest firms. Because these large, complex institutions are typically engaged in common business lines and have common funding sources and counterparties, there is an elevated correlation of distress and default.”
The higher correlations, she said, “warrant a more restrictive” 15 percent limit on credit exposures to other very large, complex firms, compared with 25 percent on large, less complex firms.