New rating system for large financial institutions

November 8, 2018 | Financial services

The new rating system applies to:

• Domestic bank holding companies (BHCs) and non-insurance, non-commercial savings, and loan companies (SLHCs) with more than $100 billion in total consolidated assets²
• US intermediate holding companies (IHCs) of foreign banking organizations (FBOs) with more than $50 billion in total consolidated assets (consistent with Regulation YY), however the board may adjust this asset threshold in the future if necessary.

The Fed’s new rating system for large financial institutions (LFIs) aligns with the supervisory program for large financial institutions that focuses on capital, liquidity, and effectiveness of governance and controls. These rating assignments remain confidential.

The rating system issues component ratings for the following areas:

1. Capital planning and positions,
2. Liquidity risk management and positions, and
3. Governance and controls.

Key takeaways:

• Rating system: The final LFI rating approach is largely the same as the Fed’s original proposed rating framework issued in August 2017
• Key differences from the original proposal include:
  • The threshold for application will increase to $100 billion (from $50 billion) in assets for US BHCs; FBO IHCs remains at $50 billion
  • The final rating system retains a four-category, non-numeric rating scale, but changed the top two categories from “Satisfactory” and “Satisfactory Watch” to “Broadly Meets Expectations” and “Conditionally Meets Expectations” to improve the category description while leaving the underlying definitions intact.
• Reliance on current supervisory guidance (including “SR” letters): The Fed will rely on current supervisory guidance for risk management and governance until its new proposals that are finalized that supplement views for the governance and controls rating
• Changes in rating category: Originally, the “Satisfactory Watch” category (now “Conditionally Meets Expectations”) expressed the expectation that issues would be remediated within 18 months or a downgrade would occur; recognizing the wide variety of issues and relevant time frame needs, the 18-month specific timeframe has been dropped from the final rating system in favor of case by case deadlines established between the Fed and institution, which would be reflective of individual timelines, action plans, progress, risks, and issues.
• FBO impact: Given FBO/IHC governance is different from a top tier US BHC, IHCs are not expected to be subject to examinations solely focused on the effectiveness of the IHC board of directors; instead issues that arise during their other examinations more broadly could reflect on supervisory comments related to the IHC board of directors. At the time of the drafting of this blog, the Federal Reserve expects separate issuance for tailoring the board effectiveness guidance to the FBOs.
• Timing: Implementation dates for the rollout of the revised LFI rating system for Large Institution Supervision Coordination Committee (LISCC) firms during the 2019 supervisory cycle and for non-LISCC firms that may be subject to the Fed’s tailoring proposal during the 2020 supervisory cycle (given an understanding of tailored expectations will be needed for any new LFI rating—non-LISCC firms will therefore be subject to the existing RFI system in 2019
• Alignment to supervisory pillars: The Fed believes its new system shows greater transparency into how the results of various examinations, horizontals, and other supervisory activities translate into safety and soundness ratings. This in turn, presents LFI boards and senior management with further opportunities to self-identify issues, hold responsible parties accountable, and proactively initiate improvement in areas that are less than satisfactory prior to regulatory mandates.
• Resolution planning: The Fed requested comments on whether resolution planning should be included in the rating system. In the final update, the Fed determined not to include a separate component rating for a firm’s resolution planning as part of the final LFI rating system. The board will continue to consider whether the LFI rating system should be modified in the future to include an assessment of the sufficiency of a firm’s resolution planning efforts.

New rating tiers

Since 2004, the Fed has used the “RFI/C (D)” rating system for US BHCs, which focused on:

• Risk management practices
• Financial condition of the consolidated organization
• Impact of a BHC’s non-depository entities on its subsidiary insured depository institutions (IDIs)
• Composite of the BHC as reflected by the R, F, and I ratings
• Depository institutions (i.e., composite CAMELS ratings assigned by primary supervisor of the IDIs)

Instead of the current RFI/C (D) approach of assigning numerical ratings from one (e.g., strong) through five (e.g., unsatisfactory), the new framework takes a four-tier approach (but non-numeric) and does not contain a tier that would be analogous to a the current one or “strong” rating.

The finalized rating tiers include:

• A “Broadly Meets Expectations” rating indicates that a firm is considered safe and sound, and broadly meets supervisory expectations. The firm may be subject to identified supervisory issues, but these issues do no present a threat to put the firm’s safety or soundness at risk.
  • Changes from the proposed rating system: The proposal’s highest rating category was “Satisfactory.” The new definition allows for supervisory issues that require corrective action, provided these issues are immaterial to the firm’s safety and soundness profile.
• A “Conditionally Meets Expectations” rating indicates that certain material financial or operational weaknesses expose the firm’s ability to remain safe and sound through a range of conditions if not resolved in a timely manner during the normal course of business.
  • Changes from the proposed rating system: The proposal’s second-highest rating category was “Satisfactory.” The new definition removes the proposal’s requirement for remediation of issues within 18 months. Issues left unresolved within the 18-month period would have downgraded a component rating, forcing the firm to lose its “well managed status.” The adopted system allows for issue-specific resolution timelines (e.g. technology implementation) and the addition of new issues that, ceteris paribus, would result in a “Conditionally Meets Expectations” rating. The final large financial institutions rating system also defines “normal course of business” which permits the firm to address its issues without changing its business profile. Finally, the rating permits “Deficient” ratings to be upgraded to “Conditionally Meets Expectations” if the firm’s remediation and mitigation activities are sufficiently advanced.
• A “Deficient-1” rating indicates that financial or operational deficiencies put the firm’s safety and soundness at risk. The firm with this rating is unable to remediate these issues during the normal course of business and requires a material change to its business model or financial profile, or its practices and capabilities.
• A “Deficient-2” rating indicates that the financial or operational deficiencies in a firm’s practices or capabilities present a threat to the firm’s safety and soundness, or have already put the firm in an unsafe and unsound condition.

Under the final new large financial institutions rating system, a firm must be rated “Broadly Meets Expectations” or “Conditionally Meets Expectations” for each of the component ratings to achieve the “well managed” status required by various statues and regulations.³

Component ratings

• The capital planning and positions component rating evaluates:
  • The effectiveness of a firm’s governance and planning processes used to determine the amount of capital necessary to cover risk and exposures, and to support activities through a range of events, and
  • The sufficiency of a firm’s capital positions to comply with applicable regulatory requirements and to supports the firm’s ability to continue to serve as a financial intermediary through a range of conditions.

Clarifications from the proposed rating system: The Fed will consider minimum regulatory capital requirements, but the Fed may determine that a firm does not meet expectations considering its idiosyncratic risks. In addition, the results from supervisory stress testing are considered inputs to the component rating, but there is no automatic link between the two. Furthermore, the Fed is evaluating comments on whether the Fed should discontinue its practice of publicly objecting or non-objecting to a firm’s capital plan.

Note: The Fed, Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) recently proposed new capital requirements for certain organizations with over $100 billion in total consolidated assets.

• The liquidity risk management and positions component rating evaluates:
  • The effectiveness of a firm’s governance and planning processes used to determine the amount of liquidity necessary to cover risk and exposures, and to support activities through a range of events, and
  • The sufficiency of a firm’s liquidity positions to comply with applicable regulatory requirements and to supports the firm’s ability to continue to serve the firms ongoing obligations through a range of conditions.

Clarifications from the proposed rating system: Supervisory findings (i.e., “matters requiring attention” and “matters requiring immediate attention”) communicated during the comprehensive liquidity assessment review will represent a material input into a firm’s liquidity rating.

Note: The Fed, OCC, and FDIC recently proposed new liquidity requirements for certain organizations with over $100 billion in total consolidated assets.

• The governance and controls component rating evaluates the effectiveness of:
  • The board of directors,
  • The management of business lines and independent risk management and controls, and
  • Recovery planning (only for domestic firms that are subject to the Large Institution Supervision Coordination Committee framework).

Clarifications from the proposed rating system: The Fed invited comment on two sets of guidance for the (1) responsibilities of the board of directors, and (2) core principles of effective senior management, business lines, and independent risk management and controls, in August 2017 and January 2018, respectively. The Fed continues to consider comments on both proposals, and is not adopting either guidance in concurrence with the new LFI rating system. The Fed will rely on the principles set forth in SR 12-17 and CA 12-14 to assess the firm’s board of directors, and will rely on supervisory expectations elsewhere in the LFI rating system to assess senior management, the management of business lines, and independent risk management and controls.

The Fed previously asked for public comment on whether to include a firm’s resolution planning within the governance and controls component rating. The Fed has determined not to include it now, but will continue to consider whether to modify the rating system in the future.

The Fed clarified that that given that the governance structure of US IHC differs from US BHCs, the effectiveness of a US IHC’s board of directors will not be directly examined. Rather, the Fed will glean this information through assessing weaknesses or deficiencies gained while conducting other supervisory work.

Conclusion

The new LFI rating system aligns the Fed’s supervisory programs, processes, and priorities. By reframing the rating system and providing clear definitions and guidance, the Fed provides transparency into how the results of various exams, horizontals, and other activities translate into safety and soundness ratings. While the Fed has yet to finalize guidance for board of directors, senior management, business lines, and independent risk management and controls, the new rating system presents stakeholders with opportunities to self-identify issues, hold responsible parties accountable and proactively initiate improvement in areas that are less than “Broadly Meeting Expectations.”

Endnotes:

¹ Updates are to Regulation K (International Banking Operations) and Regulation LL (Savings and Loan Holding Companies) and take into consideration provisions of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) passed on May 24, 2018.

² For bank holding companies with less than $100 billion in consolidated assets, the Fed will continue to apply its existing rating system. The existing system will also be adopted for non-insurance, non-commercial savings and long holding companies with less than $100 billion in total consolidated assets.

³ 12 U.S.C. § 1841 (“Bank Holding Companies”) et. seq. and 12 U.S.C. § 1461 (“Savings Associations”) et seq. See, e.g., 12 CFR 225.4(b)(6), 225.14, 225.22(a), 225.23, 225.85, and 225.86; 12 CFR 211.9(b), 211.10(a)(14), and 211.34; and 12 CFR 223.41.

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