FINANCIAL INSTITUTIONS RESEARCH

An Update Of The Dodd-Frank Act's Building Blocks Three Years Later

Primary Credit Analyst: Rodrigo Quintanilla, New York (1) 212-438-3090; rodrigo.quintanilla@standardandpoors.com Secondary Contact: Carmen Y Manoyan, New York (1) 212-438-6162; carmen.manoyan@standardandpoors.com

Table Of Contents
How Regulation Affects Our Ratings On Banks Capital Adequacy Is Generally Neutral The Importance Of Having Access To Liquidity At All Times Crisis Management And Resolution Planning Are Works In Progress Progress On Shadow Banking Reform Is Ongoing Regulatory Reform Continues To Loom Large For U.S. Bank Ratings Related Criteria And Research

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Since the onset of the financial crisis in 2007-2008, it seemed that a major overhaul of the regulatory framework for banks was in the cards, in Standard & Poor's view (see "When The Smoke Clears, What Happens Next With U.S. Financial Institutions?," published Sept. 25, 2008, on RatingsDirect). Indeed, about two years later, on July 21, 2010, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA), which has brought about the most significant changes to financial regulation since the 1930s (see "The Financial Overhaul Bill: The Rules Of The Road Have Changed, But Details Should Define By How Much," published July 22, 2010, and "U.S. Financial Regulations: Positive Change Amid Uncertainty And Missed Opportunities," published Aug. 5, 2010). It's again time to take stock of the regulatory advances made since the enactment of the DFA. To be sure, in part as a result of these regulations, U.S. banks have repaired their balance sheets significantly during the past five years, and credit quality, funding and liquidity, and tangible capital levels have all improved. As a result, the U.S. banking system is on firmer footing today than it was when the crisis ended in 2009, despite worries about potential emerging risks in leveraged lending, commercial real estate, and the student loan market. Banks, nonetheless, remain highly dependent on the path of the economy, and its health and recovery will be key in determining future credit losses, especially when the Federal Reserve Board raises the Fed funds rate. We further believe the credit cycle is about to reach a trough and credit losses are very close to bottoming out. Overview U.S. banks' current capitalization is generally a neutral ratings factor despite the increase in capital since the onset of the financial crisis. Funding and liquidity profiles are stronger than they have been in more than a decade, but we remain concerned about how liquidity could hold up in times of financial stress and possible market confidence erosion. Regulators are improving crisis management and resolution planning. We are keeping a close eye on the development of a credible resolution mechanism that aims to ensure that market confidence will not erode with the failure of a large bank. Such regulatory developments may lead us to reassess our treatment of extraordinary government support for the eight highly systemically important banks. We assess regulatory measures throughout the rating process, starting with the Banking Industry Country Risk Assessment (BICRA), our analysis of a bank's stand-alone credit profile (SACP), and our determination of whether we expect a bank to receive group or extraordinary government support.

Banks' financial fundamentals are driven by the economy, and as long as the economy remains on a healthy growth path, we anticipate relatively stable ratings for the U.S. banking industry. However, regulatory changes can also affect ratings. Ratings can move higher or lower depending on how we view regulatory developments, the regulatory framework in our industry risk assessment as part of our Banking Industry Country Risk Assessment (BICRA) analysis, how we incorporate the potential for extraordinary government support

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into issuer credit ratings, and how we view debt security subordination. As global regulatory reform gathers momentum, we anticipate more clarity this year on several issues in the U.S., including the Volcker Rule (which would prohibit banks and their affiliates from engaging in proprietary trading and limit sponsoring or investing in private equity or hedge funds), higher leverage standards for internationally active systemically important banks (G-SIBs), new liquidity rules, and minimum debt requirements at bank holding companies, at least for those banks considered systemically important to ensure their resolvability. International regulatory bodies and other global forums focus on setting consistent standards and providing guidelines, but it is up to national authorities to incorporate these changes into their legislative and regulatory frameworks. From that standpoint, divergence in terms of timing and content of regulatory reforms as well as ongoing regulatory ring-fencing are areas of concern (see "Europe's Ring-Fencing Proposals Could Make Big Banks Safer To Fail, But Also Have Broader Consequences," published July 11, 2013). We see a risk of greater fragmentation of the global banking sector as well as increasing discrepancies in the competitive level playing field. That is why international coordination and cooperation are key in securing global financial stability, be it through requiring banks to maintain higher levels of true loss-absorbing capital (tangible common equity on a redefined asset base) and to strengthen their liquidity, or by implementing feasible crisis management and resolution regimes. Some countries or regions are further along than others in this process. Nonetheless, a recent example of progress in international cooperation is the agreement that U.S. and EU regulators reached on derivatives trading. This agreement allows the recognition of each other's rules by permitting domestic authorities to apply and enforce them.

How Regulation Affects Our Ratings On Banks

We incorporate regulatory standards into all aspects of our bank rating analysis. We begin with a macro-level analysis of the economic and industry risks of each country a bank operates in, including regulations. The results contribute to our BICRAs, or "anchors," which are the starting point for determining bank ratings (see "Banking Industry Country Risk Assessment Methodology And Assumptions," published on Nov. 9, 2011). The industry risk analysis consists of our assessments of banking industries' institutional framework, competitive dynamics, and systemwide funding. The institutional framework score is where we factor in our analysis of banking regulation and supervision, regulatory track record, and governance and transparency. We believe the U.S. financial system is innovative and dynamic, reflecting the strengths of its myriad participants, including banks, brokers, institutional investors, and investment funds. However, keeping this complex system under control, while allowing for prudent risk-taking and market-based solutions, is a considerable regulatory challenge, not least because a number of regulators are looking at different parts of the sector. Having failed to prevent the banking crisis, Congress and regulators are reshaping the regulatory framework under DFA, although they're still working out the details. The legislation seeks to reduce the opportunity for banks to play one regulator against another (regulatory arbitrage) by broadening oversight to include banks and systemically important nonbank institutions and derivatives dealers. However, managing coordination and reducing regulatory overlap remains a challenge. It also proposed new limits on activities of systemically important institutions, and it established new systemic risk regulators (the Financial

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Stability Oversight Council and the Office of Financial Research). The breadth and depth of the recent crisis tarnished the U.S. regulatory track record. After remaining near negligible for many years, the number of bank failures increased substantially in 2009 and 2010, according to Federal Deposit Insurance Corp. (FDIC) data. The crisis revealed substantial gaps in supervisory authority over complex financial instruments and the interconnections between banks and nonbanks, and, thus, over the overall banking system's funding and liquidity. The ongoing regulatory overhaul aims to remedy those deficiencies and restore accountability and transparency, but we believe progress is very gradual and remains subject to changes in political realities. In our view, the complexity of regulation and supervision and the associated slow progress on regulatory reforms will continue to constrain our assessment of the U.S.' regulatory track record. At the bank level, regulation affects an institution's credit quality and financial performance, including its business position, capital and earnings, risk position, and funding and liquidity, all of which we assess independently. (We start with the anchor, and then factor in each of these assessments to determine a bank's stand-alone credit profile, or SACP.) For instance, exceeding minimum regulatory capital levels or funding requirements by a large margin could be a positive rating factor, while concentrated or high-risk exposures are typically a negative. With respect to funding and liquidity, our current bank ratings generally incorporate our expectation that institutions with weaker stand-alone funding and liquidity will steadily strengthen their positions and reduce their dependence on central banks. The liquidity coverage ratio (LCR) methodology, which Basel III proposed, assesses whether banks hold sufficient unencumbered high-quality liquid assets to cover a 30-day liquidity stress scenario. Because the horizon for the stress scenario is relatively short, we could still assess a bank's liquidity as weaker than what the LCR would otherwise imply, which could have negative rating implications. Conversely, we could take positive rating actions on banks that choose to manage their liquidity well above the minimum requirements. We expect that banks will manage their LCRs with a buffer above the 100% minimum requirement. Inadequate public disclosure currently hampers our analysis of banks' funding and liquidity positions. We support greater transparency in this area, alongside the introduction of the new LCR standards (see "How Enhanced Funding And Liquidity Disclosure Could Improve Confidence In The World's Banks," published May 29, 2012). Lastly, based on our rating criteria, we can add notches to the SACP because of expected group or extraordinary government support to reach the issuer credit rating. In this regard, resolution planning (for the orderly wind-down of a failing bank) may affect the way we think of sovereign support in times of financial stress. In addition, we could lower our ratings on certain debt instruments, depending on the scope of the proposed resolution regime, the degree of policy flexibility that the government retains, and the level of sovereign support that we may already factor into the ratings on such instruments (see "Reassessing U.S. Nonoperating Financial Holding Company Creditworthiness Under The Dodd-Frank Act," published Dec. 10, 2012). We might also change our views on the classification of the financial institution (i.e., whether or not it's systemically important). Therefore, we believe that such regimes could affect ratings by influencing our assessment of: The sovereign's willingness and capacity to support the banking system; Notching of debt (statutory or contractual bail-in features could lead to lower instrument ratings); and The availability of group support for subsidiaries or foreign branches.

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Capital Adequacy Is Generally Neutral

We concur with many market participants that most U.S. banks' current loss-absorbing capital levels are only adequate and, thus, neutral to ratings, thanks to the significant improvement since the depths of the financial crisis. Absent any breach of regulatory capital minimums, the main factor in our assessment of a bank's capital and earnings is our risk-adjusted capital (RAC) framework, which offers an alternative, globally consistent measure of capital (see "Bank Capital Methodology And Assumptions," published Dec. 6, 2010). The RAC ratio is total adjusted capital to Standard & Poor's risk-weighted assets (RWA). Our assessment indicates that most banks, particularly the largest, are currently only adequately capitalized (see "Issuer Credit Profiles For Rated U.S. And Canadian Banks (May 2013)," published May 20, 2013). We acknowledge that capital levels have improved, but we had already expected that banks would need to materially strengthen their capital positions following the crisis. Otherwise, capital would generally have been a negative rating factor. According to the Fed, the aggregate Basel I Tier 1 common equity ratio of the 18 largest U.S. banking firms more than doubled to 11.3% of RWA at year-end 2012 from 5.6% at year-end 2008. In absolute terms, these firms have increased their aggregate Tier 1 common equity from $393 billion in late 2008 to $792 billion in four years. According to our capital methodology, which includes higher risk weights than Basel I, we estimate that the industry's RAC ratio increased to 8.4% in second-quarter 2012 from 7.1% at year-end 2009. In a departure from the international capital reform agenda, U.S. banking regulators became more outspoken about the limitations of a risk-adjusted capital measure this year. Moreover, they have argued in favor of tying minimum capital and liquidity requirements together rather than having separate requirements for each for short-term wholesale funded institutions. The Basel Committee on Banking Supervision (BCBS) proposed introducing a leverage ratio as a regulatory ratio at the end of 2009 (see "The Basel III Leverage Ratio Is A Raw Measure, But Could Supplement Risk-Based Capital Metrics," published April 15, 2010). On June 26, 2013, the BCBS published its "Revised Basel III Leverage Ratio Framework and Disclosure Requirements" for consultation. Already, reporting of the leverage ratio and its components to regulators began on Jan. 1, 2013, and public disclosure should start on Jan. 1, 2015. Any final adjustments to the definition and calibration of the leverage ratio will be made by 2017, with a view to migrating to a Pillar 1 treatment on Jan. 1, 2018, based on appropriate review and calibration. The BCBS has proposed setting the minimum ratio of Tier 1 capital to adjusted assets that include derivatives and repo exposures at 3%, which we consider to be low, and some market participants are pushing for it to be established at a higher level. Our view is that a leverage ratio could supplement risk-adjusted capital metrics and identify outliers, but assigning too much importance to it could create unintended consequences for banks, particularly in regard to risk taking. The U.S. had lagged Europe and Asia in finalizing capital rules within the Basel framework because of the added complexity of coordinating it with legislation under the DFA. Domestically, there was also push back about its broader scope because it included smaller community banks. Final Basel 2.5 and draft Basel III capital rules for financial institutions were published on June 7, 2012 (see "For U.S. Banks, It's Finally Time For The Full Basel Rules," published June 18, 2012). On Aug. 30, 2012, the Office of the Comptroller of the Currency (OCC), the Fed, and the FDIC published three joint notices of proposed rulemaking on risk-based and leverage capital. The Fed approved the final

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rule that revises the advanced approaches risk-based capital rule on July 2, 2013, followed by the OCC and the FDIC (as an interim final rule) on July 9 with rules that are identical in substance. The phase-in period for larger institutions begins in January 2014 and for community banks in January 2015. In summary, these new minimum capital standards include the following for all banks: A new minimum ratio of common equity Tier 1 capital to RWA of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of RWA, consistent with the Basel framework. The rule raises the minimum ratio of Tier 1 capital to RWA from 4% to 6%. A minimum leverage ratio of 4%. Lastly, there are strict eligibility criteria for regulatory instruments and risk-sensitivity enhancements to the methodology for calculating RWAs. In addition, on July 9, the three agencies released a notice of proposed rulemaking seeking comment on a proposal for a new minimum supplementary leverage ratio that takes into account off-balance-sheet exposures for the eight largest, most internationally active banks. Bank holding companies (BHCs) with more than $700 billion in assets or $10 trillion in assets under custody would be required to maintain a Tier 1 capital leverage buffer of at least 2% above the minimum supplementary leverage ratio requirement of 3% for a total of 5%. Should this minimum be breached, regulators would impose restrictions on discretionary bonus payments and capital distributions. Moreover, the proposed rule would include a minimum 6% supplementary leverage ratio at the insured depositary institutions of the BHCs to be considered "well capitalized" for prompt corrective action purposes. The effective date for these requirements would be Jan. 1, 2018. Comments will be due 60 days after its publication in the Federal Register. Bank regulators are also keen on setting additional higher standards for the largest banks, those subject to the advanced approach rules. These include minimum long-term debt and equity levels to facilitate single-point-of-entry (SPOE) resolution under OLA, the adaptation of the BCBS' methodological refinements to the framework for capital surcharges for G-SIBs, and measures to address risks related to short-term wholesale funding, including higher capital requirements if reliance on this type of funding is high. Standard & Poor's believes that the largest banks mostly anticipated the new trading risk regulation and proposed capital rules, given capital planning requirements, including stress testing, under the DFA. Bank regulators are effectively setting dual standards, imposing less strict capital requirements for smaller community banks. Under the current definition of total assets, which includes only on-balance-sheet assets, Fed statistics indicate that the combined ratio for U.S. banks with more than $10 billion in assets was 8.23% at the end of March 2013 (see table). U.S. Bank Holding Companies: Tangible Common Equity/Tangible Assets (%)
Group Peer 1 Peer 2 Peer 3 Peer 4 Peer 5 Asset size $10 billion and over $3 billion to $10 billion $1 billion to $3 billion 2013* 8.23 8.97 8.54 2012 8.03 8.77 8.29 8.44 6.17 2011 7.73 8.62 8.00 7.99 5.92 2010 7.05 7.74 7.11 7.32 6.23 2009 5.83 6.69 6.63 6.94 6.10 2008 4.69 6.20 6.61 7.20 7.67 2007 5.60 6.72 7.19 7.94 8.50

$500 million to $1 billion 8.58 Less than $500 million 6.37

*First-quarter 2013. Source: Federal Reserve Board.

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An important international challenge, in our view, is that Basel III to date has not tackled the issue of the inconsistencies in RWAs between regions, countries, and banks. Significant variations can result from national discretion in setting risk weights and differences in banks' internal models, among other factors. In fact, the Basel Committee's recent study ("Report on the regulatory consistency of risk-weighted assets in the banking book issued by the Basel Committee," published July 5, 2013) found large variations in credit risk RWAs across banks, and earlier this year, it reached a similar conclusion regarding variations in trading risk RWAs. We are not certain whether the new capital rules in the U.S. exacerbate these differences at this point. Nonetheless, we believe that developing consistency around trading and banking book RWAs will be a priority during 2013-2014 but that tangible progress likely will be slow.

The Importance Of Having Access To Liquidity At All Times

Simply put, liquidity is having cash balances (or other assets that can readily be turned into cash) when you need them to meet unpredictable loan demand (i.e., committed lines of credit), collateral posting for margin calls, debt maturities, or deposit withdrawals on short notice, among others. Therefore, liquidity management is the process of generating funds to meet contractual or relationship obligations at a reasonable price at all times. Banks are exposed to liquidity risk mainly because they often face balance-sheet mismatches: The contractual maturity profile of their deposits and other funding is typically shorter than the profile of their assets. At one extreme, banks can experience "runs" as confidence erodes, particularly in relation to their solvency. In some instances, even a "walk" can be hurtful. At the other extreme, funding issues can arise because of sharp movements in interest rates, so liquidity is highly correlated with interest rate risk. U.S. banks have improved their funding and liquidity to their strongest levels in more than a decade. Although lending has been tepid, at best, in the past four years, all banks have reduced the amount of short-term and high-cost purchased or borrowed funds they use to support earning asset growth. To measure the reliance on noncore funding, one measure we often consider is the Fed's net short-term noncore funding ratio. Net noncore funding dependence, which the Fed defines as the difference between noncore funding and short-term investments divided by long-term assets, indicates how much a bank depends on volatile sources to finance nonliquid earning assets (i.e., loans). The median regional bank depends less on purchased and borrowed funds than the median large, complex or median trust bank does (see chart). Because they have less core deposit funding than smaller banks, larger banks depend more on noncore funding, despite a reduction in other types of borrowing. It is unclear whether the new minimum liquidity requirements Basel III establishes will reverse this trend.

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In response to the financial crisis and liquidity "runs," Basel III proposed two liquidity measures: one is the LCR, which assesses short-term liquidity, and the other is the net stable funding ratio (NSFR), which measures structural funding (i.e., whether long-term and illiquid assets are matched by long-term stable funding). The LCR was recalibrated in January 2013, and we anticipate that the NSFR is very likely to be recalibrated in 2013-2014 (see "The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks," published on Jan. 17, 2013). The LCR will be phased in and become fully effective in January 2019, and the recalibrated NSFR will probably follow the same timetable. Accordingly, banks must hold sufficient "high-quality liquid assets" (HQLAs), which is the numerator of the LCR, to cover potential net cash outflows (the denominator) under a 30-day stress scenario. These assets must be free and clear of creditor claims, that is, unencumbered. The Basel Committee has specified eligibility criteria for the HQLAs and assumptions on the outflows. It made three broad changes to the original LCR rules: a relaxation of liquidity stress assumptions; a broader definition of high-quality liquid assets; and a longer implementation timetable, with a new phase-in period. Nonetheless, the Fed still sees gaps in how access to liquidity from the central bank (as a lender of last resort) should be included and how to make sure that banks draw down from their LCR buffers in times of stress rather than engage in fire sales to maintain their LCRs. In addition, even with perfectly matched books, a firm could engage in asset fire sales or withdraw credit if access to funds is compromised. The direct and indirect contagion risks are high.

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Thus, the long-term and short-term liquidity ratios might be refashioned so as to address directly the risks of large wholesale funding books. The Fed will issue a proposal later this year for large banks to implement the LCR. As noted before, the Fed is looking into tying liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity positions are substantially stronger than minimum requirements. This approach would reflect that the market perception of a given firm's position as counterparty depends on the combination of its funding position and capital level. It would also supplement the Basel III capital surcharge system, which does not include the use of short-term wholesale funding among the factors used to calculate its systemic importance. Therefore, a systemically important financial institution (SIFI) may be left to choose between holding capital in greater amounts than would otherwise be required, or changing the amount and composition of its liabilities to reduce the contribution it could make to systemic risk in the event of a shock to short-term funding channels. This could be done by associating capital requirements to specified scores under a recalibrated NSFR or by adding as a capital surcharge a specified percentage of assets measured so as to weigh most heavily those associated with short-term funding. If the requirement were significant enough and likely to apply to any large institution with substantial capital market activities, it might also be a substitute for increasing the capital surcharge schedule already agreed to in Basel, according to Fed Governor Dan Tarullo.

Crisis Management And Resolution Planning Are Works In Progress

One of the lessons learned from the financial crisis was the lack of regulator preparedness. Therefore, governments and international bodies have been discussing extensively the need for better policies to manage failing banks that threaten to trigger a systemic crisis. Their goal is to reduce the damage that such a crisis could cause for global financial systems and economies. They have first moved to identify globally systemically important banks (G-SIBs) and then resolution regimes that allow for the orderly wind-down of a failing bank. The U.S. may be further along than other countries, in our view, but there is still work to be done. Regulators are implementing measures that include both prevention and resolution planning. Preventive measures in the U.S. include those of DFA's Title I, such as establishing higher minimum regulatory capital requirements, mandating capital stress testing (see "Stressed But Not Stressed Out: Most Of The Largest U.S. Banks Withstand The Fed's Adverse Scenario Test With Some Room To Spare," published March 19, 2013), requiring that large banks submit living wills or credible plans for a rapid and orderly resolution under the bankruptcy code, and instituting counterparty credit risk limits. Resolution measures in the U.S. relate to resolving a failing SIFI under the DFA's Title II (Orderly Liquidation Authority, or OLA), which grants an orderly liquidation authority to the FDIC as an alternative to bankruptcy proceedings under Chapter 11 of the Bankruptcy Code. Our understanding is that a financial company governed by Title II of the DFA would be subject to this process if the Financial Stability Oversight Council (FSOC) determines, among other things, that the company is in default or in danger of default and that its failure and resolution under Chapter 11 (or a new Chapter 14) of the Bankruptcy Code would pose systemic risk to the U.S. If regulators determine that an orderly resolution cannot happen through bankruptcy proceedings and systemic contagion is a real risk, then a failing institution would be resolved under OLA with the FDIC as receiver. To be effective, we believe OLA will need

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to have a well-established, transparent process that addresses the global interconnectedness and complexity of U.S. SIFIs so market participants can have confidence that a SIFI can be wound down without leading to contagion. Although the DFA established OLA, the mechanics of how it will work were not fully developed from the outset. Over the course of the last year, the FDIC has made progress on the technical aspects of OLA, in our view, but we believe hurdles remain before it can be successfully implemented. These hurdles include: Ensuring sufficient rules are in place to establish minimum levels of capital at the holding company to absorb potential losses from subsidiaries and to recapitalize the operating and new bridge holding companies while reducing the likelihood that operating subsidiary creditors would take losses. Establishing sufficient international cooperation agreements that set clear practices for the settlement of cross-border liabilities. Providing clear and transparent guidelines around how different securities will be treated under OLA at each of the holding company and operating company levels to sufficiently remove market uncertainty, which often contributes to panic. The FDIC has stated that its preferred path to resolution is to use SPOE receivership of the top holding company, which includes creating a bridge holding company and recapitalizing the operating companies so that they can do "business as usual." The living wills that banks have submitted as part of their contingency planning will aid this process. Under SPOE, we understand that the FDIC would take over the parent holding company but leave solvent operating subsidiaries operating normally and recapitalize those that are insolvent. The FDIC would establish a new bridge holding company with assets consisting mostly of the investments in subsidiaries and loans to subsidiaries. The subordinated debt and equity would remain in receivership, although certain other senior unsecured debt and contingent liabilities may or may not pass to the bridge holding company. The FDIC has suggested that the likely scenario is that preexisting shareholders and subordinated and senior debtholders at the parent company would bear losses, and the parent holding company would convert some of the senior unsecured debt to "new" equity sufficient to achieve appropriate capital levels at the new parent. Former debtholders and shareholders would likely receive either call options on financial instruments to be distributed to senior classes or warrants or other contingent value rights. In such a scenario, we anticipate that the original parent's creditors would likely receive haircuts, failing to secure the full value of the debt through a still-undetermined process and in a still-undetermined amount. We understand that by limiting resolution to the holding company, the goal is for only the bank holding company and other noncore nonstrategic subsidiaries to fail. We concur with the FDIC that this process has high execution risk, and how it would work in practice is unclear, especially when considering a Friday takeover and the market's reaction Monday morning. Also, it may be unlikely that subsidiaries of a holding company in receivership would be able to maintain "business as usual" operations. Counterparties would likely cease doing business with those subsidiaries to distance themselves from potential future losses if losses exceed the funding held at the holding company. We understand that through the bridge holding company, the FDIC would seek to recapitalize the insolvent operating subsidiaries as necessary and provide liquidity immediately to all subsidiaries through an orderly liquidation fund. In this sense, the bridge holding company would

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serve as a "source of strength" for recapitalizing subsidiaries, as necessary, and funnel liquidity downstream through intracompany advances. This includes the potential for the FDIC to issue guarantees on debt issued by the subsidiary or subsidiaries. We further understand that under OLA, equity-solvent subsidiaries would aim to operate and conduct "business as usual" and that operational restructuring and any divestitures would occur over time through supervisory agreements. The FDIC has indicated that it contemplates removing the failed holding company's CEO and replacing the original board of directors, but it is unclear whether the regulator would replace any other senior executives, including the heads of the operating subsidiaries. This would require enough potential CEOs and board members to draw from to replace the original management team. The bridge holding company would be held through a "trust" (FDIC could not be an equity owner) and would likely operate under a supervisory agreement that would include a credible operating business plan. According to the FDIC, the implementation of this proposed strategy would require: An adequate amount of unsecured long-term debt issued at the holding company level to absorb losses and recapitalize the firm, with two tiers: subordinate (for recapitalization/losses) and senior (for tail risk); "Business as usual" operations and short-term borrowing at the subsidiary level; and A stipulation that subsidiaries cannot be guarantors for contracts or obligations of the holding company. We believe that, as resolution under the OLA becomes clear and the risk to senior bondholders of the original holding company rises, under an extreme scenario the market may move toward not accepting debt at the holding company, and, instead, the operating subsidiary may issue all future debt once minimum levels of holding company debt are satisfied. We expect that in such a scenario bond investors would have to weigh the benefits of yield relative to potential haircuts in resolution. In this situation, it is not clear to us what path the resolution would take. Furthermore, many institutions that currently invest in unsecured debt have policies that limit their debt investments, making these entities unable to hold the converted equity of a new holding company. This has the potential to dampen the market for unsecured debt that is currently outstanding for SIFIs. We further believe that implementing an orderly liquidation under Title II of the DFA could increase uncertainty in the market at a time when confidence is already low. For instance, dismantling a large financial firm might spur creditors to pull out of other similar financial firms in times of stress. Creditors may react by cutting off funding sooner and accelerating other bank failures. One lesson from the recent crisis is that fund providers' loss of confidence can quickly trigger liquidity events, which can lead to a firm's failure. The FDIC recognizes the potential difficulties with implementing this process, including a lack of alignment in funding and operations across legal entities, high liquidity needs, and the distribution of operations across several jurisdictions. For one thing, assuming a Friday FDIC takeover, bondholders may need more than reassurance from the government about liquidity availability to ensure new private-sector funds on Monday morning. As for the difficulties in cross-border resolution, the Fed has noted that U.S. bank holding companies with $50 billion or more in assets own, in aggregate, more than 6,000 foreign entities. This includes over 550 foreign branches and entities that engage in a variety of activities, including investment advice, investment banking and securities lending, commercial banking, and insurance, trust, fiduciary, and custody activities, as well as act as financial vehicles. The good news is the FDIC has

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found that more than 90% of the total reported foreign activity is located in no more than three foreign jurisdictions, and more than 80% of the total reported foreign activity for each of the top five U.S. SIFIs comes from legal entities in the U.K. In our view, however, the greatest obstacle to overcome is the generally localized mechanisms for resolving distressed financial firms (including the priority of creditor claims and stays or suspension of actions against debtors) because firms' enterprisewide operations are mostly global. In addition, local regulators will have to share information in times of stress. In sum, there is still no definitive framework for the coordinated resolution of cross-border financial groups or conglomerates. A new proposed Chapter 14 in the Bankruptcy Code would incorporate features of Chapters 7 (liquidation) and 11 (reorganization) for large SIFIs. Some changes include allowing the government to provide debtor-in-possession (DIP) financing, or allowing a firm's primary regulator to initiate a bankruptcy filing. At a minimum, these proposals would appear to further limit the need for OLA. We understand that efforts are underway to align the treatment of stakeholders under the new Chapter 14 and OLA, such that ultimately the outcome may be the same regardless of the resolution path taken. We believe policymakers still need to address various obstacles and legal issues related to bank resolution regimes, especially if international consistency is a major goal. These include: Corporate and insolvency law and counterparty set-off, netting, and termination rights (cross-default provisions); Arrangements for funding aspects of resolution regimes; Potentially lengthy lead times for the structural and organizational changes that will enable resolution mechanisms to work, especially for large, complex banks; and The complexities of setting and implementing a framework for greater coordination across borders. While we assess OLA-related progress still to be made by regulators, we thought it was prudent to reflect in our outlooks on the ratings on the eight bank holding companies that we classify as SIFIs (Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street, and Wells Fargo) the possibility that we may not continue to factor support into the ratings in the future. (See "Various Outlook Actions Taken On Highly Systemically Important U.S. Banks; Ratings Affirmed," published June 11, 2013.) We believe clarity in rulemaking related to minimum levels of holding company debt, bail-in characteristics, and globally consistent resolution mechanisms would be important milestones in building a credible resolution regime in the U.S. Should we see progress toward some or all of these factors that we believe make an effective resolution under OLA more likely, we could downgrade the eight bank holding companies by removing extraordinary government support. Investors have asked whether we are considering wider notching between holding company ratings and operating company ratings (investment-grade bank holding companies are currently rated one notch lower than their operating companies) beyond potentially removing the government support we factor into our ratings on the eight banks we view as highly systemically important. Currently, we are not considering this wider notching. However, we could reconsider it if the creditworthiness of bank holding companies deteriorates broadly relative to operating company

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creditors by virtue of final regulatory requirements.

Progress On Shadow Banking Reform Is Ongoing

There has been progress on increasing the transparency of shadow banking markets to allow monitoring of excessive leverage buildup and unstable maturity transformation outside regulated banks. The Fed is still working on improved reporting in repurchase agreements and securities lending transactions to detect emerging risks. Initiatives regarding money market mutual fund reform and the tri-party repo market are also underway. On June 5, 2013, the SEC proposed to tighten money market fund (MMF) regulations by suggesting two alternative reforms that can be adopted alone or in combination along with other requirements, including stronger diversification of holdings, improved reporting, and enhanced disclosure and stress testing. Under the first alternative, prime institutional MMFs would be required to transact at a floating NAV rounded to four decimal places, not at a $1.00 stable share price. Under the second alternative, MMFs would continue to transact at a stable share price but could use liquidity fees or redemption gates (or a combination of the two) when "weekly liquid asset" balances fall below 15% of total assets. There are also proposals for stronger diversification of holdings, improved reporting, and enhanced disclosure and stress testing, which we view as positive rating factors because they aim to increase transparency and mitigate risk in money funds (see "Assessing The Impact That Recent U.S. Money Market Fund Reform Proposals Could Have On Principal Stability Fund Ratings," published June 18, 2013). On the tri-party repo market, current initiatives have already reduced discretionary intraday credit extended by the clearing banks by approximately 25%, according to the Fed. Furthermore, the Fed expects to eliminate all intraday credit in the tri-party settlement process by year-end 2014. Lastly, the FSOC has already designated AIG and General Electric Capital Corp. as systemically important financial institutions.

Regulatory Reform Continues To Loom Large For U.S. Bank Ratings

Regulators expect that proposed enhanced prudential regulations will be finalized by the end of this year, with the exception of single-counterparty credit limits. The Fed is conducting a quantitative impact study on the effects of the proposed rule and coordinating this rule with a similar large exposure rule for G-SIBS that the BCBS is developing. But, generally speaking, regulators are moving closer to a regime of compliance and enforcement rather than rule writing. We believe that potential regulatory changes--more than economic factors--are shaping the rating outlook for U.S. banks in the near term. We believe that the economy remains on relatively firm footing and that emerging risks in the sector are manageable. However, regulatory changes have the potential to change our assessment of industry risk or creditworthiness among different classes of bondholders. We expect that banking regulators will continue to work toward providing more clarity to the market during 2013.

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Related Criteria And Research

Issuer Credit Profiles For Rated U.S. And Canadian Banks (May 2013), May 20, 2013 Brown-Vitter Bill: Game-Changing Regulation For U.S. Banks, April 25, 2013 Stressed But Not Stressed Out: Most Of The Largest U.S. Banks Withstand The Fed's Adverse Scenario Test With Some Room To Spare, March 19, 2013 The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks, Jan. 13, 2013 Reassessing U.S. Nonoperating Financial Holding Company Creditworthiness Under The Dodd-Frank Act, Dec. 10, 2012 Banking Industry Country Risk Assessment: U.S., Aug. 8, 2012 It's All In The Execution: The Dodd-Frank Act Two Years Later, July 12, 2012 For U.S. Banks, It's Finally Time For The Full Basel Rules, June 18, 2012 How Enhanced Funding And Liquidity Disclosure Could Improve Confidence In The World's Banks, May 29, 2012 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011 Banks: Rating Methodology And Assumptions, Nov. 9, 2011 The U.S. Government Says Support For Banks Will Be Different "Next Time"--But Will It?, July 12, 2011 Bank Capital Methodology And Assumptions, Dec. 6, 2010 U.S. Financial Regulations: Positive Change Amid Uncertainty And Missed Opportunities, Aug. 5, 2010 The Financial Overhaul Bill: The Rules Of The Road Have Changed, But Details Should Define By How Much, July 22, 2010 The Basel III Leverage Ratio Is A Raw Measure, But Could Supplement Risk-Based Capital Metrics, April 15, 2010 When The Smoke Clears, What Happens Next With U.S. Financial Institutions?, Sept. 25, 2008

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