Introduction

In an effort to address single-counterparty concentration risk among large financial companies, section 165(e) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) ¹ directs the Federal Reserve Board to establish single-counterparty credit limits for bank holding companies and foreign banking organizations with total consolidated assets of $50 billion or more (covered companies) in order to limit the risks that the failure of any individual firm could pose to a covered company.² This section directs the Board to prescribe regulations that 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 or such lower amount as the Board may determine by regulation to be necessary to mitigate risks to the financial stability of the United States.³

As part of this process, the Board is considering a set of more stringent single-counterparty credit limits that would apply to the eight U.S. bank holding companies (BHCs) of the greatest systemic importance, which have been denominated global systemically important bank holding companies (GSIBs), as well as U.S. intermediate holding companies or U.S. operations of a foreign banking organization with total assets of $500 billion or more, collectively known as major covered entities. The proposal would establish a tighter 15 percent limit on the credit exposure of these major covered entities to any GSIB or any entity that has been designated as systemically important by the Financial Stability Oversight Council (FSOC), collectively known as major counterparties.

This paper explains the rationale for the more stringent credit limit as well as the calibration of the proposed tighter 15 percent limit. Because there is no single widely accepted framework for calibrating single-counterparty credit limits, the Board has considered several potential approaches. This paper focuses on a calibration approach that uses a portfolio credit risk model and explains the portfolio credit risk model in detail. It provides single-counterparty credit limit calibrations for credit exposures between major covered entities and major counterparties resulting from that framework under a range of plausible assumptions, incorporating the uncertainty that is inherent in the study of rare events such as the failure of SIFIs.

Background

The failures and near-failures of SIFIs were key drivers of the 2007-08 financial crisis and the resulting recession. The experience of the crisis made clear that the failure of a SIFI during a period of stress can do great damage to financial stability, that SIFIs themselves lack sufficient incentives to take precautions against their own failures, that reliance on extraordinary government interventions going forward would invite moral hazard and lead to competitive distortions, and that the pre-crisis regulatory focus on microprudential risks to individual financial firms needed to be broadened to include threats to the overall stability of the financial system.

In keeping with these lessons, post-crisis regulatory reform has placed great weight on macroprudential regulation, which seeks to address threats to financial stability. Section 165 of the Dodd-Frank Act pursues this goal by empowering the Board to establish enhanced regulatory standards for "large, interconnected financial institutions" that "are more stringent than the standards...applicable to financial institutions that do not present similar risks to the financial stability of the United States" and "increase in stringency" in proportion to the systemic importance of the financial institution in question.⁴ Section 165(e) of the act requires the Board to impose single-counterparty credit limits as a mandatory enhanced regulatory standard for SIFIs and other large BHCs.

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Rationales for a More Stringent Credit Exposure Limit on Exposures between Major Covered Entities and Major Counterparties

The Dodd-Frank Act's mandate that the Board adopt enhanced prudential standards to mitigate the risk posed to financial stability by certain large financial institutions provides the principal statutory impetus for a more stringent credit exposure limit between major covered entities and major counterparties. Because the failure of a SIFI could undermine financial stability and thus cause far greater negative externalities than could the failure of a financial institution that is less systemically important, the single-counterparty credit limit that applies when a SIFI (major covered entity) faces another SIFI (major counterparty) must reflect the greater risk that arises in the context of such inter-SIFI credit exposures.

More specifically, SIFIs are characterized by a number of important similarities that make it relatively more likely that the default or distress of a SIFI counterparty (major counterparty) would coincide with events that simultaneously threaten the viability of the credit-granting SIFI (major covered entity). SIFIs are engaged in a similar mix of global business lines that are subject to related risks so that a shock that impairs a credit-receiving SIFI could well be expected to also impair the credit-granting SIFI. Moreover, entities that fund SIFIs may have incentives to pull their funding or otherwise pull back from SIFIs in the event of a failure of a SIFI, which would add additional significant stress to a credit-granting SIFI in the event that it has extended credit to a failing SIFI. None of these considerations are as salient when a SIFI makes a credit extension to a non-SIFI such as a non-financial corporate borrower. A shock that results in the default of a non-financial corporate would not generally be expected to coincide with events that independently threaten the viability of the credit-granting SIFI.

Accordingly, the credit risk that is inherent in inter-SIFI credit extensions is larger than the risk that is inherent in SIFI to non-SIFI credit extensions. Accordingly, applying the proposal's statutory 25 percent credit limit would result in a situation in which the total default risk incurred by a credit-granting SIFI on inter-SIFI credit extensions would be greater than the total default risk incurred by a credit-granting SIFI on SIFI to non-SIFI credit extensions. Such an approach would materially threaten financial stability given the potentially large adverse consequences of multiple SIFI defaults. As a result, to ensure that inter-SIFI credit extensions do not result in heightened credit risk relative to SIFI to non-SIFI credit extensions and thereby threaten financial stability, the single-counterparty limit on inter-SIFI credit extensions should be more stringent than the limit on SIFI to non-SIFI credit extensions.

In what follows, a calibrated quantitative credit risk model is employed to provide a range of credit exposure limits that would be expected to ensure that the resulting credit risk on an inter-SIFI credit extension is no greater than the credit risk that arises in the context of a SIFI to non-SIFI credit extension. Of course, as previously discussed, the default of multiple SIFIs is likely to be significantly more damaging to the economy and financial stability than the default of a SIFI resulting from the default of a non-SIFI counterparty. As a result, it would also be consistent with maintaining financial stability to require that the credit risk incurred from inter-SIFI credit extensions be significantly less than that incurred by SIFI to non-SIFI credit extensions. Accordingly, the range of single-counterparty credit limits that are presented should be viewed as an upper bound on the appropriate level of the inter-SIFI credit limit that is consistent with maintaining financial stability.

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References

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