COVID-19 Pandemic: Streamlining Financial Institution Regulation to Encourage Lending

In recent weeks, regulators of U.S. financial institutions have heeded calls to relax or provide temporary relief from a wide array of regulations that are viewed as impediments to lending in the current crisis environment.  Some of these actions were mandated (or reinforced) by provisions of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”).  Many of the relevant regulations were enacted following the 2008/2009 financial crisis with the goal of strengthening the capital and liquidity positions of financial institutions and limiting their risk taking. The current economic and credit crisis has brought into clear relief the tensions between protecting and limiting risk-taking of financial institutions, and ensuring that those financial institutions have the capacity to lend to support the economy in a crisis, and the changes below make clear that market participants and regulators are increasingly concerned that certain regulations may limit flexibility and credit formation in a crisis like the COVID-19 pandemic.  Below we present a summary of some of the most significant recent changes that have been enacted by regulators or via statute. If you have questions about what these changes mean for your business or a financial institution you transact with, please reach out to the listed authors or your regular Polsinelli contacts.

Regulatory Streamlining Changes That Have Been Recently Adopted:

• Changes to Financial Institution Capital Requirements in Connection with Paycheck Protection Program Lending Facility and Paycheck Protection Program (PPP):  Existing capital requirements may constrain lending by increasing the amount of equity or other capital that banks must have to support expanded lending, particularly loans that would be assigned a higher risk weighting under existing capital rules.  Additionally, the Federal Reserve’s PPP Lending Facility operates by lending to banks against PPP loans they have originated, which would also have a regulatory capital impact to participating institutions.  To provide liquidity to small business lenders and relief to small businesses, a provision in the CARES Act [1], as implemented with a joint interim final rule issued by the Federal Reserve and other banking regulators [2], (1) provides that PPP loans guaranteed by the Small Business Administration (SBA) will be assigned a zero risk weight under the risk-based capital rules and (2) effects changes to the regulatory capital treatment of utilizing the PPP Lending Facility, which, together, should neutralize the regulatory capital effect of banks increasing lending under the PPP and financing those loans via the Federal Reserve’s PPP Lending Facility.

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• Limiting Troubled Debt Restructurings (TDRs) Determinations: Generally, under U.S. GAAP, lenders are required to treat loans modified due to borrower financial distress as TDRs, which triggers additional reporting obligations and accounting requirements.  Federal and State bank regulators have acted to collectively encourage financial institution to work with borrowers have indicated that they and will not direct supervised institutions to automatically categorize COVID-19 related loan modifications as troubled debt restructurings (TDRs). [3]  Additionally, the CARES Act allows lenders to suspend such determinations, with certain limitations, with respect to loan modifications from March 1, 2020 through the earlier of December 1, 2020 and 60 days after the end of the declared public health emergency. [4]

• Delay of Application of Current Expected Credit Loss (“CECL”) to Financial Institutions: FASB auditing standards require that financial institutions recognize the inherent losses in their loan and lease portfolios. CECL is a new methodology for measuring the inherent losses, and requires lenders to estimate and report expected credit losses at origination of a loan, rather than when a loan becomes distressed. The Federal Reserve and other banking agencies issued a joint interim final rule authorizing an extension in the transition period for implementing the full effects of CECL, which is intended to delay any impact that CECL might have on regulatory capital (and therefore lending). [5]  Additionally, the CARES Act specifies that insured depository institutions, bank holding companies and affiliates would not be required to adopt the standard prior to the earlier of December 31, 2020 and the termination of the declaration of national emergency—however market participants have raised questions about whether that would still require them to comply for the 2020 reporting period. [6]  Separate adoption dates apply for smaller financial institutions, and have also been delayed.

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• Temporary Change to Federal Reserve Supplementary Leverage Ratio Rule: The Supplementary Leverage Ratio applies to large financial institutions to limit their total leverage exposure. The change would exclude U.S. Treasury securities and deposits at Federal Reserve Banks from the calculation until March 31, 2021, and would therefore allow those institutions to expand their balance sheets and potentially provide additional credit to households and businesses. [7]

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• Temporary Change to Community Bank Leverage Ratio: Under existing law, qualifying community banking organizations have the option to adopt a simplified 9% leverage ratio in lieu of complying with the full panoply of BASEL III capital rules (those financial institutions meeting the leverage ratio requirement are generally deemed to be well capitalized for prompt corrective action purposes). A provision of the CARES Act, [8] as implemented by interim final rules of the Federal Reserve and other banking regulators, temporarily reduces the applicable leverage ratio to 8% (with a graduated transition to 8.5 % in 2021 and back to 9% thereafter) and provides for a grace period for covered institutions whose leverage ratios fall below the applicable requirement. [9]

• Technical Changes to Total Loss Absorbing Capital Rules (“TLAC”): TLAC rules require global systemically-important  banks to maintain loss-absorbing long term debt and other tier 1 capital at specified levels.  The Federal Reserve System revised the definition of eligible retained income for purposes of the TLAC rules. This technical change allows covered companies to continue to lend and utilize their capital buffers in a gradual manner without severely constraining their ability to distribute capital. [10]

• Deferral of Appraisals and Evaluations for Real Estate Transactions Affected by COVID-19: The federal banking agencies have issued a final interim rule [11] allowing lenders to defer certain appraisals and evaluations for up to 120 days after closing of residential or commercial real estate loan transactions to provide temporary relief by enabling regulated institutions to continue to close loans even if they are unable to arrange an appraisal/evaluation ahead of closing. [12] Real estate transaction involving acquisitions, development and constructions are excluded from the scope of the interim final rule. The temporary relief provisions will expire on December 31, 2020, unless extended. The National Credit Union Administration (NCUA) will consider a similar proposal on April 16, 2020. [13] The federal agencies along with NCUA and the Consumer Financial Protection Bureau have issued a joint statement offering guidance and describing temporary changes to Fannie Mae and Freddie Mac appraisal standards to provide assistance to lenders. [14]

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• Federal Reserve Regulatory Reporting Relief for Small Institutions: The Federal Reserve will not take action against a financial institution with $5 billion or less in total assets for submitting its March 31, 2020, Consolidated Financial Statements for Bank Holding Companies (FR Y-9C) or Financial Statements of U.S. Nonbank Subsidiaries of U.S. Bank Holding Companies (FR Y-11) after the official filing deadline, as long as the applicable report is submitted within 30 days of the official filing due date. [15] The federal financial institution regulators and state regulators also offer similar relief to financial institutions affected by COVID-19. [16]

• Temporary Modification to Wells Fargo Growth Restriction Order: One of the consequences of the Wells Fargo account opening scandal was a 2018 Consent Order that, among other things, restricted Wells Fargo’s asset growth until it met certain requirements. In light of the extraordinary events related to the COVID-19 pandemic, the Federal Reserve amended that order to temporarily lift the asset restriction to allow Wells Fargo to continue lending without violating the limits in the order. [17]

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• Six-Month Delay of the Federal Reserve’s Revised Control Framework:  The Revised Control Framework would have changed the determination of “control” for purposes of the Bank Holding Company Act and therefore the application of certain bank regulatory requirements.  The delay moves the effective date to September 30, 2020 to give additional time for implementation as well as for institutions to consult with the Federal Reserve on the effect of the change. [18]

• Early adoption of Standardized Approach for Measuring Counterparty Credit Risk Rule (“SA-CCR”): SA-CCR is a new methodology for measuring counterparty credit risk of derivatives contracts for regulatory capital purposes, The Federal Reserve and other banking regulators issued a joint notification allowing the companies early adoption of SA-CCR by banks and bank holding companies, with the intent that the early adoption could reduce regulatory capital requirements and therefore encourage lending. [19]

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_{[1] 26 U.S.C. §1102.}

_{[2] Federal Reserve, Interim Final Rule, Regulatory Capital Rule: Paycheck Protection Program Lending Facility and Paycheck Protection Program Loans (amending Sections 32 and 131 of the capital rule) https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200409a1.pdf.  See, 12 CFR 3.2, 12 CFR 3.32(a)(1)(iii), 12 CFR 3.131(e)(3)(viii) and 3.305 (OCC); 12 CFR 217.2, 12 CFR 217.32(a)(1)(iii), 12 CFR 217.131(e)(3)(viii) and 12 CFR 217.305 (Federal Reserve); 12 CFR 324.2, 12 CFR 324.32(a)(1)(iii), 12 CFR 324.131(e)(3)(viii) and 12 CFR 324.304 (FDIC).}

_{[3]  Federal Reserve et al. Press Release, Agencies Provide Additional Information to Encourage Financial Institutions to Work with Borrowers Affected by COVID-19 (March 22, 2020) https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200322a.htm. See, also, Federal Reserve et al. Press Release, Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus (March 22, 2020) https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200322a1.pdf; Federal Reserve et al. Press Release, Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working With Customers Affected by the Coronavirus (Revised) (April 7, 2020) https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200407a1.pdf.}

_{[4] 26 U.S.C. §4013.}

_{[5] Federal Register, Regulatory Capital Rule: Revised Transition of the Current Expected Credit Losses Methodology for Allowances (March 31, 2020) https://www.federalregister.gov/documents/2020/03/31/2020-06770/regulatory-capital-rule-revised-transition-of-the-current-expected-credit-losses-methodology-for.}

_{[6] 26 U.S.C. §4014.}

_{[7] Federal Reserve Press Release, Federal Reserve Board announces temporary change to its supplementary leverage ratio rule to ease strains in the Treasury market resulting from the coronavirus and increase banking organizations’ ability to provide credit to households and businesses (April 1, 2020) https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200401a.htm.}

_{[8] 26 U.S.C. §4012.}

_{[9] Federal Reserve, Interim Final Rule, Regulatory Capital Rule: Temporary Changes to the Community Bank Leverage Ratio Framework, (amending 12 CFR Chapters I, II and III), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200406a1.pdf; Federal Reserve, Interim Final Rule, Regulatory Capital Rule: Transition for the Community Bank Leverage Ratio Framework, (amending 12 CFR Chapter I, II and III), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200406a2.pdf}

_{[10] Federal Register, Total Loss-Absorbing Capacity, Long-Term Debt, and Clean Holding Company Requirements for Systemically Important U.S. Bank Holding Companies and Intermediate Holding Companies of Systemically Important Foreign Banking Organizations: Eligible Retained Income (March 26, 2020) https://www.federalregister.gov/documents/2020/03/26/2020-06371/total-loss-absorbing-capacity-long-term-debt-and-clean-holding-company-requirements-for-systemically.}

_{[11] Federal Reserve, Interim Final Rule, Real Estate Appraisals (amending 12 CFR 34, 12 CFR 225 and 12 CFR 323), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200414a1.pdf. See, 12 CFR 34.43 (OCC); 12 CFR 225.63 (Federal Reserve); 12 CFR 323.3 (FDIC).}

_{[12] Federal Reserve et al., Press Release, Federal Banking Agencies to Defer Appraisals and Evaluations for Real Estate Transactions Affected by COVID-19 (April 14, 2020) https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200414a.htm.} 

_{[13] Id.}  

_{[14] Federal Reserve et al., Interagency Statement on Appraisals and Evaluations for Real Estate Related Financial Transactions Affected by the Coronavirus (April 14, 2020) https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200414a2.pdf.}

_{[15] Federal Reserve Press Release, Federal Reserve offers regulatory reporting relief to small financial institutions affected by the coronavirus (March 26, 2020) https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200326b.htm.}

_{[16] FFIEC Press Release, Financial Regulators Highlight Coordination and Collaboration of Efforts to Address COVID-19 (March 25, 2020) https://www.ffiec.gov/press/pr032520.htm.}  

_{[17] Consent Order, In the matter of Wells Fargo & Company, Docket No. 20-007-B-HC, United States of America before the Board of Governors of the Federal Reserve System Washington, D.C., filed April 8, 2020, https://www.federalreserve.gov/newsevents/pressreleases/files/enf20200408a1.pdf.}

_{[18] Federal Reserve Press Release, Federal Reserve Board announces it will delay by six months the effective date for its revised control framework (March 31, 2020) https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200331a.htm.} 

_{[19] Federal Register, Standardized Approach for Calculating the Exposure Amount of Derivatives Contracts (March 31, 2020) https://www.federalregister.gov/documents/2020/03/31/2020-06755/standardized-approach-for-calculating-the-exposure-amount-of-derivative-contracts}