Recently, the Federal Reserve Board announced that it has finalized a new supervisory rating system for large financial institutions (LFIs) that will be effective on February 1, 2019.
The primary intention behind adopting the new rating system is to enhance the accuracy and uniformity of supervisory assessments and to communicate supervisory findings in a better way; in addition, it will better align the rating system with Federal Reserve’s existing programs and practices. Lastly, the new LFI rating system will provide more transparency to the outcomes of a specific rating.
According to the Federal Reserve Board, “The final rating framework applies to bank holding companies and non-insurance, non-commercial savings and loan holding companies with total consolidated assets of $100 billion or more, and U.S. intermediate holding companies of foreign banking organizations established under Regulation YY with total consolidated assets of $50 billion or more.”
Designed for the supervision of large financial institutions, the new rating system will eventually help strengthen them as well.
A Brief Note on Federal Reserve’s Move After 2007-2009 Financial Crisis
After the financial crisis of 2007-2009, the Federal Reserve Board designed a supervisory program to deal with the threats that LFIs pose to US financial stability. This program focuses on the factors that are supposed to affect an institution’s financial and operational efficiency and its ability to recover immediately from difficulties. In short, this program focuses on core areas like capital, liquidity, and governance controls.
The Federal Reserve Board communicates the information associated with firms that pose threats to US financial stability through the Large Institution Supervision Coordinating Committee (LISCC).
Designed to review LISCC firms, the LISCC supervisory program performs yearly horizontal reviews. It also conducts a firm-specific evaluation to get a comprehensive idea of a given firm’s ability to deal with various challenges.
The LISCC supervisory program evaluates an institution on the following areas:
● Capital adequacy under normal and stressed conditions
● Liquidity positions and risk management practices
● Recovery and resolution preparedness, and
● Governance and controls.
On the other hand, for LFIs that do not fall under the category of LISCC firms, the Federal Reserve conducts supervisory work to examine capital, liquidity, and control practices, apart from performing horizontal reviews.
The main intention behind doing that is to identify the gaps or risk factors associated with large financial institutes that do not fall under the category of LISCC firms.
And to convey the supervisory evaluation of financial institutions, the Federal Reserve started using a rating system called RFI rating system in 2004.
Now, what you need to understand here is that the Federal Reserve has not made modifications to RFI rating system, which will continue to be in use.
The New LFI rating system will provide component ratings for three following area.
● Capital planning and positions
● Liquidity risk management and positions
● Governance and controls
The new rating system consists of the following rating components.
Broadly Meets Expectations
If the Federal Reserve Board rates an institution as Broadly Meets Expectations, it means it fulfills supervisory expectations; therefore, it is safe and sound. The institution may be vulnerable to supervisory issues. However, that doesn’t necessarily mean they will affect its safety and efficiency.
Conditionally Meets Expectations
If the Federal Reserve Board assigns a Conditionally Meets Expectations rating to an institution, it means the institution in question has gaps in its policies and procedures, which can affect its safety and soundness if it fails to resolve those issues on time.
On the other hand, if an institute gets Deficient -1 rating, it means it’s facing a lot of financial and operational issues, which can pose a threat to its safety.
Federal Reserve gives a Deficient-2 rating to an institute that is dealing with the consequences of financial and operational deficiencies, which means that the financial and operational deficiencies are already affecting the institute.
The rating components of the new rating system give more clarity about the ability of a financial institute to deal with emerging challenges.
The new LFI rating system will supervise financial institutions and help them place necessary policies and procedures in place to deal with the emerging threats.