In a move that offers further clarity to US banks regarding capital relief measures, the Federal Reserve Board (‘FRB’) on September 28 posted three new FAQs on its website. The newly-released FAQs pertain to Regulation Q, which oversees the Capital Adequacy of Bank Holding Companies, Savings and Loan Holding Companies, and State Member Banks.
The guidance contained in these FAQs has been anticipated by many in the financial sector given its implications for how U.S. banks could effectively use credit-linked notes (‘CLNs’) to offer capital relief. Credit Linked Notes, complex financial instruments designed to transfer credit risk, have, till now, operated in somewhat of a grey area with respect to their interaction with capital relief measures.
For many banks, the use of CLNs as credit risk mitigating tools serve multiple purposes. On one hand, they offer protection to the bank against the risk of a client or counterpart defaulting on their repayment obligations. On the other hand, their use also increases a bank’s risk adjusted profitability. Therefore, the new guidance has far-reaching implications for the way that U.S institutions manage their balance sheets. The precise impact is dependent on both the specific characteristics of the CLN and the bank’s existing credit exposures.
This update should serve as a useful roadmap for many of the leading firms in the financial industry, providing clarity on a topic previously left to individual interpretation. As with any new guidance, the key lies in its successful interpretation and implementation. Law firms, notably Cadwalader, Wickersham & Taft LLP, will no doubt be instrumental in helping banks navigate the new regulatory landscape presented by the FAQs.