NY2 761088 NY2 Regulating Liquidity, Regulating G-SIB the Surcharge and TLAC and Surcharge

November 2015

mofo.com Agenda • Regulatory capital • Liquidity measures • LCR • NSFR • G-SIB Surcharge • TLAC • The FSB’s Proposal • The FRB Proposal

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Regulatory Capital

3 Regulatory capital • Summary • Minimum common equity Tier 1: 4.5% TWA • Additional Tier 1: 1.5% • Tier 2: 2% • Total capital ratio: 8% • Capital conservation buffer: minimum common equity of 2.5% of RWA • Countercyclical buffer: up to 2.5% of common equity of RWA • G-SIB buffers • TLAC

4 Capital concepts • Common Equity Tier 1 – CET – the gold standard • Going concern capital maintains confidence • Tier 1 • Gone concern capital absorbs losses • Aids resolution • Stabilizes markets in resolution – Tier 2 and TLAC • Risk-based capital • Capital tailored to risk of the institution’s assets • Leverage ratio • Capital based on balance sheet assets • Supplementary Leverage Ratio for Advanced Approaches Institutions • Capital based on balance sheet and some off balance sheet assets • Tier 1 capital

5 Capital concepts (cont’d) • Capital conservation buffer • Additional • Failure to meet the buffer limits capital distributions and discretionary bonus payments to executives • CET1 • Countercyclical capital buffer for Advanced Approaches Institutions • Add to CET1 • On call of the regulators • G-SIB Surcharge • Additional capital requirement for G-SIBs • Designed to reduce the probability of failure of a G-SIB and thereby make the expected harm due to a G-SIB equal to the expected harm of the failure of a hypothetical non-G-SIB

6 Capital concepts (cont’d) • Total Loss Absorbing Capacity • Loss absorbing instruments for G-SIBs • Functions as gone concern capital • Facilitates the resolution of a G-SIB by absorbing losses and potentially capitalizing a bridge institution

7 Capital Conservation Buffer Capital Conservation Buffer (“CCB”) • Ratio of CET1 capital to risk-based assets of 2.5% (on top of each RBC ratio) • A ’s actual CCB will equal the lowest of the following three amounts (but not less than zero): • Bank’s CET1 ratio minus 4.5% • Bank’s Tier 1 RBC ratio minus 6% • Bank’s Total RBC ratio minus 8% • Failure to meet buffer results in restrictions on payouts of capital distributions and discretionary bonus payments to executives • Maximum amount of restricted payout equals eligible retained income* times a specified payout ratio. Payout ratio is a function of the amount of the bank’s capital conservation buffer capital *Most recent 4 quarters of net income, net of cap distributions and certain discretionary bonus payments

8 Countercyclical Capital Buffer • For Advanced Approaches banking organizations: • Not a concern for community • A macro-economic countercyclical capital buffer of up to 2.5% of CET1 capital to risk-weighted assets • Augments the capital conservation buffer • Applied upon a joint determination by federal banking agencies • Unrestricted payouts of a capital and discretionary bonuses would require full satisfaction of countercyclical capital buffer as well as capital conservation buffer

9 Leverage Ratio • Basel leverage ratio was finalized in January 2014; public disclosure of the leverage ratio was required in January 2015 • Final calibrations and adjustments expected by 2017, with implementation required in January 2018 • Requires a bank hold a minimum of 3% of Tier 1 capital against its exposures (Exposure Measure) • Exposure Measure = On-Balance Exposures + Derivatives Exposures + Securities Financing Exposures + Other Off-Balance Sheet Items

10 Leverage Ratio (cont’d) • On-balance sheet exposures = on-balance sheet items (excluding derivatives and SFTs, but including collateral) – Tier 1 capital • Derivatives exposures = replacement cost for all transactions + add-on amounts for potential future exposures for all derivatives + gross-up of derivatives collateral less eligible assets received as variation margin + notionals of written credit derivatives, less eligible offsets and deductions – exposures related to the qualifying central counterparty leg of client-cleared derivatives • SFT exposures = gross SFT assets, less eligible netting of SFT assets + counterparty exposure for SFT assets + agent transaction exposures • Other Off-Balance Sheet Items = gross off-balance sheet exposures adjusted for drawdown assumptions

11 Supplementary Leverage Ratio • Finalized in September 2014; reporting began January 2015; compliance by January 2018 • Additional capital requirement for bank holding companies with total consolidated assets of $700 billion or greater and their insured depository institution subsidiaries • Based on total leverage exposure that includes selected off-balance sheet exposures • 5% with 2% leverage buffer for the bank holding company • 6% for insured depository institution to be considered well capitalized. • Tier 1 capital is to be calculated as of the last day of each reporting quarter. • The total leverage exposure is to be calculated as the daily average of each reporting quarter for on-balance assets and the month-end average of each reporting quarter for off-balance sheet assets

12 Supplementary Leverage Ratio (cont’d) • May affect repo, securities financing transactions and collateral transformation transactions, derivatives

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Liquidity Measures

14 Liquidity Coverage Ratio (LCR) Final Rule adopted September 2014 • Covered organizations must maintain high quality liquid assets (HQLA) equal to estimated net cash outflows over a 30-day stressed liquidity period • Applies to Advanced Approaches organizations, and any subsidiary bank with $10BB+ • Simpler modified version applies to others (“modified companies”) with $50BB+ and that do not have significant commercial or insurance operations • Effective date: covered companies must calculate their LCRs at each month- end beginning January 1, 2015 but “modified companies” begin on January 1, 2016.

15 LCR (cont’d) • Full LCR applies to: advanced approaches banks ($250b in total consolidated assets or $10b or greater in on-balance sheet foreign exposures); other institutions made subject to LCR • LCR Light (Modified LCR): depository institutions with $50b or less in total consolidated assets that are not: grandfathered SLHCs deriving 50% or greater of total assets or revenues from activities not financial in nature; insurance underwriting companies; or holding 25% or greater of total assets in insurance underwriting subsidiaries. Monthly (instead of daily) LCR calculations. • Final rule does not apply to FBOs.

16 LCR (cont’d) • LCR requires HQLA stock to be at least 100% of its total net cash outflows over a 30-day standardized liquidity stress scenario, plus a maturity mismatch add-on that includes only certain inflows/outflows likely to cause a maturity mismatch

High-Quality Liquid Assets Total Net Cash Outflows

• HQLAs are categorized as Level 1, Level 2A and Level 2B • No limit on Level 1 assets • Level 2 assets are capped at 40% of HQLAs; Level 2B assets are capped at 15% of total HQLAs

17 LCR (cont’d) • Level 1 assets are not subject to haircuts. These include: excess reserves held at Fed, US Treasuries, securities issued or guaranteed by full faith and credit of US government, etc. • Level 2A assets are subject to a 15% haircut. These include: Agency securities, claims on or guaranteed by a sovereign entity or multilateral development bank • Level 2B assets are subject to a 50% haircut. These include: certain corporate debt securities issued by non-financial companies; certain publicly traded equities of non-financial companies included in Russell 1000 Index or foreign equivalent

18 LCR-Out Flows and Inflows • 30-day measurement period • Maturity • Earliest possible for outflows • Latest possible for inflows • Flows specified by transaction type • Inflows capped at 75% of outflows

19 Modified LCR • Depository institution holding companies with total consolidated assets of $50 billion but that do not meet threshold for standard LCR • Total net cash out flow discounted to 70% • Meet ratio on last day of calendar month

20 LCR • Observations: • As with other aspects of Basel III, the banking agencies in the United States adopted a version of the LCR which is more burdensome than the Basel LCR • U.S. compliance schedule is more rigorous • Securities like municipal securities, covered bonds and RMBS are excluded form HQLAs in the U.S. • U.S. version includes a mismatch add-on • U.S. version of HQLA does not incorporate use of credit ratings • Banks will have to consider whether to discontinue certain business lines, which may be more “expensive,” such as prime brokerage • Definition of HQLA may affect availability/supply of Treasuries, Agency securities, etc. • Of course, these securities are low-yielding • Banks will look to extend liabilities past the 30-day mark

21 Enhanced Prudential Standards • The final rule sets out a qualitative liquidity framework for large bank holding companies • Requirement that Board approve institution’s liquidity risk tolerance at least annually • Review at least semi-annually compliance with established liquidity risk tolerance • Approve and periodically review liquidity risk management strategies, policies and procedures established by senior management • The final rule requires internal liquidity stress testing monthly • A large BHC also must maintain a liquidity buffer of unencumbered highly liquid assets sufficient to meet the projected net stressed cash flow need over the 30-day planning horizon of a liquidity stress test • Important to note LCR is based on prescribed calculations while EPA Liquidity Buffer Requirement is based on internal models

22 Net Stable Funding Ratio • Basel Committee on Bank Supervision • No proposal from US regulators yet • Longer term counterpart to the liquidity coverage ratio • One-year measurement period • Objective: to reduce maturity mismatches between assets and liabilities and thereby reduce funding and rollover risk • Bank’s Available Stable Funding ÷ Required Stable Funding ≥100%

23 Available Stable Funding • Available Stable Funding: most stable sources of funding, expected to be reliable over a one-year time horizon • A multiplier is applied to designated sources of funding, the ASF Factor—for example: • 100%--Capital and liabilities with maturity is excess of 1 year • 95%--stable deposits from retail and small business customers with maturities of less than 1 year • 50%--other funding with a maturity of less than one year from non financial customers, operational deposits, funding from sovereigns and public sector entities, and other funding with maturities of six months to one year from financial institutions • 0%--Other liabilities including funding from financial institutions with a maturity of less than six months, other liabilities without a stated maturity, net derivative liabilities, and trade date payables for financial transactions

24 Required Stable Funding • Required Stable Funding: “grades” assets in terms of the proportion of stable funding required to support them and assigns a factor (RSF factor)—for example: • 0%--Cash, reserves, claims on central banks with a maturity of less than 6 months, trade date receivables from financial transactions • 5%--Unencumbered Level 1 assets • 10%--Unencumbered loans to financial institutions secured by Level 1 assets and with rehypothecation rights • 15%--Unencumbered Level 2A assets and other unencumbered loans to financial institutions with maturities of less than six months • 50%--Unencumbered Level 2B assets, HQLAs that are encumbered for between six months and one year, loans to financial institutions an central banks with a maturity of six months to one year, operational deposits, and non-HQLAs with a maturity of less than one year

25 Required Stable Funding (cont’d) • 65%--unencumbered residential mortgages and other loans, with a maturity of one year or more and with a 35% or lower risk weight • 85%--initial margin for derivative contracts and assets provided to central counterparty default funds, unencumbered loans with a risk weight of greater than 35% with maturities, non-HQLA securities with a maturity of one year or more of one year or more, exchange traded equities that are not HQLAs, and physical traded commodities • 100% assets that are encumbered for one year or more, net derivative assets, other assets with a maturity of one year or more, non exchange traded equities, fixed assets, deductions from regulatory capital retained interest, insurance assets subsidiary interests, defaulted securities, negative replacement amounts for derivatives

26 Tenor and call features • If one were to consider only a single liquidity measure at once, for example, only the LCR, that might suggest that: • A bank will want to have the ability to extend the maturities of its short-term obligations past the 30-day cut-off • Moreover, if one were to layer on to the LCR analysis, the G-SIB STWF Factor, a bank would be even more focused on minimizing its reliance on short-term funding • For purposes of both the LCR and the NSFR, a bank must assume that any security with a call feature gets called; this may affect structuring preferences

27 Business lines • Application of the liquidity measures are likely to impact: • Cross holdings in other financial institutions • Repo market • Derivatives market • Prime broking • Long-term lending

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G-SIB Surcharge

29 G-SIB Surcharge • Added to Capital Conservation Buffer • CET1 • Higher of two calculations • Method 1 – systematic risk score • Method 2 – systematic risk score • Minus substitutability score • Plus short-term wholesale funding score • 0% to 5.5+% • Surcharges are based on bands of scores • Calculated annually

30 Rationale • Primary Rationale • Mitigate risk of harm from failure of a G-SIB by reducing the likelihood of failure • Secondary Rationale • Create incentive to shrink systemic footprint • Offset any funding advantage from “too big to fail”

31 Measuring Harm • Expected harm (“loss”) from G-SIB failure = systemic x • EL = LGD x PD • EL = expected loss • LGD = systemic loss given default • PD = probability of default • Goal of the surcharge is to make EL for a G-SIB the same as EL for a non G-SIB reference bank holding company

32 Equalizing Expected Loss • Systemic loss given default measured under two methods using factors discussed below • Cut-off line set based on analysis of BHC scores using both methods • Both methods show a significant drop-off between the eighth highest score and the ninth highest score • Cut-off score • 130 for Method 1 • 100 for Method 2 • There seems to be a preference for Method 2

33 Equalizing Expected Loss (cont’d) • Probability of Default based on return on risk weighted assets • Evaluated 50 largest BHCs • 1987–2014 • Underestimates risk because of financial crisis interventions • Overestimates risk because it does not include Dodd-Frank reforms • “Roughly cancel each other out” • Increase capital for G-SIBs to reduce PD

34 Method 1 • Five factors • Size • Interconnectedness • Intra-financial 12 C.F.R. § 330.5 • Intra-financial system liabilities • Securities outstanding • Substitutability • Payments activity • Assets under custody • Underwritten transactions • Complexity • Notional amount of OTC derivatives • Trading and AFS securities • Level 3 Assets • Cross-jurisdictional activity • Claims • Liabilities

35 Method 1 (cont’d) • Five factors are weighted equally as are the sub-factors • Score = ((amount of G-SIB’s systemic indicator ÷ aggregate global indicator amount) x 10,000) x indicator weight • Substitutability ≤ 100 • Method 1 score Method 1 surcharge • Below 130...... 0.0 percent • 130–229...... 1.0 percent • 230–329...... 1.5 percent • 330–429...... 2.0 percent • 430–529...... 2.5 percent • 530–629...... 3.5 percent

36 Method 2 • Substitutes short-term wholesale funding for substitutability • Score = Amount of G-SIB’s systemic indicator x the following coefficients: • Size • Total exposures.....4.423% • Interconnectedness • Intra-financial system assets…..12.007% • Intra-financial system liabilities…..12.490% • Securities outstanding…..9.056%

37 Method 2 (cont’d) • Complexity • Notional amount of over-the-counter (OTC) derivatives…..0.155% • Trading and available- for-sale (AFS) securities…..30.169% • Level 3 assets.....161.177% • Cross-jurisdictional activity • Cross-jurisdictional claims…..9.277% • Cross-jurisdictional liabilities…..9.926% • Short-Term Wholesale Funding Score = (Average weighted short- term funding amount ÷ Average G-SIB’s average risk weighted assets) x 350 • Short-term wholesale funding based on LCR concepts and 1-year maturity

38 Method 2 (cont’d) • Method 2 score Method 2 surcharge • Below 130...... 0.0% • 130–229...... 1.0% • 230–329...... 1.5% • 330–429...... 2.0% • 430–529...... 2.5% • 530–629...... 3.0% • 630–729...... 3.5% • 730–829...... 4.0% • 830–929...... 4.5% • 930–1029...... 5.0% • 1030–1129...... 5.5%

39 G-SIB Scores Firm Method 1 score Method 2 score

• JPMorgan Chase 473 857 • Citigroup 409 714 • Bank of America 311 559 • 248 585 • Morgan Stanley 224 545 • Wells Fargo 197 352 • Bank of New York Mellon 149 213 • State Street 146 275

40 Timing • Four-year phase-in • 25% each year • January 1, 2016 through January 1, 2019

41

TLAC

42 Goals • Where does TLAC fit in? • For Basel purposes, a bank must satisfy the minimum regulatory capital requirements • In addition to the minimum regulatory capital requirements, banks are subject to the capital conservation buffer and any applicable counter-cyclical capital buffer • In addition to that, G-SIBs must have “buffer” capital or a G-SIB “surcharge” • Finally, G-SIBs must meet TLAC requirements • TLAC would be relied upon to provide additional loss absorbency and facilitate resolution

43 Where does TLAC fit in?

44 FSB Timeline • Financial Stability Board Proposal for Comment was issued in November 2014 • Comment period closed in February 2015 • FSB conducted a quantitative impact study (QIS) in which it collected information from G-SIBs • A revised draft TLAC term sheet of the FSB was leaked in August 2015. This reflected the impact of commenters, the QIS findings, and discussions among Steering Committee members • Term sheet largely was consistent with the FSB November 2014 consultation, but incorporated some changes responsive to commenters • In September 2015, the FSB issued a press release that reported a consensus had been reached on a final TLAC term sheet • The final TLAC guidance is anticipated to be released in mid-November 2015 prior to the G-20 meeting.

45 The FSB Proposal • Financial Stability Board Proposal for Comment issued in November 2014 • Intended to be effective by January 2019 • Designed to facilitate orderly resolution of G-SIBs • 30 banks globally • Includes 8 U.S. banks • Minimum total loss absorbing capital of [16-20]% of risk weighted assets excluding buffers • Tier 1 and is “eligible” • Other eligible TLAC that is not regulatory capital • Minimum of a [6]% leverage ratio: ratio of TLAC to total leverage exposure must equal at least [2] times bank’s leverage ratio • Additional TLAC may be required for individual G-SIBs based on risk factors • Two elements: Risk-weighted TLAC Ratio and a TLAC Leverage Ratio

46 The FSB Proposal (cont’d) • TLAC Eligible Securities: • Issued and maintained by resolution entities (except, in some circumstances, regulatory capital issued by wholly and directly-owned funding entity will be eligible) • Unsecured • Perpetual or remaining contractual maturity of at least one year • Excludes • Insured deposits, sight deposits and deposits with original maturity of less than 1 year • Liabilities funded by the resolution entity or a related party (possible exception for parent-funded TLAC in some circumstances where a multiple point of entry resolution strategy applies) • Liabilities arising from derivatives or debt instruments with derivative-linked features—e.g., structured notes • Non-contractual liabilities, such as tax liabilities • Preferred liabilities • Other liabilities that cannot be written down or converted to equity by resolution authorities

47 The FSB Proposal (cont’d) • Junior to excluded liabilities on the balance sheet of the resolution entity • No set off or netting • No redemption without supervisory approval if this would cause a breach of G-SIB’s TLAC requirements • Resolution entity must maintain “External TLAC” • Material sub-groups in jurisdictions outside of bank’s home country must have “Internal TLAC” • Each material subsidiary must have 75-90% of the external TLAC that would be required of the material sub-group, if it were a resolution entity • For this purpose, a “material sub-group” is one whose members are incorporated in the same jurisdiction (other than the jurisdiction of the resolution entity) and are not themselves resolution entities, do not form part of another material sub-group of the resolution and that: (i) has more than 5% of consolidated RWAs of the G- SIB group; (2) generates more than 5% of consolidated RWAs of the G-SIB group; (3) has total leverage exposures that are more than 5% of the G-SIB group’s total leverage exposure; or (4) has been identified as material to the firm’s critical functions 48 Pillar 1 versus Pillar 2 • Pillar 1: a common minimum standard of loss-absorbing capacity, which is intended to ensure a level playing field • Pillar 2: a firm-specific TLAC requirement (over and above the minimum) that takes into account the firm’s business, complexity, resolution plan, and similar factors • Calibration of the Pillar 2 TLAC requirement would be subject to an FSB Resolvability Assessment Process to ensure consistency

49 Leaked FSB Working Draft • Calibration of minimum TLAC from [1 January 2019] to be [16-18]% of resolution entity’s RWA, rising later to [18-20]% and [6]% of the Basel III leverage ratio denominator • Firm-specific TLAC to be set by home country authorities

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FRB Proposal

51 FRB proposal • The FRB released its proposal on October 30, 2015 which would establish for covered BHCs and covered IHCs an external TLAC requirement in the case of covered BHCs (and an internal TLAC requirement in the case of covered IHCs), a related TLAC buffer, a minimum long-term debt requirement for covered BHCs (and a minimum internal long-term debt requirement for covered IHCs), and a “clean holding company” requirement • Premised on the view that TLAC alone is not sufficient to facilitate SPOE resolution • As a result, the FRB approach differs from the FSB approach • In addition, to avoid contagion risk, the FRB proposal also would penalize banks generally for holding unsecured debt of a covered BHC

52 FRB proposal • U.S. covered BHCs must maintain: • Outstanding eligible external long-term debt equal to the greater of: (i) 6% of RWAs, plus the applicable G-SIB buffer, and (ii) 4.5% of total leverage exposure, plus • Outstanding eligible external TLAC equal to the greater of: (i) 18% of RWAs (when fully phased-in), and (ii) 9.5% of total leverage exposure • An external TLAC buffer

53 External long-term debt • What is eligible external long-term debt? • Debt securities issued directly by the covered BHC that: • Are unsecured • Are “plain vanilla” • Are governed by U.S. law • Have a remaining maturity of over one year • Eligible external long-term debt with a maturity of less than two years would be subject to a 50% haircut • What is “plain vanilla” debt? • The debt cannot contain an embedded derivative, have a credit sensitive feature, contain any contractual conversion or exchange features, or include acceleration rights, other than on payment defaults • No structured notes

54 External TLAC • What is eligible external TLAC? • The sum of (1) common equity Tier 1 capital and AT1 capital issued by the covered BHC, and (2) eligible external LTD • What is the amount of the external TLAC buffer? • An external TLAC buffer is added on top of the 18% risk-based capital component of the external TLAC requirement, which can be met only with common equity Tier 1 capital • Equals the sum of 2.5%, any applicable CCB, and the G-SIB surcharge calculated under Method 1 • What is the consequence of failing to meet the external TLAC buffer requirement? • Restrictions on distributions and discretionary bonuses (similar to CCB)

55 IHCs of Foreign G-SIBs • A covered IHC would be subject to an internal LTD and an internal TLAC requirement • What is the internal LTD requirement? • Internal LTD will at least equal the greater of (i) 7% of RWAs, (ii) for covered IHCs subject to the Supplementary Leverage Ratio, 3% of total leverage exposure, and (iii) 4% of average total consolidated assets • What is the internal TLAC requirement? • The internal TLAC requirement depends on whether the foreign G-SIB parent of the covered IHC will undergo SPOE or Multiple Point of Entry (MPOE) resolution • For SPOE, IHC would be required to keep outstanding eligible internal TLAC at least equal to the greater of: (i) 16% of RWAs (when fully phased in), (ii) for covered IHCs subject to the SLR, 6% of total leverage exposure, and (iii) 8% of average total consolidated assets • For MPOE, IHC would be required to keep outstanding eligible internal TLAC at least equal to the greater of: (i) 18% of the RWAs (when fully phased in), (ii) for covered IHCs subject to the SLR, 6.75% of total leverage exposure, and (iii) 9% of average total consolidated assets

56 Eligible internal LTD • What are the requirements for eligible internal LTD? • Same general requirements as those applicable to eligible external LTD • In addition, eligible internal LTD: • Is required to be held by foreign parent • Must be contractually subordinated to the covered IHC’s third-party liabilities • Be required to contain contractual provisions pursuant to which the FRB could cancel the internal LTD or convert it into equity on a going-concern basis (without entering resolution) upon the occurrence of certain conditions

57 Eligible internal TLAC • Eligible internal TLAC equals the sum of (i) common equity Tier 1 capital and AT1 capital issued by the covered IHC to its foreign parent, and (ii) the covered IHC’s eligible external LTD • With respect to the RWA component of the internal TLAC requirement, an internal TLAC buffer would apply on top of the 16 or 18% risk-based capital component that could be met solely with common equity Tier 1 capital in an amount equal to the sum of 2.5% and any applicable countercyclical capital buffer (equal to the existing capital conversation buffer now applicable to IHCs under the capital rules)

58 Clean Holding Company • The proposal sets out a “clean holding company” requirement, which has two parts: • First, a covered BHC would be prohibited from • Engaging in short-term borrowings, • Entering into QFCs, • Issuing guarantees of subsidiary liabilities that could create cross-default, set-off or netting rights for creditors of the subsidiary • Second, a covered BHC’s third-party non-contingent liabilities (other than those related to eligible external TLAC) that are pari passu with or junior to its eligible external LTD to a cap of 5% of the value of its eligible external TLAC

59 Regulatory capital deduction • Banks, savings and loans, and similar entities with total assets of more than $1 billion would suffer from a regulatory capital deduction for any investments in unsecured debt issued by covered BHCs (including eligible external LTD) in excess of certain thresholds

60 Timing • As proposed, covered BHCs would be required to comply with the external LTD and TLAC requirements by January 1, 2019, but the RWA component of the external TLAC requirement would be phased in with an initial 16% requirement applicable as of January 1, 2019, and the final 18% requirement applicable as of January 1, 2022. The clean holding company requirement would be applicable as of January 1, 2019. • Covered IHCs would be subject to similar effective dates and phase-ins. • The regulatory capital deduction would become effective as of January 1, 2019.

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