United States: The Proposed Capital Rules: Application To Bank Asset

Introduction

The publication on June 7, 2012, of three related capital proposals by the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation present myriad issues for a large segment of the U.S. banking industry.¹

The proposals will require all of the covered banks² to revisit a fundamental question: how to use capital most efficiently. The answer will be based partly on the necessary components of capital, but for day-to-day operations, the issue is how particular assets will be treated for capital purposes. The Standardized Approach Proposal deals exclusively with this issue and revamps the risk-weighting process in several respects that could significantly affect the business models of some banks. For example, the treatment of residential mortgage loans has become more granular and effectively penalizes the origination of all but the most conservatively underwritten loans. Banks will see a 50% increase in the weight of their commercial real estate loans unless borrowers provide substantial, up-front equity contributions. Banks that own tranches of securitized mortgages or other assets no longer may use credit ratings to determine risk weights and will be required to apply a more complex analysis. Other changes may seem to be on the margins, including the treatment of credit risk mitigants and conversions of off-balance sheet assets but nevertheless could have substantial impact in particular situations.

The Standardized Approach Proposal is not, however, the sole set of rules that will affect the return on capital of particular assets. The Basel III Proposal requires that banks deduct certain assets from regulatory capital or make adjustments to capital based on such assets effectively resulting in onerous if not prohibitive capital charges. Indeed, certain assets must in part be deducted from or otherwise used to adjust common equity Tier 1 capital; remaining amounts must be risk weighted, often at new risk weights.

Given the complexity of the proposed rules, a specific asset-by-asset review of the new capital requirements is in order. Indeed, the federal banking agencies unveiled a "Regulatory Capital Estimation Tool" for just this purpose.³ More recently, the OCC published guidance on stress testing for capital adequacy by community banks.⁴ The annual cycle of stress testing and capital planning for large banks is under way.⁵

Readers are cautioned that changes to the proposed rules are entirely possible when they are adopted in final form (perhaps by the end of 2012). In addition to the possibility of changes to specific risk-weightings or capital requirements, the scope of the proposals' broad application to all U.S. banks has been strongly challenged by the banking industry and state financial regulators, among others. The Basel standards were designed for "internationally active" banks, and international regulators have not required that the Basel requirements be pushed down to other banks. The objections have found support in Congress and even on the part of at least one regulator.⁶ Recent Congressional hearings have highlighted these concerns.⁷

Putting aside the scope of the Basel-based proposals, the agencies intend that to the extent the proposals are based on Basel, they be consistent with the international capital standards. In that regard, the Basel Committee recently has conducted a preliminary "Level 2" assessment of the United States' compliance with the Basel Accord, which focused on the consistency of final or proposed rules with the internationally agreed-upon Basel requirements.⁸ While the Basel review gave the United States a general "incomplete" grade based on the fact that the major U.S. capital rule changes still are in the proposal stage, it also found that in 12 of 13 key components of the Basel Accord, the United States was either fully or largely compliant with Basel's capital standards and requirements. The one area that was found to be materially noncompliant was the U.S. agencies' proposed alternative regulatory capital treatment of securitization exposures, which unlike the Basel Accord, would not use external credit agency ratings in determining securitization exposure capital requirements. This alternative approach, however, is mandated by section 939A of the Dodd-Frank Act, which generally requires federal financial regulators to use their own standards of credit-worthiness in lieu of external credit agency ratings.

This paper contains a series of tables that summarize the treatment, including the underlying analysis, of bank assets and compares them to the existing rules, to which banks are accustomed. The tables are organized along the lines of the Standardized Approach Proposal, followed by a table that outlines the Basel III Proposal's rules on deductions from or adjustments to capital. Pertinent acronyms and definitions appear at the end.

Footnotes

1 The proposals were formally published in the Federal Register on August 30, 2012. See 77 Fed. Reg. 52792 (Aug. 30, 2012) ("Basel III Proposal"), available at http://www.gpo.gov/fdsys/pkg/FR-2012-08-30/pdf/2012-16757.pdf; 77 Fed. Reg. 52888 (Aug. 30, 2012) ("Standardized Approach Proposal"), available at http://www.gpo.gov/fdsys/pkg/FR-2012-08-30/pdf/2012-17010.pdf ; 77 Fed. Reg. 52978 (Aug. 30, 2012) ("Market Risk Proposal"), available at http://www.gpo.gov/fdsys/pkg/FR-2012-08-30/pdf/2012-16761.pdf . The proposals do not cover small bank holding companies those with less than $500 million in assets.

2 Throughout this paper, and unless otherwise indicated, we use "bank" in its collective sense to encompass national and state member and nonmember banks, federal and state savings associations, bank holding companies, savings and loan holding companies, and subsidiaries of any of these institutions. In a few instances, capital standards vary among different types of banking institutions, and we have so indicated in the tables below.

3 The tool is available at http://www.federalreserve.gov/bankinforeg/basel/basel3tools.htm . We have analyzed the estimation process in a recent news bulletin, Regulatory Capital Estimation Tool: Some Observations (Oct. 1, 2012), available at http://www.mofo.com/files/Uploads/Images/121001-Regulatory-Capital-Estimation-Tools.pdf .

4 OCC, Community Bank Stress Testing Supervisory Guidance, OCC Bull. 2012-33 (Oct. 18, 2002), available at http://www.occ.treas.gov/news-issuances/bulletins/2012/bulletin-2012-33.html .

5 The Comprehensive Capital Analysis and Review covers 19 banks (all of which have been subject to previous testing and planning requirements; the summary instructions and guidance are available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20121109b1.pdf . 11 other banks (that together with the 19 banks, constitute all of the U.S. banks with total consolidated assets of $50 billion or more) and that have not previously been subject to a formal testing and planning program must participate in the Capital Plan Review; the summary instructions and guidance are available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20121109b2.pdf . Both programs test capital adequacy against baseline, adverse, and severely adverse scenarios. The FRB issued the assumptions and other content in the scenarios on Nov. 15, 2012. The scenarios are available through links at http://www.federalreserve.gov/newsevents/press/bcreg/20121115a.htm .

6 See Letter from Senators Sherrod Brown and David Vitter (Oct. 17, 2012), available at http://www.brown.senate.gov/newsroom/press/release/sens-sherrod-brown-david-vitter-ask-us-banking-agencies-to-simplify-and-strengthen-bank-capital-standards ; Remarks of Thomas J. Curry, Comptroller of the Currency before the American Bankers Association (Oct. 15, 2012), available at http://www.occ.treas.gov/news-issuances/speeches/2012/pub-speech-2012-144.pdf . While the formal deadline for comments is October 22, 2012, the FDIC recently requested comments from banks with less than $175 million in assets on the application of the Regulatory Flexibility Act to the capital proposals. The deadline for comments is November 16, 2012.

7 See Examining the Impact of the Proposed Rules to Implement Basel III Capital Standards, Hearing before the House Comm. on Financial Services (Nov. 29, 2012) (testimony available at http://financialservices.house.gov/calendar/eventsingle.aspx?EventID=312618 ); Oversight of Basel III: Impact of Proposed Capital Rules, Hearing before the Sen. Comm. on Banking, Housing, and Urban Affairs (Nov. 14, 2012) (testimony available at http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=9415a6b1-5316-4954-bbb6-c1fd467e34d5 ).

8 Basel Committee on Banking Supervision, Basel III Regulatory Consistency Assessment (Level 2) Preliminary Report: United States of America (October 2012).

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