The Banking Agencies' New Regulatory Capital Proposals

On June 12, 2012 the Federal banking agencies (the Office of the Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation) (the "Agencies") formally proposed for comment, in a series of three separate but related proposals (each a "Proposal, and collectively the "Proposals"), substantial revisions to the U.S. regulatory capital regimen for banking organizations that, if adopted, will have a significant impact on the entire U.S. banking industry.1 Based on the core requirements of the 2011 international Basel III Accord ("Basel III"),2 and in significant part on the "standardized approach" for the weighting and calculation of risk-based capital requirements under the 2004-2006 Basel II Accord ("Basel II"),3 the Proposals will extend large parts of a regulatory capital regime that was originally intended only for large, internationally active banks to all U.S. banks and their holding companies, other than the smallest bank holding companies (generally, those with under $500 million in consolidated assets).

In addition, the Proposals incorporate aspects of Basel III that would apply only to those banking organizations that are subject to the "advanced approaches" or market risk rules under Basel II, including qualifying Federal and state savings associations and their holding companies. Under U.S. requirements, a banking organization is subject to the advanced approaches rules if it has consolidated assets greater than or equal to $250 billion, or if it has total consolidated on-balance sheet foreign exposures of at least $10 billion.4 The market risk capital rule currently applies to any bank with aggregate trading assets and trading liabilities equal to 10 percent or more of total assets or at least $1 billion.

The Proposals do not address the global liquidity requirements that were also a part of Basel III. The Agencies have indicated, however, that they expect to propose rules implementing these requirements in the near future. In addition, the Proposals do not address the capital surcharge requirements applicable to systemically important financial institutions (banking organizations with consolidated assets of $50 billion or more) that are expected to be developed in the near future under section 165 of the Dodd-Frank Act.5

Comments on the Proposals are due by September 7, 2012.

Due to the scope and complexity of these Proposals, we expect to report separately on specific aspects of them, including their impact on financial instruments, derivatives activities, and securitization activities.

The Run-Up to the Current Proposals

In 2004, the Basel Committee published comprehensive revisions to the legacy 1988 Basel Capital Accord. Basel II retained the basic requirements of the legacy risk-based capital scheme, namely, a total capital to risk-weighted assets requirement of 8 percent, and the existing definitions of core and total capital. The new accord, however, significantly increased the risk sensitivity of assets held on the banking book, and created a framework for covered banking organizations to calculate their risk-based capital under one of two major approaches: the "standardized approach," which would require banking organizations to calculate their risk-based capital according to quantitative inputs provided by national banking supervisors; and the "internal ratings based" ("IRB") approach, under which covered banking organizations would calculate their risk-based capital requirements using a combination of external credit ratings and internal risk models that would be applied to general credit exposures and securitization exposures. In turn, the IRB approach was subdivided into the "foundation IRB approach" where banking organizations would rely primarily on external regulatory inputs for the key risk-based capital calculation components, and the "advanced IRB approach" where eligible banking organizations ("advanced approaches banking organizations") would calculate their risk-based capital requirements primarily based on internal risk models (approved for each banking organization by its national supervisor). Basel II was also configured as a "three pillar" framework requiring specific risk-based capital requirements for credit risk, market risk, and operational risk (Pillar 1), supervisory review of capital adequacy (Pillar 2), and market discipline through enhanced public disclosures (Pillar 3).

In the wake of the financial crisis that culminated in late 2008, the international banking supervisors, including the Agencies, concluded that the financial crisis revealed significant issues about the transparency, sufficiency and resilience of regulatory capital – both risk-based and leverage – that impaired the ability of banking organizations around the world to withstand financial shocks, which in turn contributed to the severity of the financial crisis. To address these concerns about the overall quality of regulatory capital, the Basel Committee undertook a review of the core components of regulatory capital, and in 2010 published Basel III, which was later revised in 2011. In addition, the Basel Committee made a number of changes to Basel II in 2009 and 2010 to address perceived shortcomings in the existing risk-weighting framework that were revealed by the financial crisis.

In contrast to Basel II, Basel III was entirely a product of the financial crisis. Basel III included a more restrictive definition of regulatory capital, higher minimum regulatory capital requirements, and capital conservation and countercyclical capital buffers, to better enable banking organizations to absorb losses and continue to operate as financial intermediaries during periods of financial and economic stress. Basel III also placed limits on banking organizations' capital distributions and certain discretionary bonuses if they did not hold specified "buffers" of common equity Tier 1 capital in excess of the new minimum capital requirements. More specifically, Basel III redefined the components of core (Tier 1) capital by subdividing Tier 1 capital into two components: (i) "common equity Tier 1" capital, consisting of common equity and equivalent capital instruments, plus retained earnings, and (ii) "Additional Tier 1" capital, consisting of capital instruments with features of common equity but which, in the Basel Committee's view, lacked the level of capital resilience presented by common tangible equity capital. In turn, Basel III created new quantitative requirements that would require affected banking organizations to maintain the preponderance of their Tier 1 capital in tangible common equity, and would increase the levels of Tier 1 and total risk-based capital that banking organizations would be required to hold.

In addition, Basel III proposed a general leverage capital requirement that previously had not been a part of the Basel regulatory capital framework. Moreover, to address concerns that banking organizations did not build up and maintain levels of regulatory capital that were adequate in times of financial stress, Basel III introduced a separate capital conservation buffer of up to 2.5 percent of total risk-weighted assets to consist of common equity Tier 1 capital, as well as a countercyclical buffer of potentially up to 2.5 percent of total risk-weighted assets to be implemented, on a national basis, through an extension of the capital conservation buffer/ratios and corresponding restrictions on capital distributions and discretionary compensation payments to employees.

Finally, to address perceived lapses in banking organizations' liquidity during the early stages of the financial crisis, as well as the failure of banking organizations to have in place liquidity and liquidity risk management practices adequate to assure the availability and proper management of liquidity in times of financial stress, Basel III introduced a twofold global liquidity standard. These liquidity requirements include (i) a liquidity coverage ratio to promote resilience to potential liquidity disruptions over a thirty-day horizon, and (ii) a net stable funding ratio that would require a minimum amount of stable sources of funding relative to the liquidity profiles of the assets, plus contingent liquidity needs arising from off-balance sheet commitments, over a one-year horizon.

Both Basel II and Basel III provided for extended transition periods in order to give affected banking organizations adequate time to develop and implement the required architectures and infrastructures. Basel II was to have been applied by covered banking organizations on a phased-in basis and fully effective for years after 2008.

Implementation in the U.S., however, was substantially delayed until 2007, and was only in the early phases of implementation for U.S. banking organizations subject to the "advanced approaches" when the 2008 financial crisis overcame implementation efforts. Basel III provides for a transition period beginning in 2013 (2015, in the case of the required liquidity ratios), under which covered banking organizations are expected to comply with a series of gradually increasing risk-based and leverage capital measures, with full implementation generally expected by the end of 2018.

During the same period of time, the European Union has undertaken its own separate revisions to its regulatory capital rules. In July 2011, the EU Commission published a provisional draft of its much-awaited legislation in the form of a Capital Requirements Directive and Capital Requirements regulation (together known as CRD4), to implement Basel III into EU law.6 The European Parliament and the Council of the EU are still considering the EU Commission's proposals, and have offered compromise proposals of their own. The Commission has stated its intention for CRD4 to become effective on January 1, 2013, and in line with the Basel Committee's expectations on the implementation timing for Basel III. The EU Commission has also stated that if other jurisdictions do not follow Basel III's implementation timetable, it will "draw all the necessary conclusions in due time." Whereas Basel II and Basel III focus only on internationally active banks, the existing Capital Requirements Directive in Europe currently applies to all European banks, as well as to European investment firms in general. The proposed CRD4 directive and regulation will retain this approach and will require corresponding adaptations of Basel III.

The Agencies' Proposals

Since the Basel III standards were published, the Agencies have been working to develop regulations to implement its requirements in the U.S. By its terms, Basel III applies only to large, internationally active banking organizations – in essence the same banking organizations that were subject to Basel II. At the same time, a continuing issue for the Agencies was the extent to which they believed it was necessary or appropriate to extend the Basel III elements beyond the large banking organizations to the broader banking industry.

The Proposals are a clear answer to this question: the Basel III Proposal, and much of the Standardized Approach Proposal, will apply to all U.S. banks and savings banks and almost all of their holding companies, although smaller, "non-complex" banking organizations will not need to comply with all of the Standardized Approach Proposal's requirements. Only the Advanced Approaches Proposal is limited in its applicability to the largest U.S. banks. Accordingly, U.S. banks that previously thought that Basel II and Basel III were academic exercises for them now are confronted with the challenge of coming up to speed on these aspects of the Proposals in a short period of time.

In addition, the Proposals are intended to complete a core regulatory capital directive of the Dodd-Frank Act, namely to delineate and apply to all U.S. banking organizations "generally applicable" capital requirements as directed by section 171 of the Dodd-Frank Act (the "Collins Amendment").7 In this respect, the Agencies have stated plainly that the proposed regulations, if adopted, collectively will become the generally applicable capital requirements for purposes of the Dodd-Frank Act.

A. The Basel III Proposal

Applicability

The Basel III Proposal would apply to all U.S. banks that are subject to minimum capital requirements, including Federal and state savings banks, as well as to bank holding companies other than "small bank holding companies" (generally, bank holding companies with consolidated assets of less than $500 million).

General Elements of the Basel III Proposal

The Basel III Proposal, if adopted, would apply to U.S. banking organizations the general requirements for regulatory capital previously proposed in Basel III. In fact, with some exceptions, the Basel III Proposal closely tracks the requirements of its namesake Basel III. Specifically, the Basel III Proposal would do the following:

  • It would revise the definition of regulatory capital components and related calculations, and would add a new regulatory capital component, namely, common equity Tier 1 capital.
  • It would require a variety of new deductions from regulatory capital and impose new and substantial limitations on the treatment of qualifying minority interests as Tier 1 capital.
  • It would increase the minimum Tier 1 capital ratio requirement.
  • It would incorporate the new and revised regulatory capital requirements into the Agencies' respective Prompt Corrective Action ("PCA") capital categories.
  • It would create a new capital conservation buffer framework that would limit payment of capital distributions and certain discretionary bonus payments to executive officers and their functional equivalents if the banking organization does not hold certain amounts of common equity Tier 1 capital in addition to those needed to meet its minimum risk-based capital requirements.
  • It would provide for a series of transition periods for implementation of the proposed rule, including phase-in/phase-out periods for certain non-qualifying capital instruments, the new minimum capital ratio requirements, the capital conservation buffer, and the regulatory capital adjustments and deductions. By 2019, the new capital requirements would be fully effective.

These changes would apply to all U.S. banking organizations, large and small (other than small bank holding companies). The changes, and some implications of these changes, are discussed below.

Revised Definitions and Calculations of Capital

A banking organization's Tier 1 capital would consist of its common equity Tier 1 capital and its additional Tier 1 capital. Total Tier 1 capital, plus Tier 2 capital, would make up the banking organization's total risk-based capital requirement.

Common equity Tier 1 capital would be the sum of its outstanding common equity Tier 1 capital instruments and related surplus (net of treasury stock), retained earnings, accumulated other comprehensive income ("AOCI"), and common equity Tier 1 minority interest, minus certain adjustments and deductions specified. In this regard, unrealized gains and losses on all available-for-sale securities held by the banking organization would flow through to common equity Tier 1 capital, a result that is not fully consistent with Basel III, which does not require common equity Tier 1 capital adjustments for unrealized gains and losses that are recognized on the balance sheet. Qualifying common equity Tier 1 capital would have to satisfy 13 criteria that are generally designed to assure that the capital is perpetual and is unconditionally available to absorb first losses on a going-concern basis, especially in times of financial stress (see Appendix A).

Additional Tier 1 capital would be the sum of additional Tier 1 capital instruments that satisfy 13 separate criteria (14 for advanced approaches banking organizations), related surplus, and Tier 1 minority interests that are not included in a banking organization's common equity Tier 1 capital, minus applicable regulatory adjustments and deductions.

The 14 criteria in question generally are designed to assure that the instrument is available to absorb going-concern loss and does not possess credit sensitive or other terms that would impair its availability in times of financial stress (see Appendix A). Among other things, a banking organization that issues an additional Tier 1 capital instrument must limit capital distributions on the instrument to distributions that are paid out of net income and retained earnings, and must retain the ability to cancel dividends without triggering an event of default. The instrument must be perpetual in nature, have limited call rights that are exercisable only with the approval of the issuer's supervisory agency, must not have features that suggest or encourage redemption or discourage the issuance of additional capital instruments, and must be accounted as equity in accordance with generally accepted accounting principles ("GAAP").

Tier 2 capital of a banking organization similarly must satisfy 10 separate criteria (11 for advanced approaches banking organizations), all of which are designed to assure adequate subordination and stability of availability (see Appendix A). An advanced approaches banking organization may include the excess of eligible credit reserves over its total expected credit losses ("ECL") to the extent that such amount does not exceed 0.6 percent of its total credit risk-weighted assets.

The proposed criteria for common equity and additional Tier 1 capital instruments, and Tier 2 capital instruments, are broadly consistent with the Basel III criteria. One important consequence of these definitions is that non-cumulative perpetual preferred stock, which now qualifies as simple Tier 1 capital, would not qualify as common equity Tier 1 capital, but would qualify as additional Tier 1 capital. Further, cumulative preferred stock and trust preferred securities ("TruPS") no longer will qualify as Tier 1 capital of any kind.8 In turn, banking organizations that have TruPS outstanding will need to evaluate and seek advice on whether the impact of the Basel III Proposal on outstanding TruPS will permit or require a call or redemption of their specific securities.

Moreover, other hybrid or other innovative capital instruments presumably will not satisfy the criteria for common equity Tier 1 capital, although some of these instruments might qualify as additional Tier 1 capital. In addition, minority interests in consolidated subsidiaries (discussed further below) would be subject to substantially stricter treatment than under the current capital rules. Certain capital instruments, however, such as those issued under the Emergency Economic Stabilization Act (e.g., TARP preferred securities) or the Small Business Jobs Act of 2010, would be grandfathered permanently from exclusion as Tier 1 capital instruments (a departure from Basel III and CRD4) and treated as additional Tier 1 capital.

The upshot of these new definitions will be to sharply reduce the capital instruments that are eligible for common equity Tier 1 capital treatment, which will make non-qualifying instruments ineligible for satisfaction of the new common equity Tier 1 capital ratio (discussed below). Some of these now-ineligible instruments may qualify for additional Tier 1 capital treatment, but they would not include instruments that are accounted for as liabilities under GAAP, inasmuch as one of the criteria for additional Tier 1 capital is that qualifying instruments must be accounted for as equity under GAAP – a financial reporting requirement on which Basel III (and CRD4 in Europe) is silent.

The Agencies believe that the impact of the new requirements on most perpetual noncumulative preferred securities, and most Tier 2 debt instruments, should be modest, and therefore should be less of a compliance issue for affected banking organizations; whether this in fact proves to be the case, however, remains to be seen. At the same time, the Basel III Proposal suggests that the Agencies may be willing to consider the inclusion of new capital instruments – e.g., new contingent capital instruments – as additional Tier 1 capital, although it begs the question as to how much flexibility the Agencies have allowed themselves in this regard under the Basel III Proposal. The Agencies also believe that the Basel III Proposal and U.S. law (including the requirements of the Dodd-Frank Act) are consistent with the Basel III non-viability standard, namely, that non-common stock capital instruments issued by a covered banking organization include terms that subject the instrument to write-off or conversion to common equity at the point at which the banking organization's supervisory authority determines that a write-off or conversion is required, or that governmental or public sector capital assistance would be needed to keep the banking organization solvent. For this reason, the Agencies have not proposed specific non-viability loss absorption (or "bail in") requirements or triggers, unlike the Basel Committee's recommendations and the proposed European capital regulations. Advanced approaches banking organizations, however, would have to disclose in the instrument's governing documentation that claims on such instruments may be fully subordinated to interests held by the U.S. government in the event of an insolvency or a similar proceeding.

Leverage Requirement. Consistent with Basel III, the Basel III Proposal sets forth separate leverage capital requirements, measured as a ratio of Tier 1 capital to average on-balance sheet assets, for affected banking organizations. Advanced approaches banking organizations would be subject to a new and separate supplementary leverage ratio, which according to the Agencies specifically is designed to implement the Basel III leverage ratio requirement. Under this requirement, these banking organizations would maintain capital not only against their on-balance-sheet assets (less amounts deducted from Tier 1 capital), but also certain off-balance sheet assets. Covered off-balance sheet exposures would include future exposure amounts arising under certain derivatives contracts, 10 percent of the notional amount of unconditionally cancellable commitments, and the notional amount of most other off-balance-sheet exposures (excluding securities lending and borrowing, reverse repurchase agreement transactions, and unconditionally cancellable commitments).

The leverage requirement does not create any new capital obligations for U.S. banking organizations, inasmuch as U.S. banks and their holding companies have long been subject to leverage capital requirements, although it does raise the general minimum leverage ratio for all banks (including the strongest banks) to 4 percent. The supplementary leverage ratio requirement that would apply to advanced approaches banking organizations, however, could in some instances have a meaningful impact on the amount of leverage capital that a large U.S. banking organization might be required to maintain, and arguably could decrease the attractiveness of such exposures for these banking organizations. At the same time, these requirements would not appear to be "written in stone," in that the Basel Committee has indicated that it intends to evaluate the Basel III leverage requirement through supervisory monitoring during a "parallel run" period, and presumably the Agencies would seek to coordinate their implementation efforts with the activities of their international counterparts.

Exclusions and Deductions from Capital

One of the significant aspects of the Basel III Proposal are the nature and scope of the exclusions and deductions from regulatory capital that would be required. Although the specific deductions again are broadly consistent with the requirements of Basel III, they would change in several important respects the current treatment of certain balance sheet items for regulatory capital purposes, especially for banking organizations that had expected (or hoped) that they would not be subject to Basel III.

The required exclusions and deductions would be:

  • Deductions of goodwill and other intangibles from common equity Tier 1 capital, other than certain mortgage servicing assets.
  • Deductions of carry-forward deferred tax assets, and nonrealizable carryback deferred tax assets (subject to certain thresholds).
  • Deductions from common equity Tier 1 capital of after-tax gain-on-sale associated with securitization exposures.
  • Deductions from common equity Tier 1 capital of defined benefit pension fund assets other than those to which the banking organization has "unfettered access" (with supervisory approval).
  • Deductions for Federal and state savings association subsidiaries engaged in activities that are impermissible for a national bank (note that this is not part of Basel III).
  • Exclusion from common equity Tier 1 capital of unrealized gains and losses on certain cash flow hedges.
  • Adjustments to common equity Tier 1 capital to reflect unrealized gains and losses resulting from changes in the banking organization's own creditworthiness.
  • Deductions of direct and indirect investments in a banking organization's own regulatory capital instruments.
  • Deductions of direct, indirect and synthetic investments in the capital instruments of unconsolidated "financial institutions" (a broadly defined term that is designed to capture any entity whose primary business is financial activities) where such investments exceed certain thresholds.
  • Deductions of reciprocal cross-holdings in the capital instruments of financial institutions.

Investments in financial institutions are subdivided into "significant" (investments of more than 10 percent of the outstanding common shares or common share equivalents of the target entity) and "non-significant" investments (investments of 10 percent or less of the outstanding common shares and capital equivalents of the target entity). Significant common share investments would be deducted from common equity Tier 1 capital, subject to the deduction thresholds discussed below.

A potentially complicating aspect of the deductions for financial institution instruments is that the deduction applies to indirect (e.g., holdings through an equity index) and (in the case of financial institution investments) synthetic holdings, as well as direct holdings. This expansive application will pose a challenge to banking organizations that otherwise might elect to restructure their direct holdings into holdings that are not subject to deduction.

Significant unconsolidated financial institution common stock investments, non-realizable carry-back deferred tax assets, and mortgage servicing assets net of deferred tax liabilities would be deducted from common equity Tier 1 capital if they individually exceed a 10 percent common equity Tier 1 capital threshold (equal to 10 percent of common equity Tier 1 capital minus certain adjustments to and deductions from Tier 1 common equity). In addition, the sum total of the items that are not deducted under the 10 percent threshold could not exceed 15 percent of a banking organization's common equity Tier 1 capital, after applying all required regulatory adjustments and deductions to capital.

In calculating the deductions required for reciprocal cross-holdings of capital instruments, significant non-common stock financial institution investments, and nonsignificant financial institution investments, banking organizations would use the "corresponding deduction" approach, under which the banking organization is required to deduct an item from the same component of capital for which the instrument in question would qualify if it were issued by the banking organization itself.

Treatment of Minority Interests. Basel III reflects the general view of the international banking supervisors that minority interests – third party capital investments in a consolidated subsidiary of a banking organization – were not sufficient to absorb losses at the consolidated parent organization level. Basel III and the Basel III Proposal therefore limit the types and amounts of qualifying minority interests that can be included in Tier 1 capital.

Minority interests would be classified as a common equity Tier 1, Tier 1, or total capital minority interest depending on the underlying capital instrument and on the type of subsidiary issuing such instrument. In addition to meeting the eligibility criteria for common equity and additional Tier 1 capital, and Tier 2 capital (whichever is applicable under the circumstances), qualifying common equity Tier 1 minority interests would be limited to a depository institution or foreign bank that is a consolidated subsidiary of a banking organization. In addition, the limits on the amount of minority interest that may be included in the consolidated capital of a banking organization would be based on a formulaic amount of capital held by the consolidated subsidiary, relative to the amount of capital that the subsidiary would have to hold in order to avoid any restrictions on capital distributions and discretionary bonus payments under the capital conservation buffer framework discussed below.

Real estate investment trust ("REIT") preferred shares, which up to now have qualified as Tier 1 capital of the banking organization, would not qualify for common equity Tier 1 capital treatment, but could qualify as additional Tier 1 or Tier 2 capital under the same general rules as are applicable to other qualifying minority interests. The REIT also would have to qualify as an operating entity that is set up to conduct business with the intention of earning a profit in its own right. In addition, since REITs must distribute 90 percent of their earnings in order to maintain their tax status, REITs would be required to have the ability to declare consent dividends (dividends that are declared but retained by the REIT) in order to qualify for additional Tier 1 capital treatment.

Minimum Capital Requirements

The Basel III Proposal would require that banking organizations satisfy the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of 4.5 percent; (ii) a Tier 1 capital ratio of 6 percent; (iii) a total capital ratio of 8 percent; and (iv) a Tier 1 capital to average consolidated assets of 4 percent and, for advanced approaches banking organizations only, an additional leverage ratio of Tier 1 capital to total leverage exposure of 3 percent. As noted above, the common equity Tier 1 capital ratio would be a new minimum requirement. As discussed below, these capital levels would be phased in over a multi-year period beginning in 2013 and ending in 2018.

Capital Conservation Buffer

Consistent with Basel III, the Basel III Proposal would create a capital conservation buffer for all covered banking organizations that would be phased in starting in 2016, and would require additional regulatory capital of 2.5 percent on a fully phased-in basis by January 1, 2019. The capital conservation buffer would be applied to the lowest of the following three ratios: the banking organization's common equity Tier 1, its Tier 1 and total capital ratio less its minimum common equity Tier 1, or its Tier 1 and total capital ratio requirement, respectively. Besides being designed to bolster the resilience of banking organizations throughout financial cycles, one primary purpose of the capital conservation buffer is to limit the ability of a banking organization to make capital distributions and discretionary bonus payments to executive officers and persons with commensurate responsibilities unless the banking organization has sufficient capital over and above its minimum capital requirements to safely make those payments.

Under the Basel III Proposal, a "capital distribution" means: (i) a reduction of Tier 1 capital (by repurchase or otherwise); (ii) a reduction of Tier 2 capital (by repurchase or early redemption or otherwise); (iii) a dividend on Tier 1 capital; (iv) a dividend or interest payment on Tier 2 (where the banking organization has discretion to suspend that payment); and (v) any substantively similar transaction. In turn, a "discretionary bonus payment" to an executive officer (generally defined as a titled executive or person with commensurate executive responsibilities) is any payment where (i) the banking organization retains discretion as to whether to pay or the amount of payment, (ii) the amount paid is determined without prior promise to, or agreement with, the officer, and (iii) the executive officer has no contractual right to the payment. Depending on the extent to which a banking organization met its capital conservation buffer requirements, capital distributions and bonus payouts would be limited to specified payout ratios.

Banking organizations that are not subject to the Basel II advanced approaches rule would calculate their capital conservation buffer using total risk-weighted assets as calculated by all banking organizations, and banking organizations subject to the advanced approaches rule would calculate the buffer using advanced approaches total risk-weighted assets. The principle behind this distinction is that internationally active U.S. banking organizations using the advanced approaches would be expected to maintain capital conservation buffers comparable to those of their foreign competitors.

Countercyclical Capital Buffer

The countercyclical capital buffer, which is a supplemental capital requirement that is designed to take into account the macro-financial environment in which large banking organizations operate, would be applied only to advanced approaches banking organizations, consistent with the requirements of Basel III. On a fully phased-in basis, the countercyclical capital buffer would be additional regulatory capital of up to 2.5 percent of total risk-weighted assets. The countercyclical capital buffer would augment the capital conservation buffer upon a joint determination by the Agencies. The countercyclical capital buffer amount in the U.S. would initially be set at zero, but would increase if the Agencies determined that there is excessive credit in the markets, possibly leading to subsequent widespread market failures. The Agencies expect to consider a range of macroeconomic, financial, and supervisory information indicating an increase in systemic risk. Because the countercyclical capital buffer amount would be linked to the condition of the overall U.S. financial system and not the characteristics of an individual banking organization, the Agencies propose to apply the countercyclical capital buffer amount consistently at the depository institution and holding company levels.

Changes to Prompt Corrective Action Rules

Although not required by Basel III itself, the Basel III Proposal would amend the Agencies' PCA regulations under section 38 of the Federal Deposit Insurance Act to assure consistency with the new regulatory capital requirements. Specifically, the Agencies propose to:

  • augment the existing five PCA capital categories (well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized) by introducing the common equity Tier 1 capital measure for four of the five PCA categories (excluding the critically undercapitalized PCA category); and
  • for advanced approaches banking organizations, include in the leverage measure for the "adequately capitalized" and "undercapitalized" capital categories an additional leverage ratio based on the leverage ratio in Basel III.

All banking organizations would continue to be subject to leverage measure thresholds using the current "standard" leverage ratio of Tier 1 capital to total assets. Further, the Agencies would revise the three current capital measures for the five PCA categories to reflect the changes to the definition of capital, as provided in the proposed revisions to the agencies' PCA regulations.9

Transitional Periods

The Basel III Proposal provides for a series of transitional and phase-in provisions for the new capital rules. According to the Agencies, they are intended to give banking organizations adequate time to comply with the new capital requirements and also be compliant with the Dodd-Frank Act. Almost all of the requirements proposals under the Basel III proposal would be fully effective by January 1, 2019. In general, the transition provisions are as follows:

Phase-in of Minimum Capital Ratios. The minimum common equity and Tier 1 capital ratios would be phased in beginning in the 2013 calendar year with a common equity requirement of 3.5 percent and a Tier 1 requirement of 4.5 percent for that year; 4.0 percent and 5.5 percent, respectively, for the 2014 calendar year; and fully effective (4.5 percent and 6.0 percent, respectively) for the 2015 calendar year and thereafter.

Phase-in of Regulatory Capital Adjustments and Deductions. The required regulatory capital adjustments and deductions will be phased in beginning in 2013 and fully phased in by 2018. The phase-in sequence consists of a series of formulae that would apply different phase-in requirements and transitional capital treatment of adjusted or nonqualifying items according to the specific nature of the item. For example, the transition method for several capital deduction items (such as deferred tax assets, securitization gain-on-sales, and defined benefit pension fund assets) is a straight-line percentage deduction sequence (0 percent of required deductions in 2013, 20 percent of required deductions in 2014, and so forth) that requires full (100 percent) deductions in the calendar year 2018. Deductions for goodwill from common equity Tier 1 capital, however, are subject to no transitional phase-in and must be fully deducted beginning in the calendar year 2013.

Phase-out of Non-qualifying Capital Instruments. The phase-out transition period for these instruments begins in the calendar year 2013. The exact phase-out period, however, is different for banking organizations with at least $15 billion in total assets than it is for banking organizations under that threshold. For the larger banking organizations, the transition method for nonqualifying capital instruments is a straightline percentage inclusion sequence (75 percent of non-qualifying instruments may be included in Tier 1 or Tier 2 capital in 2013, 50 percent may be included in 2014, and so forth), with full effectiveness in 2016. For banking organizations with under $15 billion in total assets, the transition period begins (again on a straight-line basis) in 2013 but is not fully phased in until 2022.

Phase-in of Capital Conservation and Countercyclical Capital Buffers. The capital buffer requirements become fully effective on January 1, 2019. Each of the two buffers would be established at 0.625 percent in 2016 and then phased in on a straight-line basis up to 2.5 percent in 2019 and thereafter. Banking organizations should keep in mind that these phase-in requirements must be attained in order to avoid restrictions on capital distributions and discretionary payouts during the transition period.

Supplemental Leverage Ratio. Advanced approaches banking organizations would not be required to apply the supplemental leverage ratio until 2018. These banking organizations, however, would be required to calculate and report (but not comply with) using the advanced approaches definitions of Tier 1 capital and total exposure measure beginning in 2015.

Prompt Corrective Action. The conforming changes to the Agencies' PCA regulations would be effective on January 1, 2015, although the proposed amendments to the current PCA leverage measure for advanced approaches banking organizations would be effective on January 1, 2018.

One of the complicating aspects of these transition periods is that a banking organization will have to incorporate and harmonize different phase-in and phase-out timelines and specifications. Because there are different transition requirements for different capital ratios (risk-based, leverage and capital buffers), as well as for divergent types of regulatory deductions and nonqualifying capital instruments, the calculation of Tier 1 and Tier 2 capital requirements during these transition periods will have to be carefully structured and executed.

B. The Standardized Approach Proposal

The Standardized Approach Proposal is the result of two distinct regulatory impulses. In large measure, the Standardized Approach Proposal responds to many of the asset quality problems that emerged during the financial crisis and that were not satisfactorily addressed by the regulatory capital rules. The Standardized Approach Proposal introduces more rigorous and more calibrated capital measurements in an effort to encourage prudent lending and other banking business and to discourage those activities thought to have contributed to the crisis. The Standardized Approach Proposal also represents the continuation of the Agencies' efforts, begun even before the financial crisis, to develop more sensitive but still manageable measurements of credit risk and capital adequacy by all banks other than the largest and most internationally active banks.

Applicability

The rules set forth in the Standardized Approach Proposal would formally apply to the same universe of banking and thrift institutions that is subject to the Basel III Proposal.10 Various parts of the Standardized Approach Proposal, however, would have different effects on different types of banking organizations. The Standardized Approach Proposal includes an Addendum 1, which highlights issues that are likely to be of greatest interest to community banks, namely, those with less than $10 billion in consolidated assets. The preamble to the Standardized Approach Proposal conversely identifies those provisions likely to have little effect on community banks. Neither discussion purports to be exhaustive. The only provisions specifically not applicable to community banks are certain disclosure requirements that would apply only to banking firms with more than $50 billion in consolidated assets.

The Standardized Approach Proposal applies even to the largest U.S. banking organizations that use the advanced approaches under Basel II. As discussed above, the Collins Amendment to the Dodd-Frank Act sets a floor to the capital requirements for these organizations, and the Standardized Approach would be this floor.

Effective Date

The proposal, if finalized, will take effect on January 1, 2015. Banks have the option to adopt the rules earlier. Unlike the Basel III Proposal, the Standardized Approach Proposal does not provide for any transition period. The same residential mortgage loan that was weighted at 50 percent in the fourth quarter of 2014 could, for example, be riskweighted at 75 percent in the first quarter of 2015—an abrupt 50 percent increase in the capital charge.

General Elements of the Standardized Approach Proposal

The Standardized Approach Proposal revises a large number, although not quite all, of the risk weights (or their methodologies) for bank assets. The overall financial impact may or may not be substantial for a bank, but the changes will require virtually every bank covered by the proposal to review the capital charges for its asset classes across the board. For nearly every class, the Standardized Approach Proposal requires a more calibrated assessment of credit risk. As a result, a bank's capital planning process will require more information about many asset classes than is necessary to satisfy the existing capital rules.

The Standardized Approach Proposal changes the existing risk weights and the underlying methodologies in numerous ways. For ease of analysis, we have somewhat arbitrarily distinguished between the weighting of traditional loans and extensions of credit and the assessment of risk weights for other transactions that expose a bank to the credit risk of a counterparty. The changes are, in summary, as follows:

Traditional Loans and Extensions of Credit

  • Traditional residential mortgage loans will receive somewhat more advantageous capital treatment than the more complex loans that proved so problematic in the financial crisis. Loan-to-value ratios are critical, though, and only traditional mortgage loans with an LTV ratio of 80 percent or less will avoid a higher risk weight under the Standardized Approach Proposal. The risk weights for mortgage loan guarantees generally have not changed, which may soften the blow of these higher risk weights.
  • Commercial real estate loans would require greater economic participation by developers or other borrowers. In the absence of such participation, the risk weight on a loan would increase by 50 percent.

Footnotes

1 Office of the Comptroller of the Currency ("OCC"), Federal Reserve Board, Federal Deposit Insurance Corporation ("FDIC"), Regulatory Capital Rules: (i) Implementation of Basel III; Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Periods and Prompt Corrective Action ("Basel III Proposal"); (ii) Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements ("Standardized Approach Proposal"); and (iii) Advanced Approaches Risk-Based Capital Rule; Market Risk Capital Rule ("Advanced Approaches Proposal"). All three of these Proposals were first approved and published by the Federal Reserve Board on June 7, 2012, but the three Agencies jointly announced their publication on June 12.

2 Basel Committee on Banking Supervision ("Basel Committee"), Basel III: A global regulatory framework for more resilient banks and banking systems (Dec. 2010; rev. June 2011).

3 Basel Committee on Banking Supervision, Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework (rev. comprehensive version June 2006).

4 12 C.F.R. Part 3, Appendix C, and 12 C.F.R. Part 167, Appendix C (Office of the Comptroller of the Currency); 12 C.F.R. Part 208, Appendix F, and 12 C.F.R. Part 225, Appendix G (Federal Reserve Board); and 12 C.F.R. Part 325, Appendix D, and 12 C.F.R. Part 390, Subpart Z (Federal Deposit Insurance Corporation).

5 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, 124 Stat. 1376 (July 21, 2010), section 165 [codified to 12 U.S.C. 5365].

6 European Commission – legislative proposal for a new capital requirements directive (CRD4) (July 20, 2011).

7 Dodd-Frank Act section 171 [codified to 12 U.S.C. 5371].

8 This is not a surprising outcome, inasmuch as the Dodd-Frank Act "Collins Amendment" (section 171) effectively disqualified the TruPS of most banking organizations from Tier 1 capital treatment.

9 In addition, to align the requirements under the Home Owners Loan Act ("HOLA") that Federal savings associations maintain a minimum ratio of 1.5% "tangible equity" to total assets with other changes to the regulatory capital rules, the OCC for Federal savings banks, and the FDIC for state savings banks, propose to adopt a uniform definition of "tangible equity" for HOLA and PCA purposes.

10 Banks and bank holding companies with less than $500 million in consolidated assets would be exempt from the requirements in the Standardized Approach Proposal. The Proposal would apply to all savings associations and savings and loan holding companies, regardless of size. For convenience, we simply refer to institutions covered by the Standardized Approach Proposal collectively as "banks."

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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