The Nutter Bank Report is a monthly electronic publication of the firm’s Banking and Financial Services Group and contains regulatory and legal updates with expert commentary from our banking attorneys.

Headlines 
1. Agencies Respond to Frequently Asked Questions about Regulatory Capital Rules 
2. OCC Updates Guidance on Subordinated Debt for National Banks and Federal Thrifts 
3. Federal Reserve Issues Final Small Bank Holding Company Rule 
4. FFIEC Issues Guidance on Malware and Cyber Attacks Targeting User Credentials 
5. Other Developments: Consumer Complaints and Housing Counselors 

1. Agencies Respond to Frequently Asked Questions about Regulatory Capital Rules

The federal banking agencies have issued guidance in the form of answers to frequently asked questions (FAQs) about the agencies’ regulatory capital rules. The FAQs released on April 6 clarify the definitions of capital and high-volatility commercial real estate (HVCRE), and address issues concerning other real estate and off-balance-sheet exposures, and separate account and equity exposures to investment funds, among other topics. For example, the FAQs clarify that a banking organization’s investments in common stock or other capital instruments issued by the Federal Reserve Banks and the Federal Home Loan Banks are not considered investments in the capital of unconsolidated financial institutions that would be subject to the regulatory capital rules’ requirement that certain investments in the capital of unconsolidated financial institutions in excess of 10% of common equity tier 1 capital must be deducted from common equity tier 1 capital. The FAQs also advise that certain modifications of a residential mortgage loan, such as lowering the interest rate for customer retention purposes, would cause the risk-weighting applicable to the loan to change from 50% to 100%. However, according to the FAQs, a banking organization could retain the 50% risk-weighting by performing additional underwriting on the loan to ensure that the credit quality of the borrower has not deteriorated. The FAQs further clarify that a banking organization’s investment in a bank-owned life insurance (BOLI) hybrid product may qualify as a “separate account” which must be treated as if it were an equity exposure to an investment fund for purposes of the regulatory capital rules if the gains and losses on the pool of assets are reflected in the cash surrender value of the BOLI recorded on the banking organization’s balance sheet. The agencies plan to periodically update the FAQs with additional guidance about the regulatory capital rules.

     Nutter Notes: The FAQs provide significant guidance on the application of the definition of HVCRE under the regulatory capital rules. The FAQs clarify that acquisition, development or construction (ADC) loans made prior to the effective date of the regulatory capital rules are not grandfathered from the definition of HVCRE. Therefore, ADC loans made before the effective date of the rules must be treated as HVCRE loans unless such loans meet the criteria for an exemption provided in the definition of HVCRE. The FAQs advise that an additional contribution of capital by the borrower to an existing HVCRE loan, after the banking organization has already advanced funds to the borrower, cannot be used to meet the 15% contributed capital requirement for an exemption from the HVCRE definition. In such a case, the loan remains an HVCRE loan because any contribution of cash or land must be made before a loan’s funds are advanced for a loan to be considered a CRE loan rather than an HVCRE loan. Similarly, a banking organization must consider the loan-to-value (LTV) ratio at origination when evaluating whether an ADC loan qualifies as an HVCRE exposure according to the FAQs. Therefore, an updated appraisal or valuation after origination of an HVCRE loan results in an LTV ratio that no longer exceeds the relevant maximum LTV ratio, the loan must remain classified as an HVCRE exposure until it converts to permanent financing. In addition, cash contributions to an ADC project from sources other than the borrower, such as a grant from a community development authority or another loan secured by the same real estate, cannot be used to meet the 15% contributed capital requirement for an exemption from the HVCRE definition. Such sources of capital are not considered to be capital contributed by the borrower according to the FAQs.

2. OCC Updates Guidance on Subordinated Debt for National Banks and Federal Thrifts

The OCC has updated its guidance on subordinated debt issued by national banks, replacing Appendix A of the Subordinated Debt booklet of the Comptroller’s Licensing Manual with new Guidelines for Subordinated Debt. The new guidelines issued on April 3 apply to all subordinated debt issued by national banks and federal savings associations, regardless of whether the subordinated debt is included in regulatory capital. The guidelines provide clarification about whether a subordinated debt instrument qualifies as tier 2 capital under the regulatory capital rules and points out that all subordinated debt issued by a national bank or federal savings association must satisfy the minimum requirements in 12 C.F.R. § 5.47 or 12 C.F.R. § 163.80, as applicable, regardless of whether the subordinated debt instrument qualifies as tier 2 capital. The guidelines describe the OCC’s supervisory views on representations and warranties, affirmative covenants, negative covenants, events of default, contemporaneous loan agreements, and novel or extraordinary provisions in subordinated debt instruments. For example, any representation or warranty that would require acceleration and repayment of a subordinated debt note because of a technical violation that does not reflect underlying credit issues could be contrary to safety and soundness according to the guidelines. The guidelines recommend that any representation or warranty be worded to avoid unreasonable operation of any default clause when a default would be based on a change in the bank’s status, default on any other agreement, or any violation of charter or by-laws. The updated guidelines are effective for subordinated debt issued on or after April 3, 2015.

     Nutter Notes: The OCC also replaced the Sample Subordinated Note at Appendix B of the Subordinated Debt booklet of the Comptroller’s Licensing Manual with two sample notes for national banks. The first note provides sample language for a subordinated debt note that is meant to be included in tier 2 capital, and the second provides sample language for a subordinated debt note that is not meant to be included in tier 2 capital. The sample notes include required disclosures that must appear all in capital letters on the face of the note, the amount and date of the note, and a paragraph identifying the parties to the instrument, the amount due, and the rate of interest. The sample notes also include a paragraph specifying repayment terms, a provision that describes the order and level of subordination, and a provision that describes the OCC’s regulatory authority with respect to national banks. The sample notes apply only to subordinated debt issued by a national bank because there is no pre-existing sample note for federal savings associations. The OCC said that it is developing sample notes for federal savings associations and expects to publish the sample notes in the near future.

3. Federal Reserve Issues Final Small Bank Holding Company Rule

The Federal Reserve has issued a final rule to expand the applicability of its Small Bank Holding Company Policy Statement and to apply the Policy Statement to certain savings and loan holding companies. The final rule released on April 9 implements a law passed by Congress in December 2014 requiring the Federal Reserve to increase the asset threshold under the Policy Statement to $1 billion and extend its application to savings and loan holding companies that meet qualifying criteria similar to those for small bank holding companies. The final rule raises the asset threshold of the Policy Statement from $500 million to $1 billion in total consolidated assets and expands the application of the Policy Statement to savings and loan holding companies that meet certain qualitative requirements applicable to small bank holding companies, including those pertaining to nonbanking activities, off-balance sheet activities, and publicly-registered debt and equity. The Policy Statement allows qualifying holding companies of small community banks and savings associations to operate with higher levels of debt than would normally be permitted. Holding companies that qualify for the Policy Statement are excluded from consolidated capital requirements, though their subsidiary depository institutions continue to be subject to minimum capital requirements. The Federal Reserve retains the right to exclude any bank holding company or savings and loan holding company, regardless of size, from the Policy Statement if the Board determines that it is necessary for supervisory purposes. The final rule becomes effective on May 15.

     Nutter Notes: The expansion of the Policy Statement to savings and loan holding companies required certain modifications to the Policy Statement to take into account the status of savings associations under the Bank Holding Company Act of 1956 (BHC Act). For example, the first qualitative requirement under the Policy Statement is that the holding company must not be engaged in significant nonbanking activities either directly or through a nonbank subsidiary. Under the BHC Act, however, control of a savings association by a bank holding company is considered a nonbanking activity. Because savings and loan holding companies control savings associations, all activities of savings and loan holding companies, including the control of savings associations would be considered nonbanking activities under the old Policy Statement. The Federal Reserve pointed out that this outcome would be inconsistent with Congressional intent to apply the Policy Statement to savings and loan holding companies. Under the final rule, the Federal Reserve will treat subsidiary savings associations of savings and loan holding companies as if they were banks for purposes of applying the Policy Statement. As is the case with bank holding companies, whether a savings and loan holding company engages in “significant” nonbanking activities will depend on the scope of the activities of the savings and loan holding company, the nature and level of risk of the activities, the condition of the savings and loan holding company, and other relevant criteria according to the Federal Reserve.

4. FFIEC Issues Guidance on Malware and Cyber Attacks Targeting User Credentials

The FFIEC has published two statements that provide guidance for financial institutions on identifying and mitigating two types of cyber attacks: destructive malware attacks and cyber attacks that compromise user credentials. The Joint Statement on Destructive Malware released on March 30 advises financial institutions and their technology service providers to enhance their information security programs to ensure they are able to identify, mitigate, and respond to destructive malware introduced into systems through a variety of mechanisms, such as employees downloading attachments in phishing or spear-phishing emails, connecting external devices like USB drives, or visiting compromised web sites, or through unauthorized parties using stolen credentials to install malware directly on systems. Federal banking agencies expect an institution’s management to maintain sufficient business continuity planning processes to ensure the rapid recovery, resumption, and maintenance of the institution’s operations after a cyber attack involving destructive malware according to the statement. Those expectations include development of appropriate processes that enable recovery of data and business operations and that address rebuilding network capabilities and restoring data if the institution or its critical service providers fall victim to a malware attack. The statement recommends that business continuity planning and testing activities should incorporate response and recovery capabilities and test resilience against cyber attacks involving destructive malware, including the ability to protect offline data backups from destructive malware.

     Nutter Notes: The Joint Statement on Cyber Attacks Compromising Credentials also released on March 30 discusses the growing trend of cyber attacks designed to obtain online credentials for theft, fraud, or business disruption and recommends risk mitigation techniques. That statement advises financial institutions to address this threat by reviewing their risk management practices and controls related to information technology networks and authentication, authorization, fraud detection, and response management systems and processes. The statement warns that user credentials can be stolen in many ways, including phishing and spear-phishing, malvertising, watering holes, and web-based attacks. Stolen credentials are often sold in cyber-criminal forums and then used to commit fraud through account takeovers and identity theft according to the FFEIC. The statement also warns that users may significantly increase exposure by creating usernames and passwords that are easy to guess or using the same usernames and passwords to access accounts on multiple web sites. The statement advises financial institutions to design multiple layers of security controls to establish several lines of defense and ensure that their risk management processes also address the risk posed by compromised credentials, consistent with the risk management guidance contained in the FFIEC IT Examination Handbook, specifically the Information Security, Outsourcing Technology Services, and the Retail Payment Systems booklets.

5. Other Developments: Consumer Complaints and Housing Counselors 

  • OCABR Reports Top Consumer Issues of 2014

The Office of Consumer Affairs and Business Regulation (OCABR) on March 19 announced its top consumer complaint topics of 2014, which is an indication of the consumer protection issues on which the OCABR may focus in the near future. Insurance was the first topic on the list, followed by Banking & Non-Depository Licensing, Telecommunications, Cable Services, and Lemon Law/Auto Issues. The Massachusetts Division of Insurance, which is part of the OCABR, received a total of 12,898 complaints and inquiries from consumers by telephone and e-mail in 2014.

     Nutter Notes: The Division of Insurance reported that 898 of the 2014 consumer complaints and inquiries it received were formal complaints resolved by the Division. Of those formal complaints, 281 involved auto insurance, 190 involved health insurance, 102 involved homeowners insurance, 88 involved life insurance and 237 pertained to other issues. At the same event, the Massachusetts Attorney General’s office announced that its top consumer complaint topics included Auto Financing and Sales, Pre-Paid Cards, Debt Collection and Data Privacy.

  • CFPB Issues Guidance on Providing Lists of Homeownership Counselors

The CFPB issued a final interpretive rule on April 15 that provides guidance to mortgage lenders, including banks, about how to provide mortgage applicants with a list of local homeownership counseling organizations. The interpretive rule restates guidance the CFPB issued in 2013, and provides further guidance for lenders who are building their own lists of housing counselors.

     Nutter Notes: The regulation that implements the federal Truth in Lending Act (Regulation Z) provides that a creditor may not extend a high-cost mortgage loan to a consumer unless the creditor receives written certification that the consumer has obtained counseling on the advisability of the mortgage from an approved counselor. The regulation that implements the Real Estate Settlement Procedures Act (Regulation X) requires lenders to provide federally related mortgage loan applicants with a list of certified homeownership counselors.