Connie M. Friesen William Shirley August 2 2013 Federal Reserve approves final rule implementing Basel III capital reforms Sidley Austin LLP | Banking & Financial Services - USA Connie M. Friesen, William Shirley Banking & Financial Services IntroductionScopeQuantity and quality of capitalKey changes to proposalsCompliance datesFurther rulemakings for global systemically important institutionsIntroductionOn July 2 2013 the Board of Governors of the Federal Reserve System approved a final rule that substantially revises the existing capital rules for US banking organisations.(1) The final rule implements the regulatory capital reforms recommended by the Basel Committee on Banking Supervision in December 2010 – commonly referred to as Basel III – as well as additional capital reforms required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Key reforms include increased requirements for both the quantity and quality of capital held by banks so that they are more capable of absorbing losses and withstanding periods of financial distress, and the establishment of alternative standards of creditworthiness in place of credit ratings.Before the final rule, the Federal Reserve, together with the Comptroller of the Currency and the Federal Deposit Insurance Corporation, published three separate proposed rules(2) that, taken together, proposed a restructuring of the banking agencies' existing regulatory capital rules (for further details please see "Federal banking agencies issue proposed capital reforms"). The final rule consolidates the proposals and leaves most aspects of the proposals unchanged, including minimum risk-based capital requirements, capital buffers and many of the proposed risk weights. However, the final rule makes several revisions to the proposals in order to reduce the regulatory burden for smaller banking organisations in response to comments received by the agencies, including retaining the current risk weights for residential mortgages in lieu of the proposed risk-weighting framework. Additionally, smaller banking organisations are provided a longer transition period, with compliance starting on January 1 2015, while larger banking organisations must begin compliance on January 1 2014.The Federal Reserve coordinated the final rule with the other agencies, which have not yet approved the final rule, but were scheduled to vote on it by July 9 2013.At the Federal Reserve's meeting to approve the final rule, there was discussion of four additional rulemakings currently in development that will apply to the eight US banking organisations that have been identified as global systemically important institutions.This update highlights some of the key changes presented in the final rule.ScopeIn general, the final rule applies to all banking organisations currently subject to minimum capital requirements, including:US federal and state chartered banks and savings associations;US bank holding companies with at least $500 million in total consolidated assets; andUS savings and loan holding companies that do not engage substantially in insurance underwriting or commercial activities.Certain parts of the final rule apply only to banking organisations that are subject to the advanced approaches rules(3) or banking organisations with significant trading activities. In contrast to the proposals, savings and loan holding companies with substantial insurance underwriting or commercial activities will not be subject to the final rule at this time. The Federal Reserve will further consider the development of an appropriate capital framework for these companies.Quantity and quality of capitalConsistent with Basel III and the proposals, the final rule requires banking organisations to maintain the following minimum risk-based capital ratios, when fully phased in:a new ratio of common equity Tier 1 capital to risk-weighted assets (common equity Tier 1 capital ratio) of 4.5%;a ratio of Tier 1 capital to risk-weighted assets (Tier 1 capital ratio) of 6%, increased from 4%; anda ratio of total capital to risk-weighted assets (total capital ratio) of 8%.The final rule also imposes a leverage ratio of Tier 1 capital to average total consolidated assets of 4% without exception and, for advanced approaches banking organisations only, a supplementary leverage ratio of Tier 1 capital to total leverage exposure (including certain off-balance sheet exposures) of 3%.In addition to the minimum risk-based capital ratios, the final rule establishes a capital conservation buffer applicable to all banking organisations that consists of common equity Tier 1 capital equal to at least 2.5% of risk-weighted assets. This buffer could be extended for advanced approaches banking organisations by an additional countercyclical capital buffer if the federal banking agencies determine that the economy is experiencing excessive credit growth. The countercyclical capital buffer would initially be set at zero and could expand to as much as 2.5% of risk-weighted assets. If a banking organisation fails to hold capital above the minimum capital ratios and the capital conservation buffer (plus, for an advanced approaches banking organisation, any applicable countercyclical capital buffer amount), it will be subject to certain restrictions on capital distributions and discretionary bonus payments. The phase-in period for the capital conservation and countercyclical capital buffers for all banking organisations will begin on January 1 2016.As set forth in the proposals, the final rule revises the definition of 'capital' with an emphasis on the inclusion of common equity Tier 1 capital and establishes strict eligibility criteria for regulatory capital instruments. Deductions from and adjustments to capital are generally stricter than under the current capital rules, including with respect to goodwill and other intangibles, mortgage servicing assets, deferred tax assets and non-significant investments in the capital of unconsolidated financial institutions. The new definitions of 'regulatory capital' and 'capital ratios' are incorporated into the agencies' prompt corrective action framework. In addition, the final rule amends the agencies' current capital rules to improve the methodology for calculating risk-weighted assets to increase risk sensitivity.Key changes to proposalsAlthough the final rule retains, in large measure, many of the provisions presented in the proposals, some significant changes to the proposals have been made. These are mainly designed to accommodate concerns voiced by smaller banking organisations and community banks.Regulatory capital treatment of accumulated other comprehensive incomeAccumulated other comprehensive income generally includes accumulated unrealised gains and losses on certain assets and liabilities that have not been included in net income, yet are included in equity under US generally accepted accounting principles. Under the agencies' current general risk-based capital rules, most components of accumulated other comprehensive income are not reflected in a banking organisation's regulatory capital. In the proposals and the final rule, banking organisations must include all components of accumulated other comprehensive income in regulatory capital, excluding accumulated net gains and losses on cash-flow hedges that relate to the hedging of items that are not recognised at fair value on the balance sheet. The agencies recognised that for many smaller banking organisations, the volatility in regulatory capital that could result from this requirement could lead to significant difficulties in capital planning and asset-liability management. To address this concern, the final rule permits a non-advanced approaches banking organisation to make a one-time election to opt out of including most elements of accumulated other comprehensive income in regulatory capital, and instead effectively use the existing treatment under the general risk-based capital rules. The accumulated other comprehensive income opt-out election must be made in the first call report or FR Y-9 series report that is filed after the banking organisation becomes subject to the final rule.Grandfathering of certain trust preferred securitiesThe proposals would have required all banking organisations to phase out trust preferred securities from Tier 1 capital under either a three-year or 10-year transition period based on the organisation's total consolidated assets. Banking organisations with total consolidated assets of less than $15 billion as of December 31 2009 and banking organisations that were mutual holding companies as of May 19 2010 would have had to phase out their non-qualifying capital instruments, including trust preferred securities, from regulatory capital over 10 years.Based on comments received on the proposals, the agencies acknowledged that this proposal would unduly burden community banking organisations that have limited ability to raise capital, potentially impairing their lending capacity. The final rule therefore permanently grandfathers non-qualifying capital instruments (eg, trust preferred securities and cumulative perpetual preferred stock) issued before May 19 2010 for inclusion in the Tier 1 capital of banking organisations with total consolidated assets of less than $15 billion as of December 31 2009 and banking organisations that were mutual holding companies as of May 19 2010. This change is also consistent with the exception provided for smaller banking organisations under Section 171 of the Dodd-Frank Act.Risk weighting for residential mortgagesThe agencies proposed a new framework for banking organisations to risk weight residential mortgages in the proposals. Residential mortgage exposures would be placed into one of two categories based on certain characteristics to determine their applicable risk weight, with lower risk weights for Category 1 and higher risk weights for Category 2. To address commenter concerns about the burden of calculating the proposed risk weights for existing mortgage portfolios and the potential effect of inhibiting credit availability when combined with other mortgage-related rulemakings, the final rule does not adopt the proposed risk weights, but retains the existing risk weights for residential mortgage exposures under the general risk-based capital rules. Accordingly, the final rule assigns a 50% or 100% risk weight to exposures secured by residential mortgages.Compliance datesGenerally, advanced approaches banking organisations that are not covered savings and loan holding companies must begin complying with the final rule on January 1 2014. Banking organisations that are not subject to the advanced approaches rules and advanced approaches banking organisations that are covered savings and loan holding companies are granted more time and must begin complying with the final rule on January 1 2015.The final rule provides the following information with respect to compliance dates for advanced approaches banking organisations that are not savings and loan holding companies:January 1 2014 – begin:the transition period for the revised minimum regulatory capital ratios, definitions of regulatory capital and regulatory capital adjustments and deductions; andcompliance with the revised advanced approaches rule for determining risk-weighted assets.January 1 2015 – begin compliance with the standardised approach for determining risk-weighted assets.January 1 2016 – begin the transition period for the capital conservation and countercyclical capital buffers.The final rule provides the following information with respect to compliance dates for banking organisations not subject to the advanced approaches rule and banking organisations that are covered savings and loan holding companies:January 1 2015 – begin compliance with:the revised minimum regulatory capital ratios and begin the transition period for the revised definitions of regulatory capital and the revised regulatory capital adjustments and deductions; andthe standardised approach for determining risk-weighted assets.January 1 2016 – begin the transition period for the capital conservation and countercyclical capital buffers.If applicable, banking organisations must use the calculations under the market risk rule of the final rule concurrently with the calculation of risk-weighted assets according to either the standardised approach or advanced approaches of the final rule.There is an exception to the general compliance dates for a bank holding company subsidiary of a foreign banking organisation that is currently relying on the Federal Reserve's Supervision and Regulation Letter 01-1.(4) Such entities are not required to begin complying with the final rule until July 21 2015 in accordance with Section 171 of the Dodd-Frank Act.Further rulemakings for global systemically important institutionsAt the Federal Reserve's board meeting to approve the final rule, Governor Daniel Tarullo discussed four rulemakings that are in development for the eight US banking organisations that have been identified as global systemically important institutions.The Federal Reserve is close to completion of a proposal to establish a leverage ratio above the Basel III required minimum.The Federal Reserve expects to issue a proposal in the next few months on the combined amount of equity and long-term debt that institutions should maintain to facilitate orderly resolution in appropriate circumstances.After the Basel Committee on Banking Supervision has completed final methodological refinements to its framework for capital surcharges on global systemically important banking organisations, the Federal Reserve will issue a proposal to implement the framework in the United States.The Federal Reserve is working on a proposal that will seek comment on possible additional measures to address risks related to short-term wholesale funding, including an additional capital requirement for institutions that are substantially dependent on such funding.For further information on this topic please contact Connie M Friesen or William Shirley at Sidley Austin LLP by telephone (+1 212 839 5300), fax (+1 212 839 5599) or email ([email protected] or [email protected]).Endnotes(1) Federal Reserve press release and final rule available at www.federalreserve.gov/newsevents/press/bcreg/20130702a.htm.(2) 77 Fed Reg 52792 (August 30 2012); 77 Fed Reg 52888 (August 30 2012); 77 Fed Reg 52978 (August 30 2012).(3) Generally, the advanced approaches rules are mandatory for banking organisations that have $250 billion or more in total consolidated assets or that have total consolidated on-balance sheet foreign exposure equal to $10 billion or more.(4) SR 01-1 (January 5 2001) is available at www.federalreserve.gov/boarddocs/srletters/2001/sr0101.htm.