Introduction

Over the course of the last week, the Federal Banking Agencies (the Board of Governors of the Federal Reserve System (Federal Reserve), the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) issued final rules implementing changes to the capital requirements for bank holding companies (BHCs), savings and loan holding companies (SHLCs) and insured depository institutions (Final Rule). The Federal Reserve unanimously approved the Final Rule at an open meeting on July 2, 2013, and at the same time issued a notice of proposed rulemaking to make conforming changes to the current market risk capital rule (Market Risk NPR).1 The FDIC approved the rule as an interim final rule on July 9, 2013.2 The OCC also approved the Final Rule on July 9, 2013.3

The Final Rule implements, with some changes, the following three capital proposals issued in June 2012 (collectively, the Proposed Rule):4

  1. Basel III NPR - implementing a new common equity tier 1 (CET1) ratio as well as other increases in the quantity and quality of capital (i.e., the numerator of the capital ratio), as well as updating the prompt corrective action (PCA) requirements to incorporate the higher proposed capital requirements;
  2. Standardized Approach NPR - implementing changes to how most banking organizations (generally those with less than US$250 billion in assets) determine the risk weighting of their assets for calculation of capital ratios (i.e., the denominator of the capital ratio) that are in line with the Basel II standardized approach, as well as proposing alternatives to credit ratings as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank); and
  3. Advanced Approaches NPR - revising the advanced approaches capital rule applicable to about 20 of the largest U.S. banking organizations consistent with Basel II and 2.5 as well as Dodd-Frank’s directive to no longer rely on credit ratings in federal rules. 

In addition to the Final Rule, the Federal Banking Agencies issued a notice of proposed rulemaking on July 9 to add an “Enhanced Supplementary Leverage Ratio” (Leverage NPR) for the eight banking organizations that are designated as globally systemically important banks (G-SIBs).5 This additional leverage ratio was mentioned by Federal Reserve Governor Daniel Tarullo as coming in the very near future during his remarks at the July 2 Federal Reserve open meeting. The Leverage NPR proposes to require, beginning January 1, 2018, the eight U.S. G-SIBs to have a 6% minimum leverage ratio (as calculated pursuant to the Basel III agreement to include off-balance sheet items) in order to be well capitalized and an additional 2% buffer in order to make capital distributions.

The changes to the capital framework are driven primarily by the Basel III framework of international capital standards adopted by the Basel Committee on Banking Supervision (Basel Committee) in December 2010,6 as well as changes required by Dodd-Frank.

In broad terms, the Final Rule is largely unchanged from the Proposed Rule. However, some changes were made to the Final Rule primarily to reduce burdens on smaller banks. Most of these changes do not apply to the approximately 20 largest banking organizations that will use the advanced approaches. While concessions were made to ease some burdens for smaller banks, the Final Rule will require adjustments on the part of community banks. All indicators are, however, that this may only be the start of additional capital requirements for the largest banks. With proposals on Capitol Hill such as the bill introduced by Senators Brown and Vitter to move away from the Basel agreement and instead impose a 15% leverage ratio, the Federal Banking Agencies are under pressure to find the right balance to improve systemic stability without being too onerous on smaller banks. This is further evidenced by FDIC Vice-Chair Hoenig's vote against the FDIC's interim final rule because he believes the leverage ratio is too low.

What you need to know

  • Changes compared to Proposed Rule. The Federal Reserve staff noted that the Federal Banking Agencies received more than 2600 comments, a large portion of which expressed concern that the Proposed Rule was too burdensome for community banking organizations.7 Most of the changes reflected in the Final Rule are aimed at addressing these concerns. The most significant changes in the Final Rule from the Proposed Rule are:
    • leaving the risk weights for residential mortgage loans unchanged from current Basel I levels under the standardized approach;
    • allowing all but the largest banking organizations to make a one-time permanent choice to opt-out of the requirement to include unrealized gains and losses on available-for-sale securities in accumulated other comprehensive income (AOCI) in the calculation of CET1 capital;
    • preserving the grandfather provision in Dodd-Frank by not requiring a phase-out of trust-preferred securities (TruPS) and other non-qualifying capital instruments for smaller BHCs and SLHCs (generally those with less than US$15 billion in assets with non-qualifying capital instruments outstanding before 2010); and
    • excluding, for the time being, SLHCs that are heavily involved in insurance underwriting or commercial activities (Excluded SLHCs).
  • Implementation timing. Advanced approaches banking organizations will be required to comply with the new capital framework, including the CET1 capital requirement of 4%, on January 1, 2014. All other banking organizations, except small BHCs and Excluded SLHCs, will be required to comply with the new capital framework, including the CET1 capital requirement of 4.5%, on January 1, 2015. As was the case in the Proposed Rule, the higher capital requirements will be phased in over a 4-5 year period.
  • Broad applicability. The Final Rule maintains the Proposed Rule’s broad application of the Basel III increases in the numerator and standardized approach changes to the risk weights (other than that for residential mortgages as discussed herein) to almost all banking organizations (other than BHCs with less than US$500 million in total assets), including most community banks and their holding companies and all SLHCs (except Excluded SLHCs). However, as noted, implementation for standardized approach banking organizations is delayed until January 1, 2015.
  • Higher capital requirements. The Final Rule did not change the new higher capital levels that will ultimately require almost all banking organizations to meet a minimum CET1 capital ratio of 4.5%, and an increased 6% tier 1 capital ratio in order to be considered “adequately capitalized” under the PCA requirements. The Final Rule leaves the minimum total risk based capital ratio unchanged at 8%. Like the Proposed Rule, the Final Rule includes a 2.5% capital conservation buffer that is not part of the PCA requirements, but puts limits on capital distributions and bonuses to executive officers for organizations that do not maintain the buffer. The Final Rule gives the Federal Banking Agencies the discretion to impose a countercyclical capital buffer of up to an additional 2.5% of CET1 capital on the approximately 20 largest banking organizations subject to the advanced approaches capital rule.
  • Phase-out of certain capital instruments. Under the Final Rule, capital instruments that previously qualified as tier 1 capital instruments, such as cumulative perpetual preferred stock and TruPS, no longer qualify as tier 1 capital instruments (though they may qualify as tier 2 capital instruments). As required in the Basel III agreement, capital instruments that no longer qualify as tier 1 capital must be phased out over a 10-year period. However, consistent with section 171 of Dodd-Frank (the so-called Collins Amendment) and in a change from the Proposed Rule, the Final Rule grandfathers existing non-qualifying capital instruments for all mutual holding companies and banking organizations with less than US$15 billion in assets.
  • Limited need for capital raises. Federal Reserve staff estimates that 95% of community banking organizations with US$10 billion or less in total assets currently meet the fully phased-in CET1 requirement and that 90% currently meet the fully phased-in CET1 plus capital conservation buffer requirement.
  • Deductions of mortgage servicing assets and deferred tax assets. The Final Rule retains the Proposed Rule’s deductions from CET1 capital that some commentators believe are unfair to U.S. banking organizations, such as deductions of mortgage servicing assets (MSAs) and certain deferred tax assets (DTAs). The Final Rule deducts MSAs and DTAs that exceed 10% of CET1 capital in each category and 15% of CET1 capital in the aggregate. In response to comments requesting larger buckets or exempting smaller community banking organizations from these deductions, the Federal Reserve stated that the “lengthy transition period allows banking organizations to adequately plan for such stricter deductions and limits.”
  • Revisions to impact of unrealized gains and losses on Available-for-Sale (AFS) securities. One of the more meaningful changes reflected in the Final Rule is the option for non-advanced approaches banking organizations to make a one-time permanent opt-out of the rule’s requirement to recognize unrealized gains and losses on all AFS securities and gains and losses associated with certain cash flow hedges for purposes of calculating CET1 capital. Currently, these gains and losses are not recorded when calculating regulatory capital. This will remain unchanged for institutions that opt-out of the requirement. In the Final Rule, the Federal Reserve heeded concerns that recognizing unrealized gains and losses would likely result in greater volatility in regulatory capital positions, especially for smaller banking organizations. Like the deductions of MSAs and DTAs, this change will have more of an impact on U.S. banking organizations than banking organizations in other jurisdictions due to the differences between U.S. Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) accounting rules.
  • Application of Basel II standardized approach to almost all banking organizations. Despite comments seeking exemptions for community banks, the Final Rule continues to require standardized approach changes to the risk weights for most assets on a banking organization’s balance sheet. However, in a substantial change from the Proposed Rule, the Final Rule does not make any changes to the risk weights for residential mortgage loans, and will keep the 50% and 100% risk weights for most residential mortgage loans, rather than 35%-200% range in the Proposed Rule.
  • Treatment of SLHCs. The Final Rule imposes the first explicit capital requirements for SLHCs. In almost all respects, the Final Rule treats savings associations and their holding companies in the same manner as banks and BHCs. However, while the Final Rule continues to exempt small BHCs (less than US$500 million in total assets) from holding company capital requirements, the Final Rule does not provide a similar exemption to SLHCs with less than US$500 million in total assets.
    • The Final Rule does exclude SLHCs that are insurance companies (more than 25% of consolidated assets derived from insurance underwriting other than credit insurance) and grandfathered unitary SLHCs that are predominately commercial (more than 50% of total consolidated assets or revenues dedicated to or derived from non-financial activities) from the rule. Federal Reserve staff stated that these presumably temporary exclusions will provide more time to resolve complexities of and conflicts with capital requirements for insurance companies, as well as time to develop intermediate holding company rules for predominantly commercial grandfathered SLHCs.
  • Market Risk NPR Comment Period. The comment period for the Market Risk NPR is open until September 3, 2013. In the Market Risk NPR, the Federal Reserve proposes to revise the rule finalized in 2012 primarily to address recent changes to the country risk classifications published by the Organization for Economic Cooperation and Development, as well as to clarify the treatment of certain traded securitization positions and the timing of required market disclosures.
  • FDIC Interim Final Rule and G-SIB Leverage NPR Comment Period. The comment period for the FDIC Interim Final Rule and the interagency G-SIB Leverage NPR will be open for 60 days after publication in the Federal Register.

Further summary of the Final Rule

As has been previously reported, the markets generally did not trust the ability of existing tier 1 capital to absorb losses during the times of market stress in 2008 and 2009, and instead the markets looked to common equity more specifically. In response to the financial crisis and the weaknesses it exposed in the Basel II framework, the Basel Committee began work in 2009 to strengthen the Basel II capital framework, with particular emphasis on improving the quality of tier 1 capital by requiring more common equity. The new Basel III framework was generally agreed to by the Basel Committee and the leaders of the G20 countries in December 2010.

The Final Rule implements these changes in the United States.8 Federal Reserve staff remarked during the open meeting that the Final Rule is more stringent in some respects than the Basel III agreement, most notably in the accelerated phase-out of certain capital instruments from qualifying capital as required by Dodd-Frank, and in the more limited number of capital instruments that can be counted as tier 1 capital due to the differences between GAAP and IFRS accounting standards.

New and higher minimum capital ratios

As noted above, the Final Rule provides for new and higher minimum capital requirements. Specifically, the rule provides for a CET1 capital ratio, a tier 1 capital ratio, a total capital ratio, a leverage ratio, a capital conservation buffer and, for advances approaches banking organizations, a supplemental leverage ratio. The Final Rule further provides for a countercyclical capital buffer for advanced approaches banking organizations.

The table below, taken from the Final Rule, sets forth the regulatory capital levels at each stage of the phase-in period for non-advanced approaches banking organizations.

Click here to view table. 

The Final Rule retains the supplementary leverage ratio requirement of 3% for banking organizations under the advanced approaches, but as noted above, the Federal Banking Agencies also proposed an increase in the leverage requirement for the eight U.S. G-SIBs. Although the United States has long had a leverage ratio requirement generally of 4% of tier 1 assets to total assets, the new supplementary leverage ratio and proposed G-SIB Enhanced Supplementary Leverage Ratio are consistent with the leverage ratio established by the Basel Committee under Basel III and will capture off-balance sheet exposures that the current U.S. leverage ratio does not include.

Capital components

The Final Rule not only increases the quantity of capital necessary for a banking organization, it also removes some instruments from the definitions of capital in certain categories to improve the quality of regulatory capital. The Final Rule establishes three regulatory capital components—CET1 capital, additional tier 1 capital and tier 2 capital. Together CET1 capital and additional tier 1 capital are considered tier 1 capital.

Consistent with the Basel III agreement and the Proposed Rule, CET1 capital consists mainly of common equity and retained earnings, but can also include a portion of minority common equity interests that support the risks of subsidiary banks (i.e., common stock investments by an unaffiliated third-party investor made directly to the subsidiary bank may count as capital in the holding company).9 Moreover, up to 15% of CET 1 capital may consist of some combination of (1) significant (>10%) investments in unconsolidated financial institutions, (2) MSAs, and (3) DTAs, though MSA and DTA amounts exceeding 10% in either category and 15% in the aggregate must be deducted for purposes of capital calculations. The MSAs and DTAs that are not deducted are assigned a 250% risk weighting. Despite many comments objecting to the treatment of MSAs and DTAs, the Federal Banking Agencies have left it unchanged from the Proposed Rule and remarked that the delayed 2015 effective date for most banking organizations would provide the necessary relief to adjust business plans.

Consistent with the Dodd-Frank Collins Amendment and the Proposed Rule, the Final Rule provides that capital instruments such as TruPS that are no longer eligible for inclusion as additional tier 1 capital at banking organizations with US$15 billion or more in total assets must be phased out over time.10 Beginning in 2016, TruPS and similar non-qualifying instruments will be fully phased out of additional tier 1 capital, but will be able to count as tier 2 capital for non-advanced approaches banking organizations with more than US$15 billion in assets. Advanced approaches banking organizations must phase TruPS out of tier 2 capital. Consistent with the Collins Amendment, the Final Rule grandfathers TruPS and similar non-qualifying instruments issued before May 2010 for banking organizations with less than US$15 billion in assets such that these organizations may include these instruments in additional tier 1 capital for the life of the instrument. 

Risk weighting

The Final Rule generally retains the standardized approach risk weighting from the Proposed Rule. Therefore, risk weights will increase for high-volatility commercial real estate (HVCRE) and past due exposures to 150%. However, the Final Rule will not implement the proposed changes to risk weights for residential mortgage loans. Rather, the current Basel I risk weights of either 50% or 100% will apply to most 1-4 family residential mortgage loans. Federal Reserve staff cited changes to the mortgage market, such as the Consumer Financial Protection Bureau’s QM/ability-to-repay rule and the pending qualified residential mortgage rule, as reasons not to change risk weightings for residential mortgage loans at the current time. Federal Reserve staff also noted that for the large banking organizations subject to the Comprehensive Capital Analysis and Review (CCAR) stress tests, the more granular approach to risk weighting of mortgage loans would be an inherent part of the stress tests for those organizations.  

Next steps for large banking organizations

Governor Daniel Tarullo, the lead governor on bank supervision and capital matters, noted at the Federal Reserve's July 2 meeting that the Final Rule likely marks the end of major modifications to capital rules for most banking organizations, but that for the eight largest, globally significant U.S. banking organizations, the following four proposed rules complementing the capital framework will be forthcoming:  

  1. Establishing a leverage ratio threshold above the Basel III required minimum; this was issued as an NPR on July 9, 2013;
  2. Establishing the combined amount of equity and long-term debt these organizations should maintain in order to facilitate orderly resolution in appropriate circumstances;
  3. Establishing Basel capital surcharges on banking organizations of global systemic importance; and
  4. Issuing an advanced notice of proposed rulemaking to seek comment on possible approaches to requiring additional measures that would directly address risks related to short-term wholesale funding, including a requirement that large banking organizations substantially dependent on such funding hold additional capital. Conclusion

The Final Rule is generally consistent with the Proposed Rule and the Basel III agreement in most respects. As noted above, while concessions were made to ease some burdens for smaller banking organizations, the Final Rule will require adjustments. All indicators are, however, that this may only be the start of additional capital requirements for the largest banking organizations. With proposals on Capitol Hill, such as the Brown-Vitter bill, to move away from the Basel agreement and instead impose a 15% leverage ratio, the Federal Banking Agencies are under pressure to find the right balance to improve systemic stability without creating an undue burden on smaller banking organizations.