The Federal Reserve, OCC and FDIC have approved final rules to implement a new regulatory capital framework that incorporates the most recent regulatory capital reforms developed by the Basel Committee on Banking Supervision (“Basel III”) and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

The new regulatory capital framework will apply to all U.S. banks and thrifts, and all top-tier U.S. bank holding companies and savings and loan holding companies (“SLHCs”), other than certain SLHCs that are substantially engaged in insurance underwriting or commercial activities (all such banks, thrifts, bank holding companies and SLHCs together are referred to as “banking organizations”).

Summary of Significant Changes

The new framework imposes on all banking organizations a new minimum common equity tier 1 capital requirement, a capital conservation buffer requirement, an increase in the minimum tier 1 capital requirement, changes to the capital elements that constitute tier 1 and tier 2 capital, and changes to the methodologies for determining risk-weighted assets. The agencies have also approved amendments to the prompt corrective action (“PCA”) rules to incorporate the changes to the regulatory capital framework. For certain larger banking organizations, the new regulatory capital framework requires various public disclosures for purposes of market discipline and imposes a supplementary leverage ratio that incorporates a broader set of exposures in the denominator. The OCC’s final rule amends its market risk capital rule to apply to federal savings associations, and the Federal Reserve’s final rule amends the advanced approaches and market risk rules to apply to top-tier U.S. SLHCs, other than certain SLHCs that are substantially engaged in insurance underwriting or commercial activities.

Banking organizations with consolidated assets equal to $250 billion or more or consolidated total on-balance sheet foreign exposure equal to $10 billion or more are required to use, and any other banking organization may elect to use, the internal ratings-based and advanced measurement approaches rules for the calculation of risk-weighted assets (the “advanced approaches”). All other banking organizations are subject to the standard rules for the calculation of risk-weighted assets (the “standardized approach”).

The new regulatory capital requirements generally become effective on January 1, 2014 for advanced approaches banking organizations and on January 1, 2015 for standardized approach banking organizations.

Nutter Notes: The final rules issued by the Federal Reserve on July 2 and the OCC on July 9 consolidate three separate notices of proposed rulemaking that the OCC, Federal Reserve and FDIC published jointly on August 30, 2012. The Federal Reserve’s and the OCC’s final rules codify the agencies’ regulatory capital framework, which have previously resided in various appendices to their respective regulations, into an integrated regulation. On July 9, the FDIC took the unusual step of adopting the three notices of proposed rulemaking that the banking agencies proposed last year as an interim final rule, with revisions that make the FDIC’s interim final rule identical in substance to the final rules issued by the Federal Reserve and the OCC. The FDIC said that the measure allows it to implement the new regulatory capital framework in concert with the Federal Reserve and the OCC while considering the interactions between the revised risk-based capital regulations and a separate interagency proposal issued on July 9 that would require the largest and most systemically significant banking organizations to maintain a tier 1 capital leverage buffer of at least 2% above the new minimum supplementary leverage ratio.

Description of Significant Changes 

1. Common Equity Tier 1 Capital

The new regulatory capital framework imposes a requirement that all banking organizations maintain a ratio of common equity tier 1 capital to risk-weighted assets of 4.5%. This common equity tier 1 capital ratio is a new minimum requirement that, according to the agencies, is meant to ensure that banking organizations hold sufficient high-quality regulatory capital that is available to absorb losses on a going-concern basis. Common equity tier 1 capital is defined as the sum of a banking organization’s outstanding qualifying common equity tier 1 capital instruments, related surplus, retained earnings, accumulated other comprehensive income (“AOCI”) (subject to a one-time election to exclude AOCI available to banking organizations that are not subject to the advanced approaches risk-based capital rules), and common equity tier 1 minority interests (which are related to certain consolidated subsidiaries) subject to certain limitations, minus regulatory adjustments and deductions. To be categorized as well-capitalized under the revised PCA thresholds, beginning on January 1, 2015 an insured depository institution must have a common equity tier 1 capital ratio of 6.5%.

Nutter Notes: Consistent with Basel III, the proposed regulatory capital framework required all banking organizations to include AOCI components in the calculation of common equity tier 1 capital, except gains and losses on cash-flow hedges where the hedged item is not recognized on a banking organization’s balance sheet at fair value. In the release accompanying the final rules, the agencies acknowledged that including some AOCI components in common equity tier 1 capital, such as unrealized gains and losses related to debt securities, could introduce substantial volatility in a banking organization’s regulatory capital ratios. That volatility could lead to significant difficulties in capital planning and asset-liability management. Therefore, the new regulatory capital framework permits banking organizations that are not subject to the advanced approaches risk-based capital rules, such as community banks and other institutions with less than $250 billion in assets or less than $10 billion in foreign exposures, to elect to calculate regulatory capital by using the treatment for AOCI in the agencies’ current general risk-based capital rules, which excludes most AOCI components. Such a banking organization may make a one-time, permanent election to exclude those AOCI components from the calculation of common equity tier 1 capital (the “AOCI opt-out election”) when filing the first call report or form FR Y 9 after the date upon which the banking organization becomes subject to the final rules.

2. Capital Conservation Buffer

  • Avoiding Limits on Capital Distributions and Certain Discretionary Bonus Payments

The new regulatory capital framework establishes limits on a banking organization’s capital distributions and certain discretionary bonus payments to executive officers if the banking organization does not hold a specified amount of common equity tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements, known as the capital conservation buffer. To avoid the limitations on capital distributions and discretionary bonus payments, which are outside of the PCA framework, a banking organization will need to hold a capital conservation buffer of common equity tier 1 capital in an amount greater than 2.5% of total risk-weighted assets above the minimum risk-based capital ratio requirements. Therefore, a banking organization that maintains risk-based capital ratios at least 50 basis points above the well-capitalized PCA levels will not be subject to any restrictions imposed by the capital conservation buffer. If a capital ratio of a banking organization falls below the capital conservation buffer, the new regulatory capital framework imposes incremental limitations on distributions and discretionary bonus payments based on a maximum payout ratio.

Nutter Notes: The limitations on capital distributions under the capital conservation buffer may disadvantage banking organizations that qualify as S-corporations for federal income tax purposes. As pass-through entities for tax purposes, S-corporations generally declare a dividend to help shareholders pay their tax liabilities that arise from reporting their share of the S corporation’s profits. Shareholders of a banking organization that is an S-corporation could become liable for tax on the S corporation’s net income while the S-corporation is prohibited from paying a dividend to fund the tax payment due to the capital conservation buffer requirements—even, in some cases, where the S-corporation is well-capitalized. In declining to exempt S-corporations from the capital conservation buffer, the agencies said that the benefit from pass-through taxation enjoyed by S-corporation shareholders comes with the risk that the S-corporation may be unable to make dividend distributions to help shareholders pay their tax liabilities. Upon request, however, a banking organization’s primary federal regulator may permit the organization to make a capital distribution (or discretionary bonus payment) if the regulator determines that it would not be contrary to the purpose of the capital conservation buffer or the safety and soundness of the organization.

  • Eligible Retained Income and the Maximum Payout Ratio

The maximum payout ratio under the capital conservation buffer requirements is the percentage of eligible retained income that a banking organization is allowed to pay out in the form of capital distributions and discretionary bonus payments to executive officers during a particular current calendar quarter. The maximum payout ratio is determined by the banking organization’s capital conservation buffer as calculated as of the last day of the previous calendar quarter. A banking organization’s capital conservation buffer for purposes of determining the maximum payout ratio is the lowest of the following: the organization’s common equity tier 1 capital ratio minus the minimum common equity tier 1 capital ratio; the organization’s tier 1 capital ratio minus its minimum tier 1 capital ratio; and the organization’s total capital ratio minus its minimum total capital ratio. If the banking organization’s common equity tier 1 ratio, tier 1 ratio or total capital ratio is less than or equal to the applicable minimum ratio, the banking organization’s capital conservation buffer is zero. The capital conservation buffer requirements are divided into equal quartiles such that the maximum payout ratio ranges from 60% to 0% on distributions and discretionary bonus payments to executive officers as the capital conservation buffer approaches zero.

Nutter Notes: The new regulatory capital framework defines an executive officer in a more detailed and arguably broader way than that term is defined under the Federal Reserve’s Regulation O. For purposes of the capital conservation buffer, an executive officer includes any person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions: president, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, head of a major business line, and other staff that the board of directors of the banking organization deems to have equivalent responsibility. A discretionary bonus payment is defined as a payment made to an executive officer in which the banking organization retains discretion as to whether the payment will be made and the amount of the payment until the payment is awarded to the executive officer, the amount is determined without prior promise to, or agreement with, the executive officer, and the executive officer has no contractual right to the bonus payment.

  • Countercyclical Capital Buffer

The capital conservation buffer may be expanded for advanced approaches banking organizations at the discretion of the agencies by a countercyclical capital buffer under certain circumstances. The countercyclical capital buffer could be implemented if the agencies determine that credit growth in the economy has become excessive and could lead to wide-spread market failures. The countercyclical capital buffer would initially be set at 0%, and could be increased to as much as 2.5% of risk-weighted assets. 

3. Minimum Regulatory Capital Ratios

The new regulatory capital framework increases the minimum tier 1 capital ratio (the ratio of tier 1 capital to risk-weighted assets) from 4% to 6% and, as described above, adds a new minimum common equity tier 1 capital ratio of 4.5%. The minimum total capital ratio (the ratio of total capital to risk-weighted assets) will remain 8% and the minimum leverage ratio (the ratio of tier 1 capital to average total consolidated assets) will remain 4%. For advanced approaches banking organizations, the new framework adds an additional requirement called the supplementary leverage ratio (the ratio of tier 1 capital to total leverage exposure), which must be at least 3%. The new framework also eliminates the 3% leverage ratio exception for banking organizations with strong supervisory ratings or that are subject to the market risk rule. The 3% leverage ratio exception will no longer be available as of January 1, 2014 for advanced approaches banking organizations and as of January 1, 2015 for all other banking organizations.

Nutter Notes: The concept of the supplementary leverage ratio was introduced as part of Basel III. According to the agencies, the measure is intended to backstop the risk-based capital requirements by limiting the amount of leverage that a banking organization may incur. The ratio compares tier 1 capital to a combination of on- and off-balance sheet exposures. The agencies said that the supplementary leverage ratio will apply only to advanced approaches banking organizations because such organizations tend to have more significant amounts of off-balance sheet exposures that are not captured by the current leverage ratio. 

4. The PCA Framework

The agencies’ final rules incorporate the new minimum regulatory capital ratios into the PCA framework for banks and thrifts, including the new minimum common equity tier 1 capital ratio and, for advanced approaches institutions only, the new supplementary leverage ratio. To be categorized as adequately capitalized under the final PCA rules, a bank or thrift must maintain regulatory capital greater than or equal to the minimum regulatory capital ratios described above. To be well-capitalized for purposes of the final PCA rules, a bank or thrift must maintain a total risk-based capital ratio of 10% or more, a tier 1 capital ratio of 8% or more, a common equity tier 1 capital ratio of 6.5% or more, and a leverage ratio of 5% or more. In addition to maintaining the foregoing ratios, advanced approaches institutions need only meet the minimum supplementary leverage ratio of 3% to be considered well-capitalized. All insured depository institutions must comply with the new PCA thresholds beginning on January 1, 2015. The minimum supplementary leverage ratio requirement for advanced approaches institutions becomes effective on January 1, 2018.

Nutter Notes: Although certain minimum capital ratios remain unchanged under the new regulatory capital framework, the new ratios are more conservative than the current minimum capital ratios because they incorporate a more stringent definition of tier 1 capital as described below. Changes to the definitions of the individual capital components that are used to calculate the relevant capital measures under PCA are governed by the same transition arrangements for the definitions of regulatory capital components, so the changes to regulatory capital automatically flow through to the definitions in the PCA framework. 

5. Revised Definition of Regulatory Capital

The new regulatory capital framework redefines the components of regulatory capital. Under the new framework, a banking organization’s total capital is composed of common equity tier 1 capital, additional tier 1 capital and tier 2 capital. Non-qualifying capital instruments generally must be phased out of tier 1 and tier 2 capital, as applicable, over time in accordance with schedules set forth in the final rules.

Nutter Notes: The final rules provide that a banking organization must receive its primary federal regulator’s prior approval to include a capital element in its regulatory capital calculations that is not includable under the new framework unless that element was included in tier 1 capital or tier 2 capital prior to May 19, 2010 in accordance with the risk-based capital rules that were then in effect and the underlying instrument continues to be includable under the new framework, or the capital element is equivalent, in terms of capital quality and ability to absorb credit losses with respect to all material terms, to a regulatory capital element determined to be includable in regulatory capital in a published decision of the agency. 

  • Common Equity Tier 1 Capital

As described above, common equity tier 1 capital is defined as the sum of a banking organization’s outstanding qualifying common equity tier 1 capital instruments, related surplus, retained earnings, AOCI (subject to the AOCI opt-out election described above), and common equity tier 1 minority interest subject to certain limitations, minus regulatory adjustments and deductions. The agencies final rules set forth a list of criteria that a capital instrument will be required to meet to be included in common equity tier 1 capital, which include, for example, the requirement that the instrument is paid-in, issued directly by the banking organization and represents the most subordinated claim in a receivership, insolvency, liquidation or similar proceeding. According to the agencies, most existing common stock instruments issued by U.S. banking organizations should meet the qualifying criteria for common equity tier 1 capital instruments.

Nutter Notes: One of the proposed qualifying criteria for a common equity tier 1 capital instrument would have required cash dividend payments on the instrument to be paid out of the banking organization’s net income and retained earnings only. That proposed criterion could conflict with state corporate law, which in some states, like Delaware, permits a corporation to make dividend payments out of its capital surplus account, even when the organization does not have current or retained earnings. Therefore, the agencies’ final rules broaden the criterion to include surplus for state-chartered banking organizations. However, regardless of state law, the Federal Reserve Act and its implementing regulations subject state member banks to the same restrictions as national banks relating to distributions on capital stock. National banks and federal savings associations are not permitted to pay dividends in an amount that exceeds annual net income plus retained net income from the preceding two years (minus certain transfers) without prior approval from the OCC, so the criterion under the final rules does not include surplus for federally chartered banking organizations. 

  • Additional Tier 1 Capital

Under the new framework, additional tier 1 capital is defined to be the sum of qualifying additional tier 1 capital instruments, related surplus, and any tier 1 minority interest that is not included in a banking organization’s common equity tier 1 capital (subject to certain limitations), minus regulatory adjustments and deductions. The additional tier 1 capital qualifying criteria include, for example, that the instrument is subordinated to depositors, general creditors and subordinated debt holders in a receivership, insolvency, liquidation, or similar proceeding. The definition of additional tier 1 capital is more stringent than the definition of tier 1 capital under the current regulatory framework. For example, trust preferred securities and cumulative perpetual preferred securities, which are eligible for limited inclusion in tier 1 capital under the current risk-based capital rules for bank holding companies, generally would not qualify for inclusion in additional tier 1 capital for a bank holding company or a bank. In addition, an instrument classified as a liability under U.S. generally accepted accounting principles (“GAAP”) does not qualify as additional tier 1 capital under the new framework.

Nutter Notes: One of last year’s proposals would have completely phased out trust preferred securities from tier 1 capital under either a 3- or 10-year transition period, depending on the banking organization’s total consolidated assets. Section 171 of the Dodd-Frank Act provides an exception to the general exclusion of trust preferred securities from tier 1 capital that grandfathers trust preferred securities (and any other capital instruments that could no longer be included in tier 1 capital pursuant to the requirements of Section 171) that were issued by certain banking organizations prior to May 19, 2010. The exception permits banking organizations with total consolidated assets of less than $15 billion as of December 31, 2009 and banking organizations that were mutual holding companies as of May 19, 2010, to include grandfathered trust preferred securities in tier 1 capital. The final rules grandfather such non-qualifying capital instruments in tier 1 capital subject to a limit of 25% of tier 1 capital, excluding any non-qualifying capital instruments and after all regulatory capital deductions and adjustments are applied to tier 1 capital. In addition, the new framework permits non-advanced approaches depository institution holding companies with over $15 billion in total consolidated assets to include trust preferred securities that are phased-out of tier 1 capital in tier 2 capital. 

Under the new framework, tier 2 capital is defined to be the sum of qualifying tier 2 capital instruments, related surplus, total capital minority interests not included in a banking organization’s tier 1 capital (subject to certain limitations), and limited amounts of the allowance for loan and lease losses (“ALLL”), minus regulatory adjustments and deductions. The tier 2 capital qualifying criteria include, for example, that the instrument is subordinated to depositors and general creditors of the banking organization, the instrument is not secured, not covered by a guarantee, and not subject to any other arrangement that legally or economically enhances the seniority of the instrument in relation to more senior claims.

Nutter Notes: The revised definition of tier 2 capital does not include the current limitations on the amount of tier 2 capital that may be recognized in total capital, or the current limitations on the amount of term subordinated debt that may be included in tier 2 capital. In addition, the agencies’ finals rules allow a banking organization to request a determination that a particular capital element may be permanently or temporarily included in the calculation of total capital consistent with the loss absorption capacity of the element. However, the agencies also have authority under the new framework to selectively exclude by rule or order all or a portion of a particular capital element from common equity tier 1 capital, additional tier 1 capital, or tier 2 capital upon a determination that the capital element has characteristics or terms that diminish its ability to absorb losses, or otherwise present safety and soundness concerns. 

6. Changes to the Calculation of Risk-Weighted Assets

The new regulatory capital framework changes the methodologies for calculating risk-weighted assets, which is the figure used in the denominator to determine a banking organization’s risk-based capital ratios, for both standardized and advanced approaches banking organizations. According to the agencies, the changes are intended to harmonize their rules, enhance risk sensitivity, and address certain weaknesses, such as the risk sensitivity of the current regulatory capital treatment for credit derivatives, central counterparties, high-volatility commercial real estate and collateral and guarantees. The agencies’ final rules also provide alternatives to credit ratings for risk-weighting certain assets, as required by Section 939A of the Dodd-Frank Act. Banking organizations that are subject to the advanced approaches rules, other than SLHCs, must comply with the new advanced approaches methodologies for calculating risk-weighted assets beginning on January 1, 2014. All other banking organizations must comply with the new standardized approach methodologies for calculating risk-weighted assets beginning on January 1, 2015.

Nutter Notes: One of last year’s proposed rules would have required all banking organizations to apply new risk weights to residential mortgages based on underwriting and product features, as well as loan-to-value ratios. In response to criticisms about the burden of calculating the risk weights for existing mortgage portfolios, the potential effect of the proposal on credit availability, and other concerns, the agencies decided to retain the current treatment for residential mortgage exposures under the new framework’s general risk-based capital rules.

The new standardized approach rules generally require a banking organization to calculate its risk-weighted asset amounts for its on-balance sheet exposures by assigning on-balance sheet assets to broad risk-weight categories according to the type of counterparty, or, if relevant, the type of guarantor or collateral. Risk-weighted asset amounts for off-balance sheet items are calculated by first multiplying the amount of the off-balance sheet exposure by a credit conversion factor to determine a credit equivalent amount, and then assigning the credit equivalent amount to a relevant risk-weight category. The new standardized approach rules require a banking organization to determine its standardized total risk-weighted assets by calculating the sum of its risk-weighted assets for general credit risk, cleared transactions, default fund contributions, unsettled transactions, securitization exposures, and equity exposures, plus market risk-weighted assets, if applicable, minus the amount of the banking organization’s ALLL that is not included in tier 2 capital, and any amounts of allocated transfer risk reserves. The final rules also revise the current general risk-based capital rules’ treatment for equity exposures. 

7. Market Risk Capital Rules

Effective as of January 1, 2013, the federal banking agencies revised their respective market risk rules, which require banks and bank holding companies with aggregate trading assets and trading liabilities equal to 10% or more of total assets or $1 billion or more to measure and hold capital to cover certain exposures to market risk, including foreign exchange and commodity positions. The market risk rules also require certain public disclosure of quantitative and qualitative information about a banking organization’s trading activities. The new regulatory capital framework expands the scope of the market risk rules to include savings associations and SLHCs that meet the same thresholds, and to codify the market risk rules in a manner similar to the other regulatory capital rules. The final rules also clarify the circumstances in which a banking organization that is subject to the market risk rules must make its required market risk disclosures and how to do so in a timely manner, particularly in cases where the timing of market risk disclosures does not coincide with other required disclosures like those required under the federal securities laws.

8. Market Discipline Disclosures for Larger Banking Organizations

The new regulatory capital framework imposes new public disclosure requirements that would apply to any top-tier banking organization in the U.S. with $50 billion or more in total assets. The disclosures will provide information to market participants on scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the banking organization. The scope of application disclosures require that a top-tier banking organization name the top corporate entity in the group reporting and include descriptions of the differences in the basis for consolidating entities for accounting and regulatory purposes, and any restrictions on transferring funds within the group. A reporting organization will also be required to disclose summary information about its regulatory capital instruments, approach to categorizing and risk weighting exposures, the amount of total risk-weighted assets, capital conservation buffer, eligible retained income and any limitations on capital distributions and discretionary bonus payments. A reporting organization will also be required to disclose information related to credit risk, counterparty credit risk, credit risk mitigation, the amount of credit risk transferred and retained through securitization transactions, the value of investments in certain types of equity securities and quantitative and qualitative disclosures about the management of interest rate risks.

Nutter Notes: A banking organization subject to the market discipline disclosure rules may be able to fulfill some of the reporting requirements by relying on similar disclosures made in accordance with the federal securities laws and information provided in publicly available regulatory reports. A banking organization that relies on such other public disclosures under the final rules must explain any material differences between the public disclosures and the information required to be disclosed under the final rules. The disclosures must be publicly available (for example, on a public website) for each of the last three years or such shorter time period beginning when the banking organization became subject to the disclosure requirements. The final rules give banking organizations some discretion to determine the appropriate medium, location and formatting of the disclosures.