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.6 Based on the core requirements of the 2011 international Basel III Accord (“Basel III”),7 and in significant part on the “standardized approach” for the weighting and calculation of riskbased capital requirements under the 2004-2006 Basel II Accord (“Basel II”),8 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).

The Basel III Proposal, among other things, requires banking organizations to “look through” certain structured financial instruments linked to the banking organization’s own common equity capital in order to compute its regulatory capital. The Standardized Approach Proposal requires a banking organization to look through certain structured products linked to the common equity of unconsolidated counterparties in order to assign a proper risk weight to those instruments.

The Basel III Proposal Approach to Deducting Investments in a Banking Organization’s Own Capital Instruments

The Basel III Proposal describes how a banking organization must deduct from its regulatory capital investments in its own common equity or additional Tier 1, or Tier 2, capital instruments, whether held directly or through holdings of securities of that banking organization or any other issuer, linked to an index, a constituent of which is the banking organization’s own capital instrument.

To avoid the double-counting of regulatory capital, under the Basel III Proposal, a banking organization would be required to deduct the amount of its investments in its own capital instruments, whether held directly or indirectly, to the extent such investments are not already derecognized from regulatory capital. Specifically, a banking organization would deduct its investment in its own common equity Tier 1 from the sum of its common equity Tier 1 capital elements, investments in its own additional Tier 1 from its additional Tier 1 capital, and investments in its own Tier 2 from its total capital.

In addition, any regulatory capital instrument issued by a banking organization that the banking organization could be contractually obliged to purchase would also be deducted from the corresponding category of regulatory capital.9 “Contractually obligated to purchase” could encompass:

  • Certain options for the banking organization’s capital instruments; and
  • Mandatorily exchangeable or reverse convertible notes of any issuer linked to the banking organization’s capital instruments.

A banking organization would be required to look through its holdings of index securities to deduct investments in its own capital instruments.10 The term “index securities” is not defined in the Proposals. For this article, we treat “index securities” as including debt securities of any issuer linked to an equity index, which index contains the banking organization’s common equity or additional Tier 1 as an index constituent.

The Basel III Proposal uses the following approaches in order to assure that a banking organization avoids the double-counting of regulatory capital:

  • Gross long positions in direct investments in its own regulatory capital instruments may be netted against short positions in the same underlying instrument, as long as the short positions involve no counterparty risk.
  • Gross long positions in investments in its own regulatory capital instruments resulting from holdings of index securities may be netted against short positions in the same underlying index. 
  • Short positions in indexes that are hedging long cash or synthetic positions may be decomposed to recognize the hedge.
    • More specifically, the portion of the index that is composed of the same underlying exposure that is being hedged may be used to offset the long position only if both the exposure being hedged and the short position in the index are covered positions subject to the Basel Market Risk Rule, the positions are fair valued on the banking organization’s balance sheet, and the hedge is deemed effective by the banking organization’s internal control processes.11 In turn, those processes will be assessed by the primary supervisor of the banking organization.

If the banking organization finds it operationally burdensome to estimate the exposure amount as a result of an index holding, it may, with prior approval from the primary federal supervisor, use a conservative estimate.12

The Standardized Approach Proposal

The Standardized Approach Proposal, which is applicable to the same banking organizations that would be subject to the Basel III Proposal, revised a large number, though not all, of the risk weights (or their methodologies) for banking organization assets, including corporate debt and “Equity exposures,” which, as defined, would include a debt security of any issuer linked to the common stock of an unconsolidated counterparty (such as a reverse convertible, mandatorily exchangeable or stock-linked note).

Corporate exposures (including exposures to securities firms) are assigned a risk weight of 100 percent.13 Corporate exposures do not include Equity exposures.14

An “Equity exposure” includes not only securities and other direct ownership (or equivalent) interests, but interests mandatorily convertible into such interests, options or warrants for such interests, or other instruments to the extent the return on such instrument is based on the performance of a direct equity exposure.15 Consequently, mandatorily convertible or exchangeable debt securities linked to common stock, or a debt security, the performance of which is linked to a common stock, would fall within the definition of an Equity exposure. However, the definition of Equity exposure is not clear as to whether a debt security linked to a basket of common stocks (or shares of an exchangetraded fund) would constitute an Equity exposure.

Equity exposures to unconsolidated counterparties generally would be risk-weighted under one of two broad methods, depending on whether the exposure is to an entity other than an investment fund, or to an investment fund. Certain equity holdings in other financial institutions must be deducted from capital. The possible treatments of an Equity exposure are as follows:

  • Non-investment fund exposures are weighted according to the Simple Risk-Weight Approach, under which each exposure is risk-weighted individually from 0 percent to 600 percent. Equity investments in sovereigns, certain political subdivisions, and a Federal Home Loan Bank or Farmer Mac may be risk weighted below 100 percent. Any other equity investment that is 10 percent or less of a bank’s capital is risk weighted at 100 percent. An investment in the same equity instrument but that exceeds 10 percent of capital will be riskweighted at 300 (publicly traded equities) or 400 (non-publicly traded) percent. Significant investments in unconsolidated financial institutions that are not deducted from regulatory capital (see below) are weighted at 250 percent, while investments in certain firms with securitization features are risk weighted at 600 percent.
  • Equity exposures to investment funds are risk-weighted under one of three approaches. First, the Full Look- Through Approach risk-weights each individual exposure held by the firm and assigns the banking organization its pro rata share of the aggregate risk-weighted amounts of the fund. Second, under the Simple Modified Look-Through Approach, a banking organization’s risk-weighted investment is its pro rata share of the adjusted carrying value of the fund’s equity exposures, multiplied by the highest risk weight that the fund is permitted to hold under the prospectus (or other document). Third, under the Alternative Modified Look-Through Approach, a banking organization assigns the adjusted carrying value of its investment in a fund to different risk-weight categories provided for in the prospectus (or similar document) on a pro rata basis. 
  • Three types of equity exposures relating to other financial institutions must be deducted from capital: reciprocal cross holdings, non-significant investments in the capital of unconsolidated financial institutions, and non-common stock significant investments in the capital of unconsolidated financial institutions. The deduction must be taken from the component of capital for which the underlying instrument would qualify if issued by the bank.

For a fuller description of the Proposals and their effects, please see our news bulletin “The Federal Banking Agencies’ Regulatory Capital Proposals – A Summary” (at http://www.mofo.com/files/Uploads/Images/120613-Federal-Banking-Agencies-Regulatory-Capital-Proposals-Summary.pdf) and our client alert “The Banking Agencies’ New Regulatory Capital Proposals” (at http://www.mofo.com/files/Uploads/Images/120613-Banking-Agencies-New-Regulatory-Capital-Proposals.pdf).