At the end of July, federal bank regulators issued a notice of proposed rulemaking (“Proposed Rule” or “Proposal”) for new risk-based capital requirements that, if finalized, would be available to all but the largest U.S. banking organizations.1 Comments are due by October 27, 2008. After analysis of the comments, the agencies will issue a final rule; given the history of capital rules, this rule seems unlikely to emerge until the first quarter of 2009. This advisory highlights features of the Proposed Rule likely to have a material impact on risk-based capital calculations. A more detailed discussion is available in our Banking and Financial Regulation Report entitled Basel II: Proposed U.S. Rule Implementing Standardized Approach.2

The Proposed Rule grows out of discussions over several years about implementation of a new capital regime — Basel II — for large, internationally-active banking organizations, known as core banks.3 This regime went into effect earlier this year.4 While core banks will incur considerable compliance expense, the new rules are likely to yield lower risk-based capital charges for several classes of assets compared to the capital charges imposed by the general risk-based capital rules, which continue to apply to the vast majority of U.S. banking organizations, the non-core banking organizations.5

In response to Congressional and industry concerns about a level playing field for all U.S. banking organizations, the banking agencies issued a notice of proposed rulemaking known as “Basel IA” in September 2006, which was a mix of Basel I- and Basel II-type rules. The agencies have now abandoned the Basel IA concept, however, in favor of the Proposed Rule.

The Proposed Rule derives from the simplest set of capital rules in Basel II, known as the “Standardized Framework.”6 To students of risk-based capital rules, the framework of the Proposal for assessing capital adequacy for credit risk will look similar to that of the general rules. The one methodological innovation is a new and additional capital charge for operational risk, which is driven largely by an organization’s recent net income, rather than by particular assets. The Proposal also includes public disclosure requirements, which supplement existing periodic reporting requirements.

Other regulations relating to capital would not change. The Proposed Rule does not, for example, affect the calculation of a banking organization’s leverage ratio, and leverage ratio requirements continue to exist. The agencies’ prompt corrective action and other minimum capital ratios do not change. The elements of core and total capital remain largely the same.

The Proposal addresses at length the assignment of risk weights to various categories of on- and off-balance sheet assets. Several specific elements of the Proposal differ in important respects from the current rules, however, and may have important consequences for capital calculations. Among the noteworthy provisions are the following:

Components of capital. The Proposal does not dramatically change the elements of Tier 1 and Tier 2 capital, although the Proposal notes that the definition of Tier 1 capital will change. The most significant changes in the Proposal relate to deductions from capital — which are essentially dollarfor- dollar capital charges.

–– After-tax gains on sale in connection with securitizations must be deducted from Tier 1 capital.

–– Credit-enhancing interest-only strip receivables also must be deducted from Tier 1 capital to the extent that such receivables reflect after-tax gain-on-sale. All other I/O strips must be deducted from Tier 1 capital (50 percent) and from Tier 2 (50 percent).

–– Current deductions of nonfinancial equity investments from Tier 1 or total capital are eliminated, but new risk-based capital rules apply to such investments.

–– For bank holding companies, a deduction from Tier 1 and Tier 2 capital is required for the minimum regulatory capital requirement of any consolidated insurance underwriting subsidiary.

These deductions are not identical to the capital deductions under either the current rules or the new rules for core banking organizations. The Proposed Rule expressly requests comment on the regulatory burden and competitive equity issues arising out of potentially three different calculations of Tier 1 capital.

Range of risk weights. The Proposal includes 16 different risk weights, ranging from zero percent to 1250 percent. Under the current rules, there are only five risk weights, ranging from zero percent to 200 percent. Of the revisions to the capital rules made by the Proposed Rule, these new risk weights are likely to have the most significant impact on a banking organization’s calculation of its risk-based capital charges.

On-balance sheet asset classes. The current rules assign various asset classes to specific risk weights with little overlap among risk weights, other than for residential mortgage loans and securitization-related assets. The Proposal, by contrast, identifies eleven debtor entities or asset classes, each of which includes a range of risk weights that depend significantly on external credit ratings. The different classes are (i) sovereign entities, (ii) supranational entities and multilateral development banks, (iii) public sector entities, (iv) depository institutions, foreign banks and credit unions, (v) corporate, (vi) regulatory retail, (vii) residential mortgage, (viii) pre-sold construction loans, (ix) statutory multifamily mortgage, (x) past due and nonaccrual exposures and (xi) other assets.

Expanded use of external credit ratings. The Proposed Rule significantly expands the use of ratings from the national ratings agencies (S&P, Moody’s, Fitch) in determining appropriate risk weights. Specifically, the Proposed Rule will use external ratings in assigning risk weights to corporate exposures — to the extent such ratings are available — and to sovereign and public sector entities. If a particular asset is unrated, a rating may be inferred from any ratings for the issuer, or from other exposures from the same issuer. Under the current rules, by contrast, external ratings play a smaller role in capital determinations, affecting only recourse obligations, direct credit substitutes, certain residual interests and securitizations. The increased reliance on external credit ratings is an interesting phenomenon, given the current controversy surrounding the reliability of such ratings, and the role they may have played in the continuing credit crisis. When the Federal Reserve Board met to approve the release of the Proposal, several governors emphasized this aspect of the Proposal and specifically requested public comment.

Expanded recognition of risk mitigants. The Proposal significantly expands the ability of a banking organization to use guarantees and collateral to reduce the applicable risk weight on an asset. As a general principle, a banking organization effectively may substitute the amount of a guarantee or collateral for the same amount of an underlying asset, and risk-weight the guarantee at the weight assigned to the issuer (based largely on the issuer’s external rating) or the collateral at the weight assigned to the collateral assets (and note that the Proposal presents three alternative methods for risk-weighting collateral assets). The Proposal also significantly expands the universe of eligible guarantors to include any entity that has issued unsecured debt without credit enhancement that has a long-term external rating.

Commercial credit — new risk weight options. With a few exceptions, most commercial credits currently must be risk-weighted at 100 percent. Under the Proposal, a banking organization may choose either to continue with 100 percent risk weights across the board for commercial loans or risk-weight specific assets between 20 percent and 150 percent, based largely on external credit ratings.

Credit cards and other retail exposures — reduced risk weights. Banking organizations currently must risk-weight these assets at 100 percent. The Proposal provides for a standard 75 percent risk weight.

Residential mortgage loans — more complicated risk-weighting. The existing risk weights for these exposures are either 50 percent or 100 percent, with the more favorable weight available for first mortgages on single family residences and on certain multi-family dwellings that meet certain underwriting criteria. Partly in light of the upheaval in the housing market, the Proposal introduces a broader range of risk weights, from 20 percent to 150 percent, depending on whether the loan has a first lien or is in a junior position and on the loan-to-value (LTV) ratio. For first-lien loans, the risk weight reaches 100 percent only when the LTV ratio exceeds 90 percent; for junior loans, the 100 percent risk weight begins with LTVs above 60 percent. Loan-level, but not pool-level, private mortgage insurance may be used to reduce the LTV ratio. The Proposed Rule specifically requests comment on the private mortgage insurance and LTV issues.

Securitizations. The current risk-weighting process for securitization exposures reflects several years of revisions. The proposal continues in the same vein, and introduces a more complex methodology, but a few points warrant attention. First, as noted above, any gains on sale associated with a securitization transaction must be deducted from Tier 1 capital. Second, a wider range of risk weights — 20 percent to 350 percent — would apply to securitization exposures. Third, there are capital charges for the drawn portions of any servicer cash advance facility. Fourth, if there is recourse against, or other “implicit support” by, the sponsoring banking organization, the organization must hold capital against the full securitized pool. This fourth point is interesting: On the one hand, it arguably merely continues the existing rule and guidance on recourse; on the other hand, it is potentially suggestive of a more aggressive regulatory approach to implicit support, particularly in light of recent events in which banks have brought special purpose vehicles back onto their balance sheets, or have repurchased assets out of such vehicles. The Proposal also revises the risk-weighting process for revolving securitizations with early amortization provisions. The new methodology is more complex than that in the current rule, but appears likely to result in higher capital charges.

Off-balance sheet assets — increased risk weights. The existing rules have a series of conversion factors, from zero percent to 100 percent, for off-balance sheet assets. One type of off-balance sheet asset — commitments — has been of particular concern to the regulators over the years. Currently, shortterm and other unilaterally cancellable commitments are “converted” at zero percent, meaning there is no capital charge. The Proposal would increase the conversion factors for, and thus impose capital charges on, all short-term commitments that are not unconditionally cancellable, and create specific conversion factors for short-term self-liquidating trade-related contingent items arising from the movement of goods and for off-balance sheet securities financing transactions.

Operational risk charge. One of the innovations of Basel II is a separate and additional capital charge, not related to any specific asset, that is designed to protect against losses resulting from inadequate or failed internal processes, people and systems, or from external events. There is no comparable charge in the current rules. Under the Proposal, a banking organization would be required to hold capital equal to 15 percent of the organization’s average positive annual gross income over the previous three years, multiplied by 12.5. This calculation is designed so that there is no direct benefit to an organization that has experienced a loss — loss years essentially are excluded — but, if profits decline over time, there would be a corresponding reduction in the operational risk charge.

For example, if an organization had average positive gross income of $100 million, it would have an “asset” of $12.5 million that would be risk-weighted at 15 percent, or $1.875 million. If the organization generally were to hold eight percent Tier 1 capital against risk-weighted assets, then it would need $150,000 in Tier 1 capital to cover operational risk. As a rule of thumb, then, the Proposal imposes a capital charge close to 15 basis points of average positive gross income.

The Proposed Rule also contains public disclosure requirements for banking organizations. The requirements are in addition to the quarterly reports required for publicly traded entities and the quarterly call reports. The substance of the required disclosures is not significantly greater than what U.S. banking organizations already disclose, but compliance will require review of internal board and management policies and possible implementation of new policies. Most U.S. banking organizations will have a choice between the current, general risk-based capital rules and the Proposed Rule (or likely something very close to it). An important step for any banking organization in making this choice will be to compare its current risk-based capital charges against some possibly lower charges on assets plus the operational risk charge.