On August 26, 2009, four federal banking and thrift regulatory agencies (the Board of Governors of the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision) jointly released a Notice of Proposed Rulemaking regarding the accounting treatment of asset-backed commercial paper assets. The proposed rule seeks comment on the agencies’ proposal to amend risk-based capital standards based on recent accounting standards releases from the Financial Accounting Standards Board (FASB). It also permits the regulatory agencies to treat certain unconsolidated entities as consolidated with a banking organization for risk-based capital purposes.
On June 12, 2009, FASB issued Financial Accounting Standards No. 166 (FAS 166) and Financial Accounting Standards No. 167 (FAS 167). FAS 166 and FAS 167 amended Financial Accounting Standards 140 (FAS 140), which governs the GAAP treatment for structured finance transactions using a special purpose entity (SPE). Under FAS 140, transfers of assets to an entity that meets the definition of a qualifying special purpose entity (QSPE) are usually recognized as sales, permitting the transferor to remove the assets from its balance sheet. QSPEs are excluded from the consolidation requirements of FASB Interpretation No. 46(R) (FIN 46(R)) which requires consolidation by business enterprises of certain variable interest entities (VIEs). A VIE is an entity whose equity investment at risk is insufficient to permit the entity to finance its activities without additional subordinated financial support. One type of VIE, as defined by FIN 46(R), is an asset-backed commercial paper conduit (ABCP conduit), which is created by a banking organization and then filled with an array of assets, including receivables, loans or mortgages. This ABCP conduit then uses these assets as collateral and sells commercial paper to institutional investors seeking a relatively safe, short-term investment offered by commercial paper which generally provides a higher yield than a comparable Treasury bill or certificate of deposit. The cash received from the sale of the commercial paper goes to the originating banking organization that put the assets into the ABCP conduit, which was until FAS 166 and FAS 167 permitted to keep the conduit off of its balance sheet, resulting in a more favorable treatment for regulatory capital purposes.
FAS 166 and FAS 167 removed the concept of a QSPE from GAAP and thus subjected many unconsolidated VIEs to consolidation requirements. FASB, in FAS 166, acknowledged that this would require certain banking organizations to consolidate the assets, liabilities and equity of VIEs, including ABCP conduits, onto their balance sheets for financial and regulatory purposes. Importantly, FASB did not provide for grandfathering of existing financial structures, so that as of January 1, 2010, banking organizations would be required to consolidate and recognize on their balance sheets previously unconsolidated VIEs. These newly-consolidated entities would then be included in relevant regulatory reports of banking organizations, thus eliminating the favorable capital treatment previously obtained. Additionally, banking organizations may need to establish loan loss reserves to cover incurred losses on the assets consolidated pursuant to FAS 166 and FAS 167.
Banking organizations’ regulatory capital requirements incorporate both leverage and risk-based measures. The leverage measure uses on-balance sheet assets as the basis for setting capital requirements that are intended to limit the degree to which a banking organization can leverage its equity capital base. The risk-based measures establish capital requirements intended to reflect the risks associated with on-balance sheet, as well as off-balance sheet, exposures. Bank regulatory agencies use GAAP as the initial basis for determining whether an exposure is treated as on- or off-balance sheet for regulatory capital purposes.
By mandating consolidation of the ABCP conduits onto the banking organization’s balance sheet, FAS 166 and FAS 167 altered the regulatory capital requirements by significantly increasing the amount of assets and liabilities reported on the balance sheet and thereby resulting in significantly higher capital levels to maintain the same capital ratios. If the assets of a banking organization are transferred to an ABCP conduit but remain on the banking organization’s balance sheet under GAAP consolidation, the ABCP conduit’s assets are risk-weighted like any other consolidated asset on the balance sheet. If the assets are sold, rather than transferred, to an ABCP conduit, then the banking organization is required to hold risk-based capital only against its contractual exposures to the ABCP conduit. By eliminating the exclusion from consolidation, FAS 166 and FAS 167 thus result in higher capital requirements for banking organizations that previously did not consolidate ABCP conduits. Under bank capital requirements, Tier 1 capital is assessed against a measure of a bank’s total assets, net of any allowance for loan losses. Therefore, previously unconsolidated assets that now must be recognized on the bank’s balance sheet will increase the denominator of the leverage capital ratio (resulting in a decrease of the leverage capital ratio). Although FAS 166 and FAS 167 will also affect the numerator of the risk-based and leverage capital ratios of affected banking organizations, in most cases these ratios will decrease as a result of the implementation of FAS 166 and FAS 167. The risk-based capital rules specify the components of regulatory capital and recognize variations of risk levels among different risk-weight assignments. The risk-based capital rules use GAAP as a basis for regulatory reporting requirements, but adjust GAAP balance sheet inputs where appropriate to capture an exposure’s risk.
The proposed rule also permits banking organization regulatory agencies to treat any unconsolidated structures as if they were consolidated for risk-based capital purposes.
The agencies, in the joint rule proposal, sought comment on whether a phase-in of the increase in regulatory capital requirements is needed. They also sought comment and supporting data on the features and characteristics of transactions that, although consolidated under FAS 166 and FAS 167, might merit an alternative capital treatment.
Comments on all aspects of the proposed rule are due within 30 days after publication in the Federal Register (which is due to be released soon).