Federal banking agencies issue proposed capital reforms

Introduction
Overview
Basel III proposal

Introduction

The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) recently released three proposed rules and one final rule (the market risk rule) which would substantially revise the federal banking agencies' current capital rules.(1)

The proposals and the market risk rule are expected to be published in the Federal Register shortly and comments on the proposals are due by September 7 2012. The market risk rule will become effective on January 1 2013. The proposals would implement the regulatory capital reforms recommended in December 2010 by the Basel Committee on Banking Supervision (Basel III), as well as additional capital reforms required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Overview

The first proposal, Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions and Prompt Corrective Action (the Basel III proposal), would revise the risk-based and leverage capital ratio minimum requirements and the definition of 'capital'. The Basel III proposal also would introduce new capital conservation and countercyclical capital buffer requirements and incorporate the new regulatory capital minimums into the agencies' prompt corrective action framework.

The remaining two proposals would:

• revise the rules for calculating risk-weighted assets to reflect a more risk-sensitive weighting approach;
• replace references to credit ratings with alternative quality measurements;
• revise the advanced approaches risk-based capital rules consistent with Basel III and the Dodd-Frank Act;
• expand the application of the market risk capital rules to savings associations and the application of both the advanced approaches and market risk capital rules to US top-tier savings and loan holding companies; and
• impose certain disclosure requirements on US banking organisations with $50 billion or more in total assets.

The proposals and the market risk rule are extensive (totalling more than 800 pages) and complex. According to the federal banking agencies, the proposals were released in three parts to reflect the distinct objectives of each proposal and to assist interested parties in focusing their review and comments.

Basel III proposal

The Basel III proposal is consistent with the Basel III framework in many respects. Highlights are outlined below.

Scope
In general, the Basel III proposal would apply to all US federal and state-chartered banks and savings associations, US bank holding companies with more than $500 million in total consolidated assets and US savings and loan holding companies regardless of asset size.

Revisions to minimum capital requirements
As with the Basel III framework, the Basel III proposal would introduce a common equity Tier 1 capital requirement which, when fully phased in, would require a minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5%. It would also increase the minimum ratio of Tier 1 capital to risk-weighted assets from 4% to 6%. In addition, it would require all banking organisations to maintain a minimum leverage ratio of 4% without exception. The minimum ratio of total capital to risk-weighted assets would remain unchanged at 8%. Banking organisations that are subject to the advanced approaches rules would also be required to maintain a supplementary leverage ratio of Tier 1 capital to total leverage exposure of 3%. (Generally, the advanced approaches rules are mandatory for banking organisations and their subsidiaries that have $250 billion or more in total consolidated assets or that have consolidated total on-balance sheet foreign exposure at the most recent year-end equal to $10 billion or more.) The denominator of the supplementary leverage ratio would include certain off-balance sheet exposures.

Capital conservation buffer
The Basel III proposal would also establish a capital conservation buffer consisting of common equity Tier 1 capital equal to at least 2.5% of risk-weighted assets. A banking organisation's capital conservation buffer would be the lowest of the following measures:

• the banking organisation's common equity Tier 1 capital ratio (in per cent) minus its minimum common equity Tier 1 capital ratio (4.5%);
• the banking organisation's Tier 1 capital ratio (in per cent) minus its minimum Tier 1 capital ratio (6%); and
• the banking organisation's total capital ratio (in per cent) minus its minimum total capital ratio (8%).

Any banking organisation failing to maintain the 2.5% minimum buffer (plus, for an advanced approaches banking organisation, 100% of any applicable countercyclical capital buffer amount) would be subject to limits on its capital distributions (including dividend payments, discretionary payments on Tier 1 instruments and share buybacks) and certain discretionary bonus payments to executives, with the restrictions increasing as the banking organisation's capital conservation buffer decreases. The limit would be expressed as a maximum payout ratio that would be the percentage of eligible retained income that a banking organisation would be allowed to pay out in the form of capital distributions and certain discretionary bonus payments during the current calendar quarter and would be determined by the amount of the capital conservation buffer held by the banking organisation during the previous calendar quarter. Under the Basel III proposal, eligible retained income would be defined as a banking organisation's net income (as reported in the banking organisation's quarterly regulatory reports) for the four calendar quarters preceding the current calendar quarter, net of any capital distributions, certain discretionary bonus payments and associated tax effects not already reflected in net income. A banking organisation's maximum payout amount for the current calendar quarter would be equal to the banking organisation's eligible retained income, multiplied by the applicable maximum payout ratio as described in the table below. Because the capital conservation buffer would apply in addition to the regulatory minimum requirements, the restrictions on capital distributions and discretionary bonus payments would not by itself give rise to any applicable restrictions under the agencies' prompt corrective action regulations.

Countercyclical capital buffer
The countercyclical capital buffer is designed to take into account the macro-financial environment in which banking organisations function and to protect the banking system from the systemic vulnerabilities that may build up during periods of excessive credit growth and then potentially unwind in a disorderly way that may cause disruptions to financial institutions and ultimately economic activity. As proposed, and consistent with Basel III, the countercyclical capital buffer would serve as an extension of the capital conservation buffer. The agencies propose to apply the countercyclical capital buffer only to advanced approaches banking organisations, because large banking organisations generally are more interconnected with other institutions in the financial system. The countercyclical capital buffer amount in the United States would initially be set to zero.

Definition of 'capital'
Consistent with the Basel III framework, the Basel III proposal would revise the definition of 'capital' to include the following regulatory capital components: common equity Tier 1 capital, additional Tier 1 capital and Tier 2 capital. Common equity Tier 1 capital would consist of the following, minus regulatory adjustments and deductions:

• common stock instruments that meet the following criteria:
  • the instrument is paid in, issued directly by the banking organisation and represents the most subordinated claim in a receivership, insolvency, liquidation or similar proceeding of the banking organisation;
  • the holder of the instrument is entitled to a claim on the residual assets of the banking organisation that is proportional with the holder's share of the banking organisation's issued capital after all senior claims have been satisfied in a receivership, insolvency, liquidation or similar proceeding;
  • the instrument has no maturity date, can be redeemed only via discretionary repurchases with prior regulatory approval and contains no term or feature that creates an incentive to redeem;
  • the banking organisation did not create at issuance of the instrument through any action or communication an expectation that it will buy back, cancel or redeem the instrument and the instrument does not include any term or feature that might give rise to such an expectation;
  • any cash dividend payments on the instrument are paid out of the banking organisation's net income and retained earnings and are not subject to a limit imposed by the contractual terms governing the instrument;
  • the banking organisation has full discretion at all times to refrain from paying any dividends and making any other capital distributions on the instrument without triggering an event of default, a requirement to make a payment-in-kind or an imposition of any other restrictions on the banking organisation;
  • dividend payments and any other capital distributions on the instrument may be paid only after all legal and contractual obligations of the banking organisation have been satisfied, including payments due on more senior claims;
  • the holders of the instrument bear losses as they occur equally, proportionately and simultaneously with the holders of all other common stock instruments before any losses are borne by holders of claims on the banking organisation with greater priority in a receivership, insolvency, liquidation or similar proceeding;
  • the paid-in amount is classified as equity under generally accepted accounting principles (GAAP);
  • the banking organisation, or an entity that the banking organisation controls, did not purchase or directly or indirectly fund the purchase of the instrument;
  • the instrument is not secured, not covered by a guarantee of the banking organisation or of an affiliate of the banking organisation, and not subject to any other arrangement that legally or economically enhances the seniority of the instrument;
  • the instrument has been issued in accordance with applicable law and regulations; and
  • the instrument is reported on the banking organisation's regulatory financial statements separately from other capital instruments;
• retained earnings;
• accumulated other comprehensive income; and
• a limited amount of common equity Tier 1 minority interests.

Additional Tier 1 capital would consist of the following, minus regulatory adjustments and deductions:

• instruments (plus any related surplus) that meet the following criteria:
  • the instrument is issued and paid in;
  • the instrument is subordinated to depositors, general creditors and subordinated debt holders of the banking organisation in a receivership, insolvency, liquidation or similar proceeding;
  • the instrument is not secured, not covered by a guarantee of the banking organisation or of an affiliate of the banking organisation, and not subject to any other arrangement that legally or economically enhances the seniority of the instrument;
  • the instrument has no maturity date and does not contain a dividend step-up or any other term or feature that creates an incentive to redeem;
  • if callable by its terms, the instrument may be called by the banking organisation only after a minimum of five years following issuance, except that the terms of the instrument may allow it to be called earlier than five years upon the occurrence of a regulatory event that precludes the instrument from being included in additional Tier 1 capital or a tax event. In addition:
    • the banking organisation must receive prior regulatory approval to exercise a call option on the instrument;
    • the banking organisation does not create at issuance of the instrument, through any action or communication, an expectation that the call option will be exercised; and
    • prior to exercising the call option, or immediately thereafter, the banking organisation must either replace the instrument to be called with an equal amount of instruments that meet the criteria for common equity Tier 1 capital or additional Tier 1 capital or demonstrate to regulatory satisfaction that following redemption, the banking organisation will continue to hold capital commensurate with its risk.
  • redemption or repurchase of the instrument requires prior regulatory approval;
  • the banking organisation has full discretion at all times to cancel dividends or other capital distributions on the instrument without triggering an event of default, a requirement to make a payment-in-kind or an imposition of other restrictions on the banking organisation except in relation to any capital distributions to holders of common stock;
  • any capital distributions on the instrument are paid out of the banking organisation's net income and retained earnings;
  • the instrument does not have a credit-sensitive feature, such as a dividend rate that is reset periodically based in whole or in part on the banking organisation's credit quality, but may have a dividend rate that is adjusted periodically independent of the banking organisation's credit quality, in relation to general market interest rates or similar adjustments;
  • the paid-in amount is classified as equity under GAAP;
  • the banking organisation, or an entity that the banking organisation controls, did not purchase or directly or indirectly fund the purchase of the instrument;
  • the instrument has no features that would limit or discourage additional issuance of capital by the banking organisation, such as provisions that require the banking organisation to compensate holders of the instrument if a new instrument is issued at a lower price during a specified timeframe;
  • if the instrument is not issued directly by the banking organisation or by a subsidiary of the banking organisation that is an operating entity, the only asset of the issuing entity is its investment in the capital of the banking organisation, and proceeds must be immediately available without limitation to the banking organisation or its top-tier holding company in a form which meets or exceeds all of the other criteria for additional Tier 1 capital instruments; and
  • for an advanced approaches banking organisation, the governing agreement offering circular or prospectus of an instrument issued after January 1 2013 must disclose that the holders of the instrument may be fully subordinated to interests held by the US government in the event that the banking organisation enters into a receivership, insolvency, liquidation or similar proceeding;
• a limited amount of Tier 1 minority interests; and
• any and all instruments that qualified as Tier 1 capital under the general risk-based capital rules then in effect that were issued under the Small Business Jobs Act 2010 or prior to October 4 2010 under the Emergency Economic Stabilisation Act 2008.

Tier 2 capital would consist of the following, minus regulatory adjustments and deductions:

• instruments (plus related surplus) that meet the following criteria:
  • the instrument is issued and paid in;
  • the instrument is subordinated to depositors and general creditors of the banking organisation;
  • the instrument is not secured, not covered by a guarantee of the banking organisation or of an affiliate of the banking organisation and not subject to any other arrangement that legally or economically enhances the seniority of the instrument in relation to more senior claims;
  • the instrument has a minimum original maturity of at least five years. At the beginning of each of the last five years of the life of the instrument, the amount that is eligible to be included in Tier 2 capital is reduced by 20% of the original amount of the instrument (net of redemptions) and is excluded from regulatory capital when remaining maturity is less than one year. In addition, the instrument must not have any terms or features that require, or create significant incentives for, the banking organisation to redeem the instrument prior to maturity;
  • the instrument, by its terms, may be called by the banking organisation only after a minimum of five years following issuance, except that the terms of the instrument may allow it to be called sooner upon the occurrence of an event that would preclude the instrument from being included in Tier 2 capital or a tax event. In addition:
    • the banking organisation must receive prior regulatory approval to exercise a call option on the instrument;
    • the banking organisation does not create at issuance of the instrument, through any action or communication, an expectation that the call option will be exercised; and
    • prior to exercising the call option, or immediately thereafter, the banking organisation must either replace any amount called with an equivalent amount of an instrument that meet the criteria for regulatory capital or demonstrate to regulatory satisfaction that following redemption, the banking organisation will continue to hold capital commensurate with its risk;
  • the holder of the instrument has no contractual right to accelerate payment of principal or interest on the instrument, except in the event of a receivership, insolvency, liquidation or similar proceeding of the banking organisation;
  • the instrument has no credit-sensitive feature, such as a dividend or interest rate that is reset periodically based in whole or in part on the banking organisation's credit standing, but may have a dividend rate that is adjusted periodically independent of the banking organisation's credit standing, in relation to general market interest rates or similar adjustments;
  • the banking organisation, or an entity that the banking organisation controls, did not purchase or directly or indirectly fund the purchase of the instrument;
  • if the instrument is not issued directly by the banking organisation, or by a subsidiary of the banking organisation that is an operating entity, the only asset of the issuing entity is its investment in the capital of the banking organisation and proceeds must be immediately available without limitation to the banking organisation or its top-tier holding company in a form which meets or exceeds all of the other criteria for Tier 2 capital instruments;
  • redemption of the instrument before maturity or repurchase requires prior regulatory approval; and
  • for an advanced approaches banking organisation, the governing agreement, offering circular or prospectus of an instrument issued after January 1 2013 discloses that the holders of the instrument may be fully subordinated to interests held by the US government in the event that the banking organisation enters into a receivership, insolvency, liquidation or similar proceeding;
• a limited amount of total capital minority interests;
• a limited amount of allowance for loan and lease losses; and
• any instrument that qualified as Tier 2 capital under the general risk-based capital rules then in effect that were issued under the Small Business Jobs Act 2010 or prior to October 4 2010 under the Emergency Economic Stabilisation Act 2008.

The proposed deductions from and adjustments to capital generally are stricter than under the agencies' current capital rules - including, with respect to goodwill and other intangibles, mortgage servicing assets, deferred tax assets, gain-on-sale associated with a securitisation exposure, unrealised gains and losses on certain cash flow hedges and non-significant investments in the capital of unconsolidated financial institutions. The majority of deductions would be taken from common equity Tier 1 capital.

Phase-out of non-qualifying capital instruments
Under the Basel III proposal, capital instruments issued before and included in Tier 1 or Tier 2 capital as of May 19 2010 that no longer meet the eligibility requirements specified above for additional Tier 1 capital or Tier 2 capital (referred to as non-qualifying capital instruments) would be phased out of Tier 1 or Tier 2 capital over time, based on the size of the issuing banking organisation and the type of capital instrument involved. In particular, trust preferred securities and cumulative perpetual preferred stock would be phased out of Tier 1 capital.

Depository institution holding companies with total consolidated assets of $15 billion or more would be required to phase out non-qualifying capital instruments over a three-year period beginning January 1 2013. For calendar year 2013, they would be permitted to include, in capital, 75% of the aggregate outstanding principal amount of such instruments, with such amount decreasing to 50% and 25% in 2014 and 2015, respectively. Depository institution holding companies with less than $15 billion in total consolidated assets would have until January 1 2022 to fully phase out such instruments, with the initial inclusion amount set at 90% for calendar year 2013 and decreasing by 10% thereafter. The amount of non-qualifying capital instruments excluded from additional Tier 1 capital would be permitted to be included in Tier 2 capital without limitation.

Changes in risk-weighted assets
Certain exposures that currently are deducted under the risk-based capital rules, such as certain credit enhancing interest-only strips, would receive a risk weighting of 1,250%.

Adjustments to prompt corrective action thresholds
The Basel III proposal would update the prompt corrective action categories to reflect the proposed revisions to the definition of capital and the revised minimum capital ratios. The prompt corrective action revisions would take effect from January 1 2015, when the minimum regulatory capital ratios are fully phased in.

Timing

The new minimum capital ratios and other changes would be phased in over time, as illustrated in the transition table below.

For further information on this topic please contact William S Eckland, Joel D Feinberg or Amber M Tofilon at Sidley Austin LLP by telephone (+1 202 736 8000), fax (+1 202 736 8711) or email ([email protected], [email protected]or [email protected]).

Endnotes

(1) The Federal Reserve approved the proposals for publication on June 7 2012. The Federal Reserve press release is available at: http://www.federalreserve.gov/newsevents/press/bcreg/20120612a.htm. The OCC and the FDIC approved the proposals on June 12 2012. The OCC press release can be found at: http://www.occ.treas.gov/news-issuances/news-releases/2012/nr-ia-2012-88.html, and the FDIC press release is available at: http://www.fdic.gov/news/news/press/2012/pr12068.html.