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.
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.
- 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.
Nutter Bank Report
Nutter Bank Report is a monthly electronic publication of the
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