United States: Alternatives To The Use Of External Credit Ratings In OCC Regulations (Financial Services Alert - July 3, 2012)

Developments of Note

• Alternatives to the Use of External Credit Ratings in OCC Regulations
• OCC Issues Corporate Decision Authorizing Federal Savings Association to Count Value of Bank-Owned Life Insurance as Capital
• New ERISA Litigation Update Available
• CFTC Proposes Rules to Enhance Identification of Futures and Swap Market Participants

Alternatives to the Use of External Credit Ratings in OCC Regulations

In accordance with Section 939A of the Dodd-Frank Act, the OCC published final rules that revise its regulations pertaining to investment securities, securities offerings, and foreign bank capital equivalency deposits at 12 CFR Parts 1, 16, 28 and 160, o replace references to credit ratings with alternative standards of credit worthiness.  The OCC also revised its regulations pertaining to financial subsidiaries of national banks at 12 CFR Part 5, to remove references to credit ratings and eliminate the distinction between the first 50 largest insured banks and the second 50 largest insured banks.  The OCC has also published guidance for national banks and Federal savings associations in connection with the final rules.

Background

Section 939A of the Dodd-Frank Act requires federal agencies to review any regulation that requires the use of an assessment of creditworthiness of a security or money market instrument and any references to or requirements in such regulations regarding credit ratings.  Section 939A also requires the agencies to remove any references to, or requirements of reliance on, credit ratings and substitute such standard of creditworthiness as each agency determines is appropriate.

On November 29, 2011, the OCC issued a notice of proposed rulemaking, seeking comment on the proposed revisions.  The final rules reflect the rules as proposed.

Final Rules

National Bank Regulations.  The final rules remove references to credit ratings and instead require national banks to make assessments of a security's creditworthiness, similar to the assessments currently required for the purchase of unrated securities.  Under the revised 12 CFR Parts 1 and 16, a security would be "investment grade" if the issuer of the security has an adequate capacity to meet financial commitments under the security for the projected life of the asset or exposure.  This new standard will require national banks to determine that (i) the risk of default by the obligor is low, and (ii) the full and timely payment of principal and interest is expected.  National banks are permitted to use a variety of factors to make the "investment grade" determination, and may continue to consider credit ratings as part of their determination and due diligence, provided that they supplement the credit ratings with a degree of due diligence processes and additional analyses that are appropriate for the bank's risk profile and for the size and complexity of the instrument.

Federal Savings Association Regulations.12 CFR 160.42 currently imposes limitations on federal savings associations in connection with their investments in municipal bonds.  Currently, the rule permits a federal savings association to invest in general obligations of a state or political subdivision without limit and to invest in municipal revenue bonds rated in one of the four highest "investment grade" rating categories subject to a per issuer limit of 10 percent of total capital.  As revised, the rule still permits investment in general obligation bonds, but it only permits investment in municipal revenue bonds if the federal savings association determines that the issuer has an adequate capacity to meet financial commitments under the security for the life of the asset.  The revised rule provides that an issuer meets this standard if the risk of default by the obligor is low, and full and timely repayment of principal and interest is expected.  With respect to all investments in municipal bonds, the revised rule requires federal savings associations to consider, as appropriate, the interest rate, credit, liquidity, price, transaction and other risks associated with the investment and determine that the investment is appropriate for the institution and that the obligor has adequate resources and willingness to provide for all required payments on its obligations in a timely manner. 

Separately, 12 USC 1831e and OCC regulations generally prohibit savings associations from investing in corporate debt unless it is rated investment grade.  However, the Dodd-Frank Act modifies this limitation, effective July 21, 2012, by prohibiting savings associations from investing in corporate debt unless it meets standards of creditworthiness to be established by the FDIC.  As a result, the OCC has modified its regulations to replace the current definition of "investment grade" with a cross-reference to the statutory requirement.  As a result, the definition will continue to refer to the investment grade standard until such time as the FDIC issues standards for creditworthiness.

Safety and Soundness Regulations.  The final rules do not amend the requirement that national banks and federal savings associations conduct their investment activities in a manner that is consistent with safe and sound practices appropriate for the particular institution.

Foreign Banking Institutions.  The OCC's capital equivalency deposit regulation at 12 CFR 28.15 previously allowed for the use of certificates of deposit or bankers' acceptances as part of the deposit if the issuer is rated "investment grade" by an internationally recognized rating agency.  The final rule removes the reference to credit ratings, and instead, the issuer of the certificate of deposit or banker's acceptance must have an adequate capacity to meet financial commitments for the projected life of the asset or exposure.

Financial Subsidiaries.  The final rules make a technical change to 12 CFR 5.39, which pertains to financial subsidiaries of national banks, to conform with Section 939(d) of the Dodd-Frank Act, which amends the criteria applicable to national banks seeking to control or hold an interest in a financial subsidiary set forth at 12 USC 24a.Under the final rules, references to credit ratings and distinctions between the first 50 largest insured banks and the second 50 largest insured banks are eliminated, such that a national bank that is one of the 100 largest insured banks may control a financial subsidiary, directly or indirectly, or hold an interest in a financial subsidiary if the bank has not fewer than one issue of outstanding debt that meets such standards of creditworthiness or other criteria as the Secretary of the Treasury and the FRB may jointly establish.

The Secretary of the Treasury and the FRB have not yet established alternative non-ratings-based creditworthiness requirements applicable to the 100 largest insured banks under this revised provision of the National Bank Act. Until specific creditworthiness standards are established under 12 USC 24a, as modified by the Dodd-Frank Act, no specific creditworthiness requirements will be required of national banks applying to control or hold an interest in a financial subsidiary. However, the requirements at 12 CFR 5.39(g)(1) and (2) still apply and generally provide that a national bank may control or hold an interest in a financial subsidiary only if it and each depository institution affiliate is well-capitalized and well-managed, and the aggregate consolidated total assets of all financial subsidiaries of the national bank do not exceed the lesser of 45 percent of the consolidated total assets of the parent bank or $50 billion.

Guidance

The OCC has issued guidance to clarify (i) steps national banks ordinarily are expected to take to demonstrate they have properly verified that their investments meet the newly established credit quality standards, and (ii) steps national banks and federal savings associations are expected to take to demonstrate that they are in compliance with due diligence requirements when purchasing investment securities and conducting ongoing reviews of their investment portfolios.  The guidance contains a matrix providing examples of factors for national banks and federal savings associations to consider as part of a robust credit risk assessment framework for designated types of instruments.

Effectiveness

The new rules with respect to 12 CFR 1, 16, 28 and 160 become effective on January 1, 2013, and the new rules with respect to 12 CFR 5 become effective on July 21, 2012.  The OCC has advised national banks and savings associations that it expects these institutions to review their securities portfolios to determine whether they are in compliance with OCC regulations as modified by these final rules.

OCC Issues Corporate Decision Authorizing Federal Savings Association to Count Value of Bank-Owned Life Insurance as Capital

The OCC issued a Corporate Decision ("Corporate Decision 2012-11") in which it concluded that the cash surrender value ("CSV") of bank-owned life insurance ("BOLI") policies contributed by a holding company to its federal savings association ("FSA") subsidiary could be counted as capital by the FSA. In the matter that was the subject of Corporate Decision 2012-11, the FSA did not need to raise additional capital, but stated that it intended to use the capital to support potential long-term growth.

In reaching its decision, the OCC found that an FSA may hold BOLI as an activity incidental to the FSA's powers under the Home Owners' Loan Act and that the FSA had complied with the legal requirements and supervisory guidance of the 2004 federal banking agencies' Interagency Statement on the Purchase and Risk Management of Life Insurance.

In Corporate Decision 2012-11, the OCC further concluded the FSA could count the CSV of the BOLI contributed to it by the FSA's holding company because: (1) the BOLI is clearly identifiable and can be sold separately from the FSA; (2) the FSA had established an independent market value for the BOLI and the BOLI was likely to hold its market value; (3) the transaction did not involve a purchase of assets from an affiliate or another type of covered transaction under the FRB's Regulation W; (4) the FSA was well capitalized; and (5) the proposed noncash contribution of capital to the FSA involved less than 25% of the FSA's capital.

The OCC concluded in Corporate Decision 2012-11 by stating that the CSV of BOLI could be included in the FSA's common stock surplus and therefore could be counted for bank regulatory capital purposes as part of the FSA's core (Tier 1) capital.

New ERISA Litigation Update Available

Goodwin Procter's  ERISA Litigation Practice published its latest quarterly ERISA Litigation Update.  The update discusses (a) two Sixth Circuit decisions, (i) one finding that ERISA preempts state law claims against a non-fiduciary plan custodian, and (ii) the other dismissing a stock drop claim for failure to allege "actual injury," (b) an Eleventh Circuit dismissal of a stock drop claim, and (c) a dismissal by the U.S. District Court for the Southern District of New York of claims regarding the alleged imprudence of securities lending investments.  The update also provides (1) a link to a recent  Financial Services Alert discussing new disclosure obligations for sponsors of ERISA plans and service providers with ERISA clients and a (2) listing of upcoming conferences on ERISA litigation at which members of Goodwin Procter's ERISA Litigation Practice will be making presentations.

CFTC Proposes Rules to Enhance Identification of Futures and Swap Market Participants

The CFTC withdrew a July 2010 rule proposal and published a new rule proposal to collect account ownership and control information.  The new proposal would require the electronic submission of expanded trader identification and market participant data on various new and amended forms; it would also collect ownership and control information through an ownership and control report for trading accounts that are active on designated contract markets or swap execution facilities.  The proposed rules are intended to help the CFTC better deter and prevent market manipulation and abusive or disruptive trading practices, and to help it better perform risk-based monitoring and surveillance. 

Comments are due 60 days after the proposal's forthcoming publication in the Federal Register. 

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