Capital. Regulatory Capital Standards: Better Focused, Better Aligned, Better Value

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1 Capital Regulatory Capital Standards: Better Focused, Better Aligned, Better Value

2 Capital Regulatory Capital Standards: Better Focused, Better Aligned, Better Value The Core Principles for Regulating the United States Financial System, enumerated in Executive Order 13772, include the following that are particularly relevant to an evaluation of current U.S. capital rules: (b) prevent taxpayer-funded bailouts; (c) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry; (d) enable American companies to be competitive with foreign firms in domestic and foreign markets; (e) advance American interests in international financial regulatory negotiations and meetings; (f) make regulation efficient, effective, and appropriately tailored; and (g) restore public accountability within Federal financial regulatory agencies and rationalize the Federal financial regulatory framework. The American Bankers Association 1 offers these views to the Secretary of the Treasury in relation to the Directive that he has received under Section 2 of the Executive Order. The achievement of adequate levels of high quality capital should be preserved. Capital rules are in all cases excessively complex and in many cases a poor fit for the banks to which they are applied. Prominent attention needs to be focused on access to capital by community banks. Unwise capital treatment of MSAs, Sub S-Corp banks, TruPS investments, and riskless assets (among other issues) needs correction. Fluctuations in AOCI should not be run through capital measures. Banks should be allowed to adopt an enhanced Standardized Approach in place of the Advanced Approaches capital rules. 1 The American Bankers Association is the voice of the nation s $17 trillion banking industry, which is composed of small, regional, and large banks that together employ more than 2 million people, safeguard $13 trillion in deposits, and extend more than $9 trillion in loans.

3 Introduction It is a primordial view of the American Bankers Association and its members that adequate levels of quality capital are fundamental to the safety and soundness of the banking system. Fortunately, the U.S. banking industry is exceedingly well capitalized. 2 That being said, capital regulation for U.S. banks is far more complex than need be to achieve that supervisory result. There is some tailoring of capital standards, but more can be done to make capital regulations better aligned with the risks presented by the variety of business models and activities of our diverse banking industry, a diversity that we applaud and that wise regulation should encourage. Better tailoring can be achieved with less not more complexity, built upon an optimal mix of risk-based and leverage capital. Tailoring of capital standards is needed, applied across the entire banking industry, to achieve optimal capital levels for purposes of supervision as well as financial support for the economy. Initial regulatory efforts have demonstrated general regulatory acceptance of the importance of tailoring. In practice, the initial rudimentary efforts at tailoring have done little to align capital standards with risk. The monofactorial reliance on asset size a measure not unrelated to risk but which taken alone poorly corresponds to risk has harbored an overall program with too many bells and whistles and stifling complexity that exceeds workability for bank managers and supervisors alike. Consider the current regulatory capital structure. In line with international standards developed by the Basel Committee on Banking Supervision, as implemented in the United States, banking organizations with $250 billion or more in total assets, or $10 billion or more in on-balance sheet foreign exposure in the United States, are subject to the Advanced Approaches risk-based capital requirements. These institutions are also subject to a supplemental leverage ratio. In addition, all banking organizations are subject to the U.S. Standardized Approach risk-based regulatory capital requirements, which is also based in large part on the international Basel standards. All banks and bank holding companies are also subject to leverage capital ratio requirements (defined in a variety of ways). Waiting in the wings are two years of work at Basel to develop a significant number of new proposals to modify the Standardized Approach and the Advanced Approaches, not inappropriately dubbed Basel IV. In addition, with respect to the Advanced Approaches, the U.S. Agencies are considering whether to pursue an entirely different alternative, including whether to replace the Advanced Approaches with some version of a Standardized Approach. If the consideration is whether to layer on yet one more capital regime, or to replace a layer with one that remains risk-sensitive without excessive complexity, we encourage a focus on the latter. 2 The FDIC, in its Quarterly Banking Profile for Fourth Quarter 2016, states, At the end of the quarter, 99.7 percent of all banks, representing 99.9 percent of industry assets, met or exceeded the requirements for the highest regulatory capital category as defined for Prompt Corrective Action purposes. The Federal Deposit Insurance Corporation, Quarterly Banking Profile, All Institutions Performance Fourth Quarter 2016, 2

4 We urge policymakers to stop short of simplistic formulas when remedying excess complexity. There has been academic debate pitting risk-based capital measures against leverage capital measures. In reality, bankers and regulators have been taught by painful experience to use both in order to manage and supervise the capital condition of banks. While acknowledging some degree of model error in risk-based capital, it should be understood that the leverage ratio is a model, too, one that assumes that all bank assets present equal risk. Whatever might be said about the likelihood of errors in risk-based measures, we can be certain that the risk-blind simplicity of the leverage ratio means that it is always wrong. We believe that the regulatory design of both of these types of ratios can be improved to enhance economic growth. We believe that the Agencies, in consultation with Treasury, should actively seek to reduce the number of regulatory capital ratios banks must calculate to those that are most effective for management and supervisory purposes to promote safety and soundness and economic growth. I. Capital Problems A. Treatment of Mortgage Servicing Assets Under the Basel III capital rules, mortgage servicing assets (MSAs) are deducted from regulatory Tier 1 capital if the bank holds a concentration in excess of 10 percent of Common Equity Tier 1 (CET1) capital. The rules also impose an overall limitation of 15 percent of CET1 on the combined balance of includable MSAs, deferred tax assets, and investments in the common stock of unconsolidated financial institutions. Finally, MSAs that are not deducted from CET1 are subject to a 250 percent risk weight. Although the Basel III rules do remove the 10 percent haircut on the fair market value of MSAs imposed by Section 475 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), the rules treatment of MSAs places broad constraints on MSAs that operate to impel a significant reduction in the retail mortgage servicing operations of banks, particularly community, midsize, and regional banks. Servicing mortgage loans is a specialty of many banks and has provided a strong source of fee income for decades. For even more banks, particularly community, midsize, and regional institutions, mortgage servicing is an important way to maintain valuable long-term customer relationship, while allowing the bank to sell a long term asset to manage its interest rate risk. As a result of these rules, we have seen a larger portion of the mortgage servicing business migrate to non-bank mortgage servicers, a shift of market share that we do not believe was intended by the Agencies. Customers and the long term relationships that they have built with banks should not be penalized by the capital rules punitive MSA capital treatment. B. Applying Capital Ratios to Riskless Assets The inclusion of riskless assets (such as cash and bank reserves place with the Federal Reserve) in the denominator of leverage ratios could feed systemic risk. This would be especially likely during times of financial market stress when banks receive significant inflows of deposits. During the recession of , U.S. banks saw an increase in deposits of more than $600 billion. A number of factors drive these inflows. Among the most significant is the liquidation by customers of investment positions outside of the bank as they reassess their view of the financial markets and seek to reduce perceived risks, for example by adjusting their investment 3

5 allocations out of stocks or real estate. Investors then place the resulting cash on deposit with their bank, increasing the bank s balance sheet. Recognizing that these are sudden, temporary increases in deposit balances, banks tend to position these funds in very liquid assets as part of a sound liquidity risk management strategy. Depending upon the bank s business model, these inflows may be invested in short-term Treasury securities, held in cash, or placed with the Federal Reserve. Such flight to safety inflows are not driven by bank efforts to increase its portfolio and, indeed, are caused by factors outside the bank s control. This inflow of deposits caused few concerns in the past, since the risk-based capital framework has assigned a zero percent risk-weight to cash, or short-term Treasuries, or reserves at the Federal Reserve. This zero percent risk-weight is appropriate, because these assets do not present the risk of loss that capital is intended to offset. Leverage ratios in their current regulatory design, however, penalize banks that receive significant inflows of deposits, because such deposits, whether held in vault cash, or converted into short-term Treasuries, or placed as reserves at the Federal Reserve, would be included in total leverage exposure. Where customers deposit large sums, the increase in funds could materially weaken the leverage ratios at the bank. This erosion of capital as measured by the leverage ratios could result in substantial adverse and unnecessary consequences for investors and for the bank, such as dividend and other capital restrictions and negative market signals. Banking organizations could even be forced to turn away new customers or charge for deposits from customers to avoid further erosion of their capital position. C. Treatment of Subchapter S Corporation Banks The capital conservation buffer provisions of the Basel III capital rules seriously and inappropriately disadvantage some 2,000 U.S. community banks that have elected Subchapter S Corporation tax status (S Corp banks). Under the Subchapter S rules, shareholders are required to pay federal income taxes on a firm s profits proportionate to the shareholders ownership interest in the company regardless of whether profits are actually distributed to the shareholders. Generally, shareholders in S Corp banks are able to meet their tax obligations from distributions they receive from their S Corp bank. However, under the Basel III capital conservation buffer requirements, a bank may be limited or prohibited from making distributions if the bank s capital levels fall below the required capital buffer, even though the bank is profitable and prosperous enough to incur a tax liability. In such a case, the tax obligation would remain, forcing the bank s shareholders to pay taxes on income that they have not received. The possibility of that treatment places the S Corp bank at a competitive disadvantage to C Corp institutions in attracting investors. To illustrate the problem, assume that a bank has taxable income of $1,000,000, and its capital is below the conservation buffer limitation. Neither a C Corp nor an S Corp would be allowed to make distributions to shareholders, even though taxes would be due on the bank s income. If the bank is a C Corp, the bank would remit $340,000 to the U.S. government to pay its federal taxes. If the bank is an S Corp, the shareholders, rather than the bank, would be required to remit approximately the same $340,000 to the U.S. government to pay federal taxes. Because the capital conservation buffer rule does not allow distributions even for the purpose of paying federal income tax the S Corp shareholders would be forced to pay these taxes out of their own 4

6 resources out of income that they never actually received; had they been C Corp investors they would have no such tax liability. The above example demonstrates that, effectively, a distribution is allowed to be made from the C Corp profits to meet tax obligations, but no similar tax payment is made by the S Corp. This result will create a powerful disincentive for investment in community banks that have elected Subchapter S status, critically harming the capitalization and growth of S Corp community banks, especially in times of economic stress, and frustrating the purpose of Congress in creating the S Corp category to stimulate investment in small businesses. This rule also undermines safety and soundness purposes. The same shareholders that are required to pay taxes on income not received are the shareholders that will likely be called upon to provide the additional capital to boost the capital conservation buffer of the bank. In effect, the existing investors will be asked to add to the capital of the bank and increase their uncovered tax liability. It is not hard to see the difficulty in persuading such investors. D. Treatment of Accumulated Other Comprehensive Income (AOCI) Under the final Basel III rule, banks subject to the Advanced Approaches risk-based capital standards (Advanced Approaches banks) are required to flow through to CET1 all unrealized gains and losses from a banking organization s available for sale (AFS) portfolio. Including unrealized gains and losses in capital introduces purposeless volatility into the capital calculation, unrelated to the actual condition of the bank. It also undermines prudent risk management by penalizing Advance Approaches banks for holding high-quality liquid assets, in disharmony with applicable liquidity rules. By that same process, this volatility in the bank s capital account adds volatility to the broader economy, to some degree subduing the important role that banks play in moderating the ups and downs of the business cycle. Volatility in a bank s capital account, unrelated to the bank s performance, introduces volatility into the bank s provision of financial services. This is not imagined. In recent quarters, AOCI has introduced irrelevant penalties and bonuses into bank capital measurements, penalized by $39.5 billion in fourth quarter 2016, by $3.7 billion in the third quarter, while gaining $10 billion in a capital bonus from AOCI in the second quarter of 2016 all unrelated to the actual financial condition of the industry. This is not sound bank supervision. The debt securities generally held in AFS portfolios are highly liquid bonds, such as U.S. Treasuries, the sale value of which is primarily impacted by changes in interest rates. Therefore, in a rising rate environment, the value of those securities will decrease, creating a generally unrealized loss reflected in a bank s AFS portfolio that is likely only temporary in nature and will never be realized if a bank holds the securities to maturity. In a declining rate environment, bank capital accounts will be artificially boosted by the AOCI calculation. To take into account the volatility introduced into capital calculations, Advanced Approaches banks now hold volatility buffers above any set regulatory capital levels. 5

7 E. Trust Preferred Securities: Basel Rules Frustrate Congressional Intent Smaller banking organizations historically have had more difficulty than their larger counterparts in accessing markets through the issuance of capital instruments. Trust Preferred Securities (TruPS) collateralized debt obligations (CDOs) provided a means for smaller banking organizations (by issuing TruPS that were pooled into CDOs) to access capital/debt markets. In practice, TruPS could absorb losses when an individual bank was in difficulty, but they tended to generate losses when the market as a whole was in decline. For those reasons, the Dodd-Frank Act ended the recognition of TruPS for capital purposes going forward, but through grandfathering for most banks allowed existing TruPS investments to phase out as they matured so as to avoid retroactive capital hits to community banks. Banking organizations can be issuers and/or investors of TruPS. On the issuing side, congressional action has eliminated TruPS as a permitted tier 1 capital instrument for banks above $15 billion in assets. Matching what is expressly permitted by the Dodd-Frank Act, for banks below $15 billion, the final Basel III rules grandfather these securities as tier 1 capital instruments. On the investing side, however, these same instruments are subject to the corresponding deduction method under the Basel III capital rules. The corresponding deduction method deducts TruPS exposures from regulatory capital if held in excess of 10 percent of CET1 or when the amount exceeds 15 percent when pooled with other types of exposures. Notably the Agencies have maintained the corresponding deduction method even though they have acknowledged the congressional intent of the Dodd-Frank Act was to maintain the status quo for the TruPS market, allowing them to phase out as they matured. In recent Volcker Rule guidance the Agencies expressly cite this congressional intent to provide relief for bank investors in TruPS instruments, and yet they fail to apply it in the capital rules for banks investing in TruPS, unnecessarily punishing the capital position of these banks. F. Capital Rules Have Become Unnecessarily Complex Most of the money in a modern economy is generated by means of the banking system, through the process of banks taking in deposits and making loans. Optimal capital levels support that process as a base of confidence and a platform from which to take a chance on borrowers. Sustained effort has resulted in more and better quality capital across the industry, capital levels that are at historic highs. Evaluating what is the optimal level of capital, however, has been clouded by regulatory capital rules that are in all cases excessively complex and in many cases a bad fit for the banks to which they are applied. Capital problems are transmitted through the banking system and their impact on the money supply generally and financial activity in particular. Facilitating regulatory supervision and bank management of capital should be a policy priority. Regulatory capital today is measured in too many ways for proficient bank supervision and management. Regulations pursuant to the 1988 the Basel Capital Accord (Basel I) contained two risk-based capital ratios, composed of two tiers of capital (Tier 1 and Tier 2). As part of the riskbased framework, the U.S. also maintained a GAAP based leverage ratio (a risk-blind measure) to address unknown or unpredictable risks. As a result, at the end of the Twentieth Century U.S. banks were subject to three regulatory capital ratios. Today there are at least eight regulatory 6

8 capital ratios applied in the United States, to which are added requirements for various minimums, buffers, and surcharges. Section 171 of the Dodd-Frank Act establishes a Basel I risk-based capital floor for banks operating under the Basel II models-based framework. These institutions must meet three riskbased capital ratios using Basel II methodologies as well as three risk-based capital ratios using Basel I methodologies. This duplicative work would be further complicated by the most recent round of Basel Committee proposals (Basel IV). The announced goal of these proposals is to simplify the Basel capital standards by establishing yet another series of risk-based capital ratios. For U.S. banks, as discussed in ABA s past comment letters, 3 this recent Basel Committee simplification effort has raised the possibility of internationally active U.S. banks being permanently subject to nine measures of risk-based capital, including two risk- based capital floors simultaneously, 4 besides the applicable leverage ratios. The complex capital program for the largest banks has corresponding excessive complexities for banks of all sizes and business models, be they regional, midsize, or community banks. II. Capital Ideas A. Mortgage Servicing Assets: End the Penalty on Banks We recommend that the MSA deduction threshold be increased from ten to at least twenty-five percent of CET1, and MSAs should be eliminated from the fifteen percent aggregate deduction. A twenty-five percent deduction, although still a significant restriction compared to previous capital treatment, would lessen the disruption to customers and the relationships that they have chosen to build with their bank. Moreover, for the portion of MSAs that are not deducted we believe the risk weight should be set at no higher than 100%. B. Applying Capital Ratios: Treat Riskless Assets as Riskless ABA recommends that the Agencies exclude riskless assets such as cash and reserves on deposit at the Federal Reserve entirely from total leverage ratio calculations, because these assets simply does not increase risk to the banks, the purpose for holding capital. Moreover, the capital framework should complement the liquidity framework, which requires banking organizations to hold robust liquidity reserves. 3 ABA comment letter to Agencies on Basel Standardized Proposal at optinginternationalstandards.pdf. 4 The first, which is applied as a result of provisions contained in the Dodd-Frank Act, has the current U.S. Standardized Approach acting as a floor to the Advanced Approaches risk-based capital standard. The second is potentially the Basel Committee s Revised Standardized Approach. 7

9 C. Subchapter S Corporation Banks: Redress the Penalty The Basel capital disadvantaged treatment of S Corp banks can be easily addressed by allowing S Corp banks to make distributions for the limited purpose of allowing shareholders to make tax payments on their share of the S Corp bank s undistributed income in an amount comparable to the effective tax rate for C Corps. Hence, an S Corp should be allowed to distribute an amount that is equal to the tax due on the S Corp s income, so that the investors in the S Corp are not placed at a disadvantage compared to C Corp investors. This would put the S Corp banks on the same footing as C Corp banks, as well as provide the same treatment for recapitalizing the bank, regardless of whether there is a restriction on dividend distributions. D. AOCI: Exclude Unrealized Gains and Losses for All Banks We recommend that the Basel III capital rules be amended so that unrealized gains and losses (AOCI) are not channeled through any banking organization s capital calculation, no matter the size of the institution. This would not change the treatment of realized gains and losses. E. Trust Preferred Securities: Follow Congressional Intent ABA recommends that the Agencies not subject existing TruPS held by banks to the Basel capital deduction. We believe the corresponding deduction fails to address effectively TruPS CDO investments held by a bank and violates congressional intent of the Dodd-Frank Act to grandfather the investments. F. Reduce Complexity, Focus on Supervisory and Bank Management Value We believe that there are too many versions of regulatory measurement of bank capital. There is no need to evaluate which, if any, have little value. Rather, we recommend that the Agencies, in consultation with industry and the public, identify which of the many regulatory capital ratios offer the most value, which are the most useful for supervisory and bank management purposes. Once identified, other measures should be discarded as distracting attention from the most valuable measures. This review should include consideration of the following, among other relevant concerns: Adequate Levels, High Quality One of the most significant achievements of the regulatory capital requirements developed in recent years has been the practical realization of adequate levels of high quality capital in practice. This achievement must be preserved. Community Banks Prominent attention needs to be focused on access to capital by community banks. The most significant attraction for investors is return on equity (RoE). For a prosperous banking industry, attractive RoE levels are essential. Unfortunately, recent RoE levels for community banks in particular have not recovered from the recession as policymakers and industry participants would hope and that the industry needs for its progress. Prudent measures to address this problem must receive priority attention. 8

10 Simplification Simplification should begin with reduction in the number of capital measurement regimes and streamlining methods of calculation. We observe with dismay that recent efforts at simplification by the Basel Committee actually threaten to add complexity. Simplification should also include application of modes of measuring capital appropriate to the size and business models of banks. The Role of Stress Testing Regulatory capital structure review should include recognition of the contribution and appropriate role of stress testing, including integration of stress testing and capital review as part of overall bank supervision rather than as separate and distinct exercises. Stress tests have the value, among others, of introducing dynamic risk evaluations into capital rules that, following Basel formulas, rely upon excessively static measures of risk. Risk Sensitivity Sound capital provisioning must not be risk blind. While risk evaluation is evolving and will always be a combination of art and science, it is far better than pretending in regulation that there are not significant differences in risk among assets. Appropriate requirements for leverage capital are an essential part of a risk-based system, covering model risks as well as risks that are unknown or unknowable; they should be balanced with and not overwhelm other capital measures of risk. Excessive reliance on leverage measures would be an irresponsibly blind approach to capital requirements. Capital calculations, for banks of all types and business plans, need to be compatible with and tailored to the scale of resources reasonably available for capital management. Enhanced Standardized Approach Option The excessive number of capital measurements can be relieved, in part, by offering the option of a more risk-sensitive version of the Standardized Approach in place of the Advanced Approaches. All large banks are already subject to the Standardize Approach. A version of the Standardized Approach with some additional risk sensitivity, combined with existing stress test programs (such as the Comprehensive Capital Analysis and Review), would make the Advanced Approaches redundant for either supervisory or management purposes for many of these banks. For more sophisticated banks, the basic Standardized Approach is not sufficiently risk-sensitive in its calculation of certain exposure classes to serve as the sole or primary methodology for calculating risk weights. In this context, our members have developed a proposal to enhance the risk-sensitivity and accuracy of the Standardized Approach for exposures to banks, securities firms, and corporates (to which a flat risk weight is currently applied, regardless of how credit worthy the obligor might be to other banks or corporate obligors). Under this proposal, which is summarized in the Annex 5 to this paper, a bank would calculate the risk weight of an exposure to a bank or corporate obligor under the Standardized Approach in three steps: 1. First, the bank would make an internal credit risk assessment to determine a base risk weight for the exposure, grounded on whether the exposure is Senior Investment Grade, Investment Grade, Other Exposures That Are Not In Default, or High Risk. 5 Annex A was first submitted as part of a comment letter to the Basel Committee. See 9

11 2. Second, in recognition of the effect on risk of the remaining maturity, the bank would make adjustments based on whether the exposure has a remaining maturity of less than one year, between one year and three years, between three years and five years, or five years or greater. 3. Third, in recognition of the effect on risk of seniority, the bank would introduce a recovery adjustment based on whether the exposure is a senior secured exposure, a senior unsecured exposure, another unsecured exposure, or a subordinated exposure. In addition, our proposal would apply a total risk weight minimum of 20 percent to every exposure to banks and corporates, notwithstanding any lower risk weight that would result based on the three steps above. After calculating the total risk weight based on the three steps above, subject to the 20 percent minimum, the bank would multiply the total risk weight by the amount of its exposure at default (EAD) to generate its risk-weighted assets for the exposure. As an example, suppose a bank made a 10-year senior secured loan of $10 million to a corporation that the bank determined to be Investment Grade based on its due diligence. The base risk weight of the exposure would be 50 percent, because the bank determined the corporation to be Investment Grade. The bank would then multiply that base risk weight by a maturity adjustment of 140 percent (because the exposure has a remaining maturity of 5 years or more), for a maturityadjusted risk weight of 70 percent. The bank would then multiply that maturity-adjusted risk weight by a recovery adjustment of 50 percent (because the loan is a senior secured loan), for a total risk weight of 35 percent. Finally, the bank would multiply the total risk weight of 35 percent by its EAD of $10 million for a total risk-weighted asset amount of $3.5 million. We believe that our proposal to offer such an Enhanced Standardize Approach option in place of Advanced Approaches would be a significant improvement in terms of risk-sensitivity but also in reducing excess complexity. Our proposal would recognize that banks are well suited to make their own assessments of credit risk by incorporating internal credit risk assessments into the base risk weight calculation. Our proposal would also recognize that an exposure s remaining maturity and seniority are significant drivers of risk by incorporating maturity and recovery adjustments. Importantly, those adjustments for maturity and seniority would be set by regulators under a lookup table, so that there is no scope for bank discretion or inconsistency in implementation. Our proposal would also have the virtue of simplicity, because it would include only three steps for risk-weighting, each of which would include distinct categories. In addition, the use of three steps with multiple categories of adjustment would result in highly granular outcomes. Moreover, our risk weight minimum of 20 percent would ensure that risk weights would never be lower than the lowest possible risk weight under the current Standardized Approach. In fact, risk weights under our proposal could in some instances be appropriately much higher than is possible under the current Standardized Approach. All of these benefits would be achieved while minimizing opportunities for unwarranted variability, thereby ensuring improved comparability. We recognize that this proposal may not have immediate application for all banks. Some banks may prefer to retain application of the Advanced Approaches. And some banks have so much capital that greater risk sensitivity provided by our proposal would not justify the cost of implementation. As a result, we recommend that our proposal be adopted into the Standardized Approach as an option for all banks. 10

12 Annex 11

13 Enhanced Standardized Approach Improve risk sensitivity of standardized risk weights while maintaining simplicity 1. The risk sensitivity of standardized approach must be improved Without improvements, there will be significant increases in capital requirements that are both unjustified by the risk, and inconsistent with the G-20 stated target that there should be no such increase. The basic standardized approach does not have sufficient granularity or differentiation of credit quality to be a replacement for the Advanced Approaches. 2. Banks should be able to use internal assessments of credit risk to determine base risk weights Banks are good at rank ordering the likelihood of default, therefore internal credit risk assessments should be incorporated The Dodd-Frank Act prohibits the use of external ratings putting US banks and corporates at a competitive disadvantage to EU 3. Introduce a Recovery adjustment to recognize lower credit losses from exposures with higher recovery rates In the event of a default the magnitude of credit risk losses depends on the recovery rate There are a number of risk drivers that influence the recovery rate, including seniority, security, region and industry. Banks model these drivers in the Advanced Approaches but there are sufficient data to incorporate a simple recovery adjustment in the Standardized Approach 4. Introduce a Maturity adjustment to recognize the lower risk of short term credit exposures Without a suitable maturity adjustment, capital will be overstated for short term transactions and understated for long term transactions 5. Apply a risk weight floor of 20% American Bankers Association 12

14 Enhanced Standardized Approach Determine risk-weights using internal credit risk assessments Recognize the lower credit risk of short term exposures through a Maturity adjustment Multiplier Senior Investment Grade Investment Grade Other Exposures that are not in default High Risk Base RW n/a 20% 50% 100% 150% Senior Investment Grade Investment Grade Other Exposures that are not in default High Risk Exposures < 1 Year 60% 12% 30% 60% 90% Exposures > 1 Year < 3 Years 75% 15% 38% 75% 113% STEP 1: Calculate base risk weight STEP 2: Apply the Maturity multiplier [50% RW * 140% for 10y exposure = 70%] Exposures > 3 Years < 5 Years 100% 20% 50% 100% 150% Recognize the lower credit losses from exposures with higher recovery rates through a Recovery adjustment Exposure > 5 Years 140% 28% 70% 140% 210% Senior Investment Grade Investment Grade Other Exposures that are not in default High Risk Senior Secured Loans* 50% 10% 25% 50% 75% Senior Unsecured Exposures 85% 17% 42% 85% 128% Other Unsecured Exposures 100% 20% 50% 100% 150% Subordinated Exposures 150% 30% 75% 150% 225% STEP 3: Apply the Recovery adjustment [70% * 50% for senior secured = 35%] STEP 4: Apply risk weight to EAD to determine RWAs * And other senior secured exposures ranking pari-passu American Bankers Association 13