How much Capital is Enough? Understanding the Proposed Capital Rules

Transcription

1 2012 Morrison & Foerster LLP All Rights Reserved mofo.com How much Capital is Enough? Understanding the Proposed Capital Rules August 1, 2012 Dwight Smith, Morrison & Foerster LLP

2 Introduction On June 12, 2012, the Federal banking agencies (the OCC, Federal Reserve Board and FDIC) (the Agencies ) formally proposed three sets of significant changes to the U.S. regulatory capital framework: The Basel III Proposal The Standardized Approach Proposal The Advanced Approaches Proposal Deadline for comments on all three proposals is Sept. 7, This deadline may be extended, but probably not for any extended period of time. This is MoFo. 2

3 Introduction Status Comment deadline: Sept. 7, Intended completion: Dec. 31, Application of Basel III and Standardized Approach All bank and thrift depositories subject to minimum capital requirements All bank and thrift holding companies Exemption for bank holding companies <$500 million in consolidated assets Top-tier U.S. holding company in FBO structure This is MoFo. 3

4 Introduction Structure of regulatory capital rules Capital components Risk adjusted assets Ratios Purpose Better loss absorption on a going-concern basis Behavior modification Legal Foundations Commitment to Basel III Collins Amendment New explicit authority to impose capital requirements This is MoFo. 4

5 Capital Components This is MoFo. 5

6 Capital Components Common equity Tier 1 Additional Tier 1 Tier 2 This is MoFo. 6

7 Capital Components Common Equity Tier 1 Loss absorption Capital is perpetual and unconditionally available to absorb first losses on a going-concern basis. Elements Common stock and related surplus net of treasury stock Must satisfy 13 criteria Retained earnings Accumulated other comprehensive income ( AOCI ) Qualifying common equity Tier 1 minority interest Bear in mind certain adjustments will be necessary. This is MoFo. 7

8 Capital Components Additional Tier 1 Loss Absorption Capacity to absorb losses on a going-concern basis. Elements: Capital instruments (and related surplus) that satisfy 13 separate criteria (14 for advanced approaches banking organizations) Tier 1 minority interests that are not included in a banking organization s common equity Tier 1 capital Qualifying TARP and Small Business Jobs Act preferred securities that previously were included in Tier 1 capital Non-cumulative perpetual preferred This is MoFo. 8

9 Capital Components Significant Exclusions from Tier 1 Capital Cumulative preferred stock would no longer qualify as Tier 1 capital of any kind. Certain hybrid capital instruments, including trust preferred securities, no longer will qualify as Tier 1 capital of any kind. This is MoFo. 9

10 Capital Components Tier 2 Loss Absorption Adequate subordination and stability of availability. Elements Qualifying instruments that satisfy 10 separate criteria (11 for advanced approaches banking organizations) Qualifying total capital minority interest not included in Tier 1 capital Allowance for loan and lease losses ( ALLL ) up to 1.25% of standardized total risk-weighted assets excluding ALLL Qualifying TARP and Small Business Jobs Act preferred securities that previously were included in Tier 2 capital This is MoFo. 10

11 Capital Components Deductions from common equity Tier 1 capital Goodwill, net of associated deferred tax liabilities ( DTLs ) Intangible assets other than mortgage servicing assets ( MSAs ), net of associated DTLs Deferred tax assets Securitization gain-on-sale Defined benefit plan assets (excluding those of depository institutions ( DIs )) Advanced approaches banks: expected credit losses exceeding eligible credit reserves Savings association impermissible activities Items subject to 10%/15% common equity Tier 1 capital thresholds (certain DTAs, MSAs, significant unconsolidated FI common stock investments) This is MoFo. 11

12 Capital Components Deductions from Tier1/Tier2 capital Direct and indirect investments in own capital instruments Reciprocal cross-holdings in financial institution capital instruments Direct, indirect and synthetic investments in unconsolidated financial institutions. Three basic types: Significant Tier 1 common stock investments Significant non-common-stock Tier 1 investments Non-significant investments (aggregate 10% ceiling) The corresponding deduction approach Volcker Rule covered fund investments (from Tier 1)(when Volcker Rule regulatory capital requirements are final) Insurance underwriting subsidiaries This is MoFo. 12

13 Capital Components Minority Interests Limits on type and amount of qualifying minority interests that can be included in Tier 1 capital. Minority interests would be classified as a common equity Tier 1, additional Tier 1, or total capital minority interest depending on the underlying capital instrument and on the type of subsidiary issuing such instrument. Qualifying common equity Tier 1 minority interests are limited to a depository institution ( DI ) or foreign bank that is a consolidated subsidiary of a banking organization. Limits on the amount of includable minority interest would be based on a computation generally based on the amount and distribution of capital of the consolidated subsidiary. This is MoFo. 13

14 Risk-Adjusted Assets This is MoFo. 14

15 Risk-Adjusted Assets Risk weights Credit risk mitigants This is MoFo. 15

16 Risk-Adjusted Assets Eleven broad asset classes Residential mortgages Commercial lending high volatility CRE loans Corporate exposures Off-balance sheet exposures OTC derivatives Cleared transactions This is MoFo. 16

17 Risk-Adjusted Assets Eleven broad asset classes Unsettled transactions Securitization exposures Equity exposures Sovereign, public sector entities ( PSEs ) and foreign bank exposures Other assets This is MoFo. 17

18 Risk-Adjusted Assets 1. Residential first mortgages Generally higher risk weights Category 1 (traditional) vs. Category 2 (non-traditional) Duration Regular periodic payments Underwriting requirements Limits on rate adjustments Income documented and verified Loan-to-value ratio This is MoFo. 18

19 Risk-Adjusted Assets 1. Residential first mortgages LTV Category 1 Category 2 <60% 35% 75% >60, < >80, < > This is MoFo. 19

20 Risk-Adjusted Assets 1. Residential mortgages Government supports continue to be recognized FHA/VA: 0% Fannie Mae/Freddie Mac: 20% Private mortgage insurance has limited effect Restructured or modified loans Mortgage-servicing assets Past-due loans This is MoFo. 20

21 Risk-Adjusted Assets 2. Commercial lending Current 100% default weight still applies High volatility CRE 150%, unless LTV equal to or less than maximum supervisory ratio typically 80%. Developer contributes up front capital of at least 15% of appraised as completed value. Capital remains in project through the life of the project. Financing of 1- to 4-family properties exempt from rule Past-due loans This is MoFo. 21

22 Risk-Adjusted Assets 3. Corporate exposures 100% Includes exposures to securities firms Essentially a default category exposure where the corporate exposure does not fall into another category This is MoFo. 22

23 Risk-Adjusted Assets 4. Off-balance sheet exposures 0% -- only unconditionally cancelable commitments [10% -- short-term ABCP facilities -- eliminated] 20% -- short-term commitments (and trade-related contingent claims) 50% -- no change (long-term commitments and transaction-related contingent claims) 100% -- repo-style transactions, in addition to guarantees, financial standby letters of credit, and forward agreements This is MoFo. 23

24 Risk-Adjusted Assets 5. OTC derivatives Risk weight is a function of counterparty s credit risk Current 50% cap is eliminated Capital impact depends on measurement of exposure current credit exposure plus probability of future exposure. Multiple contracts subject to qualifying master netting agreement Agreement must be enforceable in insolvency. This is MoFo. 24

25 Risk-Adjusted Assets 6. Cleared transactions Qualifying central clearing party ( QCCP ) QCCP must be designated FMU Only eight FMUs designated to date Clearing member: 2% (versus counterparty risk weight) Clearing member client: 2-4% (versus counterparty risk weight) Weight applied to trade exposure amount value plus any posted collateral that is not bankruptcy remote Default fund contributions This is MoFo. 25

26 Risk-Adjusted Assets 7. Unsettled transactions New asset class not addressed in current rules Risk of delayed settlement or delivery settlement outside the market standard Mutual performance DvP (securities/commodities) and PvP (forex) transactions Net exposure risk-weighted at 100% begins after 5 days Risk weight escalates, up to 1,250% after 45 days Unilateral performance After 1 day, counterparty risk weight After 5 days, 1,250% This is MoFo. 26

27 Risk-Adjusted Assets 8. Securitization exposures Due diligence Risk-weighting alternatives SSFA Gross-Up Approach Other ABCP liquidity facility; second-loss position to ABCP program Treatment of gain-on-sale 20% minimum risk-weighting This is MoFo. 27

28 Risk-Adjusted Assets 9. Equity exposures -- unconsolidated entities Current rule 100% Exposure baseline adjusted carrying value Simple risk weight approach for exposures to companies (but not investment funds) 0% to 600% Look-through approaches for investment fund exposures Full look-through Simple modified look-through Alternative modified look-through Hedged transactions Insurance exposures This is MoFo. 28

29 Risk-Adjusted Assets 10. Sovereign, PSE and foreign bank exposures Sovereign exposures Current rule OECD membership Proposal OECD country risk classification ( CRC ) Risk weights range from 0% to 150% PSE exposures CRC-based scale for general obligation bonds, from 20% to 150% CRC-based scale for revenue bonds, from 50% to 150% Foreign bank exposures CRC-based scale, from 20% to 150% This is MoFo. 29

30 Risk-Adjusted Assets 11. Other assets Cash 0% Own-vault gold bullion, and conditionally other-vault bullion 0% Certain cash-settled transactions with a CCP Items in process of collection 20% DTAs 100% for realizable NOL carrybacks, and 250% for non-realizable NOL carrybacks MSAs 250% if not deducted from capital Any asset not otherwise assigned a risk-weight 100% This is MoFo. 30

31 Risk-Adjusted Assets Credit risk mitigants Government guarantees of residential mortgages Guarantees and credit derivatives Protection providers now include investment-grade companies Terms: unconditional and uncancellable Certain adjustments for maturity and foreign currency mismatches Collateral Simple 20% minimum risk weight (with some exceptions) Collateral haircut allowed for certain exposures; assessment of market volatility of collateral This is MoFo. 31

32 Risk-Adjusted Assets Disclosures Banks with more than $50 billion in consolidated assets but not subject to advanced approaches Disclosure policy Quarterly disclosures Templates This is MoFo. 32

33 Capital Ratios This is MoFo. 33

34 Capital Ratios Minimum Capital Requirements (fully phased-in): Common equity Tier 1 capital ratio to standardized total riskweighted assets ( TRWA ) of 4.5 percent Tier 1 capital ratio to standardized TRWA of 6 percent Total capital ratio to standardized TRWA of 8 percent Tier 1 leverage ratio to average consolidated assets of 4 percent Advanced approach banking organizations must use lower of standardized TRWA or advanced approaches TRWA For advanced approaches banking organizations, a supplemental leverage ratio of Tier 1 capital to total leverage exposure of 3 percent. Common equity Tier 1 capital ratio is a new minimum requirement. This is MoFo. 34

35 Capital Ratios Leverage Requirement: Measured as a ratio of Tier 1 capital (minus required deductions) to average on-balance sheet assets for all U.S. banking organizations Supplementary Leverage Requirement: Applies only to advanced approaches banking organizations Ratio of Tier 1 capital (minus required deductions) to average onbalance sheet assets, plus certain off-balance sheet assets and exposures: Future exposure amounts arising under certain derivatives contracts 10% of notional amount of unconditionally cancelable commitments Notional amount of most other off-balance sheet exposures (excluding securities lending and borrowing, reverse repurchase agreement transactions, and unconditionally cancelable commitments). This is MoFo. 35

36 Capital Ratios Capital Conservation Buffer: A new phased-in capital conservation buffer for all banking organizations equal to a ratio to TRWA of 2.5% common equity Tier 1 capital Unrestricted payouts of capital distributions and discretionary bonus payments to executives and their functional equivalents would require full satisfaction of capital conservation buffer requirement. Maximum amount of restricted payouts would be the banking organization s eligible retained income times a specified payout ratio. These ratios would be established as a function of the amount of the banking organization s capital conservation buffer capital. This is MoFo. 36

37 Capital Ratios Countercyclical Capital Buffer: A macro-economic countercyclical capital buffer of up to 2.5% of common equity Tier 1 capital to TRWA applicable only to advanced approaches banking organizations. Countercyclical capital buffer, applied upon a joint determination by federal banking agencies, would augment the capital conservation buffer. Unrestricted payouts of capital and discretionary bonuses would require full satisfaction of countercyclical capital buffer as well as capital conservation buffer. This is MoFo. 37

38 Capital Ratios Supervisory Assessment of Capital Adequacy Banking organizations must maintain capital commensurate with the level and nature of all risks to which the banking organization is exposed General authority for regulatory approval, on a joint consultation basis, of other Tier 1 or Tier 2 instruments on a temporary or permanent basis The regulators also can invalidate/modify capital instruments and risk-weighting charges on a case-by case basis. This is MoFo. 38

39 Capital Ratios Changes to Prompt Corrective Action ( PCA ) Rules: PCA regulations changed to assure consistency with the new regulatory capital requirements. PCA capital categories would include a separate requirement for minimum common equity Tier 1 capital for top 4 PCA categories (6.5%/4.5%/<4.5%/<3%). Well-capitalized DIs would have to have at least 8% Tier 1 capital (up from current 6%), and adequately capitalized DIs 6% Tier 1 capital (up from current 4%). Adequately capitalized PCA category for advanced approaches banks would include a minimum 3% supplementary leverage ratio requirement. Revisions to the definition of tangible equity for critically undercapitalized DIs, and HOLA/savings institutions. This is MoFo. 39

40 Effective Dates This is MoFo. 40

41 Dates Components of Capital Adjustments and deductions: Non-qualifying capital instruments BHCs of $15 BB+ in assets: BHCs under $15BB and all depositories: Risk-Adjusted Assets All new risk weights are effective Jan. 1, 2015 Capital Ratios Minimum Tier 1 capital ratios: Minimum total capital: no change and therefore no phase-in Capital buffers, and related payout ratios: This is MoFo. 41

42 Advanced Approaches Proposal This is MoFo. 42

43 Advanced Approaches Proposal Applicability and Coverage: Applies to banking organizations that are subject to the advanced approaches rule under Basel II, including qualifying Federal and state savings associations and their holding companies Addresses counterparty credit risk, removal of credit rating references, securitization exposures, changes in treatment of certain exposures previously subject to deduction, and conforming technical changes Proposes to expand those banking organizations that are subject to the market risk capital rule to include savings institutions and their holding companies Proposed Effective Date: None specified This is MoFo. 43

44 Advanced Approaches Proposal Counterparty Credit Risk. Changes proposed include: Revisions to the recognition of eligible financial collateral Lengthening the assumed holding periods and the calculation of certain collateralized OTC exposures under the collateral haircut and simple Value-at-Risk (VaR) approaches Increasing capital requirements associated with the internal models methodology Better identification and management of wrong-way risk associated with certain counterparty exposures This is MoFo. 44

45 Advanced Approaches Proposal Counterparty Credit Risk Changes (cont.): Additional capital requirement for credit value adjustments relating to OTC derivatives exposures Changing the capital requirements for qualifying and other central counterparty ( CCP ) exposures, including capital calculations for CCP default fund contributions Requiring application of a continuous 12-month stress period in calculating market price and foreign volatility exposures under the collateral haircut method, based on internal estimates This is MoFo. 45

46 Advanced Approaches Proposal Removal of Credit Rating References: Consistent with section 939A of the Dodd-Frank Act, the Advanced Approaches Proposal would remove references to credit ratings that currently exist in the advanced approaches capital rules and replace these references with alternative standards of creditworthiness. Affects, among other things, treatment of guarantors, OTC derivatives exposures, money market fund exposures, operational risk mitigants and securitization exposures This action is also consistent with removal of credit rating references in the Standardized Approach Proposal. This is MoFo. 46

47 Advanced Approaches Proposal Changes to Securitization Exposures: Proposed new definition of resecuritization exposures Proposed broadening of the definition of securitization exposures, while excluding certain traditional investment firms from definition Resecuritization definition would capture exposures to securitizations that are comprised of asset-backed securities (e.g., CDOs and some ABCP conduits) and which are now subject to higher risk-weightings under the 2009 changes to Basel II. Removal of ratings-based and internal assessment approaches for securitization exposures; new hierarchy for exposure treatment General use of supervisory formula approach ( SFA ) or its simplified version ( SSFA ) in calculating capital requirements for securitization exposures, as well as guarantees and credit derivatives referencing such exposures This is MoFo. 47

48 Advanced Approaches Proposal Revised Capital Treatment of Certain Exposures Exposures affected: certain securitization exposures (CEIOs, high-risk exposures, low-rated exposures); eligible credit reserves shortfall; certain failed capital markets transactions New treatment assigned a general 1,250 percent risk-weighting instead of deduction from capital Market Risk Capital Rule: Federal and state savings banks and their holding companies that meet the market risk capital rule threshold criteria would become subject to the rule. This is MoFo. 48

49 Impact This is MoFo. 49

50 Impact The overall impact of the regulatory capital proposals on the banking sector will vary depending on the size and characteristics of the banking organization. Most U.S. banks are liquid and have excess capital positions, even factoring in the possible impact of the Basel III and Standardized Approach Proposals. Changes in capital structure and planning will be needed. Banks already are selectively redeeming or repurchasing TruPS. Full impact on creative variations of Tier 1 capital (mostly additional Tier 1 capital) remain to be seen. Capital-raising may be more of a challenge for community banks. This is MoFo. 50

51 Impact The changes in risk weightings and deductions from capital under the Standardized Approach Proposal will have an impact on the credit markets, although it is too early to predict the magnitude of this impact. Residential mortgages: Category 1 and 2 markers and LTV benchmarks will create disincentives for certain loan products. Securitizations: impact will be a function of capital costs of directly owning assets versus an exposure to a securitized portfolio. MSAs and other deductions from capital will influence balance sheet management behaviors. Some commercial real estate loans will become more expensive to hold. This is MoFo. 51

52 Impact There also will be operational challenges for many banking organizations, especially smaller banks in the implementation of the these proposals Risk-weightings under the Standardized Approach Proposal are materially more dynamic: for many risk-weightings, there is no set it and forget it. Nonaccrual status, loan restructurings, failed settlements and sovereign downgrades are just some of the events that may trigger risk-weighting recalculations. Banking organizations therefore will need to actively manage their balance sheets for regulatory capital purposes. The development and implementation of data processing and information systems could prove to be a substantial and expensive challenge. This is MoFo. 52

53 Contact Dwight Smith Morrison & Foerster LLP This is MoFo. 53