Capital in the Capitol: The New U.S. Regulatory Capital Framework August 7, 2013 Presented By Augus Oliver I. Ireland Morrison & Foerster LLP

Transcription

1 2013 Morrison & Foerster LLP All Rights Reserved mofo.com Capital in the Capitol: The New U.S. Regulatory Capital Framework August 7, 2013 Presented By Augus Oliver I. Ireland Morrison & Foerster LLP

2 Introduction On July 9, 2013, the Federal banking agencies (the OCC, Federal Reserve Board and FDIC) (the Agencies ) formally adopted final regulations ( Final Rules ) that establish a new regulatory capital framework for U.S. banking organizations. The new framework in large part will implement the international regulatory capital framework ( Basel III ) developed by the Basel Committee on Banking Supervision ( Basel Committee ). 2

3 Introduction The Final Rules have three major elements Application of the Basel III minimum capital requirements and components of required capital to almost all U.S. banking organizations. Application of a variation of the Basel II/III Standardized Approach for credit risk weightings to almost all U.S. banking organizations. Changes to the Basel III Advanced Approaches framework that applies to large U.S. banking organizations. The Final Rules adopt, in large part, changes to the U.S. regulatory capital regulations that were proposed by the Agencies in June 2012 ( Proposed Rules ), with some accommodations primarily to the concerns of smaller banking organizations that were expressed in the comments to the Proposed Rules. 3

4 Today s Presentation The Agencies Final Rules Minimum capital requirements and the components of capital. The Standardized Approach requirements risk-weightings of on-balance and off-balance sheets assets, commitments and contingencies The Advanced Approaches requirements regulatory capital proposals affecting large, internationally active banking organizations. Disclosure requirements. Changes to the market risk capital rules Implementation and phase-in requirements 4

5 Today s Presentation Highlights of changes from the Proposed Rules Impact of the Final Rules: Nature and composition of capital ( numerator impact). Composition and costs of on- and off-balance sheet activities ( denominator impact). Impact on banking organization behaviors. 5

6 Minimum Capital Requirements Applicability: All U.S. banks that are subject to minimum capital requirements, including Federal and state savings banks. Bank and savings and loan holding companies other than small bank holding companies (generally bank holding companies with consolidated assets of less than $500 million). Top-tier domestic bank and savings and loan holding companies of foreign banking organizations. Excluded from coverage: Foreign banking organizations. (Temporarily) Savings and loan holding companies substantially engaged in insurance underwriting or commercial activities (change from Proposed Rules). 6

7 Minimum Capital Requirements Components of capital Tier 1 capital common equity Tier 1 capital and additional Tier 1 capital. Total Tier 1 capital, plus Tier 2 capital, would constitute total risk-based capital. Proposed criteria for common equity and additional Tier 1 capital instruments, and Tier 2 capital instruments, are broadly consistent with the Basel III criteria. Unchanged from Proposed Rules 7

8 Minimum Capital Requirements Common Equity Tier 1 ( CET 1 ) capital elements Common stock and related surplus net of treasury stock satisfying 13 criteria. Retained earnings. Accumulated other comprehensive income ( AOCI ). Qualifying common equity Tier 1 minority interest. CET 1 criteria are generally designed to assure that the capital is perpetual and is unconditionally available to absorb first losses on a going-concern basis, especially in times of financial stress. With exception of changes to AOCI treatment (see below), unchanged from Proposed Rules 8

9 Minimum Capital Requirements Additional Tier 1 capital elements Qualifying 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. The 13/14 criteria generally are designed to assure that the capital instrument can absorb going-concern losses and does not possess credit sensitive or other terms that would impair its availability in times of financial stress. Unchanged from Proposed Rules 9

10 Minimum Capital Requirements Tier 2 capital 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 (Advanced approaches bank may include excess of eligible credit reserves over total expected credit losses not to exceed 0.6 percent of its total credit RWA). Qualifying TARP and Small Business Jobs Act preferred securities that previously were included in Tier 2 capital. Tier 2 capital elements are designed to assure adequate subordination and stability of availability. Unchanged from Proposed Rules 10

11 Minimum Capital Requirements Significant exclusions from Tier 1 capital Non-cumulative perpetual preferred stock, which presently qualifies as simple Tier 1 capital, would not qualify as CET 1 capital, but would qualify as additional 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. Trust preferred securities and cumulative perpetual preferred stock issued by depository institution holding companies with less than $15 billion in total consolidated assets as of December 31, 2009, and banking organizations that were mutual holding companies as of May 19, 2010, are permanently grandfathered and may be included in Tier 1 capital, subject to certain limits (change from Proposed Rules). 11

12 Minimum Capital Requirements Regulatory capital adjustments CET 1 Accumulated net gains/losses on specified cash flow hedges included in AOCI. Unrealized gains and losses on AFS securities. Unrealized gains on AFS securities includable in Tier 2 would be eliminated. Unrealized gains and losses resulting from changes in banking organization creditworthiness. Change from Proposed Rules: non-advanced Approaches banking organizations are permitted to elect a one-time opt out (at the time March 31, 2015 call report or FR Y-9C is filed) not to include most AOCI components in CET1 regulatory capital adjustments. 12

13 Minimum Capital Requirements Deductions from CET 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 ( DTAs ). 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% CET 1 capital thresholds (certain DTAs, MSAs, significant unconsolidated FI common stock investments). 13

14 Minimum Capital Requirements Deductions from Tier1/Tier 2 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). Note Final Rules narrow the definition of financial institution The corresponding deduction approach. Volcker Rule covered fund investments (from Tier 1) (when Volcker Rule regulatory capital requirements are final). Insurance underwriting subsidiaries. 14

15 Minimum Capital Requirements Treatment of minority interests Limits on type and amount of qualifying minority interests that can be included in Tier 1 capital. Minority interests are classified as a CET 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 CET 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 are based on a computation generally based on the amount and distribution of capital of the consolidated subsidiary. 15

16 Minimum Capital Requirements New minimum capital requirements CET 1 capital ratio to standardized total risk-weighted 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 Approaches 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. CET 1 capital ratio is a new minimum requirement. These minimum capital ratios are unchanged from the Proposed Rules. 16

17 Minimum Capital Requirements Leverage requirement 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 on-balance 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). 17

18 Minimum Capital Requirements 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. 18

19 Minimum Capital Requirements 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. 19

20 Minimum Capital Requirements 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-bycase basis. 20

21 Minimum Capital Requirements 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 8% Tier 1 capital (up from current 6%). Adequately capitalized DIs 6% Tier 1 capital (up from current 4%). Adequately capitalized PCA category for advanced approaches banks includes a minimum 3% supplementary leverage ratio requirement. Revisions to the definition of tangible equity for critically undercapitalized DIs, and savings institutions. 21

22 Minimum Capital Requirements Effective dates/transitional periods numerator Minimum capital ratios Minimum CET 1, Tier 1 and total capital: January 1, 2015 for banks other than Advanced Approaches banks, and Advanced Approaches SLHCs; no phase-in. January 1, 2014 for Advanced Approaches banks with a one calendar year transition (4.0 percent CET1, 5.5 percent Tier 1, and 8.0 percent total capital during the calendar year 2014). Regulatory capital adjustments and deductions transitions begin as follows and generally end as of January 1, 2018 January 2015 for banks other than Advanced Approaches banks, and Advanced Approaches SLHCs. January 1, 2014 for Advanced Approaches banks. Note: goodwill deduction is fully effective in 2015 (banking institutions other than Advanced Approaches banks) or January 1, 2014 (Advanced Approaches banks); no phase-in period. 22

23 Minimum Capital Requirements Effective dates/transitional periods numerator Non-qualifying capital instruments: BHCs of $15 BB+ in assets January 1, BHCs under $15 BB and all DIs January 1, 2015 (but note grandfathering of TruPS and cumulative perpetual preferred stock). Capital conservation buffer (all banking organizations) and countercyclical capital buffer (Advanced Approaches banks), and related payout ratios are subject to a phase-in period. Transition begins January 1, 2016 and ends as of January 1, Supplemental leverage ratio for Advanced Approaches banks. January 1, 2018; calculation and reporting required beginning January 1, PCA changes: January 1, 2015; no phase-in. 23

24 Risk-Weighting Rules Introduction to the Standardized Approach Risk weights Credit risk mitigants Impact of the changes 24

25 Applicability All banking organizations. Effective date Standardized Approach January 1, 2015; there is no-phase-in for the new risk-weightings. Core features of the standardized approach Improved sensitivity to credit risk. Elimination of reliance on credit ratings. Behavior modification. Lessons learned from the financial crisis. Banks that are subject to the market risk capital rules also must compute their market risk-weighted assets in addition to their Standardized Approach risk-weighted assets. 25

26 Standardized Approach Risk weights 11 broad asset classes: Residential mortgages Commercial lending high volatility CRE loans Corporate exposures Off-balance sheet exposures OTC derivatives Cleared transactions Unsettled transactions Securitization exposures Equity exposures Sovereign, public sector entities ( PSEs ) and foreign bank exposures Other assets 26

27 Residential mortgages Standardized Approach The banking agencies had proposed to assign residential mortgage exposures to a range of risk weight categories (between 35 and 200 percent) based upon the loan-to-value (LTV) ratio of the mortgage and certain mortgage product features. This proposal drew extensive industry criticism, especially from community banks. The final rules do not include the previously-proposed risk weights and instead incorporate the risk weights for residential mortgages under the current general risk-based capital rules. The current rules assigns a risk weight of either 50 percent (for most first-lien exposures) or 100 percent for other residential mortgage exposures, and these risk-weights will be carried over into the new rules. Past-due loans >90 days: 100%. 27

28 Standardized Approach Commercial lending Current 100% default weight still applies. High volatility commercial real estate loans ( HVCRE ), including ADC loans 150%. ADC loans that are not treated as HVCRE loans: LTV ratio is less than or equal to the applicable maximum LTV in banking agencies real estate lending standards. 15+% equity (cash or liquid assets) contribution by borrower. Borrower equity contribution precedes facility advances and is contractually required to remain during project lifespan. ADC loans do not include loans to finance 1 to 4-family residential properties, to facilitate qualified community development projects, or are secured by agricultural land. Past-due loans: 150% of unsecured/unguaranteed portion. 28

29 Standardized Approach Corporate exposures 100% risk-weight. Now includes exposures to securities firms (up from 20% riskweighting in current regulatory capital rules). Essentially a default category exposure where the corporate exposure does not fall into another category. 29

30 Standardized Approach Off-balance sheet exposures 0% only unconditionally cancelable commitments. [10% eliminated] 20% short-term commitments of less than one year original maturity and trade-related contingent claims; no change from current rules. 50% long-term commitments and transaction-related contingent claims; no change from current rules. 100% guarantees, repos, securities borrowing and lending transactions, financial stability letters of credit, forward agreements; no change from current rules. 30

31 Standardized Approach OTC derivatives Capital impact depends on measurement of exposure. Single contracts. Current credit exposure plus probability of future exposure (no change from current rules). Multiple contracts subject to qualifying master netting agreement. Qualifying agreements. Exposure calculation. Risk weight is a function of the counterparty s credit risk. Conversion to on-balance sheet amount: 50% conversion cap under the current rules has been eliminated. 31

32 Standardized Approach Cleared transactions Exposure. Bank as clearing member. Bank as clearing member client. Risk weights qualifying central clearing party ( QCCP ). QCCP must be designated FMU. Clearing member: 2% versus 100% Clearing member client: 2-4% versus 100%. Formula calculation. Default fund contributions. Non QCCP exposures 1,250%. 32

33 Standardized Approach Unsettled transactions Risk of delayed settlement or delivery. Exemptions. DvP (securities/commodities) and PvP (forex) transactions. Normal settlement is market standard for that instrument and 5 or fewer business days. Extended settlement periods are subject to significant riskweightings. Non-DvP/PvP transactions: counterparty deliverables are riskweighted even within the normal settlement period. After that 1,250%. 33

34 Standardized Approach Securitization exposures Definitional and operational requirements. Due diligence. Calculation of exposures. Risk-weighting alternatives. Simplified Supervisory Formula Approach ( SSFA ). Gross-Up Approach (not available to banks that are subject to the market risk capital rules). Other. Treatment of gain-on-sale. 20% minimum risk-weighting; 1,250% maximum. 34

35 Standardized Approach Equity exposures unconsolidated entities Current rule 100% risk-weight. New rules: 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. 35

36 Standardized Approach Sovereign, public sector entity ( PSE ) and foreign bank exposures Current rule OECD membership-driven. New rules OECD country risk classification ( CRC ) Risk weights range from 0% to 100% for sovereigns. 20% to 100% for PSEs and foreign banks. Sovereign crises 150% Country default. CRC downgrade. OECD member countries without a CRC rating will receive a risk weight of zero while non-member countries without a CRC rating will receive a risk weight of 100 percent. 36

37 Standardized Approach Other assets Cash 0% risk-weight. 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 nonrealizable NOL carrybacks. MSAs 250% if not deducted from capital. Any asset not otherwise assigned a risk-weight 100%. 37

38 Standardized Approach Credit risk mitigants Government guarantees of residential mortgages. Guarantees and credit derivatives wider range of eligible instruments. Issuers. Terms. Two approaches. Substitution approach (this is the treatment of guarantees under the current capital rules). Maturity mismatch haircut approach. Collateral two approaches. Simple approach (this is the treatment of collateral under the current capital rules). Collateral haircut approach allowed for certain exposures. 38

39 Standardized Approach Impact All asset classes affected. Dodd-Frank Act impact Standardized Approach does not allow reliance on credit rating references, as required by Dodd-Frank Act section 939A. The new U.S. standard is investment grade, which is a more qualitative approach. To be investment grade, a counterparty or reference entity must have: adequate capacity to meet financial commitments for the projected life of the asset or exposure; adequate capacity means risk of default is low and the full and timely repayment of principal and interest is expected. 39

40 Standardized Approach Denominator impact of Dodd-Frank Act section 939A requirement is broad. Basel II ratings-based approach and internal assessment approaches for securitization exposures are removed. Sovereign, residential mortgage and debt exposures affected. Impact on eligible guarantees and guarantors, credit derivatives and credit risk mitigants. Affects potential future exposure of OTC derivatives for purposes of on-balance sheet credit conversion. 40

41 Disclosure Requirements Applicability Top-tier banks with more than $50 billion in consolidated assets but not subject to Advanced Approaches. Advanced Approaches banks are subject to more detailed disclosure requirements. Disclosure elements qualitative and quantitative Scope Capital Risk exposures Risk assessments Capital adequacy 41

42 Disclosure Requirements Formal disclosure policy is required Must address internal controls and procedures. Board of directors and senior management are responsible. Quarterly disclosure is the core requirement Disclosure templates are provided. Location(s) of disclosures May be provided on in one place (bank web site) or in more than one financial reports (with public summary table). Treatment of nonpublic information Information exempt under Freedom of Information Act need not be specifically disclosed. Effective date: January 1, 2015 (2014 for Advanced Approaches banks). 42

43 Applicability and coverage: Advanced Approaches Applies to banking organizations that are subject to the Basel II Advanced Approaches rules as implemented in the U.S. Consolidated total assets of $250 billion or more; or Consolidated total on-balance sheet foreign exposure of $10 billion or more. Covers banking organizations that meet size thresholds, and covered savings institutions 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. Effective date: January 1, 2014; no phase-in period. 43

44 Advanced Approaches Counterparty credit risk Changes 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. 44

45 Advanced Approaches Counterparty credit risk (cont.) Additional capital requirement for credit value adjustments relating to OTC derivatives exposures. Changes the capital requirements for qualifying and other central counterparty ( CCP ) exposures, including capital calculations for CCP default fund contributions. Requires 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. 45

46 Advanced Approaches Removal of credit rating references Consistent with section 939A of the Dodd-Frank Act and the Standardized Approach rules, the Advanced Approaches rule removes references to credit ratings that currently exist in the current Advanced Approaches rules and replaces these references with alternative standards of creditworthiness. 46

47 Advanced Approaches Changes to securitization exposures: New definition of resecuritization exposures. Broadening of the definition of securitization exposures, while excluding certain traditional investment firms from definition. Resecuritization definition to capture exposures to securitizations that are comprised of asset-backed securities (e.g., CDOs and some ABCP conduits). Removal of ratings-based and internal assessment approaches for securitization exposures; new hierarchy for exposure treatment. General use of supervisory formula approach ( SFA ) or simplified SSFA in calculating capital requirements for securitization exposures, as well as guarantees and credit derivatives referencing such exposures. 47

48 Advanced Approaches Capital treatment of certain exposures certain securitization exposures (CEIOs, high-risk exposures, low-rated exposures). eligible credit reserves shortfall. certain failed capital markets transactions. new treatment 1,250 percent risk-weighting instead of deduction from capital. Risk-weighted assets calculated under the Advanced Approaches rules must exclude covered positions that are subject to the market risk capital rules. Note: As of January 1, 2015, Advanced Approaches banks must calculate capital ratios under both the Standardized and the Advanced Approaches. 48

49 Market Risk Rule Changes Essentially add on amendments to changes in the market risk rule adopted in August Changes include: Making federal and state savings banks and their holding companies that meet the market risk capital rule threshold subject to the market risk rule. Includes any savings association or covered SLHC whose trading activity (the gross sum of its trading assets and trading liabilities) is equal to 10 percent or more of its total assets or $1 billion or more. Applies as of January 1, Other conforming and technical changes. 49

50 Impact of New Rules The overall impact of the regulatory capital rules 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 new capital rules. 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. 50

51 Impact of New Rules The changes in risk weightings and deductions from capital under the Standardized Approach will have an impact on the credit markets, although it is too early to predict the magnitude of this impact. Residential mortgages: preservation of existing risk-weightings under the current rules will avoid possible negative impact of the changes that were previously proposed. 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. 51

52 Impact of New Rules There also will be operational challenges for many banking organizations, especially smaller banks in the implementation of the new requirements. Risk-weightings under the Standardized Approach are materially more dynamic: for more 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. 52

53 Impact of New Rules What about the regulatory compliance risks? First of all, what are they? Under the Standardized Approach, there may be an increased risk of getting the risk-based calculations wrong. If that happens, overstatements of regulatory capital, call report (and maybe SEC report) misstatements and possible PCA downgrades are a possibility. Relief provided for AOCI opt-out (numerator) and residential mortgages (denominator) will have a mitigating impact. Does a failure to have in place an adequate capital calculation and compliance infrastructure become an internal controls or a safety-and-soundness issue? 53

54 Questions and Answers Concluding Remarks dc