Financial Services and Products ADVISORY

Transcription

1 Financial Services and Products ADVISORY Supervisory Capital Assessment Program Results And Their Meaning for Other Financial Institutions May 11, 2009 The results of the Supervisory Capital Assessment Program (SCAP) were released on Thursday, May 7, 2009, by the Board of Governors of the Federal Reserve System ( Federal Reserve ), in connection with the U.S. Treasury Department ( Treasury ), the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC). 1 Each of the agencies involved in the SCAP emphasized that the examination of the 19 largest banking organizations was not a test of their respective solvency but, rather, a method of determining whether and to what extent a capital buffer would be needed for these organizations to (i) remain sufficiently capitalized and (ii) continue lending, should economic conditions prove worse than expected through the end of The stress test that is part of SCAP, and the responses to the stress test results, hold important lessons for all banking organizations, their shareholders and prospective investors. The test may serve as a model for the capital adequacy assessments that all banking institutions and their regulators will have to make over the coming months. The responses of the 19 banking firms are instructive as well: those that will obtain additional capital have developed or are likely to develop plans that include no government assistance, and many of those not raising additional capital intend to repurchase the outstanding senior preferred stock that Treasury already holds. 2 Background Leading up to the release of the results, the Federal Reserve released The Supervisory Capital Assessment Program: Design and Implementation on April 24, 2009 ( Report ), and a Joint Statement with Treasury, FDIC and OCC on May 6, 2009 ( Joint Statement ). Both the Report and Joint Statement described in general terms the nature of the SCAP, commonly referred to as the stress tests, applied to the organizations. The concept of the SCAP was first announced on February 10, as part of the Treasury Department s Capital Assistance Plan (CAP), which was designed as a supplement to Treasury s Capital Purchase Plan (CPP). The CAP will provide additional Treasury investments to banking institutions that may need additional capital in order to continue lending. Treasury has not yet made any investments under CAP and, with respect to the 19 largest firms, would not likely make investments under CAP until November. 1 2 Available at The relationship between SCAP and repurchases of senior preferred stock previously sold to Treasury is an important one; we discuss repurchases in a companion advisory also released today, Repurchases of Senior Preferred Stock Held by Treasury: A Critical Decision for CPP Participants. This advisory is published by Alston & Bird LLP to provide a summary of significant developments to our clients and friends. It is intended to be informational and does not constitute legal advice regarding any specific situation. This material may also be considered attorney advertising under court rules of certain jurisdictions.

2 According to the Report, the SCAP was intended to determine whether any of the 19 banking organizations need an additional capital buffer. This SCAP capital buffer represents the additional capital that an organization might need to cover anticipated or possible future losses, yet remain sufficiently capitalized. Put another way, the buffer reflects the difference between the amount of capital left in a firm after expected future losses occur and the amount of capital deemed necessary for the firm to remain in sound condition. The Joint Statement specified that the goal of SCAP was to ensure that the 19 institutions could maintain a Tier 1 risk-based capital ratio of at least six percent and a Tier 1 Common risk-based ratio 3 of at least four percent at the end of 2010, even under adverse conditions. The Joint Statement also emphasized that the buffer was intended to increase market confidence in the banking organizations and that the agencies would focus on both the quantity and the quality of the banking organization s Tier 1 capital. The Report described in general terms the assumptions used in the stress tests, the information provided by the firms and the nature of the analysis: The test for each institution involved two assessments: the impact on capital based on a baseline scenario set of assumptions about the future performance of the U.S. economy and the impact based on an adverse scenario set of more pessimistic assumptions. The baseline scenario assumed a decline in real GDP in 2009 of two percent and an increase of 2.1 percent in 2010; civilian unemployment of 8.4 percent in 2009 and 8.8 percent in 2010; and a decrease in house prices of 14 percent in 2009 and four percent in The adverse scenario assumed a decline in real GDP in 2009 of 3.3 percent and an increase of 0.5 percent in 2010; civilian unemployment of 8.9 percent in 2009 and 10.3 percent in 2010; and a decrease in housing prices of 22 percent in 2009 and seven percent in The Joint Statement stated that any banking organization that, after the stress test results were analyzed, was determined to require additional capital would have until June 8 to develop a plan, to be approved by the organization s primary supervisor, in consultation with the FDIC, to obtain the necessary capital. The Joint Statement encouraged such organizations to seek non-governmental sources of capital. These and other private sources include new offerings of common stock, the restructuring of current capital instruments (e.g., conversion of privately held preferred stock into common stock), sales of business lines or assets privately or through the Public-Private Investment Program, use of joint ventures, spin-offs or other capital enhancing transactions, and conservation of internal capital generation through various methods, including dividend reductions or deferrals and retention of earnings. 3 Tier 1 Common capital is defined as Tier 1 capital less (i) qualifying perpetual preferred stock, (ii) qualifying minority interests in subsidiaries and (iii) qualifying trust preferred securities. Essentially, this Tier 1 Common risk-based ratio applies the expectation of regulators that common equity, or the organization s voting common stock, should be the dominant component of Tier 1 capital. See, e.g., 12 C.F.R. Part 225, Appendix A, 11.A.1.c.(3) (noting that, although other types of capital may be treated as Tier 1, voting common stockholders equity, which is the most desirable capital element from a supervisory standpoint, generally should be the dominant element within Tier 1 capital. ). Thus, this Tier 1 Common risk-based ratio is calculated using the risk-weighted asset denominator from a typical Tier 1 risk-based capital ratio with the organization s non-common stock components removed from the qualifying Tier 1 numerator. -2-

3 If these efforts do not succeed (and each organization has until November 9 to implement its capital plan), Treasury is prepared, under CAP, to make capital available for a bridge to future private capital. Treasury s CAP investment would take the form of Mandatory Convertible Preferred (MCP) in a presumptive amount up to two percent of risk-weighted assets, with more potentially available. According to the Joint Statement, the MCP is designed to serve as a source of contingent common capital for the firm and is convertible into common equity when and if needed to meet supervisory expectations regarding the amount and composition of capital. SCAP Results In order to determine the size of the appropriate capital buffer for each of the 19 firms, the agencies estimated each firm s losses on loans, securities and other assets and resources available to absorb those losses, such as earnings and reserve accounts, to determine the additional amount of capital the institution would need to meet the Tier 1 risk-based capital ratio and Tier 1 Common capital ratio described above. The assumptions used to calculate loss estimates resulted, in some cases, in loss rates in excess of those seen during the Great Depression. To arrive at the estimated losses, the 19 banking organizations were asked to estimate their potential losses on (i) loans, including forward-looking, undiscounted credit losses; (ii) securities, with specific focus on the inherent credit risk associated with their respective available-for-sale and held-to-maturity investment portfolios, the impairment of any securitized assets and any material exposures to corporate bonds, mutual funds and other asset-backed securities; (iii) and trading positions, including potential trading-related market and counterparty credit losses under a market stress scenario. The organizations ability to absorb these losses during 2009 and 2010 was estimated under the stress case scenario by evaluating the organization s pre-provision net revenue (net interest income, fees and other non-interest income, net of non-credit related expenses) and reserves already established during the fourth quarter of 2008, including the allowance for loan and lease losses. These estimates were then evaluated against independent benchmarks developed by supervisors to arrive at the estimated SCAP capital buffer. Under the adverse scenario, based on fourth quarter 2008 results, the 19 banking organizations would need to raise $185 billion in aggregate to reach the SCAP capital buffer target ratios. However, after the agencies took into account certain results and actions taken by the banking organizations in the first quarter of 2009, the supplemental capital needs were reduced to approximately $75 billion in aggregate. The majority of this amount must be in the form of Tier 1 Common capital. Examples of actions taken by the banking organizations during the first quarter of 2009 that reduced the amount of capital needed to be raised for the SCAP capital buffer included plans to convert certain preferred stock to common stock, the sale of business lines and other assets, the issuance of common shares, dividend reductions and increased earnings retention. -3-

4 Results differed across the 19 organizations, due in part to the specific level of detail provided with respect to a given organization s loan and credit risk profile, and ability to absorb projected losses through current and future reserves and profitability under the stress-case scenario. Specifically, Treasury and the Federal Reserve determined that 10 of the banking organizations should raise additional capital in the following amounts: Bank of America Corporation Citigroup, Inc. Fifth Third Bancorp GMAC LLC KeyCorp Morgan Stanley PNC Financial Services Group, Inc. Regions Financial Corporation SunTrust Banks, Inc. Wells Fargo & Company Total $33.9 billion $5.5 billion $1.1 billion $11.5 billion $1.8 billion $1.8 billion $600 million $2.5 billion $2.2 billion $13.7 billion $74.6 billion As noted above, each of these banking organizations will have 30 days to develop a plan to raise the needed capital. The planning process includes four elements: A detailed description of the actions to be taken to increase the quantity and quality of the organization s capital and establish the SCAP buffer. Such actions include the (i) issuance of new private capital instruments; (ii) restructuring current capital instruments; (iii) sales of business lines, assets or minority interests, both privately and through the Public-Private Investment Partnership; (iv) use of joint ventures, spin-offs or other capital enhancing transactions; and (v) internal capital generation that may include restrictions on or deferral of dividends and waivers and suspensions on preferred securities and trust preferred securities. Specifically, the organization s plan must be developed without reliance on potential near-term revenue increases to meet the capital buffer. A list of steps to address weaknesses in the firm s internal processes for assessing capital needs and engaging in effective capital planning. A review of existing management and the board, in order to assure that the leadership of the firm has sufficient expertise and ability to manage the risks presented by the current economic environment and maintain balance sheet capacity sufficient to continue prudent lending to meet the credit needs of the economy. An outline of the steps the firm will take over time to repay Treasury s CPP investment, Targeted Investment Program or the CAP investments, and to reduce reliance on guaranteed debt issued under the FDIC s Temporary Liquidity Guaranty Program. -4-

5 Preliminary responses from many of the 10 emphasized that they could reasonably look to non-governmental sources of additional capital. None the 10 suggested that additional Treasury investments would be necessary. Treasury and the Federal Reserve did not require additional capital for the other nine institutions American Express, Bank of New York Mellon, BB&T, Capital One, Goldman Sachs, JPMorgan Chase, MetLife, State Street and U.S. Bancorp but many of them recently have raised or have near-term plans to raise substantial amounts of additional capital. In addition to emphasizing financial health, the new private infusions will enhance the ability of these organizations to repay the senior preferred stock held by Treasury under the CPP, and thus exit most or all of the government assistance programs. A prerequisite for such repurchases is that each prospective repurchaser must issue five-year senior unsecured debt that is not guaranteed by the FDIC. The agencies have not specified a minimum amount of debt, but the Joint Statement observes that the amount must be sufficient to demonstrate a capacity to meet funding needs independent of government guarantees. Lessons for Other Banking Organizations The Report states that the SCAP buffer result for each institution does not represent a new capital standard and is not expected to be maintained on an ongoing basis. However, the concepts of a buffer and of the underlying stress test necessary to determine such a buffer are likely to inform pending and upcoming reviews of the capital adequacy of many banks outside the top 19. Of course, capital adequacy is nearly continuously under review, even in a strong economic environment, and the regulators conduct informal stress tests already. Now, however, there is a specific model that may be the precedent for future supervisory action well beyond the top 19. Additionally, the repurchase by any banking institution of senior preferred stock issued to Treasury under the CPP will be permitted only if the institution can demonstrate its continuing financial strength after the repurchase. As above, the latest methodology for reaching this result is a stress test along the lines of the SCAP test. Any hopeful repurchaser should consider preparing financial projections based on assumptions similar to the base-case and adverse-scenario assumptions used in the stress tests. Finally, Treasury also has said that any of the 19 institutions seeking to repurchase senior preferred stock must issue senior unsecured debt for a term of five years or longer that is not backed by the FDIC. Such a requirement for smaller institutions may be impractical and cumbersome, but this requirement for the top 19 signals that Treasury will look for some assurances about liquidity and the ability to tap the debt markets. -5-

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