The Impact of Basel III on Capital Instruments

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 Proposals to be published in Federal Register on August 30 Basel III and Standardized Approach Proposals have been revised slightly, but in non-substantive ways. This is MoFo. 2

Introduction Status Comment deadline: Oct. 22, 2012. Agencies almost certainly cannot meet intended completion date: Dec. 31, 2012. 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 Proposal would apply even to Basel II advanced-approaches bank holding companies Top-tier U.S. holding company in FBO structure This is MoFo. 3

Common equity Tier 1 Capital is perpetual and unconditionally available to absorb first losses on a going-concern basis Additional Tier 1 Capacity to absorb losses on a going-concern basis Tier 2 Adequate subordination and stability of availability No gone-concern capital requirement FDIC powers under OLA Bank receivership powers This is MoFo. 4

Common Equity Tier 1 Elements Common stock and related surplus net of treasury stock Must satisfy several 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. 5

Common Equity Tier 1 Criteria Paid-in, issued directly the bank, and represents the most subordinated claim Holder entitled to claim on residual assets of the bank in proportion to holder s share of issued capital after all senior claims have been satisified No maturity date Instrument can only be redeemed via discretionary repurchases with prior approval of bank s primary regulator No incentive to redeem No action or communication by bank at issuance to create expectation that bank would buy back, cancel, or redeem instrument This is MoFo. 6

Common Equity Tier 1 Criteria (cont d) No term or feature that would give risk to expectation of buy-back, cancellation, or redemption Cash dividends paid out of net income and retained earnings and are not subject to limit imposed by contractual terms of instrument Full discretion on part of bank to pay no dividends without triggering event of default, a PIC requirement, or any other restriction on bank Dividends and other distributions on instrument to be paid only after all legal and contractual obligations have been satisfied, including payments on more senior claims Holders to bear losses as they occur equally, proportionately, and simultaneously with holders of all other common stock instruments before losses are borne by holders of higher priority instruments This is MoFo. 7

Common Equity Tier 1 Criteria (cont d) Paid-in amount classified as equity under GAAP Purchase of instrument not funded directly or indirectly by bank or bank subsidiary Unsecured No guarantee of bank or any bank affiliate No arrangement that legally or economically enhances seniority Instrument issued in accordance with applicable laws and regulations Instrument reported on bank s regulatory financial statements separately from other capital instruments This is MoFo. 8

Minority interests includable in common equity Tier 1 Only interests issued by depository institution or foreign bank that is a consolidated subsidiary of bank Must meet common equity Tier 1 requirements Minority interests in required capital of subsidiary only. Surplus common equity held by third parties not includable This is MoFo. 9

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. 10

Adjustments to common equity Tier 1 capital Deduct unrealized gains and add unrealized losses on certain cash flow hedges included in AOCI Deduct unrealized gains and add unrealized losses related to changes in fair value of liabilities due to changes in bank s own credit risk Deduct investment in own capital instruments Corresponding deductions for Reciprocal cross-holdings in capital of other financial institutions Non-significant investments in unconsolidated financial institutions in excess of common equity Tier 1 as otherwise adjusted Significant investments in capital of unconsolidated financial institutions, other than common stock 10% and 15% rules for DTAs, MSAs, and significant investments in common stock of unconsolidated financial institutions This is MoFo. 11

Transition Deductions and Adjustments Goodwill fully deducted in 2013 DTAs, securitization gains on sale, credit losses exceeding credit reserves, and (for non-insured depository institutions) defined benefit pension fund asset fully deducted from Tier 1 in 2013, transitioning over 5 years to be fully deducted from common equity Tier 1 capital Phase-ins over 5 years beginning in 2014 Intangible asset deduction from common equity Tier 1 Adjustments for unrealized gains or losses on cash flow hedges phase out as a deduction from Tier 1 and phase in as a deduction from common equity Tier 1 over 5 years beginning in 2014 Deduction for investments in capital instruments 10% and 15% rules AOCI adjustment amount eliminated from common equity Tier 1 over 5 years beginning in 2014 This is MoFo. 12

Additional Tier 1 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 Current Tier 1 instruments issued before May 19, 2010, that fail to qualify under Collins Amendment are phased out as follows: For holding companies with assets of $15 billion or more, phase-out in 25% increments beginning in 2013 ending in 2016 For holding companies with assets of less than $15 billion, phase-out in 10% increments beginning in 2013 and ending in 2022 This is MoFo. 13

Additional Tier 1 Criteria Issued and paid in Instrument subordinated to depositors, general creditors, and sub debt holders Unsecured No guarantee of bank or any bank affiliate No maturity date No dividend step-up or other term or feature that creates incentive to redeem No credit sensitive feature e.g., dividend rate that resets based on bank s credit quality. Dividend rates may be adjusted periodically in relation to general market interest rates or similar adjustments. This is MoFo. 14

Additional Tier 1 Criteria (cont d) If callable by its terms, call is permissible no earlier than five years after issuance. Earlier call is permissible, if: Terms provide for earlier call upon occurrence of a regulatory event that precludes inclusion of capital in additional Tier 1 capital or of a tax event Prior approval of primary federal regulator No expectation created at issuance that bank would exercise call option Bank must either Replace amount of instrument with equal amount of additional Tier 1 capital, or Demonstrate capital sufficiency following redemption This is MoFo. 15

Additional Tier 1 Criteria (cont d) Prior approval of federal regulator required before any redemption or repurchase Full discretion on part of bank to cancel dividends or other capital distributions without triggering event of default, PIK, or other restrictions, except with respect to common stock. Capital distributions paid out of net income and retained earnings Paid-in amount classified as equity under GAAP Purchase of instrument not funded by bank or bank affiliate No features that would limit or discourage additional issuance of capital, such as a requirement that bank compensate holders of instrument if new instrument is issued at lower price This is MoFo. 16

Additional Tier 1 Criteria (cont d) If instrument issued by non-operating bank subsidiary, sole asset of subsidiary is investment in capital of bank and proceeds of sale must be immediately available without limitation to bank or bank s top-tier holding company in a form that meets all other requirements for additional Tier 1 capital. This is MoFo. 17

Minority interests includable in additional Tier 1 Interests issued by consolidated subsidiary not limited to bank subsidiaries Must meet additional Tier 1 requirements Minority interests in required capital of subsidiary only. Surplus common equity held by third parties not includable Net of any minority interests included in common equity Tier 1 This is MoFo. 18

Exclusions from Tier 1 Capital Cumulative preferred stock Trust preferred securities and certain other hybrid instruments This is MoFo. 19

Tier 2 Elements Qualifying instruments that satisfy several criteria 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 Current Tier 2 instruments issued before May 19, 2010, that fail to qualify under Collins Amendment are phased out as follows: For holding companies with assets of $15 billion or more, phase-out in 25% increments beginning in 2013 ending in 2016 For holding companies with assets of less than $15 billion, phase-out in 10% increments beginning in 2013 and ending in 2022 This is MoFo. 20

Tier 2 Criteria Issued directly by the bank and paid in Subordinated to depositors and general creditors Not secured Not covered by bank s own guarantee Not subject to any arrangement that enhances seniority Minimum original maturity of at least 5 years 20% straight-line amortization over last 5 years No features to incent redemption before maturity This is MoFo. 21

Tier 2 Criteria (cont d) Callable only after 5 years, except earlier call permissible if event would cause instrument to be excluded from Tier 2, or tax event Prior regulatory approval to exercise call option No expectation that call option will be exercised Before exercise, bank must either Replace amount called with equivalent amount of Tier 1 or Tier 2; or Demonstrate to regulate that it will continue to maintain capital commensurate with risk Right to accelerate principal or interest only in event of receivership, insolvency, or similar proceeding No credit-sensitive feature, i.e., no rate step-up for credit quality Periodic adjustments to reflect market interest rates are permissible This is MoFo. 22

Tier 2 Criteria (cont d) Purchase not funded by bank or bank subsidiary Instrument not purchased by bank or bank subsidiary If instrument issued by company other than bank or bank operating subsidiary, company must be non-operating, and sole asset must be stock of bank. Proceeds must be immediately available to bank in form that meets Tier 2 requirements. Prior regulatory approval necessary for redemption prior to maturity or repurchase For advanced approaches bank, disclosure in offering document for instrument issued after Jan. 1, 2013, must disclose full subordination to U.S. government in receivership or similar proceeding This is MoFo. 23

Minority interests includable in Tier 2 Interests issued by consolidated subsidiary not limited to bank subsidiaries Must meet additional Tier 1 requirements Minority interests in required capital of subsidiary only. Surplus common equity held by third parties not includable Net of amounts of any minority interests included in Tier 1 This is MoFo. 24

Deductions and adjustments Unrealized gains on AFS equity securities Phase in over 6 years beginning in 2013 This is MoFo. 25

Capital Ratios % of Risk Weighted Assets This is MoFo. 26

Contact Dwight Smith Morrison & Foerster LLP 202.887.1562 dsmith@mofo.com This is MoFo. 27