Final Bank Capital Rules and Basel III Implementation

On July 2, 2013, the Board of Governors of the Federal Reserve System (the “FRB”) unanimously approved final rules (the “Final Rules”) establishing a new comprehensive capital framework for U.S. banking organizations [1] that would implement the Basel III capital framework [2] as well as certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The Final Rules largely adhere to the rules as initially proposed in June 2012 (the “Proposed Rules”), [3] notwithstanding that the industry objected, sometimes strenuously, to certain aspects of the Proposed Rules. Most of the changes made in response to the industry’s most fundamental concerns were effectively limited to community banks and other smaller banking organizations; the most stringent rules for “advanced approaches banking organizations”—those with $250 billion or more in total consolidated assets or $10 billion or more in foreign exposures—were maintained. For example:

• All segments of the industry objected to the Proposed Rules’ elimination of the so-called “AOCI Filter”, which is a provision in existing capital rules that permits banking organizations to reverse fair-value adjustments to shareholders’ equity (for example, marks-to-market of available-for-sale-securities recorded in accumulated other comprehensive income and loss) in regulatory capital calculations. Banking organizations are concerned that removing the AOCI Filter will create substantial earnings volatility and force banking organizations to address that risk by shortening the duration of their assets. Nevertheless, the Final Rules, like the Proposed Rules and Basel III, remove the AOCI Filter for advanced approaches banking organizations. However, the Final Rules permit a one-time permanent election by non-advanced approaches banking organizations to opt out of the provisions removing the AOCI Filter.
• The Final Rules retain the existing rules’ risk-weightings for residential mortgage loans of 50% for high quality seasoned residential mortgage loans and 100% for all other residential mortgage loans instead of adopting the Proposed Rules’ provisions that would have applied risk-weightings to residential mortgages ranging from 35% to 150% depending, in the case of a particular mortgage loan, on its loan-to-value ratio and its particular terms (including its seniority). Concerns with the Proposed Rules’ treatment of residential mortgages were particularly important to regional and community banks, as acknowledged at yesterday’s FRB open meeting. FRB Governor Daniel Tarullo pointed out during the discussion of this issue that the application of the FRB’s stress test rules and capital planning rules (under which it administers its annual comprehensive capital adequacy review, or “CCAR”) to banking organizations with $50 billion or more in total consolidated assets has the practical effect of imposing a “higher capital expectation” with respect to higher-risk mortgages held by those banking organizations notwithstanding the official risk-weighting.
• For bank holding companies that had total consolidated assets of less than $15 billion at December 31, 2009, the Final Rules permanently grandfather as a component of Additional Tier 1 Capital trust preferred securities and other non-qualifying Tier 1 capital instruments (for example, cumulative perpetual preferred stock) that were issued prior to May 19, 2010. At yesterday’s open meeting, the FRB cited the more limited access of these banking organizations to the capital markets as the reason for including this grandfathering provision.

Governor Tarullo, in prepared remarks at yesterday’s open meeting, previewed an extensive, and potentially much more rigorous, set of additional capital requirements for the eight U.S. banking organizations already identified as having global systemic importance (“G-SIBs”) [4] and potentially for an expanded group of large U.S. banking organizations. A separate Sullivan & Cromwell memorandum addressing those remarks and potential requirements is available at http://www.sullcrom.com/Bank_Capital_Rules_7_03_13/.

In addition to approving the Final Rules at yesterday’s meeting, the FRB approved a notice of proposed rulemaking regarding changes to the FRB’s, the Office of the Comptroller of the Currency’s (the “OCC”) and the Federal Deposit Insurance Corporation’s (the “FDIC” and, together with the OCC and the FRB, the “Agencies”) market risk capital rules (the “Market Risk NPR”) to align their treatment of foreign sovereigns and securitizations involving certain student and consumer loans for specific risk-weighting purposes with the treatment of those items under the Final Rules and to make certain clarifying and technical amendments. Comments on the Market Risk NPR are due by September 3, 2013.

The Final Rules will be joint rulemakings of the Agencies. The OCC has indicated that it anticipates acting by July 9, 2013 to approve the Final Rules for publication. Yesterday, the FDIC provided notice that it will consider these rules, but as an interim final rule at its meeting on July 9, 2013 (presumably for procedural reasons relating to the FDIC’s intention also to consider an enhanced supplementary leverage ratio for the largest banking organizations, which is one of the initiatives Governor Tarullo mentioned in his prepared remarks referenced above).

Advanced approaches banking organizations will be required to comply with the Final Rules starting on January 1, 2014, subject to phase-in provisions (discussed further below) that are generally consistent with Basel III. Other banking organizations as well as savings and loan holding companies (“SLHCs”) that are not excluded from the Final Rules due to their insurance or commercial activities (discussed further below) will be required to comply starting January 1, 2015.

The text of the Final Rules, together with explanatory staff memos and preambles, is extraordinarily lengthy, running to nearly 1,000 pages. This memorandum serves only to highlight certain key features of the Final Rules, focusing on changes as compared to the Proposed Rules and areas where the industry sought changes in the Proposed Rules that the Agencies rejected. We anticipate preparing a more detailed memorandum to clients addressing the Final Rules in the coming days.

Discussion—Highlights

The Final Rules complete the key aspects of the Agencies’ implementation of the Basel III capital framework for U.S. banking organizations. They also implement two capital-related provisions of Dodd-Frank: (i) Section 171, commonly referred to as the “Collins Amendment”, which, among other things, provides that the general risk-based and leverage capital requirements applicable to depository institutions that are not advanced approaches depository institutions act as a floor for the requirements applicable to bank holding companies (irrespective of whether they are advanced approaches banking organizations) and to all advanced approaches banking organizations (both bank holding companies and depository institutions); and (ii) Section 939A’s requirement that references to external credit ratings be removed from the Agencies’ rules and replaced with alternative standards of creditworthiness.

The changes to the Agencies’ capital rules represent the most substantial revisions to these rules since the Agencies’ adoption in 1989 of risk-based capital rules based on the Basel Committee on Banking Supervision’s (“BCBS”) 1988 Accord known as “Basel I”. The Final Rules consolidate into a single regulation, with a single set of definitions used with common meanings throughout the Final Rules, the Agencies’ existing general risk-based capital rules, advanced approaches risk-based capital rules, leverage capital rules and market-risk rules. The Final Rules, consistent with the Proposed Rules, replace the Agencies’ Basel I-based general rules with a “Standardized Approach” based in substantial part upon the standardized approach in Basel II [5] that was never adopted for U.S. banking organizations.

Highlights of the Final Rules include the following.

Initial Applicability

• Non-advanced Approaches Banking Organizations and Covered SLHCs. Banking organizations that are not subject to the advanced approaches rules or that are savings and loan holding companies (“SLHCs”) subject to the Final Rules (“covered SLHCs”) must generally begin complying with the Final Rules on January 1, 2015.
• Advanced Approaches Banking Organizations. Advanced approaches banking organizations that are not SLHCs must begin complying with the Final Rules on January 1, 2014.
• Intermediate Subsidiaries of Foreign Banking Organizations. The Final Rules did not change the Proposed Rules’ approach, consistent with the Collins Amendment, providing that a bank holding company subsidiary of a foreign banking organization that is currently relying on the FRB’s Supervision and Regulation Letter 01-1 is not required to comply with the Final Rules until July 21, 2015. [6]

The initial compliance dates for elements of the Final Rules for different types of banking organizations are set forth in Table 1 below.

Table 1
Initial Applicability

Components of Capital

• Definitions. The Final Rules generally adopt the Proposed Rules’ definitions of the three components of capital—CET1, Additional Tier 1 Capital (which, together with CET1, is “Tier 1 Capital”) and Total Capital—in most respects. The Final Rules incorporate changes to accommodate certain industry concerns but do not accommodate others, some of which are important. Specifically:
  • Tier 2 Subordinated Debt. The Final Rules retain the provision in the Proposed Rules requiring that Tier 2 instruments be subordinated to “general creditors”. The Agencies did not accept industry comments requesting a carve-out or exclusion from “general creditors” for trade creditors. Many banking organizations’ Tier 2 subordinated debt carves out trade creditors from the scope of general creditors to which the subordinated debt is subordinated (generally in the definition of “senior debt” or a similar term). The purpose of the carve-out for trade creditors is to enhance the debt characteristics of the instruments for tax purposes. Absent relief on this issue, subordinated debt issued by U.S. banking organizations on or after May 19, 2010 with a trade creditors carve-out will not qualify as Tier 2 Capital, and such securities issued before May 19, 2010 will be subject to phase out as non-qualifying instruments. Although the Final Rules include broad reservation of authority provisions allowing the Agencies to treat instruments as components of capital—including Tier 2 subordinated debt that carves out trade receivables from general creditors—notwithstanding the absence of compliance with each specific component in the Final Rules, there is no certainty that the Agencies will reconsider this issue and grant relief under these provisions. Accordingly, banking organizations, as a priority, should review the subordination provisions in their Tier 2 Capital instruments to determine whether the Final Rules’ failure to include a carve-out for trade payables is an issue for them.
  • Payment of Dividends Out of Surplus. Commenters had noted that certain technical aspects of the Proposed Rules would disqualify ordinary common stock and non-cumulative perpetual preferred stock from inclusion in CET1 and Additional Tier 1 Capital—for example, the requirement that dividends be paid out of income notwithstanding that most corporate statutes permit dividends to be paid out of capital surplus even in the absence of current income. The Final Rules address this comment by permitting dividends to be paid out of surplus.
  • Pari Passu Preferred Stock. The Proposed Rules, read literally, would have excluded from Additional Tier 1 Capital multiple series of parity non-cumulative perpetual preferred stock that, by their terms, require all parity series to pay pro rata dividends if any series pays less than full dividends. The Final Rules correct this problem.
  • Penny Dividends. In the release accompanying the Proposed Rules, the Agencies asked whether they should permit inclusion in CET1 and Additional Tier 1 Capital of securities that allow the issuer to pay dividends of $.01 per share in order to accommodate investors that may only purchase dividend-paying securities, notwithstanding the otherwise applicable general requirement that the issuer’s Board of Directors must have unfettered authority to stop paying dividends. The Final Rules do not permit penny dividends as an exception to the Board of Directors’ required authority to cause the issuer to stop paying dividends.
• Trust Preferred Securities; Cumulative Perpetual Preferred Stock. The ability of a bank holding company to include in the components of capital trust preferred securities and cumulative perpetual preferred stock disqualified from inclusion in Additional Tier 1 Capital largely depends upon the total consolidated assets of the bank holding company as of December 31, 2009. The Final Rules draw distinctions among three groups of bank holding companies with respect to trust preferred securities.
  • The Final Rules permit bank holding companies with less than $15 billion in total consolidated assets as of December 31, 2009, or banking organizations that were mutual holding companies as of May 19, 2010, to include in Additional Tier 1 Capital trust preferred securities and cumulative perpetual preferred stock issued and included in Tier 1 Capital prior to May 19, 2010 on a permanent basis, without any phase-out.
  • The Final Rules permit bank holding companies with $15 billion or more in total consolidated assets as of December 31, 2009 that are not advanced approaches banking organizations to phase out trust preferred securities and cumulative perpetual preferred stock from Tier 1 Capital by the end of 2015 but to include in Tier 2 Capital, on a permanent basis without phase-out, trust preferred securities and cumulative perpetual preferred stock that are phased-out of Tier 1 Capital.
  • Bank holding companies that are advanced approaches banking organizations, however, will not be allowed to permanently include trust preferred securities or cumulative perpetual preferred stock that are phased-out of Tier 1 Capital in Tier 2 Capital. Instead, these banking organizations will only be permitted to do so until year-end 2015.

  Additionally, the Final Rules make an important change in the base against which the amount of grandfathered disqualified instruments is calculated (although the Agencies did not specifically comment on the change in the preamble to the Final Rules and may view it as a clarification). Most industry participants read the Proposed Rules to use, as the base against which the phase-out percentages in the relevant tables are calculated, disqualified instruments issued before May 19, 2010 and outstanding as of that date. Under that reading, if an advanced approaches banking organization had $100x of trust preferred securities outstanding as of May 19, 2010 and redeemed $50x of those trust preferred securities before the effective date of the Final Rules, the banking organization would be permitted to include in Additional Tier 1 Capital during 2014 (when the percentage of non-qualifying instruments included in Additional Tier 1 Capital is 50%) its entire $50x of remaining trust preferred securities. Under the Final Rules, the base is disqualified instruments issued before May 19, 2010 and outstanding on the effective date of the Final Rules, with the consequence that, in the foregoing example, only $25x (or 50% of $50x) of the trust preferred securities that remain outstanding as of the effective date of the Final Rules could be included during 2014.

• Exchangeable REIT Preferred Securities. Under both the Proposed Rules and the Final Rules so-called “exchangeable REIT preferred securities”—that is, customarily, non-cumulative perpetual preferred stock of a REIT subsidiary of a banking organization that, upon designated trigger events relating to the banking organization’s capital levels or the applicable Agency’s determination that the banking organization is in danger of bankruptcy or receivership automatically exchange into non-cumulative perpetual preferred stock of the banking organization—are treated as minority interests, with the consequence that the parent banking organization receives little capital credit for the exchangeable REIT preferred securities. Commenters had argued that, because of the exchange feature, exchangeable REIT preferred securities should be analyzed as though the exchange had occurred (that is, effectively as non-cumulative perpetual preferred stock of the banking organization into which an exchange would occur). The Agencies declined to accept that comment.
• AOCI Filter. Consistent with Basel III, the Proposed Rules would have removed the AOCI Filter and provided a limited exception for unrealized gains and losses on cash flow hedges of items not recognized at fair value on the balance sheet. Commenters expressed a wide range of concerns regarding the removal of the AOCI Filter, including, among many others, that the removal could (i) overstate the economic impact of interest rate changes, because available-for-sale debt securities are often used to hedge interest rate risk arising from deposit liabilities (which are not marked to fair value) and thus only one aspect of the hedging strategy would be reflected in capital; (ii) result in volatile capital levels and impair capital planning; and (iii) cause banking organizations to have to increase their overall capital levels to create a buffer above minimums, which could be costly and decrease lending. As noted in the introduction to this memorandum, the Final Rules permit non-advanced approaches banking organizations, subject to a limited exception, [9] to make a one-time, permanent election to use the existing AOCI Filter. [10] However, advanced approaches banking organizations are not entitled to this opt-out and must instead calculate regulatory capital based upon removal of the AOCI Filter. In the preamble to the Final Rules, the Agencies explained that the distinction rests on their recognition “that the tools used by larger, more complex banking organizations for managing interest rate risk are not necessarily readily available for all banking organizations.” [11]
• Investments in Mortgage Servicing Assets (“MSAs”), Deferred Tax Assets (“DTAs”) and Investments in Non-consolidated Financial Entities. Consistent with Basel III and the Proposed Rules, the Final Rules require banking organizations to deduct from CET1 any of the following assets to the extent that individually the asset category exceeds 10% of CET1 or, in the aggregate, 15% of CET1: (i) DTAs arising from temporary differences that could not be realized through net operating loss carry-backs; (ii) MSAs net of associated deferred tax liabilities (“DTLs”); and (iii) significant investments in the capital of financial institutions in the form of common stock.The Final Rules preserve this basic framework for the treatment of these items. However, they do provide relief or clarification in several areas:
  • Under the Proposed Rules, if the amount of MSAs a banking organization, after applying the 10% and 15% CET1 deduction thresholds, deducts is less than 10% of the fair value of its MSAs, then the banking organization would have been required to deduct an additional amount of MSAs such that the total amount of MSAs deducted equaled at least 10% of the fair value of its MSAs. The Agencies attributed that provision, which is not based on Basel III, to the requirements of Section 475 of the Federal Deposit Insurance Corporation Improvements Act of 1991, as amended. The Agencies eliminated this requirement in the Final Rules in response to views expressed in a number of comment letters that Section 475 does not require the Agencies to impose this fair value limitation.
  • The Final Rules include a number of clarifications as to when and to what extent DTLs may offset other adjustments to the components of CET1, including DTAs.
  • Commenters had expressed significant concerns with the broad scope of the definition of the term “financial institution”. For the most part the Agencies did not make changes responsive to these industry comments. However, they did respond in at least one important respect, by clarifying in the preamble to the Final Rules that investment or financial advisors (whether they provide discretionary or non-discretionary advisory services) are not covered under the definition of financial institution.

Standardized Approach Risk Weightings

The framework for determining risk weightings in the Final Rules is broadly consistent with that of the Proposed Rules. Nevertheless, the Agencies did make (and in some cases failed to make) changes in response to concerns raised by commenters. Noteworthy aspects of the Final Rules include:

• Residential Mortgages. The Proposed Rules would generally have assigned residential mortgage exposures to one of two categories, with risk weights ranging from 35% to 150%. Residential mortgage exposures that did not have product features that the Proposed Rules associated with higher credit risk were assigned to “category 1”. The other mortgages were assigned to “category 2” and received relatively higher risk weights. Within both categories, mortgage exposures would receive lower and higher risk weights depending on the exposure’s loan-to-value ratio. Commenters voiced a wide range of concerns with the Agencies’ proposal, including that it would inhibit lending, was administratively burdensome, would place U.S. banking organizations at a competitive disadvantage relative to foreign banking organizations subject to the Basel II standardized framework (which generally assigns residential mortgage exposures a 35% risk weight), and the proposal failed to take into account other regulatory actions involving the mortgage industry. In response to these and other concerns, the Agencies determined to retain the existing treatment of residential mortgage exposures, which assigns exposures secured by one-to-four family residential properties to either a 50% or 100% risk-weight category.
• High Volatility Commercial Real Estate (“HVCRE”). Under the Proposed Rules, HVCRE exposures were assigned a 150% risk weight, an increase over the 100% risk weight required under the Agencies’ existing general risk-based capital rules. The Final Rules retain this risk weighting. However, the Agencies, in response to industry comments, provided guidance and narrowed the definition of HVCRE to, among other things, make clear that, as a general matter, (i) a loan that starts as an acquisition, development and construction loan but then converts to a permanent financing is no longer an HVCRE, (ii) cash used to purchase land is a form of borrower-contributed capital for purposes of the requirement that the borrower contribute capital to the project equal to at least 15% of the real estate’s appraised “as completed” value, (iii) loans that finance the acquisition, development or construction of real property that would qualify as community development investments are not HVCRE, and (iv) loans for the purchase or development of agricultural land are not HVCRE.
• Credit Enhancing Representations and Warranties. Under the Proposed Rules, a banking organization providing a credit-enhancing representation or warranty on assets it sold would treat such an arrangement as an off-balance sheet guarantee and apply a 100% credit conversion factor to determine the exposure amount, provided the exposure did not meet the definition of a securitization. A credit-enhancing representation would include early default clauses that permit the return of, or premium refund clauses covering, one-to-four family residential first mortgage loans. Under the existing risk-based capital rules, in contrast, there is an exception (which was not preserved by the Proposed Rules) in the definition of credit-enhancing representations and warranties for such early default and premium refund clauses on such mortgage loans when these clauses apply for a period not to exceed 120 days. Commenters argued that the elimination of this 120-day safe harbor could significantly increase capital requirements for certain banks given that, for example, the GSEs’ seller/servicer standards contain early default clauses covering a borrower’s failure to make payments in the first three months following a loan’s sale to the GSEs. The Final Rules reinstitute this 120-day safe harbor.
• Past Due Exposures. The Final Rules retain the 150% risk weight for the portion of a past due exposure (other than a sovereign exposure or residential mortgages exposure, the capital treatment of which is addressed in different parts of the Final Rules) that is not guaranteed or secured and that is more than 90 days past due. Some commenters had urged the Agencies to adopt the Basel IIstandardized approach’s treatment of such exposures because it used a graduated approach, assigning these exposures a risk weight between 50% to 150% depending on the amount of specific provisions for the exposure, and avoided double counting capital by calculating the exposure net of specific provisions. Consistent with the Proposed Rules, the Final Rules do not contain any language, stating that the exposure is calculated net of specific provisions.
• Retail Exposures. Some commenters had requested that the Agencies assign these exposures a 75% risk weight consistent with the Basel II standardized approach and CRD IV, [12] which generally implements the Basel III capital framework for members of the European Union. [13] The Agencies declined to accommodate these comments and instead retained the Proposed Rules’ treatment of these exposures, assigning them a 100% risk weight under the Final Rules.
• Exposures to Central Counterparties (“CCPs”). Following the initial publication of the Proposed Rules in June 2012, the BCBS published an interim framework for the capital treatment of bank exposures to CCPs. [14] The Final Rules have generally incorporated the material terms of this interim framework.

Securitizations

The Final Rules retained the general framework for risk weighting securitization exposures set forth in the Proposed Rules, under which a banking organization must generally (i) apply the simplified supervisory formula approach (the “SSFA”); (ii) if the banking organization is not subject to the Agencies’ market risk rules, apply a gross-up approach similar to that provided under the general risk-based capital rule; or (iii) assign the exposure a 1250% risk weight. In response to concerns raised in the comment process, the Agencies modified aspects of the Proposed Rules relating to the treatment of securitizations. For example, unlike the Proposed Rules, the Final Rules recognize common deferral features associated with student and consumer loans for purposes of the SSFA. Under the Proposed Rules, such deferral features would have been treated as past due amounts, and securitization exposures with such underlying exposures would have attracted higher capital charges.

The Agencies declined to modify several important features of the Proposed Rules with respect to which commenters expressed concerns:

• Resecuritizations. The Proposed Rules defined a resecuritization as a securitization in which one or more of the underlying exposures is a securitization exposure. Certain commenters encouraged the Agencies to narrow this definition by exempting resecuritizations in which 5% or more of the underlying exposures are securitizations. The Final Rules, however, did not adopt such a materiality threshold in the definition of “resecuritization” although the definition now refers to securitizations that have (i) more than one underlying exposure and (ii) one or more underlying exposures that are securitization exposures. The Agencies explained that the addition of clause (i) clarifies that the term was not intended to cover the retranching of a single underlying exposure.
• Due Diligence Requirements. The Proposed Rules would impose a 1250% risk weight for securitizations as to which banking organizations fail to satisfy their due diligence requirements. These requirements are very detailed and require banking organizations to demonstrate a comprehensive understanding of the features of a securitization exposure that would materially affect performance. Commenters expressed reservations about the stringent nature of this penalty. The Agencies declined to accommodate these concerns, and the Final Rules retain this penalty provision.
• Cap on Maximum Capital. Under certain circumstances under the Proposed Rules, banking organizations could be required to assign a 1250% risk weight to a securitization exposure (for example, as discussed above, as a result of failing to satisfy the due diligence requirements). Commenters had requested that the Agencies cap the amount of risk-based capital required to be held against a banking organization’s exposure at the exposure amount because, at capital levels above 8%, a 1250% risk weighting would impose a capital requirement in excess of dollar-for-dollar capital. The Agencies did not make changes to address these comments. Accordingly, consistent with the Proposed Rules, the Final Rules do not impose such a cap.
• Country Risk Classification (“CRC”). In light of Section 939A’s limitations on the use of credit ratings, the Proposed Rules assigned a risk weight for foreign sovereign exposures based on the Organization for Economic Co-operation and Development (“OECD”) Country Risk Classifications (“CRCs” and such methodology, the “CRC methodology”). The CRC methodology generally assigns countries to one of eight risk categories (0-7) based on the CRC of that country, with risk weights ranging from 0% to 150%. Following the publication of the Proposed Rules, the OECD determined to no longer assign a CRC to certain high income countries receiving a CRC of 0 in 2012. The Final Rules provide that these countries are assigned a 0% risk weight, although these countries could still receive a 150% risk weight in the event of a sovereign default (generally defined to include noncompliance with external debt service obligations or an inability or unwillingness to service an existing loan according to its original terms).

Leverage

The Final Rules adopt with no material change the Proposed Rules’ approach to leverage. In particular:

• The Final Rules retain for all banking organizations the Agencies’ existing capital rules’ ratio of Tier 1 Capital to average consolidated assets, but change the minimum required ratio to 4%, removing the existing permission for those banking organizations with a supervisory composite rating of 1 to have a 3% ratio.
• The Final Rules apply the Basel III capital framework’s leverage ratio, referred to in both the Final Rules and the Proposed Rules as the “supplementary leverage ratio”, only to advanced approaches banking organizations. The Final Rules’ and Basel III’s minimum requirement for that ratio is 3% and, like in the Proposed Rules, the Final Rules include the supplementary leverage ratio as a metric for the prompt corrective action (“PCA”) regulations as applied to depository institutions that are advanced approaches banking organizations.

Notwithstanding that the Final Rules’ leverage provisions follow the leverage provisions of the Proposed Rules, there is more to come with respect to leverage. In particular:

• On June 26, 2013, the BCBS published a consultative document proposing significant revisions to the Basel III capital framework’s leverage ratio (which, as indicated above, is incorporated into the Final Rules as the supplementary leverage ratio applicable only to advanced approaches banking organizations). [15] Although the Final Rules do not reflect the BCBS’s proposed revisions, the Agencies note in the preamble to the Final Rules that they “will consider” any changes to the supplementary leverage ratio “as the BCBS revises the Basel III leverage ratio”.
• There has been much discussion among regulators, legislators and other policymakers in the United States concerning the adequacy of both the existing U.S. leverage ratio and the Basel III-based supplementary leverage ratio. Consistent with those reports, Governor Tarullo noted in prepared comments at yesterday’s FRB open meeting that the Agencies “are very close to completion” of a notice of proposed rulemaking that “will establish a leverage ratio threshold for the eight U.S. banking organizations already identified as G-SIBs, [16] above the 3% minimum provided for in the Basel III capital framework and incorporated in the Final Rules’ supplementary leverage ratio. Press reports have indicated that the higher minimum ratio for those banking organizations will likely be in the 5% to 6% range.

Capital Conservation Buffer

The capital conservation buffer, generally described, requires banking organizations to maintain an additional 2.5% of capital (composed entirely of CET1) on top of the minimum CET1, Additional Tier 1 Capital and Tier 2 Capital ratios that otherwise apply. A banking organization that dips into its buffer is restricted in its ability to pay dividends and compensate senior executives, with the amount of the restriction depending upon how far the banking organization has dipped into its buffer. The Final Rules, like the Proposed Rules, apply the capital conservation buffer to all banking organizations irrespective of size. However, the Final Rules did make several changes in the capital conservation buffer as compared to the Proposed Rules, including:

• The Proposed Rules provided that a banking organization that had dipped into its buffer would be limited not only as to dividends but also as to repurchases or redemptions of capital securities. The Final Rules provide that a redemption or repurchase of a capital instrument is not a distribution, provided that the banking organization fully replaces that capital instrument by issuing another capital instrument of the same or better quality (that is, equally or more subordinate) based on the Final Rules’ eligibility criteria for capital instruments, and provided that such issuance is completed within the same calendar quarter in which the banking organization announces the repurchase or redemption.
• Under the Proposed Rules, advanced approaches banking organizations would have calculated their capital conservation buffer (as well as any applicable countercyclical capital buffer amount) using their advanced approaches total risk-weighted assets. The Final Rules require advanced approaches banking organizations to calculate their buffers using the higher of risk-weighted assets as calculated under the advanced approaches and the general risk-based capital rules (which will be the Standardized Approach commencing January 1, 2015).

Countercyclical Capital Buffer

The Final Rules, like the Proposed Rules, only subject advanced approaches banking organizations to the countercyclical capital buffer requirement. That buffer requirement calls for these banking organizations to hold up to an additional 2.5% of CET1 during certain Agency-specified periods. Where the Proposed Rules excluded from the base against which the countercyclical capital buffer would be calculated market risk exposures, the Final Rules include covered positions under the market risk rules in the base (and do so by including such positions in the Final Rules’ definition of “private sector credit exposure”).

SLHCS Engaging in Commercial and Insurance Activities

In the Final Rules, the Agencies responded to comments from SLHCs engaged in insurance and commercial activities. As a result, the Final Rules include a temporary exemption for:

• A top-tier grandfathered unitary SLHC if as of June 30 of the previous calendar year it derived either 50% or more of its total consolidated assets or 50% or more of its total revenues on an enterprise-wide basis (calculated under GAAP) from activities that are not financial in nature pursuant to Section 4(k) of the Bank Holding Company Act, [17] and
• a top-tier SLHC that is itself an insurance underwriting company [18] or that, as of June 30 of the previous year, held 25% or more of its total consolidated assets (calculated under GAAP) in subsidiaries that are insurance underwriting companies (other than assets associated with insurance underwriting for credit risk). [19]

The FRB expects to develop “appropriate consolidated capital requirements” for these exempt SLHCs before they are required to be covered by generally applicable regulatory capital rules in 2015. SLHCs that do not qualify for the temporary exemption (that is, covered SLHCs) are subject to the Final Rules.

Transition Provisions

Because the initial compliance dates of the Final Rules have been delayed for a period of one or two years as compared to the Proposed Rules and to Basel III, certain transition periods for the implementation of the Final Rules have correspondingly been compressed so as to generally result in consistency with the full compliance dates set by Basel III and the Proposed Rules. Below are some key transition provisions.

• Compliance with Minimum Ratios. Full compliance with the minimum risk-based capital ratios (that is, the minimum required ratios of CET1, Tier 1 and Total Capital of 4.5%, 6% and 8%, without giving effect to buffers or the phase-ins of adjustments and deductions from regulatory capital, which are described below and continue through 2017) for non-advanced approaches banking organizations and for covered SLHCs will be required on the initial compliance date for such institutions, which is January 1, 2015. Advanced approaches banking organizations are subject to a one-year transition period, with minimum ratios of 4.0%, 5.5%, and 8.0% of CET1, Tier 1, and Total Capital, respectively, required during the 2014 calendar year and full compliance required thereafter.
• Capital Buffers. Consistently with Basel III and the Proposed Rules, the capital conservation and countercyclical capital buffers will be phased-in in equal increments starting on January 1, 2016 with full compliance by January 1, 2019.
• Adjustments and Deductions from Regulatory Capital. These adjustments and deductions will generally be phased-in starting on January 1, 2015 for non-advanced approaches banking organizations and covered SLHCs and starting on January 1, 2014 for advanced approaches banking organizations that are not SLHCs. Full compliance is required by January 1, 2018. These provisions are generally consistent with the Proposed Rules, except that the initial compliance levels for non-advanced approaches banking organizations and for covered SLHCs will be higher (for example, non-advanced approaches banking organizations and covered SLHCs will be required to deduct 40% of intangibles other than goodwill and MSAs immediately upon their initial compliance date, which is January 1, 2015, while advanced approaches banking organizations will be required to deduct 20% of such intangibles on their initial compliance date, which is January 1, 2014); this corresponds with the fact that the initial compliance date for such organizations has been delayed for two years. Such transition provisions are also generally consistent with Basel III, except where U.S. statutes require otherwise.
• Phase-out of Non-qualifying Capital Instruments. See the discussion above under “Components of Capital—Trust Preferred Securities; Cumulative Perpetual Preferred Stock.”

Prompt Corrective Action

The Final Rules adopt the Proposed Rules changes to the Agencies’ PCA rules without any change. The changes adopted by the Final Rules include (i) the introduction of CET1 to risk-weighted assets requirements in each PCA category (other than critically undercapitalized); (ii) an increase of the minimum Tier 1 Capital ratio in each PCA category (other than critically undercapitalized); and (iii) introduction of the 3% supplementary leverage ratio as a criterion for advanced approaches banking organizations qualifying as adequately capitalized or well capitalized. The effective dates of these provisions are also unchanged from the Proposed Rules.

Endnotes:

[1] Except where otherwise indicated, we are using the term “banking organization” to include, as applicable, U.S. bank holding companies, savings and loan holding companies and depository institutions (both banks and thrifts).
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[2] “Basel III”, as used in this memorandum, refers to the Basel Committee on Banking Supervision’s (“BCBS”) publications titled (i) Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems and (ii) Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring (the “Basel III liquidity framework”). “Basel III capital framework”, as used in this memorandum, refers to the publication referenced in clause (i) above. The Agencies have yet to propose rules implementing the Basel III liquidity framework. For additional information regarding the Basel III capital framework, see our memorandum to clients titled, Basel Committee Issues Final Revisions to International Regulation of Bank Capital and Liquidity, dated December 31, 2010.
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[3] The Proposed Rules were published by the Agencies in the Federal Register in August 2012. Agencies, Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III—Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action, 77 Fed. Reg. 52,792 (Aug. 30, 2012); Agencies, Regulatory Capital Rules—Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements, 77 Fed. Reg. 52,888 (Aug. 30, 2012); Agencies, Regulatory Capital Rules: Advanced Approaches Risk-Based Capital Rules; Market Risk Capital Rule, 77 Fed. Reg. 52,978 (Aug. 30, 2012). For additional information regarding the Proposed Rules, see our memorandum to clients titled, Bank Capital Rules: Federal Reserve Approves NPRs Addressing Basel III Implementation and Substantial Revisions to Basel I-Based Rules for All Banks and Finalizes Amendments to Market Risk Rules, dated June 8, 2012,
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[4] The eight U.S. G-SIBs are Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., Goldman Sachs, J.P. Morgan, Morgan Stanley, State Street Corporation and Wells Fargo. Financial Stability Board, Update of Group of Global Systemically Important Banks (G-SIBs) (Nov. 1, 2012), available at http://www.financialstabilityboard.org/publications/r_121031ac.htm.
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[5] “Basel II”, as used in this memorandum, refers to the BCBS’s comprehensive accord titled International Convergence of Capital Measurement and Capital Standards—A Revised Framework.
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[6] Additionally, the Final Rules would not apply to bank holding companies with consolidated assets of less than $500 million or to SLHCs substantially engaged in insurance underwriting or commercial activities.
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[7] The supplementary leverage ratio for advanced approaches banking organizations becomes effective on January 1, 2018.
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[8] See supra note 7.
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[9] In the event of a merger, acquisition or purchase transaction involving all or substantially all of the assets or voting stock between two banking organizations, where one has made an opt out election, the resulting organization may make an AOCI election with prior Agency approval.
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[10] These banking organizations would make this election, if at all, when filing the first Call Report or FR Y-9 series report after the effective date of the Final Rules.
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[11] Agencies, Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, Standardized Approach for Riskweighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital Rule (July 2, 2013), at 38.
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[12] “CRD IV” as used in this letter refers to the “Proposal for a Directive of the European Parliament and of the Council” promulgated by the European Commission (2011/0203 (COD)), together with its proposed implementing regulations
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[13] CRD IV, Part I, Article 118.
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[14] See BCBS, Capital Requirements for Bank Exposures to Central Counterparties (July 2012), available at http://www.bis.org/publ/bcbs227.pdf.
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[15] BCBS, Consultative Document: Revised Basel III Leverage Ratio Framework and Disclosure Requirements (June 2013), available at www.bis.org/publ/bcbs251.htm. For additional information regarding this consultative document, see our memorandum to clients titled, Basel III Leverage Ratio Framework: Basel Committee Publishes Consultative Document Proposing Changes to Exposure Measure and Disclosure Requirements, dated June 27, 2013.
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[16] See supra note 4.
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[17] 12 U.S.C. 1843(k). This statute sets forth the activities permissible for financial holding companies.
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[18] An insurance underwriting company is any insurance company (as that term is defined in Section 201 of Dodd-Frank) that engages in insurance underwriting activities.
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[19] The FRB will permit a SLHC that does not calculate its total consolidated assets under GAAP for any regulatory purpose to use an estimated non-GAAP measure, subject to review and adjustment by the FRB.
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