Final Capital Rules Adopted

On July 2, 2013, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a final capital rule that overhauls its existing capital adequacy rules and implements both the Basel III Capital Framework issued by the Basel Committee on Banking Supervision (the “Basel Committee”) in 2010 and certain requirements imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). While the Final Rule consolidates and largely adopts unchanged the three proposals issued by the federal banking agencies (the “agencies”) last June, the rule contains several significant burden-reducing modifications adopted in response to comments from community banking organizations. By contrast, the rule provides little relief for the approximately 18 banking organizations subject to the advanced approaches capital rules (“advanced approaches banking organizations”), and increases the burden on these organizations in certain significant respects—most notably by expanding the application of the Collins Amendment Floor to the capital conservation and countercyclical capital buffers.

On July 9, the Federal Deposit Insurance Corporation (the “FDIC”) also voted to adopt the Final Rule, and was the first of the three agencies to issue an interagency notice of proposed rulemaking that would amend the Final Rule to significantly increase the supplementary leverage ratio requirement applicable to the eight U.S. banking organizations that have been identified as global systemically important banks (“G-SIBs”) by the Financial Stability Board (the “FSB”) (the “Supplementary Leverage Ratio Proposal”). Under the Supplementary Leverage Ratio Proposal, the eight U.S. G-SIBs would effectively be subject to a 5% supplementary leverage ratio minimum at the parent level and a 6% supplementary leverage ratio minimum at the level of each bank subsidiary—each of which represents a significant surcharge above the current Basel III 3% minimum leverage ratio applicable from January 1, 2018 to all advanced approaches banking organizations under the Final Rule.

Overview and Key Takeaways

While community banks did not receive the general exemption from enhanced capital requirements that they requested, the Final Rule does provide significant relief to community banking organizations. Specifically, banking organizations that are not subject to the advanced approaches will be permitted to opt out of the requirement that banking organizations include the components of accumulated other comprehensive income (“AOCI”) in common equity Tier 1 (“CET 1”) capital. Similarly, banking organizations that are not subject to the advanced approaches will have more time to comply with the Final Rule. Advanced approaches banking organizations (other than savings and loan holding companies (“SLHCs”)) will be required to comply with the Final Rule, subject to certain transition provisions, beginning on January 1, 2014, while all other banking organizations will have until January 1, 2015 to begin compliance, thus providing these institutions more time to accrete capital through retained earnings. In addition, banking organizations with less than $15 billion in total assets will not be subject to the phase-out of non-qualifying Tier 1 capital instruments, such as trust preferred securities (“TruPS”) and cumulative preferred securities, which should further reduce the burden of compliance with the Final Rule on smaller institutions.

The Final Rule does provide some burden relief that will benefit all banking organizations by eliminating the Proposals’ complex categorization and risk weighting requirements for residential mortgages, in favor of retaining the current approach in the general risk-based capital rules which weights most first-lien mortgages at 50%. The elimination of this approach to residential mortgage exposures also has substantial indirect burden-reducing benefits by simplifying the risk weight determinations for residential mortgage-backed securitization exposures, which rely on a look-through to the risk weights applicable to mortgages in the underlying pool. However, at the Federal Reserve’s board meeting to adopt the rules, staff indicated that they may revisit the mortgage risk weightings after they have had an opportunity to observe the interaction between the capital rules and other rules on residential mortgage loans, some of which are still in the process of being implemented.

Notwithstanding certain beneficial modifications, the agencies rejected an almost innumerable amount of comments that requested further flexibility, and proceeded to tighten the capital requirements in a number of areas. Further detail and highlights of these additional burdens are described throughout this memo, but at least one significant issue deserves immediate mention. The Final Rule disqualifies certain subordinated debt issuances by bank holding companies (“BHCs”) from Tier 2 capital by indicating that subordinated debt instruments must be subordinated to the claims of trade creditors in order to qualify as Tier 2 capital. The current BHC capital rules applicable to TruPs and BHC subordinated debt explicitly permit such instruments to be pari passu with trade creditors—a feature that is important from a tax perspective to enhance the debt characteristics of the instrument. However, Federal Reserve staff have confirmed that the Final Rule reverses this past policy in order to comply with the Collins Amendment (which requires BHCs with total assets of $15 billion or more to phase out capital instruments that would not qualify as regulatory capital under the guidelines generally applicable to depository institutions). Accordingly, outstanding subordinated debt issued by BHCs in reliance on this precedent will be disqualified from Tier 2 capital (and without the benefit of a phase-out, if issued after May 19, 2010).

While there are several aspects of the Final Rule that will increase burden on advanced approaches banking organizations, the Supplementary Leverage Ratio Proposal is a more significant development, as it would considerably increase the amount of equity capital the eight U.S. G-SIBs would effectively be required to hold. The agencies estimate that if the proposed increases to the supplementary leverage ratios had been in effect as of the third quarter of 2012, these eight banking organizations would have needed to increase their Tier 1 capital by approximately $63 billion in the aggregate to meet the parent-level ratio and by approximately $89 billion in the aggregate to meet the bank-level ratio. While the agencies anticipate that “almost all” the U.S. G-SIBs and all their subsidiary banks are on track to meet the ratios by year-end 2017, when the proposal is set to take effect, they acknowledge that these higher capital standards could increase the cost and reduce the availability of credit in the wider economy.

Overall, given the Supplementary Leverage Ratio Proposal and the number of Basel Committee issuances in the last two weeks proposing further alterations to the Basel Capital Framework, the Final Rule represents a “living” document that the agencies will undoubtedly be substantially revisiting in the near future to incorporate further changes. In addition, in opening remarks on the Final Rule, Governor Tarullo alerted the eight U.S. G-SIBs that there would be a series of forthcoming rules, in addition to the Supplementary Leverage Ratio Proposal, that will further ratchet up the capital requirements applicable to these banking organizations. Specifically, with regard to these and other banking organizations, he noted the following:

• A proposal should be released in the next few months imposing a combined equity and long-term debt requirement;
• A proposal to implement the G-SIB capital surcharge should be released by year-end;

and

• An advanced notice of proposed rulemaking is being drafted to increase capital requirements for, and apply additional measures to, firms dependent on short-term wholesale funding.

The full memorandum provides a high-level analysis of the Final Rule and the Supplementary Leverage Ratio Proposal and highlights the agencies’ responses to certain key concerns addressed in the more than 2,500 comments received on the Proposals. In addition, the full memorandum provides an overview of anticipated U.S. proposals (and recent Basel Committee proposals) that would further increase capital requirements for large, internationally active banking organizations in the near term.

The full memorandum is available here.