Federal Reserve Moves To Implement More Rigorous Capital Regulation by the Consumer Financial Services Group

Moving to amend the risk-based capital rules for banks, the Federal Reserve Board has issued three notices of proposed rulemaking that, if adopted, would substantially track the requirements of the Basel III accord.

Basel III is a global regulatory framework addressing, among other things, bank capital adequacy, that was agreed upon in 2011 by the members, representing 27 nations, of the Basel Committee on Banking Supervision.

The three notices of proposed rulemaking in the area of Regulatory Capital Rules are:

  • Advanced Approaches Risk-based Capital Rule; Market Risk Capital Rule
  • Standardized Approach for Risk-weighted Assets; Market Discipline and Disclosure Requirements
  • Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action

At the same time, the Fed also approvedfinal amendments to the market risk capital rules (the Market Risk Amendments), often referred to as Basel II.5. The changes to capital regulation that would be affected by these issuances represent the most dramatic overhaul of capital rules since the inauguration of risk-based capital rules in the legislation that arose out of the S&L crisis of the 1980s.

The Basel III accord itself will be phased in between 2013 and 2019 and will require banks to maintain a top-level capital ratio of 7 percent of risk-weighted assets. This level is approximately three times what banks have been required to hold under the existing regime.

The Fed’s approach has largely been to adhere to the Basel III minimum capital ratio requirements except where a more rigorous approach is required by the Dodd-Frank legislation or is otherwise deemed appropriate by the Fed. These Fed issuances are intended to become joint rulemakings with the Office of the Comptroller of the Currency and the FDIC and will be published in the Federal Register after they receive approvals from the latter two agencies. Those approvals are expected during the next several weeks.

The text of the three rulemakings and the Market Risk Amendments is quite lengthy—more than 800 pages without regard to cross-referenced documents from the Basel Committee. We plan to issue a more comprehensive discussion of these proposed rules in the near future. For now, we will simply highlight the most significant items.

Overall, the new capital standards will force financial institutions and their holding companies to rely more on equity than debt, the better to provide a more substantial cushion against potentially significant losses, which, as recent experience shows, can arise abruptly and unexpectedly. While the banking industry has been urging the Fed to allow counting certain components—such as mortgage servicing rights and unrealized gains on certain securities—toward meeting capital adequacy requirements, the Fed appears to have rejected that approach.

The first proposal, following the Basel III approach, would raise minimum Tier 1 capital ratios from 4 percent to at least 6 percent and would include a minimum common equity Tier 1, or CET1, ratio of 4.5 percent of risk-weighted assets and a CET1 capital conservation buffer of 2.5 percent of risk-weighted assets. This also follows Basel III, which provides for a 2.5 percent capital conservation buffer comprised of CET1 and added to each of the minimum CET1, Tier 1, and Total Capital requirements.

The proposal would apply to all depository institutions, bank holding companies with more than $500 million in total consolidated assets, and savings and loan holding companies, with phase-in periods that will generally track those in Basel III. It is possible, however, that the agencies will engage in a back-door acceleration of those phase-in periods by interim restrictions on growth until the institution achieves full compliance.

The proposal would apply the new capital regime to savings and loan holding companies as soon as the proposed rules are finalized and take effect, which likely will be much sooner than the outside date of July 22, 2015, permitted by Dodd-Frank.

Section 171, popularly known as the “Collins Amendment,” also provides that debt or equity instruments (including, for example, trust preferred securities) issued prior to May 19, 2010, by smaller banking organizations (i.e., those with total consolidated assets as of year-end 2009 of less than $15 billion) or by mutual holding companies would not be subject to the restrictions otherwise mandated by that Section. Nevertheless, the proposed rulemaking inexplicably would render that grandfathering nugatory and would subject such capital instruments to a 10-year phase-out.

The second proposal builds upon existing Basel I-based capital rules—referred to by the Fed as “general risk-based capital requirements”—by inaugurating a more nuanced approach to risk weighting than the four Basel I categories (risk weightings of 0 percent, 20 percent, 50 percent, and 100 percent). Based in part on Basel II’s approach, what the Fed now proposes is designed to enhance risk sensitivity and address weaknesses identified during the financial crisis. This will yield a much larger and more risk-sensitive number of categories, ranging from 0 percent risk weighting for U.S. government securities to risk weights of higher than 100 percent for certain types of assets (e.g., residential mortgages and commercial real estate), all the way up to 600 percent for certain equity exposures.

The “general risk-based capital requirements,” as modified by this proposal, is referred to by the Fed as the new “Standardized Approach.”

The third proposal, containing advanced risk-based capital approaches, would implement changes to international capital standards, including those related to counterparty credit risk, securitization, and disclosure requirements.

Both the “Standardized Approach” and the Market Risk Amendments also implement Section 939A of the Dodd-Frank legislation, which, consistent with Dodd-Frank’s wholesale rejection of pre-existing federal statutory seals of approval for nationally recognized investment rating agencies, requires the agencies to modify regulations that either require or refer to credit ratings by eliminating credit ratings as a factor and therefor substituting other standards of creditworthiness.

The comment period for the proposed rules ends on September 7, 2012. The Market Risk Amendments become effective on January 1, 2013, and the proposed rules contemplate that the Basel III requirements will become effective on January 1, 2013, subject to a phase-in period. The Standardized Approach is expected to become effective on January 1, 2015, subject to the possibility of earlier adoption.

The attorneys in Ballard Spahr’s Consumer Financial Services Group and Bank Regulation and Supervision Group are experienced in assisting clients in the preparation and filing of comments in agency rulemaking proceedings. For more information, please contact CFS Practice Leader Alan S. Kaplinsky at 215.864.8544 or kaplinsky@ballardspahr.com, CFS Practice Leader Jeremy T. Rosenblum at 215.864.8505 or rosenblum@ballardspahr.com, or Keith R. Fisher in the Bank Regulatory Practice Group at 202.661.2284 or fisherk@ballardspahr.com.

Copyright © 2012 by Ballard Spahr LLP.

www.ballardspahr.com

(No claim to original U.S. government material.)

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the author and publisher.

This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.