Client Alert: Basel III In Bite-Sized Pieces - Part III

A 5-Part Series For Community Banks

Key Elements Of The New Capital Rules

The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency adopted the much anticipated new capital rules implementing Basel III. The new rules will become effective for community banks on January 1, 2015, with many provisions of the new rules phasing-in over a four-year period. This series will discuss the following:

Part I. Overview | Entities Affected By The New Capital Rules (July 31, 2013)
Part II. Changes To The Minimum Capital Requirements (August 13, 2013)
Part III. Revised Regulatory Capital Calculation
Part IV. Changes To The Risk-Weighting Of Assets
Part V. The Impact Of The Capital Conservation Buffer

Steps You Can Take To Prepare For The Revised Regulatory Capital Calculation

Implement a review of your current regulatory capital to determine whether it is adequate under the new rules
Review your current assets and holdings to determine whether they will need to be deducted from regulatory capital

Part III. Revised Regulatory Capital Calculation

The new capital rules emphasize the importance of capital and, consequently, increase the amount of capital that a banking organization must maintain.

Part II of this series focused on the increase in the capital ratios and the implementation of a new Common Equity Tier 1 (“CET1”) capital ratio. This Part III will discuss how the new capital rules further increase the capital requirements by limiting what qualifies as regulatory capital. Because the new minimum capital ratios are calculated by dividing capital by assets, understanding the new capital requirements requires an understanding of these revised capital definitions, including CET1.

Because this series is only a summary of these issues, we encourage you to contact us directly with any questions.

Common Equity Tier 1

Generally speaking, CET1 consists of: (i) outstanding common stock and related surplus (net of treasury stock); (ii) retained earnings; (iii) certain qualifying capital instruments issued by consolidated subsidiaries; and (iv) accumulated other comprehensive income (“AOCI”). Although AOCI is included in the calculation of CET1, bank holding companies with less than $250 billion in assets are allowed a one-time option to filter AOCI from their regulatory capital. This AOCI opt-out must be made on the organization’s first Call Report, FR Y-9C or FR Y-9SP, as applicable, filed after January 1, 2015.

Point of Interest
After a merger between two banking organizations that made different AOCI elections, the surviving entity must decide whether to make the AOCI opt-out by its first regulatory reporting date following the merger.

In addition, capital instruments equivalent to common stock (in terms of subordination and availability to absorb losses), which do not possess features that could cause a banking organization to weaken during periods of market stress, may also be considered CET1 capital.

Point of Interest
Shares of common stock issued under an ESOP by a banking organization that is not publicly traded also count as CET1.

Additional Tier 1 Capital

In addition to CET1, a banking organization can include in Tier 1 capital certain instruments that are “available to absorb losses” on a going-concern basis. To qualify for this category, the capital instrument must, among other criteria: (i) be issued and paid-in, with the paid-in amount classified as equity under GAAP; (ii) be subordinated to depositors, general creditors and subordinated debt holders; (iii) be unsecured and not guaranteed by the organization or an affiliate of the organization; (iv) have no maturity date, dividend step-up or other inducement to redeem; (v) be callable only after a minimum of five years, with certain exceptions; (vi) have the ability to cancel dividends or capital distributions without default; (vii) not be credit-sensitive; (viii) not be purchased or directly or indirectly funded by the organization or an entity controlled by the organization; and (ix) not have a feature that limits or discourages additional capital issuances. Consequently, Tier 1 capital instruments are generally limited to non-cumulative perpetual preferred stock and certain qualified minority interests in capital instruments that qualify as Tier 1.

Point of Interest

Newly issued trust preferred securities and cumulative perpetual preferred stock no longer qualify as Tier 1 capital.

Bank holding companies with less than $15 billion in assets may still include in Tier 1 capital trust preferred securities and cumulative perpetual preferred stock issued prior to May 19, 2010, provided that such instruments do not make up more than 25% of total Tier 1 capital.

Tier 2 Capital

Tier 2 capital consists of: (i) certain capital instruments that qualify as Tier 2 capital and their related surplus; (ii) minority interests that are not included as Tier 1 capital; and (iii) the amount of an organization’s allowance for loan and lease losses that does not exceed 1.25% of the organization’s standardized risk-weighted assets. Tier 2 capital instruments are restricted to instruments that, among other things, are paid-in, unsecured and subordinated to depositors and general creditors and have maturities of at least five years. Practically speaking, the majority of Tier 2 capital instruments will be subordinated debt, subject to certain restrictions, and any trust preferred securities and cumulative perpetual preferred stock that do not otherwise qualify as Tier 1 capital.

Minority Interests In Consolidated Subsidiaries

In certain circumstances and subject to various restrictions and quantitative limits, a parent company may be able to count a limited amount of capital issued by a consolidated subsidiary to third-parties (a “minority interest”) as part of the parent company’s consolidated regulatory capital. A minority interest may only be counted toward a parent company’s capital if the minority interest satisfies all criteria that would apply for the capital category (CET1, Tier 1 or Tier 2) if the parent company had issued the capital itself.

To count a minority interest as CET1 of the parent company, (i) the consolidated subsidiary issuing the capital instrument must be a bank, and (ii) the capital instrument must otherwise qualify as CET1. A capital instrument issued by a bank or non-bank consolidated subsidiary may qualify as:

Tier 1 capital of the parent if the capital issued by the subsidiary:

satisfies the criteria for Tier 1 capital, or
satisfies the criteria for CET1 and the subsidiary is not a bank; or

Tier 2 capital of the parent if the capital issued by the subsidiary satisfies the criteria for Tier 2 capital.

In addition to the qualitative restrictions on minority interests, the new capital rules contain a complex methodology designed to limit the amount of minority interests that may be included in the consolidated capital of a banking organization. The rules governing the capital treatment of minority interests of consolidated subsidiaries and the applicable quantitative limits are extremely complex and subject to various carve-outs and exceptions.

General Deductions From Regulatory Capital

A banking organization is required, under the new capital rules, to deduct from its CET1 capital the following: (i) goodwill and other intangibles, other than mortgage servicing assets (“MSAs” which are addressed below), net of associated deferred tax losses (“DTLs”); (ii) after-tax gain-on-sale associated with a security exposure (i.e., an increase in equity capital as a result of a securitization); (iii) pension fund assets net of associated DTLs; and (iv), in the case of advanced approaches banking organizations (i.e., a bank holding company with more than $250 billion in assets or that satisfies certain other criteria), any expected credit loss that exceeds the banking organization’s eligible credit reserves. In addition, banks are required to deduct any investment in a financial subsidiary from their CET1. These deductions will be phased-in beginning in 2015 and will be fully phased-in by 2018. However, the final rules do not include a transition period for the deduction of goodwill.

A banking organization also is required to deduct from CET1 any of the following that (a) exceed 10% of the organization’s CET1 individually; or (b) exceed, in the aggregate (after taking into account any deductions made as a result of the 10% deduction threshold), 15% of an organization’s CET1: (i) deferred tax assets (“DTAs”) that could not be realized through net operating loss carrybacks (net of related valuation allowances and DTLs); (ii) MSAs net of associated DTLs; and (iii) certain investments in the capital of unconsolidated financial institutions. These deductions will be phased-in beginning in 2015 and will be fully phased-in by 2018.

Deductions For Deferred Tax Assets And Mortgage Servicing Assets

The deductions relating to DTAs and MSAs are conceptually straightforward, although the details are highly technical. If an organization has DTAs or MSAs and those DTAs or MSAs, after deducting DTLs, individually exceed 10% of the organization’s CET1, then the organization must deduct any amount that exceeds the 10% CET1 threshold directly from the organization’s CET1.

Point of Interest
The inclusion of MSAs in regulatory capital is no longer limited to 90% of fair value. Instead, the new capital rules require a deduction from an organization’s CET1 of any MSAs that exceed 10% of CET1 individually or 15% in the aggregate.

Deductions For Investments In Unconsolidated Financial Institutions

Deductions relating to the investment in capital of unconsolidated financial institutions are more difficult to calculate and vary depending on whether the investment is significant or non-significant. A significant investment is an investment in more than 10% of the unconsolidated financial institution’s common equity. If an organization has a significant investment in common equity, then any other capital investment in the unconsolidated subsidiary also is significant. A non-significant investment, on the other hand, is any investment in the capital of an unconsolidated financial institution when the banking organization owns less than 10% of the common equity of the financial institution.

A non-significant investment that is less than 10% of a banking organization’s CET1 does not need to be deducted from an organization’s regulatory capital. However, a non-significant investment that exceeds 10% of the organization’s CET1 must be deducted from an organization’s regulatory capital using the “corresponding deduction approach.” The corresponding deduction approach requires that the investment be deducted from the organization’s corresponding capital component. Thus, if a banking organization has an investment in the capital instruments of an unconsolidated financial institution that would qualify as Tier 2 capital of the banking organization, then the investment amount exceeding the 10% threshold must be deducted from the organization’s Tier 2 capital. However, if the organization does not have sufficient Tier 2 capital for the deduction, then the shortfall must be deducted from the next highest regulatory capital component, which in this case would be Tier 1.

A significant investment is treated in a similar fashion. If a banking organization holds 10% or more of the common equity of an unconsolidated financial institution, then the organization must deduct any amounts exceeding 10% of the organization’s CET1 from the organization’s CET1. If – in addition to holding 10% or more of an unconsolidated financial institution’s common equity – the banking organization holds any other capital instruments of the unconsolidated financial institution, then the full amount of the organization’s holdings in that capital instrument must also be deducted from the organization’s regulatory capital using the corresponding deduction approach. Consequently, if a banking organization owns 10% of the common equity of an unconsolidated financial institution and 5% of such institution’s non-cumulative perpetual preferred stock, the banking organization must deduct the common equity that exceeds 10% of the organization’s CET1 from the organization’s CET1 and the full 5% of its holdings in the institution’s non-cumulative perpetual preferred stock from its Tier 1 capital.

Aggregate Deductions To Regulatory Capital

Finally, under the new rules, the aggregate amount of the items subject to the 10% threshold deduction that are not deducted from a banking organization’s CET1 may not exceed 15% of the organization’s CET1. This calculation does not include any amounts already deducted for exceeding the 10% threshold discussed above. The 15% threshold is thus calculated by aggregating the banking organization’s MSAs, DTAs and significant investments that are below the 10% threshold. If the aggregate of such amounts exceeds 15% of the organization’s CET1, then such amounts also must be deducted from a banking organization’s CET1.

Point of Interest
A banking organization must deduct from its capital any DTAs, MSAs or investments in unconsolidated financial institutions that exceed 10% individually or 15% in the aggregate of the organization’s CET1.

Resources

As with any new rulemaking, implementation of the required changes and thorough planning for the impact of new concepts will take time. We urge you to begin the process of understanding how these rules will impact your organization as soon as possible. To aid in this understanding, we have provided links to Parts I and II of our series, Basel III in Bite-Sized Pieces, and the following useful regulatory guidance for community banks:

Barack Ferrazzano Materials