US Banks: Primer on New US Rules for Regulatory Capital

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

July 8, 2013

US Banks: Primer on New US Rules for Regulatory Capital

  • On Tuesday, the Federal Reserve Board approved final new capital rules establishing a minimum leverage ratio of 4%, and raising the minimum Tier 1 capital ratio from 4 to 6% of which the common equity component must be at least 4.5%.
    • The rules establish a “capital conservation buffer” for common equity of 2.5% over and above this 4.5%; banks in the “conservation range” of 4.5-7% will face restrictions on capital-depleting activities such as buying back stock and paying dividends/bonuses.
  • In addition to stress-testing, “living will” requirements to improve the chance of orderly resolution if necessary, and early phase-in of capital rules beginning January 2014, large financial institutions also face “macro-prudentialrequirements to:
    • post additional capital for counterparty credit risk and, at the discretion of regulators in times of excessive credit growth, a “counter-cyclical” capital conservation buffer above the usual 2.5%; and to include certain off balance-sheet items in the leverage ratio.
    • calculate capital ratios under two regimes (the “standard” of the baseline and an “advanced” to reflect the individual portfolio) and choose the most conservative result.
  • On top of all this, the US banks designated as G-SIFI (i.e., JPM, BAC, C, GS, MS, WFC, BK, and STT) will face additional yet-to-be-finalized rules on capital surcharges for complexity and wholesale funding, on a higher leverage ratio, and on minimum long-term debt.
    • In contrast, community banks get several breaks: rules phase-in begins a year later; they can opt-out of the requirement that unrealized gains/losses in AOCI impact regulatory capital; and, if small, can grandfather trust preferred securities into Tier 1 capital.
  • The US rules for large financial institutions are more stringent than the Basel 3 framework in the definition of Tier 1 capital (debt securities cannot qualify) and the timetable for phasing out non-qualifying securities; also, the 4% minimum leverage ratio (which will be increased for G-SIFIs) compares with a proposed 3% under Basel 3.

Exhibit: Tier 1 Regulatory Timetable for Basel 3 Applies to Large Financial Institutions in the US

Overview

“Perhaps a touchstone of future regulatory reform might be either a narrowing of the banks covered by full deposit insurance or a reduction of insurance coverage. The clear goal should be to reduce the moral hazard in – and hence the regulation imposed upon – our banking system.” Roger Ferguson Jr, Federal Reserve Governor, June 1998

“Deutsche Bank loses $2 billion and raises their capital ratio – I don’t want to say insane, but it is ridiculous”. FDIC Vice Chairman Thomas Hoenig commenting on Deutsche results announced this January

“I do worry about the very, very, very, very bad market … banks continue to be hardly well-capitalized.” Sallie Krawcheck, Former CFO Citigroup and Executive, Bank of America, May 2013

“Managers of some large institutions know how to hide loss exposures by transacting in ever more complex instruments and arbitrage away the risk-weights of capital requirements.” Sarah Raskin, Federal Reserve Governor, July 2013

In the wake of the financial crisis of 2008, the touchstone of financial reform in the US has turned out to be not the roll-back of deposit insurance envisioned by a Federal Reserve Governor as recently as 1998 but a massive increase in regulation – much driven statutorily by the Dodd-Frank Act of 2010 but some arising from a sense, intimated by the FDIC Vice-Chairman, that banks may have too much latitude to assess the risk-sensitivity of assets and, according to Governor Raskin, may be outright gaming capital standards.

An important milestone was the adoption last week by the Federal Reserve Board of bank capital rules implementing the Basel 3 framework albeit with important variations particularly as to timetable, the leverage ratio, and the definition of capital. The Board recognized the safety and soundness of the overall financial system was vulnerable to institutions not covered by regulation both in the US and overseas (although rules largely consistent with Basel 3 standards have now been adopted in Europe, Switzerland, and Japan).

Baseline Rules for Tier 1 Capital

The US rules reflect two core philosophies: first, that the best protection against involvement of deposit insurance funds and taxpayer resources was for banks to improve the quantity and quality of capital, particularly equity capital; and, second, the notion of a “layering” of regulatory measures, including capital requirements, so that they increase in stringency as banks become larger and more systemically important.

Beyond some technical changes[1], the rules establish a minimum leverage ratio (i.e. ratio of Tier 1 capital to assets) of 4%, raise the minimum “risk-based” ratio for Tier 1 capital (i.e. ratio of Tier 1 capital to “risk-weighted” assets) from 4% to 6%; and establish a minimum for the common equity component of Tier 1 capital is 4.5% of risk-weighted assets.

Beyond these minimums, there is a “capital conservation buffer” for Tier 1 common equity of 2.5% of risk-weighted assets. The intention is to encourage banks to build capital during benign economic environments so as to be able to withstand a stress event without the capital ratio falling below the regulatory minimum; banks falling into the “conservation range” of 4.5-7% will be able to continue normal operations but will face restrictions on capital-depleting activities such as dividend payments, stock buybacks, and discretionary bonus payments to staff.

Differences with the Basel 3 Framework

Large, internationally-active financial institutions will begin phasing-in the new rules in January 2014 on the regulatory timetable of the Basel 3 framework (see Exhibit 1) except that, as a statutory requirement of Dodd Frank, trust preferred and other non-qualifying securities must be phased out of Tier 1 capital over 3 years. Community banks do not need to begin phasing-in until January 2015 and those with assets of less than $15 billion can grandfather in to Tier 1 capital trust preferred and certain other securities that otherwise would no longer qualify.

The Dodd-Frank statute gives rise to two other important differences between the US baseline rules for large financial institutions and the Basel 3 framework:

  1. Assessment of credit risk: Basel 3 allows the use of credit ratings while Dodd-Frank requires US federal agencies to remove references to credit ratings from their regulations so that the new rules embed alternative measures of creditworthiness.
  2. Tier 1 Capital: Basel 3 allows certain debt securities to qualify for Tier 1 capital while, in the US, Dodd-Frank restricts Tier 1 capital to equity securities.

Beyond these differences in framework, there are implementation differences in the US versus overseas including, for example, the different treatment of credit risk in OTC derivatives and for the assessment of risk in sovereign debt instruments; these differences will be explored through “comparability” assessments to be conducted by the Basel Committee on Banking Supervision (the “Basel Committee”).

Exhibit: Tier 1 Regulatory Timetable for Basel 3 Applies to Large Financial Institutions in the US

Source: PWC

Additional Requirements for Large Financial Institutions

In adopting the new rules, the Board acknowledged that capital ratios:

  • do not provide complete protection against financial instability and, in particular, do not substitute for proper governance of banks by management and proper supervision of banks.
  • need to be comprehensible by the banks needing to comply with them, by examiners needing to monitor compliance with them, and by the public needing to trust in them; in particular, uncertainty about capital standards complicated planning by banks and may have contributed to under-lending to creditworthy borrowers.
  • have raised complexity and burden-concerns particularly among smaller financial institutions.

To balance the need to increase protection against the need to manage complexity and regulatory burden, the Board adopted different treatments for large, internationally-active institutions, particularly the eight US institutions[2] designated as global systemically-important financial institutions or “G-SIFIs”, and smaller “community banking” institutions not engaged in international activity. This distinction also allowed the Board to bring certainty to community banks which are not likely to face major modifications to capital rules while setting expectations for additional rules that will be faced by the G-SIFIs as described below.

For large financial institutions (with $50 billion+ in consolidated assets), the Board expects by year-end to extend its annual program of supervisory stress-testing and capital planning and to establish “living will” plans to improve the chance for orderly resolution in the event on-going operations cease to be viable. In addition, large institutions face additional “macro-prudential” requirements including: the possible need, at the discretion of regulators and at times of excessive credit growth, to post a “counter-cyclical” capital conservation buffer above the baseline 2.5%; the inclusion of off-balance sheet items in calculation of the leverage ratio; additional risk-based capital assessments for counterparty credit risk; and a requirement to calculate capital ratios under both the standard and an “advanced” approach and choose the more conservative of the two methods.

A concern about the advanced methodology is that, in an attempt to allow the capital rules to reflect the complexity of large financial institutions, it allows banks to calculate risk-weights using their own models creating the potential for a lack of comparability of risk-based capital ratios across banks. Indeed, a recent report from the Basel Committee found that a lot of variability in capital ratios arising from differences in the internal bank models used to calculate risk-weightings: specifically, differences in discretionary credit risk-weightings could give rise to as much 40% variation in risk-based capital ratios (see Exhibit 2). We note the Exhibit suggests European banks, comprising 50% of the sample of 32 institutions, were disproportionately aggressive in their risk-weightings.

To mitigate this, the Committee plans to impose a minimum leverage ratio of 3% to be adopted by 2018 (versus the baseline 4% included in the new US rules) and to conduct comparability studies to identify best and outlier practices. In the US, large financial institutions must calculate risk-based capital ratios under a standard approach (which includes minimum risk-weights for risk-weighted assets) and use this if it is more conservative than the advanced approach; as a result, US banks have less latitude than overseas counterparts.

Exhibit 2: Impact of Credit Risk-Weight Variation in Banking Books on Capital Ratio

Source: Regulatory Consistency Assessment Program, Basel Committee on Banking Supervision

Further Additional Capital Requirements Expected for G-SIFIs

For the G-SIFIs, the Board announced its intention to issue notices of proposed rule-making in four areas to supplement the baseline capital rules and additional requirements for large institutions:

  1. G-SIFI Buffer: Capital surcharges over and above the 7% standard for the Tier 1 capital ratio and likely amounting in practice to 1-2.5% of risk-weighted assets (see Exhibit 3); the Board expects these surcharges to be announced later in the year.
  2. Wholesale Funding Surcharges: Additional capital surcharges, over and above the G-SIFI buffers, for those institutions with significant dependence on short-term wholesale funding.
  3. Leverage Ratio Requirement: A higher leverage ratio than the baseline 4%.
  4. Resolution Planning: Requirements for a minimum amount of equity and long-term debt as part of the resolution planning process.

Exhibit 3: Potential Common Equity Tier 1 Capital Surcharges for G-SIFIs as estimated by Goldman Sachs

Source: Goldman Sachs

Addressing the Complexity and Burden-Concerns of Community Banks

While large financial institutions, and particularly G-SIFIs, face capital requirements above the baseline established in the new rules, community banks may not need to meet all the requirements of the baseline. In particular:

  • Community banks can make a one-time election to opt-out of the requirement that components of Accumulated Other Comprehensive Income or “AOCI”, and particularly unrealized gains and losses on debt securities designated as available-for-sale or “AFS”, be included in Tier 1 capital. The reasoning was that AOCI effects complicated capital planning by introducing interest rate-based volatility into the capital calculation which smaller institutions may not have the hedging sophistication to manage. Staff noted that, while there were economic losses on AFS debt securities when interest rates rose, there were also economic gains to bank deposit franchises which are not included in the capital calculation because we do not have full “fair value” accounting; furthermore, examiners could continue to gauge the risk to banks of rising interest rates through other tools including the usual testing of the economic impact of +/- moves in the yield curve.
  • Community banks with less than $15 billion in consolidated assets may “grandfather” into Tier 1 capital trust preferred and certain other securities that otherwise do not qualify under the new capital rules.

We note that the new rules represent the outcome of inter-agency cooperation with the Federal Deposit Insurance Corporation (“FDIC”) and Office of the Comptroller of the Currency (“OCC”) expected to vote on the July 9th.

  1. Including more stringent limits on the inclusion of mortgage-servicing and deferred tax assets in Tier 1 capital; and higher risk-weights for these assets as well as for past-due, non-accrual, and high-risk commercial real-estate loans.
  2. C, JPM, BAC, WFC, GS, MS, BK, STT
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