Final Basel III Capital Rule Issued by U.S. Bank Regulators: Some Relief for Community Banks; for SIFIs, Just the End of the Beginning

July 9, 2013

On July 2, 2013, the Board of Governors of the Federal Reserve System (Federal Reserve) unanimously approved its final rule implementing Basel III (Final Rule) and thus established the post-Financial Crisis capital framework for institutions under its jurisdiction.  The Final Rule was issued jointly with the Office of the Comptroller of the Currency (OCC), which approved the rule as a final rule today, July 9th.

The Final Rule provides some relief to community banks, which had argued that the implementation of Basel III as the regulators had originally proposed would impose substantial costs on their business models.  This said, the agencies made it very clear that they believe that increasing the quantity and quality of bank capital is a supervisory priority that far outweighs any concerns about retarding the availability of credit and hampering economic growth.  This is particularly true for systemically significant financial institutions (SIFIs), which will be required to conduct their businesses in accordance with much higher capital requirements than before the Financial Crisis.

Indeed, the July 2 Federal Reserve meeting was perhaps most consequential for what lies ahead for SIFIs.  Governor Tarullo, the Federal Reserve Governor who has played the largest role in the development of bank supervision since the Financial Crisis, indicated that the Federal Reserve would be conducting additional rulemakings that would impose heightened capital and related requirements on SIFIs.  One such rulemaking took only a week to appear:  today, the Federal Reserve, the OCC, and the Federal Deposit Insurance Corporation (FDIC) issued a notice of proposed rulemaking (Supplementary Leverage Proposal) that would impose a heightened supplementary leverage ratio on certain SIFIs and their insured depository institution subsidiaries.

This Alert discusses the Supplementary Leverage Proposal and the following principal provisions of the Final Rule:

• Institutions to Which the Final Rule Applies
• Compliance Dates and Grandfathering
• New Minimum Capital Ratios and Capital Buffers
• New Requirements for the Components of Tier 1 and Tier 2 Capital
• New Rules on Deductions from Capital
• Asset Risk-Weightings — Standardized Approach
• Basel III Advanced Approaches

I.    Applicability

The Final Rule applies to national banks, state member banks, Federal savings associations, top-tier bank holding companies (BHCs) domiciled in the United States that are not subject to the Federal Reserve’s Small Bank Holding Company Policy Statement — that is, BHCs with $500 million or more in total consolidated assets, and to top-tier savings and loan holding companies (SLHCs) domiciled in the United States other than those substantially engaged in insurance underwriting or commercial activities.[1]

Because the Office of Thrift Supervision did not historically impose consolidated capital requirements on SLHCs, those top-tier SLHCs not excluded from the Final Rule will be subject to consolidated capital requirements for the first time.  Also to be covered for the first time, if the Federal Reserve maintains its intermediate holding company (IHC) requirement as proposed in the final Section 165 rule for foreign banking organizations (FBOs), will be those IHCs required to be established by purportedly “systemic” FBOs — those with total global consolidated assets of $50 billion or more and total consolidated U.S. nonbranch assets of $10 billion or more.

The Final Rule excludes the following top-tier SLHCs from coverage:

• Grandfathered unitary SLHCs — as defined in section 10(c)(9)(A) of the Home Owners’ Loan Act (HOLA) — that derive either 50 percent or more of their total consolidated assets or 50 percent or more of their revenues on an enterprise-wide basis as calculated under GAAP from activities that are not financial in nature under Section 4(k) of the Bank Holding Company Act, or
• SLHCs that are themselves insurance underwriting companies, or hold 25 percent or more of their total consolidated assets in insurance underwriting subsidiaries (other than assets associated with insurance underwriting for credit risk)[2]

With respect to those SLHCs substantially engaged in commercial activities, the preamble to the Final Rule states that those companies would be excluded from the Final Rule’s coverage “while [the Federal Reserve] continues to contemplate a proposal for SLHC intermediate holding companies”[3] under Section 626 of the Dodd-Frank Act (Dodd-Frank).  The preamble further states that the Federal Reserve anticipates releasing a proposal for public comment on such IHCs that would specify the criteria for establishing and transferring activities to IHCs and would apply the Final Rule’s capital requirements to IHCs.  It also notes that the Federal Reserve expects “to implement a framework for SLHCs that are not subject to the final rule by the time covered SLHCs must comply with the final rule in 2015.”[4]

All banking organizations subject to the Final Rule must calculate their risk-weighted assets under the Final Rule’s standardized approach.  Those banking organizations subject to the Final Rule that have $250 billion or more in consolidated total assets or $10 billion or more in consolidated total on-balance sheet foreign exposure (advanced approaches banking organizations) must also calculate their risk-weighted assets under the Final Rule’s advanced approaches.  Because of the Collins Amendment contained in Section 171 of Dodd-Frank, however, advanced approaches banking organizations must use the approach that results in lower risk-based capital ratios when determining compliance with minimum capital requirements.

II.    General Compliance Dates and Grandfathering

The general compliance dates established by the Final Rule are informed by the agencies’ view that covered SLHCs and banking organizations not subject to the advanced approaches will require more time to comply than advanced approaches banking organizations.

Banking organizations that are not advanced approaches banking organizations and advanced approaches banking organizations that are covered SLHCs are subject to one set of compliance dates:

Advanced approaches banking organizations that are not SLHCs are subject to a second set of compliance dates:

From January 1, 2014 to December 31, 2014, an advanced approaches banking organization that is on parallel run must calculate risk-weighted assets using existing risk-based capital rules and use such risk-weighted assets for purposes of determining its risk-based capital ratios.  During 2014, an advanced approaches banking organization that has completed the parallel run process and has received the necessary notification from its primary Federal supervisor to use the advanced approaches must use the risk-based capital rules currently in effect for purposes of the Collins Amendment floor and calculate advanced approaches risk-weighted assets under the Final Rule.  Regardless of their parallel run status, all advanced approaches banking organizations must switch to the Final Rule on January 1, 2015 to calculate risk-weighted assets under the standardized approach.

Top-tier BHC subsidiaries of non-U.S. banks currently relying on Supervision and Regulation  Letter (SR) 01-1 are permitted until July 21, 2015 to comply with the Final Rule’s requirements.

With respect to the Collins Amendment’s treatment of non-qualifying capital instruments, the Final Rule requires banking organizations that had $15 billion or more in consolidated assets as of December 31, 2009 to phase non-qualifying capital instruments out of Tier 1 capital by January 1, 2016.  In addition, the agencies retreated from their position in the proposed rule and will permit banking organizations with total consolidated assets of less than $15 billion as of December 31, 2009 and banking organizations that were mutual holding companies as of May 19, 2010 to continue to include in Tier 1 capital such non-qualifying capital instruments, including trust preferred securities (TruPS), that were issued prior to May 19, 2010, subject to a limit of 25 percent of qualifying Tier 1 capital elements less all regulatory capital deductions and adjustments applied to Tier 1 capital.

III.    New Minimum Capital Ratios and Capital Buffers

The Final Rule revises minimum capital requirements for all banking organizations subject to its provisions, including a new common equity Tier 1 capital ratio, a higher minimum Tier 1 capital ratio, a supplementary leverage ratio for advanced approaches banking organizations, a new capital conservation buffer, and a new countercyclical capital buffer for advanced approaches banking organizations.

Minimum Capital Ratios

Applicable to all banking organizations, changes to minimum capital and leverage ratios will increase the quantity of regulatory capital.  The minimum capital and leverage ratios applicable to all banking organizations under the Final Rule are:

• Common equity Tier 1 capital to risk-weighted assets ratio of 4.5%
• Tier 1 capital to risk-weighted assets ratio of 6%
• Total capital to risk-weighted assets ratio of 8%
• Leverage ratio (Tier 1 capital to average total assets, minus amounts deducted from Tier 1 capital) of 4%.[5]

In addition, advanced approaches banking organizations will be required to maintain a minimum supplementary leverage ratio — Tier 1 capital to total leverage exposure — of 3%, consistent with Basel III.  Total leverage exposure equals the sum of the following:

• The balance sheet carrying value of all of the banking organization’s on-balance sheet assets less certain amounts deducted from Tier 1 capital;
• The potential future exposure (PFE) for each derivative transaction to which the banking organization is a counterparty, or each single-product netting set of such transactions, as calculated under the Final Rule;
• 10 percent of the notional amount of unconditionally cancellable commitments made by the banking organization; and
• The notional amount of all other off-balance sheet exposures of the banking organization, excluding securities lending, securities borrowing, reverse repurchase agreements, derivatives, and unconditionally cancelable commitments.

For standardized approaches banking organizations and covered SLHCs, the new minimum capital requirements become applicable on January 1, 2015.  For advanced approaches banking organizations that are not SLHCs, there is a transition period for the heightened capital requirements, as set forth in the table below, with the minimum supplemental leverage ratio becoming effective on January 1, 2018.

Capital Conservation Buffer

Reacting to evidence that, during the Financial Crisis, some banking organizations continued to pay dividends and substantial discretionary bonuses as their financial condition weakened, Basel III incorporated the concept of a “capital conservation buffer.”  The Final Rule implements the capital conservation buffer for all banking organizations, under which the ability of a banking organization to pay dividends and make discretionary bonus payments will be limited if the banking organization does not hold a specified amount of common equity Tier 1 capital above the minimum risk-based capital requirements.

The Final Rule implements the capital conservation buffer through the concept of the “maximum payout ratio” — the percentage of eligible retained income that a banking organization is allowed to pay out in the form of distributions and discretionary bonus payments during a current calendar quarter.  This “maximum payout ratio” is determined by the size of a banking organization’s capital conservation buffer, which is the lowest of the following ratios:

• the banking organization’s actual common equity Tier 1 capital ratio minus its minimum common equity Tier 1 capital ratio (4.5%);
• the banking organization’s actual Tier 1 capital ratio minus its minimum tier 1 capital ratio (6.0%); and
• the banking organization’s actual total capital ratio minus its minimum total capital ratio (8.0%).

Subject to a transition period, a banking organization must maintain a capital conservation buffer greater than 2.5 percent in order to avoid limitations on dividend and discretionary bonus payments.  The limitations take the form of percentage-based reductions in the maximum payout ratio, although supervisors retain the right to grant case-by-case exemptions should they determine that the payment or distribution is not contrary to the purposes of the capital conservation buffer of the safety and soundness of the banking institution.  The limitations on capital distributions and transition period for the capital conservation buffer are set forth in the table below.

Countercyclical Capital Buffer

Beginning in 2016, advanced approaches banking organizations will be subject to an additional, discretionary countercyclical capital buffer that could raise their capital buffer by as much as 2.5 percent by 2019.  The agencies stated that the countercyclical buffer seeks to reduce systemic vulnerabilities in two ways — first, “when [a] credit cycle turns following a period of excessive credit growth, accumulated buffers act to absorb the above-normal losses that a banking organization would likely face,” and second, “by increasing the amount of capital required for further credit extensions, a countercyclical capital buffer may limit excessive credit.”[7]

As a general matter, the agencies stated that they expected to announce an increase in the U.S. countercyclical capital buffer amount[8] with an effective date of at least 12 months after announcement, to provide banking organizations with sufficient time to adjust to any changes.  A decrease in the buffer will be effective on the day following announcement of the determination or the earliest date permissible under applicable law or regulation, whichever is later.  In addition, the buffer amount will return to zero 12 months after its effective date, unless the agencies announce a determination to maintain the amount or adjust it again before the expiration of the 12-month period.  The operation of the countercyclical capital buffer in tandem with the capital conservation buffer for a year after 2018 may be seen in the following table:

Taken together, the two buffers will effectively require advanced approaches banking organizations to maintain substantially higher capital ratios that currently, as demonstrated in the following table:

IV.    New Requirements for the Components of Tier 1 and Tier 2 Capital

The Final Rule revises the components of Tier 1 and Tier 2 capital and emphasizes the current mantra that common equity is the most important constituent of Tier 1 capital.  Total capital is now viewed as containing three sub-categories:

Common Equity Tier 1 Capital:  Common equity Tier 1 capital includes qualifying common stock instruments, retained earnings, accumulated other comprehensive income (AOCI) (unless, for standardized approach banking organizations, a one-time election is made to exclude it), and qualifying minority interests.  The preamble to the Final Rule, however, states that the agencies believe that “voting common stockholders’ equity (net of the adjustments to and deductions from common equity Tier 1 capital) should be the dominant element within common equity tier 1 capital.”[9]

The Final Rule’s criteria for common equity Tier 1 capital instruments are generally as proposed, except for the following modifications:

• For state-chartered companies under the Federal Reserve’s supervision, dividend payments may be paid out of surplus in addition to current and retained earnings; and
• Shares issued as part of an ESOP by banking organizations that are not publicly-traded are exempted from the conditions that common equity Tier 1 instruments can be redeemed only via discretionary repurchases and cannot be subject to any other arrangement that legally or economically enhances their seniority, that the banking organization not create an expectation that the shares will be redeemed, and that the banking organization not directly or indirectly fund the purchase of the instrument.

Additional Tier 1 Capital:  Additional Tier 1 capital equals the sum of additional qualifying Tier 1 capital instruments, related surplus, and any Tier 1 minority interest that is not included in a banking organization’s common equity Tier 1 capital, less applicable regulatory adjustments and deductions.

With the Final Rule, TruPS and cumulative preferred securities are generally no longer eligible for inclusion in Tier 1 capital, but perpetual noncumulative preferred stock should qualify as long as it meets the other requirements of the Final Rule — for example, that it be subordinated to all debt holders in an insolvency, that it be generally callable by the banking organization only after a minimum of five years following issuance, and that it not have credit-sensitive features or features that would limit or discourage additional issuances of capital.  Like common equity Tier 1 instruments, additional Tier 1 instruments must be redeemable by the banking organization only upon prior supervisory approval in order to qualify as capital.

The Final Rule’s criteria for additional Tier 1 capital instruments differ from proposal by:

• Permitting dividend payments out of surplus in addition to current and retained earnings;
• Exempting additional Tier 1 instruments issued under an ESOP by a banking organization that is not publicly traded from the criterion that additional Tier 1 instruments not be callable for at least five years after issuance;
• Including a provision to clarify that the criterion prohibiting a banking organization from directly or indirectly funding a capital instrument, the criterion prohibiting a capital instrument from being covered by a guarantee of the banking organization or from being subject to an arrangement that enhances the seniority of the instrument, and the criterion pertaining to the creation of an expectation that the instrument will be redeemed shall not prevent an instrument issued by a non-publicly traded banking organization as part of an ESOP from being included in additional Tier 1 capital;
• Including a provision to clarify that capital instruments held by an ESOP trust that are unawarded or unearned by employees or reported as “temporary equity” under GAAP (in the case of U.S. SEC registrants) may not be counted as equity under GAAP and therefore may not be included in additional Tier 1 capital;
• Revising the rule to permit a banking organization to call an instrument prior to five years after issuance in the event that the issuing entity is required to register as an investment company pursuant to the Investment Company Act of 1940;
• Revising the rule to allow an instrument that may be called prior to five years after its issuance upon the occurrence of a rating agency event to be included into additional Tier 1 capital, provided that (i) the instrument was issued and included in a banking organization’s Tier 1 capital prior to the effective date of the rule, and (ii) that such instrument meets all other criteria for additional tier 1 capital instruments under the Final Rule; and
• Clarifying that restrictions on capital distributions to holders of common stock instruments and holders of other capital instruments that are pari passu in liquidation with the instrument are acceptable.

Tier 2 Capital.  Tier 2 capital includes qualifying Tier 2 instruments, such as cumulative and limited-life preferred stock and subordinated debt, related surplus, minority interest not included in Tier 1 capital, and limited amounts of the allowance for loan and lease losses (ALLL), less applicable regulatory adjustments and deductions.  Importantly, the Final Rule, like the proposal, eliminates currently existing limitations on the amount of Tier 2 capital that can be recognized in total capital, as well as limitations on the amount of capital instruments like term subordinated debt that can be included in Tier 2 capital.

With respect to TruPS, although the agencies observed that the majority of existing TruPS would not technically comply with the Final Rule’s Tier 2 eligibility criteria, they stated that the inclusion of existing TruPS in Tier 2 capital until redemption or maturity would benefit certain banking organizations until they are able to replace such instruments with fully compliant capital instruments.  Non-advanced approaches depository institution holding companies with over $15 billion in total consolidated assets, therefore, are permitted to include in Tier 2 capital all of their TruPS that are phased out of Tier 1 capital.  Advanced approaches banking organizations, however, are required to phase out their TruPS from Tier 2 capital from January 1, 2016 to December 31, 2021.

The agencies finalized the criteria for Tier 2 capital instruments generally as proposed, except that they:

• Clarified that subordinated debt instruments must be subordinated to the claims of depositors and general creditors, as well as to the claims of trade creditors;
• Clarified that the five-year minimum maturity requirement would not apply to a debt instrument that automatically converts to an equity instrument within five years of issuance and that satisfies all criteria for Tier 2 instruments other than the five-year maturity requirement;
• Allowed instruments that may be called prior to five years after their issuance upon the occurrence of a rating agency event to be included in Tier 2 capital, provided that the instrument was issued and included in the banking organization’s Tier 1 or Tier 2 capital prior to the effective date of the Final Rule, and that the instrument meets all the other criteria for Tier 2 treatment; and
• Clarified that an advanced approaches banking organization will always include in total capital its ALLL up to 1.25 percent of (non-market risk) risk-weighted assets when measuring its total capital relative to standardized risk-weighted assets.

The agencies indicated that they believed that most existing regulatory capital instruments — other than TruPS as discussed above — will continue to be includable in regulatory capital, but, as in the proposal, it included a process to consider the eligibility of new capital instruments.  The Final Rule therefore provides that a banking organization must receive its primary federal supervisor’s prior approval to include a capital element in capital, unless the element:

• was included in capital prior to May 19, 2010 in accordance with the relevant supervisor’s risk-based capital rules in effect on that date and the instrument continues to be includable under the Final Rule; or
• is equivalent, in terms of capital quality and ability to absorb credit losses with respect to all material terms, to a regulatory capital element determined by that supervisor to be includable in regulatory capital.

V.    New Deductions from and Adjustments to Capital

The Final Rule imposes new deductions from and adjustments to capital, which are stricter than under existing capital rules and which are mostly taken from common equity Tier 1 capital, in an effort to increase the loss-absorbency of the capital structures of banking organizations.  The principal deductions, which are generally phased in over a period ending on January 1, 2018, relate to:

• minority interest in consolidated subsidiaries
• goodwill and other intangible assets, other than mortgage servicing assets
• after-tax gain on sale associated with a securitization exposure
• bank equity investments in financial subsidiaries
• federal savings association investments and extensions of credit to subsidiaries engaged in activities not permissible for a national bank
• investments in unconsolidated financial institutions above certain thresholds[10]

One of the more controversial elements of the proposed rule was its requirement to include almost all AOCI components in common equity Tier 1 capital — including unrealized gains and losses on available for sale securities.  Commenters argued that including all such components would introduce significant volatility in regulatory capital and lead to significant difficulties in capital planning.  The agencies were sympathetic — up to a point — to these concerns, and in the Final Rule permitted banking organizations not subject to the advanced approaches to make a one-time, permanent election to continue AOCI treatment under existing capital rules.  The agencies did not grant such flexibility to advanced approaches banking organizations, believing that they had the systems in place to manage their capital with AOCI components included.  The agencies also reserved the authority to require a banking organization to recognize all or some AOCI components in regulatory capital if appropriate.

Finally, the Final Rule does not address the capital deductions required by the Volcker Rule; instead, the preamble states that “the agencies intend to address [the Volcker Rule] capital requirement, as it applies to banking organizations, within the context of the agencies’ entire regulatory capital framework, so that its potential interaction with all other regulatory capital requirements can be fully assessed.”[11]

VI.    Asset Risk Weightings — Standardized Approach

The Final Rule’s asset risk weightings under the standardized approach is the area in which community banking organizations obtained some relief, particularly with respect to risk weightings for residential mortgages.

The risk weightings of certain assets did not change from existing non-advanced approaches rules.  Examples of maintained weightings are:

• cash and bullion (zero percent)
• exposures to the U.S. government, its central bank, and government agencies, including the portion of exposures unconditionally guaranteed by such entities, such as deposits insured by the FDIC and National Credit Union Administration (NCUA) (zero percent)
• exposures conditionally guaranteed by the U.S. government, its central bank, and government agencies, including the FDIC or NCUA (20 percent)
• general obligation exposures to U.S. public-sector entities (20 percent)
• exposures to U.S. government-sponsored entities (20 percent generally; 100 percent for preferred stock)[12]
• uninsured debt exposures to U.S. depository institutions (20 percent)
• corporate debt exposures generally (100 percent)

Also maintained are the risk-weighting of residential mortgages.  Although the proposed rule assigned a range of risk weight categories based on loan-to-value ratios and certain other product features, the Final Rule reverts to the treatment under existing risk-based capital rules, which assign a risk-weight of either 50 percent (for most first-lien exposures) or 100 percent for other exposures.

Foreign Sovereigns and Foreign Banks.  As a general matter, the Final Rule uses the Organization for Economic Co-operation and Development’s (OECD) country risk classification (CRC) to assign risk weights to exposures of foreign sovereign entities.  OECD member countries that do not receive a CRC rating — as a result of the OECD’s determination to cease rating certain high-income jurisdictions — receive a risk weight of zero while non-OECD member countries without a CRC rating receive a risk weight of 100 percent.  In addition, exposures to foreign sovereign entities that have experienced an event of default in the last five years receive a risk weight of 150 percent.

Foreign bank exposures generally receive a risk weight one category higher than the risk weight assigned to an exposure to the foreign bank’s home country, with a bank from an OECD country without a CRC rating having a risk weight of 20 percent, and a bank from a non-OECD country without a CRC rating have a risk weight of 100 percent.  The 150 percent risk weight applies to banks from countries that themselves are subject to a 150 percent risk weight due to an event of default.

Supranational Entity and Multilateral Development Bank Exposures.  The Final Rule applies a zero risk weight to exposures to the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, and a broad range of multilateral development banks (MDBs).^[13]

Obligations of Securities Firms.  The agencies specifically rejected the approach of the Basel capital framework that would permit exposures to securities firms that meet certain requirements to be assigned the same risk weight as exposures to depository institutions.  Such exposures therefore are assigned a 100 percent risk weight, the same risk weight applied to BHCs, SLHCs, and other financial institutions that are not insured depository institutions or credit unions.

High-Volatility Commercial Real Estate.  The Final Rule departs from existing treatment by assigning a 150 percent risk weight — as opposed to 100 percent — to high-volatility commercial real estate (HVCRE) exposures, which are defined to include any credit facility that finances or has financed the acquisition, development, or construction of real property, unless the facility finances one- to four-family residential mortgage property, as well as commercial real estate projects that meet certain prudential criteria.  The Final Rule excludes from the definition of HVCRE loans to facilitate certain community development projects as well as loans secured by agricultural land.

Past Due and Nonaccrual Loans.  The Final Rule increases from 100 percent to 150 percent the risk weight for exposures, other than sovereign exposures and residential mortgage exposures, that are more than 90 days past due or on nonaccrual, stating that the ALLL, although it reflects past due and nonaccrual loans, does not serve the same function as increasing the risk weight on such assets.

Transactions with Central Counterparties.  The Final Rule introduces capital requirements for cleared transactions with central counterparties, as well as for default fund contributions to central counterparties (CCPs) by clearing member banking organizations.  Under the Final Rule, to determine the risk-weighted asset amount for a cleared transaction with a CCP, a clearing member banking organization or a clearing member client banking organization must generally multiply the trade exposure amount for the cleared transaction by the appropriate risk weight.  Consistent with the Basel Committee’s interim framework, the risk weight for a cleared transaction depends on whether the CCP is a qualifying central counterparty (QCCP).  A clearing member banking organization must apply a 2 percent risk weight to its trade exposure amount to a QCCP.  A clearing member client banking organization, however, may apply a 2 percent risk weight to the trade exposure amount only if certain conditions are met, including that the collateral posted is subject to an arrangement that prevents loss to the clearing member client in the event of an insolvency, liquidation, or receivership; otherwise a 4 percent risk weight must be applied.  For a cleared transaction with a CCP that is not a QCCP, the trade exposure amount must generally be risk weighted at 100 percent.

OTC Derivative Contracts.  As under existing capital rules, banking organizations are required to hold risk-based capital for counterparty credit risk on OTC derivatives contracts.  The Final Rule updates the definition of an over the counter (OTC) derivative contract to mean a “derivative contract that is not a cleared transaction” and specifically to include a transaction (i) between a banking organization that is a clearing member and a counterparty where the banking organization is acting as a financial intermediary and enters into a cleared transaction with a CCP that offsets the transaction with the counterparty; or (ii) in which a banking organization that is a clearing member provides a CCP a guarantee on the performance of the counterparty to the transaction.  Banking organizations must first determine the exposure amount of each OTC derivative contract and multiply that exposure amount by the risk weight appropriate to the exposure based on the exposure type or counterparty, eligible guarantor, or financial collateral.  The exposure amount for a single OTC derivative contract that is not subject to a qualifying master netting agreement is generally equal to the sum of the banking entity’s current credit exposure, which is the greater of fair value and zero, and its potential future credit exposure (PFE), which is calculated by multiplying the notional principal amount of the OTC derivative contract by the relevant conversion factor.  The Final Rule revises the conversion factor matrix for calculating PFE, revises the criteria for recognizing the netting benefits of qualifying master netting agreements and of financial collateral, and removes the existing 50% risk weight cap on OTC derivative contracts.

Equity Exposures.  The Final Rule establishes several risk-weight categories for equity exposures based on the type of exposure and the type of issuer.  Among other things, the Final Rule generally requires a banking organization to apply the simple risk-weight approach (SRWA) for equity exposures that are not exposures to an investment fund, with risk weights ranging from zero to 600%.  The following table shows the simple risk-weight approach applied to equities.

Simple Risk-Weight Approach

Securitization Exposures.  Banking organizations are to determine the risk-based capital requirement for securitization exposures by applying either (1) the gross-up approach from the general risk-based capital rules based on the subordination of securitization exposure or (2) a simplified supervisory formula approach (SSFA) which is a simplified version of the supervisory formula approach in the advanced approaches rule. These changes reflected the need to remove references to and reliance on credit ratings to determine risk weights for exposures by using alternative standards of creditworthiness, as required by section 939A of the Dodd-Frank Act.

Disclosure Requirements for Certain Large U.S. Banking Organizations.  The Final Rule applies certain public quantitative and qualitative disclosure requirements to banking organizations with total consolidated assets of $50 billion or more that are not a consolidated subsidiary of a BHC, covered SLHC, or depository institution that is subject to the disclosure requirements, or a subsidiary of a non-U.S. banking organization that is subject to comparable public disclosure requirements in its home jurisdiction, or an advanced approaches banking organization making public disclosures pursuant to the advanced approaches requirements of the Final Rule.

Under the Final Rule, such banking organizations must have a formal disclosure policy approved by its board of directors that addresses the banking organization’s approach for determining the disclosures it should make, and that addresses associated internal controls, disclosure controls, and procedures.  One of more senior officers of the banking organization must attest that the disclosures meet the requirements of the Final Rule.

As a general matter, banking organizations subject to these disclosure requirements must provide the required disclosures timely after each calendar quarter, although qualitative disclosures that provide a general summary of risk-management objectives and policies, reporting system, and definitions may be disclosed annually after the end of the fourth calendar quarter, as long as any significant changes are disclosed in the interim.

In terms of timeliness, for calendar quarters that do not correspond to fiscal year end, disclosures will generally be timely if made within 45 days of the end of the calendar quarter (or within 60 days for the limited purpose of a banking organization’s first reporting period in which it is subject to the rule’s disclosure requirements).  For reporting companies, where a banking organization’s fiscal year-end coincides with the end of a calendar quarter, qualitative and quantitative disclosures are timely if they are made no later than the applicable disclosure deadline for the company’s 10-K.  In cases where the institution’s fiscal year end does not coincide with the end of a calendar quarter, timeliness will be considered on a case-by-case basis.

The required disclosures must be publicly available for each of the last three years or such shorter time period beginning when the banking organization becomes subject to the disclosure requirements — for example, a banking organization that begins to make public disclosures in the first quarter of 2015 must make all of its required disclosures publicly available until the first quarter of 2018, after which it must make its required disclosures for the previous three years publicly available.  The agencies expect that disclosures of common equity Tier 1, Tier 1, and total capital ratios would be tested by external auditors as part of the financial statement audit.[14]

VII.    Basel III Advanced Approaches

As a result of the Collins Amendment, under which an advanced approaches banking organization is not permitted to use capital calculations made under its internal models to meet minimum capital requirements if those calculations would result in the advanced approaches banking organization maintaining less capital than it would under the standardized approach, the advanced approaches aspects of the Final Rule are less significant.  What is most noteworthy is a higher counterparty credit risk capital requirement for credit valuation adjustments, the fair value adjustments that reflect credit risk in the valuation of an over-the-counter derivative contract; increased capital requirements for exposures to non-regulated financial institutions and to regulated financial institutions with consolidated assets of greater than or equal to $100 billion; and new approaches to securitizations exposures replacing ratings-based and internal assessment approaches.

VIII.    SIFIs:  The End of the Beginning

Taken together, the provisions of the Final Rule that apply only to SIFIs impose substantial additional requirements, and indeed, burdens, on those companies, but at the July 2 Federal Reserve meeting, Governor Tarullo indicated that for SIFIs the Final Rule is not the end, nor even the beginning of the end, but rather just the end of the beginning.  In this vein, he stated that four additional rulemakings would occur in the near future:

• A notice of proposed rulemaking (NPRM) to established heightened leverage thresholds;
• A NPRM concerning the combined amount of equity and long-term debt necessary to facilitate orderly resolutions;
• A NPRM to implement the G-SIFI framework after the Basel Committee has completed its final refinements for G-SIFIs requirements; and
• An advance notice of proposed rulemaking that will request comments on possible supervisory approaches to risks from short-term wholesale funding.

With respect the first NPRM, the near future was one week, as on July 9, the Federal Reserve, the OCC, and the FDIC issued the Supplementary Leverage Proposal, which would apply to any U.S top-tier bank holding company with at least $700 billion in total consolidated assets or at least $10 trillion in assets under custody (Covered BHC) and any insured depository institution subsidiary of these BHCs.

Under the Supplementary Leverage Proposal, Covered BHCs would be subject to a leverage buffer like the capital conservation buffer in the Final Rule.  In order to avoid limitations on distributions and discretionary bonus payments, a Covered BHC would be required to maintain a leverage buffer of tier 1 capital in an amount greater than 2 percent of its total leverage exposure (i.e., on- and off-balance sheet exposure).  The leverage buffer would follow the same general mechanics as the Final Rule’s capital conservation buffer.  In addition, an insured depository institution that is a subsidiary of a Covered BHC would be required to have a 6 percent supplementary leverage ratio to be considered well-capitalized for Prompt Corrective Action purposes.

IX.    Conclusion

For all banking organizations but SIFIs, the Basel III process has essentially come to an end, whereas SIFIs are looking at a future of additional requirements.  The debate over the proper approach to bank capital, however, shows no sign of ending.

Today, FDIC Director Thomas Hoenig stated that he could not support the Basel III interim final rule the FDIC Board was adopting — arguing that “a capital standard, to be useful, must be understandable and enforceable and must be sufficient to absorb unexpected loss. Unfortunately, the Basel III interim final rule, as proposed, fails to fully meet these criteria.”  Today as well, FDIC Director Jeremiah Norton noted that the Basel III interim final rule appeared to ignore five known and potential risks to the banking system:

• The U.S. housing market was at the center of the financial crisis — yet the rule does not modernize the risk-weights on banks’ mortgage loans;
• Government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac were placed into government-controlled conservatorships — yet the banking agencies continue to assign low risk-weights to GSE exposures;
• Linkages between highly levered financial institutions are a significant risk to the financial system — yet, subject to deductions, exposures to supervised depository institutions carry a risk weight that is one-fifth of the risk weight of non-financial investment grade corporate exposures;
• Since 2008 many sovereign nations have experienced severe stress in the sovereign debt markets — yet the rule assigns a risk weight of zero to sovereign OECD exposures that do not have a country risk classification rating; and
• Notwithstanding the Federal Reserve’s unconventional monetary policy to hold long-term interest rates below market-based prices, for regulatory purposes the rule does not require some banks to recognize the effects that changes in interest rates would have on the value of their securities — even at a time when securities holdings as a percentage of assets are at relatively high levels.

It is clear that Basel III as implemented will maintain more capital in the banking system.  What is considerably less clear, however, is whether for all its new capital ratios and the attendant complexity, Basel III as implemented tackles bank risk in a manner that will both maintain financial stability and sustain economic growth.

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