Capital American Style:
The Federal Banking
Agencies’ Regulatory
Capital Proposals
June 28, 2012
Charles M. Horn
Dwight C. Smith
Morrison & Foerster LLP
Adriaan Van der Knaap
StormHarbour Securities Ltd.
Introduction
 On June 12, 2012, the Federal banking agencies (the OCC, Federal
Reserve Board and FDIC) (the “Agencies”) formally proposed three
sets of significant changes to the U.S. regulatory capital framework:
The Basel III Proposal, which applies the Basel III capital framework to
almost all U.S. banking organizations
The Standardized Approach Proposal, which applies certain elements of
the Basel II standardized approach for credit risk weightings to almost all
U.S. banking organizations
The Advanced Approaches Proposal, which applies changes made to
Basel II and Basel III in the past few years to large U.S. banking
organizations subject to the advanced Basel II capital framework.
 Deadline for comments on all three proposals is Sept. 7,
2012. We understand there have been some informal
discussions regarding extension of the deadline.
2
Today’s Presentation
 The Agencies’ proposals
Basel III Proposal – the components of capital
Standardized Approach Proposal – risk-weightings of on-balance
and off-balance sheets assets, commitments and contingencies
Advanced Approaches Proposal – regulatory capital proposals
affecting large, internationally active banking organizations
 Implementation and phase-in requirements
 Impact of the proposals
Nature and composition of capital (“numerator” impact)
Composition and costs of on- and off-balance sheet activities
(“denominator” impact)
Impact on banking organization behaviors
3
Basel III Proposal
Applicability
All U.S. banks that are subject to minimum capital requirements,
including Federal and state savings banks
Bank and savings and loan holding companies other than “small
bank holding companies” (generally bank holding companies with
consolidated assets of less than $500 million)
Top-tier domestic bank and savings and loan holding companies
of foreign banking organizations
Does not apply to foreign banking organizations, but does
apply (with a few exceptions) to U.S. bank subsidiaries,
and top-tier U.S. bank holding company subsidiaries, of
foreign banking organizations
4
Basel III Proposal
Components of Capital:
Tier 1 Capital -- common equity Tier 1 capital and additional Tier 1
capital
Total Tier 1 capital, plus Tier 2 capital, would constitute total riskbased capital
Proposed criteria for common equity and additional tier 1
capital instruments, and Tier 2 capital instruments, are
broadly consistent with the Basel III criteria.
5
Basel III Proposal
Common Equity Tier 1 Capital elements:
Common stock and related surplus net of treasury stock satisfying
13 criteria
Retained earnings
Accumulated other comprehensive income (“AOCI”)
Qualifying common equity Tier 1 minority interest
Common equity Tier 1 criteria are generally designed to
assure that the capital is perpetual and is unconditionally
available to absorb first losses on a going-concern basis,
especially in times of financial stress.
6
Basel III Proposal
Additional Tier 1 Capital elements:
Qualifying capital instruments (and related surplus) that satisfy 13
separate criteria (14 for advanced approaches banking
organizations)
 Tier 1 minority interests that are not included in a banking
organization’s common equity Tier 1 capital
Qualifying TARP and Small Business Jobs Act preferred securities
that previously were included in Tier 1 capital
The 13/14 criteria generally are designed to assure that
the capital instrument can absorb going-concern losses
and does not possess credit sensitive or other terms that
would impair its availability in times of financial stress.
7
Basel III Proposal
Tier 2 Capital elements:
Qualifying instruments that satisfy 10 separate criteria (11 for
advanced approaches banking organizations)
Qualifying total capital minority interest not included in Tier 1
capital
Allowance for loan and lease losses (“ALLL”) up to 1.25% of
standardized total risk-weighted assets excluding ALLL (Advanced
approaches bank may include excess of eligible credit reserves
over total expected credit losses not to exceed 0.6 percent of its
total credit RWA.)
Qualifying TARP and Small Business Jobs Act preferred securities
that previously were included in Tier 2 capital
Tier 2 capital elements are designed to assure adequate
subordination and stability of availability.
8
Basel III Proposal
Significant Exclusions from Tier 1 Capital
Non-cumulative perpetual preferred stock, which presently
qualifies as simple Tier 1 capital, would not qualify as common
equity Tier 1 capital, but would qualify as additional Tier 1 capital.
Cumulative preferred stock would no longer qualify as Tier 1
capital of any kind.
Certain hybrid capital instruments, including trust preferred
securities, no longer will qualify as Tier 1 capital of any kind.
Some of these results are mandated more by the DoddFrank Act (section 171, or the “Collins Amendment”) than
by Basel III itself.
9
Basel III Proposal
Regulatory Capital Adjustments – Common Equity Tier 1:
Accumulated net gains/losses on specified cash flow hedges
included in AOCI
Unrealized gains and losses on AFS securities
Unrealized gains on AFS securities includable in Tier 2 would
be eliminated.
Unrealized gains and losses resulting from of changes in banking
organization creditworthiness
10
Basel III Proposal
Deductions from Tier 1 common equity capital:
Goodwill, net of associated deferred tax liabilities (“DTLs”)
Intangible assets other than mortgage servicing assets (“MSAs”),
net of associated DTLs
Deferred tax assets (“DTAs”)
Securitization gain-on-sale
Defined benefit plan assets (excluding those of depository
institutions (“DIs”))
Advanced approaches banks: expected credit losses exceeding
eligible credit reserves
Savings association impermissible activities
Items subject to 10%/15% common equity Tier 1 capital thresholds
(certain DTAs, MSAs, significant unconsolidated FI common stock
investments)
11
Basel III Proposal
Deductions from Tier1/Tier2 capital:
Direct and indirect investments in own capital instruments
Reciprocal cross-holdings in financial institution capital
instruments
Direct, indirect and synthetic investments in unconsolidated
financial institutions. Three basic types:
Significant Tier 1 common stock investments
Significant non-common-stock Tier 1 investments
Non-significant investments (aggregate 10% ceiling)
The “corresponding deduction” approach
Volcker Rule covered fund investments (from Tier 1)(when Volcker
Rule regulatory capital requirements are final)
Insurance underwriting subsidiaries
12
Basel III Proposal
Minority Interests:
Limits on type and amount of qualifying minority interests that can
be included in Tier 1 capital
Minority interests would be classified as a common equity Tier 1,
additional Tier 1, or total capital minority interest depending on the
underlying capital instrument and on the type of subsidiary issuing
such instrument.
Qualifying common equity Tier 1 minority interests are limited to a
depository institution (“DI”) or foreign bank that is a consolidated
subsidiary of a banking organization.
Limits on the amount of includable minority interest would be
based on a computation generally based on the amount and
distribution of capital of the consolidated subsidiary
13
Basel III Proposal
Minimum Capital Requirements (fully phased-in):
Common equity Tier 1 capital ratio to standardized total riskweighted assets (“TRWA”) of 4.5 percent
Tier 1 capital ratio to standardized TRWA of 6 percent
Total capital ratio to standardized TRWA of 8 percent
Tier 1 leverage ratio to average consolidated assets of 4 percent
Advanced approach banking organizations must use lower of
standardized TRWA or advanced approaches TRWA
For advanced approaches banking organizations, a supplemental
leverage ratio of Tier 1 capital to total leverage exposure of 3
percent
Common equity Tier 1 capital ratio is a new minimum
requirement.
14
Basel III Proposal
Leverage Requirement:
Ratio of Tier 1 capital (minus required deductions) to average onbalance sheet assets for all U.S. banking organizations
Supplementary Leverage Requirement:
Applies only to advanced approaches banking organizations
Ratio of Tier 1 capital (minus required deductions) to average onbalance sheet assets, plus certain off-balance sheet assets and
exposures:
Future exposure amounts arising under certain derivatives
contracts
10% of notional amount of unconditionally cancelable
commitments
Notional amount of most other off-balance sheet exposures
(excluding securities lending and borrowing, reverse
repurchase agreement transactions, and unconditionally
cancelable commitments).
15
Basel III Proposal
Capital Conservation Buffer:
A new phased-in capital conservation buffer for all banking
organizations equal to a ratio to TRWA of 2.5% common equity
Tier 1 capital
Unrestricted payouts of capital distributions and discretionary
bonus payments to executives and their functional equivalents
would require full satisfaction of capital conservation buffer
requirement.
Maximum amount of restricted payouts would be the banking
organization’s eligible retained income times a specified payout
ratio. These ratios would be established as a function of the
amount of the banking organization’s capital conversation buffer
capital.
16
Basel III Proposal
Countercyclical Capital Buffer:
A macro-economic countercyclical capital buffer of up to 2.5% of
common equity Tier 1 capital to TRWA applicable only to
advanced approaches banking organizations.
Countercyclical capital buffer, applied upon a joint determination
by federal banking agencies, would augment the capital
conservation buffer.
Unrestricted payouts of capital and discretionary bonuses would
require full satisfaction of countercyclical capital buffer as well as
capital conservation buffer.
17
Basel III Proposal
 Supervisory Assessment of Capital Adequacy
Banking organizations must maintain capital “commensurate with
the level and nature of all risks” to which the banking organization
is exposed
 General authority for regulatory approval, on a joint
consultation basis, of other Tier 1 or Tier 2 instruments on
a temporary or permanent basis
18
Basel III Proposal
Changes to Prompt Corrective Action (“PCA”) Rules:
PCA regulations changed to assure consistency with the new
regulatory capital requirements
PCA capital categories would include a separate requirement for
minimum common equity Tier 1 capital for top 4 PCA categories
(6.5%/4.5%/<4.5%/<3%).
“Well-capitalized” DIs would have to have at least 8% Tier 1
capital (up from current 6%), and “adequately capitalized” DIs 6%
Tier 1 capital (up from current 4%).
“Adequately capitalized” PCA category for advanced approaches
banks would include a minimum 3% supplementary leverage ratio
requirement.
Revisions to the definition of “tangible equity” for critically
undercapitalized DIs, and HOLA/savings institutions
19
Basel III Proposal
Effective Dates/Transitional Periods:
Minimum Tier 1 capital ratios -- 2013-2015
Minimum total capital: no change and therefore no phase-in
Regulatory capital adjustments and deductions -- 2013 -2018;
goodwill deduction is fully effective in 2013
Non-qualifying capital instruments
BHCs of $15 BB+ in assets -- 2013-2016
BHCs under $15BB and all DIs -- 2013-2022
Capital conservation and countercyclical capital buffers, and
related payout ratios -- 2016-2019
Supplemental leverage ratio for advanced approaches banks –
2018; calculation and reporting required in 2015
PCA changes – 2015 (2018 for supplemental leverage ratio)
20
Numerator Comparisons
 The US Basel III Proposal is consistent with its BIS and
European counterparts (EU CRD IV). “Consistent,”
however, does not mean identical
 US proposal applies to all banks and their holding
companies except “small bank holding companies.”
 Common Equity Tier 1 --- US Treatment
US: GAAP treatment of qualifying instruments must be non-liability
Common equity instruments do not expressly have to be “shares”
Unrealized AFS losses and gains flow through to common equity
Tier 1 capital
Cash dividends paid only out of net income and retained earnings
21
Numerator Comparisons
 Additional Equity Tier 1 --- US Treatment
GAAP treatment of qualifying instruments must be non-liability
No specific going-concern loss requirements specified
Cash dividends paid only out of net income and retained earnings
Permanent grandfathering of US government capital investments
such as TARP and Small Business Jobs Act securities
Subordination disclosure requirements for advanced approaches
banks
 Leverage ratio
US banks are already subject to leverage ratio
Supplemental leverage ratio applies to advanced approaches
banks.
22
Numerator Comparisons
Countercyclical capital buffer – US Treatment
Applies only to advanced approaches banking organizations
23
Standardized Approach Proposal
Introduction to the standardized approach
Risk weights
Credit risk mitigants
Impact of the changes
24
Standardized Approach Proposal
Applicability. Generally, the same banks that
would be subject to the Basel III Proposal.
Proposed Effective Date. Jan. 1, 2015. Banks
may opt in earlier.
25
Standardized Approach Proposal
Themes of the Standardized Approach
Improved sensitivity to credit risk
Elimination of reliance on credit ratings
Behavior modification
26
Standardized Approach Proposal
Risk weights – 9 broad asset classes
Residential mortgages
Commercial lending – “high volatility” CRE loans
Off-balance sheet exposures
OTC Derivatives
Cleared transactions
Unsettled transactions
Securitization exposures
Equity exposures
Sovereign and foreign bank exposures
27
Standardized Approach Proposal
1. Residential first mortgages – private
 Category 1 (traditional) vs. Category 2 (non-traditional)
Duration
Payment schedule
Documentation
 Loan-to-value ratio
 Eight sets of risk weights—generally higher than current
rules
 Public policy
28
Standardized Approach Proposal
Private residential
mortgages riskweight chart
LTV
Traditional
Non-traditional
<60%
35%
75%
>60, <80
50
100
>80, <90
75
150
>90
100
200
29
Standardized Approach Proposal
Residential mortgages – other issues
 Restructured or modified loans
 Junior liens
 Mortgage-servicing assets
30
Standardized Approach Proposal
2. Commercial lending
 Current 100% default weight still applies
 High volatility CRE – 150%
 Behavior modification
Enhanced equity contribution by developer
Pre-sold lots
Ability to cancel
 Past-due loans
31
Standardized Approach Proposal
3. Off-balance sheet exposures
 0% -- only unconditionally cancelable commitments
 [10% -- eliminated]
 20% -- short-term commitments (and trade-related
contingent claims)
 50% -- no change (long-term commitments and
transaction-related contingent claims)
 100% -- guarantees, repos, securities borrowing and
lending transactions, financial stability letters of credit,
forward agreements
32
Standardized Approach Proposal
4. OTC Derivatives
 Capital impact depends on measurement of exposure.
 Single contracts
Current credit exposure plus probability of future exposure
 Multiple contracts subject to “qualifying master netting
agreement”
“Qualifying”
Exposure
 Risk weight is a function of the counterparty’s credit risk.
50% cap eliminated
33
Standardized Approach Proposal
5. Cleared transactions
 Exposure
Bank as clearing member
Bank as clearing member client
 Risk weights – “qualifying central clearing party”
QCCP – must be designated FMU
Clearing member: 2% versus 100%
Clearing member client: 2-4% versus 100%
 Default fund contributions
34
Standardized Approach Proposal
6. Unsettled transactions
 Risk of delayed settlement or delivery
Exemptions
 DvP and PvP transactions
 Non-DvP and PvP transactions
35
Standardized Approach Proposal
7. Securitization exposures
 Operational requirements
 Due diligence
 Calculation of exposures
 Risk-weighting alternatives
SSFA Approach
Gross-Up Approach
Other
 Treatment of gain-on-sale
36
Standardized Approach Proposal
8. Equity exposures to unconsolidated
entities
 Current rule – 100%
 Exposure – adjusted carrying value
 Simple Risk Weight Approach – for exposures to
companies (but not investment funds)
 Look-through approaches for investment fund exposures
Full look-through
Simple modified look-through
Alternative modified look-through
37
Standardized Approach Proposal
9. Sovereign and foreign bank exposures
 Current rule – OECD membership
 Proposal – OECD country risk classification (“CRC”)
Risk weights range from 0% to 100% for sovereigns
20% to 100% for PSEs and foreign banks
 Sovereign crises -- 150%
Default
Reduced CRC
38
Standardized Approach Proposal
Credit risk mitigants
 Government guarantees of residential mortgages
 Guarantees and credit derivatives
Issuers
Terms
 Collateral
 Mitigants in securitizations
39
Standardized Approach Proposal
Disclosures
 Banks with more than $50 billion in consolidated assets
but not subject to advanced approaches
 Disclosure policy
 Quarterly disclosures
Templates
40
Standardized Approach Proposal
Impact: all asset classes affected
 Private residential mortgage lending
 Commercial lending
 Off-balance sheet transactions
 OTC derivatives
 Cleared transactions
 Unsettled transactions
 Securitizations
 Equity exposures
 Sovereign exposures
41
Denominator Comparisons
 Standardized Approach Proposal would apply to all
banks and their holding companies other than “small
bank holding companies.”
 US proposal does not allow reliance on credit rating
references, as required by Dodd-Frank Act section 939A.
 The new US standard is “investment grade,” which is a
more qualitative approach. To be investment grade, a
counterparty or reference entity must have:
“adequate capacity” to meet financial commitments for the
projected life of the asset or exposure
“adequate capacity” means risk of default is low and the full and
timely repayment of principal and interest is expected
42
Denominator Comparisons
 Denominator impact of section 939A requirement is
broad.
Basel II ratings-based approach and internal assessment
approaches for securitization exposures are removed
 Sovereign, residential mortgage and debt exposures affected
Impact on eligible guarantees and guarantors, credit derivatives
and credit risk mitigants
Affects potential future exposure of OTC derivatives for purposes
of on-balance sheet credit conversion
43
Denominator Comparisons
 Other US denominator variances:
Risk-weightings of residential mortgage exposures is significantly
more granular than under Basel II.
Treatment of high-volatility commercial real estate exposures
Exposures to securities firms are treated as corporate exposures,
not DI exposures
 Basel II, however, does anticipate national application of
its risk-weighting requirements, which affords the US –
like any other participating jurisdiction – some latitude in
Basel II’s implementation (particularly where it is being
applied to non-Basel II banks!).
44
Advanced Approaches Proposal
Applicability and Coverage:
Applies to banking organizations that are subject to the “advanced
approaches” rule under Basel II, including qualifying Federal and
state savings associations and their holding companies
Addresses counterparty credit risk, removal of credit rating
references, securitization exposures, changes in treatment of
certain exposures previously subject to deduction, and
conforming technical changes
Proposes to expand those banking organizations that are subject
to the market risk capital rule to include savings institutions and
their holding companies
Proposed Effective Date: None specified
45
Advanced Approaches Proposal
 Counterparty Credit Risk. Changes proposed include:
Revisions to the recognition of eligible financial collateral
Lengthening the assumed holding periods and the calculation of
certain collateralized OTC exposures under the collateral haircut
and simple Value-at-Risk (VaR) approaches
Increasing capital requirements associated with the internal models
methodology
Better identification and management of wrong-way risk
associated with certain counterparty exposures
46
Advanced Approaches Proposal
 Counterparty Credit Risk Changes (cont.):
Additional capital requirement for credit value adjustments relating
to OTC derivatives exposures
Changing the capital requirements for qualifying and other central
counterparty (“CCP”) exposures, including capital calculations for
CCP default fund contributions
Requiring application of a continuous 12-month stress period in
calculating market price and foreign volatility exposures under the
collateral haircut method, based on internal estimates
47
Advanced Approaches Proposal
Removal of Credit Rating References:
Consistent with section 939A of the Dodd-Frank Act, the Advanced
Approaches Proposal would remove references to credit ratings
that currently exist in the advanced approaches capital rules and
replace these references with alternative standards of
creditworthiness.
Affects, among other things, treatment of guarantors, OTC
derivatives exposures, money market fund exposures, operational
risk mitigants and securitization exposures
This action is also consistent with removal of credit rating
references in the Standardized Approach Proposal.
48
Advanced Approaches Proposal
Changes to Securitization Exposures:
Proposed new definition of resecuritization exposures
Proposed broadening of the definition of securitization exposures,
while excluding certain traditional investment firms from definition
Resecuritization definition would capture exposures to
securitizations that are comprised of asset-backed securities (e.g.,
CDOs and some ABCP conduits) and which are now subject to
higher risk-weightings under the 2009 changes to Basel II.
Removal of ratings-based and internal assessment approaches for
securitization exposures; new hierarchy for exposure treatment
General use of supervisory formula approach (“SFA”) or its
simplified version (“SSFA”) in calculating capital requirements for
securitization exposures, as well as guarantees and credit
derivatives referencing such exposures
49
Advanced Approaches Proposal
Revised Capital Treatment of Certain Exposures
Exposures affected: certain securitization exposures (CEIOs,
high-risk exposures, low-rated exposures); eligible credit reserves
shortfall; certain failed capital markets transactions
New treatment – assigned a general 1,250 percent risk-weighting
instead of deduction from capital
Market Risk Capital Rule:
Federal and state savings banks and their holding companies that
meet the market risk capital rule threshold criteria would become
subject to the rule.
50
Impact of These Developments
 In general, US financial institutions are taking a “waitand-see” attitude to the various Dodd-Frank Act and
regulatory capital proposals, with some exceptions (e.g.,
the Volcker Rule).
Most rules are not finalized and there is considerable time left to
work on implementation before compliance deadlines.
 Further, a majority of US banks are very liquid and in
excess capital positions (even factoring in the possible
impact of the Basel III and Standardized Approach
Proposals), which may reduce their collective sense of
urgency.
51
Impact of These Developments
 The overall impact on the banking sector varies
depending on the size of the banking organizations.
The larger regional banks currently have excess liquidity and
capital, and, as there is no pressure on capital, are selectively
expanding their asset bases (although the current regulatory
uncertainty has depressed M&A activity).
The smaller banks are under the most pressure, as the uncertainty
and the costs of complying with the new rules are weighing heavily
on their cost ratios.
The largest banks are already selling certain businesses (private
equity, proprietary trading) or are reducing and re-balancing their
assets (Citi/BoA) or aggressively expanding traditional lending
(Wells, JPM, Citi)
52
Impact of These Developments
 Most banks in the US have strong capital ratios, and
regulators have generally put restrictions on repatriation
of common equity capital. Thus, the Basel III Proposal
has not resulted in much activity as of yet to optimize
capital structures.
Going forward, the only hybrid capital element that will qualify as
Tier I capital will be perpetual noncumulative preferred stock;
some recent issuances, but limited compared to expected capacity
Banks already are selectively redeeming or repurchasing trust
preferred securities.
As European banks generally have lower capital ratios, and have
not raised as much equity since the 2008 financial crisis, there is
more focus on capital raisings in Europe.
53
Impact of These Developments
 The changes in risk weightings and deductions from
capital under the Standardized Approach Proposal will
have an impact on the credit markets, although it is too
early to predict the magnitude of this impact.
Nonbank finance companies are actively seeking capital to enter
certain loan markets.
Mortgages: some mortgage products will become more expensive
for banks to hold.
Securitizations: impact will be a function of capital costs of directly
owning assets versus an exposure to a securitized portfolio.
MSAs and other deductions from capital will influence balance
sheet management behaviors.
Commercial real estate loans may become more expensive to
hold.
54
Impact of These Developments
 Conclusion: there is still a lot of uncertainty, but US
institutions are liquid and well capitalized, and therefore
can afford to be patient and focus on organic growth of
their balance sheets.
In Europe, the situation is different due to liquidity issues and
lower capital levels.
Therefore, more immediate action in Europe is required to
maintain minimum capital levels and de-leverage.
55
Concluding Remarks
 Questions and Answers
56