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Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, Standardized Approach for Risk-weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital Rule

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AGENCY:

Office of the Comptroller of the Currency, Treasury; and the Board of Governors of the Federal Reserve System.

ACTION:

Final rule.

SUMMARY:

The Office of the Comptroller of the Currency (OCC) and Board of Governors of the Federal Reserve System (Board), are adopting a final rule that revises their risk-based and leverage capital requirements for banking organizations. The final rule consolidates three separate notices of proposed rulemaking that the OCC, Board, and FDIC published in the Federal Register on August 30, 2012, with selected changes. The final rule implements a revised definition of regulatory capital, a new common equity tier 1 minimum capital requirement, a higher minimum tier 1 capital requirement, and, for banking organizations subject to the advanced approaches risk-based capital rules, a supplementary leverage ratio that incorporates a broader set of exposures in the denominator. The final rule incorporates these new requirements into the agencies' prompt corrective action (PCA) framework. In addition, the final rule establishes limits on a banking organization's capital distributions and certain discretionary bonus payments if the banking organization does not hold a specified amount of common equity tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. Further, the final rule amends the methodologies for determining risk-weighted assets for all banking organizations, and introduces disclosure requirements that would apply to top-tier banking organizations domiciled in the United States with $50 billion or more in total assets. The final rule also adopts changes to the agencies' regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The final rule also codifies the agencies' regulatory capital rules, which have previously resided in various appendices to their respective regulations, into a harmonized integrated regulatory framework. In addition, the OCC is amending the market risk capital rule (market risk rule) to apply to Federal savings associations, and the Board is amending the advanced approaches and market risk rules to apply to top-tier savings and loan holding companies domiciled in the United States, except for certain savings and loan holding companies that are substantially engaged in insurance underwriting or commercial activities, as described in this preamble.

DATES:

Effective date: January 1, 2014, except that the amendments to Appendixes A, B and E to 12 CFR Part 208, 12 CFR 225.1, and Appendixes D and E to Part 225 are effective January 1, 2015, and the amendment to Appendix A to 12 CFR Part 225 is effective January 1, 2019. Mandatory compliance date: January 1, 2014 for advanced approaches banking organizations that are not savings and loan holding companies; January 1, 2015 for all other covered banking organizations.

Start Further Info

FOR FURTHER INFORMATION CONTACT:

OCC: Margot Schwadron, Senior Risk Expert, (202) 649-6982; David Elkes, Risk Expert, (202) 649-6984; Mark Ginsberg, Risk Expert, (202) 649-6983, Capital Policy; or Ron Shimabukuro, Senior Counsel; Patrick Tierney, Special Counsel; Carl Kaminski, Senior Attorney; or Kevin Korzeniewski, Attorney, Legislative and Regulatory Activities Division, (202) 649-5490, Office of the Comptroller of the Currency, 400 7th Street SW., Washington, DC 20219.

Board: Anna Lee Hewko, Deputy Associate Director, (202) 530-6260; Thomas Boemio, Manager, (202) 452-2982; Constance M. Horsley, Manager, (202) 452-5239; Juan C. Climent, Senior Supervisory Financial Analyst, (202) 872-7526; or Elizabeth MacDonald, Senior Supervisory Financial Analyst, (202) 475-6316, Capital and Regulatory Policy, Division of Banking Supervision and Regulation; or Benjamin McDonough, Senior Counsel, (202) 452-2036; April C. Snyder, Senior Counsel, (202) 452-3099; Christine Graham, Senior Attorney, (202) 452-3005; or David Alexander, Senior Attorney, (202) 452-2877, Legal Division, Board of Governors of the Federal Reserve System, 20th and C Streets NW., Washington, DC 20551. For the hearing impaired only, Telecommunication Device for the Deaf (TDD), (202) 263-4869.

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SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

II. Summary of the Three Notices of Proposed Rulemaking

A. The Basel III Notice of Proposed Rulemaking

B. The Standardized Approach Notice of Proposed Rulemaking

C. The Advanced Approaches Notice of Proposed Rulemaking

III. Summary of General Comments on the Basel III Notice of Proposed Rulemaking and on the Standardized Approach Notice of Proposed Rulemaking; Overview of the Final Rule

A. General Comments on the Basel III Notice of Proposed Rulemaking and on the Standardized Approach Notice of Proposed Rulemaking

1. Applicability and Scope

2. Aggregate Impact

3. Competitive Concerns

4. Costs

B. Comments on Particular Aspects of the Basel III Notice of Proposed Rulemaking and on the Standardized Approach Notice of Proposed Rulemaking

1. Accumulated Other Comprehensive Income

2. Residential Mortgages

3. Trust Preferred Securities for Smaller Banking Organizations

4. Insurance Activities

C. Overview of the Final Rule

D. Timeframe for Implementation and Compliance

IV. Minimum Regulatory Capital Ratios, Additional Capital Requirements, and Overall Capital Adequacy

A. Minimum Risk-Based Capital Ratios and Other Regulatory Capital Provisions

B. Leverage Ratio

C. Supplementary Leverage Ratio for Advanced Approaches Banking Organizations

D. Capital Conservation Buffer

E. Countercyclical Capital Buffer

F. Prompt Corrective Action Requirements

G. Supervisory Assessment of Overall Capital Adequacy

H. Tangible Capital Requirement for Federal Savings Associations

V. Definition of Capital

A. Capital Components and Eligibility Criteria for Regulatory Capital Instruments

1. Common Equity Tier 1 Capital Start Printed Page 62019

2. Additional Tier 1 Capital

3. Tier 2 Capital

4. Capital Instruments of Mutual Banking Organizations

5. Grandfathering of Certain Capital Instruments

6. Agency Approval of Capital Elements

7. Addressing the Point of Non-Viability Requirements Under Basel III

8. Qualifying Capital Instruments Issued by Consolidated Subsidiaries of a Banking Organization

9. Real Estate Investment Trust Preferred Capital

B. Regulatory Adjustments and Deductions

1. Regulatory Deductions From Common Equity Tier 1 Capital

a. Goodwill and Other Intangibles (Other Than Mortgage Servicing Assets)

b. Gain-on-sale Associated With a Securitization Exposure

c. Defined Benefit Pension Fund Net Assets

d. Expected Credit Loss That Exceeds Eligible Credit Reserves

e. Equity Investments in Financial Subsidiaries

f. Deduction for Subsidiaries of Savings Associations That Engage in Activities That Are Not Permissible for National Banks

2. Regulatory Adjustments to Common Equity Tier 1 Capital

a. Accumulated Net Gains and Losses on Certain Cash-Flow Hedges

b. Changes in a Banking Organization's Own Credit Risk

c. Accumulated Other Comprehensive Income

d. Investments in Own Regulatory Capital Instruments

e. Definition of Financial Institution

f. The Corresponding Deduction Approach

g. Reciprocal Crossholdings in the Capital Instruments of Financial Institutions

h. Investments in the Banking Organization's Own Capital Instruments or in the Capital of Unconsolidated Financial Institutions

i. Indirect Exposure Calculations

j. Non-Significant Investments in the Capital of Unconsolidated Financial Institutions

k. Significant Investments in the Capital of Unconsolidated Financial Institutions That Are Not in the Form of Common Stock

l. Items Subject to the 10 and 15 Percent Common Equity Tier 1 Capital Threshold Deductions

m. Netting of Deferred Tax Liabilities Against Deferred Tax Assets and Other Deductible Assets

3. Investments in Hedge Funds and Private Equity Funds Pursuant to Section 13 of the Bank Holding Company Act

VI. Denominator Changes Related to the Regulatory Capital Changes

VII. Transition Provisions

A. Transitions Provisions for Minimum Regulatory Capital Ratios

B. Transition Provisions for Capital Conservation and Countercyclical Capital Buffers

C. Transition Provisions for Regulatory Capital Adjustments and Deductions

1. Deductions for Certain Items Under Section 22(a) of the Final Rule

2. Deductions for Intangibles Other Than Goodwill and Mortgage Servicing Assets

3. Regulatory Adjustments Under Section 22(b)(1) of the Final Rule

4. Phase-out of Current Accumulated Other Comprehensive Income Regulatory Capital Adjustments

5. Phase-out of Unrealized Gains on Available for Sale Equity Securities in Tier 2 Capital

6. Phase-in of Deductions Related to Investments in Capital Instruments and to the Items Subject to the 10 and 15 Percent Common Equity Tier 1 Capital Deduction Thresholds (Sections 22(c) and 22(d)) of the Final Rule

D. Transition Provisions for Non-qualifying Capital Instruments

1. Depository Institution Holding Companies With Less Than $15 Billion in Total Consolidated Assets as of December 31, 2009 and 2010 Mutual Holding Companies

2. Depository Institutions

3. Depository Institution Holding Companies With $15 Billion or More in Total Consolidated Assets as of December 31, 2009 That Are Not 2010 Mutual Holding Companies

4. Merger and Acquisition Transition Provisions

5. Phase-out Schedule for Surplus and Non-Qualifying Minority Interest

VIII. Standardized Approach for Risk-weighted Assets

A. Calculation of Standardized Total Risk-weighted Assets

B. Risk-weighted Assets for General Credit Risk

1. Exposures to Sovereigns

2. Exposures to Certain Supranational Entities and Multilateral Development Banks

3. Exposures to Government-sponsored Enterprises

4. Exposures to Depository Institutions, Foreign Banks, and Credit Unions

5. Exposures to Public-sector Entities

6. Corporate Exposures

7. Residential Mortgage Exposures

8. Pre-sold Construction Loans and Statutory Multifamily Mortgages

9. High-volatility Commercial Real Estate

10. Past-Due Exposures

11. Other Assets

C. Off-balance Sheet Items

1. Credit Conversion Factors

2. Credit-Enhancing Representations and Warranties

D. Over-the-Counter Derivative Contracts

E. Cleared Transactions

1. Definition of Cleared Transaction

2. Exposure Amount Scalar for Calculating for Client Exposures

3. Risk Weighting for Cleared Transactions

4. Default Fund Contribution Exposures

F. Credit Risk Mitigation

1. Guarantees and Credit Derivatives

a. Eligibility Requirements

b. Substitution Approach

c. Maturity Mismatch Haircut

d. Adjustment for Credit Derivatives Without Restructuring as a Credit Event

e. Currency Mismatch Adjustment

f. Multiple Credit Risk Mitigants

2. Collateralized Transactions

a. Eligible Collateral

b. Risk-management Guidance for Recognizing Collateral

c. Simple Approach

d. Collateral Haircut Approach

e. Standard Supervisory Haircuts

f. Own Estimates of Haircuts

g. Simple Value-at-Risk and Internal Models Methodology

G. Unsettled Transactions

H. Risk-weighted Assets for Securitization Exposures

1. Overview of the Securitization Framework and Definitions

2. Operational Requirements

a. Due Diligence Requirements

b. Operational Requirements for Traditional Securitizations

c. Operational Requirements for Synthetic Securitizations

d. Clean-up Calls

3. Risk-weighted Asset Amounts for Securitization Exposures

a. Exposure Amount of a Securitization Exposure

b. Gains-on-sale and Credit-enhancing Interest-only Strips

c. Exceptions Under the Securitization Framework

d. Overlapping Exposures

e. Servicer Cash Advances

f. Implicit Support

4. Simplified Supervisory Formula Approach

5. Gross-up Approach

6. Alternative Treatments for Certain Types of Securitization Exposures

a. Eligible Asset-backed Commercial Paper Liquidity Facilities

b. A Securitization Exposure in a Second-loss Position or Better to an Asset-Backed Commercial Paper Program

7. Credit Risk Mitigation for Securitization Exposures

8. Nth-to-default Credit Derivatives

IX. Equity Exposures

A. Definition of Equity Exposure and Exposure Measurement

B. Equity Exposure Risk Weights

C. Non-significant Equity Exposures

D. Hedged Transactions

E. Measures of Hedge Effectiveness

F. Equity Exposures to Investment Funds

1. Full Look-Through Approach

2. Simple Modified Look-Through Approach

3. Alternative Modified Look-Through Approach

X. Insurance-related Activities

A. Policy Loans

B. Separate Accounts

C. Additional Deductions—Insurance Underwriting Subsidiaries

XI. Market Discipline and Disclosure Requirements

A. Proposed Disclosure Requirements

B. Frequency of Disclosures

C. Location of Disclosures and Audit Requirements

D. Proprietary and Confidential Information

E. Specific Public Disclosure Requirements

XII. Risk-Weighted Assets—Modifications to the Advanced Approaches

A. Counterparty Credit Risk

1. Recognition of Financial Collateral Start Printed Page 62020

a. Financial Collateral

b. Revised Supervisory Haircuts

2. Holding Periods and the Margin Period of Risk

3. Internal Models Methodology

a. Recognition of Wrong-Way Risk

b. Increased Asset Value Correlation Factor

4. Credit Valuation Adjustments

a. Simple Credit Valuation Adjustment Approach

b. Advanced Credit Valuation Adjustment Approach

5. Cleared Transactions (Central Counterparties)

6. Stress Period for Own Estimates

B. Removal of Credit Ratings

1. Eligible Guarantor

2. Money Market Fund Approach

3. Modified Look-through Approaches for Equity Exposures to Investment Funds

C. Revisions to the Treatment of Securitization Exposures

1. Definitions

2. Operational Criteria for Recognizing Risk Transference in Traditional Securitizations

3. The Hierarchy of Approaches

4. Guarantees and Credit Derivatives Referencing a Securitization Exposure

5. Due Diligence Requirements for Securitization Exposures

6. Nth-to-Default Credit Derivatives

D. Treatment of Exposures Subject to Deduction

E. Technical Amendments to the Advanced Approaches Rule

1. Eligible Guarantees and Contingent U.S. Government Guarantees

2. Calculation of Foreign Exposures for Applicability of the Advanced Approaches—Insurance Underwriting Subsidiaries

3. Calculation of Foreign Exposures for Applicability of the Advanced Approaches—Changes to Federal Financial Institutions Examination Council 009

4. Applicability of the Final Rule

5. Change to the Definition of Probability of Default Related to Seasoning

6. Cash Items in Process of Collection

7. Change to the Definition of Qualifying Revolving Exposure

8. Trade-related Letters of Credit

9. Defaulted Exposures That Are Guaranteed by the U.S. Government

10. Stable Value Wraps

11. Treatment of Pre-Sold Construction Loans and Multi-Family Residential Loans

F. Pillar 3 Disclosures

1. Frequency and Timeliness of Disclosures

2. Enhanced Securitization Disclosure Requirements

3. Equity Holdings That Are Not Covered Positions

XIII. Market Risk Rule

XIV. Additional OCC Technical Amendments

XV. Abbreviations

XVI. Regulatory Flexibility Act

XVII. Paperwork Reduction Act

XVIII. Plain Language

XIX. OCC Unfunded Mandates Reform Act of 1995 Determinations

I. Introduction

On August 30, 2012, the Office of the Comptroller of the Currency (OCC) the Board of Governors of the Federal Reserve System (Board) (collectively, the agencies), and the Federal Deposit Insurance Corporation (FDIC) published in the Federal Register three joint notices of proposed rulemaking seeking public comment on revisions to their risk-based and leverage capital requirements and on methodologies for calculating risk-weighted assets under the standardized and advanced approaches (each, a proposal, and together, the NPRs, the proposed rules, or the proposals).[1] The proposed rules, in part, reflected agreements reached by the Basel Committee on Banking Supervision (BCBS) in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (Basel III), including subsequent changes to the BCBS's capital standards and recent BCBS consultative papers.[2] Basel III is intended to improve both the quality and quantity of banking organizations' capital, as well as to strengthen various aspects of the international capital standards for calculating regulatory capital. The proposed rules also reflect aspects of the Basel II Standardized Approach and other Basel Committee standards.

The proposals also included changes consistent with the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act); [3] would apply the risk-based and leverage capital rules to top-tier savings and loan holding companies (SLHCs) domiciled in the United States; and would apply the market risk capital rule (the market risk rule) [4] to Federal and state savings associations (as appropriate based on trading activity).

The NPR titled “Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action” [5] (the Basel III NPR), provided for the implementation of the Basel III revisions to international capital standards related to minimum capital requirements, regulatory capital, and additional capital “buffer” standards to enhance the resilience of banking organizations to withstand periods of financial stress. (Banking organizations include national banks, state member banks, Federal savings associations, and top-tier bank holding companies domiciled in the United States not subject to the Board's Small Bank Holding Company Policy Statement (12 CFR part 225, appendix C)), as well as top-tier savings and loan holding companies domiciled in the United States, except certain savings and loan holding companies that are substantially engaged in insurance underwriting or commercial activities, as described in this preamble.) The proposal included transition periods for many of the requirements, consistent with Basel III and the Dodd-Frank Act. The NPR titled “Regulatory Capital Rules: Standardized Approach for Risk-weighted Assets; Market Discipline and Disclosure Requirements” [6] (the Standardized Approach NPR), would revise the methodologies for calculating risk-weighted assets in the agencies' and the FDIC's general risk-based capital rules [7] (the general risk-based capital rules), incorporating aspects of the Basel II standardized approach,[8] and establish alternative standards of creditworthiness in place of credit ratings, consistent with section 939A of the Dodd-Frank Act.[9] The proposed minimum capital requirements in section 10(a) of the Basel III NPR, as determined using the standardized capital ratio calculations in section 10(b), would establish minimum capital requirements that would be the “generally applicable” capital requirements for purpose of section 171 of the Dodd-Frank Act.[10]

The NPR titled “Regulatory Capital Rules: Advanced Approaches Risk-Based Capital Rule; Market Risk Capital Start Printed Page 62021Rule” [11] (the Advanced Approaches NPR) included proposed changes to the agencies' and the FDIC's current advanced approaches risk-based capital rules (the advanced approaches rule) [12] to incorporate applicable provisions of Basel III and the “Enhancements to the Basel II framework” (2009 Enhancements) published in July 2009 [13] and subsequent consultative papers, to remove references to credit ratings, to apply the market risk rule to savings associations and SLHCs, and to apply the advanced approaches rule to SLHCs meeting the scope of application of those rules. Taken together, the three proposals also would have restructured the agencies' and the FDIC's regulatory capital rules (the general risk-based capital rules, leverage rules,[14] market risk rule, and advanced approaches rule) into a harmonized, codified regulatory capital framework.

The agencies are adopting the Basel III NPR, Standardized Approach NPR, and Advanced Approaches NPR in this final rule, with certain changes to the proposals, as described further below. (The Board approved this final rule on July 2, 2013, and the OCC approved this final rule on July 9, 2013. The FDIC approved a similar regulation as an interim final rule on July 9, 2013.) This final rule applies to all banking organizations currently subject to minimum capital requirements, including national banks, state member banks, state nonmember banks, state and Federal savings associations, top-tier bank holding companies (BHCs) that are domiciled in the United States and are not subject to the Board's Small Bank Holding Company Policy Statement, and top-tier SLHCs that are domiciled in the United States and that do not engage substantially in insurance underwriting or commercial activities, as discussed further below (together, banking organizations). Generally, BHCs with total consolidated assets of less than $500 million (small BHCs) remain subject to the Board's Small Bank Holding Company Policy Statement.[15]

Certain aspects of this final rule apply only to banking organizations subject to the advanced approaches rule (advanced approaches banking organizations) or to banking organizations with significant trading activities, as further described below.

Likewise, the enhanced disclosure requirements in the final rule apply only to banking organizations with $50 billion or more in total consolidated assets. Consistent with section 171 of the Dodd-Frank Act, a BHC subsidiary of a foreign banking organization that is currently relying on the Board's Supervision and Regulation Letter (SR) 01-1 is not required to comply with the requirements of the final rule until July 21, 2015. Thereafter, all top-tier U.S.-domiciled BHC subsidiaries of foreign banking organizations will be required to comply with the final rule, subject to applicable transition arrangements set forth in subpart G of the rule.[16] The final rule reorganizes the agencies' regulatory capital rules into a harmonized, codified regulatory capital framework.

As under the proposal, the minimum capital requirements in section 10(a) of the final rule, as determined using the standardized capital ratio calculations in section 10(b), which apply to all banking organizations, establish the “generally applicable” capital requirements under section 171 of the Dodd-Frank Act.[17]

Under the final rule, as under the proposal, in order to determine its minimum risk-based capital requirements, an advanced approaches banking organization that has completed the parallel run process and that has received notification from its primary Federal supervisor pursuant to section 121(d) of subpart E must determine its minimum risk-based capital requirements by calculating the three risk-based capital ratios using total risk-weighted assets under the standardized approach and, separately, total risk-weighted assets under the advanced approaches.[18] The lower ratio for each risk-based capital requirement is the ratio the banking organization must use to determine its compliance with the minimum capital requirement.[19] These enhanced prudential standards help ensure that advanced approaches banking organizations, which are among the largest and most complex banking organizations, have capital adequate to address their more complex operations and risks.

II. Summary of the Three Notices of Proposed Rulemaking

A. The Basel III Notice of Proposed Rulemaking

As discussed in the proposals, the recent financial crisis demonstrated that the amount of high-quality capital held by banking organizations was insufficient to absorb the losses generated over that period. In addition, some non-common stock capital instruments included in tier 1 capital did not absorb losses to the extent previously expected. A lack of clear and easily understood disclosures regarding the characteristics of regulatory capital instruments, as well as inconsistencies in the definition of capital across jurisdictions, contributed to difficulties in evaluating a banking organization's capital strength. Accordingly, the BCBS assessed the international capital framework and, in 2010, published Basel III, a comprehensive reform package designed to improve the quality and quantity of regulatory capital and build additional capacity into the banking system to absorb losses in times of market and economic stress. On August 30, 2012, the agencies and the FDIC published the NPRs in the Federal Register to revise regulatory capital requirements, as discussed above. As proposed, the Basel III NPR generally would have applied to all U.S. banking organizations.

Consistent with Basel III, the Basel III NPR would have required banking organizations to comply with the following minimum capital ratios: (i) A new requirement for a ratio of common equity tier 1 capital to risk-weighted assets (common equity tier 1 capital ratio) of 4.5 percent; (ii) a ratio of tier 1 capital to risk-weighted assets (tier 1 capital ratio) of 6 percent, increased from 4 percent; (iii) a ratio of total capital to risk-weighted assets (total capital ratio) of 8 percent; (iv) a ratio of Start Printed Page 62022tier 1 capital to average total consolidated assets (leverage ratio) of 4 percent; and (v) for advanced approaches banking organizations only, an additional requirement that the ratio of tier 1 capital to total leverage exposure (supplementary leverage ratio) be at least 3 percent.

The Basel III NPR also proposed implementation of a capital conservation buffer equal to 2.5 percent of risk-weighted assets above the minimum risk-based capital ratio requirements, which could be expanded by a countercyclical capital buffer for advanced approaches banking organizations under certain circumstances. If a banking organization failed to hold capital above the minimum capital ratios and proposed capital conservation buffer (as potentially expanded by the countercyclical capital buffer), it would be subject to certain restrictions on capital distributions and discretionary bonus payments. The proposed countercyclical capital buffer was designed to take into account the macro-financial environment in which large, internationally active banking organizations function. The countercyclical capital buffer could be implemented if the agencies and the FDIC determined that credit growth in the economy became excessive. As proposed, the countercyclical capital buffer would initially be set at zero, and could expand to as much as 2.5 percent of risk-weighted assets.

The Basel III NPR proposed to apply a 4 percent minimum leverage ratio requirement to all banking organizations (computed using the new definition of capital), and to eliminate the exceptions for banking organizations with strong supervisory ratings or subject to the market risk rule. The Basel III NPR also proposed to require advanced approaches banking organizations to satisfy a minimum supplementary leverage ratio requirement of 3 percent, measured in a manner consistent with the international leverage ratio set forth in Basel III. Unlike the agencies' current leverage ratio requirement, the proposed supplementary leverage ratio incorporates certain off-balance sheet exposures in the denominator.

To strengthen the quality of capital, the Basel III NPR proposed more conservative eligibility criteria for regulatory capital instruments. For example, the Basel III NPR proposed that trust preferred securities (TruPS) and cumulative perpetual preferred securities, which were tier-1-eligible instruments (subject to limits) at the BHC level, would no longer be includable in tier 1 capital under the proposal and would be gradually phased out from tier 1 capital. The proposal also eliminated the existing limitations on the amount of tier 2 capital that could be recognized in total capital, as well as the limitations on the amount of certain capital instruments (for example, term subordinated debt) that could be included in tier 2 capital.

In addition, the proposal would have required banking organizations to include in common equity tier 1 capital accumulated other comprehensive income (AOCI) (with the exception of gains and losses on cash-flow hedges related to items that are not fair-valued on the balance sheet), and also would have established new limits on the amount of minority interest a banking organization could include in regulatory capital. The proposal also would have established more stringent requirements for several deductions from and adjustments to regulatory capital, including with respect to deferred tax assets (DTAs), investments in a banking organization's own capital instruments and the capital instruments of other financial institutions, and mortgage servicing assets (MSAs). The proposed revisions would have been incorporated into the regulatory capital ratios in the prompt corrective action (PCA) framework for depository institutions.

B. The Standardized Approach Notice of Proposed Rulemaking

The Standardized Approach NPR proposed changes to the agencies' and the FDIC's general risk-based capital rules for determining risk-weighted assets (that is, the calculation of the denominator of a banking organization's risk-based capital ratios). The proposed changes were intended to revise and harmonize the agencies' and the FDIC's rules for calculating risk-weighted assets, enhance risk sensitivity, and address weaknesses in the regulatory capital framework identified over recent years, including by strengthening the risk sensitivity of the regulatory capital treatment for, among other items, credit derivatives, central counterparties (CCPs), high-volatility commercial real estate, and collateral and guarantees.

In the Standardized Approach NPR, the agencies and the FDIC also proposed alternatives to credit ratings for calculating risk-weighted assets for certain assets, consistent with section 939A of the Dodd-Frank Act. These alternatives included methodologies for determining risk-weighted assets for exposures to sovereigns, foreign banks, and public sector entities, securitization exposures, and counterparty credit risk. The Standardized Approach NPR also proposed to include a framework for risk weighting residential mortgages based on underwriting and product features, as well as loan-to-value (LTV) ratios, and disclosure requirements for top-tier banking organizations domiciled in the United States with $50 billion or more in total assets, including disclosures related to regulatory capital instruments.

C. The Advanced Approaches Notice of Proposed Rulemaking

The Advanced Approaches NPR proposed revisions to the advanced approaches rule to incorporate certain aspects of Basel III, the 2009 Enhancements, and subsequent consultative papers. The proposal also would have implemented relevant provisions of the Dodd-Frank Act, including section 939A (regarding the use of credit ratings in agency regulations),[20] and incorporated certain technical amendments to the existing requirements. In addition, the Advanced Approaches NPR proposed to codify the market risk rule in a manner similar to the codification of the other regulatory capital rules under the proposals.

Consistent with Basel III and the 2009 Enhancements, under the Advanced Approaches NPR, the agencies and the FDIC proposed further steps to strengthen capital requirements for internationally active banking organizations. This NPR would have required advanced approaches banking organizations to hold more appropriate levels of capital for counterparty credit risk, credit valuation adjustments (CVA), and wrong-way risk; would have strengthened the risk-based capital requirements for certain securitization exposures by requiring advanced approaches banking organizations to conduct more rigorous credit analysis of securitization exposures; and would have enhanced the disclosure requirements related to those exposures.

The Board proposed to apply the advanced approaches rule to SLHCs, and the agencies and the FDIC proposed to apply the market risk rule to SLHCs and to state and Federal savings associations.Start Printed Page 62023

III. Summary of General Comments on the Basel III Notice of Proposed Rulemaking and on the Standardized Approach Notice of Proposed Rulemaking; Overview of the Final Rule

A. General Comments on the Basel III Notice of Proposed Rulemaking and on the Standardized Approach Notice of Proposed Rulemaking

Each agency received over 2,500 public comments on the proposals from banking organizations, trade associations, supervisory authorities, consumer advocacy groups, public officials (including members of the U.S. Congress), private individuals, and other interested parties. Overall, while most commenters supported more robust capital standards and the agencies' and the FDIC's efforts to improve the resilience of the banking system, many commenters expressed concerns about the potential costs and burdens of various aspects of the proposals, particularly for smaller banking organizations. A substantial number of commenters also requested withdrawal of, or significant revisions to, the proposals. A few commenters argued that new capital rules were not necessary at this time. Some commenters requested that the agencies and the FDIC perform additional studies of the economic impact of part or all of the proposed rules. Many commenters asked for additional time to transition to the new requirements. A more detailed discussion of the comments provided on particular aspects of the proposals is provided in the remainder of this preamble.

1. Applicability and Scope

The agencies and the FDIC received a significant number of comments regarding the proposed scope and applicability of the Basel III NPR and the Standardized Approach NPR. The majority of comments submitted by or on behalf of community banking organizations requested an exemption from the proposals. These commenters suggested basing such an exemption on a banking organization's asset size—for example, total assets of less than $500 million, $1 billion, $10 billion, $15 billion, or $50 billion—or on its risk profile or business model. Under the latter approach, the commenters suggested providing an exemption for banking organizations with balance sheets that rely less on leverage, short-term funding, or complex derivative transactions.

In support of an exemption from the proposed rule for community banking organizations, a number of commenters argued that the proposed revisions to the definition of capital would be overly conservative and would prohibit some of the instruments relied on by community banking organizations from satisfying regulatory capital requirements. Many of these commenters stated that, in general, community banking organizations have less access to the capital markets relative to larger banking organizations and could increase capital only by accumulating retained earnings. Owing to slow economic growth and relatively low earnings among community banking organizations, the commenters asserted that implementation of the proposal would be detrimental to their ability to serve local communities while providing reasonable returns to shareholders. Other commenters requested exemptions from particular sections of the proposed rules, such as maintaining capital against transactions with particular counterparties, or based on transaction types that they considered lower-risk, such as derivative transactions hedging interest rate risk.

The commenters also argued that application of the Basel III NPR and Standardized Approach NPR to community banking organizations would be unnecessary and inappropriate for the business model and risk profile of such organizations. These commenters asserted that Basel III was designed for large, internationally-active banking organizations in response to a financial crisis attributable primarily to those institutions. Accordingly, the commenters were of the view that community banking organizations require a different capital framework with less stringent capital requirements, or should be allowed to continue to use the general risk-based capital rules. In addition, many commenters, in particular minority depository institutions (MDIs), mutual banking organizations, and community development financial institutions (CDFIs), expressed concern regarding their ability to raise capital to meet the increased minimum requirements in the current environment and upon implementation of the proposed definition of capital. One commenter asked for an exemption from all or part of the proposed rules for CDFIs, indicating that the proposal would significantly reduce the availability of capital for low- and moderate-income communities. Another commenter stated that the U.S. Congress has a policy of encouraging the creation of MDIs and expressed concern that the proposed rules contradicted this purpose.

In contrast, however, a few commenters supported the proposed application of the Basel III NPR to all banking organizations. For example, one commenter stated that increasing the quality and quantity of capital at all banking organizations would create a more resilient financial system and discourage inappropriate risk-taking by forcing banking organizations to put more of their own “skin in the game.” This commenter also asserted that the proposed scope of the Basel III NPR would reduce the probability and impact of future financial crises and support the objectives of sustained growth and high employment. Another commenter favored application of the Basel III NPR to all banking organizations to ensure a level playing field among banking organizations within the same competitive market.

Comments submitted by or on behalf of banking organizations that are engaged primarily in insurance activities also requested an exemption from the Basel III NPR and the Standardized Approach NPR to recognize differences in their business model compared with those of more traditional banking organizations. According to the commenters, the activities of these organizations are fundamentally different from traditional banking organizations and have a unique risk profile. One commenter expressed concern that the Basel III NPR focuses primarily on assets in the denominator of the risk-based capital ratio as the primary basis for determining capital requirements, in contrast to capital requirements for insurance companies, which are based on the relationship between a company's assets and liabilities. Similarly, other commenters expressed concern that bank-centric rules would conflict with the capital requirements of state insurance regulators and provide regulatory incentives for unsound asset-liability mismatches. Several commenters argued that the U.S. Congress intended that banking organizations primarily engaged in insurance activities should be covered by different capital regulations that accounted for the characteristics of insurance activities. These commenters, therefore, encouraged the agencies and the FDIC to recognize capital requirements adopted by state insurance regulators. Further, commenters asserted that the agencies and the FDIC did not appropriately consider regulatory capital requirements for insurance-based banking organizations Start Printed Page 62024whose banking operations are a small part of their overall operations.

Some SLHC commenters that are substantially engaged in commercial activities also asserted that the proposals would be inappropriate in scope as proposed and asked that capital rules not be applied to them until an intermediate holding company regime could be established. They also requested that any capital regime applicable to them be tailored to take into consideration their commercial operations and that they be granted longer transition periods.

As noted above, small BHCs are exempt from the final rule (consistent with the proposals and section 171 of the Dodd-Frank Act) and continue to be subject to the Board's Small Bank Holding Company Policy Statement. Comments submitted on behalf of SLHCs with assets less than $500 million requested an analogous exemption to that for small BHCs. These commenters argued that section 171 of the Dodd-Frank Act does not prohibit such an exemption for small SLHCs.

2. Aggregate Impact

A majority of the commenters expressed concern regarding the potential aggregate impact of the proposals, together with other provisions of the Dodd-Frank Act. Some of these commenters urged the agencies and the FDIC to withdraw the proposals and to conduct a quantitative impact study (QIS) to assess the potential aggregate impact of the proposals on banking organizations and the overall U.S. economy. Many commenters argued that the proposals would have significant negative consequences for the financial services industry. According to the commenters, by requiring banking organizations to hold more capital and increase risk weighting on some of their assets, as well as to meet higher risk-based and leverage capital measures for certain PCA categories, the proposals would negatively affect the banking sector. Commenters cited, among other potential consequences of the proposals: restricted job growth; reduced lending or higher-cost lending, including to small businesses and low-income or minority communities; limited availability of certain types of financial products; reduced investor demand for banking organizations' equity; higher compliance costs; increased mergers and consolidation activity, specifically in rural markets, because banking organizations would need to spread compliance costs among a larger customer base; and diminished access to the capital markets resulting from reduced profit and from dividend restrictions associated with the capital buffers. The commenters also asserted that the recovery of the U.S. economy would be impaired by the proposals as a result of reduced lending by banking organizations that the commenters believed would be attributable to the higher costs of regulatory compliance. In particular, the commenters expressed concern that a contraction in small-business lending would adversely affect job growth and employment.

3. Competitive Concerns

Many commenters raised concerns that implementation of the proposals would create an unlevel playing field between banking organizations and other financial services providers. For example, a number of commenters expressed concern that credit unions would be able to gain market share from banking organizations by offering similar products at substantially lower costs because of differences in taxation combined with potential costs from the proposals. The commenters also argued that other financial service providers, such as foreign banks with significant U.S. operations, members of the Federal Farm Credit System, and entities in the shadow banking industry, would not be subject to the proposed rule and, therefore, would have a competitive advantage over banking organizations. These commenters also asserted that the proposals could cause more consumers to choose lower-cost financial products from the unregulated, nonbank financial sector.

4. Costs

Commenters representing all types of banking organizations expressed concern that the complexity and implementation cost of the proposals would exceed their expected benefits. According to these commenters, implementation of the proposals would require software upgrades for new internal reporting systems, increased employee training, and the hiring of additional employees for compliance purposes. Some commenters urged the agencies and the FDIC to recognize that compliance costs have increased significantly over recent years due to other regulatory changes and to take these costs into consideration. As an alternative, some commenters encouraged the agencies and the FDIC to consider a simple increase in the minimum regulatory capital requirements, suggesting that such an approach would provide increased protection to the Deposit Insurance Fund and increase safety and soundness without adding complexity to the regulatory capital framework.

B. Comments on Particular Aspects of the Basel III Notice of Proposed Rulemaking and on the Standardized Approach Notice of Proposed Rulemaking

In addition to the general comments described above, the agencies and the FDIC received a significant number of comments on four particular elements of the proposals: the requirement to include most elements of AOCI in regulatory capital; the new framework for risk weighting residential mortgages; the requirement to phase out TruPS from tier 1 capital for all banking organizations; and the application of the rule to BHCs and SLHCs (collectively, depository institution holding companies) with substantial insurance and commercial activities.

1. Accumulated Other Comprehensive Income

AOCI generally includes accumulated unrealized gains and losses on certain assets and liabilities that have not been included in net income, yet are included in equity under U.S. generally accepted accounting principles (GAAP) (for example, unrealized gains and losses on securities designated as available-for-sale (AFS)). Under the agencies' and the FDIC's general risk-based capital rules, most components of AOCI are not reflected in a banking organization's regulatory capital. In the proposed rule, consistent with Basel III, the agencies and the FDIC proposed to require banking organizations to include the majority of AOCI components in common equity tier 1 capital.

The agencies and the FDIC received a significant number of comments on the proposal to require banking organizations to recognize AOCI in common equity tier 1 capital. Generally, the commenters asserted that the proposal would introduce significant volatility in banking organizations' capital ratios due in large part to fluctuations in benchmark interest rates, and would result in many banking organizations moving AFS securities into a held-to-maturity (HTM) portfolio or holding additional regulatory capital solely to mitigate the volatility resulting from temporary unrealized gains and losses in the AFS securities portfolio. The commenters also asserted that the proposed rules would likely impair lending and negatively affect banking organizations' ability to manage liquidity and interest rate risk and to maintain compliance with legal lending limits. Commenters representing community banking organizations in Start Printed Page 62025particular asserted that they lack the sophistication of larger banking organizations to use certain risk-management techniques for hedging interest rate risk, such as the use of derivative instruments.

2. Residential Mortgages

The Standardized Approach NPR would have required banking organizations to place residential mortgage exposures into one of two categories to determine the applicable risk weight. Category 1 residential mortgage exposures were defined to include mortgage products with underwriting and product features that have demonstrated a lower risk of default, such as consideration and documentation of a borrower's ability to repay, and generally excluded mortgage products that included terms or other characteristics that the agencies and the FDIC have found to be indicative of higher credit risk, such as deferral of repayment of principal. Residential mortgage exposures with higher risk characteristics were defined as category 2 residential mortgage exposures. The agencies and the FDIC proposed to apply relatively lower risk weights to category 1 residential mortgage exposures, and higher risk weights to category 2 residential mortgage exposures. The proposal provided that the risk weight assigned to a residential mortgage exposure also depended on its LTV ratio.

The agencies and the FDIC received a significant number of comments objecting to the proposed treatment for one-to-four family residential mortgages and requesting retention of the mortgage treatment in the agencies' and the FDIC's general risk-based capital rules. Commenters generally expressed concern that the proposed treatment would inhibit lending to creditworthy borrowers and could jeopardize the recovery of a still-fragile housing market. Commenters also criticized the distinction between category 1 and category 2 mortgages, asserting that the characteristics proposed for each category did not appropriately distinguish between lower- and higher-risk products and would adversely impact certain loan products that performed relatively well even during the recent crisis. Commenters also highlighted concerns regarding regulatory burden and the uncertainty of other regulatory initiatives involving residential mortgages. In particular, these commenters expressed considerable concern regarding the potential cumulative impact of the proposed new mortgage requirements combined with the Dodd-Frank Act's requirements relating to the definitions of qualified mortgage and qualified residential mortgage [21] and asserted that when considered together with the proposed mortgage treatment, the combined effect could have an adverse impact on the mortgage industry.

3. Trust Preferred Securities for Smaller Banking Organizations

The proposed rules would have required all banking organizations to phase-out TruPS from tier 1 capital under either a 3- or 10-year transition period based on the organization's total consolidated assets. The proposal would have required banking organizations with more than $15 billion in total consolidated assets (as of December 31, 2009) to phase-out of tier 1 capital any non-qualifying capital instruments (such as TruPS and cumulative preferred shares) issued before May 19, 2010. The exclusion of non-qualifying capital instruments would have taken place incrementally over a three-year period beginning on January 1, 2013. Section 171 provides an exception that permits 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 (2010 MHCs), to include in tier 1 capital all TruPS (and other instruments that could no longer be included in tier 1 capital pursuant to the requirements of section 171) that were issued prior to May 19, 2010.[22] However, consistent with Basel III and the general policy purpose of the proposed revisions to regulatory capital, the agencies and the FDIC proposed to require banking organizations with total consolidated assets less than $15 billion as of December 31, 2009 and 2010 MHCs to phase out their non-qualifying capital instruments from regulatory capital over ten years.[23]

Many commenters representing community banking organizations criticized the proposal's phase-out schedule for TruPS and encouraged the agencies and the FDIC to grandfather TruPS in tier 1 capital to the extent permitted by section 171 of the Dodd-Frank Act. Commenters asserted that this was the intent of the U.S. Congress, including this provision in the statute. These commenters also asserted that this aspect of the proposal would unduly burden community banking organizations that have limited ability to raise capital, potentially impairing the lending capacity of these banking organizations.

4. Insurance Activities

The agencies and the FDIC received numerous comments from SLHCs, trade associations, insurance companies, and members of the U.S. Congress on the proposed capital requirements for SLHCs, in particular those with significant insurance activities. As noted above, commenters raised concerns that the proposed requirements would apply what are perceived as bank-centric consolidated capital requirements to these entities. Commenters suggested incorporating insurance risk-based capital requirements established by the state insurance regulators into the Board's consolidated risk-based capital requirements for the holding company, or including certain insurance risk-based metrics that, in the commenters' view, would measure the risk of insurance activities more accurately. A few commenters asked the Board to conduct an additional cost-benefit analysis prior to implementing the proposed capital requirements for this subset of SLHCs. In addition, several commenters expressed concern with the burden associated with the proposed requirement to prepare financial statements according to GAAP, because a few SLHCs with substantial insurance operations only prepare financial statements according to Statutory Accounting Principles (SAP). These commenters noted that the Board has accepted non-GAAP financial statements from foreign entities in the past for certain non-consolidated reporting requirements related to the foreign subsidiaries of U.S. banking organizations.[24]

Some commenters stated that the proposal presents serious issues in light Start Printed Page 62026of the McCarran-Ferguson Act.[25] These commenters stated that section 171 of the Dodd-Frank Act does not specifically refer to the business of insurance. Further, the commenters asserted that the proposal disregards the state-based regulatory capital and reserving regimes applicable to insurance companies and thus would impair the solvency laws enacted by the states for the purpose of regulating insurance. The commenters also said that the proposal would alter the risk-management practices and other aspects of the insurance business conducted in accordance with the state laws, in contravention of the McCarran-Ferguson Act. Some commenters also cited section 502 of the Dodd-Frank Act, asserting that it continues the primacy of state regulation of insurance companies.[26]

C. Overview of the Final Rule

The final rule will replace the agencies' general risk-based capital rules, advanced approaches rule, market risk rule, and leverage rules in accordance with the transition provisions described below. After considering the comments received, the agencies have made substantial modifications in the final rule to address specific concerns raised by commenters regarding the cost, complexity, and burden of the proposals.

During the recent financial crisis, lack of confidence in the banking sector increased banking organizations' cost of funding, impaired banking organizations' access to short-term funding, depressed values of banking organizations' equities, and required many banking organizations to seek government assistance. Concerns about banking organizations arose not only because market participants expected steep losses on banking organizations' assets, but also because of substantial uncertainty surrounding estimated loss rates, and thus future earnings. Further, heightened systemic risks, falling asset values, and reduced credit availability had an adverse impact on business and consumer confidence, significantly affecting the overall economy. The final rule addresses these weaknesses by helping to ensure a banking and financial system that will be better able to absorb losses and continue to lend in future periods of economic stress. This important benefit in the form of a safer, more resilient, and more stable banking system is expected to substantially outweigh any short-term costs that might result from the final rule.

In this context, the agencies are adopting most aspects of the proposals, including the minimum risk-based capital requirements, the capital conservation and countercyclical capital buffers, and many of the proposed risk weights. The agencies have also decided to apply most aspects of the Basel III NPR and Standardized Approach NPR to all banking organizations, with some significant changes. Implementing the final rule in a consistent fashion across the banking system will improve the quality and increase the level of regulatory capital, leading to a more stable and resilient system for banking organizations of all sizes and risk profiles. The improved resilience will enhance their ability to continue functioning as financial intermediaries, including during periods of financial stress and reduce risk to the deposit insurance fund and to the financial system. The agencies believe that, together, the revisions to the proposals meaningfully address the commenters' concerns regarding the potential implementation burden of the proposals.

The agencies have considered the concerns raised by commenters and believe that it is important to take into account and address regulatory costs (and their potential effect on banking organizations' role as financial intermediaries in the economy) when the agencies establish or revise regulatory requirements. In developing regulatory capital requirements, these concerns are considered in the context of the agencies' broad goals—to enhance the safety and soundness of banking organizations and promote financial stability through robust capital standards for the entire banking system.

The agencies participated in the development of a number of studies to assess the potential impact of the revised capital requirements, including participating in the BCBS's Macroeconomic Assessment Group as well as its QIS, the results of which were made publicly available by the BCBS upon their completion.[27] The BCBS analysis suggested that stronger capital requirements help reduce the likelihood of banking crises while yielding positive net economic benefits.[28] To evaluate the potential reduction in economic output resulting from the new framework, the analysis assumed that banking organizations replaced debt with higher-cost equity to the extent needed to comply with the new requirements, that there was no reduction in the cost of equity despite the reduction in the riskiness of banking organizations' funding mix, and that the increase in funding cost was entirely passed on to borrowers. Given these assumptions, the analysis concluded there would be a slight increase in the cost of borrowing and a slight decrease in the growth of gross domestic product. The analysis concluded that this cost would be more than offset by the benefit to gross domestic product resulting from a reduced likelihood of prolonged economic downturns associated with a banking system whose lending capacity is highly vulnerable to economic shocks.

The agencies' analysis also indicates that the overwhelming majority of banking organizations already have sufficient capital to comply with the final rule. In particular, the agencies estimate that over 95 percent of all insured depository institutions would be in compliance with the minimums and buffers established under the final rule if it were fully effective immediately. The final rule will help to ensure that these banking organizations maintain their capacity to absorb losses in the future. Some banking organizations may need to take advantage of the transition period in the final rule to accumulate retained earnings, raise additional external regulatory capital, or both. As noted above, however, the overwhelming majority of banking organizations have sufficient capital to comply with the final rule, and the agencies believe that the resulting improvements to the stability and resilience of the banking system outweigh any costs associated with its implementation.

The final rule includes some significant revisions from the proposals in response to commenters' concerns, particularly with respect to the treatment of AOCI; residential mortgages; tier 1 non-qualifying capital instruments such as TruPS issued by smaller depository institution holding companies; the applicability of the rule to SLHCs with substantial insurance or commercial activities; and the Start Printed Page 62027implementation timeframes. The timeframes for compliance are described in the next section and more detailed discussions of modifications to the proposals are provided in the remainder of the preamble.

Consistent with the proposed rules, the final rule requires all banking organizations to recognize in regulatory capital all components of AOCI, excluding accumulated net gains and losses on cash-flow hedges that relate to the hedging of items that are not recognized at fair value on the balance sheet. However, while the agencies believe that the proposed AOCI treatment results in a regulatory capital measure that better reflects banking organizations' actual loss absorption capacity at a specific point in time, the agencies recognize that for many banking organizations, the volatility in regulatory capital that could result from the proposals could lead to significant difficulties in capital planning and asset-liability management. The agencies also recognize that the tools used by larger, more complex banking organizations for managing interest rate risk are not necessarily readily available for all banking organizations.

Accordingly, under the final rule, and as discussed in more detail in section V.B of this preamble, a banking organization that is not subject to the advanced approaches rule may make a one-time election not to include most elements of AOCI in regulatory capital under the final rule and instead effectively use the existing treatment under the general risk-based capital rules that excludes most AOCI elements from regulatory capital (AOCI opt-out election). Such a banking organization must make its AOCI opt-out election in the banking organization's Consolidated Reports of Condition and Income (Call Report) or FR Y-9 series report filed for the first reporting period after the banking organization becomes subject to the final rule. Consistent with regulatory capital calculations under the agencies' general risk-based capital rules, a banking organization that makes an AOCI opt-out election under the final rule must adjust common equity tier 1 capital by: (1) Subtracting any net unrealized gains and adding any net unrealized losses on AFS securities; (2) subtracting any unrealized losses on AFS preferred stock classified as an equity security under GAAP and AFS equity exposures; (3) subtracting any accumulated net gains and adding any accumulated net losses on cash-flow hedges; (4) subtracting amounts recorded in AOCI attributed to defined benefit postretirement plans resulting from the initial and subsequent application of the relevant GAAP standards that pertain to such plans (excluding, at the banking organization's option, the portion relating to pension assets deducted under section 22(a)(5) of the final rule); and (5) subtracting any net unrealized gains and adding any net unrealized losses on held-to-maturity securities that are included in AOCI. Consistent with the general risk-based capital rules, common equity tier 1 capital includes any net unrealized losses on AFS equity securities and any foreign currency translation adjustment. A banking organization that makes an AOCI opt-out election may incorporate up to 45 percent of any net unrealized gains on AFS preferred stock classified as an equity security under GAAP and AFS equity exposures into its tier 2 capital.

A banking organization that does not make an AOCI opt-out election on the Call Report or applicable FR Y-9 report filed for the first reporting period after the banking organization becomes subject to the final rule will be required to recognize AOCI (excluding accumulated net gains and losses on cash-flow hedges that relate to the hedging of items that are not recognized at fair value on the balance sheet) in regulatory capital as of the first quarter in which it calculates its regulatory capital requirements under the final rule and continuing thereafter.

The agencies have decided not to adopt the proposed treatment of residential mortgages. The agencies have considered the commenters' observations about the burden of calculating the risk weights for banking organizations' existing mortgage portfolios, and have taken into account the commenters' concerns that the proposal did not properly assess the use of different mortgage products across different types of markets in establishing the proposed risk weights. The agencies are also particularly mindful of comments regarding the potential effect of the proposal and other mortgage-related rulemakings on credit availability. In light of these considerations, as well as others raised by commenters, the agencies have decided to retain in the final rule the current treatment for residential mortgage exposures under the general risk-based capital rules.

Consistent with the general risk-based capital rules, the final rule assigns a 50 or 100 percent risk weight to exposures secured by one-to-four family residential properties. Generally, residential mortgage exposures secured by a first lien on a one-to-four family residential property that are prudently underwritten and that are performing according to their original terms receive a 50 percent risk weight. All other one- to four-family residential mortgage loans, including exposures secured by a junior lien on residential property, are assigned a 100 percent risk weight. If a banking organization holds the first and junior lien(s) on a residential property and no other party holds an intervening lien, the banking organization must treat the combined exposure as a single loan secured by a first lien for purposes of assigning a risk weight.

The agencies also considered comments on the proposal to require banking organizations with total consolidated assets less than $15 billion as of December 31, 2009, and 2010 MHCs, to phase out their non-qualifying tier 1 capital instruments from regulatory capital over ten years. Although the agencies continue to believe that TruPS do not absorb losses sufficiently to be included in tier 1 capital as a general matter, the agencies are also sensitive to the difficulties community banking organizations often face when issuing new capital instruments and are aware of the importance their capacity to lend can play in local economies. Therefore, the final rule permanently grandfathers non-qualifying capital instruments in the tier 1 capital of depository institution holding companies with total consolidated assets of less than $15 billion as of December 31, 2009, and 2010 MHCs (subject to limits). Non-qualifying capital instruments under the final rule include TruPS and cumulative perpetual preferred stock issued before May 19, 2010, that BHCs included in tier 1 capital under the limitations for restricted capital elements in the general risk-based capital rules.

After considering the comments received from SLHCs substantially engaged in commercial activities or insurance underwriting activities, the Board has decided to consider further the development of appropriate capital requirements for these companies, taking into consideration information provided by commenters as well as information gained through the supervisory process. The Board will explore further whether and how the proposed rule should be modified for these companies in a manner consistent with section 171 of the Dodd-Frank Act and safety and soundness concerns.

Consequently, as defined in the final rule, a covered SLHC that is subject to the final rule (covered SLHC) is a top-tier SLHC other than a top-tier SLHC that meets the exclusion criteria set forth in the definition. With respect to commercial activities, a top-tier SLHC that is a grandfathered unitary savings Start Printed Page 62028and loan holding company (as defined in section 10(c)(9)(A) of the Home Owners' Loan Act (HOLA)) [29] is not a covered SLHC if as of June 30 of the previous calendar year, either 50 percent or more of the total consolidated assets of the company or 50 percent of the revenues of the company on an enterprise-wide basis (as calculated under GAAP) were derived from activities that are not financial in nature under section 4(k) of the Bank Holding Company Act.[30] This exclusion is similar to the exemption from reporting on the form FR Y-9C for grandfathered unitary savings and loan holding companies with significant commercial activities and is designed to capture those SLHCs substantially engaged in commercial activities.[31]

The Board is excluding grandfathered unitary savings and loan holding companies that meet these criteria from the capital requirements of the final rule while it continues to contemplate a proposal for SLHC intermediate holding companies. Under section 626 of the Dodd-Frank Act, the Board may require a grandfathered unitary savings and loan holding company to establish and conduct all or a portion of its financial activities in or through an intermediate holding company and the intermediate holding company itself becomes an SLHC subject to Board supervision and regulation.[32] The Board anticipates that it will release a proposal for public comment on intermediate holding companies in the near term that would specify the criteria for establishing and transferring activities to intermediate holding companies, consistent with section 626 of the Dodd-Frank Act, and propose to apply the Board's capital requirements in this final rule to such intermediate holding companies.

Under the final rule, top-tier SLHCs that are substantially engaged in insurance underwriting activities are also excluded from the definition of “covered SLHC” and the requirements of the final rule. SLHCs that are themselves insurance underwriting companies (as defined in the final rule) are excluded from the definition.[33] Also excluded are SLHCs that, as of June 30 of the previous calendar year, held 25 percent or more of their total consolidated assets in insurance underwriting subsidiaries (other than assets associated with insurance underwriting for credit risk). Under the final rule, the calculation of total consolidated assets for this purpose must generally be in accordance with GAAP. Many SLHCs that are substantially engaged in insurance underwriting activities do not calculate total consolidated assets under GAAP. Therefore, the Board has determined to allow estimated calculations at this time for the purposes of determining whether a company is excluded from the definition of “covered SLHC,” subject to possible review and adjustment by the Board. The Board 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. The final rule also contains provisions applicable to insurance underwriting activities conducted within a BHC or covered SLHC. These provisions are effective as part of the final rule.

D. Timeframe for Implementation and Compliance

In order to give covered SLHCs and non-internationally active banking organizations more time to comply with the final rule and simplify their transition to the new regime, the final rule will require compliance from different types of organizations at different times. Generally, and as described in further detail below, banking organizations that are not subject to the advanced approaches rule must begin complying with the final rule on January 1, 2015, whereas advanced approaches banking organizations must begin complying with the final rule on January 1, 2014. The agencies believe that advanced approaches banking organizations have the sophistication, infrastructure, and capital markets access to implement the final rule earlier than either banking organizations that do not meet the asset size or foreign exposure threshold for application of those rules or covered SLHCs that have not previously been subject to consolidated capital requirements.

A number of commenters requested that the agencies and the FDIC clarify the point at which a banking organization that meets the asset size or foreign exposure threshold for application of the advanced approaches rule becomes subject to subpart E of the proposed rule, and thus all of the provisions that apply to an advanced approaches banking organization. In particular, commenters requested that the agencies and the FDIC clarify whether subpart E of the proposed rule only applies to those banking organizations that have completed the parallel run process and that have received notification from their primary Federal supervisor pursuant to section 121(d) of subpart E, or whether subpart E would apply to all banking organizations that meet the relevant thresholds without reference to completion of the parallel run process.

The final rule provides that an advanced approaches banking organization is one that meets the asset size or foreign exposure thresholds for or has opted to apply the advanced approaches rule, without reference to whether that banking organization has completed the parallel run process and has received notification from its primary Federal supervisor pursuant to section 121(d) of subpart E of the final rule. The agencies have also clarified in the final rule when completion of the parallel run process and receipt of notification from the primary Federal supervisor pursuant to section 121(d) of subpart E is necessary for an advanced approaches banking organization to comply with a particular aspect of the rules. For example, only an advanced approaches banking organization that has completed parallel run and received notification from its primary Federal supervisor under section 121(d) of subpart E must make the disclosures set forth under subpart E of the final rule. However, an advanced approaches banking organization must recognize most components of AOCI in common equity tier 1 capital and must meet the supplementary leverage ratio when applicable without reference to whether the banking organization has completed its parallel run process.

Beginning on January 1, 2015, banking organizations that are not subject to the advanced approaches rule, as well as advanced approaches banking organizations that are covered SLHCs, become subject to: The revised definitions of regulatory capital; the new minimum regulatory capital ratios; and the regulatory capital adjustments and deductions according to the transition provisions.[34] All banking organizations must begin calculating standardized total risk-weighted assets in accordance with subpart D of the final rule, and if applicable, the revised Start Printed Page 62029market risk rule under subpart F, on January 1, 2015.[35]

Beginning on January 1, 2014, advanced approaches banking organizations that are not SLHCs must begin the transition period for the revised minimum regulatory capital ratios, definitions of regulatory capital, and regulatory capital adjustments and deductions established under the final rule. The revisions to the advanced approaches risk-weighted asset calculations will become effective on January 1, 2014.

From January 1, 2014 to December 31, 2014, an advanced approaches banking organization that is on parallel run must calculate risk-weighted assets using the general risk-based capital rules and substitute such risk-weighted assets for its standardized total risk-weighted assets for purposes of determining its risk-based capital ratios. An advanced approaches banking organization on parallel run must also calculate advanced approaches total risk-weighted assets using the advanced approaches rule in subpart E of the final rule for purposes of confidential reporting to its primary Federal supervisor on the Federal Financial Institutions Examination Council's (FFIEC) 101 report. An advanced approaches banking organization that has completed the parallel run process and that has received notification from its primary Federal supervisor pursuant to section 121(d) of subpart E will calculate its risk-weighted assets using the general risk-based capital rules and substitute such risk-weighted assets for its standardized total risk-weighted assets and also calculate advanced approaches total risk-weighted assets using the advanced approaches rule in subpart E of the final rule for purposes of determining its risk-based capital ratios from January 1, 2014 to December 31, 2014. Regardless of an advanced approaches banking organization's parallel run status, on January 1, 2015, the banking organization must begin to apply subpart D, and if applicable, subpart F, of the final rule to determine its standardized total risk-weighted assets.

The transition period for the capital conservation and countercyclical capital buffers for all banking organizations will begin on January 1, 2016.

A banking organization that is required to comply with the market risk rule must comply with the revised market risk rule (subpart F) as of the same date that it must comply with other aspects of the rule for determining its total risk-weighted assets.

DateBanking organizations not subject to the advanced approaches rule and banking organizations that are covered SLHCs *
January 1, 2015Begin compliance with the revised minimum regulatory capital ratios and begin the transition period for the revised definitions of regulatory capital and the revised regulatory capital adjustments and deductions.
Begin compliance with the standardized approach for determining risk-weighted assets.
January 1, 2016Begin the transition period for the capital conservation and countercyclical capital buffers.
DateAdvanced approaches banking organizations that are not SLHCs *
January 1, 2014Begin the transition period for the revised minimum regulatory capital ratios, definitions of regulatory capital, and regulatory capital adjustments and deductions.
Begin compliance with the revised advanced approaches rule for determining risk-weighted assets.
January 1, 2015Begin compliance with the standardized approach for determining risk-weighted assets.
January 1, 2016Begin the transition period for the capital conservation and countercyclical capital buffers.
* If applicable, banking organizations must use the calculations in subpart F of the final rule (market risk) concurrently with the calculation of risk-weighted assets according either to subpart D (standardized approach) or subpart E (advanced approaches) of the final rule.

IV. Minimum Regulatory Capital Ratios, Additional Capital Requirements, and Overall Capital Adequacy

A. Minimum Risk-Based Capital Ratios and Other Regulatory Capital Provisions

Consistent with Basel III, the proposed rule would have required banking organizations to comply with the following minimum capital ratios: a common equity tier 1 capital to risk-weighted assets ratio of 4.5 percent; a tier 1 capital to risk-weighted assets ratio of 6 percent; a total capital to risk-weighted assets ratio of 8 percent; a leverage ratio of 4 percent; and for advanced approaches banking organizations only, a supplementary leverage ratio of 3 percent. The common equity tier 1 capital ratio is a new minimum requirement designed to ensure that banking organizations hold sufficient high-quality regulatory capital that is available to absorb losses on a going-concern basis. The proposed capital ratios would apply to a banking organization on a consolidated basis.

The agencies received a substantial number of comments on the proposed minimum risk-based capital requirements. Several commenters supported the proposal to increase the minimum tier 1 risk-based capital requirement. Other commenters commended the agencies and the FDIC for proposing to implement a minimum capital requirement that focuses primarily on common equity. These commenters argued that common equity is the strongest form of capital and that the proposed minimum common equity tier 1 capital ratio of 4.5 percent would promote the safety and soundness of the banking industry.

Other commenters provided general support for the proposed increases in minimum risk-based capital requirements, but expressed concern that the proposals could present unique challenges to mutual institutions because they can only raise common equity through retained earnings. A number of commenters asserted that the objectives of the proposal could be achieved through regulatory mechanisms other than the proposed risk-based capital requirements, including enhanced safety and soundness examinations, more stringent underwriting standards, and alternative measures of capital.

Other commenters objected to the proposed increase in the minimum tier 1 capital ratio and the implementation of a common equity tier 1 capital ratio. One commenter indicated that increases in regulatory capital ratios would severely limit growth at many community banking organizations and could encourage consolidation through mergers and acquisitions. Other commenters stated that for banks under $750 million in total assets, increased Start Printed Page 62030compliance costs would not allow them to provide a reasonable return to shareholders, and thus would force them to consolidate. Several commenters urged the agencies and the FDIC to recognize community banking organizations' limited access to the capital markets and related difficulties raising capital to comply with the proposal.

One banking organization indicated that implementation of the common equity tier 1 capital ratio would significantly reduce its capacity to grow and recommended that the proposal recognize differences in the risk and complexity of banking organizations and provide favorable, less stringent requirements for smaller and non-complex institutions. Another commenter suggested that the proposed implementation of an additional risk-based capital ratio would confuse market observers and recommended that the agencies and the FDIC implement a regulatory capital framework that allows investors and the market to ascertain regulatory capital from measures of equity derived from a banking organization's balance sheet.

Other commenters expressed concern that the proposed common equity tier 1 capital ratio would disadvantage MDIs relative to other banking organizations. According to the commenters, in order to retain their minority-owned status, MDIs historically maintain a relatively high percentage of non-voting preferred stockholders that provide long-term, stable sources of capital. Any public offering to increase common equity tier 1 capital levels would dilute the minority investors owning the common equity of the MDI and could potentially compromise the minority-owned status of such institutions. One commenter asserted that, for this reason, the implementation of the Basel III NPR would be contrary to the statutory mandate of section 308 of the Financial Institutions, Reform, Recovery and Enforcement Act (FIRREA).[36] Accordingly, the commenters encouraged the agencies and the FDIC to exempt MDIs from the proposed common equity tier 1 capital ratio requirement.

The agencies believe that all banking organizations must have an adequate amount of loss-absorbing capital to continue to lend to their communities during times of economic stress, and therefore have decided to implement the regulatory capital requirements, including the minimum common equity tier 1 capital requirement, as proposed. For the reasons described in the NPR, including the experience during the crisis with lower quality capital instruments, the agencies do not believe it is appropriate to maintain the general risk-based capital rules or to rely on the supervisory process or underwriting standards alone. Accordingly, the final rule maintains the minimum common equity tier 1 capital to total risk-weighted assets ratio of 4.5 percent. The agencies have decided not to pursue the alternative regulatory mechanisms suggested by commenters, as such alternatives would be difficult to implement consistently across banking organizations and would not necessarily fulfill the objective of increasing the amount and quality of regulatory capital for all banking organizations.

In view of the concerns expressed by commenters with respect to MDIs, the agencies and the FDIC evaluated the risk-based and leverage capital levels of MDIs to determine whether the final rule would disproportionately impact such institutions. This analysis found that of the 178 MDIs in existence as of March 31, 2013, 12 currently are not well capitalized for PCA purposes, whereas (according to the agencies' and the FDIC's estimates) 14 would not be considered well capitalized for PCA purposes under the final rule if it were fully implemented without transition today. Accordingly, the agencies do not believe that the final rule would disproportionately impact MDIs and are not adopting any exemptions or special provisions for these institutions. While the agencies recognize MDIs may face impediments in meeting the common equity tier 1 capital ratio, the agencies believe that the improvements to the safety and soundness of these institutions through higher capital standards are warranted and consistent with their obligations under section 308 of FIRREA. As a prudential matter, the agencies have a long-established regulatory policy that banking organizations should hold capital commensurate with the level and nature of the risks to which they are exposed, which may entail holding capital significantly above the minimum requirements, depending on the nature of the banking organization's activities and risk profile. Section IV.G of this preamble describes the requirement for overall capital adequacy of banking organizations and the supervisory assessment of capital adequacy.

Furthermore, consistent with the agencies' authority under the general risk-based capital rules and the proposals, section 1(d) of the final rule includes a reservation of authority that allows a banking organization's primary Federal supervisor to require the banking organization to hold a greater amount of regulatory capital than otherwise is required under the final rule, if the supervisor determines that the regulatory capital held by the banking organization is not commensurate with its credit, market, operational, or other risks. In exercising reservation of authority under the rule, the agencies expect to consider the size, complexity, risk profile, and scope of operations of the banking organization; and whether any public benefits would be outweighed by risk to an insured depository institution or to the financial system.

B. Leverage Ratio

The proposals would require a banking organization to satisfy a leverage ratio of 4 percent, calculated using the proposed definition of tier 1 capital and the banking organization's average total consolidated assets, minus amounts deducted from tier 1 capital. The agencies and the FDIC also proposed to eliminate the exception in the agencies' and the FDIC's leverage rules that provides for a minimum leverage ratio of 3 percent for banking organizations with strong supervisory ratings or BHCs that are subject to the market risk rule.

The agencies and the FDIC received a number of comments on the proposed leverage ratio applicable to all banking organizations. Several of these commenters supported the proposed leverage ratio, stating that it serves as a simple regulatory standard that constrains the ability of a banking organization to leverage its equity capital base. Some of the commenters encouraged the agencies and the FDIC to consider an alternative leverage ratio measure of tangible common equity to tangible assets, which would exclude non-common stock elements from the numerator and intangible assets from the denominator of the ratio and thus, according to these commenters, provide a more reliable measure of a banking organization's viability in a crisis.

A number of commenters criticized the proposed removal of the 3 percent exception to the minimum leverage ratio requirement for certain banking organizations. One of these commenters argued that removal of this exception is unwarranted in view of the cumulative impact of the proposals and that raising the minimum leverage ratio requirement for the strongest banking organizations may lead to a deleveraging by the institutions most able to extend credit in a safe and sound manner. In addition, the commenters cautioned the agencies and the FDIC that a restrictive leverage measure, together with more stringent Start Printed Page 62031risk-based capital requirements, could magnify the potential impact of an economic downturn.

Several commenters suggested modifications to the minimum leverage ratio requirement. One commenter suggested increasing the minimum leverage ratio requirement for all banking organizations to 6 percent, whereas another commenter recommended a leverage ratio requirement as high as 20 percent. Another commenter suggested a tiered approach, with minimum leverage ratio requirements of 6.25 percent and 8.5 percent for community banking organizations and large banking organizations, respectively. According to this commenter, such an approach could be based on the risk characteristics of a banking organization, including liquidity, asset quality, and local deposit levels, as well as its supervisory rating. Another commenter suggested a fluid leverage ratio requirement that would adjust based on certain macroeconomic variables. Under such an approach, the agencies and the FDIC could require banking organizations to meet a minimum leverage ratio of 10 percent under favorable economic conditions and a 6 percent leverage ratio during an economic contraction.

In addition, a number of commenters encouraged the agencies and the FDIC to reconsider the scope of exposures that banking organizations include in the denominator of the leverage ratio, which is based on average total consolidated assets under GAAP. Several of these commenters criticized the proposed minimum leverage ratio requirement because it would not include an exemption for certain exposures that are unique to banking organizations engaged in insurance activities. Specifically, these commenters encouraged the Board to consider excluding assets held in separate accounts and stated that such assets are not available to satisfy the claims of general creditors and do not affect the leverage position of an insurance company. A few commenters asserted that the inclusion of separate account assets in the calculation of the leverage ratio stands in contrast to the agencies' and the FDIC's treatment of banking organization's trust accounts, bank-affiliated mutual funds, and bank-maintained common and collective investment funds. In addition, some of these commenters argued for a partial exclusion of trading account assets supporting insurance liabilities because, according to these commenters, the risks attributable to these assets accrue to contract owners.

The agencies continue to believe that a minimum leverage ratio requirement of 4 percent for all banking organizations is appropriate in light of its role as a complement to the risk-based capital ratios. The proposed leverage ratio is more conservative than the current leverage ratio because it incorporates a more stringent definition of tier 1 capital. In addition, the agencies believe that it is appropriate for all banking organizations, regardless of their supervisory rating or trading activities, to meet the same minimum leverage ratio requirements. As a practical matter, the agencies generally have found a leverage ratio of less than 4 percent to be inconsistent with a supervisory composite rating of “1.” Modifying the scope of the leverage ratio measure or implementing a fluid or tiered approach for the minimum leverage ratio requirement would create additional operational complexity and variability in a minimum ratio requirement that is intended to place a constraint on the maximum degree to which a banking organization can leverage its equity base. Accordingly, the final rule retains the existing minimum leverage ratio requirement of 4 percent and removes the 3 percent leverage ratio exception as of January 1, 2014 for advanced approaches banking organizations and as of January 1, 2015 for all other banking organizations.

With respect to including separate account assets in the leverage ratio denominator, the Board continues to consider this issue together with other issues raised by commenters regarding the regulatory capital treatment of insurance activities. The final rule continues to include separate account assets in total assets, consistent with the proposal and the leverage ratio rule for BHCs.

C. Supplementary Leverage Ratio for Advanced Approaches Banking Organizations

As part of Basel III, the BCBS introduced a minimum leverage ratio requirement of 3 percent (the Basel III leverage ratio) as a backstop measure to the risk-based capital requirements, designed to improve the resilience of the banking system worldwide by limiting the amount of leverage that a banking organization may incur. The Basel III leverage ratio is defined as the ratio of tier 1 capital to a combination of on- and off-balance sheet exposures.

As discussed in the Basel III NPR, the agencies and the FDIC proposed the supplementary leverage ratio only for advanced approaches banking organizations because these banking organizations tend to have more significant amounts of off-balance sheet exposures that are not captured by the current leverage ratio. Under the proposal, consistent with Basel III, advanced approaches banking organizations would be required to maintain a minimum supplementary leverage ratio of 3 percent of tier 1 capital to on- and off-balance sheet exposures (total leverage exposure).

The agencies and the FDIC received a number of comments on the proposed supplementary leverage ratio. Several commenters stated that the proposed supplementary leverage ratio is unnecessary in light of the minimum leverage ratio requirement applicable to all banking organizations. These commenters stated that the implementation of the supplementary leverage ratio requirement would create market confusion as to the inter-relationships among the ratios and as to which ratio serves as the binding constraint for an individual banking organization. One commenter noted that an advanced approaches banking organization would be required to calculate eight distinct regulatory capital ratios (common equity tier 1, tier 1, and total capital to risk-weighted assets under the advanced approaches and the standardized approach, as well as two leverage ratios) and encouraged the agencies and the FDIC to streamline the application of regulatory capital ratios. In addition, commenters suggested that the agencies and the FDIC postpone the implementation of the supplementary leverage ratio until January 1, 2018, after the international supervisory monitoring process is complete, and to collect supplementary leverage ratio information on a confidential basis until then.

At least one commenter encouraged the agencies and the FDIC to consider extending the application of the proposed supplementary leverage ratio on a case-by-case basis to banking organizations with total assets of between $50 billion and $250 billion, stating that such institutions may have significant off-balance sheet exposures and engage in a substantial amount of repo-style transactions. Other commenters suggested increasing the proposed supplementary leverage ratio requirement to at least 8 percent for BHCs, under the Board's authority in section 165 of the Dodd-Frank Act to implement enhanced capital requirements for systemically important financial institutions.[37]

With respect to specific aspects of the supplementary leverage ratio, some Start Printed Page 62032commenters criticized the methodology for the total leverage exposure. Specifically, one commenter expressed concern that using GAAP as the basis for determining a banking organization's total leverage exposure would exclude a wide range of off-balance sheet exposures, including derivatives and securities lending transactions, as well as permit extensive netting. To address these issues, the commenter suggested requiring advanced approaches banking organizations to determine their total leverage exposure using International Financial Reporting Standards (IFRS), asserting that it restricts netting and, relative to GAAP, requires the recognition of more off-balance sheet securities lending transactions.

Several commenters criticized the proposed incorporation of off-balance sheet exposures into the total leverage exposure. One commenter argued that including unfunded commitments in the total leverage exposure runs counter to the purpose of the supplementary leverage ratio as an on-balance sheet measure of capital that complements the risk-based capital ratios. This commenter was concerned that the proposed inclusion of unfunded commitments would result in a duplicative assessment against banking organizations when the forthcoming liquidity ratio requirements are implemented in the United States. The commenter noted that the proposed 100 percent credit conversion factor for all unfunded commitments is not appropriately calibrated to the vastly different types of commitments that exist across the industry. If the supplementary leverage ratio is retained in the final rule, the commenter requested that the agencies and the FDIC align the credit conversion factors for unfunded commitments under the supplementary leverage ratio and any forthcoming liquidity ratio requirements.

Another commenter encouraged the agencies and the FDIC to allow advanced approaches banking organizations to exclude from total leverage exposure the notional amount of any unconditionally cancellable commitment. According to this commenter, unconditionally cancellable commitments are not credit exposures because they can be extinguished at any time at the sole discretion of the issuing entity. Therefore, the commenter argued, the inclusion of these commitments could potentially distort a banking organization's measure of total leverage exposure.

A few commenters requested that the agencies and the FDIC exclude off-balance sheet trade finance instruments from the total leverage exposure, asserting that such instruments are based on underlying client transactions (for example, a shipment of goods) and are generally short-term. The commenters argued that trade finance instruments do not create excessive systemic leverage and that they are liquidated by fulfillment of the underlying transaction and payment at maturity. Another commenter requested that the agencies and the FDIC apply the same credit conversion factors to trade finance instruments as under the general risk-based capital rules—that is, 20 percent of the notional value for trade-related contingent items that arise from the movement of goods, and 50 percent of the notional value for transaction-related contingent items, including performance bonds, bid bonds, warranties, and performance standby letters of credit. According to this commenter, such an approach would appropriately consider the low-risk characteristics of these instruments and ensure price stability in trade finance.

Several commenters supported the proposed treatment for repo-style transactions (including repurchase agreements, securities lending and borrowing transactions, and reverse repos). These commenters stated that securities lending transactions are fully collateralized and marked to market daily and, therefore, the on-balance sheet amounts generated by these transactions appropriately capture the exposure for purposes of the supplementary leverage ratio. These commenters also supported the proposed treatment for indemnified securities lending transactions and encouraged the agencies and the FDIC to retain this treatment in the final rule. Other commenters stated that the proposed measurement of repo-style transactions is not sufficiently conservative and recommended that the agencies and the FDIC implement a methodology that includes in total leverage exposure the notional amounts of these transactions.

A few commenters raised concerns about the proposed methodology for determining the exposure amount of derivative contracts. Some commenters criticized the agencies and the FDIC for not allowing advanced approaches banking organizations to use the internal models methodology to calculate the exposure amount for derivative contracts. According to these commenters, the agencies and the FDIC should align the methods for calculating exposure for derivative contracts for purposes of the supplementary leverage ratio and the advanced approaches risk-based capital ratios to more appropriately reflect the risk-management activities of advanced approaches banking organizations and to measure these exposures consistently across the regulatory capital ratios. At least one commenter requested clarification of the proposed treatment of collateral received in connection with derivative contracts. This commenter also encouraged the agencies and the FDIC to permit recognition of eligible collateral for purposes of reducing total leverage exposure, consistent with proposed legislation in other BCBS member jurisdictions.

The introduction of an international leverage ratio requirement in the Basel III capital framework is an important development that would provide a consistent leverage ratio measure across internationally-active institutions. Furthermore, the supplementary leverage ratio is reflective of the on- and off-balance sheet activities of large, internationally active banking organizations. Accordingly, consistent with Basel III, the final rule implements for reporting purposes the proposed supplementary leverage ratio for advanced approaches banking organizations starting on January 1, 2015 and requires advanced approaches banking organizations to comply with the minimum supplementary leverage ratio requirement starting on January 1, 2018. Public reporting of the supplementary leverage ratio during the international supervisory monitoring period is consistent with the international implementation timeline and enables transparency and comparability of reporting the leverage ratio requirement across jurisdictions.

The agencies are not applying the supplementary leverage ratio requirement to banking organizations that are not subject to the advanced approaches rule in the final rule. Applying the supplementary leverage ratio routinely could create operational complexity for smaller banking organizations that are not internationally active, and that generally do not have off-balance sheet activities that are as extensive as banking organizations that are subject to the advanced approaches rule. The agencies note that the final rule imposes risk-based capital requirements on all repo-style transactions and otherwise imposes constraints on all banking organizations' off-balance sheet exposures.

With regard to the commenters' views to require the use of IFRS for purposes of the supplementary leverage ratio, the agencies note that the use of GAAP in the final rule as a starting point to Start Printed Page 62033measure exposure of certain derivatives and repo-style transactions, has the advantage of maintaining consistency between regulatory capital calculations and regulatory reporting, the latter of which must be consistent with GAAP or, if another accounting principle is used, no less stringent than GAAP.[38]

In response to the commenters' views regarding the scope of the total leverage exposure, the agencies note that the supplementary leverage ratio is intended to capture on- and off-balance sheet exposures of a banking organization. Commitments represent an agreement to extend credit and thus including commitments (both funded and unfunded) in the supplementary leverage ratio is consistent with its purpose to measure the on- and off-balance sheet leverage of a banking organization, as well as with safety and soundness principles. Accordingly, the agencies believe that total leverage exposure should include banking organizations' off-balance sheet exposures, including all loan commitments that are not unconditionally cancellable, financial standby letters of credit, performance standby letters of credit, and commercial and other similar letters of credit.

The proposal to include unconditionally cancellable commitments in the total leverage exposure recognizes that a banking organization may extend credit under the commitment before it is cancelled. If the banking organization exercises its option to cancel the commitment, its total leverage exposure amount with respect to the commitment will be limited to any extension of credit prior to cancellation. The proposal considered banking organizations' ability to cancel such commitments and, therefore, limited the amount of unconditionally cancellable commitments included in total leverage exposure to 10 percent of the notional amount of such commitments.

The agencies note that the credit conversion factors used in the supplementary leverage ratio and in any forthcoming liquidity ratio requirements have been developed to serve the purposes of the respective frameworks and may not be identical. Similarly, the commenters' proposed modifications to credit conversion factors for trade finance transactions would be inconsistent with the purpose of the supplementary leverage ratio—to capture all off-balance sheet exposures of banking organizations in a primarily non-risk-based manner.

For purposes of incorporating derivative contracts in the total leverage exposure, the proposal would require all advanced approaches banking organizations to use the same methodology to measure such exposures. The proposed approach provides a uniform measure of exposure for derivative contracts across banking organizations, without regard to their models. Accordingly, the agencies do not believe a banking organization should be permitted to use internal models to measure the exposure amount of derivative contracts for purposes of the supplementary leverage ratio.

With regard to commenters requesting a modification of the proposed treatment for repo-style transactions, the agencies do not believe that the proposed modifications are warranted at this time because international discussions and quantitative analysis of the exposure measure for repo-style transactions are still ongoing.

The agencies are continuing to work with the BCBS to assess the Basel III leverage ratio, including its calibration and design, as well as the impact of any differences in national accounting frameworks material to the denominator of the Basel III leverage ratio. The agencies will consider any changes to the supplementary leverage ratio as the BCBS revises the Basel III leverage ratio.

Therefore, the agencies have adopted the proposed supplementary leverage ratio in the final rule without modification. An advanced approaches banking organization must calculate the supplementary leverage ratio as the simple arithmetic mean of the ratio of the banking organization's tier 1 capital to total leverage exposure as of the last day of each month in the reporting quarter. The agencies also note that collateral may not be applied to reduce the potential future exposure (PFE) amount for derivative contracts.

Under the final rule, total leverage exposure equals the sum of the following:

(1) The balance sheet carrying value of all of the banking organization's on-balance sheet assets less amounts deducted from tier 1 capital under section 22(a), (c), and (d) of the final rule;

(2) The PFE amount for each derivative contract to which the banking organization is a counterparty (or each single-product netting set of such transactions) determined in accordance with section 34 of the final rule, but without regard to section 34(b);

(3) 10 percent of the notional amount of unconditionally cancellable commitments made by the banking organization; and

(4) The notional amount of all other off-balance sheet exposures of the banking organization (excluding securities lending, securities borrowing, reverse repurchase transactions, derivatives and unconditionally cancellable commitments).

Advanced approaches banking organizations must maintain a minimum supplementary leverage ratio of 3 percent beginning on January 1, 2018, consistent with Basel III. However, as noted above, beginning on January 1, 2015, advanced approaches banking organizations must calculate and report their supplementary leverage ratio.

D. Capital Conservation Buffer

During the recent financial crisis, some banking organizations continued to pay dividends and substantial discretionary bonuses even as their financial condition weakened. Such capital distributions had a significant negative impact on the overall strength of the banking sector. To encourage better capital conservation by banking organizations and to enhance the resilience of the banking system, the proposed rule would have limited capital distributions and discretionary bonus payments for banking organizations that do not hold a specified amount of common equity tier 1 capital in addition to the amount of regulatory capital necessary to meet the minimum risk-based capital requirements (capital conservation buffer), consistent with Basel III. In this way, the capital conservation buffer is intended to provide incentives for banking organizations to hold sufficient capital to reduce the risk that their capital levels would fall below their minimum requirements during a period of financial stress.

The proposed rules incorporated a capital conservation buffer composed of common equity tier 1 capital in addition to the minimum risk-based capital requirements. Under the proposal, a banking organization would need to hold a capital conservation buffer in an amount greater than 2.5 percent of total risk-weighted assets (plus, for an advanced approaches banking organization, 100 percent of any applicable countercyclical capital buffer amount) to avoid limitations on capital distributions and discretionary bonus payments to executive officers, as defined in the proposal. The proposal provided that the maximum dollar amount that a banking organization could pay out in the form of capital distributions or discretionary bonus payments during the current calendar quarter (the maximum payout amount) Start Printed Page 62034would be equal to a maximum payout ratio, multiplied by the banking organization's eligible retained income, as discussed below. The proposal provided that a banking organization with a buffer of more than 2.5 percent of total risk-weighted assets (plus, for an advanced approaches banking organization, 100 percent of any applicable countercyclical capital buffer), would not be subject to a maximum payout amount. The proposal clarified that the agencies and the FDIC reserved the ability to restrict capital distributions under other authorities and that restrictions on capital distributions and discretionary bonus payments associated with the capital conservation buffer would not be part of the PCA framework. The calibration of the buffer is supported by an evaluation of the loss experience of U.S. banking organizations as part of an analysis conducted by the BCBS, as well as by evaluation of historical levels of capital at U.S. banking organizations.[39]

The agencies and the FDIC received a significant number of comments on the proposed capital conservation buffer. In general, the commenters characterized the capital conservation buffer as overly conservative, and stated that the aggregate amount of capital that would be required for a banking organization to avoid restrictions on dividends and discretionary bonus payments under the proposed rule exceeded the amount required for a safe and prudent banking system. Commenters expressed concern that the capital conservation buffer could disrupt the priority of payments in a banking organization's capital structure, as any restrictions on dividends would apply to both common and preferred stock. Commenters also questioned the appropriateness of restricting a banking organization that fails to comply with the capital conservation buffer from paying dividends or bonus payments if it has established and maintained cash reserves to cover future uncertainty. One commenter supported the establishment of a formal mechanism for banking organizations to request agency approval to make capital distributions even if doing so would otherwise be restricted under the capital conservation buffer.

Other commenters recommended an exemption from the proposed capital conservation buffer for certain types of banking organizations, such as community banking organizations, banking organizations organized in mutual form, and rural BHCs that rely heavily on bank stock loans for growth and expansion purposes. Commenters also recommended a wide range of institutions that should be excluded from the buffer based on a potential size threshold, such as banking organizations with total consolidated assets of less than $250 billion. Commenters also recommended that S-corporations be exempt from the proposed capital conservation buffer because under the U.S. Internal Revenue Code, S-corporations are not subject to a corporate-level tax; instead, S-corporation shareholders must report income and pay income taxes based on their share of the corporation's profit or loss. An S-corporation generally declares a dividend to help shareholders pay their tax liabilities that arise from reporting their share of the corporation's profits. According to some commenters, the proposal disadvantaged S-corporations because shareholders of S-corporations would be liable for tax on the S-corporation's net income, and the S-corporation may be prohibited from making a dividend to these shareholders to fund the tax payment.

One commenter criticized the proposed composition of the capital conservation buffer (which must consist solely of common equity tier 1 capital) and encouraged the agencies and the FDIC to allow banking organizations to include noncumulative perpetual preferred stock and other tier 1 capital instruments. Several commenters questioned the empirical basis for a capital conservation buffer of 2.5 percent, and encouraged the agencies and the FDIC to provide a quantitative analysis for the proposal. One commenter suggested application of the capital conservation buffer only during economic downturn scenarios, consistent with the agencies' and the FDIC's objective to restrict dividends and discretionary bonus payments during these periods. According to this commenter, a banking organization that fails to maintain a sufficient capital conservation buffer during periods of economic stress also could be required to submit a plan to increase its capital.

After considering these comments, the agencies have decided to maintain common equity tier 1 capital as the basis of the capital conservation buffer and to apply the capital conservation buffer to all types of banking organizations at all times. Application of the buffer to all types of banking organizations and maintenance of a capital buffer during periods of market and economic stability is appropriate to encourage sound capital management and help ensure that banking organizations will maintain adequate amounts of loss-absorbing capital going forward, strengthening the ability of the banking system to continue serving as a source of credit to the economy in times of stress. A buffer framework that restricts dividends and discretionary bonus payments only for certain types of banking organizations or only during an economic contraction would not achieve these objectives. Similarly, basing the capital conservation buffer on the most loss-absorbent form of capital is most consistent with the purpose of the capital conservation buffer as it helps to ensure that the buffer can be used effectively by banking organizations at a time when they are experiencing losses.

The agencies recognize that S-corporation banking organizations structure their tax payments differently from C corporations. However, the agencies note that this distinction results from S-corporations' pass-through taxation, in which profits are not subject to taxation at the corporate level, but rather at the shareholder level. The agencies are charged with evaluating the capital levels and safety and soundness of the banking organization. At the point where a decrease in the organization's capital triggers dividend restrictions, the agencies believe that capital should stay within the banking organization. S-corporation shareholders may receive a benefit from pass-through taxation, but with that benefit comes the risk that the corporation has no obligation to make dividend distributions to help shareholders pay their tax liabilities. Therefore, the final rule does not exempt S-corporations from the capital conservation buffer.

Accordingly, under the final rule a banking organization must maintain a capital conservation buffer of common equity tier 1 capital in an amount greater than 2.5 percent of total risk-weighted assets (plus, for an advanced approaches banking organization, 100 percent of any applicable countercyclical capital buffer amount) to avoid being subject to limitations on capital distributions and discretionary bonus payments to executive officers.

The proposal defined eligible retained income as a banking organization's net income (as reported in the banking organization's quarterly regulatory reports) for the four calendar quarters preceding the current calendar quarter, net of any capital distributions and associated tax effects not already reflected in net income. The agencies and the FDIC received a number of comments regarding the proposed Start Printed Page 62035definition of eligible retained income, which is used to calculate the maximum payout amount. Some commenters suggested that the agencies and the FDIC limit capital distributions based on retained earnings instead of eligible retained income, citing the Board's Regulation H as an example of this regulatory practice.[40] Several commenters representing banking organizations organized as S-corporations recommended revisions to the definition of eligible retained income so that it would be net of pass-through tax distributions to shareholders that have made a pass-through election for tax purposes, allowing S-corporation shareholders to pay their tax liability notwithstanding any dividend restrictions resulting from failure to comply with the capital conservation buffer. Some commenters suggested that the definition of eligible retained income be adjusted for items such as goodwill impairment that are captured in the definition of “net income” for regulatory reporting purposes but which do not affect regulatory capital.

The final rule adopts the proposed definition of eligible retained income without change. The agencies believe the commenters' suggested modifications to the definition of eligible retained income would add complexity to the final rule and in some cases may be counter-productive by weakening the incentives of the capital conservation buffer. The agencies note that the definition of eligible retained income appropriately accounts for impairment charges, which reduce eligible retained income but also reduce the balance sheet amount of goodwill that is deducted from regulatory capital. Further, the proposed definition of eligible retained income, which is based on net income as reported in the banking organization's quarterly regulatory reports, reflects a simple measure of a banking organization's recent performance upon which to base restrictions on capital distributions and discretionary payments to executive officers. For the same reasons as described above regarding the application of the capital conservation buffer to S-corporations generally, the agencies have determined that the definition of eligible retained income should not be modified to address the tax-related concerns raised by commenters writing on behalf of S-corporations.

The proposed rule generally defined a capital distribution as a reduction of tier 1 or tier 2 capital through the repurchase or redemption of a capital instrument or by other means; a dividend declaration or payment on any tier 1 or tier 2 capital instrument if the banking organization has full discretion to permanently or temporarily suspend such payments without triggering an event of default; or any similar transaction that the primary Federal supervisor determines to be in substance a distribution of capital.

Commenters provided suggestions on the definition of “capital distribution.” One commenter requested that a “capital distribution” be defined to exclude any repurchase or redemption to the extent the capital repurchased or redeemed was replaced in a contemporaneous transaction by the issuance of capital of an equal or higher quality tier. The commenter maintained that the proposal would unnecessarily penalize banking organizations that redeem capital but contemporaneously replace such capital with an equal or greater amount of capital of an equivalent or higher quality. In response to comments, and recognizing that redeeming capital instruments that are replaced with instruments of the same or similar quality does not weaken a banking organization's overall capital position, the final rule provides that a redemption or repurchase of a capital instrument is not a distribution provided that the banking organization fully replaces that capital instrument by issuing another capital instrument of the same or better quality (that is, more subordinate) based on the final rule's eligibility criteria for capital instruments, and provided that such issuance is completed within the same calendar quarter the banking organization announces the repurchase or redemption. For purposes of this definition, a capital instrument is issued at the time that it is fully paid in. For purposes of the final rule, the agencies changed the defined term from “capital distribution” to “distribution” to avoid confusion with the term “capital distribution” used in the Board's capital plan rule.[41]

The proposed rule defined discretionary bonus payment as a payment made to an executive officer of a banking organization (as defined below) that meets the following conditions: the banking organization retains discretion as to the fact of the payment and as to the amount of the payment until the payment is awarded to the executive officer; the amount paid is determined by the banking organization without prior promise to, or agreement with, the executive officer; and the executive officer has no contractual right, express or implied, to the bonus payment.

The agencies and the FDIC received a number of comments on the proposed definition of discretionary bonus payments to executive officers. One commenter expressed concern that the proposed definition of discretionary bonus payment may not be effective unless the agencies and the FDIC provided clarification as to the type of payments covered, as well as the timing of such payments. This commenter asked whether the proposed rule would prohibit the establishment of a pre-funded bonus pool with mandatory distributions and sought clarification as to whether non-cash compensation payments, such as stock options, would be considered a discretionary bonus payment.

The final rule's definition of discretionary bonus payment is unchanged from the proposal. The agencies note that if a banking organization prefunds a pool for bonuses payable under a contract, the bonus pool is not discretionary and, therefore, is not subject to the capital conservation buffer limitations. In addition, the definition of discretionary bonus payment does not include non-cash compensation payments that do not affect capital or earnings such as, in some cases, stock options.

Commenters representing community banking organizations maintained that the proposed restrictions on discretionary bonus payments would disproportionately impact such institutions' ability to attract and retain qualified employees. One commenter suggested revising the proposed rule so that a banking organization that fails to satisfy the capital conservation buffer would be restricted from making a discretionary bonus payment only to the extent it exceeds 15 percent of the employee's salary, asserting that this would prevent excessive bonus payments while allowing community banking organizations flexibility to compensate key employees. The final rule does not incorporate this suggestion. The agencies note that the potential limitations and restrictions under the capital conservation buffer framework do not automatically translate into a prohibition on discretionary bonus payments. Instead, the overall dollar amount of dividends and bonuses to executive officers is capped based on how close the banking organization's regulatory capital ratios are to its minimum capital ratios and on the earnings of the banking organization that are available for distribution. This approach provides appropriate Start Printed Page 62036incentives for capital conservation while preserving flexibility for institutions to decide how to allocate income available for distribution between discretionary bonus payments and other distributions.

The proposal defined executive officer as a person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions: President, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, or head of a major business line, and other staff that the board of directors of the banking organization deems to have equivalent responsibility.[42]

Commenters generally supported a more restrictive definition of executive officer, arguing that the definition of executive officer should be no broader than the definition under the Board's Regulation O,[43] which governs any extension of credit between a member bank and an executive officer, director, or principal shareholder. Some commenters, however, favored a more expansive definition of executive officer, with one commenter supporting the inclusion of directors of the banking organization or directors of any of the banking organization's affiliates, any other person in control of the banking organization or the banking organizations' affiliates, and any person in control of a major business line. In accordance with the agencies' objective to include those individuals within a banking organization with the greatest responsibility for the organization's financial condition and risk exposure, the final rule maintains the definition of executive officer as proposed.

Under the proposal, advanced approaches banking organizations would have calculated their capital conservation buffer (and any applicable countercyclical capital buffer amount) using their advanced approaches total risk-weighted assets. Several commenters supported this aspect of the proposal, and one stated that the methodologies for calculating risk-weighted assets under the advanced approaches rule would more effectively capture the individual risk profiles of such banking organizations, asserting further that advanced approaches banking organizations would face a competitive disadvantage relative to foreign banking organizations if they were required to use standardized total risk-weighted assets to determine compliance with the capital conservation buffer. In contrast, another commenter suggested that advanced approaches banking organizations be allowed to use the advanced approaches methodologies as the basis for calculating the capital conservation buffer only when it would result in a more conservative outcome than under the standardized approach in order to maintain competitive equity domestically. Another commenter expressed concerns that the capital conservation buffer is based only on risk-weighted assets and recommended additional application of a capital conservation buffer to the leverage ratio to avoid regulatory arbitrage opportunities and to accomplish the agencies' and the FDIC's stated objective of ensuring that banking organizations have sufficient capital to absorb losses.

The final rule requires that advanced approaches banking organizations that have completed the parallel run process and that have received notification from their primary Federal supervisor pursuant to section 121(d) of subpart E use their risk-based capital ratios under section 10 of the final rule (that is, the lesser of the standardized and the advanced approaches ratios) as the basis for calculating their capital conservation buffer (and any applicable countercyclical capital buffer). The agencies believe such an approach is appropriate because it is consistent with how advanced approaches banking organizations compute their minimum risk-based capital ratios.

Many commenters discussed the interplay between the proposed capital conservation buffer and the PCA framework. Some commenters encouraged the agencies and the FDIC to reset the buffer requirement to two percent of total risk-weighted assets in order to align it with the margin between the “adequately-capitalized” category and the “well-capitalized” category under the PCA framework. Similarly, some commenters characterized the proposal as confusing because a banking organization could be considered well capitalized for PCA purposes, but at the same time fail to maintain a sufficient capital conservation buffer and be subject to restrictions on capital distributions and discretionary bonus payments. These commenters encouraged the agencies and the FDIC to remove the capital conservation buffer for purposes of the final rule, and instead use their existing authority to impose restrictions on dividends and discretionary bonus payments on a case-by-case basis through formal enforcement actions. Several commenters stated that compliance with a capital conservation buffer that operates outside the traditional PCA framework adds complexity to the final rule, and suggested increasing minimum capital requirements if the agencies and the FDIC determine they are currently insufficient. Specifically, one commenter encouraged the agencies and the FDIC to increase the minimum total risk-based capital requirement to 10.5 percent and remove the capital conservation buffer from the rule.

The capital conservation buffer has been designed to give banking organizations the flexibility to use the buffer while still being well capitalized. Banking organizations that maintain their risk-based capital ratios at least 50 basis points above the well capitalized PCA levels will not be subject to any restrictions imposed by the capital conservation buffer, as applicable. As losses begin to accrue or a banking organization's risk-weighted assets begin to grow such that the capital ratios of a banking organization are below the capital conservation buffer but above the well capitalized thresholds, the incremental limitations on distributions are unlikely to affect planned capital distributions or discretionary bonus payments but may provide a check on rapid expansion or other activities that would weaken the organization's capital position.

Under the final rule, the maximum payout ratio is the percentage of eligible retained income that a banking organization is allowed to pay out in the form of distributions and discretionary bonus payments, each as defined under the rule, during the current calendar quarter. The maximum payout ratio is determined by the banking organization's capital conservation buffer as calculated as of the last day of the previous calendar quarter.

A banking organization's capital conservation buffer is the lowest of the following ratios: (i) The banking organization's common equity tier 1 capital ratio minus its minimum common equity tier 1 capital ratio; (ii) the banking organization's tier 1 capital ratio minus its minimum tier 1 capital ratio; and (iii) the banking organization's total capital ratio minus its minimum total capital ratio. If the banking organization's common equity tier 1, tier 1 or total capital ratio is less than or equal to its minimum common equity tier 1, tier 1 or total capital ratio, respectively, the banking organization's capital conservation buffer is zero.

The mechanics of the capital conservation buffer under the final rule are unchanged from the proposal. A Start Printed Page 62037banking organization's maximum payout amount for the current calendar quarter is equal to the banking organization's eligible retained income, multiplied by the applicable maximum payout ratio, in accordance with Table 1. A banking organization with a capital conservation buffer that is greater than 2.5 percent (plus, for an advanced approaches banking organization, 100 percent of any applicable countercyclical capital buffer) is not subject to a maximum payout amount as a result of the application of this provision. However, a banking organization may otherwise be subject to limitations on capital distributions as a result of supervisory actions or other laws or regulations.[44]

Table 1 illustrates the relationship between the capital conservation buffer and the maximum payout ratio. The maximum dollar amount that a banking organization is permitted to pay out in the form of distributions or discretionary bonus payments during the current calendar quarter is equal to the maximum payout ratio multiplied by the banking organization's eligible retained income. The calculation of the maximum payout amount is made as of the last day of the previous calendar quarter and any resulting restrictions apply during the current calendar quarter.

Table 1—Capital Conservation Buffer and Maximum Payout Ratio 45

Capital conservation buffer (as a percentage of standardized or advanced total risk-weighted assets, as applicable)Maximum payout ratio (as a percentage of eligible retained income)
Greater than 2.5 percentNo payout ratio limitation applies.
Less than or equal to 2.5 percent, and greater than 1.875 percent60 percent.
Less than or equal to 1.875 percent, and greater than 1.25 percent40 percent.
Less than or equal to 1.25 percent, and greater than 0.625 percent20 percent.
Less than or equal to 0.625 percent0 percent.

Table 1 illustrates that the capital conservation buffer requirements are divided into equal quartiles, each associated with increasingly stringent limitations on distributions and discretionary bonus payments to executive officers as the capital conservation buffer approaches zero. As described in the next section, each quartile expands proportionately for advanced approaches banking organizations when the countercyclical capital buffer amount is greater than zero. In a scenario where a banking organization's risk-based capital ratios fall below its minimum risk-based capital ratios plus 2.5 percent of total risk-weighted assets, the maximum payout ratio also would decline. A banking organization that becomes subject to a maximum payout ratio remains subject to restrictions on capital distributions and certain discretionary bonus payments until it is able to build up its capital conservation buffer through retained earnings, raising additional capital, or reducing its risk-weighted assets. In addition, as a general matter, a banking organization cannot make distributions or certain discretionary bonus payments during the current calendar quarter if the banking organization's eligible retained income is negative and its capital conservation buffer was less than 2.5 percent as of the end of the previous quarter.

Compliance with the capital conservation buffer is determined prior to any distribution or discretionary bonus payment. Therefore, a banking organization with a capital buffer of more than 2.5 percent is not subject to any restrictions on distributions or discretionary bonus payments even if such distribution or payment would result in a capital buffer of less than or equal to 2.5 percent in the current calendar quarter. However, to remain free of restrictions for purposes of any subsequent quarter, the banking organization must restore capital to increase the buffer to more than 2.5 percent prior to any distribution or discretionary bonus payment in any subsequent quarter.

In the proposal, the agencies and the FDIC solicited comment on the impact, if any, of prohibiting a banking organization that is subject to a maximum payout ratio of zero percent from making a penny dividend to common stockholders. One commenter stated that such banking organizations should be permitted to pay a penny dividend on their common stock notwithstanding the limitations imposed by the capital conservation buffer. This commenter maintained that the inability to pay any dividend on common stock could make it more difficult to attract equity investors such as pension funds that often are required to invest only in institutions that pay a quarterly dividend. While the agencies did not incorporate a blanket exemption for penny dividends on common stock, under the final rule, as under the proposal, the primary Federal supervisor may permit a banking organization to make a distribution or discretionary bonus payment if the primary Federal supervisor determines that such distribution or payment would not be contrary to the purpose of the capital conservation buffer or the safety and soundness of the organization. In making such determinations, the primary Federal supervisor would consider the nature of and circumstances giving rise to the request.

E. Countercyclical Capital Buffer

The proposed rule introduced a countercyclical capital buffer applicable to advanced approaches banking organizations to augment the capital conservation buffer during periods of excessive credit growth. Under the proposed rule, the countercyclical capital buffer would have required advanced approaches banking organizations to hold additional common equity tier 1 capital during specific, agency-determined periods in order to avoid limitations on distributions and discretionary bonus payments. The agencies and the FDIC requested comment on the countercyclical capital buffer and, specifically, on any factors that should be considered for purposes of determining whether to activate it. One commenter encouraged the agencies and the FDIC to consider readily available indicators of economic growth, employment levels, and financial sector profits. This commenter stated generally that the agencies and the FDIC should activate the countercyclical capital Start Printed Page 62038buffer during periods of general economic growth or high financial sector profits, instead of reserving it only for periods of “excessive credit growth.”

Other commenters did not support using the countercyclical capital buffer as a macroeconomic tool. One commenter encouraged the agencies and the FDIC not to include the countercyclical capital buffer in the final rule and, instead, rely on the Board's longstanding authority over monetary policy to mitigate excessive credit growth and potential asset bubbles. Another commenter questioned the buffer's effectiveness and encouraged the agencies and the FDIC to conduct a QIS prior to its implementation. One commenter recommended expanding the applicability of the proposed countercyclical capital buffer on a case-by-case basis to institutions with total consolidated assets between $50 and $250 billion. Another commenter, however, supported the application of the countercyclical capital buffer only to institutions with total consolidated assets above $250 billion.

The Dodd-Frank Act requires the agencies to consider the use of countercyclical aspects of capital regulation, and the countercyclical capital buffer is an explicitly countercyclical element of capital regulation.[46] The agencies note that implementation of the countercyclical capital buffer for advanced approaches banking organizations is an important part of the Basel III framework, which aims to enhance the resilience of the banking system and reduce systemic vulnerabilities. The agencies believe that the countercyclical capital buffer is most appropriately applied only to advanced approaches banking organizations because, generally, such organizations are more interconnected with other financial institutions. Therefore, the marginal benefits to financial stability from a countercyclical capital buffer function should be greater with respect to such institutions. Application of the countercyclical capital buffer only to advanced approaches banking organizations also reflects the fact that making cyclical adjustments to capital requirements may produce smaller financial stability benefits and potentially higher marginal costs for smaller banking organizations. The countercyclical capital buffer is designed to take into account the macro-financial environment in which banking organizations function and to protect the banking system from the systemic vulnerabilities that may build-up during periods of excessive credit growth, which may potentially unwind in a disorderly way, causing disruptions to financial institutions and ultimately economic activity.

The countercyclical capital buffer aims to protect the banking system and reduce systemic vulnerabilities in two ways. First, the accumulation of a capital buffer during an expansionary phase could increase the resilience of the banking system to declines in asset prices and consequent losses that may occur when the credit conditions weaken. Specifically, when the credit cycle turns following a period of excessive credit growth, accumulated capital buffers act to absorb the above-normal losses that a banking organization likely would face. Consequently, even after these losses are realized, banking organizations would remain healthy and able to access funding, meet obligations, and continue to serve as credit intermediaries. Second, a countercyclical capital buffer also may reduce systemic vulnerabilities and protect the banking system by mitigating excessive credit growth and increases in asset prices that are not supported by fundamental factors. By increasing the amount of capital required for further credit extensions, a countercyclical capital buffer may limit excessive credit.[47] Thus, the agencies believe that the countercyclical capital buffer is an appropriate macroeconomic tool and are including it in the final rule. One commenter expressed concern that the proposed rule would not require the agencies and the FDIC to activate the countercyclical capital buffer pursuant to a joint, interagency determination. This commenter encouraged the agencies and the FDIC to adopt an interagency process for activating the buffer for purposes of the final rule. As discussed in the Basel III NPR, the agencies and the FDIC anticipate making such determinations jointly. Because the countercyclical capital buffer amount would be linked to the condition of the overall U.S. financial system and not the characteristics of an individual banking organization, the agencies expect that the countercyclical capital buffer amount would be the same at the depository institution and holding company levels. The agencies and the FDIC solicited comment on the appropriateness of the proposed 12-month prior notification period for the countercyclical capital buffer amount. One commenter expressed concern regarding the potential for the agencies and the FDIC to activate the countercyclical capital buffer without providing banking organizations sufficient notice, and specifically requested the implementation of a prior notification requirement of not less than 12 months for purposes of the final rule.

In general, to provide banking organizations with sufficient time to adjust to any changes to the countercyclical capital buffer under the final rule, the agencies and the FDIC expect to announce an increase in the U.S. countercyclical capital buffer amount with an effective date at least 12 months after their announcement. However, if the agencies and the FDIC determine that a more immediate implementation is necessary based on economic conditions, the agencies may require an earlier effective date. The agencies and the FDIC will follow the same procedures in adjusting the countercyclical capital buffer applicable for exposures located in foreign jurisdictions.

For purposes of the final rule, consistent with the proposal, a decrease in the countercyclical capital buffer amount will be effective on the day following announcement of the final determination or the earliest date permissible under applicable law or regulation, whichever is later. In addition, the countercyclical capital buffer amount will return to zero percent 12 months after its effective date, unless the agencies and the FDIC announce a decision to maintain the adjusted countercyclical capital buffer amount or adjust it again before the expiration of the 12-month period.

The countercyclical capital buffer augments the capital conservation buffer by up to 2.5 percent of a banking organization's total risk-weighted assets. Consistent with the proposal, the final rule requires an advanced approaches banking organization to determine its countercyclical capital buffer amount by calculating the weighted average of the countercyclical capital buffer amounts established for the national jurisdictions where the banking organization has private sector credit exposures. The contributing weight assigned to a jurisdiction's countercyclical capital buffer amount is calculated by dividing the total risk-weighted assets for the banking organization's private sector credit exposures located in the jurisdiction by the total risk-weighted assets for all of the banking Start Printed Page 62039organization's private sector credit exposures.

Under the proposed rule, private sector credit exposure was defined as an exposure to a company or an individual that is included in credit risk-weighted assets, not including an exposure to a sovereign entity, the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, a multilateral development bank (MDB), a public sector entity (PSE), or a Government-sponsored Enterprise (GSE). While the proposed definition excluded covered positions with specific risk under the market risk rule, the agencies and the FDIC explicitly recognized that they should be included in the measure of risk-weighted assets for private-sector exposures and asked a question regarding how to incorporate these positions in the measure of risk-weighted assets, particularly for positions for which a banking organization uses models to measure specific risk. The agencies and the FDIC did not receive comments on this question.

The final rule includes covered positions under the market risk rule in the definition of private sector credit exposure. Thus, a private sector credit exposure is an exposure to a company or an individual, not including an exposure to a sovereign entity, the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, an MDB, a PSE, or a GSE. The final rule is also more specific than the proposal regarding how to calculate risk-weighted assets for private sector credit exposures, and harmonizes that calculation with the advanced approaches banking organization's determination of its capital conservation buffer generally. An advanced approaches banking organization is subject to the countercyclical capital buffer regardless of whether it has completed the parallel run process and received notification from its primary Federal supervisor pursuant to section 121(d) of the rule. The methodology an advanced approaches banking organization must use for determining risk-weighted assets for private sector credit exposures must be the methodology that the banking organization uses to determine its risk-based capital ratios under section 10 of the final rule. Notwithstanding this provision, the risk-weighted asset amount for a private sector credit exposure that is a covered position is its specific risk add-on, as determined under the market risk rule's standardized measurement method for specific risk, multiplied by 12.5. The agencies chose this methodology because it allows the specific risk of a position to be allocated to the position's geographic location in a consistent manner across banking organizations.

Consistent with the proposal, under the final rule the geographic location of a private sector credit exposure (that is not a securitization exposure) is the national jurisdiction where the borrower is located (that is, where the borrower is incorporated, chartered, or similarly established or, if it is an individual, where the borrower resides). If, however, the decision to issue the private sector credit exposure is based primarily on the creditworthiness of a protection provider, the location of the non-securitization exposure is the location of the protection provider. The location of a securitization exposure is the location of the underlying exposures, determined by reference to the location of the borrowers on those exposures. If the underlying exposures are located in more than one national jurisdiction, the location of a securitization exposure is the national jurisdiction where the underlying exposures with the largest aggregate unpaid principal balance are located.

Table 2 illustrates how an advanced approaches banking organization calculates its weighted average countercyclical capital buffer amount. In the following example, the countercyclical capital buffer established in the various jurisdictions in which the banking organization has private sector credit exposures is reported in column A. Column B contains the banking organization's risk-weighted asset amounts for the private sector credit exposures in each jurisdiction. Column C shows the contributing weight for each countercyclical capital buffer amount, which is calculated by dividing each of the rows in column B by the total for column B. Column D shows the contributing weight applied to each countercyclical capital buffer amount, calculated as the product of the corresponding contributing weight (column C) and the countercyclical capital buffer set by each jurisdiction's national supervisor (column A). The sum of the rows in column D shows the banking organization's weighted average countercyclical capital buffer, which is 1.4 percent of risk-weighted assets.

Table 2—Example of Weighted Average Buffer Calculation for an Advanced Approaches Banking Organization

Countercyclical capital buffer amount set by national supervisor (percent)Banking organization's risk-weighted assets for private sector credit exposures ($b)Contributing weight (column B/ column B total)Contributing weight applied to each countercyclical capital buffer amount (column A * column C)
(A)(B)(C)(D)
Non-U.S. jurisdiction 12.02500.290.6
Non-U.S. jurisdiction 21.51000.120.2
U.S15000.590.6
Total8501.001.4

The countercyclical capital buffer expands a banking organization's capital conservation buffer range for purposes of determining the banking organization's maximum payout ratio. For instance, if an advanced approaches banking organization's countercyclical capital buffer amount is equal to zero percent of total risk-weighted assets, the banking organization must maintain a buffer of greater than 2.5 percent of total risk-weighted assets to avoid restrictions Start Printed Page 62040on its distributions and discretionary bonus payments. However, if its countercyclical capital buffer amount is equal to 2.5 percent of total risk-weighted assets, the banking organization must maintain a buffer of greater than 5 percent of total risk-weighted assets to avoid restrictions on its distributions and discretionary bonus payments.

As another example, if the advanced approaches banking organization from the example in Table 2 above has a capital conservation buffer of 2.0 percent, and each of the jurisdictions in which it has private sector credit exposures sets its countercyclical capital buffer amount equal to zero, the banking organization would be subject to a maximum payout ratio of 60 percent. If, instead, each country sets its countercyclical capital buffer amount as shown in Table 2, resulting in a countercyclical capital buffer amount of 1.4 percent of total risk-weighted assets, the banking organization's capital conservation buffer ranges would be expanded as shown in Table 3 below. As a result, the banking organization would now be subject to a stricter 40 percent maximum payout ratio based on its capital conservation buffer of 2.0 percent.

Table 3—Capital Conservation Buffer and Maximum Payout Ratio 48

Capital conservation buffer as expanded by the countercyclical capital buffer amount from Table 2Maximum payout ratio (as a percentage of eligible retained income)
Greater than 3.9 percent (2.5 percent + 100 percent of the countercyclical capital buffer of 1.4)No payout ratio limitation applies.
Less than or equal to 3.9 percent, and greater than 2.925 percent (1.875 percent plus 75 percent of the countercyclical capital buffer of 1.4)60 percent.
Less than or equal to 2.925 percent, and greater than 1.95 percent (1.25 percent plus 50 percent of the countercyclical capital buffer of 1.4)40 percent.
Less than or equal to 1.95 percent, and greater than 0.975 percent (.625 percent plus 25 percent of the countercyclical capital buffer of 1.4)20 percent.
Less than or equal to 0.975 percent0 percent.

The countercyclical capital buffer amount under the final rule for U.S. credit exposures is initially set to zero, but it could increase if the agencies and the FDIC determine that there is excessive credit in the markets that could lead to subsequent wide-spread market failures. Generally, a zero percent countercyclical capital buffer amount will reflect an assessment that economic and financial conditions are consistent with a period of little or no excessive ease in credit markets associated with no material increase in system-wide credit risk. A 2.5 percent countercyclical capital buffer amount will reflect an assessment that financial markets are experiencing a period of excessive ease in credit markets associated with a material increase in system-wide credit risk.

F. Prompt Corrective Action Requirements

All insured depository institutions, regardless of total asset size or foreign exposure, currently are required to compute PCA capital levels using the agencies' and the FDIC's general risk-based capital rules, as supplemented by the market risk rule. Section 38 of the Federal Deposit Insurance Act directs the federal banking agencies and the FDIC to resolve the problems of insured depository institutions at the least cost to the Deposit Insurance Fund.[49] To facilitate this purpose, the agencies and the FDIC have established five regulatory capital categories in the PCA regulations that include capital thresholds for the leverage ratio, tier 1 risk-based capital ratio, and the total risk-based capital ratio for insured depository institutions. These five PCA categories under section 38 of the Act and the PCA regulations are: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” Insured depository institutions that fail to meet these capital measures are subject to increasingly strict limits on their activities, including their ability to make capital distributions, pay management fees, grow their balance sheet, and take other actions.[50] Insured depository institutions are expected to be closed within 90 days of becoming “critically undercapitalized,” unless their primary Federal supervisor takes such other action as that primary Federal supervisor determines, with the concurrence of the FDIC, would better achieve the purpose of PCA.[51]

The proposal maintained the structure of the PCA framework while increasing some of the thresholds for the PCA capital categories and adding the proposed common equity tier 1 capital ratio. For example, under the proposed rule, the thresholds for adequately capitalized banking organizations would be equal to the minimum capital requirements. The risk-based capital ratios for well capitalized banking organizations under PCA would continue to be two percentage points higher than the ratios for adequately-capitalized banking organizations, and the leverage ratio for well capitalized banking organizations under PCA would be one percentage point higher than for adequately-capitalized banking organizations. Advanced approaches banking organizations that are insured depository institutions also would be required to satisfy a supplementary leverage ratio of 3 percent in order to be considered adequately capitalized. While the proposed PCA levels do not incorporate the capital conservation buffer, the PCA and capital conservation buffer frameworks would complement each other to ensure that banking organizations hold an adequate amount of common equity tier 1 capital.

The agencies and the FDIC received a number of comments on the proposed PCA framework. Several commenters suggested modifications to the proposed PCA levels, particularly with respect to the leverage ratio. For example, a few commenters encouraged the agencies and the FDIC to increase the adequately-capitalized and well capitalized categories for the leverage ratio to six percent or more and eight percent or Start Printed Page 62041more, respectively. According to one commenter, such thresholds would more closely align with the actual leverage ratios of many state-charted depository institutions.

Another commenter expressed concern regarding the operational complexity of the proposed PCA framework in view of the addition of the common equity tier 1 capital ratio and the interaction of the PCA framework and the capital conservation buffer. For example, under the proposed rule a banking organization could be well capitalized for PCA purposes and, at the same time, be subject to restrictions on dividends and bonus payments. Other banking organizations expressed concern that the proposed PCA levels would adversely affect their ability to lend and generate income. This, according to a commenter, also would reduce net income and return-on-equity.

The agencies believe the capital conservation buffer complements the PCA framework—the former works to keep banking organizations above the minimum capital ratios, whereas the latter imposes increasingly stringent consequences on depository institutions, particularly as they fall below the minimum capital ratios. Because the capital conservation buffer is designed to absorb losses in stressful periods, the agencies believe it is appropriate for a depository institution to be able to use some of its capital conservation buffer without being considered less than well capitalized for PCA purposes.

A few comments pertained specifically to issues affecting BHCs and SLHCs. A commenter encouraged the Board to require an advanced approaches banking organization, including a BHC, to use the advanced approaches rule for determining whether it is well capitalized for PCA purposes. This commenter maintained that neither the Bank Holding Company Act [52] nor section 171 of the Dodd-Frank Act requires an advanced approaches banking organization to use the lower of its minimum ratios as calculated under the general risk-based capital rules and the advanced approaches rule to determine well capitalized status. Another commenter requested clarification from the Board that section 171 of the Dodd-Frank Act does not apply to determinations regarding whether a BHC is a financial holding company under Board regulations. In order to elect to be a financial holding company under the Bank Holding Company Act, as amended by section 616 of the Dodd-Frank Act, a BHC and all of its depository institution subsidiaries must be well capitalized and well managed. The final rule does not establish the standards for determining whether a BHC is “well-capitalized.”

Consistent with the proposal, the final rule augments the PCA capital categories by introducing a common equity tier 1 capital measure for four of the five PCA categories (excluding the critically undercapitalized PCA category).[53] In addition, the final rule revises the three current risk-based capital measures for four of the five PCA categories to reflect the final rule's changes to the minimum risk-based capital ratios, as provided in the agency-specific revisions to the agencies' PCA regulations. All banking organizations that are insured depository institutions will remain subject to leverage measure thresholds using the current leverage ratio in the form of tier 1 capital to average total consolidated assets. In addition, the final rule amends the PCA leverage measure for advanced approaches depository institutions to include the supplementary leverage ratio that explicitly applies to the “adequately capitalized” and “undercapitalized” capital categories.

All insured depository institutions must comply with the revised PCA thresholds beginning on January 1, 2015. Consistent with transition provisions in the proposed rules, the supplementary leverage measure for advanced approaches banking organizations that are insured depository institutions becomes effective on January 1, 2018. Changes to the definitions of the individual capital components that are used to calculate the relevant capital measures under PCA are governed by the transition arrangements discussed in section VIII.3 below. Thus, the changes to these definitions, including any deductions from or adjustments to regulatory capital, automatically flow through to the definitions in the PCA framework.

Table 4 sets forth the risk-based capital and leverage ratio thresholds under the final rule for each of the PCA capital categories for all insured depository institutions. For each PCA category except critically undercapitalized, an insured depository institution must satisfy a minimum common equity tier 1 capital ratio, in addition to a minimum tier 1 risk-based capital ratio, total risk-based capital ratio, and leverage ratio. In addition to the aforementioned requirements, advanced approaches banking organizations that are insured depository institutions are also subject to a supplementary leverage ratio.

Table 4—PCA Levels for All Insured Depository Institutions

PCA categoryTotal risk-based capital (RBC) measure (total RBC ratio— (percent))Tier 1 RBC measure (tier 1 RBC ratio (percent))Common equity tier 1 RBC measure (common equity tier 1 RBC ratio (percent))Leverage measurePCA requirements
Leverage ratio (percent)Supplementary leverage ratio (percent) *
Well capitalized≥10≥8≥6.5≥5Not applicableUnchanged from current rule *
Adequately-capitalized≥8≥6≥4.5≥4≥3.0*
Undercapitalized<8<6<4.5<4<3.00*
Significantly undercapitalized<6<4<3<3Not applicable*
Critically undercapitalizedTangible equity (defined as tier 1 capital plus non-tier 1 perpetual preferred stock) to total assets ≤2Not applicable*
* The supplementary leverage ratio as a PCA requirement applies only to advanced approaches banking organizations that are insured depository institutions. The supplementary leverage ratio also applies to advanced approaches bank holding companies, although not in the form of a PCA requirement.
Start Printed Page 62042

To be well capitalized for purposes of the final rule, an insured depository institution must maintain a total risk-based capital ratio of 10 percent or more; a tier 1 capital ratio of 8 percent or more; a common equity tier 1 capital ratio of 6.5 percent or more; and a leverage ratio of 5 percent or more. An adequately-capitalized depository institution must maintain a total risk-based capital ratio of 8 percent or more; a tier 1 capital ratio of 6 percent or more; a common equity tier 1 capital ratio of 4.5 percent or more; and a leverage ratio of 4 percent or more.

An insured depository institution is undercapitalized under the final rule if its total capital ratio is less than 8 percent, if its tier 1 capital ratio is less than 6 percent, its common equity tier 1 capital ratio is less than 4.5 percent, or its leverage ratio is less than 4 percent. If an institution's tier 1 capital ratio is less than 4 percent, or its common equity tier 1 capital ratio is less than 3 percent, it would be considered significantly undercapitalized. The other numerical capital ratio thresholds for being significantly undercapitalized remain unchanged from the current rules.[54]

The determination of whether an insured depository institution is critically undercapitalized for PCA purposes is based on its ratio of tangible equity to total assets.[55] This is a statutory requirement within the PCA framework, and the experience of the recent financial crisis has confirmed that tangible equity is of critical importance in assessing the viability of an insured depository institution. Tangible equity for PCA purposes is currently defined as including core capital elements,[56] which consist of: (1) Common stockholder's equity, (2) qualifying noncumulative perpetual preferred stock (including related surplus), and (3) minority interest in the equity accounts of consolidated subsidiaries; plus outstanding cumulative preferred perpetual stock; minus all intangible assets except mortgage servicing rights to the extent permitted in tier 1 capital. The current PCA definition of tangible equity does not address the treatment of DTAs in determining whether an insured depository institution is critically undercapitalized.

Consistent with the proposal, the final rule revises the calculation of the capital measure for the critically undercapitalized PCA category by revising the definition of tangible equity to consist of tier 1 capital, plus outstanding perpetual preferred stock (including related surplus) not included in tier 1 capital. The revised definition more appropriately aligns the calculation of tangible equity with the calculation of tier 1 capital generally for regulatory capital requirements. Assets included in a banking organization's equity under GAAP, such as DTAs, are included in tangible equity only to the extent that they are included in tier 1 capital. The agencies believe this modification promotes consistency and provides for clearer boundaries across and between the various PCA categories.

In addition to the changes described in this section, the OCC proposed to integrate its PCA rules for national banks and Federal savings associations. Specifically, the OCC proposed to make 12 CFR part 6 applicable to Federal savings associations, and to rescind the current PCA rules in 12 CFR part 165 governing Federal savings associations, with the exception of § 165.8 (Procedures for reclassifying a federal savings association based on criteria other than capital), and § 165.9 (Order to dismiss a director or senior executive officer). The OCC proposed to retain §§ 165.8 and 165.9 because those sections relate to enforcement procedures and the procedural rules in 12 CFR part 19 do not apply to Federal savings associations at this time. Therefore, the OCC must retain §§ 165.8 and 165.9. Finally, the proposal also made non-substantive, technical amendments to part 6 and §§ 165.8 and 165.9.

The OCC received no comments on these proposed changes and therefore is adopting these proposed amendments as final, with minor technical edits. The OCC notes that, consistent with the proposal, as part of the integration of Federal savings associations, Federal savings associations will now calculate tangible equity based on average total assets rather than period-end total assets.

G. Supervisory Assessment of Overall Capital Adequacy

Capital helps to ensure that individual banking organizations can continue to serve as credit intermediaries even during times of stress, thereby promoting the safety and soundness of the overall U.S. banking system. The agencies' general risk-based capital rules indicate that the capital requirements are minimum standards generally based on broad credit-risk considerations.[57] The risk-based capital ratios under these rules do not explicitly take account of the quality of individual asset portfolios or the range of other types of risk to which banking organizations may be exposed, such as interest-rate, liquidity, market, or operational risks.[58]

A banking organization is generally expected to have internal processes for assessing capital adequacy that reflect a full understanding of its risks and to ensure that it holds capital corresponding to those risks to maintain overall capital adequacy.[59] The nature of such capital adequacy assessments should be commensurate with banking organizations' size, complexity, and risk-profile. Consistent with longstanding practice, supervisory assessment of capital adequacy will take account of whether a banking organization plans appropriately to maintain an adequate level of capital given its activities and risk profile, as well as risks and other factors that can affect a banking organization's financial condition, including, for example, the level and severity of problem assets and its exposure to operational and interest rate risk, and significant asset concentrations. For this reason, a supervisory assessment of capital adequacy may differ significantly from conclusions that might be drawn solely from the level of a banking organization's regulatory capital ratios.

In light of these considerations, as a prudential matter, a banking organization is generally expected to operate with capital positions well Start Printed Page 62043above the minimum risk-based ratios and to hold capital commensurate with the level and nature of the risks to which it is exposed, which may entail holding capital significantly above the minimum requirements. For example, banking organizations contemplating significant expansion proposals are expected to maintain strong capital levels substantially above the minimum ratios and should not allow significant diminution of financial strength below these strong levels to fund their expansion plans. Banking organizations with high levels of risk are also expected to operate even further above minimum standards. In addition to evaluating the appropriateness of a banking organization's capital level given its overall risk profile, the supervisory assessment takes into account the quality and trends in a banking organization's capital composition, including the share of common and non-common-equity capital elements.

Some commenters stated that they manage their capital so that they operate with a buffer over the minimum and that examiners expect such a buffer. These commenters expressed concern that examiners will expect even higher capital levels, such as a buffer in addition to the new higher minimums and capital conservation buffer (and countercyclical capital buffer, if applicable). Consistent with the longstanding approach employed by the agencies in their supervision of banking organizations, section 10(d) of the final rule maintains and reinforces supervisory expectations by requiring that a banking organization maintain capital commensurate with the level and nature of all risks to which it is exposed and that a banking organization have a process for assessing its overall capital adequacy in relation to its risk profile, as well as a comprehensive strategy for maintaining an appropriate level of capital.

The supervisory evaluation of a banking organization's capital adequacy, including compliance with section 10(d), may include such factors as whether the banking organization is newly chartered, entering new activities, or introducing new products. The assessment also would consider whether a banking organization is receiving special supervisory attention, has or is expected to have losses resulting in capital inadequacy, has significant exposure due to risks from concentrations in credit or nontraditional activities, or has significant exposure to interest rate risk, operational risk, or could be adversely affected by the activities or condition of a banking organization's holding company or other affiliates.

Supervisors also evaluate the comprehensiveness and effectiveness of a banking organization's capital planning in light of its activities and capital levels. An effective capital planning process involves an assessment of the risks to which a banking organization is exposed and its processes for managing and mitigating those risks, an evaluation of its capital adequacy relative to its risks, and consideration of the potential impact on its earnings and capital base from current and prospective economic conditions.[60] While the elements of supervisory review of capital adequacy would be similar across banking organizations, evaluation of the level of sophistication of an individual banking organization's capital adequacy process would be commensurate with the banking organization's size, sophistication, and risk profile, similar to the current supervisory practice.

H. Tangible Capital Requirement for Federal Savings Associations

As part of the OCC's overall effort to integrate the regulatory requirements for national banks and Federal savings associations, the OCC proposed to include a tangible capital requirement for Federal savings associations.[61] Under section 5(t)(2)(B) of HOLA,[62] Federal savings associations are required to maintain tangible capital in an amount not less than 1.5 percent of total assets.[63] This statutory requirement is implemented in the OCC's current capital rules applicable to Federal savings associations at 12 CFR 167.9.[64] Under that rule, tangible capital is defined differently from other capital measures, such as tangible equity in current 12 CFR part 165.

After reviewing HOLA, the OCC determined that a unique regulatory definition of tangible capital is not necessary to satisfy the requirement of the statute. Therefore, the OCC is defining “tangible capital” as the amount of tier 1 capital plus the amount of outstanding perpetual preferred stock (including related surplus) not included in tier 1 capital. This definition mirrors the proposed definition of “tangible equity” for PCA purposes.[65] While the OCC recognizes that the terms used are not identical (“capital” as compared to “equity”), the OCC believes that this revised definition of tangible capital will reduce the computational burden on Federal savings associations in complying with this statutory mandate, as well as remaining consistent with both the purposes of HOLA and PCA.

The final rule adopts this definition as proposed. In addition, in § 3.10(b)(5) and (c)(5) of the proposal, the OCC defined the term “Federal savings association tangible capital ratio” to mean the ratio of the Federal savings association's core capital (Tier 1 capital) to total adjusted assets as calculated under subpart B of part 3. The OCC notes that this definition is inconsistent with the proposed definition of the tangible equity ratio for national banks and Federal savings associations, at § 6.4(b)(5) and (c)(5), in which the denominator of the ratio is quarterly average total assets. Accordingly, in keeping with the OCC's goal of integrating rules for Federal savings associations and national banks wherever possible and reducing implementation burden associated with a separate measure of tangible capital, the final rule replaces the term “total adjusted assets” in the definition of “Federal savings association tangible capital ratio” with the term “average total assets.” As a result of the changes in these definitions, Federal savings associations will no longer calculate the tangible capital ratio using period end total assets.Start Printed Page 62044

V. Definition of Capital

A. Capital Components and Eligibility Criteria for Regulatory Capital Instruments

1. Common Equity Tier 1 Capital

Under the proposed rule, common equity tier 1 capital was defined as the sum of a banking organization's outstanding common equity tier 1 capital instruments that satisfy the criteria set forth in section 20(b) of the proposal, related surplus (net of treasury stock), retained earnings, AOCI, and common equity tier 1 minority interest subject to certain limitations, minus regulatory adjustments and deductions.

The proposed rule set forth a list of criteria that an instrument would be required to meet to be included in common equity tier 1 capital. The proposed criteria were designed to ensure that common equity tier 1 capital instruments do not possess features that would cause a banking organization's condition to further weaken during periods of economic and market stress. In the proposals, the agencies and the FDIC indicated that they believe most existing common stock instruments issued by U.S. banking organizations already would satisfy the proposed criteria.

The proposed criteria also applied to instruments issued by banking organizations such as mutual banking organizations where ownership of the organization is not freely transferable or evidenced by certificates of ownership or stock. For these entities, the proposal provided that instruments issued by such organizations would be considered common equity tier 1 capital if they are fully equivalent to common stock instruments in terms of their subordination and availability to absorb losses, and do not possess features that could cause the condition of the organization to weaken as a going concern during periods of market stress.

The agencies and the FDIC noted in the proposal that stockholders' voting rights generally are a valuable corporate governance tool that permits parties with an economic interest to participate in the decision-making process through votes on establishing corporate objectives and policy, and in electing the banking organization's board of directors. Therefore, the agencies believe that voting common stockholders' equity (net of the adjustments to and deductions from common equity tier 1 capital proposed under the rule) should be the dominant element within common equity tier 1 capital. The proposal also provided that to the extent that a banking organization issues non-voting common stock or common stock with limited voting rights, the underlying stock must be identical to those underlying the banking organization's voting common stock in all respects except for any limitations on voting rights.

To ensure that a banking organization's common equity tier 1 capital would be available to absorb losses as they occur, the proposed rule would have required common equity tier 1 capital instruments issued by a banking organization to satisfy the following criteria:

(1) The instrument is paid-in, issued directly by the banking organization, and represents the most subordinated claim in a receivership, insolvency, liquidation, or similar proceeding of the banking organization.

(2) The holder of the instrument is entitled to a claim on the residual assets of the banking organization that is proportional with the holder's share of the banking organization's issued capital after all senior claims have been satisfied in a receivership, insolvency, liquidation, or similar proceeding. That is, the holder has an unlimited and variable claim, not a fixed or capped claim.

(3) The instrument has no maturity date, can only be redeemed via discretionary repurchases with the prior approval of the banking organization's primary Federal supervisor, and does not contain any term or feature that creates an incentive to redeem.

(4) The banking organization did not create at issuance of the instrument, through any action or communication, an expectation that it will buy back, cancel, or redeem the instrument, and the instrument does not include any term or feature that might give rise to such an expectation.

(5) Any cash dividend payments on the instrument are paid out of the banking organization's net income and retained earnings and are not subject to a limit imposed by the contractual terms governing the instrument.

(6) The banking organization has full discretion at all times to refrain from paying any dividends and making any other capital distributions on the instrument without triggering an event of default, a requirement to make a payment-in-kind, or an imposition of any other restrictions on the banking organization.

(7) Dividend payments and any other capital distributions on the instrument may be paid only after all legal and contractual obligations of the banking organization have been satisfied, including payments due on more senior claims.

(8) The holders of the instrument bear losses as they occur equally, proportionately, and simultaneously with the holders of all other common stock instruments before any losses are borne by holders of claims on the banking organization with greater priority in a receivership, insolvency, liquidation, or similar proceeding.

(9) The paid-in amount is classified as equity under GAAP.

(10) The banking organization, or an entity that the banking organization controls, did not purchase or directly or indirectly fund the purchase of the instrument.

(11) The instrument is not secured, not covered by a guarantee of the banking organization or of an affiliate of the banking organization, and is not subject to any other arrangement that legally or economically enhances the seniority of the instrument.

(12) The instrument has been issued in accordance with applicable laws and regulations. In most cases, the agencies understand that the issuance of these instruments would require the approval of the board of directors of the banking organization or, where applicable, of the banking organization's shareholders or of other persons duly authorized by the banking organization's shareholders.

(13) The instrument is reported on the banking organization's regulatory financial statements separately from other capital instruments.

The agencies and the FDIC requested comment on the proposed criteria for inclusion in common equity tier 1, and specifically on whether any of the criteria would be problematic, given the main characteristics of existing outstanding common stock instruments.

A substantial number of comments addressed the criteria for common equity tier 1 capital. Generally, commenters stated that the proposed criteria could prevent some instruments currently included in tier 1 capital from being included in the new common equity tier 1 capital measure. Commenters stated that this could create complicated and unnecessary burden for banking organizations that either would have to raise capital to meet the common equity tier 1 capital requirement or shrink their balance sheets by selling off or winding down assets and exposures. Many commenters stated that the burden of raising new capital would have the effect of reducing lending overall, and that it would be especially acute for smaller banking organizations that have limited access to capital markets.

Many commenters asked the agencies and the FDIC to clarify several aspects of the proposed criteria. For instance, a Start Printed Page 62045few commenters asked the agencies and the FDIC to clarify the proposed requirement that a common equity tier 1 capital instrument be redeemed only with prior approval by a banking organization's primary Federal supervisor. These commenters asked if this criterion would require a banking organization to note this restriction on the face of a regulatory capital instrument that it may be redeemed only with the prior approval of the banking organization's primary Federal supervisor.

The agencies note that the requirement that common equity tier 1 capital instruments be redeemed only with prior agency approval is consistent with the agencies' rules and federal law, which generally provide that a banking organization may not reduce its capital by redeeming capital instruments without receiving prior approval from its primary Federal supervisor.[66] The final rule does not obligate the banking organization to include this restriction explicitly in the common equity tier 1 capital instrument's documentation. However, regardless of whether the instrument documentation states that its redemption is subject to agency approval, the banking organization must receive prior approval before redeeming such instruments. The agencies believe that the approval requirement is appropriate as it provides for the monitoring of the strength of a banking organization's capital position, and therefore, have retained the proposed requirement in the final rule.

Several commenters also expressed concern about the proposed requirement that dividend payments and any other distributions on a common equity tier 1 capital instrument may be paid only after all legal and contractual obligations of the banking organization have been satisfied, including payments due on more senior claims. Commenters stated that, as proposed, this requirement could be construed to prevent a banking organization from paying a dividend on a common equity tier 1 capital instrument because of obligations that have not yet become due or because of immaterial delays in paying trade creditors [67] for obligations incurred in the ordinary course of business.

The agencies note that this criterion should not prevent a banking organization from paying a dividend on a common equity tier 1 capital instrument where it has incurred operational obligations in the normal course of business that are not yet due or that are subject to minor delays for reasons unrelated to the financial condition of the banking organization, such as delays related to contractual or other legal disputes.

A number of commenters also suggested that the proposed criteria providing that dividend payments may be paid only out of current and retained earnings potentially could conflict with state corporate law, including Delaware state law. According to these commenters, Delaware state law permits a corporation to make dividend payments out of its capital surplus account, even when the organization does not have current or retained earnings.

The agencies observe that requiring that dividends be paid only out of net income and retained earnings is consistent with federal law and the existing regulations applicable to insured depository institutions. Under applicable statutes and regulations, a national bank or federal savings association may not declare and pay dividends in any year in an amount that exceeds the sum of its total net income for that year plus its retained net income for the preceding two years (minus certain transfers), unless it receives prior approval from the OCC. Therefore, as applied to national banks and Federal savings associations, this aspect of the proposal did not include any substantive changes from the general risk-based capital rules.[68] Accordingly, with respect to national banks and savings associations, the criterion does not include surplus.

However, because this criterion applies to the terms of the capital instrument, which is governed by state law, the Board is broadening the criterion in the final rule to include surplus for state-chartered companies under its supervision that are subject to the final rule. However, regardless of provisions of state law, under the Federal Reserve Act, state member banks are subject to the same restrictions as national banks that relate to the withdrawal or impairment of their capital stock, and the Board's regulations for state member banks reflect these limitations on dividend payments.[69] It should be noted that restrictions may be applied to BHC dividends under the Board's capital plan rule for companies subject to that rule.[70]

Finally, several commenters expressed concerns about the potential impact of the proposed criteria on stock issued as part of certain employee stock ownership plans (ESOPs) (as defined under Employee Retirement Income Security Act of 1974 [71] (ERISA) regulations at 29 CFR 2550.407d-6). Under the proposed rule, an instrument would not be included in common equity tier 1 capital if the banking organization creates an expectation that it will buy back, cancel, or redeem the instrument, or if the instrument includes any term or feature that might give rise to such an expectation. Additionally, the criteria would prevent a banking organization from including in common equity tier 1 capital any instrument that is subject to any type of arrangement that legally or economically enhances the seniority of the instrument. Commenters noted that under ERISA, stock that is not publicly traded and issued as part of an ESOP must include a “put option” that requires the company to repurchase the stock. By exercising the put option, an employee can redeem the stock instrument upon termination of employment. Commenters noted that this put option clearly creates an expectation that the instrument will be redeemed and arguably enhances the seniority of the instrument. Therefore, the commenters stated that the put option could prevent a privately-held banking organization from including earned ESOP shares in its common equity tier 1 capital.

The agencies do not believe that an ERISA-mandated put option should prohibit ESOP shares from being included in common equity tier 1 capital. Therefore, under the final rule, shares issued under an ESOP by a banking organization that is not publicly-traded are exempt from the criteria that the shares can be redeemed only via discretionary repurchases and are not subject to any other arrangement that legally or economically enhances their seniority, and that the banking organization not create an expectation that the shares will be redeemed. In addition to the concerns described above, because stock held in an ESOP is awarded by a banking organization for the retirement benefit of its employees, some commenters expressed concern Start Printed Page 62046that such stock may not conform to the criterion prohibiting a banking organization from directly or indirectly funding a capital instrument. Because the agencies believe that a banking organization should have the flexibility to provide an ESOP as a benefit for its employees, the final rule provides that ESOP stock does not violate such criterion. Under the final rule, a banking organization's common stock held in trust for the benefit of employees as part of an ESOP in accordance with both ERISA and ERISA-related U.S. tax code requirements will qualify for inclusion as common equity tier 1 capital only to the extent that the instrument is includable as equity under GAAP and that it meets all other criteria of section 20(b)(1) of the final rule. Stock instruments held by an ESOP that are unawarded or unearned by employees or reported as “temporary equity” under GAAP (in the case of U.S. Securities and Exchange Commission (SEC) registrants), may not be counted as equity under GAAP and therefore may not be included in common equity tier 1 capital.

After reviewing the comments received, the agencies have decided to finalize the proposed criteria for common equity tier 1 capital instruments, modified as discussed above. Although it is possible some currently outstanding common equity instruments may not meet the common equity tier 1 capital criteria, the agencies believe that most common equity instruments that are currently eligible for inclusion in banking organizations' tier 1 capital meet the common equity tier 1 capital criteria, and have not received information that would support a different conclusion. The agencies therefore believe that most banking organizations will not be required to reissue common equity instruments in order to comply with the final common equity tier 1 capital criteria. The final revised criteria for inclusion in common equity tier 1 capital are set forth in section 20(b)(1) of the final rule.

2. Additional Tier 1 Capital

Consistent with Basel III, the agencies and the FDIC proposed that additional tier 1 capital would equal the sum of: Additional tier 1 capital instruments that satisfy the criteria set forth in section 20(c) of the proposal, related surplus, and any tier 1 minority interest that is not included in a banking organization's common equity tier 1 capital (subject to the proposed limitations on minority interest), less applicable regulatory adjustments and deductions. The agencies and the FDIC proposed the following criteria for additional tier 1 capital instruments in section 20(c):

(1) The instrument is issued and paid-in.

(2) The instrument is subordinated to depositors, general creditors, and subordinated debt holders of the banking organization in a receivership, insolvency, liquidation, or similar proceeding.

(3) The instrument is not secured, not covered by a guarantee of the banking organization or of an affiliate of the banking organization, and not subject to any other arrangement that legally or economically enhances the seniority of the instrument.

(4) The instrument has no maturity date and does not contain a dividend step-up or any other term or feature that creates an incentive to redeem.

(5) If callable by its terms, the instrument may be called by the banking organization only after a minimum of five years following issuance, except that the terms of the instrument may allow it to be called earlier than five years upon the occurrence of a regulatory event (as defined in the agreement governing the instrument) that precludes the instrument from being included in additional tier 1 capital or a tax event. In addition:

(i) The banking organization must receive prior approval from its primary Federal supervisor to exercise a call option on the instrument.

(ii) The banking organization does not create at issuance of the instrument, through any action or communication, an expectation that the call option will be exercised.

(iii) Prior to exercising the call option, or immediately thereafter, the banking organization must either:

(A) Replace the instrument to be called with an equal amount of instruments that meet the criteria under section 20(b) or (c) of the proposed rule (replacement can be concurrent with redemption of existing additional tier 1 capital instruments); or

(B) Demonstrate to the satisfaction of its primary Federal supervisor that following redemption, the banking organization will continue to hold capital commensurate with its risk.

(6) Redemption or repurchase of the instrument requires prior approval from the banking organization's primary Federal supervisor.

(7) The banking organization has full discretion at all times to cancel dividends or other capital distributions on the instrument without triggering an event of default, a requirement to make a payment-in-kind, or an imposition of other restrictions on the banking organization except in relation to any capital distributions to holders of common stock.

(8) Any capital distributions on the instrument are paid out of the banking organization's net income and retained earnings.

(9) The instrument does not have a credit-sensitive feature, such as a dividend rate that is reset periodically based in whole or in part on the banking organization's credit quality, but may have a dividend rate that is adjusted periodically independent of the banking organization's credit quality, in relation to general market interest rates or similar adjustments.

(10) The paid-in amount is classified as equity under GAAP.

(11) The banking organization, or an entity that the banking organization controls, did not purchase or directly or indirectly fund the purchase of the instrument.

(12) The instrument does not have any features that would limit or discourage additional issuance of capital by the banking organization, such as provisions that require the banking organization to compensate holders of the instrument if a new instrument is issued at a lower price during a specified time frame.

(13) If the instrument is not issued directly by the banking organization or by a subsidiary of the banking organization that is an operating entity, the only asset of the issuing entity is its investment in the capital of the banking organization, and proceeds must be immediately available without limitation to the banking organization or to the banking organization's top-tier holding company in a form which meets or exceeds all of the other criteria for additional tier 1 capital instruments.[72]

(14) For an advanced approaches banking organization, the governing agreement, offering circular, or prospectus of an instrument issued after January 1, 2013, must disclose that the holders of the instrument may be fully subordinated to interests held by the U.S. government in the event that the banking organization enters into a receivership, insolvency, liquidation, or similar proceeding.

The proposed criteria were designed to ensure that additional tier 1 capital instruments would be available to absorb losses on a going-concern basis. TruPS and cumulative perpetual preferred securities, which are eligible for limited inclusion in tier 1 capital Start Printed Page 62047under the general risk-based capital rules for bank holding companies, generally would not qualify for inclusion in additional tier 1 capital.[73] As explained in the proposal, the agencies believe that instruments that allow for the accumulation of interest payable, like cumulative preferred securities, are not likely to absorb losses to the degree appropriate for inclusion in tier 1 capital. In addition, the exclusion of these instruments from the tier 1 capital of depository institution holding companies would be consistent with section 171 of the Dodd-Frank Act.

The agencies noted in the proposal that under Basel III, instruments classified as liabilities for accounting purposes could potentially be included in additional tier 1 capital. However, the agencies and the FDIC proposed that an instrument classified as a liability under GAAP could not qualify as additional tier 1 capital, reflecting the agencies' and the FDIC's view that allowing only instruments classified as equity under GAAP in tier 1 capital helps strengthen the loss-absorption capabilities of additional tier 1 capital instruments, thereby increasing the quality of the capital base of U.S. banking organizations.

The agencies and the FDIC also proposed to allow banking organizations to include in additional tier 1 capital instruments that were: (1) Issued under the Small Business Jobs Act of 2010 [74] or, prior to October 4, 2010, under the Emergency Economic Stabilization Act of 2008,[75] and (2) included in tier 1 capital under the agencies' and the FDIC's general risk-based capital rules. Under the proposal, these instruments would be included in tier 1 capital regardless of whether they satisfied the proposed qualifying criteria for common equity tier 1 or additional tier 1 capital. The agencies and the FDIC explained in the proposal that continuing to permit these instruments to be included in tier 1 capital is important to promote financial recovery and stability following the recent financial crisis.[76]

A number of commenters addressed the proposed criteria for additional tier 1 capital. Consistent with comments on the criteria for common equity tier 1 capital, commenters generally argued that imposing new restrictions on qualifying regulatory capital instruments would be burdensome for many banking organizations that would be required to raise additional capital or to shrink their balance sheets to phase out existing regulatory capital instruments that no longer qualify as regulatory capital under the proposed rule.

With respect to the proposed criteria, commenters requested that the agencies and the FDIC make a number of changes and clarifications. Specifically, commenters asked the agencies and the FDIC to clarify the use of the term “secured” in criterion (3) above. In this context, a “secured” instrument is an instrument that is backed by collateral. In order to qualify as additional tier 1 capital, an instrument may not be collateralized, guaranteed by the issuing organization or an affiliate of the issuing organization, or subject to any other arrangement that legally or economically enhances the seniority of the instrument relative to more senior claims. Instruments backed by collateral, guarantees, or other arrangements that affect their seniority are less able to absorb losses than instruments without such enhancements. Therefore, instruments secured by collateral, guarantees, or other enhancements would not be included in additional tier 1 capital under the proposal. The agencies have adopted this criterion as proposed.

Commenters also asked the agencies and the FDIC to clarify whether terms allowing a banking organization to convert a fixed-rate instrument to a floating rate in combination with a call option, without any increase in credit spread, would constitute an “incentive to redeem” under criterion (4). The agencies do not consider the conversion from a fixed rate to a floating rate (or from a floating rate to a fixed rate) in combination with a call option without any increase in credit spread to constitute an “incentive to redeem” for purposes of this criterion. More specifically, a call option combined with a change in reference rate where the credit spread over the second reference rate is equal to or less than the initial dividend rate less the swap rate (that is, the fixed rate paid to the call date to receive the second reference rate) would not be considered an incentive to redeem. For example, if the initial reference rate is 0.9 percent, the credit spread over the initial reference rate is 2 percent (that is, the initial dividend rate is 2.9 percent), and the swap rate to the call date is 1.2 percent, a credit spread over the second reference rate greater than 1.7 percent (2.9 percent minus 1.2 percent) would be considered an incentive to redeem. The agencies believe that the clarification above should address the commenters' concerns, and the agencies are retaining this criterion in the final rule as proposed.

Several commenters noted that the proposed requirement that a banking organization seek prior approval from its primary Federal supervisor before exercising a call option is redundant with the existing requirement that a banking organization seek prior approval before reducing regulatory capital by redeeming a capital instrument. The agencies believe that the proposed requirement clarifies existing requirements and does not add any new substantive restrictions or burdens. Including this criterion also helps to ensure that the regulatory capital rules provide banking organizations a complete list of the requirements applicable to regulatory capital instruments in one location. Accordingly, the agencies have retained this requirement in the final rule.

Banking industry commenters also asserted that some of the proposed criteria could have an adverse impact on ESOPs. Specifically, the commenters noted that the proposed requirement that instruments not be callable for at least five years after issuance could be problematic for compensation plans that enable a company to redeem shares after employment is terminated. Commenters asked the agencies and the FDIC to exempt from this requirement stock issued as part of an ESOP. For the reasons stated above in the discussion of common equity tier 1 capital instruments, under the final rule, additional tier 1 instruments issued under an ESOP by a banking organization that is not publicly traded are exempt from the criterion that additional tier 1 instruments not be callable for at least five years after issuance. Moreover, similar to the discussion above regarding the criteria for common equity tier 1 capital, the agencies believe that required compliance with ERISA and ERISA-related tax code requirements alone should not prevent an instrument from being included in regulatory capital. Therefore, the agencies are including a provision in the final rule 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 Start Printed Page 62048part of an ESOP from being included in additional tier 1 capital. In addition, 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.

Commenters also asked the agencies and the FDIC to add exceptions for early calls within five years of issuance in the case of an “investment company event” or a “rating agency event,” in addition to the proposed exceptions for regulatory and tax events. After considering the comments on these issues, the agencies have decided to revise 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.[77] The agencies recognize that the legal and regulatory burdens of becoming an investment company could make it uneconomic to leave some structured capital instruments outstanding, and thus would permit the banking organization to call such instruments early.

In order to ensure the loss-absorption capacity of additional tier 1 capital instruments, the agencies have decided not to revise the rule to permit a banking organization to include in its additional tier 1 capital instruments issued on or after the effective date of the rule that may be called prior to five years after issuance upon the occurrence of a rating agency event. However, understanding that many currently outstanding instruments have this feature, the agencies have decided to revise 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.

In addition, a number of commenters reiterated the concern that restrictions on the payment of dividends from net income and current and retained earnings may conflict with state corporate laws that permit an organization to issue dividend payments from its capital surplus accounts. This criterion for additional tier 1 capital in the final rule reflects the identical final criterion for common equity tier 1 for the reasons discussed above with respect to common equity tier 1 capital.

Commenters also noted that proposed criterion (10), which requires the paid-in amounts of tier 1 capital instruments to be classified as equity under GAAP before they may be included in regulatory capital, generally would prevent contingent capital instruments, which are classified as liabilities, from qualifying as additional tier 1 capital. These commenters asked the agencies and the FDIC to revise the rules to provide that contingent capital instruments will qualify as additional tier 1 capital, regardless of their treatment under GAAP. Another commenter noted the challenges for U.S. banking organizations in devising contingent capital instruments that would satisfy the proposed criteria, and noted that if U.S. banking organizations develop an acceptable instrument, the instrument likely would initially be classified as debt instead of equity for GAAP purposes. Thus, in order to accommodate this possibility, the commenter urged the agencies and the FDIC to revise the criterion to allow the agencies and the FDIC to permit such an instrument in additional tier 1 capital through interpretive guidance or specifically in the case of a particular instrument.

The agencies continue to believe that restricting tier 1 capital instruments to those classified as equity under GAAP will help to ensure those instruments' capacity to absorb losses and further increase the quality of U.S. banking organizations' regulatory capital. The agencies therefore have decided to retain this aspect of the proposal. To the extent that a contingent capital instrument is considered a liability under GAAP, a banking organization may not include the instrument in its tier 1 capital under the final rule. At such time as an instrument converts from debt to equity under GAAP, the instrument would then satisfy this criterion.

In the preamble to the proposed rule, the agencies included a discussion regarding whether criterion (7) should be revised to require banking organizations to reduce the dividend payment on tier 1 capital instruments to a penny when a banking organization reduces dividend payments on a common equity tier 1 capital instrument to a penny per share. Such a revision would increase the capacity of additional tier 1 instruments to absorb losses as it would permit a banking organization to reduce its capital distributions on additional tier 1 instruments without eliminating entirely its common stock dividend. Commenters asserted that such a revision would be unnecessary and could affect the hierarchy of subordination in capital instruments. Commenters also claimed the revision could prove burdensome as it could substantially increase the cost of raising capital through additional tier 1 capital instruments. In light of these comments the agencies have decided to not modify criterion (7) to accommodate the issuance of a penny dividend as discussed in the proposal.

Several commenters expressed concern that criterion (7) for additional tier 1 capital, could affect the tier 1 eligibility of existing noncumulative perpetual preferred stock. Specifically, the commenters were concerned that such a criterion would disallow contractual terms of an additional tier 1 capital instrument that restrict payment of dividends on another capital instrument that is pari passu in liquidation with the additional tier 1 capital instrument (commonly referred to as dividend stoppers). Consistent with Basel III, the agencies agree that restrictions related to capital distributions to holders of common stock instruments and holders of other capital instruments that are pari passu in liquidation with such additional tier 1 capital instruments are acceptable, and have amended this criterion accordingly for purposes of the final rule.

After considering the comments on the proposal, the agencies have decided to finalize the criteria for additional tier 1 capital instruments with the modifications discussed above. The final revised criteria for additional tier 1 capital are set forth in section 20(c)(1) of the final rule. The agencies expect that most outstanding noncumulative perpetual preferred stock that qualifies as tier 1 capital under the agencies' general risk-based capital rules will qualify as additional tier 1 capital under the final rule.

3. Tier 2 Capital

Consistent with Basel III, under the proposed rule, tier 2 capital would equal the sum of: Tier 2 capital instruments that satisfy the criteria set forth in section 20(d) of the proposal, related surplus, total capital minority interest not included in a banking organization's tier 1 capital (subject to certain limitations and requirements), and limited amounts of the allowance for loan and lease losses (ALLL) less any applicable regulatory adjustments and deductions. Consistent with the general risk-based capital rules, when calculating its total capital ratio using Start Printed Page 62049the standardized approach, a banking organization would be permitted to include in tier 2 capital the amount of ALLL that does not exceed 1.25 percent of its standardized total risk-weighted assets which would not include any amount of the ALLL. A banking organization subject to the market risk rule would exclude its standardized market risk-weighted assets from the calculation.[78] In contrast, when calculating its total capital ratio using the advanced approaches, a banking organization would be permitted to include in tier 2 capital the excess of its eligible credit reserves over its total expected credit loss, provided the amount does not exceed 0.6 percent of its credit risk-weighted assets.

Consistent with Basel III, the agencies and the FDIC proposed the following criteria for tier 2 capital instruments:

(1) The instrument is issued and paid-in.

(2) The instrument is subordinated to depositors and general creditors of the banking organization.

(3) The instrument is not secured, not covered by a guarantee of the banking organization or of an affiliate of the banking organization, and not subject to any other arrangement that legally or economically enhances the seniority of the instrument in relation to more senior claims.

(4) The instrument has a minimum original maturity of at least five years. At the beginning of each of the last five years of the life of the instrument, the amount that is eligible to be included in tier 2 capital is reduced by 20 percent of the original amount of the instrument (net of redemptions) and is excluded from regulatory capital when remaining maturity is less than one year. In addition, the instrument must not have any terms or features that require, or create significant incentives for, the banking organization to redeem the instrument prior to maturity.

(5) The instrument, by its terms, may be called by the banking organization only after a minimum of five years following issuance, except that the terms of the instrument may allow it to be called sooner upon the occurrence of an event that would preclude the instrument from being included in tier 2 capital, or a tax event. In addition:

(i) The banking organization must receive the prior approval of its primary Federal supervisor to exercise a call option on the instrument.

(ii) The banking organization does not create at issuance, through action or communication, an expectation the call option will be exercised.

(iii) Prior to exercising the call option, or immediately thereafter, the banking organization must either:

(A) Replace any amount called with an equivalent amount of an instrument that meets the criteria for regulatory capital under section 20 of the proposed rule; [79] or

(B) Demonstrate to the satisfaction of the banking organization's primary Federal supervisor that following redemption, the banking organization would continue to hold an amount of capital that is commensurate with its risk.

(6) The holder of the instrument must have no contractual right to accelerate payment of principal or interest on the instrument, except in the event of a receivership, insolvency, liquidation, or similar proceeding of the banking organization.

(7) The instrument has no credit-sensitive feature, such as a dividend or interest rate that is reset periodically based in whole or in part on the banking organization's credit standing, but may have a dividend rate that is adjusted periodically independent of the banking organization's credit standing, in relation to general market interest rates or similar adjustments.

(8) The banking organization, or an entity that the banking organization controls, has not purchased and has not directly or indirectly funded the purchase of the instrument.

(9) If the instrument is not issued directly by the banking organization or by a subsidiary of the banking organization that is an operating entity, the only asset of the issuing entity is its investment in the capital of the banking organization, and proceeds must be immediately available without limitation to the banking organization or the banking organization's top-tier holding company in a form that meets or exceeds all the other criteria for tier 2 capital instruments under this section.[80]

(10) Redemption of the instrument prior to maturity or repurchase requires the prior approval of the banking organization's primary Federal supervisor.

(11) For an advanced approaches banking organization, the governing agreement, offering circular, or prospectus of an instrument issued after January 1, 2013, must disclose that the holders of the instrument may be fully subordinated to interests held by the U.S. government in the event that the banking organization enters into a receivership, insolvency, liquidation, or similar proceeding.

The agencies and the FDIC also proposed to eliminate the inclusion of a portion of certain unrealized gains on AFS equity securities in tier 2 capital given that unrealized gains and losses on AFS securities would flow through to common equity tier 1 capital under the proposed rules.

As a result of the proposed new minimum common equity tier 1 capital requirement, higher tier 1 capital requirement, and the broader goal of simplifying the definition of tier 2 capital, the proposal eliminated the existing limitations on the amount of tier 2 capital that could be recognized in total capital, as well as the existing limitations on the amount of certain capital instruments (that is, term subordinated debt) that could be included in tier 2 capital.

Finally, the agencies and the FDIC proposed to allow an instrument that qualified as tier 2 capital under the general risk-based capital rules and that was issued under the Small Business Jobs Act of 2010,[81] or, prior to October 4, 2010, under the Emergency Economic Stabilization Act of 2008, to continue to be includable in tier 2 capital regardless of whether it met all of the proposed qualifying criteria.

Several commenters addressed the proposed eligibility criteria for tier 2 capital. A few banking industry commenters asked the agencies and the FDIC to clarify criterion (2) above to provide that trade creditors are not among the class of senior creditors whose claims rank ahead of subordinated debt holders. In response to these comments, the agencies note that the intent of the final rule, with its requirement that tier 2 capital instruments be subordinated to depositors and general creditors, is to effectively retain the subordination standards for tier 2 capital subordinated debt under the general risk-based capital rules. Therefore, the agencies are clarifying that under the final rule, and consistent with the agencies' general risk-based capital rules, subordinated debt instruments that qualify as tier 2 capital must be subordinated to general creditors, which generally means senior indebtedness, excluding trade creditors. Such creditors include at a minimum all borrowed money, similar obligations Start Printed Page 62050arising from off-balance sheet guarantees and direct-credit substitutes, and obligations associated with derivative products such as interest rate and foreign-exchange contracts, commodity contracts, and similar arrangements, and, in addition, for depository institutions, depositors.

In addition, one commenter noted that while many existing banking organizations' subordinated debt indentures contain subordination provisions, they may not explicitly include a subordination provision with respect to “general creditors” of the banking organization. Thus, they recommended that this aspect of the rules be modified to have only prospective application. The agencies note that if it is clear from an instrument's governing agreement, offering circular, or prospectus, that the instrument is subordinated to general creditors despite not specifically stating “general creditors,” criterion (2) above is satisfied (that is, criterion (2) should not be read to mean that the phrase “general creditors” must appear in the instrument's governing agreement, offering circular, or prospectus, as the case may be).

One commenter also asked whether 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, would qualify as tier 2 capital. The agencies note that because such an instrument would automatically convert to a permanent form of regulatory capital, the five-year maturity requirement would not apply and, thus, it would qualify as tier 2 capital. The agencies have clarified the final rule in this respect.

Commenters also expressed concern about the impact of a number of the proposed criteria on outstanding TruPS. For example, commenters stated that a strict reading of criterion (3) above could exclude certain TruPS under which the banking organization guarantees that any payments made by the banking organization to the trust will be used by the trust to pay its obligations to security holders. However, the proposed rule would not have disqualified an instrument with this type of guarantee, which does not enhance or otherwise alter the subordination level of an instrument. Additionally, the commenters asked the agencies and the FDIC to allow in tier 2 capital instruments that provide for default and the acceleration of principal and interest if the issuer banking organization defers interest payments for five consecutive years. Commenters stated that these exceptions would be necessary to accommodate existing TruPS, which generally include such call, default and acceleration features.

Commenters also asked the agencies and the FDIC to clarify the use of the term “secured” in criterion (3). As discussed above with respect to the criteria for additional tier 1 capital, a “secured” instrument is an instrument where payments on the instrument are secured by collateral. Therefore, under criterion (3), a collateralized instrument will not qualify as tier 2 capital. Instruments secured by collateral are less able to absorb losses than instruments without such enhancement.

With respect to subordinated debt instruments included in tier 2 capital, a commenter recommended eliminating criterion (4)'s proposed five-year amortization requirement, arguing that that it was unnecessary given other capital planning requirements that banking organizations must satisfy. The agencies declined to adopt the commenter's recommendation, as they believe that the proposed amortization schedule results in a more accurate reflection of the loss-absorbency of a banking organization's tier 2 capital. The agencies note that if a banking organization begins deferring interest payments on a TruPS instrument included in tier 2 capital, such an instrument will be treated as having a maturity of five years at that point and the banking organization must begin excluding the appropriate amount of the instrument from capital in accordance with section 20(d)(1)(iv) of the final rule.

Similar to the comments received on the criteria for additional tier 1 capital, commenters asked the agencies and the FDIC to add exceptions to the prohibition against call options that could be exercised within five years of the issuance of a capital instrument, specifically for an “investment company event” and a “rating agency event.”

Although the agencies declined to permit instruments that include acceleration provisions in tier 2 capital in the final rule, the agencies believe that the inclusion in tier 2 capital of existing TruPS, which allow for acceleration after five years of interest deferral, does not raise safety and soundness concerns. Although the majority of existing TruPS would not technically comply with the final rule's tier 2 eligibility criteria, the agencies acknowledge that the inclusion of existing TruPS in tier 2 capital (until they are redeemed or they mature) would benefit certain banking organizations until they are able to replace such instruments with new capital instruments that fully comply with the eligibility criteria of the final rule. Accordingly, the agencies have decided to permit non-advanced approaches depository institution holding companies with over $15 billion in total consolidated assets to include in tier 2 capital TruPS that are phased-out of tier 1 capital in tier 2 capital. However, advanced approaches depository institution holding companies would not be allowed to permanently include existing TruPS in tier 2 capital. Rather, these banking organizations would include in tier 2 capital TruPS phased out of tier 1 capital from January 1, 2014 to year-end 2015. From January 1, 2016 to year-end 2021, these banking organizations would be required to phase out TruPS from tier 2 capital in line with Table 9 of the transitions section of the final rule.

As with additional tier 1 capital instruments, the final rule permits a banking organization to call an instrument prior to five years after issuance in the event that the issuing entity is required to register with the SEC as an investment company pursuant to the Investment Company Act of 1940, for the reasons discussed above with respect to additional tier 1 capital. Also for the reasons discussed above with respect to additional tier 1 capital instruments, the agencies have decided not to permit a banking organization to include in its tier 2 capital an instrument issued on or after the effective date of the final rule that may be called prior to five years after its issuance upon the occurrence of a rating agency event. However, the agencies have decided to allow such an instrument to be included in tier 2 capital, provided that the instrument was issued and included in a banking organization's tier 1 or tier 2 capital prior to January 1, 2014, and that such instrument meets all other criteria for tier 2 capital instruments under the final rule.

In addition, similar to the comment above with respect to the proposed criteria for additional tier 1 capital instruments, commenters noted that the proposed criterion that a banking organization seek prior approval from its primary Federal supervisor before exercising a call option is redundant with the requirement that a banking organization seek prior approval before reducing regulatory capital by redeeming a capital instrument. Again, the agencies believe that this proposed requirement restates and clarifies existing requirements without adding any new substantive restrictions, and that it will help to ensure that the Start Printed Page 62051regulatory capital rules provide banking organizations with a complete list of the requirements applicable to their regulatory capital instruments. Therefore, the agencies are retaining the requirement as proposed.

Under the proposal, an advanced approaches banking organization may include in tier 2 capital the excess of its eligible credit reserves over expected credit loss (ECL) to the extent that such amount does not exceed 0.6 percent of credit risk-weighted assets, rather than including the amount of ALLL described above. Commenters asked the agencies and the FDIC to clarify whether an advanced approaches banking organization that is in parallel run includes in tier 2 capital its ECL or ALLL (as described above). To clarify, for purposes of the final rule, 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. When measuring its total capital relative to its advanced approaches risk-weighted assets, as described in section 10(c)(3)(ii) of the final rule, an advanced approaches banking organization that has completed the parallel run process and that has received notification from its primary Federal supervisor pursuant to section 121(d) of subpart E must adjust its total capital to reflect its excess eligible credit reserves rather than its ALLL.

Some commenters recommended that the agencies and the FDIC remove the limit on the amount of the ALLL includable in regulatory capital. Specifically, one commenter recommended allowing banking organizations to include ALLL in tier 1 capital equal to an amount of up to 1.25 percent of total risk-weighted assets, with the balance in tier 2 capital, so that the entire ALLL would be included in regulatory capital. Moreover, some commenters recommended including in tier 2 capital the entire amount of reserves held for residential mortgage loans sold with recourse, given that the proposal would require a 100 percent credit conversion factor for such loans. Consistent with the ALLL treatment under the general risk-based capital rules, for purposes of the final rule the agencies have elected to permit only limited amounts of the ALLL in tier 2 capital given its limited purpose of covering incurred rather than unexpected losses. For similar reasons, the agencies have further elected not to recognize in tier 2 capital reserves held for residential mortgage loans sold with recourse.

As described above, a banking organization that has made an AOCI opt-out election may incorporate up to 45 percent of any net unrealized gains on AFS preferred stock classified as an equity security under GAAP and AFS equity exposures into its tier 2 capital.

Some commenters requested that the eligibility criteria for tier 2 capital be clarified with regard to surplus notes. For example, commenters suggested that the requirement for approval of any payment of principal or interest on a surplus note by the applicable insurance regulator is deemed to satisfy the criterion of the tier 2 capital instrument for prior approval for redemption of the instrument prior to maturity by a Federal banking agency.

As described under the proposal, surplus notes generally are financial instruments issued by insurance companies that are included in surplus for statutory accounting purposes as prescribed or permitted by state laws and regulations, and typically have the following features: (1) The applicable state insurance regulator approves in advance the form and content of the note; (2) the instrument is subordinated to policyholders, to claimant and beneficiary claims, and to all other classes of creditors other than surplus note holders; and (3) the applicable state insurance regulator is required to approve in advance any interest payments and principal repayments on the instrument. The Board notes that a surplus note could be eligible for inclusion in tier 2 capital provided that the note meets the proposed tier 2 capital eligibility criteria. However, the Board does not consider approval of payments by an insurance regulator to satisfy the criterion for approval by a Federal banking agency. Accordingly, the Board has adopted the final rule without change.

After reviewing the comments received on this issue, the agencies have determined to finalize the criteria for tier 2 capital instruments to include the aforementioned changes. The revised criteria for inclusion in tier 2 capital are set forth in section 20(d)(1) of the final rule.

4. Capital Instruments of Mutual Banking Organizations

Under the proposed rule, the qualifying criteria for common equity tier 1, additional tier 1, and tier 2 capital generally would apply to mutual banking organizations. Mutual banking organizations and industry groups representing mutual banking organizations encouraged the agencies and the FDIC to expand the qualifying criteria for additional tier 1 capital to recognize certain cumulative instruments. These commenters stressed that mutual banking organizations, which do not issue common stock, have fewer options for raising regulatory capital relative to other types of banking organizations.

The agencies do not believe that cumulative instruments are able to absorb losses sufficiently reliably to be included in tier 1 capital. Therefore, after considering these comments, the agencies have decided not to include in tier 1 capital under the final rule any cumulative instrument. This would include any previously-issued mutual capital instrument that was included in the tier 1 capital of mutual banking organizations under the general risk-based capital rules, but that does not meet the eligibility requirements for tier 1 capital under the final rule. These cumulative capital instruments will be subject to the transition provisions and phased out of the tier 1 capital of mutual banking organizations over time, as set forth in Table 9 of section 300 in the final rule. However, if a mutual banking organization develops a new capital instrument that meets the qualifying criteria for regulatory capital under the final rule, such an instrument may be included in regulatory capital with the prior approval of the banking organization's primary Federal supervisor under section 20(e) of the final rule.

The agencies note that the qualifying criteria for regulatory capital instruments under the final rule permit mutual banking organizations to include in regulatory capital many of their existing regulatory capital instruments (for example, non-withdrawable accounts, pledged deposits, or mutual capital certificates). The agencies believe that the quality and quantity of regulatory capital currently maintained by most mutual banking organizations should be sufficient to satisfy the requirements of the final rule. For those organizations that do not currently hold enough capital to meet the revised minimum requirements, the transition arrangements are designed to ease the burden of increasing regulatory capital over time.

5. Grandfathering of Certain Capital Instruments

As described above, a substantial number of commenters objected to the proposed phase-out of non-qualifying capital instruments, including TruPS and cumulative perpetual preferred stock, from tier 1 capital. Community banking organizations in particular expressed concerns that the costs related to the replacement of such Start Printed Page 62052capital instruments, which they generally characterized as safe and loss-absorbent, would be excessive and unnecessary. Commenters noted that the proposal was more restrictive than section 171 of the Dodd-Frank Act, which requires the phase-out of non-qualifying capital instruments issued prior to May 19, 2010, only for depository institution holding companies with $15 billion or more in total consolidated assets as of December 31, 2009. Commenters argued that the agencies and the FDIC were exceeding Congressional intent by going beyond what was required under the Dodd-Frank Act. Commenters requested that the agencies and the FDIC grandfather existing TruPS and cumulative perpetual preferred stock issued by depository institution holding companies with less than $15 billion and 2010 MHCs.

The agencies agree that under the Dodd-Frank Act the agencies have the flexibility to permit depository institution holding companies with less than $15 billion in total consolidated assets as of December 31, 2009 and banking organizations that were mutual holding companies as of May 19, 2010 (2010 MHCs) to include in additional tier 1 capital TruPS and cumulative perpetual preferred stock issued and included in tier 1 capital prior to May 19, 2010. Although the agencies continue to believe that TruPS are not sufficiently loss-absorbing to be includable in tier 1 capital as a general matter, the agencies are also sensitive to the difficulties community banking organizations often face when issuing new capital instruments and are aware of the importance their capacity to lend plays in local economies. Therefore the agencies have decided in the final rule to grandfather such non-qualifying capital instruments in tier 1 capital subject to a limit of 25 percent of tier 1 capital elements excluding any non-qualifying capital instruments and after all regulatory capital deductions and adjustments applied to tier 1 capital, which is substantially similar to the limit in the general risk-based capital rules. In addition, the agencies acknowledge that the inclusion of existing TruPS in tier 2 capital would benefit certain banking organizations until they are able to replace such instruments with new capital instruments that fully comply with the eligibility criteria of the final rule. Accordingly, the agencies have decided to permit depository institution holding companies not subject to the advanced approaches rule with over $15 billion in total consolidated assets to permanently include in tier 2 capital TruPS that are phased-out of tier 1 capital in accordance with Table 8 of the transitions section of the final rule.

6. Agency Approval of Capital Elements

The agencies and the FDIC noted in the proposal that they believe most existing regulatory capital instruments will continue to be includable in banking organizations' regulatory capital. However, over time, capital instruments that are equivalent in quality and capacity to absorb losses to existing instruments may be created to satisfy different market needs. Therefore, the agencies and the FDIC proposed to create a process to consider the eligibility of such instruments on a case-by-case basis. Under the proposed rule, a banking organization must request approval from its primary Federal supervisor before including a capital element in regulatory capital, unless: (i) Such capital element is currently included in regulatory capital under the agencies' and the FDIC's general risk-based capital and leverage rules and the underlying instrument complies with the applicable proposed eligibility criteria for regulatory capital instruments; or (ii) the capital element is equivalent, in terms of capital quality and ability to absorb losses, to an element described in a previous decision made publicly available by the banking organization's primary Federal supervisor.

In the preamble to the proposal, the agencies and the FDIC indicated that they intend to consult each other when determining whether a new element should be included in common equity tier 1, additional tier 1, or tier 2 capital, and indicated that once one agency determines that a capital element may be included in a banking organization's common equity tier 1, additional tier 1, or tier 2 capital, that agency would make its decision publicly available, including a brief description of the capital element and the rationale for the conclusion.

The agencies continue to believe that it is appropriate to retain the flexibility necessary to consider new instruments on a case-by-case basis as they are developed over time to satisfy different market needs. The agencies have decided to move the agencies' authority in section 20(e)(1) of the proposal to the agencies' reservation of authority provision included in section 1(d)(2)(ii) of the final rule. Therefore, the agencies are adopting this aspect of the final rule substantively as proposed to create a process to consider the eligibility of such instruments on a permanent or temporary basis, in accordance with the applicable requirements in subpart C of the final rule (section 20(e) of the final rule).

Section 20(e)(1) of the final rule provides that a banking organization must receive its primary Federal supervisor's prior approval to include a capital element in its common equity tier 1 capital, additional tier 1 capital, or tier 2 capital unless that element: (i) Was included in the banking organization's tier 1 capital or tier 2 capital prior to May 19, 2010 in accordance with that supervisor's risk-based capital rules that were effective as of that date and the underlying instrument continues to be includable under the criteria set forth in this section; or (ii) 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 pursuant to paragraph (e)(3) of section 20. In exercising this reservation of authority, the agencies expect to consider the requirements for capital elements in the final rule; the size, complexity, risk profile, and scope of operations of the banking organization, and whether any public benefits would be outweighed by risk to an insured depository institution or to the financial system.

7. Addressing the Point of Non-Viability Requirements Under Basel III

During the recent financial crisis, the United States and foreign governments lent to, and made capital investments in, banking organizations. These investments helped to stabilize the recipient banking organizations and the financial sector as a whole. However, because of the investments, the recipient banking organizations' existing tier 2 capital instruments, and (in some cases) tier 1 capital instruments, did not absorb the banking organizations' credit losses consistent with the purpose of regulatory capital. At the same time, taxpayers became exposed to potential losses.

On January 13, 2011, the BCBS issued international standards for all additional tier 1 and tier 2 capital instruments issued by internationally-active banking organizations to ensure that such regulatory capital instruments fully absorb losses before taxpayers are exposed to such losses (the Basel non-viability standard). Under the Basel non-viability standard, all non-common stock regulatory capital instruments issued by an internationally-active banking organization must include terms that subject the instruments to write-off or conversion to common Start Printed Page 62053equity at the point at which either: (1) The write-off or conversion of those instruments occurs; or (2) a public sector injection of capital would be necessary to keep the banking organization solvent. Alternatively, if the governing jurisdiction of the banking organization has established laws that require such tier 1 and tier 2 capital instruments to be written off or otherwise fully absorb losses before taxpayers are exposed to loss, the standard is already met. If the governing jurisdiction has such laws in place, the Basel non-viability standard states that documentation for such instruments should disclose that information to investors and market participants, and should clarify that the holders of such instruments would fully absorb losses before taxpayers are exposed to loss.[82]

U.S. law is consistent with the Basel non-viability standard. The resolution regime established in Title II, section 210 of the Dodd-Frank Act provides the FDIC with the authority necessary to place failing financial companies that pose a significant risk to the financial stability of the United States into receivership.[83] The Dodd-Frank Act provides that this authority shall be exercised in a manner that minimizes systemic risk and moral hazard, so that (1) Creditors and shareholders will bear the losses of the financial company; (2) management responsible for the condition of the financial company will not be retained; and (3) the FDIC and other appropriate agencies will take steps necessary and appropriate to ensure that all parties, including holders of capital instruments, management, directors, and third parties having responsibility for the condition of the financial company, bear losses consistent with their respective ownership or responsibility.[84] Section 11 of the Federal Deposit Insurance Act has similar provisions for the resolution of depository institutions.[85] Additionally, under U.S. bankruptcy law, regulatory capital instruments issued by a company would absorb losses in bankruptcy before instruments held by more senior unsecured creditors.

Consistent with the Basel non-viability standard, under the proposal, additional tier 1 and tier 2 capital instruments issued by advanced approaches banking organizations after the date on which such organizations would have been required to comply with any final rule would have been required to include a disclosure that the holders of the instrument may be fully subordinated to interests held by the U.S. government in the event that the banking organization enters into a receivership, insolvency, liquidation, or similar proceeding. The agencies are adopting this provision of the proposed rule without change.

8. Qualifying Capital Instruments Issued by Consolidated Subsidiaries of a Banking Organization

As highlighted during the recent financial crisis, capital issued by consolidated subsidiaries and not owned by the parent banking organization (minority interest) is available to absorb losses at the subsidiary level, but that capital does not always absorb losses at the consolidated level. Accordingly, and consistent with Basel III, the proposed rule revised limitations on the amount of minority interest that may be included in regulatory capital at the consolidated level to prevent highly capitalized subsidiaries from overstating the amount of capital available to absorb losses at the consolidated organization.

Under the proposal, minority interest would have been classified as a common equity tier 1, tier 1, or total capital minority interest depending on the terms of the underlying capital instrument and on the type of subsidiary issuing such instrument. Any instrument issued by a consolidated subsidiary to third parties would have been required to satisfy the qualifying criteria under the proposal to be included in the banking organization's common equity tier 1, additional tier 1, or tier 2 capital, as appropriate. In addition, common equity tier 1 minority interest would have been limited to instruments issued by a depository institution or a foreign bank that is a consolidated subsidiary of a banking organization.

The proposed limits on the amount of minority interest that could have been included in the consolidated capital of a banking organization would have been based on the amount of capital held by the consolidated subsidiary, relative to the amount of capital the subsidiary would have had to hold to avoid any restrictions on capital distributions and discretionary bonus payments under the capital conservation buffer framework. For example, a subsidiary with a common equity tier 1 capital ratio of 8 percent that needs to maintain a common equity tier 1 capital ratio of more than 7 percent to avoid limitations on capital distributions and discretionary bonus payments would have been considered to have “surplus” common equity tier 1 capital and, at the consolidated level, the banking organization would not have been able to include the portion of such surplus common equity tier 1 capital that is attributable to third party investors.

In general, the amount of common equity tier 1 minority interest that could have been included in the common equity tier 1 capital of a banking organization under the proposal would have been equal to:

(i) The common equity tier 1 minority interest of the subsidiary minus

(ii) The ratio of the subsidiary's common equity tier 1 capital owned by third parties to the total common equity tier 1 capital of the subsidiary, multiplied by the difference between the common equity tier 1 capital of the subsidiary and the lower of:

(1) The amount of common equity tier 1 capital the subsidiary must hold to avoid restrictions on capital distributions and discretionary bonus payments, or

(2)(a) the standardized total risk-weighted assets of the banking organization that relate to the subsidiary, multiplied by

(b) The common equity tier 1 capital ratio needed by the banking organization subsidiary to avoid restrictions on capital distributions and discretionary bonus payments.

If a subsidiary were not subject to the same minimum regulatory capital requirements or capital conservation buffer framework as the banking organization, the banking organization would have needed to assume, for the purposes of the calculation described above, that the subsidiary is in fact subject to the same minimum capital requirements and the same capital conservation buffer framework as the banking organization.

To determine the amount of tier 1 minority interest that could be included in the tier 1 capital of the banking organization and the total capital minority interest that could be included in the total capital of the banking organization, a banking organization would follow the same methodology as the one outlined previously for common equity tier 1 minority interest. The proposal set forth sample calculations. The amount of tier 1 minority interest that could have been included in the additional tier 1 capital of a banking organization under the proposal was equivalent to the banking organization's tier 1 minority interest, subject to the limitations outlined above, less any common equity tier 1 minority interest included in the banking organization's Start Printed Page 62054common equity tier 1 capital. Likewise, the amount of total capital minority interest that could have been included in the tier 2 capital of the banking organization was equivalent to its total capital minority interest, subject to the limitations outlined above, less any tier 1 minority interest that is included in the banking organization's tier 1 capital.

Under the proposal, minority interest related to qualifying common or noncumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary, which is eligible for inclusion in tier 1 capital under the general risk-based capital rules without limitation, generally would qualify for inclusion in common equity tier 1 and additional tier 1 capital, respectively, subject to the proposed limits. However, under the proposal, minority interest related to qualifying cumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary, which is eligible for limited inclusion in tier 1 capital under the general risk-based capital rules, generally would not have qualified for inclusion in additional tier 1 capital under the proposal.

A number of commenters addressed the proposed limits on the inclusion of minority interest in regulatory capital. Commenters generally asserted that the proposed methodology for calculating the amount of minority interest that could be included in regulatory capital was overly complex, overly conservative, and would reduce incentives for bank subsidiaries to issue capital to third-party investors. Several commenters suggested that the agencies and the FDIC should adopt a more straightforward and simple approach that would provide a single blanket limitation on the amount of minority interest includable in regulatory capital. For example, one commenter suggested allowing a banking organization to include minority interest equal to 18 percent of common equity tier 1 capital. Another commenter suggested that minority interest where shareholders have commitments to provide additional capital, as well as minority interest in joint ventures where there are guarantees or other credit enhancements, should not be subject to the proposed limitations.

Commenters also objected to any limitations on the amount of minority interest included in the regulatory capital of a parent banking organization attributable to instruments issued by a subsidiary when the subsidiary is a depository institution. These commenters stated that restricting such minority interest could create a disincentive for depository institutions to issue capital instruments directly or to maintain capital at levels substantially above regulatory minimums. To address this concern, commenters asked the agencies and the FDIC to consider allowing a depository institution subsidiary to consider a portion of its capital above its minimum as not being part of its “surplus” capital for the purpose of calculating the minority interest limitation. Alternatively, some commenters suggested allowing depository institution subsidiaries to calculate surplus capital independently for each component of capital.

Several commenters also addressed the proposed minority interest limitation as it would apply to subordinated debt issued by a depository institution. Generally, these commenters stated that the proposed minority interest limitation either should not apply to such subordinated debt, or that the limitation should be more flexible to permit a greater amount to be included in the total capital of the consolidated organization. Commenters also suggested that the agencies and the FDIC create an exception to the limitation for bank holding companies with only a single subsidiary that is a depository institution. These commenters indicated that the limitation should not apply in such a situation because a BHC that conducts all business through a single bank subsidiary is not exposed to losses outside of the activities of the subsidiary.

Finally, some commenters pointed out that the application of the proposed calculation for the minority interest limitation was unclear in circumstances where a subsidiary depository institution does not have “surplus” capital. With respect to this comment, the agencies have revised the proposed rule to specifically provide that the minority interest limitation will not apply in circumstances where a subsidiary's capital ratios are equal to or below the level of capital necessary to meet the minimum capital requirements plus the capital conservation buffer. That is, in the final rule the minority interest limitation would apply only where a subsidiary has “surplus” capital.

The agencies continue to believe that the proposed limitations on minority interest are appropriate, including for capital instruments issued by depository institution subsidiaries, tier 2 capital instruments, and situations in which a depository institution holding company conducts the majority of its business through a single depository institution subsidiary. As noted above, the agencies' experience during the recent financial crisis showed that while minority interest generally is available to absorb losses at the subsidiary level, it may not always absorb losses at the consolidated level. Therefore, the agencies continue to believe limitations on including minority interest will prevent highly-capitalized subsidiaries from overstating the amount of capital available to absorb losses at the consolidated organization. The increased safety and soundness benefits resulting from these limitations should outweigh any compliance burden issues related to the complexity of the calculations. Therefore, the agencies are adopting the proposed treatment of minority interest without change, except for the clarification described above.

9. Real Estate Investment Trust Preferred Capital

A real estate investment trust (REIT) is a company that is required to invest in real estate and real estate-related assets and make certain distributions in order to maintain a tax-advantaged status. Some banking organizations have consolidated subsidiaries that are REITs, and such REITs may have issued capital instruments included in the regulatory capital of the consolidated banking organization as minority interest under the general risk-based capital rules.

Under the general risk-based capital rules, preferred stock issued by a REIT subsidiary generally can be included in a banking organization's tier 1 capital as minority interest if the preferred stock meets the eligibility requirements for tier 1 capital.[86] The agencies and the FDIC interpreted this to require that the REIT-preferred stock be exchangeable automatically into noncumulative perpetual preferred stock of the banking organization under certain circumstances. Specifically, the primary Federal supervisor may direct the banking organization in writing to convert the REIT preferred stock into noncumulative perpetual preferred stock of the banking organization because the banking organization: (1) Became undercapitalized under the PCA regulations; [87] (2) was placed into conservatorship or receivership; or (3) Start Printed Page 62055was expected to become undercapitalized in the near term.[88]

Under the proposed rule, the limitations described previously on the inclusion of minority interest in regulatory capital would have applied to capital instruments issued by consolidated REIT subsidiaries. Specifically, preferred stock issued by a REIT subsidiary that met the proposed definition of an operating entity (as defined below) would have qualified for inclusion in the regulatory capital of a banking organization subject to the limitations outlined in section 21 of the proposed rule only if the REIT preferred stock met the criteria for additional tier 1 or tier 2 capital instruments outlined in section 20 of the proposed rules. Because a REIT must distribute 90 percent of its earnings to maintain its tax-advantaged status, a banking organization might be reluctant to cancel dividends on the REIT preferred stock. However, for a capital instrument to qualify as additional tier 1 capital the issuer must have the ability to cancel dividends. In cases where a REIT could maintain its tax status, for example, by declaring a consent dividend and it has the ability to do so, the agencies generally would consider REIT preferred stock to satisfy criterion (7) of the proposed eligibility criteria for additional tier 1 capital instruments.[89] The agencies note that the ability to declare a consent dividend need not be included in the documentation of the REIT preferred instrument, but the banking organization must provide evidence to the relevant banking agency that it has such an ability. The agencies do not expect preferred stock issued by a REIT that does not have the ability to declare a consent dividend or otherwise cancel cash dividends to qualify as tier 1 minority interest under the final rule; however, such an instrument could qualify as total capital minority interest if it meets all of the relevant tier 2 capital eligibility criteria under the final rule.

Commenters requested clarification on whether a REIT subsidiary would be considered an operating entity for the purpose of the final rule. For minority interest issued from a subsidiary to be included in regulatory capital, the subsidiary must be either an operating entity or an entity whose only asset is its investment in the capital of the parent banking organization and for which proceeds are immediately available without limitation to the banking organization. Since a REIT has assets that are not an investment in the capital of the parent banking organization, minority interest in a REIT subsidiary can be included in the regulatory capital of the consolidated parent banking organization only if the REIT is an operating entity. For purposes of the final rule, an operating entity is defined as a company established to conduct business with clients with the intention of earning a profit in its own right. However, certain REIT subsidiaries currently used by banking organizations to raise regulatory capital are not actively managed for the purpose of earning a profit in their own right, and therefore, will not qualify as operating entities for the purpose of the final rule. Minority interest investments in REIT subsidiaries that are actively managed for purposes of earning a profit in their own right will be eligible for inclusion in the regulatory capital of the banking organization subject to the limits described in section 21 of the final rule. To the extent that a banking organization is unsure whether minority interest investments in a particular REIT subsidiary will be includable in the banking organization's regulatory capital, the organization should discuss the concern with its primary Federal supervisor prior to including any amount of the minority interest in its regulatory capital.

Several commenters objected to the application of the limitations on the inclusion of minority interest resulting from noncumulative perpetual preferred stock issued by REIT subsidiaries. Commenters noted that to be included in the regulatory capital of the consolidated parent banking organization under the general risk-based capital rules, REIT preferred stock must include an exchange feature that allows the REIT preferred stock to absorb losses at the parent banking organization through the exchange of REIT preferred instruments into noncumulative perpetual preferred stock of the parent banking organization. Because of this exchange feature, the commenters stated that REIT preferred instruments should be included in the tier 1 capital of the parent consolidated organization without limitation. Alternatively, some commenters suggested that the agencies and the FDIC should allow REIT preferred instruments to be included in the tier 2 capital of the consolidated parent organization without limitation. Commenters also noted that in light of the eventual phase-out of TruPS pursuant to the Dodd-Frank Act, REIT preferred stock would be the only tax-advantaged means for bank holding companies to raise tier 1 capital. According to these commenters, limiting this tax-advantaged option would increase the cost of doing business for many banking organizations.

After considering these comments, the agencies have decided not to create specific exemptions to the limitations on the inclusion of minority interest with respect to REIT preferred instruments. As noted above, the agencies believe that the inclusion of minority interest in regulatory capital at the consolidated level should be limited to prevent highly-capitalized subsidiaries from overstating the amount of capital available to absorb losses at the consolidated organization.

B. Regulatory Adjustments and Deductions

1. Regulatory Deductions From Common Equity Tier 1 Capital

Under the proposal, a banking organization must deduct from common equity tier 1 capital elements the items described in section 22 of the proposed rule. A banking organization would exclude the amount of these deductions from its total risk-weighted assets and leverage exposure. This section B discusses the deductions from regulatory capital elements as revised for purposes of the final rule.

a. Goodwill and Other Intangibles (Other Than Mortgage Servicing Assets)

U.S. federal banking statutes generally prohibit the inclusion of goodwill (as it is an “unidentified intangible asset”) in the regulatory capital of insured depository institutions.[90] Accordingly, goodwill and other intangible assets have long been either fully or partially excluded from regulatory capital in the United States because of the high level of uncertainty regarding the ability of the banking organization to realize value from these assets, especially under Start Printed Page 62056adverse financial conditions.[91] Under the proposed rule, a banking organization was required to deduct from common equity tier 1 capital elements goodwill and other intangible assets other than MSAs [92] net of associated deferred tax liabilities (DTLs). For purposes of this deduction, goodwill would have included any goodwill embedded in the valuation of significant investments in the capital of an unconsolidated financial institution in the form of common stock. This deduction of embedded goodwill would have applied to investments accounted for under the equity method.[93] Consistent with Basel III, these items would have been deducted from common equity tier 1 capital elements. MSAs would have been subject to a different treatment under Basel III and the proposal, as explained below in this section.

One commenter sought clarification regarding the amount of goodwill that must be deducted from common equity tier 1 capital elements when a banking organization has an investment in the capital of an unconsolidated financial institution that is accounted for under the equity method of accounting under GAAP. The agencies have revised section 22(a)(1) in the final rule to clarify that it is the amount of goodwill that is embedded in the valuation of a significant investment in the capital of an unconsolidated financial institution in the form of common stock that is accounted for under the equity method, and reflected in the consolidated financial statements of the banking organization that a banking organization must deduct from common equity tier 1 capital elements.

Another commenter requested clarification regarding the amount of embedded goodwill that a banking organization would be required to deduct where there are impairments to the embedded goodwill subsequent to the initial investment. The agencies note that, for purposes of the final rule, a banking organization must deduct from common equity tier 1 capital elements any embedded goodwill in the valuation of significant investments in the capital of an unconsolidated financial institution in the form of common stock net of any related impairments (subsequent to the initial investment) as determined under GAAP, not the goodwill reported on the balance sheet of the unconsolidated financial institution.

The proposal did not include a transition period for the implementation of the requirement to deduct goodwill from common equity tier 1 capital. A number of commenters expressed concern that this could disadvantage U.S. banking organizations relative to those in jurisdictions that permit such a transition period. The agencies note that section 221 of FIRREA (12 U.S.C. 1828(n)) requires all unidentifiable intangible assets (goodwill) acquired after April 12, 1989, to be deducted from a banking organization's capital elements. The only exception to this requirement, permitted under 12 U.S.C. 1464(t) (applicable to Federal savings association), has expired. Therefore, consistent with the requirements of section 221 of FIRREA and the general risk-based capital rules, the agencies believe that it is not appropriate to permit any goodwill to be included in a banking organization's capital. The final rule does not include a transition period for the deduction of goodwill.

b. Gain-on-Sale Associated With a Securitization Exposure

Under the proposal, a banking organization would deduct from common equity tier 1 capital elements any after-tax gain-on-sale associated with a securitization exposure. Under the proposal, gain-on-sale was defined as an increase in the equity capital of a banking organization resulting from a securitization (other than an increase in equity capital resulting from the banking organization's receipt of cash in connection with the securitization).

A number of commenters requested clarification that the proposed deduction for gain-on-sale would not require a double deduction for MSAs. According to the commenters, a sale of loans to a securitization structure that creates a gain may include an MSA that also meets the proposed definition of “gain-on-sale.” The agencies agree that a double deduction for MSAs is not required, and the final rule clarifies in the definition of “gain-on-sale” that a gain-on-sale excludes any portion of the gain that was reported by the banking organization as an MSA. The agencies also note that the definition of gain-on-sale was intended to relate only to gains associated with the sale of loans for the purpose of traditional securitization. Thus, the definition of gain-on-sale has been revised in the final rule to mean an increase in common equity tier 1 capital of the banking organization resulting from a traditional securitization except where such an increase results from the banking organization's receipt of cash in connection with the securitization or initial recognition of an MSA.

c. Defined Benefit Pension Fund Net Assets

For banking organizations other than insured depository institutions, the proposal required the deduction of a net pension fund asset in calculating common equity tier 1 capital. A banking organization was permitted to make such deduction net of any associated DTLs. This deduction would be required where a defined benefit pension fund is over-funded due to the high level of uncertainty regarding the ability of the banking organization to realize value from such assets. The proposal did not require a BHC or SLHC to deduct the net pension fund asset of its insured depository institution subsidiary.

The proposal provided that, with supervisory approval, a banking organization would not have been required to deduct defined benefit pension fund assets to which the banking organization had unrestricted and unfettered access.[94] In this case, the proposal established that the banking organization would have assigned to such assets the risk weight they would receive if the assets underlying the plan were directly owned and included on the balance sheet of the banking organization. The proposal set forth that unrestricted and unfettered access would mean that a banking organization would not have been required to request and receive specific approval from pension beneficiaries each time it accessed excess funds in the plan.

One commenter asked whether shares of a banking organization that are owned by the banking organization's pension fund are subject to deduction. The agencies note that the final rule does not require deduction of banking organization shares owned by the pension fund. Another commenter asked for clarification regarding the treatment of an overfunded pension asset at an insured depository institution if the pension plan sponsor is the parent BHC. The agencies clarify that the requirement to deduct a defined benefit pension plan net asset is not dependent upon the sponsor of the plan; rather it is dependent upon whether the Start Printed Page 62057net pension fund asset is an asset of an insured depository institution. The agencies and the FDIC also received questions regarding the appropriate risk-weight treatment for a pension fund asset. As discussed above, with the prior agency approval, a banking organization that is not an insured depository institution may elect to not deduct any defined benefit pension fund net asset to the extent such banking organization has unrestricted and unfettered access to the assets in that defined benefit pension fund. Any portion of the defined benefit pension fund net asset that is not deducted by the banking organization must be risk-weighted as if the banking organization directly holds a proportional ownership share of each exposure in the defined benefit pension fund. For example, if the banking organization has a defined benefit pension fund net asset of $10 and it has unfettered and unrestricted access to the assets of defined benefit pension fund, and assuming 20 percent of the defined benefit pension fund is composed of assets that are risk-weighted at 100 percent and 80 percent is composed of assets that are risk-weighted at 300 percent, the banking organization would risk weight $2 at 100 percent and $8 at 300 percent. This treatment is consistent with the full look-through approach described in section 53(b) of the final rule. If the defined benefit pension fund invests in the capital of a financial institution, including an investment in the banking organization's own capital instruments, the banking organization would risk weight the proportional share of such exposure in accordance with the treatment under subparts D or E, as appropriate.

The agencies are adopting as final this section of the proposal with the changes described above.

d. Expected Credit Loss That Exceeds Eligible Credit Reserves

The proposal required an advanced approaches banking organization to deduct from common equity tier 1 capital elements the amount of expected credit loss that exceeds the banking organization's eligible credit reserves.

Commenters sought clarification that the proposed deduction would not apply for advanced approaches banking organizations that have not received the approval of their primary Federal supervisor to exit parallel run. The agencies agree that the deduction would not apply to banking organizations that have not received approval from their primary Federal supervisor to exit parallel run. In response, the agencies have revised this provision of the final rule to apply to a banking organization subject to subpart E of the final rule that has completed the parallel run process and that has received notification from its primary Federal supervisor under section 121(d) of the advanced approaches rule.

e. Equity Investments in Financial Subsidiaries

Section 121 of the Gramm-Leach-Bliley Act allows national banks and insured state banks to establish entities known as financial subsidiaries.[95] One of the statutory requirements for establishing a financial subsidiary is that a national bank or insured state bank must deduct any investment in a financial subsidiary from the depository institution's assets and tangible equity.[96] The agencies implemented this statutory requirement through regulation at 12 CFR 5.39(h)(1) (OCC) and 12 CFR 208.73 (Board).

Under section 22(a)(7) of the proposal, investments by a national bank or insured state bank in financial subsidiaries would be deducted entirely from the bank's common equity tier 1 capital.[97] Because common equity tier 1 capital is a component of tangible equity, the proposed deduction from common equity tier 1 would have automatically resulted in a deduction from tangible equity. The agencies believe that the more conservative treatment is appropriate for financial subsidiaries given the risks associated with nonbanking activities, and are adopting this treatment as proposed. Therefore, under the final rule, a depository institution must deduct the aggregate amount of its outstanding equity investment in a financial subsidiary, including the retained earnings of a subsidiary from common equity tier 1 capital elements, and the assets and liabilities of the subsidiary may not be consolidated with those of the parent bank.

f. Deduction for Subsidiaries of Savings Associations That Engage in Activities That Are Not Permissible for National Banks

Section 5(t)(5) [98] of HOLA requires a separate capital calculation for Federal savings associations for “investments in and extensions of credit to any subsidiary engaged in activities not permissible for a national bank.” This statutory provision was implemented in the Federal savings associations' capital rules through a deduction from the core (tier 1) capital of the Federal savings association for those subsidiaries that are not “includable subsidiaries.” [99]

The OCC proposed to continue the general risk-based capital treatment of includable subsidiaries, with some technical modifications. Aside from those technical modifications, the proposal would have transferred, without substantive change, the current general regulatory treatment of deducting subsidiary investments where a subsidiary is engaged in activities not permissible for a national bank. Such treatment is consistent with how a national bank deducts its equity investments in financial subsidiaries. The FDIC proposed an identical treatment for state savings associations.[100]

The OCC received no comments on this proposed deduction. The final rule adopts the proposal with one change and other minor technical edits, consistent with 12 U.S.C. 1464(t)(5), to clarify that the required deduction for a Federal savings association's investment in a subsidiary that is engaged in activities not permissible for a national bank includes extensions of credit to such a subsidiary.

2. Regulatory Adjustments to Common Equity Tier 1 Capital

a. Accumulated Net Gains and Losses on Certain Cash-Flow Hedges

Consistent with Basel III, under the proposal, a banking organization would have been required to exclude from regulatory capital any accumulated net gains and losses on cash-flow hedges relating to items that are not recognized at fair value on the balance sheet.

This proposed regulatory adjustment was intended to reduce the artificial volatility that can arise in a situation in which the accumulated net gain or loss of the cash-flow hedge is included in regulatory capital but any change in the fair value of the hedged item is not. The agencies and the FDIC received a number of comments on this proposed regulatory capital adjustment. In general, the commenters noted that while the intent of the adjustment is to remove an element that gives rise to artificial volatility in common equity, the proposed adjustment may actually increase volatility in the measure of common equity tier 1 capital. These commenters indicated that the proposed adjustment, together with the proposed treatment of net unrealized gains and losses on AFS debt securities, would create incentives for banking Start Printed Page 62058organizations to avoid hedges that reduce interest rate risk; shorten maturity of their investments in AFS securities; or move their investment securities portfolio from AFS to HTM. To address these concerns, commenters suggested several alternatives, such as including all accumulated net gains and losses on cash-flow hedges in common equity tier 1 capital to match the proposal to include in common equity tier 1 capital net unrealized gains and losses on AFS debt securities; retaining the provisions in the agencies' and the FDIC's general risk-based capital rules that exclude most elements of AOCI from regulatory capital; or using a principles-based approach to accommodate variations in the interest rate management techniques employed by each banking organization.

Under the final rule, the agencies have retained the requirement that all banking organizations subject to the advanced approaches rule, and those banking organizations that elect to include AOCI in common equity tier 1 capital, must subtract from common equity tier 1 capital elements any accumulated net gains and must add any accumulated net losses on cash-flow hedges included in AOCI that relate to the hedging of items that are not recognized at fair value on the balance sheet. The agencies believe that this adjustment removes an element that gives rise to artificial volatility in common equity tier 1 capital as it would avoid a situation in which the changes in the fair value of the cash-flow hedge are reflected in capital but the changes in the fair value of the hedged item are not.

b. Changes in a Banking Organization's Own Credit Risk

The proposal provided that a banking organization would not be permitted to include in regulatory capital any change in the fair value of a liability attributable to changes in the banking organization's own credit risk. In addition, the proposal would have required advanced approaches banking organizations to deduct the credit spread premium over the risk-free rate for derivatives that are liabilities. Consistent with Basel III, these provisions were intended to prevent a banking organization from recognizing increases in regulatory capital resulting from any change in the fair value of a liability attributable to changes in the banking organization's own creditworthiness. Under the final rule, all banking organizations not subject to the advanced approaches rule must deduct any cumulative gain from and add back to common equity tier 1 capital elements any cumulative loss attributed to changes in the value of a liability measured at fair value arising from changes in the banking organization's own credit risk. This requirement would apply to all liabilities that a banking organization must measure at fair value under GAAP, such as derivative liabilities, or for which the banking organization elects to measure at fair value under the fair value option.[101]

Similarly, advanced approaches banking organizations must deduct any cumulative gain from and add back any cumulative loss to common equity tier 1 capital elements attributable to changes in the value of a liability that the banking organization elects to measure at fair value under GAAP. For derivative liabilities, advanced approaches banking organizations must implement this requirement by deducting the credit spread premium over the risk-free rate.

c. Accumulated Other Comprehensive Income

Under the agencies' general risk-based capital rules, most of the components of AOCI included in a company's GAAP equity are not included in a banking organization's regulatory capital. Under GAAP, AOCI includes unrealized gains and losses on certain assets and liabilities that are not included in net income. Among other items, AOCI includes unrealized gains and losses on AFS securities; other than temporary impairment on securities reported as HTM that are not credit-related; cumulative gains and losses on cash-flow hedges; foreign currency translation adjustments; and amounts attributed to defined benefit post-retirement plans resulting from the initial and subsequent application of the relevant GAAP standards that pertain to such plans

Under the agencies' general risk-based capital rules, banking organizations do not include most amounts reported in AOCI in their regulatory capital calculations. Instead, they exclude these amounts by subtracting unrealized or accumulated net gains from, and adding back unrealized or accumulated net losses to, equity capital. The only amounts of AOCI included in regulatory capital are unrealized losses on AFS equity securities and foreign currency translation adjustments, which are included in tier 1 capital. Additionally, banking organizations may include up to 45 percent of unrealized gains on AFS equity securities in their tier 2 capital.

In contrast, consistent with Basel III, the proposed rule required banking organizations to include all AOCI components in common equity tier 1 capital elements, except gains and losses on cash-flow hedges where the hedged item is not recognized on a banking organization's balance sheet at fair value. Unrealized gains and losses on all AFS securities would flow through to common equity tier 1 capital elements, including unrealized gains and losses on debt securities due to changes in valuations that result primarily from fluctuations in benchmark interest rates (for example, U.S. Treasuries and U.S. government agency debt obligations), as opposed to changes in credit risk.

In the Basel III NPR, the agencies and the FDIC indicated that the proposed regulatory capital treatment of AOCI would better reflect an institution's actual risk. In particular, the agencies and the FDIC stated that while unrealized gains and losses on AFS debt securities might be temporary in nature and reverse over a longer time horizon (especially when those gains and losses are primarily attributable to changes in benchmark interest rates), unrealized losses could materially affect a banking organization's capital position at a particular point in time and associated risks should therefore be reflected in its capital ratios. In addition, the agencies and the FDIC observed that the proposed treatment would be consistent with the common market practice of evaluating a firm's capital strength by measuring its tangible common equity, which generally includes AOCI.

However, the agencies and the FDIC also acknowledged that including unrealized gains and losses related to debt securities (especially those whose valuations primarily change as a result of fluctuations in a benchmark interest rate) could introduce substantial volatility in a banking organization's regulatory capital ratios. Specifically, the agencies and the FDIC observed that for some banking organizations, including unrealized losses on AFS debt securities in their regulatory capital calculations could mean that fluctuations in a benchmark interest rate could lead to changes in their PCA categories from quarter to quarter. Recognizing the potential impact of such fluctuations on regulatory capital management for some institutions, the agencies and the FDIC described possible alternatives to the proposed treatment of unrealized gains and losses on AFS debt securities, including an approach that would exclude from regulatory capital calculations those unrealized gains and losses that are Start Printed Page 62059related to AFS debt securities whose valuations primarily change as a result of fluctuations in benchmark interest rates, including U.S. government and agency debt obligations, GSE debt obligations, and other sovereign debt obligations that would qualify for a zero percent risk weight under the standardized approach.

A large proportion of commenters addressed the proposed treatment of AOCI in regulatory capital. Banking organizations of all sizes, banking and other industry groups, public officials (including members of the U.S. Congress), and other individuals strongly opposed the proposal to include most AOCI components in common equity tier 1 capital.

Specifically, commenters asserted that the agencies and the FDIC should not implement the proposal and should instead continue to apply the existing treatment for AOCI that excludes most AOCI amounts from regulatory capital. Several commenters stated that the accounting standards that require banking organizations to take a charge against earnings (and thus reduce capital levels) to reflect credit-related losses as part of other-than-temporary impairments already achieve the agencies' and the FDIC's goal to create regulatory capital ratios that provide an accurate picture of a banking organization's capital position, without also including AOCI in regulatory capital. For unrealized gains and losses on AFS debt securities that typically result from changes in benchmark interest rates rather than changes in credit risk, most commenters expressed concerns that the value of such securities on any particular day might not be a good indicator of the value of those securities for a banking organization, given that the banking organization could hold them until they mature and realize the amount due in full. Most commenters argued that the inclusion of unrealized gains and losses on AFS debt securities in regulatory capital could result in volatile capital levels and adversely affect other measures tied to regulatory capital, such as legal lending limits, especially if and when interest rates rise from their current historically-low levels.

Accordingly, several commenters requested that the agencies and the FDIC permit banking organizations to remove from regulatory capital calculations unrealized gains and losses on AFS debt securities that have low credit risk but experience price movements based primarily on fluctuations in benchmark interest rates. According to commenters, these debt securities would include securities issued by the United States and other stable sovereign entities, U.S. agencies and GSEs, as well as some municipal entities. One commenter expressed concern that the proposed treatment of AOCI would lead banking organizations to invest excessively in securities with low volatility. Some commenters also suggested that unrealized gains and losses on high-quality asset-backed securities and high-quality corporate securities should be excluded from regulatory capital calculations. The commenters argued that these adjustments to the proposal would allow regulatory capital to reflect unrealized gains or losses related to the credit quality of a banking organization's AFS debt securities.

Additionally, commenters noted that, under the proposal, offsetting changes in the value of other items on a banking organization's balance sheet would not be recognized for regulatory capital purposes when interest rates change. For example, the commenters observed that banking organizations often hold AFS debt securities to hedge interest rate risk associated with deposit liabilities, which are not marked to fair value on the balance sheet. Therefore, requiring banking organizations to include AOCI in regulatory capital would mean that interest rate fluctuations would be reflected in regulatory capital only for one aspect of this hedging strategy, with the result that the proposed treatment could greatly overstate the economic impact that interest rate changes have on the safety and soundness of the banking organization.

Several commenters used sample AFS securities portfolio data to illustrate how an upward shift in interest rates could have a substantial impact on a banking organization's capital levels (depending on the composition of its AFS portfolio and its defined benefit postretirement obligations). According to these commenters, the potential negative impact on capital levels that could follow a substantial increase in interest rates would place significant strains on banking organizations.

To address the potential impact of incorporating the volatility associated with AOCI into regulatory capital, banking organizations also noted that they could increase their overall capital levels to create a buffer above regulatory minimums, hedge or reduce the maturities of their AFS debt securities, or shift more debt securities into their HTM portfolio. However, commenters asserted that these strategies would be complicated and costly, especially for smaller banking organizations, and could lead to a significant decrease in lending activity. Many community banking organization commenters observed that hedging or raising additional capital may be especially difficult for banking organizations with limited access to capital markets, while shifting more debt securities into the HTM portfolio would impair active management of interest rate risk positions and negatively impact a banking organization's liquidity position. These commenters also expressed concern that this could be especially problematic given the increased attention to liquidity by banking regulators and industry analysts.

A number of commenters indicated that in light of the potential impact of the proposed treatment of AOCI on a banking organization's liquidity position, the agencies and the FDIC should, at the very least, postpone implementing this aspect of the proposal until after implementation of the BCBS's revised liquidity standards. Commenters suggested that postponing the implementation of the AOCI treatment would help to ensure that the final capital rules do not create disincentives for a banking organization to increase its holdings of high-quality liquid assets. In addition, several commenters suggested that the agencies and the FDIC not require banking organizations to include in regulatory capital unrealized gains and losses on assets that would qualify as “high quality liquid assets” under the BCBS's “liquidity coverage ratio” under the Basel III liquidity framework.

Finally, several commenters addressed the inclusion in AOCI of actuarial gains and losses on defined benefit pension fund obligations. Commenters stated that many banking organizations, particularly mutual banking organizations, offer defined benefit pension plans to attract employees because they are unable to offer stock options to employees. These commenters noted that actuarial gains and losses on defined benefit obligations represent the difference between benefit assumptions and, among other things, actual investment experiences during a given year, which is influenced predominantly by the discount rate assumptions used to determine the value of the plan obligation. The discount rate is tied to prevailing long-term interest rates at a point in time each year, and while market returns on the underlying assets of the plan and the discount rates may fluctuate year to year, the underlying liabilities typically are longer term—in some cases 15 to 20 years. Therefore, changing interest rate environments Start Printed Page 62060could lead to material fluctuations in the value of a banking organization's defined benefit post-retirement fund assets and liabilities, which in turn could create material swings in a banking organization's regulatory capital that would not be tied to changes in the credit quality of the underlying assets. Commenters stated that the added volatility in regulatory capital could lead some banking organizations to reconsider offering defined benefit pension plans.

The agencies have considered the comments on the proposal to incorporate most elements of AOCI in regulatory capital, and have taken into account the potential effects that the proposed AOCI treatment could have on banking organizations and their function in the economy. As discussed in the proposal, the agencies believe that the proposed AOCI treatment results in a regulatory capital measure that better reflects banking organizations' actual risk at a specific point in time. The agencies also believe that AOCI is an important indicator that market observers use to evaluate the capital strength of a banking organization.

However, the agencies recognize that for many banking organizations, the volatility in regulatory capital that could result from the proposal could lead to significant difficulties in capital planning and asset-liability management. The agencies also recognize that the tools used by advanced approaches banking organizations and other larger, more complex banking organizations for managing interest rate risk are not necessarily readily available to all banking organizations.

Therefore, in the final rule, the agencies have decided to permit those banking organizations that are not subject to the advanced approaches risk-based capital rules to elect to calculate regulatory capital by using the treatment for AOCI in the agencies' general risk-based capital rules, which excludes most AOCI amounts. Such banking organizations, may make a one-time, permanent election [102] to effectively continue using the AOCI treatment under the general risk-based capital rules for their regulatory calculations (“AOCI opt-out election”) when filing the Call Report or FR Y-9 series report for the first reporting period after the date upon which they become subject to the final rule.

Pursuant to a separate notice under the Paperwork Reduction Act, the agencies intend to propose revisions to the Call Report and FR Y-9 series report to implement changes in reporting items that would correspond to the final rule. These revisions will include a line item for banking organizations to indicate their AOCI opt-out election in their first regulatory report filed after the date the banking organization becomes subject to the final rule. Information regarding the AOCI opt-out election will be made available to the public and will be reflected on an ongoing basis in publicly-available regulatory reports. A banking organization that does not make an AOCI opt-out election on the Call Report or FR Y-9 series report filed for the first reporting period after the effective date of the final rule must include all AOCI components, except accumulated net gains and losses on cash-flow hedges related to items that are not recognized at fair value on the balance sheet, in regulatory capital elements starting the first quarter in which the banking organization calculates its regulatory capital requirements under the final rule.

Consistent with regulatory capital calculations under the agencies' general risk-based capital rules, a banking organization that makes an AOCI opt-out election under the final rule must adjust common equity tier 1 capital elements by: (1) Subtracting any net unrealized gains and adding any net unrealized losses on AFS securities; (2) subtracting any net unrealized losses on AFS preferred stock classified as an equity security under GAAP and AFS equity exposures; (3) subtracting any accumulated net gains and adding back any accumulated net losses on cash-flow hedges included in AOCI; (4) subtracting amounts attributed to defined benefit postretirement plans resulting from the initial and subsequent application of the relevant GAAP standards that pertain to such plans (excluding, at the banking organization's option, the portion relating to pension assets deducted under section 22(a)(5)); and (5) subtracting any net unrealized gains and adding any net unrealized losses on held-to-maturity securities that are included in AOCI. In addition, consistent with the general risk-based capital rules, the banking organization must incorporate into common equity tier 1 capital any foreign currency translation adjustment. A banking organization may also incorporate up to 45 percent of any net unrealized gains on AFS preferred stock classified as an equity security under GAAP and AFS equity exposures into its tier 2 capital elements. However, the primary Federal supervisor may exclude all or a portion of these unrealized gains from a banking organization's tier 2 capital under the reservation of authority provision of the final rule if the primary Federal supervisor determines that such preferred stock or equity exposures are not prudently valued.

The agencies believe that banking organizations that apply the advanced approaches rule or that have opted to use the advanced approaches rule should already have the systems in place necessary to manage the added volatility resulting from the new AOCI treatment. Likewise, pursuant to the Dodd-Frank Act, these large, complex banking organizations are subject to enhanced prudential standards, including stress-testing requirements, and therefore should be prepared to manage their capital levels through the types of stressed economic environments, including environments with shifting interest rates, that could lead to substantial changes in amounts reported in AOCI. Accordingly, under the final rule, advanced approaches banking organizations will be required to incorporate all AOCI components, except accumulated net gains and losses on cash-flow hedges that relate to items that are not measured at fair value on the balance sheet, into their common equity tier 1 capital elements according to the transition provisions set forth in the final rule.

The final rule additionally provides that in a merger, acquisition, or purchase transaction between two banking organizations that have each made an AOCI opt-out election, the surviving entity will be required to continue with the AOCI opt-out election, unless the surviving entity is an advanced approaches banking organization. Similarly, in a merger, acquisition, or purchase transaction between two banking organizations that have each not made an AOCI opt-out election, the surviving entity must continue implementing such treatment going forward. If an entity surviving a merger, acquisition, or purchase transaction becomes subject to the advanced approaches rule, it is no longer permitted to make an AOCI opt-out election and, therefore, must include most elements of AOCI in regulatory capital in accordance with the final rule.

However, following a merger, acquisition or purchase transaction involving all or substantially all of the assets or voting stock between two banking organizations of which only Start Printed Page 62061one made an AOCI opt-out election (and the surviving entity is not subject to the advanced approaches rule), the surviving entity must decide whether to make an AOCI opt-out election by its first regulatory reporting date following the consummation of the transaction.[103] For example, if all of the equity of a banking organization that has made an AOCI opt-out election is acquired by a banking organization that has not made such an election, the surviving entity may make a new AOCI opt-out election in the Call Report or FR Y-9 series report filed for the first reporting period after the effective date of the merger. The final rule also provides the agencies with discretion to allow a new AOCI opt-out election where a merger, acquisition or purchase transaction between two banking organizations that have made different AOCI opt-out elections does not involve all or substantially all of the assets or voting stock of the purchased or acquired banking organization. In making such a determination, the agencies may consider the terms of the merger, acquisition, or purchase transaction, as well as the extent of any changes to the risk profile, complexity, and scope of operations of the banking organization resulting from the merger, acquisition, or purchase transaction. The agencies may also look to the Bank Merger Act [104] for guidance on the types of transactions that would allow the surviving entity to make a new AOCI opt-out election. Finally, a de novo banking organization formed after the effective date of the final rule is required to make a decision to opt out in the first Call Report or FR Y-9 series report it is required to file.

The final rule also provides that if a top-tier depository institution holding company makes an AOCI opt-out election, any subsidiary insured depository institution that is consolidated by the depository institution holding company also must make an AOCI opt-out election. The agencies are concerned that if some banking organizations subject to regulatory capital rules under a common parent holding company make an AOCI opt-out election and others do not, there is a potential for these organizations to engage in capital arbitrage by choosing to book exposures or activities in the legal entity for which the relevant components of AOCI are treated most favorably.

Notwithstanding the availability of the AOCI opt-out election under the final rule, the agencies have reserved the authority to require a banking organization to recognize all or some components of AOCI in regulatory capital if an agency determines it would be appropriate given a banking organization's risks under the agency's general reservation of authority under the final rule. The agencies will continue to expect each banking organization to maintain capital appropriate for its actual risk profile, regardless of whether it has made an AOCI opt-out election. Therefore, the agencies may determine that a banking organization with a large portfolio of AFS debt securities, or that is otherwise engaged in activities that expose it to high levels of interest-rate or other risks, should raise its common equity tier 1 capital level substantially above the regulatory minimums, regardless of whether that banking organization has made an AOCI opt-out election.

d. Investments in Own Regulatory Capital Instruments

To avoid the double-counting of regulatory capital, the proposal would have required a banking organization to deduct the amount of its investments in its own capital instruments, including direct and indirect exposures, to the extent such instruments are not already excluded from regulatory capital. Specifically, the proposal would require a banking organization to deduct its investment in its own common equity tier 1, additional tier 1, and tier 2 capital instruments from the sum of its common equity tier 1, additional tier 1, and tier 2 capital, respectively. In addition, under the proposal any common equity tier 1, additional tier 1, or tier 2 capital instrument issued by a banking organization that the banking organization could be contractually obligated to purchase also would have been deducted from common equity tier 1, additional tier 1, or tier 2 capital elements, respectively. The proposal noted that if a banking organization had already deducted its investment in its own capital instruments (for example, treasury stock) from its common equity tier 1 capital, it would not need to make such deductions twice.

The proposed rule would have required a banking organization to look through its holdings of an index to deduct investments in its own capital instruments. Gross long positions in investments in its own regulatory capital instruments resulting from holdings of index securities would have been netted against short positions in the same underlying index. Short positions in indexes to hedge long cash or synthetic positions could have been decomposed to recognize the hedge. More specifically, the portion of the index composed of the same underlying exposure that is being hedged could have been used to offset the long position only if both the exposure being hedged and the short position in the index were covered positions under the market risk rule and the hedge was deemed effective by the banking organization's internal control processes which would have been assessed by the primary Federal supervisor of the banking organization. If the banking organization found it operationally burdensome to estimate the investment amount of an index holding, the proposal permitted the institution to use a conservative estimate with prior approval from its primary Federal supervisor. In all other cases, gross long positions would have been allowed to be deducted net of short positions in the same underlying instrument only if the short positions involved no counterparty risk (for example, the position was fully collateralized or the counterparty is a qualifying central counterparty (QCCP)).

As discussed above, under the proposal, a banking organization would be required to look through its holdings of an index security to deduct investments in its own capital instruments. Some commenters asserted that the burden of the proposed look-through approach outweighs its benefits because it is not likely a banking organization would re-purchase its own stock through such indirect means. These commenters suggested that the agencies and the FDIC should not require a look-through test for index securities on the grounds that they are not “covert buybacks,” but rather are incidental positions held within a banking organization's trading book, often entered into on behalf of clients, customers or counterparties, and are economically hedged. However, the agencies believe that it is important to avoid the double-counting of regulatory capital, whether held directly or indirectly. Therefore, the final rule implements the look-through requirements of the proposal without change. In addition, consistent with the treatment for indirect investments in a banking organization's own capital Start Printed Page 62062instruments, the agencies have clarified in the final rule that banking organizations must deduct synthetic exposures related to investments in own capital instruments.

e. Definition of Financial Institution

Under the proposed rule, a banking organization would have been required to deduct an investment in the capital of an unconsolidated financial institution exceeding certain thresholds, as described below. The proposed definition of financial institution was designed to include entities whose activities and primary business are financial in nature and therefore could contribute to interconnectedness in the financial system. The proposed definition covered entities whose primary business is banking, insurance, investing, and trading, or a combination thereof, and included BHCs, SLHCs, nonbank financial institutions supervised by the Board under Title I of the Dodd-Frank Act, depository institutions, foreign banks, credit unions, insurance companies, securities firms, commodity pools, covered funds for purposes of section 13 of the Bank Holding Company Act and regulations issued thereunder, companies “predominantly engaged” in financial activities, non-U.S.-domiciled entities that would otherwise have been covered by the definition if they were U.S.-domiciled, and any other company that the agencies and the FDIC determined was a financial institution based on the nature and scope of its activities. The definition excluded GSEs and firms that were “predominantly engaged” in activities that are financial in nature but focus on community development, public welfare projects, and similar objectives. Under the proposed definition, a company would have been “predominantly engaged” in financial activities if (1) 85 percent or more of the total consolidated annual gross revenues (as determined in accordance with applicable accounting standards) of the company in either of the two most recent calendar years were derived, directly or indirectly, by the company on a consolidated basis from the activities; or (2) 85 percent or more of the company's consolidated total assets (as determined in accordance with applicable accounting standards) as of the end of either of the two most recent calendar years were related to the activities.

The proposed definition of “financial institution” was also relevant for purposes of the Advanced Approaches NPR. Specifically, the proposed rule would have required banking organizations to apply a multiplier of 1.25 to the correlation factor for wholesale exposures to unregulated financial institutions that generate a majority of their revenue from financial activities. The proposed rule also would have required advanced approaches banking organizations to apply a multiplier of 1.25 to wholesale exposures to regulated financial institutions with consolidated assets greater than or equal to $100 billion.[105]

The agencies and the FDIC received a number of comments on the proposed definition of “financial institution.” Commenters expressed concern that the definition of a financial institution was overly broad and stated that it should not include investments in funds, commodity pools, or ERISA plans. Other commenters stated that the “predominantly engaged” test would impose significant operational burdens on banking organizations in determining what companies would be included in the proposed definition of “financial institution.” Commenters suggested that the agencies and the FDIC should risk weight such exposures, rather than subjecting them to a deduction from capital based on the definition of financial institution.

Some of the commenters noted that many of the exposures captured by the financial institution definition may be risk-weighted under certain circumstances, and expressed concerns that overlapping regulation would result in confusion. For similar reasons, commenters recommended that the agencies and the FDIC limit the definition of financial institution to specific enumerated entities, such as regulated financial institutions, including insured depository institutions and holding companies, nonbank financial companies designated by the Financial Stability Oversight Council, insurance companies, securities holding companies, foreign banks, securities firms, futures commission merchants, swap dealers, and security based swap dealers. Other commenters stated that the definition should cover only those entities subject to consolidated regulatory capital requirements. Commenters also encouraged the agencies and the FDIC to adopt alternatives to the “predominantly engaged” test for identifying a financial institution, such as the use of standard industrial classification codes or legal entity identifiers. Other commenters suggested that the agencies and the FDIC should limit the application of the “predominantly engaged” test in the definition of “financial institution” to companies above a specified size threshold. Similarly, others requested that the agencies and the FDIC exclude any company with total assets of less than $50 billion. Many commenters indicated that the broad definition proposed by the agencies and the FDIC was not required by Basel III and was unnecessary to promote systemic stability and avoid interconnectivity. Some commenters stated that funds covered by Section 13 of the Bank Holding Company Act also should be excluded. Other commenters suggested that the agencies and the FDIC should exclude investment funds registered with the SEC under the Investment Company Act of 1940 and their foreign equivalents, while some commenters suggested methods of narrowing the definition to cover only leveraged funds. Commenters also requested that the agencies and the FDIC clarify that investment or financial advisory activities include providing both discretionary and non-discretionary investment or financial advice to customers, and that the definition would not capture either registered investment companies or investment advisers to registered funds.

After considering the comments, the agencies have modified the definition of “financial institution” to provide more clarity around the scope of the definition as well as reduce operational burden. Separate definitions are adopted under the advanced approaches provisions of the final rule for “regulated financial institution” and “unregulated financial institution” for purposes of calculating the correlation factor for wholesale exposures, as discussed in section XII.A of this preamble.

Under the final rule, the first paragraph of the definition of a financial institution includes an enumerated list of regulated institutions similar to the list that appeared in the first paragraph of the proposed definition: A BHC; SLHC; nonbank financial institution supervised by the Board under Title I of the Dodd-Frank Act; depository institution; foreign bank; credit union; industrial loan company, industrial bank, or other similar institution described in section 2 of the Bank Holding Company Act; national association, state member bank, or state Start Printed Page 62063nonmember bank that is not a depository institution; insurance company; securities holding company as defined in section 618 of the Dodd-Frank Act; broker or dealer registered with the SEC; futures commission merchant and swap dealer, each as defined in the Commodity Exchange Act; or security-based swap dealer; or any designated financial market utility (FMU). The definition also includes foreign companies that would be covered by the definition if they are supervised and regulated in a manner similar to the institutions described above that are included in the first paragraph of the definition of “financial institution.” The agencies also have retained in the final definition of “financial institution” a modified version of the proposed “predominantly engaged” test to capture additional entities that perform certain financial activities that the agencies believe appropriately addresses those relationships among financial institutions that give rise to concerns about interconnectedness, while reducing operational burden. Consistent with the proposal, a company is “predominantly engaged” in financial activities for the purposes of the definition if it meets the test to the extent the following activities make up more than 85 percent of the company's total assets or gross revenues:

(1) Lending money, securities or other financial instruments, including servicing loans;

(2) Insuring, guaranteeing, indemnifying against loss, harm, damage, illness, disability, or death, or issuing annuities;

(3) Underwriting, dealing in, making a market in, or investing as principal in securities or other financial instruments; or

(4) Asset management activities (not including investment or financial advisory activities).

In response to comments expressing concerns regarding operational burden and potential lack of access to necessary information in applying the proposed “predominantly engaged” test, the agencies have revised that portion of the definition. Now, the banking organization would only apply the test if it has an investment in the GAAP equity instruments of the company with an adjusted carrying value or exposure amount equal to or greater than $10 million, or if it owns more than 10 percent of the company's issued and outstanding common shares (or similar equity interest). The agencies believe that this modification would reduce burden on banking organizations with small exposures, while those with larger exposures should have sufficient information as a shareholder to conduct the predominantly engaged analysis.[106]

In cases when a banking organization's investment in the banking organization exceeds one of the thresholds described above, the banking organization must determine whether the company is predominantly engaged in financial activities, in accordance with the final rule. The agencies believe that this modification will substantially reduce operational burden for banking organizations with investments in multiple institutions. The agencies also believe that an investment of $10 million in or a holding of 10 percent of the outstanding common shares (or equivalent ownership interest) of an entity has the potential to create a risk of interconnectedness, and also makes it reasonable for the banking organization to gain information necessary to understand the operations and activities of the company in which it has invested and to apply the proposed “predominantly engaged” test under the definition. The agencies are clarifying that, consistent with the proposal, investment or financial advisers (whether they provide discretionary or non-discretionary advisory services) are not covered under the definition of financial institution. The revised definition also specifically excludes employee benefit plans. The agencies believe, upon review of the comments, that employee benefit plans are heavily regulated under ERISA and do not present the same kind of risk of systemic interconnectedness that the enumerated financial institutions present. The revised definition also explicitly excludes investment funds registered with the SEC under the Investment Company Act of 1940, as the agencies believe that such funds create risks of systemic interconnectedness largely through their investments in the capital of financial institutions. These investments are addressed directly by the final rule's treatment of indirect investments in financial institutions. Although the revised definition does not specifically include commodities pools, under some circumstances a banking organization's investment in a commodities pool might meet the requirements of the modified “predominantly engaged” test.

Some commenters also requested that the agencies and the FDIC establish an asset threshold below which an entity would not be included in the definition of “financial institution.” The agencies have not included such a threshold because they are concerned that it could create an incentive for multiple investments and aggregated exposures in smaller financial institutions, thereby undermining the rationale underlying the treatment of investments in the capital of unconsolidated financial institutions. The agencies believe that the definition of financial institution appropriately captures both large and small entities engaged in the core financial activities that the agencies believe should be addressed by the definition and associated deductions from capital. The agencies believe, however, that the modification to the “predominantly engaged” test, should serve to alleviate some of the burdens with which the commenters who made this point were concerned.

Consistent with the proposal, investments in the capital of unconsolidated financial institutions that are held indirectly (indirect exposures) are subject to deduction. Under the proposal, a banking organization's entire investment in, for example, a registered investment company would have been subject to deduction from capital. Although those entities are excluded from the definition of financial institution in the final rule unless the ownership threshold is met, any holdings in the capital instruments of financial institutions held indirectly through investment funds are subject to deduction from capital. More generally, and as described later in this section of the preamble, the final rule provides an explicit mechanism for calculating the amount of an indirect investment subject to deduction.

f. The Corresponding Deduction Approach

The proposals incorporated the Basel III corresponding deduction approach for the deductions from regulatory capital related to reciprocal crossholdings, non-significant investments in the capital of unconsolidated financial institutions, and non-common stock significant investments in the capital of unconsolidated financial institutions. Under the proposal, a banking organization would have been required to make any such deductions from the same component of capital for which the underlying instrument would qualify if it were issued by the banking organization itself. If a banking organization did not have a sufficient amount of a specific regulatory capital component against which to effect the deduction, the shortfall would have Start Printed Page 62064been deducted from the next higher (that is, more subordinated) regulatory capital component. For example, if a banking organization did not have enough additional tier 1 capital to satisfy the required deduction, the shortfall would be deducted from common equity tier 1 capital elements.

Under the proposal, if the banking organization invested in an instrument issued by an financial institution that is not a regulated financial institution, the banking organization would have treated the instrument as common equity tier 1 capital if the instrument is common stock (or if it is otherwise the most subordinated form of capital of the financial institution) and as additional tier 1 capital if the instrument is subordinated to all creditors of the financial institution except common shareholders. If the investment is in the form of an instrument issued by a regulated financial institution and the instrument does not meet the criteria for any of the regulatory capital components for banking organizations, the banking organization would treat the instrument as: (1) Common equity tier 1 capital if the instrument is common stock included in GAAP equity or represents the most subordinated claim in liquidation of the financial institution; (2) additional tier 1 capital if the instrument is GAAP equity and is subordinated to all creditors of the financial institution and is only senior in liquidation to common shareholders; and (3) tier 2 capital if the instrument is not GAAP equity but it is considered regulatory capital by the primary supervisor of the financial institution.

Some commenters sought clarification on whether, under the corresponding deduction approach, TruPS would be deducted from tier 1 or tier 2 capital. In response to these comments the agencies have revised the final rule to clarify the deduction treatment for investments of non-qualifying capital instruments, including TruPS, under the corresponding deduction approach. The final rule includes a new paragraph section 22(c)(2)(iii) to provide that if an investment is in the form of a non-qualifying capital instrument described in section 300(d) of the final rule, the banking organization must treat the instrument as a: (1) Tier 1 capital instrument if it was included in the issuer's tier 1 capital prior to May 19, 2010; or (2) tier 2 capital instrument if it was included in the issuer's tier 2 capital (but not eligible for inclusion in the issuer's tier 1 capital) prior to May 19, 2010.

In addition, to avoid a potential circularity issue (related to the combined impact of the treatment of ALLL and the risk-weight treatment for threshold items that are not deducted from common equity tier 1 capital) in the calculation of common equity tier 1 capital, the final rule clarifies that banking organizations must apply any deductions under the corresponding deduction approach resulting from insufficient amounts of a specific regulatory capital component after applying any deductions from the items subject to the 10 and 15 percent common equity tier 1 capital deduction thresholds discussed further below. This was accomplished by removing proposed paragraph 22(c)(2)(i) from the corresponding deduction approach section and inserting paragraph 22(f). Under section 22(f) of the final rule, and as noted above, if a banking organization does not have a sufficient amount of a specific component of capital to effect the required deduction under the corresponding deduction approach, the shortfall must be deducted from the next higher (that is, more subordinated) component of regulatory capital.

g. Reciprocal Crossholdings in the Capital Instruments of Financial Institutions

A reciprocal crossholding results from a formal or informal arrangement between two financial institutions to swap, exchange, or otherwise intend to hold each other's capital instruments. The use of reciprocal crossholdings of capital instruments to artificially inflate the capital positions of each of the financial institutions involved would undermine the purpose of regulatory capital, potentially affecting the stability of such financial institutions as well as the financial system.

Under the agencies' general risk-based capital rules, reciprocal crossholdings of capital instruments of banking organizations are deducted from regulatory capital. Consistent with Basel III, the proposal would have required a banking organization to deduct reciprocal crossholdings of capital instruments of other financial institutions using the corresponding deduction approach. The final rule maintains this treatment.

h. Investments in the Banking Organization's Own Capital Instruments or in the Capital of Unconsolidated Financial Institutions

In the final rule, the agencies made several non-substantive changes to the wording in the proposal to clarify that the amount of an investment in the banking organization's own capital instruments or in the capital of unconsolidated financial institutions is the net long position (as calculated under section 22(h) of the final rule) of such investments. The final rule also clarifies how to calculate the net long position of these investments, especially for the case of indirect exposures. It is the net long position that is subject to deduction. In addition, the final rule generally harmonizes the recognition of hedging for own capital instruments and for investments in the capital of unconsolidated financial institutions. Under the final rule, an investment in a banking organization's own capital instrument is deducted from regulatory capital and an investment in the capital of an unconsolidated financial institution is subject to deduction from regulatory capital if such investment exceeds certain thresholds.

An investment in the capital of an unconsolidated financial institution refers to the net long position (calculated in accordance with section 22(h) of the final rule) in an instrument that is recognized as capital for regulatory purposes by the primary supervisor of an unconsolidated regulated financial institution or in an instrument that is part of GAAP equity of an unconsolidated unregulated financial institution. It includes direct, indirect, and synthetic exposures to capital instruments, and excludes underwriting positions held by a banking organization for fewer than five business days.

An investment in the banking organization's own capital instrument means a net long position calculated in accordance with section 22(h) of the final rule in the banking organization's own common stock instrument, own additional tier 1 capital instrument or own tier 2 capital instrument, including direct, indirect or synthetic exposures to such capital instruments. An investment in the banking organization's own capital instrument includes any contractual obligation to purchase such capital instrument.

The final rule also clarifies that the gross long position for an investment in the banking organization's own capital instrument or the capital of an unconsolidated financial institution that is an equity exposure refers to the adjusted carrying value (determined in accordance with section 51(b) of the final rule). For the case of an investment in the banking organization's own capital instrument or the capital of an unconsolidated financial institution that is not an equity exposure, the gross long position is defined as the exposure amount (determined in accordance with section 2 of the final rule).

Under the proposal, the agencies and the FDIC included the methodology for Start Printed Page 62065the recognition of hedging and for the calculation of the net long position regarding investments in the banking organization's own capital instruments and in investments in the capital of unconsolidated financial institutions in the definitions section. However, such methodology appears in section 22 of the final rule as the agencies believe it is more appropriate to include it in the adjustments and deductions to regulatory capital section.

The final rule provides that the net long position is the gross long position in the underlying instrument (including covered positions under the market risk rule) net of short positions in the same instrument where the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least one year. A banking organization may only net a short position against a long position in the banking organization's own capital instrument if the short position involves no counterparty credit risk. The long and short positions in the same index without a maturity date are considered to have matching maturities. If both the long position and the short position do not have contractual maturity dates, then the positions are considered maturity-matched. For positions that are reported on a banking organization's regulatory report as trading assets or trading liabilities, if the banking organization has a contractual right or obligation to sell a long position at a specific point in time, and the counterparty to the contract has an obligation to purchase the long position if the banking organization exercises its right to sell, this point in time may be treated as the maturity of the long position. Therefore, if these conditions are met, the maturity of the long position and the short position would be deemed to be matched even if the maturity of the short position is less than one year.

Gross long positions in own capital instruments or in the capital instruments of unconsolidated financial institutions resulting from positions in an index may be netted against short positions in the same underlying index. Short positions in indexes that are hedging long cash or synthetic positions may be decomposed to recognize the hedge. More specifically, the portion of the index that is composed of the same underlying exposure that is being hedged may be used to offset the long position, provided both the exposure being hedged and the short position in the index are trading assets or trading liabilities, and the hedge is deemed effective by the banking organization's internal control processes, which the banking organization's primary Federal supervisor has found not to be inadequate.

An indirect exposure results from a banking organization's investment in an investment fund that has an investment in the banking organization's own capital instrument or the capital of an unconsolidated financial institution. A synthetic exposure results from a banking organization's investment in an instrument where the value of such instrument is linked to the value of the banking organization's own capital instrument or a capital instrument of a financial institution. Examples of indirect and synthetic exposures include: (1) An investment in the capital of an investment fund that has an investment in the capital of an unconsolidated financial institution; (2) a total return swap on a capital instrument of the banking organization or another financial institution; (3) a guarantee or credit protection, provided to a third party, related to the third party's investment in the capital of another financial institution; (4) a purchased call option or a written put option on the capital instrument of another financial institution; (5) a forward purchase agreement on the capital of another financial institution; and (6) a trust preferred security collateralized debt obligation (TruPS CDO).

Investments, including indirect and synthetic exposures, in the capital of unconsolidated financial institutions are subject to the corresponding deduction approach if they surpass certain thresholds described below. With the prior written approval of the primary Federal supervisor, for the period of time stipulated by the supervisor, a banking organization is not required to deduct investments in the capital of unconsolidated financial institutions described in this section if the investment is made in connection with the banking organization providing financial support to a financial institution in distress, as determined by the supervisor. Likewise, a banking organization that is an underwriter of a failed underwriting can request approval from its primary Federal supervisor to exclude underwriting positions related to such failed underwriting held for longer than five days.

Some commenters requested clarification that a long position and short hedging position are considered “maturity matched” if (1) the maturity period of the short position extends beyond the maturity period of the long position or (2) both long and short positions mature or terminate within the same calendar quarter. The agencies note that they concur with these commenters' interpretation of the maturity matching of long and short hedging positions.

For purposes of calculating the net long position in the capital of an unconsolidated financial institution, several commenters expressed concern that allowing banking organizations to net gross long positions with short positions only where the maturity of the short position either matches the maturity of the long position or has a maturity of at least one year is not practical, as some exposures, such as cash equities, have no maturity. These commenters expressed concern that such a maturity requirement could result in banking organizations deducting equities held as hedges for equity swap transactions with a client, making the latter transactions uneconomical and resulting in disruptions to market activity. Similarly, these commenters argued that providing customer accommodation equity swaps could become burdensome as a strict reading of the proposal could affect the ability of banking organizations to offset the equity swap with the long equity position because the maturity of the equity swap is typically less than one year. The agencies have considered the comments and have decided to retain the maturity requirement as proposed. The agencies believe that the proposed maturity requirements will reduce the possibility of “cliff effects” resulting from the deduction of open equity positions when a banking organization is unable to replace the hedge or sell the long equity position.

i. Indirect Exposure Calculations

The proposal provided that an indirect exposure would result from a banking organization's investment in an unconsolidated entity that has an exposure to a capital instrument of a financial institution, while a synthetic exposure would result from the banking organization's investment in an instrument where the value of such instrument is linked to the value of a capital instrument of a financial institution. With the exception of index securities, the proposal did not, however, provide a mechanism for calculating the amount of the indirect exposure that is subject to deduction. The final rule clarifies the methodologies for calculating the net long position related to an indirect exposure (which is subject to deduction under the final rule) by providing a methodology for calculating the gross long position of such indirect exposure. Start Printed Page 62066The agencies believe that the options provided in the final rule will provide banking organizations with increased clarity regarding the treatment of indirect exposures, as well as increased risk-sensitivity to the banking organization's actual potential exposure.

In order to limit the potential difficulties in determining whether an unconsolidated entity in fact holds the banking organization's own capital or the capital of unconsolidated financial institutions, the final rule also provides that the indirect exposure requirements only apply when the banking organization holds an investment in an investment fund, as defined in the rule. Accordingly, a banking organization invested in, for example, a commercial company is not required to determine whether the commercial company has any holdings of the banking organization's own capital or the capital instruments of financial institutions.

The final rule provides that a banking organization may determine that its gross long position is equivalent to its carrying value of its investment in an investment fund that holds the banking organization's own capital or that holds an investment in the capital of an unconsolidated financial institution, which would be subject to deduction according to section 22(c). Recognizing, however, that the banking organization's exposure to those capital instruments may be less than its carrying value of its investment in the investment fund, the final rule provides two alternatives for calculating the gross long position of an indirect exposure. For an indirect exposure resulting from a position in an index, a banking organization may, with the prior approval of its primary Federal supervisor, use a conservative estimate of the amount of its investment in its own capital instruments or the capital instruments of other financial institutions. If the investment is held through an investment fund, a banking organization may use a look-through approach similar to the approach used for risk weighting equity exposures to investment funds. Under this approach, a banking organization may multiply the carrying value of its investment in an investment fund by either the exact percentage of the banking organization's own capital instrument or capital instruments of unconsolidated financial institutions held by the investment fund or by the highest stated prospectus limit for such investments held by the investment fund. Accordingly, if a banking organization with a carrying value of $10,000 for its investment in an investment fund knows that the investment fund has invested 30 percent of its assets in the capital of financial institutions, then the banking organization could subject $3,000 (the carrying value times the percentage invested in the capital of financial institutions) to deduction from regulatory capital. The agencies believe that the approach is flexible and benefits a banking organization that obtains and maintains information about its investments through investment funds. It also provides a simpler calculation method for a banking organization that either does not have information about the holdings of the investment fund or chooses not to do the more complex calculation.

j. Non-Significant Investments in the Capital of Unconsolidated Financial Institutions

The proposal provided that non-significant investments in the capital of unconsolidated financial institutions would be the net long position in investments where a banking organization owns 10 percent or less of the issued and outstanding common stock of an unconsolidated financial institution.

Under the proposal, if the aggregate amount of a banking organization's non-significant investments in the capital of unconsolidated financial institutions exceeds 10 percent of the sum of the banking organization's own common equity tier 1 capital, minus certain applicable deductions and other regulatory adjustments to common equity tier 1 capital (the 10 percent threshold for non-significant investments), the banking organization would have been required to deduct the amount of the non-significant investments that are above the 10 percent threshold for non-significant investments, applying the corresponding deduction approach.[107]

Under the proposal, the amount to be deducted from a specific capital component would be equal to the amount of a banking organization's non-significant investments in the capital of unconsolidated financial institutions exceeding the 10 percent threshold for non-significant investments multiplied by the ratio of: (1) The amount of non-significant investments in the capital of unconsolidated financial institutions in the form of such capital component to (2) the amount of the banking organization's total non-significant investments in the capital of unconsolidated financial institutions. The amount of a banking organization's non-significant investments in the capital of unconsolidated financial institutions that does not exceed the 10 percent threshold for non-significant investments would, under the proposal, generally be assigned the applicable risk weight under section 32 or section 131, as applicable (in the case of non-common stock instruments), section 52 or section 152, as applicable (in the case of common stock instruments), or section 53, section 154, as applicable (in the case of indirect investments via an investment fund), or, in the case of a covered position, in accordance with subpart F, as applicable.

One commenter requested clarification that a banking organization would not have to take a “double deduction” for an investment made in unconsolidated financial institutions held through another unconsolidated financial institution in which the banking organization has invested. The agencies note that, under the final rule, where a banking organization has an investment in an unconsolidated financial institution (Institution A) and Institution A has an investment in another unconsolidated financial institution (Institution B), the banking organization would not be deemed to have an indirect investment in Institution B for purposes of the final rule's capital thresholds and deductions because the banking organization's investment in Institution A is already subject to capital thresholds and deductions. However, if a banking organization has an investment in an investment fund that does not meet the definition of a financial institution, it must consider the assets of the investment fund to be indirect holdings.

Some commenters requested clarification that the deductions for non-significant investments in the capital of unconsolidated financial institutions may be net of associated DTLs. The agencies have clarified in the final rule that a banking organization must deduct the net long position in non-significant investments in the capital of unconsolidated financial institutions, Start Printed Page 62067net of associated DTLs in accordance with section 22(e) of the final rule, that exceeds the 10 percent threshold for non-significant investments. Under section 22(e) of the final rule, the netting of DTLs against assets that are subject to deduction or fully deducted under section 22 of the final rule is permitted but not required.

Other commenters asked the agencies and the FDIC to confirm that the proposal would not require that investments in TruPS CDOs be treated as investments in the capital of unconsolidated financial institutions, but rather treat the investments as securitization exposures. The agencies believe that investments in TruPS CDOs are synthetic exposures to the capital of unconsolidated financial institutions and are thus subject to deduction. Under the final rule, any amounts of TruPS CDOs that are not deducted are subject to the securitization treatment.

k. Significant Investments in the Capital of Unconsolidated Financial Institutions That Are Not in the Form of Common Stock

Under the proposal, a significant investment in the capital of an unconsolidated financial institution would be the net long position in an investment where a banking organization owns more than 10 percent of the issued and outstanding common stock of the unconsolidated financial institution. Significant investments in the capital of unconsolidated financial institutions that are not in the form of common stock are investments where the banking organization owns capital of an unconsolidated financial institution that is not in the form of common stock in addition to 10 percent of the issued and outstanding common stock of that financial institution. Such a non-common stock investment would be deducted by applying the corresponding deduction approach. Significant investments in the capital of unconsolidated financial institutions that are in the form of common stock would be subject to 10 and 15 percent common equity tier 1 capital threshold deductions described below in this section.

A number of commenters sought clarification as to whether under section 22(c) of the proposal, a banking organization may deduct any significant investments in the capital of unconsolidated financial institutions that are not in the form of common stock net of associated DTLs. The final rule clarifies that such deductions may be net of associated DTLs in accordance with paragraph 22(e) of the final rule. Other than this revision, the final rule adopts the proposed rule.

More generally, commenters also sought clarification on the treatment of investments in the capital of unconsolidated financial institutions (for example, the distinction between significant and non-significant investments). Thus, the chart below summarizes the treatment of investments in the capital of unconsolidated financial institutions.

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l. Items Subject to the 10 and 15 Percent Common Equity Tier 1 Capital Threshold Deductions

Under the proposal, a banking organization would have deducted from the sum of its common equity tier 1 capital elements the amount of each of the following items that individually exceeds the 10 percent common equity tier 1 capital deduction threshold described below: (1) DTAs arising from temporary differences that could not be realized through net operating loss carrybacks (net of any related valuation allowances and net of DTLs, as described in section 22(e) of the proposal); (2) MSAs, net of associated DTLs in accordance with section 22(e) of the proposal; and (3) significant investments in the capital of unconsolidated financial institutions in the form of common stock (referred to herein as items subject to the threshold deductions).

Under the proposal, a banking organization would have calculated the 10 percent common equity tier 1 capital deduction threshold by taking 10 percent of the sum of a banking organization's common equity tier 1 elements, less adjustments to, and deductions from common equity tier 1 capital required under sections 22(a) through (c) of the proposal.

As mentioned above in section V.B, under the proposal banking organizations would have been required to deduct from common equity tier 1 capital any goodwill embedded in the valuation of significant investments in the capital of unconsolidated financial institutions in the form of common stock. A banking organization would have been allowed to reduce the investment amount of such significant investment by the goodwill embedded in such investment. For example, if a banking organization has deducted $10 of goodwill embedded in a $100 significant investment in the capital of an unconsolidated financial institution in the form of common stock, the banking organization would be allowed to reduce the investment amount of such significant investment by the amount of embedded goodwill (that is, the value of the investment would be $90 for purposes of the calculation of the amount that would be subject to deduction under this part of the proposal).

In addition, under the proposal the aggregate amount of the items subject to the threshold deductions that are not deducted as a result of the 10 percent common equity tier 1 capital deduction threshold described above must not exceed 15 percent of a banking organization's common equity tier 1 capital, as calculated after applying all regulatory adjustments and deductions required under the proposal (the 15 percent common equity tier 1 capital deduction threshold). That is, a banking organization would have been required to deduct in full the amounts of the items subject to the threshold deductions on a combined basis that exceed 17.65 percent (the proportion of 15 percent to 85 percent) of common equity tier 1 capital elements, less all regulatory adjustments and deductions required for the calculation of the 10 percent common equity tier 1 capital deduction threshold mentioned above, and less the items subject to the 10 and 15 percent deduction thresholds. As described below, the proposal required a banking organization to include the amounts of these three items that are not deducted from common equity tier 1 capital in its risk-weighted assets and assign a 250 percent risk weight to them.

Some commenters asserted that subjecting DTAs resulting from net unrealized losses in an investment portfolio to the proposed 10 percent common equity tier 1 capital deduction threshold under section 22(d) of the proposal would result in a “double deduction” in that the net unrealized losses would have already been included in common equity tier 1 through the AOCI treatment. Under GAAP, net unrealized losses recognized in AOCI are reported net of tax effects (that is, taxes that give rise to DTAs). The tax effects related to net unrealized losses would reduce the amount of net unrealized losses reflected in common equity tier 1 capital. Given that the tax effects reduce the losses that would otherwise accrue to common equity tier 1 capital, the agencies are of the view that subjecting these DTAs to the 10 percent limitation would not result in a “double deduction.”

More generally, several commenters noted that the proposed 10 and 15 percent common equity tier 1 capital deduction thresholds and the proposed 250 percent risk-weight are unduly punitive. Commenters recommended several alternatives including, for example, that the agencies and the FDIC should only retain the 10 percent limit on each threshold item but eliminate the 15 percent aggregate limit. The agencies believe that the proposed thresholds are appropriate as they increase the quality and loss-absorbency of regulatory capital, and are therefore adopting the proposed deduction thresholds as final. The agencies realize that these stricter limits on threshold items may require banking organizations to make appropriate changes in their capital structure or business model, and thus have provided a lengthy transition period to allow banking organizations to adequately plan for the new limits.

Under section 475 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) (12 U.S.C. 1828 note), the amount of readily marketable purchased mortgage servicing rights (PMSRs) that a banking organization may include in regulatory capital cannot be more than 90 percent of their fair value. In addition to this statutory requirement, the general risk-based capital rules require the same treatment for all MSAs, including PMSRs. Under the proposed rule, if the amount of MSAs a banking organization deducts after applying the 10 percent and 15 percent common equity tier 1 deduction threshold is less than 10 percent of the fair value of its MSAs, then the banking organization would have deducted an additional amount of MSAs so that the total amount of MSAs deducted is at least 10 percent of the fair value of its MSAs.

Some commenters requested removal of the 90 percent MSA fair value limitation, including for PMSRs under FDICIA. These commenters note that section 475(b) of FDICIA provides the agencies and the FDIC with authority to remove the 90 percent limitation on PMSRs, subject to a joint determination by the agencies and the FDIC that its removal would not have an adverse effect on the deposit insurance fund or the safety and soundness of insured depository institutions. The commenters asserted that removal of the 90 percent limitation would be appropriate because other provisions of the proposal pertaining to MSAs (including PMSRs) would require more capital to be retained even if the fair value limitation were removed.

The agencies agree with these commenters and, pursuant to section 475(b) of FDICIA, have determined that PMSRs may be valued at not more than 100 percent of their fair value, because the capital treatment of PMSRs in the final rule (specifically, the deduction approach for MSAs (including PMSRs) exceeding the 10 and 15 common equity deduction thresholds and the 250 percent risk weight applied to all MSAs not subject to deduction) is more conservative than the FDICIA fair value limitation and the 100 percent risk weight applied to MSAs under existing rules and such approach will not have an adverse effect on the deposit insurance fund or safety and soundness of insured depository institutions. For the same reasons, the agencies are also Start Printed Page 62070removing the 90 percent fair value limitation for all other MSAs.

Commenters also provided a variety of recommendations related to the proposed limitations on the inclusion of MSAs in regulatory capital. For instance, some commenters advocated removing the proposed deduction provision for hedged and commercial and multifamily-related MSAs, as well as requested an exemption from the proposed deduction requirement for community banking organizations with less than $10 billion.

Other commenters recommended increasing the amount of MSAs includable in regulatory capital. For example, one commenter recommended that MSAs should be limited to 100 percent of tier l capital if the underlying loans are prudently underwritten. Another commenter requested that the final rule permit thrifts and commercial banking organizations to include in regulatory capital MSAs equivalent to 50 and 25 percent of tier 1 capital, respectively.

Several commenters also objected to the proposed risk weights for MSAs, asserting that a 250 percent risk weight for an asset that is marked-to-fair value quarterly is unreasonably punitive and that a 100 percent risk weight should apply; that MSAs allowable in capital should be increased, at a minimum, to 30 percent of tier 1 capital, with a risk weight of no greater than 50 percent for existing MSAs; that commercial MSAs should continue to be subject to the risk weighting and deduction methodology under the general risk-based capital rules; and that originated MSAs should retain the same risk weight treatment under the general risk-based capital rules given that the ability to originate new servicing to replace servicing lost to prepayment in a falling-rate environment provides for a substantial hedge. Another commenter recommended that the agencies and the FDIC grandfather all existing MSAs that are being fair valued on banking organizations' balance sheets and exclude MSAs from the proposed 15 percent deduction threshold.

After considering these comments, the agencies are adopting the proposed limitation on MSAs includable in common equity tier 1 capital without change in the final rule. MSAs, like other intangible assets, have long been either fully or partially excluded from regulatory capital in the United States because of the high level of uncertainty regarding the ability of banking organizations to realize value from these assets, especially under adverse financial conditions.

m. Netting of Deferred Tax Liabilities Against Deferred Tax Assets and Other Deductible Assets

Under the proposal, banking organizations would have been permitted to net DTLs against assets (other than DTAs) subject to deduction under section 22 of the proposal, provided the DTL is associated with the asset and the DTL would be extinguished if the associated asset becomes impaired or is derecognized under GAAP. Likewise, banking organizations would be prohibited from using the same DTL more than once for netting purposes. This practice would be generally consistent with the approach that the agencies currently take with respect to the netting of DTLs against goodwill.

With respect to the netting of DTLs against DTAs, under the proposal the amount of DTAs that arise from net operating loss and tax credit carryforwards, net of any related valuation allowances, and the amount of DTAs arising from temporary differences that the banking organization could not realize through net operating loss carrybacks, net of any related valuation allowances, could be netted against DTLs if certain conditions are met.

The agencies and the FDIC received numerous comments recommending changes to and seeking clarification on various aspects of the proposed treatment of deferred taxes. Certain commenters asked whether deductions of significant and non-significant investments in the capital of unconsolidated financial institutions under section 22(c)(4) and 22(c)(5) of the proposed rule may be net of associated DTLs. A commenter also recommended that a banking organization be permitted to net a DTA against a fair value measurement or similar adjustment to an asset (for example, in the case of a certain cash-flow hedges) or a liability (for example, in the case of changes in the fair value of a banking organization's liabilities attributed to changes in the banking organization's own credit risk) that is associated with the adjusted value of the asset or liability that itself is subject to a capital adjustment or deduction under the Basel III NPR. These DTAs would be derecognized under GAAP if the adjustment were reversed. Accordingly, one commenter recommended that proposed text in section 22(e) be revised to apply to netting of DTAs as well as DTLs.

The agencies agree that for regulatory capital purposes, a banking organization may exclude from the deduction thresholds DTAs and DTLs associated with fair value measurement or similar adjustments to an asset or liability that are excluded from common equity tier 1 capital under the final rule. The agencies note that GAAP requires net unrealized gains and losses [108] recognized in AOCI to be recorded net of deferred tax effects. Moreover, under the agencies' general risk-based capital rules and associated regulatory reporting instructions, banking organizations must deduct certain net unrealized gains, net of applicable taxes, and add back certain net unrealized losses, again, net of applicable taxes. Permitting banking organizations to exclude net unrealized gains and losses included in AOCI without netting of deferred tax effects would cause a banking organization to overstate the amount of net unrealized gains and losses excluded from regulatory capital and potentially overstate or understate deferred taxes included in regulatory capital.

Accordingly, under the final rule, banking organizations must make all adjustments to common equity tier 1 capital under section 22(b) of the final rule net of any associated deferred tax effects. In addition, banking organizations may make all deductions from common equity tier 1 capital elements under section 22(c) and (d) of the final rule net of associated DTLs, in accordance with section 22(e) of the final rule.

Commenters also sought clarification as to whether banking organizations may change from reporting period to reporting period their decision to net DTLs against DTAs as opposed to netting DTLs against other assets subject to deduction. Consistent with the agencies' general risk-based capital rules, the final rule permits, but does not require, a banking organization to net DTLs associated with items subject to regulatory deductions from common equity tier 1 capital under section 22(a). The agencies' general risk-based capital rules do not explicitly address whether or how often a banking organization may change its DTL netting approach for items subject to deduction, such as goodwill and other intangible assets.

If a banking organization elects to either net DTLs against DTAs or to net DTLs against other assets subject to deduction, the final rule requires that it must do so consistently. For example, a banking organization that elects to deduct goodwill net of associated DTLs will be required to continue that Start Printed Page 62071practice for all future reporting periods. Under the final rule, a banking organization must obtain approval from its primary Federal supervisor before changing its approach for netting DTLs against DTAs or assets subject to deduction under section 22(a), which would be permitted, for example, in situations where a banking organization merges with or acquires another banking organization, or upon a substantial change in a banking organization's business model.

Commenters also asked whether banking organizations would be permitted or required to exclude (from the amount of DTAs subject to the threshold deductions under section 22(d) of the proposal) deferred tax assets and liabilities relating to net unrealized gains and losses reported in AOCI that are subject to: (1) Regulatory adjustments to common equity tier 1 capital (section 22(b) of the proposal), (2) deductions from regulatory capital related to investments in capital instruments (section 22(c) of the proposal), and (3) items subject to the 10 and 15 percent common equity tier 1 capital deduction thresholds (section 22(d) of the proposal).

Under the agencies' general risk-based capital rules, before calculating the amount of DTAs subject to the DTA limitations for inclusion in tier 1 capital, a banking organization may eliminate the deferred tax effects of any net unrealized gains and losses on AFS debt securities. A banking organization that adopts a policy to eliminate such deferred tax effects must apply that approach consistently in all future calculations of the amount of disallowed DTAs.

For purposes of the final rule, the agencies have decided to permit banking organizations to eliminate from the calculation of DTAs subject to threshold deductions under section 22(d) of the final rule the deferred tax effects associated with any items that are subject to regulatory adjustment to common equity tier 1 capital under section 22(b). A banking organization that elects to eliminate such deferred tax effects must continue that practice consistently from period to period. A banking organization must obtain approval from its primary Federal supervisor before changing its election to exclude or not exclude these amounts from the calculation of DTAs. Additionally, the agencies have decided to require DTAs associated with any net unrealized losses or differences between the tax basis and the accounting basis of an asset pertaining to items (other than those items subject to adjustment under section 22(b)) that are: (1) Subject to deduction from common equity tier 1 capital under section 22(c) or (2) subject to the threshold deductions under section 22(d) to be subject to the threshold deductions under section 22(d) of the final rule.

Commenters also sought clarification as to whether banking organizations would be required to compute DTAs and DTLs quarterly for regulatory capital purposes. In this regard, commenters stated that GAAP requires annual computation of DTAs and DTLs, and that more frequent computation requirements for regulatory capital purposes would be burdensome.

Some DTA and DTL items must be adjusted at least quarterly, such as DTAs and DTLs associated with certain gains and losses included in AOCI. Therefore, the agencies expect banking organizations to use the DTA and DTL amounts reported in the regulatory reports for balance sheet purposes to be used for regulatory capital calculations. The final rule does not require banking organizations to perform these calculations more often than would otherwise be required in order to meet quarterly regulatory reporting requirements.

A few commenters also asked whether the agencies and the FDIC would continue to allow banking organizations to use DTLs embedded in the carrying value of a leveraged lease to reduce the amount of DTAs subject to the 10 percent and 15 percent common equity tier 1 capital deduction thresholds contained in section 22(d) of the proposal. The valuation of a leveraged lease acquired in a business combination gives recognition to the estimated future tax effect of the remaining cash-flows of the lease. Therefore, any future tax liabilities related to an acquired leveraged lease are included in the valuation of the leveraged lease, and are not separately reported under GAAP as DTLs. This can artificially increase the amount of net DTAs reported by banking organizations that acquire a leveraged lease portfolio under purchase accounting. Accordingly, the agencies' currently allow banking organizations to treat future taxes payable included in the valuation of a leveraged lease portfolio as a reversing taxable temporary difference available to support the recognition of DTAs.[109] The final rule amends the proposal by explicitly permitting a banking organization to use the DTLs embedded in the carrying value of a leveraged lease to reduce the amount of DTAs consistent with section 22(e).

In addition, commenters asked the agencies and the FDIC to clarify whether a banking organization is required to deduct from the sum of its common equity tier 1 capital elements net DTAs arising from timing differences that the banking organization could realize through net operating loss carrybacks. The agencies confirm that under the final rule, DTAs that arise from temporary differences that the banking organization may realize through net operating loss carrybacks are not subject to the 10 percent and 15 percent common equity tier 1 capital deduction thresholds (deduction thresholds). This is consistent with the agencies' general risk-based capital rules, which do not limit DTAs that can potentially be realized from taxes paid in prior carryback years. However, consistent with the proposal, the final rule requires that banking organizations deduct from common equity tier 1 capital elements the amount of DTAs arising from temporary differences that the banking organization could not realize through net operating loss carrybacks that exceed the deduction thresholds under section 22(d) of the final rule.

Some commenters recommended that the agencies and the FDIC retain the provision in the agencies' and the FDIC's general risk-based capital rules that permits a banking organization to measure the amount of DTAs subject to inclusion in tier 1 capital by the amount of DTAs that the banking organization could reasonably be expected to realize within one year, based on its estimate of future taxable income.[110] In addition, commenters argued that the full deduction of net operating loss and tax credit carryforwards from common equity tier 1 capital is an inappropriate reaction to concerns about DTAs as an element of capital, and that there are Start Printed Page 62072appropriate circumstances where an institution should be allowed to include the value of its DTAs related to net operating loss carryforwards in regulatory capital.

The deduction thresholds for DTAs in the final rule are intended to address the concern that GAAP standards for DTAs could allow banking organizations to include in regulatory capital excessive amounts of DTAs that are dependent upon future taxable income. The concern is particularly acute when banking organizations begin to experience financial difficulty. In this regard, the agencies and the FDIC observed that as the recent financial crisis began, many banking organizations that had included DTAs in regulatory capital based on future taxable income were no longer able to do so because they projected more than one year of losses for tax purposes.

The agencies note that under the proposal and final rule, DTAs that arise from temporary differences that the banking organization may realize through net operating loss carrybacks are not subject to the deduction thresholds and will be subject to a risk weight of 100 percent. Further, banking organizations will continue to be permitted to include some or all of their DTAs that are associated with timing differences that are not realizable through net operating loss carrybacks in regulatory capital. In this regard, the final rule strikes an appropriate balance between prudential concerns and practical considerations about the ability of banking organizations to realize DTAs.

The proposal stated: “A [BANK] is not required to deduct from the sum of its common equity tier 1 capital elements net DTAs arising from timing differences that the [BANK] could realize through net operating loss carrybacks (emphasis added).” [111] Commenters requested that the agencies and the FDIC clarify that the word “net” in this sentence was intended to refer to DTAs “net of valuation allowances.” The agencies have amended section 22(e) of the final rule text to clarify that the word “net” in this instance was intended to refer to DTAs “net of any related valuation allowances and net of DTLs.”

In addition, a commenter requested that the agencies and the FDIC remove the condition in section 22(e) of the final rule providing that only DTAs and DTLs that relate to taxes levied by the same taxing authority may be offset for purposes of the deduction of DTAs. This commenter notes that under a GAAP, a company generally calculates its DTAs and DTLs relating to state income tax in the aggregate by applying a blended state rate. Thus, banking organizations do not typically track DTAs and DTLs on a state-by-state basis for financial reporting purposes.

The agencies recognize that under GAAP, if the tax laws of the relevant state and local jurisdictions do not differ significantly from federal income tax laws, then the calculation of deferred tax expense can be made in the aggregate considering the combination of federal, state, and local income tax rates. The rate used should consider whether amounts paid in one jurisdiction are deductible in another jurisdiction. For example, since state and local taxes are deductible for federal purposes, the aggregate combined rate would generally be (1) the federal tax rate plus (2) the state and local tax rates, minus (3) the federal tax effect of the deductibility of the state and local taxes at the federal tax rate. Also, for financial reporting purposes, consistent with GAAP, the agencies allow banking organizations to offset DTAs (net of valuation allowance) and DTLs related to a particular tax jurisdiction. Moreover, for regulatory reporting purposes, consistent with GAAP, the agencies require separate calculations of income taxes, both current and deferred amounts, for each tax jurisdiction. Accordingly, banking organizations must calculate DTAs and DTLs on a state-by-state basis for financial reporting purposes under GAAP and for regulatory reporting purposes.

3. Investments in Hedge Funds and Private Equity Funds Pursuant to Section 13 of the Bank Holding Company Act

Section 13 of the Bank Holding Company Act, which was added by section 619 of the Dodd-Frank Act, contains a number of restrictions and other prudential requirements applicable to any “banking entity” [112] that engages in proprietary trading or has certain interests in, or relationships with, a hedge fund or a private equity fund.[113]

Section 13(d)(3) of the Bank Holding Company Act provides that the relevant agencies “shall . . . adopt rules imposing additional capital requirements and quantitative limitations, including diversification requirements, regarding activities permitted under [Section 13] if the appropriate Federal banking agencies, the SEC, and the Commodity Futures Trading Commission (CFTC) determine that additional capital and quantitative limitations are appropriate to protect the safety and soundness of banking entities engaged in such activities.” The Dodd-Frank Act also added section 13(d)(4)(B)(iii) to the Bank Holding Company Act, which pertains to investments in a hedge fund or private equity fund organized and offered by a banking entity and provides for deductions from the assets and tangible equity of the banking entity for these investments in hedge funds or private equity funds.

On November 7, 2011, the agencies, the FDIC, and the SEC issued a proposal to implement Section 13 of the Bank Holding Company Act.[114] The proposal would require a “banking entity” to deduct from tier 1 capital its investments in a hedge fund or a private equity fund that the banking entity organizes and offers.[115] The agencies intend to address this 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.

VI. Denominator Changes Related to the Regulatory Capital Changes

Consistent with Basel III, the proposal provided a 250 percent risk weight for the portion of the following items that are not otherwise subject to deduction: (1) MSAs, (2) DTAs arising from temporary differences that a banking organization could not realize through net operating loss carrybacks (net of any related valuation allowances and net of Start Printed Page 62073DTLs, as described in section 22(e) of the rule), and (3) significant investments in the capital of unconsolidated financial institutions in the form of common stock that are not deducted from tier 1 capital.

Several commenters objected to the proposed 250 percent risk weight and stated that the agencies and the FDIC instead should apply a 100 percent risk weight to the amount of these assets below the deduction thresholds. Commenters stated that the relatively high risk weight would drive business, particularly mortgage servicing, out of the banking sector and into unregulated shadow banking entities.

After considering the comments, the agencies continue to believe that the 250 percent risk weight is appropriate in light of the relatively greater risks inherent in these assets, as described above. These risks are sufficiently significant that concentrations in these assets warrant deductions from capital, and any exposure to these assets merits a higher-than 100 percent risk weight. Therefore, the final rule adopts the proposed treatment without change.

The final rule, consistent with the proposal, requires banking organizations to apply a 1,250 percent risk weight to certain exposures that were subject to deduction under the general risk-based capital rules. Therefore, for purposes of calculating total risk-weighted assets, the final rule requires a banking organization to apply a 1,250 percent risk weight to the portion of a credit-enhancing interest-only strip (CEIO) that does not constitute an after-tax-gain-on-sale.

VII. Transition Provisions

The proposal established transition provisions for: (i) Minimum regulatory capital ratios; (ii) capital conservation and countercyclical capital buffers; (iii) regulatory capital adjustments and deductions; (iv) non-qualifying capital instruments; and (v) the supplementary leverage ratio. Most of the transition periods in the proposal began on January 1, 2013, and would have provided banking organizations between three and six years to comply with the requirements in the proposed rule. Among other provisions, the proposal would have provided a transition period for the phase-out of non-qualifying capital instruments from regulatory capital under either a three- or ten-year transition period based on the organization's consolidated total assets. The proposed transition provisions were designed to give banking organizations sufficient time to adjust to the revised capital framework while minimizing the potential impact that implementation could have on their ability to lend. The transition provisions also were designed to ensure compliance with the Dodd-Frank Act. As a result, they would have been, in certain circumstances, more stringent than the transition arrangements set forth in Basel III.

The agencies and the FDIC received multiple comments on the proposed transition framework. Most of the commenters characterized the proposed transition schedule for the minimum capital ratios as overly aggressive and expressed concern that banking organizations would not be able to meet the increased capital requirements (in accordance with the transition schedule) in the current economic environment. Commenters representing community banking organizations argued that such organizations generally have less access to the capital markets relative to larger banking organizations and, therefore, usually increase capital primarily by accumulating retained earnings. Accordingly, these commenters requested additional time to satisfy the minimum capital requirements under the proposed rule, and specifically asked the agencies and the FDIC to provide banking organizations until January 1, 2019 to comply with the proposed minimum capital requirements. Other commenters commenting on behalf of community banking organizations, however, considered the transition period reasonable. One commenter requested a shorter implementation timeframe for the largest banking organizations, asserting that these organizations already comply with the proposed standards. Another commenter suggested removing the transition period and delaying the effective date until the industry more fully recovers from the recent crisis. According to this commenter, the effective date should be delayed to ensure that implementation of the rule would not result in a contraction in aggregate U.S. lending capacity.

Several commenters representing SLHCs asked the agencies and the FDIC to delay implementation of the final rule for such organizations until July 21, 2015. Banking organizations not previously supervised by the Board, including SLHCs, become subject to the applicable requirements of section 171 on that date.[116] Additionally, these commenters expressed concern that SLHCs would not be able to comply with the new minimum capital requirements before that date because they were not previously subject to the agencies' risk-based capital framework. The commenters asserted that SLHCs would therefore need additional time to change their capital structure, balance sheets, and internal systems to comply with the proposal. These commenters also noted that the Board provided a three-year implementation period for BHCs when the general risk-based capital rules were initially adopted. Commenters representing SLHCs with substantial insurance activity also requested additional time to comply with the proposal because some of these organizations currently operate under a different accounting framework and would require a longer period of time to adapt their systems to the proposed capital rules, which generally are based on GAAP.

A number of commenters suggested an effective date based on the publication date of the final rule in the Federal Register. According to the commenters, such an approach would provide banking organizations with certainty regarding the effective date of the final rule that would allow them to plan for and implement any required system and process changes. One commenter requested simultaneous implementation of all three proposals because some elements of the Standardized Approach NPR affect the implementation of the Basel III NPR. A number of commenters also requested additional time to comply with the proposed capital conservation buffer. According to these commenters, implementation of the capital conservation buffer would make the equity instruments of banking organizations less attractive to potential investors and could even encourage divestment among existing shareholders. Therefore, the commenters maintained, the proposed rule would require banking organizations to raise capital by accumulating retained earnings, and doing so could take considerable time in the current economic climate. For these reasons, the commenters asked the agencies and the FDIC to delay implementation of the capital conservation buffer for an additional five years to provide banking organizations sufficient time to increase retained earnings without curtailing lending activity. Other commenters requested that the agencies and the FDIC fully exempt banks with total consolidated assets of $50 billion or less from the capital conservation buffer, further recommending that if the agencies and the FDIC declined to make this accommodation then the phase-in period for the capital conservation buffer should be extended by at least Start Printed Page 62074three years to January 1, 2022, to provide community banking organizations with enough time to meet the new regulatory minimums.

A number of commenters noted that Basel III phases in the deduction of goodwill from 2014 to 2018, and requested that the agencies and the FDIC adopt this transition for goodwill in the United States to prevent U.S. institutions from being disadvantaged relative to their global competitors.

Many commenters objected to the proposed schedule for the phase out of TruPS from tier 1 capital, particularly for banking organizations with less than $15 billion in total consolidated assets. As discussed in more detail in section V.A., the commenters requested that the agencies and the FDIC grandfather existing TruPS issued by depository institution holding companies with less than $15 billion and 2010 MHCs, as permitted by section 171 of the Dodd-Frank Act. In general, these commenters characterized TruPS as a relatively safe, low-cost form of capital issued in full compliance with regulatory requirements that would be difficult for smaller institutions to replace in the current economic environment. Some commenters requested that community banking organizations be exempt from the phase-out of TruPS and from the phase-out of cumulative preferred stock for these reasons. Another commenter requested that the agencies and the FDIC propose that institutions with under $5 billion in total consolidated assets be allowed to continue to include TruPS in regulatory capital at full value until the call or maturity of the TruPS instrument.

Some commenters encouraged the agencies and the FDIC to adopt the ten-year transition schedule under Basel III for TruPS of banking organizations with total consolidated assets of more than $15 billion. These commenters asserted that the proposed transition framework for TruPS would disadvantage U.S. banking organizations relative to foreign competitors. One commenter expressed concern that the transition framework under the proposed rule also would disrupt payment schedules for TruPS CDOs.

Commenters proposed several additional alternative transition frameworks for TruPS. For example, one commenter recommended a 10 percent annual reduction in the amount of TruPS banking organizations with $15 billion or more of total consolidated assets may recognize in tier 1 capital beginning in 2013, followed by a phase-out of the remaining amount in 2015. According to the commenter, such a framework would comply with the Dodd-Frank Act and allow banking organizations more time to replace TruPS. Another commenter suggested that the final rule allow banking organizations to progressively reduce the amount of TruPS eligible for inclusion in tier 1 capital by 1.25 to 2.5 percent per year. One commenter encouraged the agencies and the FDIC to avoid penalizing banking organizations that elect to redeem TruPS during the transition period. Specifically, the commenter asked the agencies and the FDIC to revise the proposed transition framework so that any TruPS redeemed during the transition period would not reduce the total amount of TruPS eligible for inclusion in tier 1 capital. Under such an approach, the amount of TruPS eligible for inclusion in tier 1 capital during the transition period would equal the lesser of: (a) The remaining outstanding balance or (b) the percentage decline factor times the balance outstanding at the time the final rule is published in the Federal Register.

One commenter encouraged the agencies and the FDIC to allow a banking organization that grows to more than $15 billion in total assets as a result of merger and acquisition activity to remain subject to the proposed transition framework for non-qualifying capital instruments issued by organizations with less than $15 billion in total assets. According to the commenter, such an approach should apply to either the buyer or seller in the transaction. Other commenters asked the agencies and the FDIC to allow banking organizations whose total consolidated assets grew to over $15 billion just prior to May 19, 2010, and whose asset base subsequently declined below that amount to include all TruPS in their tier 1 capital during 2013 and 2014 on the same basis as institutions with less than $15 billion in total consolidated assets and, thereafter, be subject to the deductions required by section 171 of the Dodd-Frank Act.

Commenters representing advanced approaches banking organizations generally objected to the proposed transition framework for the supplementary leverage ratio, and requested a delay in its implementation. For example, one commenter recommended the agencies and the FDIC defer implementation of the supplementary leverage ratio until the agencies and the FDIC have had an opportunity to consider whether it is likely to result in regulatory arbitrage and international competitive inequality as a result of differences in national accounting frameworks and standards. Another commenter asked the agencies and the FDIC to delay implementation of the supplementary leverage ratio until no earlier than January 1, 2018, as provided in Basel III, or until the BCBS completes its assessment and reaches international agreement on any further adjustments. A few commenters, however, supported the proposed transition framework for the supplementary leverage ratio because it could be used as an important regulatory tool to ensure there is sufficient capital in the financial system.

After considering the comments and the potential challenges some banking organizations may face in complying with the final rule, the agencies have agreed to delay the compliance date for banking organizations that are not advanced approaches banking organizations and for covered SLHCs until January 1, 2015. Therefore, such entities are not required to calculate their regulatory capital requirements under the final rule until January 1, 2015. Thereafter, these banking organizations must calculate their regulatory capital requirements in accordance with the final rule, subject to the transition provisions set forth in subpart G of the final rule.

The final rule also establishes the effective date of the final rule for advanced approaches banking organizations that are not SLHCs as January 1, 2014. In accordance with Tables 5-17 below, the transition provisions for the regulatory capital adjustments and deductions in the final rule commence either one or two years later than in the proposal, depending on whether the banking organization is or is not an advanced approaches banking organization. The December 31, 2018, end-date for the transition period for regulatory capital adjustments and deductions is the same under the final rule as under the proposal.

A. Transitions Provisions for Minimum Regulatory Capital Ratios

In response to the commenters' concerns, the final rule modifies the proposed transition provisions for the minimum capital requirements. Banking organizations that are not advanced approaches banking organizations and covered SLHCs are not required to comply with the minimum capital requirements until January 1, 2015. This is a delay of two years from the beginning of the proposed transition period. Because the agencies are not requiring compliance with the final rule until January 1, 2015 for these entities, there is no additional transition period for the minimum regulatory capital ratios. This approach should give Start Printed Page 62075banking organizations sufficient time to raise or accumulate any additional capital needed to satisfy the new minimum requirements and upgrade internal systems without adversely affecting their lending capacity.

Under the final rule, an advanced approaches banking organization that is not an SLHC must comply with minimum common equity tier 1, tier 1, and total capital ratio requirements of 4.0 percent, 5.5 percent, and 8.0 percent during calendar year 2014, and 4.5 percent, 6.0 percent, 8.0 percent, respectively, beginning January 1, 2015. These transition provisions are consistent with those under Basel III for internationally-active banking organizations. During calendar year 2014, advanced approaches banking organizations must calculate their minimum common equity tier 1, tier 1, and total capital ratios using the definitions for the respective capital components in section 20 of the final rule (adjusted in accordance with the transition provisions for regulatory adjustments and deductions and for the non-qualifying capital instruments for advanced approaches banking organizations described in this section).

B. Transition Provisions for Capital Conservation and Countercyclical Capital Buffers

The agencies have finalized transitions for the capital conservation and countercyclical capital buffers as proposed. The capital conservation buffer transition period begins in 2016, a full year after banking organizations that are not advanced approaches banking organizations and banking organizations that are covered SLHCs are required to comply with the final rule, and two years after advanced approaches banking organizations that are not SLHCs are required to comply with the final rule. The agencies believe that this is an adequate time frame to meet the buffer level necessary to avoid restrictions on capital distributions. Table 5 shows the regulatory capital levels advanced approaches banking organizations that are not SLHCs generally must satisfy to avoid limitations on capital distributions and discretionary bonus payments during the applicable transition period, from January 1, 2016 until January 1, 2019.

Table 5—Regulatory Capital Levels for Advanced Approaches Banking Organizations

Jan. 1, 2014 (percent)Jan. 1, 2015 (percent)Jan. 1, 2016 (percent)Jan. 1, 2017 (percent)Jan. 1, 2018 (percent)Jan. 1, 2019 (percent)
Capital conservation buffer0.6251.251.8752.5
Minimum common equity tier 1 capital ratio + capital conservation buffer4.04.55.1255.756.3757.0
Minimum tier 1 capital ratio + capital conservation buffer5.56.06.6257.257.8758.5
Minimum total capital ratio + capital conservation buffer8.08.08.6259.259.87510.5
Maximum potential countercyclical capital buffer0.6251.251.8752.5

Table 6 shows the regulatory capital levels banking organizations that are not advanced approaches banking organizations and banking organizations that are covered SLHCs generally must satisfy to avoid limitations on capital distributions and discretionary bonus payments during the applicable transition period, from January 1, 2016 until January 1, 2019.

Table 6—Regulatory Capital Levels for Non-Advanced Approaches Banking Organizations

Jan. 1, 2015 (percent)Jan. 1, 2016 (percent)Jan. 1, 2017 (percent)Jan. 1, 2018 (percent)Jan. 1, 2019 (percent)
Capital conservation buffer0.6251.251.8752.5
Minimum common equity tier 1 capital ratio + capital conservation buffer4.55.1255.756.3757.0
Minimum tier 1 capital ratio + capital conservation buffer6.06.6257.257.8758.5
Minimum total capital ratio + capital conservation buffer8.08.6259.259.87510.5

As provided in Table 5 and Table 6, the transition period for the capital conservation and countercyclical capital buffers does not begin until January 1, 2016. During this transition period, from January 1, 2016 through December 31, 2018, all banking organizations are subject to transition arrangements with respect to the capital conservation buffer as outlined in more detail in Table 7. For advanced approaches banking organizations, the countercyclical capital buffer will be phased in according to the transition schedule set forth in Table 7 by proportionately expanding each of the quartiles of the capital conservation buffer.

Table 7—Transition Provision for the Capital Conservation and Countercyclical Capital Buffer

Transition periodCapital conservation bufferMaximum payout ratio (as a percentage of eligible retained income)
Calendar year 2016Greater than 0.625 percent (plus 25 percent of any applicable countercyclical capital buffer amount)No payout ratio limitation applies.
Less than or equal to 0.625 percent (plus 25 percent of any applicable countercyclical capital buffer amount), and greater than 0.469 percent (plus 18.75 percent of any applicable countercyclical capital buffer amount)60.
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Less than or equal to 0.469 percent (plus 18.75 percent of any applicable countercyclical capital buffer amount), and greater than 0.313 percent (plus 12.5 percent of any applicable countercyclical capital buffer amount)40.
Less than or equal to 0.313 percent (plus 12.5 percent of any applicable countercyclical capital buffer amount), and greater than 0.156 percent (plus 6.25 percent of any applicable countercyclical capital buffer amount)20.
Less than or equal to 0.156 percent (plus 6.25 percent of any applicable countercyclical capital buffer amount)0.
Calendar year 2017Greater than 1.25 percent (plus 50 percent of any applicable countercyclical capital buffer amount)No payout ratio limitation applies.
Less than or equal to 1.25 percent (plus 50 percent of any applicable countercyclical capital buffer amount), and greater than 0.938 percent (plus 37.5 percent of any applicable countercyclical capital buffer amount)60.
Less than or equal to 0.938 percent (plus 37.5 percent of any applicable countercyclical capital buffer amount), and greater than 0.625 percent (plus 25 percent of any applicable countercyclical capital buffer amount)40.
Less than or equal to 0.625 percent (plus 25 percent of any applicable countercyclical capital buffer amount), and greater than 0.313 percent (plus 12.5 percent of any applicable countercyclical capital buffer amount)20.
Less than or equal to 0.313 percent (plus 12.5 percent of any applicable countercyclical capital buffer amount)0.
Calendar year 2018Greater than 1.875 percent (plus 75 percent of any applicable countercyclical capital buffer amount)No payout ratio limitation applies.
Less than or equal to 1.875 percent (plus 75 percent of any applicable countercyclical capital buffer amount), and greater than 1.406 percent (plus 56.25 percent of any applicable countercyclical capital buffer amount)60.
Less than or equal to 1.406 percent (plus 56.25 percent of any applicable countercyclical capital buffer amount), and greater than 0.938 percent (plus 37.5 percent of any applicable countercyclical capital buffer amount)40.
Less than or equal to 0.938 percent (plus 37.5 percent of any applicable countercyclical capital buffer amount), and greater than 0.469 percent (plus 18.75 percent of any applicable countercyclical capital buffer amount)20.
Less than or equal to 0.469 percent (plus 18.75 percent of any applicable countercyclical capital buffer amount)0.

C. Transition Provisions for Regulatory Capital Adjustments and Deductions

To give sufficient time to banking organizations to adapt to the new regulatory capital adjustments and deductions, the final rule incorporates transition provisions for such adjustments and deductions that commence at the time at which the banking organization becomes subject to the final rule. As explained above, the final rule maintains the proposed transition periods, except for non-qualifying capital instruments as described below.

Banking organizations that are not advanced approaches banking organizations and banking organizations that are covered SLHCs will begin the transitions for regulatory capital adjustments and deductions on January 1, 2015. From January 1, 2015, through December 31, 2017, these banking organizations will be required to make the regulatory capital adjustments to and deductions from regulatory capital in section 22 of the final rule in accordance with the proposed transition provisions for such adjustments and deductions outlined below. Starting on January 1, 2018, these banking organizations will apply all regulatory capital adjustments and deductions as set forth in section 22 of the final rule.

For an advanced approaches banking organization that is not an SLHC, the first year of transition for adjustments and deductions begins on January 1, 2014. From January 1, 2014, through December 31, 2017, such banking organizations will be required to make the regulatory capital adjustments to and deductions from regulatory capital in section 22 of the final rule in accordance with the proposed transition provisions for such adjustments and deductions outlined below. Starting on January 1, 2018, advanced approaches banking organizations will be subject to all regulatory capital adjustments and deductions as described in section 22 of the final rule.

1. Deductions for Certain Items Under Section 22(a) of the Final Rule

The final rule provides that banking organizations will deduct from common equity tier 1 capital or tier 1 capital in accordance with Table 8 below: (1) Goodwill (section 22(a)(1)); (2) DTAs that arise from operating loss and tax credit carryforwards (section 22(a)(3)); (3) gain-on-sale associated with a securitization exposure (section 22(a)(4)): (4) defined benefit pension fund assets (section 22(a)(5)); (5) for an advanced approaches banking organization that has completed the parallel run process and that has received notification from its primary Federal supervisor pursuant to section 121(d) of subpart E of the final rule, expected credit loss that exceeds eligible credit reserves (section 22(a)(6)); and (6) financial subsidiaries (section 22(a)(7)). During the transition period, the percentage of these items that is not deducted from common equity tier 1 capital must be deducted from tier 1 capital.Start Printed Page 62077

Table 8—Transition Deductions Under Section 22(a)(1) and Sections 22(a)(3)-(a)(7) of the Final Rule

Transition periodTransition deductions under section 22(a)(1) and (7) 1Transition deductions under sections 22(a)(3)-(a)(6)
Percentage of the deductions from common equity tier 1 capitalPercentage of the deductions from common equity tier 1 capitalPercentage of the deductions from tier 1 capital
January 1, 2014 to December 31, 2014 (advanced approaches banking organizations only)1002080
January 1, 2015 to December 31, 20151004060
January 1, 2016 to December 31, 20161006040
January 1, 2017 to December 31, 20171008020
January 1, 2018 and thereafter1001000
1 In addition, a FSA should deduct from common equity tier 1 non-includable subsidiaries. See 12 CFR 3.22(a)(8).

Beginning on January 1, 2014, advanced approaches banking organizations that are not SLHCs will be required to deduct the full amount of goodwill (which may be net of any associated DTLs), including any goodwill embedded in the valuation of significant investments in the capital of unconsolidated financial institutions, from common equity tier 1 capital. All other banking organizations will begin deducting goodwill (which may be net of any associated DTLs), including any goodwill embedded in the valuation of significant investments in the capital of unconsolidated financial institutions from common equity tier 1 capital, on January 1, 2015. This approach is stricter than the Basel III approach, which transitions the goodwill deduction from common equity tier 1 capital through 2017. However, as discussed in section V.B of this preamble, under U.S. law, goodwill cannot be included in a banking organization's regulatory capital and has not been included in banking organizations' regulatory capital under the general risk-based capital rules.[117] Additionally, the agencies believe that fully deducting goodwill from common equity tier 1 capital from the date a banking organization must comply with the final rule will result in a more appropriate measure of common equity tier 1 capital.

Beginning on January 1, 2014, a national bank or insured state bank subject to the advanced approaches rule will be required to deduct 100 percent of the aggregate amount of its outstanding equity investment, including the retained earnings, in any financial subsidiary from common equity tier 1 capital. All other national and insured state banks will begin deducting 100 percent of the aggregate amount of their outstanding equity investment, including the retained earnings, in a financial subsidiary from common equity tier 1 capital on January 1, 2015. The deduction from common equity tier 1 capital represents a change from the general risk-based capital rules, which require the deduction to be made from total capital. As explained in section V.B of this preamble, similar to goodwill, this deduction is required by statute and is consistent with the general risk-based capital rules. Accordingly, the deduction is not subject to a transition period.

The final rule also retains the existing deduction for Federal associations' investments in, and extensions of credit to, non-includable subsidiaries at 12 CFR 3.22(a)(8).[118] This deduction is required by statute [119] and is consistent with the general risk-based capital rules. Accordingly, the deduction is not subject to a transition period and must be fully deducted in the first year that the Federal or state savings association becomes subject to the final rule.

2. Deductions for Intangibles Other Than Goodwill and Mortgage Servicing Assets

For deductions of intangibles other than goodwill and MSAs, including purchased credit-card relationships (PCCRs) (see section 22(a)(2) of the final rule), the applicable transition period in the final rule is set forth in Table 9. During the transition period, any of these items that are not deducted will be subject to a risk weight of 100 percent. Advanced approaches banking organizations that are not SLHCs will begin the transition on January 1, 2014, and other banking organizations will begin the transition on January 1, 2015.

Table 9—Transition Deductions Under Section 22(a)(2) of the Proposal

Transition periodTransition deductions under section 22(a)(2)—Percentage of the deductions from common equity tier 1 capital
January 1, 2014 to December 31, 2014 (advanced approaches banking organizations only)20
January 1, 2015 to December 31, 201540
January 1, 2016 to December 31, 201660
January 1, 2017 to December 31, 201780
January 1, 2018 and thereafter100
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3. Regulatory Adjustments Under Section 22(b)(1) of the Final Rule

During the transition period, any of the adjustments required under section 22(b)(1) that are not applied to common equity tier 1 capital must be applied to tier 1 capital instead, in accordance with Table 10. Advanced approaches banking organizations that are not SLHCs will begin the transition on January 1, 2014, and other banking organizations will begin the transition on January 1, 2015.

Table 10—Transition Adjustments Under Section 22(b)(1)

Transition periodTransition adjustments under section 22(b)(1)
Percentage of the adjustment applied to common equity tier 1 capitalPercentage of the adjustment applied to tier 1 capital
January 1, 2014, to December 31, 2014 (advanced approaches banking organizations only)2080
January 1, 2015, to December 31, 20154060
January 1, 2016, to December 31, 20166040
January 1, 2017, to December 31, 20178020
January 1, 2018 and thereafter1000

4. Phase-out of Current Accumulated Other Comprehensive Income Regulatory Capital Adjustments

Under the final rule, the transition period for the inclusion of the aggregate amount of: (1) Unrealized gains on available-for-sale equity securities; (2) net unrealized gains or losses on available-for-sale debt securities; (3) any amounts recorded in AOCI attributed to defined benefit postretirement plans resulting from the initial and subsequent application of the relevant GAAP standards that pertain to such plans (excluding, at the banking organization's option, the portion relating to pension assets deducted under section 22(a)(5)); (4) accumulated net gains or losses on cash-flow hedges related to items that are reported on the balance sheet at fair value included in AOCI; and (5) net unrealized gains or losses on held-to-maturity securities that are included in AOCI (transition AOCI adjustment amount) only applies to advanced approaches banking organizations and other banking organizations that have not made an AOCI opt-out election under section 22(b)(2) of the rule and described in section V.B of this preamble. Advanced approaches banking organizations that are not SLHCs will begin the phase out of the current AOCI regulatory capital adjustments on January 1, 2014; other banking organizations that have not made the AOCI opt-out election will begin making these adjustments on January 1, 2015. Specifically, if a banking organization's transition AOCI adjustment amount is positive, it will adjust its common equity tier 1 capital by deducting the appropriate percentage of such aggregate amount in accordance with Table 11 below. If such amount is negative, it will adjust its common equity tier 1 capital by adding back the appropriate percentage of such aggregate amount in accordance with Table 11 below. The agencies and the FDIC did not include net unrealized gains or losses on held-to-maturity securities that are included in AOCI as part of the transition AOCI adjustment amount in the proposal. However, the agencies have decided to add such an adjustment as it reflects the agencies' approach towards AOCI adjustments in the general risk: Based capital rules.

Table 11—Percentage of the Transition AOCI Adjustment Amount

Transition periodPercentage of the transition AOCI adjustment amount to be applied to common equity tier 1 capital
January 1, 2014, to December 31, 2014 (advanced approaches banking organizations only)80
January 1, 2015, to December 31, 2015 (advanced approaches banking organizations and banking organizations that have not made an opt-out election)60
January 1, 2016, to December 31, 2016 (advanced approaches banking organizations and banking organizations that have not made an opt-out election)40
January 1, 2017, to December 31, 2017 (advanced approaches banking organizations and banking organizations that have not made an opt-out election)20
January 1, 2018 and thereafter (advanced approaches banking organizations and banking organizations that have not made an opt-out election)0

Beginning on January 1, 2018, advanced approaches banking organizations and other banking organizations that have not made an AOCI opt-out election must include AOCI in common equity tier 1 capital, with the exception of accumulated net gains and losses on cash-flow hedges related to items that are not measured at fair value on the balance sheet, which must be excluded from common equity tier 1 capital.

5. Phase-Out of Unrealized Gains on Available for Sale Equity Securities in Tier 2 Capital

Advanced approaches banking organizations and banking organizations not subject to the advanced approaches rule that have not made an AOCI opt-out election will decrease the amount of unrealized gains on AFS preferred stock classified as an equity security under GAAP and AFS equity exposures currently held in tier 2 capital during the transition period in accordance with Table 12. An advanced approaches banking organization that is not an SLHC will begin the adjustments on January 1, 2014; all other banking organizations that have not made an Start Printed Page 62079AOCI opt-out election will begin the adjustments on January 1, 2015.

Table 12—Percentage of Unrealized Gains on AFS Preferred Stock Classified as an Equity Security Under GAAP and AFS Equity Exposures That May Be Included in Tier 2 Capital

Transition periodPercentage of unrealized gains on AFS preferred stock classified as an equity security under GAAP and AFS equity exposures that may be included in tier 2 capital
January 1, 2014, to December 31, 2014 (advanced approaches banking organizations only)36
January 1, 2015, to December 31, 2015 (advanced approaches banking organizations and banking organizations that have not made an opt-out election)27
January 1, 2016, to December 31, 2016 (advanced approaches banking organizations and banking organizations that have not made an opt-out election)18
January 1, 2017, to December 31, 2017 (advanced approaches banking organizations and banking organizations that have not made an opt-out election)9
January 1, 2018 and thereafter (advanced approaches banking organizations and banking organizations that have not made an opt-out election)0

6. Phase-in of Deductions Related to Investments in Capital Instruments and to the Items Subject to the 10 and 15 Percent Common Equity Tier 1 Capital Deduction Thresholds (Sections 22(c) and 22(d)) of the Final Rule

Under the final rule, a banking organization must calculate the appropriate deductions under sections 22(c) and 22(d) of the rule related to investments in the capital of unconsolidated financial institutions and to the items subject to the 10 and 15 percent common equity tier 1 capital deduction thresholds (that is, MSAs, DTAs arising from temporary differences that the banking organization could not realize through net operating loss carrybacks, and significant investments in the capital of unconsolidated financial institutions in the form of common stock) as set forth in Table 13. Advanced approaches banking organizations that are not SLHCs will apply the transition framework beginning January 1, 2014. All other banking organizations will begin applying the transition framework on January 1, 2015. During the transition period, a banking organization will make the aggregate common equity tier 1 capital deductions related to these items in accordance with the percentages outlined in Table 13 and must apply a 100 percent risk-weight to the aggregate amount of such items that is not deducted. On January 1, 2018, and thereafter, each banking organization will be required to apply a 250 percent risk weight to the aggregate amount of the items subject to the 10 and 15 percent common equity tier 1 capital deduction thresholds that are not deducted from common equity tier 1 capital.

Table 13—Transition Deductions Under Sections 22(c) and 22(d) of the Proposal

Transition periodTransition deductions under sections 22(c) and 22(d)—Percentage of the deductions from common equity tier 1 capital
January 1, 2014, to December 31, 2014 (advanced approaches banking organizations only)20
January 1, 2015, to December 31, 201540
January 1, 2016, to December 31, 201660
January 1, 2017, to December 31, 201780
January 1, 2018 and thereafter100

During the transition period, banking organizations will phase in the deduction requirement for the amounts of DTAs arising from temporary differences that could not be realized through net operating loss carryback, MSAs, and significant investments in the capital of unconsolidated financial institutions in the form of common stock that exceed the 10 percent threshold in section 22(d) according to Table 13.

During the transition period, banking organizations will not be subject to the methodology to calculate the 15 percent common equity deduction threshold for DTAs arising from temporary differences that could not be realized through net operating loss carrybacks, MSAs, and significant investments in the capital of unconsolidated financial institutions in the form of common stock described in section 22(d) of the final rule. During the transition period, a banking organization will be required to deduct from its common equity tier 1 capital the percentage as set forth in Table 13 of the amount by which the aggregate sum of the items subject to the 10 and 15 percent common equity tier 1 capital deduction thresholds exceeds 15 percent of the sum of the banking organization's common equity tier 1 capital after making the deductions and adjustments required under sections 22(a) through (c).

D. Transition Provisions for Non-Qualifying Capital Instruments

Under the final rule, there are different transition provisions for non-qualifying capital instruments depending on the type and size of a banking organization as discussed below.Start Printed Page 62080

1. Depository Institution Holding Companies With Less than $15 Billion in Total Consolidated Assets as of December 31, 2009 and 2010 Mutual Holding Companies

BHCs have historically included (subject to limits) in tier 1 capital “restricted core capital elements” such as cumulative perpetual preferred stock and TruPS, which generally would not comply with the eligibility criteria for additional tier 1 capital instruments outlined in section 20 of the final rule. As discussed in section V.A of this preamble, section 171 of the Dodd-Frank Act would not require depository institution holding companies with less than $15 billion in total consolidated assets as of December 31, 2009, (depository institution holding companies under $15 billion) or 2010 MHCs to deduct these types of instruments from tier 1 capital. However, as discussed in section V.A of this preamble, above, because these instruments would no longer qualify as tier 1 capital under the proposed criteria and have been found to be less able to absorb losses, the agencies and the FDIC proposed to require depository institution holding companies under $15 billion and 2010 MHCs to phase these instruments out of capital over a 10-year period consistent with Basel III.

For the reasons discussed in section V.A of this preamble, as permitted by section 171 of the Dodd-Frank Act, the agencies have decided not to adopt this proposal in the final rule. Depository institution holding companies under $15 billion and 2010 MHCs may continue to include non-qualifying instruments that were issued prior to May 19, 2010 in tier 1 or tier 2 capital in accordance with the general risk-based capital rules, subject to specific limitations. More specifically, these depository institution holding companies will be able to continue including outstanding tier 1 capital non-qualifying capital instruments in additional tier 1 capital (subject to the limit of 25 percent of tier 1 capital elements excluding any non-qualifying capital instruments and after all regulatory capital deductions and adjustments applied to tier 1 capital) until they redeem the instruments or until the instruments mature. Likewise, consistent with the general risk-based capital rules, any tier 1 capital instrument that is excluded from tier 1 because it exceeds the 25 percent limit referenced above can be included in tier 2 capital.[120]

2. Depository Institutions

Under the final rule, beginning on January 1, 2014, an advanced approaches depository institution and beginning on January 1, 2015, a depository institution that is not a depository institution subject to the advanced approaches rule may include in regulatory capital debt or equity instruments issued prior to September 12, 2010 that do not meet the criteria for additional tier 1 or tier 2 capital instruments in section 20 of the final rule, but that were included in tier 1 or tier 2 capital, respectively, as of September 12, 2010 (non-qualifying capital instruments issued prior to September 12, 2010). These instruments may be included up to the percentage of the outstanding principal amount of such non-qualifying capital instruments as of the effective date of the final rule in accordance with the phase-out schedule in Table 14.

As of January 1, 2014 for advanced approaches banking organizations that are not SLHCs, and January 1, 2015 for all other banking organizations and for covered SLHCs that are advanced approaches organizations, debt or equity instruments issued after September 12, 2010, that do not meet the criteria for additional tier 1 or tier 2 capital instruments in section 20 of the final rule may not be included in additional tier 1 or tier 2 capital.

Table 14—Percentage of Non-Qualifying Capital Instruments Issued Prior to September 12, 2010 Includable in Additional Tier 1 or Tier 2 Capital

Transition Period (calendar year)Percentage of non-qualifying capital instruments issued prior to September 2010 includable in additional tier 1 or tier 2 capital for depository institutions
Calendar year 2014 (advanced approaches banking organizations only)80
Calendar year 201570
Calendar year 201660
Calendar year 201750
Calendar year 201840
Calendar year 201930
Calendar year 202020
Calendar year 202110
Calendar year 2022 and thereafter0

3. Depository Institution Holding Companies With $15 Billion or More in Total Consolidated Assets as of December 31, 2009 That Are Not 2010 Mutual Holding Companies

Under the final rule, consistent with the proposal and with section 171 of the Dodd-Frank Act, debt or equity instruments that do not meet the criteria for additional tier 1 or tier 2 capital instruments in section 20 of the final rule, but that were issued and included in tier 1 or tier 2 capital, respectively, prior to May 19, 2010 (non-qualifying capital instruments) and were issued by a depository institution holding company with total consolidated assets greater than or equal to $15 billion as of December 31, 2009 (depository institution holding company of $15 billion or more) that is not a 2010 MHC must be phased out as set forth in Table 15 below.[121] More specifically, depository institution holding companies of $15 billion or more that are advanced approaches banking organizations and that are not SLHCs must begin to apply this phase-out on January 1, 2014; other depository institution holding companies of $15 billion or more, including covered SLHCs, must begin to apply the phase-out on January 1, 2015. Accordingly, Start Printed Page 62081under the final rule, a depository institution holding company of $15 billion or more that is an advanced approaches banking organization and that is not an SLHC will be allowed to include only 50 percent of non-qualifying capital instruments in regulatory capital as of January 1, 2014; all depository institution holding companies of $15 billion or more will be allowed to include only 25 percent as of January 1, 2015, and 0 percent as of January 1, 2016, and thereafter.

The agencies acknowledge that the majority of existing TruPS would not technically comply with the final rule's tier 2 capital eligibility criteria (given that existing TruPS allow for acceleration after 5 years of interest deferral) even though these instruments are eligible for inclusion in tier 2 capital under the general risk-based capital rules. However, the agencies believe that: (1) The inclusion of existing TruPS in tier 2 capital (until they are redeemed or they mature) does not raise safety and soundness concerns, and (2) it may be less disruptive to the banking system to allow certain banking organizations to include TruPS in tier 2 capital until they are able to replace such instruments with new capital instruments that fully comply with the eligibility criteria of the final rule. Accordingly, the agencies have decided to permit non-advanced approaches depository institution holding companies with over $15 billion in total consolidated assets permanently to include non-qualifying capital instruments, including TruPS that are phased out of tier 1 capital in tier 2 capital and not phase-out those instruments.

Under the final rule, advanced approaches depository institution holding companies will not be permitted to permanently include existing non-qualifying capital instruments in tier 2 capital if they do not meet tier 2 criteria under the final rule. Such banking organizations generally face fewer market obstacles in replacing non-qualifying capital instruments than smaller banking organizations. From January 1, 2016, until December 31, 2021, these banking organizations will be required to phase out non-qualifying capital instruments from tier 2 capital in accordance with the percentages in Table 14 above. Consequently, an advanced approaches depository institution holding company will be allowed to include in tier 2 capital in calendar year 2016 up to 60 percent of the principal amount of TruPS that such banking organization had outstanding as of January 1, 2014, but will not be able to include any of these instruments in regulatory capital after year-end 2021.

Table 15—Percentage of Non-Qualifying Capital Instruments Includable in Additional Tier 1 or Tier 2 Capital

Transition period (calendar year)Percentage of non-qualifying capital instruments includable in additional tier 1 or tier 2 capital for depository institution holding companies of $15 billion or more
Calendar year 2014 (advanced approaches banking organizations only)50
Calendar year 201525
Calendar year 2016 And thereafter0

4. Merger and Acquisition Transition Provisions

Under the final rule, consistent with the proposal, if a depository institution holding company of $15 billion or more acquires a depository institution holding company with total consolidated assets of less than $15 billion as of December 31, 2009 or a 2010 MHC, the non-qualifying capital instruments of the resulting organization will be subject to the phase-out schedule outlined in Table 15, above. Likewise, if a depository institution holding company under $15 billion makes an acquisition and the resulting organization has total consolidated assets of $15 billion or more, its non-qualifying capital instruments also will be subject to the phase-out schedule outlined in Table 15, above. Some commenters argued that this provision could create disincentives for mergers and acquisitions, but the agencies continue to believe these provisions appropriately subject institutions that are larger (or that become larger) to the stricter phase-out requirements for non-qualifying capital instruments, consistent with the language and intent of section 171 of the Dodd-Frank Act. Depository institution holding companies under $15 billion and 2010 MHCs that merge with or acquire other banking organizations that result in organizations that remain below $15 billion or remain MHCs would be able to continue to include non-qualifying capital instruments in regulatory capital.

5. Phase-Out Schedule for Surplus and Non-Qualifying Minority Interest

Under the transition provisions in the final rule, a banking organization is allowed to include in regulatory capital a portion of the common equity tier 1, tier 1, or total capital minority interest that is disqualified from regulatory capital as a result of the requirements and limitations outlined in section 21 (surplus minority interest). If a banking organization has surplus minority interest outstanding when the final rule becomes effective, that surplus minority interest will be subject to the phase-out schedule outlined in Table 16. Advanced approaches banking organizations that are not SLHCs must begin to phase out surplus minority interest in accordance with Table 16 beginning on January 1, 2014. All other banking organizations will begin the phase out for surplus minority interest on January 1, 2015.

During the transition period, a banking organization will also be able to include in tier 1 or total capital a portion of the instruments issued by a consolidated subsidiary that qualified as tier 1 or total capital of the banking organization on the date the rule becomes effective, but that do not qualify as tier 1 or total capital under section 20 of the final rule (non-qualifying minority interest) in accordance with Table 16.Start Printed Page 62082

Table 16 —Percentage of the Amount of Surplus or Non-qualifying Minority Interest Includable in Regulatory Capital During Transition Period

Transition periodPercentage of the amount of surplus or non-qualifying minority interest that can be included in regulatory capital during the transition period
January 1, 2014, to December 31, 2014 (advanced approaches banking organizations only)80
January 1, 2015, to December 31, 201560
January 1, 2016, to December 31, 201640
January 1, 2017, to December 31, 201720
January 1, 2018 and thereafter0

VIII. Standardized Approach for Risk-Weighted Assets

In the Standardized Approach NPR, the agencies and the FDIC proposed to revise methodologies for calculating risk-weighted assets. As discussed above and in the proposal, these revisions were intended to harmonize the agencies' and the FDIC's rules for calculating risk-weighted assets and to enhance the risk sensitivity and remediate weaknesses identified over recent years.[122] The proposed revisions incorporated elements of the Basel II standardized approach [123] as modified by the 2009 Enhancements, certain aspects of Basel III, and other proposals in recent consultative papers published by the BCBS.[124] Consistent with section 939A of the Dodd-Frank Act, the agencies and the FDIC also proposed alternatives to credit ratings for calculating risk weights for certain assets.

The proposal also included potential revisions for the recognition of credit risk mitigation that would allow for greater recognition of financial collateral and a wider range of eligible guarantors. In addition, the proposal set forth more risk-sensitive treatments for residential mortgages, equity exposures and past due loans, derivatives and repo-style transactions cleared through CCPs, and certain commercial real estate exposures that typically have higher credit risk, as well as operational requirements for securitization exposures. The agencies and the FDIC also proposed to apply disclosure requirements to top-tier banking organizations with $50 billion or more in total assets that are not subject to the advanced approaches rule.

The agencies and the FDIC received a significant number of comments regarding the proposed standardized approach for risk-weighted assets. Although a few commenters observed that the proposals would provide a sound framework for determining risk-weighted assets for all banking organizations that would generally benefit U.S. banking organizations, a significant number of other commenters asserted that the proposals were too complex and burdensome, especially for smaller banking organizations, and some argued that it was inappropriate to apply the proposed requirements to such banking organizations because such institutions did not cause the recent financial crisis. Other commenters expressed concern that the new calculation for risk-weighted assets would adversely affect banking organizations' regulatory capital ratios and that smaller banking organizations would have difficulties obtaining the data and performing the calculations required by the proposals. A number of commenters also expressed concern about the burden of the proposals in the context of multiple new regulations, including new standards for mortgages and increased regulatory capital requirements generally. One commenter urged the agencies and the FDIC to maintain key aspects of the proposed risk-weighted asset treatment for community banking organizations, but generally requested that the agencies and the FDIC reduce the perceived complexity. The agencies have considered these comments and, where applicable, have focused on simplicity, comparability, and broad applicability of methodologies for U.S. banking organizations under the standardized approach.

Some commenters asked that the proposed requirements be optional for community banking organizations until the effects of the proposals have been studied, or that the proposed standardized approach be withdrawn entirely. A number of the commenters requested specific modifications to the proposals. For example, some requested an exemption for community banking organizations from the proposed due diligence requirements for securitization exposures. Other commenters requested that the agencies and the FDIC grandfather the risk weighting of existing loans, arguing that doing so would lessen the proposed rule's implementation burden.

To address commenters' concerns about the standardized approach's burden and the accessibility of credit, the agencies have revised elements of the proposed rule, as described in further detail below. In particular, the agencies have modified the proposed approach to risk weighting residential mortgage loans to reflect the approach in the agencies general risk-based capital rules. The agencies believe the standardized approach more accurately captures the risk of banking organizations' assets and, therefore, are applying this aspect of the final rule to all banking organizations subject to the rule.

This section of the preamble describes in detail the specific proposals for the standardized treatment of risk-weighted assets, comments received on those proposals, and the provisions of the final rule in subpart D as adopted by the agencies. These sections of the preamble discuss how subpart D of the final rule differs from the general risk-based capital rules, and provides examples for how a banking organization must calculate risk-weighted asset amounts under the final rule.

Beginning on January 1, 2015, all banking organizations will be required to calculate risk-weighted assets under subpart D of the final rule. Until then, banking organizations must calculate risk-weighted assets using the methodologies set forth in the general risk-based capital rules. Advanced approaches banking organizations are subject to additional requirements, as described in section III.D of this Start Printed Page 62083preamble, regarding the timeframe for implementation.

A. Calculation of Standardized Total Risk-Weighted Assets

Consistent with the Standardized Approach NPR, the final rule requires a banking organization to calculate its risk-weighted asset amounts for its on- and off-balance sheet exposures and, for market risk banks only, standardized market risk-weighted assets as determined under subpart F.[125] Risk-weighted asset amounts generally are determined by assigning on-balance sheet assets to broad risk-weight categories according to the counterparty, or, if relevant, the guarantor or collateral. Similarly, risk-weighted asset amounts for off-balance sheet items are calculated using a two-step process: (1) Multiplying the amount of the off-balance sheet exposure by a credit conversion factor (CCF) to determine a credit equivalent amount, and (2) assigning the credit equivalent amount to a relevant risk-weight category.

A banking organization must determine its standardized total risk-weighted assets by calculating the sum of (1) its risk-weighted assets for general credit risk, cleared transactions, default fund contributions, unsettled transactions, securitization exposures, and equity exposures, each as defined below, plus (2) market risk-weighted assets, if applicable, minus (3) the amount of the banking organization's ALLL that is not included in tier 2 capital, and any amounts of allocated transfer risk reserves.

B. Risk-Weighted Assets for General Credit Risk

Consistent with the proposal, under the final rule total risk-weighted assets for general credit risk equals the sum of the risk-weighted asset amounts as calculated under section 31(a) of the final rule. General credit risk exposures include a banking organization's on-balance sheet exposures (other than cleared transactions, default fund contributions to CCPs, securitization exposures, and equity exposures, each as defined in section 2 of the final rule), exposures to over-the-counter (OTC) derivative contracts, off-balance sheet commitments, trade and transaction-related contingencies, guarantees, repo-style transactions, financial standby letters of credit, forward agreements, or other similar transactions.

Under the final rule, the exposure amount for the on-balance sheet component of an exposure is generally the banking organization's carrying value for the exposure as determined under GAAP. The agencies believe that using GAAP to determine the amount and nature of an exposure provides a consistent framework that can be easily applied across all banking organizations. Generally, banking organizations already use GAAP to prepare their financial statements and regulatory reports, and this treatment reduces potential burden that could otherwise result from requiring banking organizations to comply with a separate set of accounting and measurement standards for risk-based capital calculation purposes under non-GAAP standards, such as regulatory accounting practices or legal classification standards.

For purposes of the definition of exposure amount for AFS or held-to-maturity debt securities and AFS preferred stock not classified as equity under GAAP that are held by a banking organization that has made an AOCI opt-out election, the exposure amount is the banking organization's carrying value (including net accrued but unpaid interest and fees) for the exposure, less any net unrealized gains, and plus any net unrealized losses. For purposes of the definition of exposure amount for AFS preferred stock classified as an equity security under GAAP that is held by a banking organization that has made an AOCI opt-out election, the exposure amount is the banking organization's carrying value (including net accrued but unpaid interest and fees) for the exposure, less any net unrealized gains that are reflected in such carrying value but excluded from the banking organization's regulatory capital.

In most cases, the exposure amount for an off-balance sheet component of an exposure is determined by multiplying the notional amount of the off-balance sheet component by the appropriate CCF as determined under section 33 of the final rule. The exposure amount for an OTC derivative contract or cleared transaction is determined under sections 34 and 35, respectively, of the final rule, whereas exposure amounts for collateralized OTC derivative contracts, collateralized cleared transactions, repo-style transactions, and eligible margin loans are determined under section 37 of the final rule.

1. Exposures to Sovereigns

Consistent with the proposal, the final rule defines a sovereign as a central government (including the U.S. government) or an agency, department, ministry, or central bank of a central government. In the Standardized Approach NPR, the agencies and the FDIC proposed to retain the general risk-based capital rules' risk weights for exposures to and claims directly and unconditionally guaranteed by the U.S. government or its agencies. The final rule adopts the proposed treatment and provides that exposures to the U.S. government, its central bank, or a U.S. government agency and the portion of an exposure that is directly and unconditionally guaranteed by the U.S. government, the U.S. central bank, or a U.S. government agency receive a zero percent risk weight.[126] Consistent with the general risk-based capital rules, the portion of a deposit or other exposure insured or otherwise unconditionally guaranteed by the FDIC or the National Credit Union Administration also is assigned a zero percent risk weight. An exposure conditionally guaranteed by the U.S. government, its central bank, or a U.S. government agency receives a 20 percent risk weight.[127] This includes an exposure that is conditionally guaranteed by the FDIC or the National Credit Union Administration.

The agencies and the FDIC proposed in the Standardized Approach NPR to revise the risk weights for exposures to foreign sovereigns. The agencies' general risk-based capital rules generally assign risk weights to direct exposures to sovereigns and exposures directly guaranteed by sovereigns based on whether the sovereign is a member of the Organization for Economic Co-operation and Development (OECD) and, as applicable, whether the exposure is unconditionally or conditionally guaranteed by the sovereign.[128]

Under the proposed rule, the risk weight for a foreign sovereign exposure Start Printed Page 62084would have been determined using OECD Country Risk Classifications (CRCs) (the CRC methodology).[129] The CRCs reflect an assessment of country risk, used to set interest rate charges for transactions covered by the OECD arrangement on export credits. The CRC methodology classifies countries into one of eight risk categories (0-7), with countries assigned to the zero category having the lowest possible risk assessment and countries assigned to the 7 category having the highest possible risk assessment. Using CRCs to risk weight sovereign exposures is an option that is included in the Basel II standardized framework. The agencies and the FDIC proposed to map risk weights ranging from 0 percent to 150 percent to CRCs in a manner consistent with the Basel II standardized approach, which provides risk weights for foreign sovereigns based on country risk scores.

The agencies and the FDIC also proposed to assign a 150 percent risk weight to foreign sovereign exposures immediately upon determining that an event of sovereign default has occurred or if an event of sovereign default has occurred during the previous five years. The proposal defined sovereign default as noncompliance by a sovereign with its external debt service obligations or the inability or unwillingness of a sovereign government to service an existing loan according to its original terms, as evidenced by failure to pay principal or interest fully and on a timely basis, arrearages, or restructuring. Restructuring would include a voluntary or involuntary restructuring that results in a sovereign not servicing an existing obligation in accordance with the obligation's original terms.

The agencies and the FDIC received several comments on the proposed risk weights for foreign sovereign exposures. Some commenters criticized the proposal, arguing that CRCs are not sufficiently risk sensitive and basing risk weights on CRCs unduly benefits certain jurisdictions with unstable fiscal positions. A few commenters asserted that the increased burden associated with tracking CRCs to determine risk weights outweighs any increased risk sensitivity gained by using CRCs relative to the general risk-based capital rules. Some commenters also requested that the CRC methodology be disclosed so that banking organizations could perform their own due diligence. One commenter also indicated that community banking organizations should be permitted to maintain the treatment under the general risk-based capital rules.

Following the publication of the proposed rule, the OECD determined that certain high-income countries that received a CRC of 0 in 2012 will no longer receive any CRC.[130]

Despite the limitations associated with risk weighting foreign sovereign exposures using CRCs, the agencies have decided to retain this methodology, modified as described below to take into account that some countries will no longer receive a CRC. Although the agencies recognize that the risk sensitivity provided by the CRCs is limited, they consider CRCs to be a reasonable alternative to credit ratings for sovereign exposures and the CRC methodology to be more granular and risk sensitive than the current risk-weighting methodology based solely on OECD membership. Furthermore, the OECD regularly updates CRCs and makes the assessments publicly available on its Web site.[131] Accordingly, the agencies believe that risk weighting foreign sovereign exposures with reference to CRCs (as applicable) should not unduly burden banking organizations. Additionally, the 150 percent risk weight assigned to defaulted sovereign exposures should mitigate the concerns raised by some commenters that the use of CRCs assigns inappropriate risk weights to exposures to countries experiencing fiscal stress.

The final rule assigns risk weights to foreign sovereign exposures as set forth in Table 17 below. The agencies modified the final rule to reflect a change in OECD practice for assigning CRCs for certain member countries so that those member countries that no longer receive a CRC are assigned a zero percent risk weight. Applying a zero percent risk weight to exposures to these countries is appropriate because they will remain subject to the same market credit risk pricing formulas of the OECD's rating methodologies that are applied to all OECD countries with a CRC of 0. In other words, OECD member countries that are no longer assigned a CRC exhibit a similar degree of country risk as that of a jurisdiction with a CRC of zero. The final rule, therefore, provides a zero percent risk weight in these cases. Additionally, a zero percent risk weight for these countries is generally consistent with the risk weight they would receive under the agencies' general risk-based capital rules.

Table 17—Risk Weights for Sovereign Exposures

Risk weight (in percent)
CRC:
0-10
220
350
4-6100
7150
OECD Member with No CRC0
Non-OECD Member with No CRC100
Sovereign Default150

Consistent with the proposal, the final rule provides that if a banking supervisor in a sovereign jurisdiction allows banking organizations in that jurisdiction to apply a lower risk weight to an exposure to the sovereign than Table 17 provides, a U.S. banking organization may assign the lower risk weight to an exposure to the sovereign, provided the exposure is denominated in the sovereign's currency and the U.S. banking organization has at least an equivalent amount of liabilities in that foreign currency.

2. Exposures to Certain Supranational Entities and Multilateral Development Banks

Under the general risk-based capital rules, exposures to certain supranational entities and MDBs receive a 20 percent risk weight. Consistent with the Basel II standardized framework, the agencies and the FDIC proposed to apply a zero percent risk weight to exposures to the Bank for International Settlements, the European Central Bank, the European Commission, and the International Monetary Fund. The agencies and the FDIC also proposed to apply a zero percent risk weight to exposures to an MDB in accordance with the Basel framework. The proposal defined an MDB to include the International Bank for Reconstruction and Development, the Multilateral Investment Guarantee Agency, the International Finance Corporation, the Inter-American Development Bank, the Asian Start Printed Page 62085Development Bank, the African Development Bank, the European Bank for Reconstruction and Development, the European Investment Bank, the European Investment Fund, the Nordic Investment Bank, the Caribbean Development Bank, the Islamic Development Bank, the Council of Europe Development Bank, and any other multilateral lending institution or regional development bank in which the U.S. government is a shareholder or contributing member or which the primary Federal supervisor determines poses comparable credit risk.

As explained in the proposal, the agencies believe this treatment is appropriate in light of the generally high-credit quality of MDBs, their strong shareholder support, and a shareholder structure comprised of a significant proportion of sovereign entities with strong creditworthiness. The agencies have adopted this aspect of the proposal without change. Exposures to regional development banks and multilateral lending institutions that are not covered under the definition of MDB generally are treated as corporate exposures assigned to the 100 percent risk weight category.

3. Exposures to Government-Sponsored Enterprises

The general risk-based capital rules assign a 20 percent risk weight to exposures to GSEs that are not equity exposures and a 100 percent risk weight to GSE preferred stock in the case of the Board (the OCC has assigned a 20 percent risk weight to GSE preferred stock).

The agencies and the FDIC proposed to continue to assign a 20 percent risk weight to exposures to GSEs that are not equity exposures and to also assign a 100 percent risk weight to preferred stock issued by a GSE. As explained in the proposal, the agencies believe these risk weights remain appropriate for the GSEs under their current circumstances, including those in the conservatorship of the Federal Housing Finance Agency and receiving capital support from the U.S. Treasury. The agencies maintain that the obligations of the GSEs, as private corporations whose obligations are not explicitly guaranteed by the full faith and credit of the United States, should not receive the same treatment as obligations that have such an explicit guarantee.

4. Exposures to Depository Institutions, Foreign Banks, and Credit Unions

The general risk-based capital rules assign a 20 percent risk weight to all exposures to U.S. depository institutions and foreign banks incorporated in an OECD country. Under the general risk-based capital rules, short-term exposures to foreign banks incorporated in a non-OECD country receive a 20 percent risk weight and long-term exposures to such entities receive a 100 percent risk weight.

The proposed rule would assign a 20 percent risk weight to exposures to U.S. depository institutions and credit unions.[132] Consistent with the Basel II standardized framework, under the proposed rule, an exposure to a foreign bank would receive a risk weight one category higher than the risk weight assigned to a direct exposure to the foreign bank's home country, based on the assignment of risk weights by CRC, as discussed above.[133] A banking organization would be required to assign a 150 percent risk weight to an exposure to a foreign bank immediately upon determining that an event of sovereign default has occurred in the foreign bank's home country, or if an event of sovereign default has occurred in the foreign bank's home country during the previous five years.

A few commenters asserted that the proposed 20 percent risk weight for exposures to U.S. banking organizations—when compared to corporate exposures that are assigned a 100 percent risk weight—would continue to encourage banking organizations to become overly concentrated in the financial sector. The agencies have concluded that the proposed 20 percent risk weight is an appropriate reflection of risk for this exposure type when taking into consideration the extensive regulatory and supervisory frameworks under which these institutions operate. In addition, the agencies note that exposures to the capital of other financial institutions, including depository institutions and credit unions, are subject to deduction from capital if they exceed certain limits as set forth in section 22 of the final rule (discussed above in section V.B of this preamble). Therefore, the final rule retains, as proposed, the 20 percent risk weight for exposures to U.S. banking organizations.

The agencies have adopted the proposal with modifications to take into account the OECD's decision to withdraw CRCs for certain OECD member countries. Accordingly, exposures to a foreign bank in a country that does not have a CRC, but that is a member of the OECD, are assigned a 20 percent risk weight and exposures to a foreign bank in a non-OECD member country that does not have a CRC continue to receive a 100 percent risk weight.

Additionally, the agencies have adopted the proposed requirement that exposures to a financial institution that are included in the regulatory capital of such financial institution receive a risk weight of 100 percent, unless the exposure is (1) An equity exposure, (2) a significant investment in the capital of an unconsolidated financial institution in the form of common stock under section 22 of the final rule, (3) an exposure that is deducted from regulatory capital under section 22 of the final rule, or (4) an exposure that is subject to the 150 percent risk weight under Table 2 of section 32 of the final rule.

As described in the Standardized Approach NPR, in 2011, the BCBS revised certain aspects of the Basel capital framework to address potential adverse effects of the framework on trade finance in low-income countries.[134] In particular, the framework was revised to remove the sovereign floor for trade finance-related claims on banking organizations under the Basel II standardized approach.[135] The proposal incorporated this revision and would have permitted a banking organization to assign a 20 percent risk weight to self-liquidating trade-related contingent items that arise from the movement of goods and that have a maturity of three months or less.[136] Consistent with the proposal, the final rule permits a banking organization to assign a 20 percent risk weight to self-liquidating, trade-related contingent items that arise from the movement of Start Printed Page 62086goods and that have a maturity of three months or less.

As discussed in the proposal, although the Basel capital framework permits exposures to securities firms that meet certain requirements to be assigned the same risk weight as exposures to depository institutions, the agencies do not believe that the risk profile of securities firms is sufficiently similar to depository institutions to justify assigning the same risk weight to both exposure types. Therefore, the agencies and the FDIC proposed that banking organizations assign a 100 percent risk weight to exposures to securities firms, which is the same risk weight applied to BHCs, SLHCs, and other financial institutions that are not insured depository institutions or credit unions, as described in section VIII.B of this preamble.

Several commenters asserted that the final rule should be consistent with the Basel framework and permit lower risk weights for exposures to securities firms, particularly for securities firms in a sovereign jurisdiction with a CRC of 0 or 1. The agencies considered these comments and have concluded that that exposures to securities firms exhibit a similar degree of risk as exposures to other financial institutions that are assigned a 100 percent risk weight, because of the nature and risk profile of their activities, which are more expansive and exhibit more varied risk profiles than the activities permissible for depository institutions and credit unions. Accordingly, the agencies have adopted the 100 percent risk weight for securities firms without change.

5. Exposures to Public-Sector Entities

The proposal defined a PSE as a state, local authority, or other governmental subdivision below the level of a sovereign, which includes U.S. states and municipalities. The proposed definition did not include government-owned commercial companies that engage in activities involving trade, commerce, or profit that are generally conducted or performed in the private sector. The agencies and the FDIC proposed to define a general obligation as a bond or similar obligation that is backed by the full faith and credit of a PSE, whereas a revenue obligation would be defined as a bond or similar obligation that is an obligation of a PSE, but which the PSE has committed to repay with revenues from a specific project rather than general tax funds. In the final rule, the agencies are adopting these definitions as proposed.

The agencies and the FDIC proposed to assign a 20 percent risk weight to a general obligation exposure to a PSE that is organized under the laws of the United States or any state or political subdivision thereof, and a 50 percent risk weight to a revenue obligation exposure to such a PSE. These are the risk weights assigned to U.S. states and municipalities under the general risk-based capital rules.

Some commenters asserted that available default data does not support a differentiated treatment between revenue obligations and general obligations. In addition, some commenters contended that higher risk weights for revenue obligation bonds would needlessly and adversely affect state and local agencies' ability to meet the needs of underprivileged constituents. One commenter specifically recommended assigning a 20 percent risk weight to investment-grade revenue obligations. Another commenter recommended that exposures to U.S. PSEs should receive the same treatment as exposures to the U.S. government.

The agencies considered these comments, including with respect to burden on state and local programs, but concluded that the higher regulatory capital requirement for revenue obligations is appropriate because those obligations are dependent on revenue from specific projects and generally a PSE is not legally obligated to repay these obligations from other revenue sources. Although some evidence may suggest that there are not substantial differences in credit quality between general and revenue obligation exposures, the agencies believe that such dependence on project revenue presents more credit risk relative to a general repayment obligation of a state or political subdivision of a sovereign. Therefore, the proposed differentiation of risk weights between general obligation and revenue exposures is retained in the final rule. The agencies also continue to believe that PSEs collectively pose a greater credit risk than U.S. sovereign debt and, therefore, are appropriately assigned a higher risk weight under the final rule.

Consistent with the Basel II standardized framework, the agencies and the FDIC proposed to require banking organizations to risk weight exposures to a non-U.S. PSE based on (1) the CRC assigned to the PSE's home country and (2) whether the exposure is a general obligation or a revenue obligation. The risk weights assigned to revenue obligations were proposed to be higher than the risk weights assigned to a general obligation issued by the same PSE.

For purposes of the final rule, the agencies have adopted the proposed risk weights for non-U.S. PSEs with modifications to take into account the OECD's decision to withdraw CRCs for certain OECD member countries (discussed above), as set forth in Table 18 below. Under the final rule, exposures to a non-U.S. PSE in a country that does not have a CRC and is not an OECD member receive a 100 percent risk weight. Exposures to a non-U.S. PSE in a country that has defaulted on any outstanding sovereign exposure or that has defaulted on any sovereign exposure during the previous five years receive a 150 percent risk weight.

Table 18—Risk Weights for Exposures to Non-U.S. PSE General Obligations and Revenue Obligations

[In percent]

Risk weight for exposures to non- U.S. PSE general obligationsRisk weight for exposures to non- U.S.PSE revenue obligations
CRC:
0-12050
250100
3100100
4-7150150
OECD Member with No CRC2050
Non-OECD member with No CRC100100
Sovereign Default150150
Start Printed Page 62087

Consistent with the general risk-based capital rules as well as the proposed rule, a banking organization may apply a different risk weight to an exposure to a non-U.S. PSE if the banking organization supervisor in that PSE's home country allows supervised institutions to assign the alternative risk weight to exposures to that PSE. In no event, however, may the risk weight for an exposure to a non-U.S. PSE be lower than the risk weight assigned to direct exposures to the sovereign of that PSE's home country.

6. Corporate Exposures

Generally consistent with the general risk-based capital rules, the agencies and the FDIC proposed to require banking organizations to assign a 100 percent risk weight to all corporate exposures, including bonds and loans. The proposal defined a corporate exposure as an exposure to a company that is not an exposure to a sovereign, the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, an MDB, a depository institution, a foreign bank, a credit union, a PSE, a GSE, a residential mortgage exposure, a pre-sold construction loan, a statutory multifamily mortgage, a high-volatility commercial real estate (HVCRE) exposure, a cleared transaction, a default fund contribution, a securitization exposure, an equity exposure, or an unsettled transaction. The definition also captured all exposures that are not otherwise included in another specific exposure category.

Several commenters recommended differentiating the proposed risk weights for corporate bonds based on a bond's credit quality. Other commenters requested the agencies and the FDIC align the final rule with the Basel international standard that aligns risk weights with credit ratings. A few commenters asserted that a single 100 percent risk weight would disproportionately and adversely impact insurance companies that generally hold a higher share of corporate bonds in their investment portfolios. Another commenter contended that corporate bonds should receive a 50 percent risk weight, arguing that other exposures included in the corporate exposure category (such as commercial and industrial bank loans) are empirically of greater risk than corporate bonds.

One commenter requested that the standardized approach provide a distinct capital treatment of a 75 percent risk weight for retail exposures, consistent with the international standard under Basel II. The agencies have concluded that the proposed 100 percent risk weight assigned to retail exposures is appropriate given their risk profile in the United States and have retained the proposed treatment in the final rule. Consistent with the proposal, the final rule neither defines nor provides a separate treatment for retail exposures in the standardized approach.

As described in the proposal, the agencies removed the use of ratings from the regulatory capital framework, consistent with section 939A of the Dodd-Frank Act. The agencies therefore evaluated a number of alternatives to credit ratings to provide a more granular risk weight treatment for corporate exposures.[137] For example, the agencies considered market-based alternatives, such as the use of credit default and bond spreads, and use of particular indicators or parameters to differentiate between relative levels of credit risk. However, the agencies viewed each of the possible alternatives as having significant drawbacks, including their operational complexity, or insufficient development. For instance, the agencies were concerned that bond markets may sometimes misprice risk and bond spreads may reflect factors other than credit risk. The agencies also were concerned that such approaches could introduce undue volatility into the risk-based capital requirements.

The agencies considered suggestions offered by commenters and understand that a 100 percent risk weight may overstate the credit risk associated with some high-quality bonds. However, the agencies believe that a single risk weight of less than 100 percent would understate the risk of many corporate exposures and, as explained, have not yet identified an alternative methodology to credit ratings that would provide a sufficiently rigorous basis for differentiating the risk of various corporate exposures. In addition, the agencies believe that, on balance, a 100 percent risk weight is generally representative of a well-diversified corporate exposure portfolio. The final rule retains without change the 100 percent risk weight for all corporate exposures as well as the proposed definition of corporate exposure.

A few commenters requested clarification on the treatment for general-account insurance products. Under the final rule, consistent with the proposal, if a general-account exposure is to an organization that is not a banking organization, such as an insurance company, the exposure must receive a risk weight of 100 percent. Exposures to securities firms are subject to the corporate exposure treatment under the final rule, as described in section VIII.B of this preamble.

7. Residential Mortgage Exposures

Under the general risk-based capital requirements, first-lien residential mortgages made in accordance with prudent underwriting standards on properties that are owner-occupied or rented typically are assigned to the 50 percent risk-weight category. Otherwise, residential mortgage exposures are assigned to the 100 percent risk weight category.

The proposal would have substantially modified the risk-weight framework applicable to residential mortgage exposures and differed materially from both the general risk-based capital rules and the Basel capital framework. The agencies and the FDIC proposed to divide residential mortgage exposures into two categories. The proposal applied relatively low risk weights to residential mortgage exposures that did not have product features associated with higher credit risk, or “category 1” residential mortgages as defined in the proposal. The proposal defined all other residential mortgage exposures as “category 2” mortgages, which would receive relatively high risk weights. For both category 1 and category 2 mortgages, the proposed risk weight assigned also would have depended on the mortgage exposure's LTV ratio. Under the proposal, a banking organization would not be able to recognize private mortgage insurance (PMI) when calculating the LTV ratio of a residential mortgage exposure. Due to the varying degree of financial strength of mortgage insurance providers, the agencies stated that they did not believe that it would be prudent to consider PMI in the determination of LTV ratios under the proposal.

The agencies and the FDIC received a significant number of comments in opposition to the proposed risk weights for residential mortgages and in favor of retaining the risk-weight framework for residential mortgages in the general risk-based capital rules. Many commenters asserted that the increased risk weights for certain mortgages would inhibit lending to creditworthy borrowers, particularly when combined with the other proposed statutory and regulatory requirements being implemented under the authority of the Dodd-Frank Act, and could ultimately jeopardize the recovery of a still-fragile residential real estate market. Various commenters Start Printed Page 62088asserted that the agencies and the FDIC did not provide sufficient empirical support for the proposal and stated the proposal was overly complex and would not contribute meaningfully to the risk sensitivity of the regulatory capital requirements. They also asserted that the proposal would require some banking organizations to raise revenue through other, more risky activities to compensate for the potential increased costs.

Commenters also indicated that the distinction between category 1 and category 2 residential mortgages would adversely impact certain loan products that performed relatively well even during the recent crisis, such as balloon loans originated by community banking organizations. Other commenters criticized the proposed increased capital requirements for various loan products, including balloon and interest-only mortgages. Community banking organization commenters in particular asserted that such mortgage products are offered to hedge interest-rate risk and are frequently the only option for a significant segment of potential borrowers in their regions.

A number of commenters argued that the proposal would place U.S. banking organizations at a competitive disadvantage relative to foreign banking organizations subject to the Basel II standardized framework, which generally assigns a 35 percent risk weight to residential mortgage exposures. Several commenters indicated that the proposed treatment would potentially undermine government programs encouraging residential mortgage lending to lower-income individuals and underserved regions. Commenters also asserted that PMI should receive explicit recognition in the final rule through a reduction in risk weights, given the potential negative impact on mortgage availability (particularly to first-time borrowers) of the proposed risk weights.

In addition to comments on the specific elements of the proposal, a significant number of commenters alleged that the agencies and the FDIC did not sufficiently consider the potential impact of other regulatory actions on the mortgage industry. For instance, commenters expressed considerable concern regarding the new requirements associated with the Dodd-Frank Act's qualified mortgage definition under the Truth in Lending Act.[138] Many of these commenters asserted that when combined with this proposal, the cumulative effect of the new regulatory requirements could adversely impact the residential mortgage industry.

The agencies and the FDIC also received specific comments concerning potential logistical difficulties they would face implementing the proposal. Many commenters argued that tracking loans by LTV and category would be administratively burdensome, requiring the development or purchase of new systems. These commenters requested that, at a minimum, existing mortgages continue to be assigned the risk weights they would receive under the general risk-based capital rules and exempted from the proposed rules. Many commenters also requested clarification regarding the method for calculating the LTV for first and subordinate liens, as well as how and whether a loan could be reclassified between the two residential mortgage categories. For instance, commenters raised various technical questions on how to calculate the LTV of a restructured mortgage and under what conditions a restructured loan could qualify as a category 1 residential mortgage exposure.

The agencies considered the comments pertaining to the residential mortgage proposal, particularly comments regarding the issuance of new regulations designed to improve the quality of mortgage underwriting and to generally reduce the associated credit risk, including the final definition of “qualified mortgage” as implemented by the Consumer Financial Protection Bureau (CFPB) pursuant to the Dodd-Frank Act.[139] Additionally, the agencies are mindful of the uncertain implications that the proposal, along with other mortgage-related rulemakings, could have had on the residential mortgage market, particularly regarding underwriting and credit availability. The agencies also considered the commenters' observations about the burden of calculating the risk weights for banking organizations' existing mortgage portfolios, and have taken into account the commenters' concerns about the availability of different mortgage products across different types of markets.

In light of these considerations, the agencies have decided to retain in the final rule the treatment for residential mortgage exposures that is currently set forth in the general risk-based capital rules. The agencies may develop and propose changes in the treatment of residential mortgage exposures in the future, and in that process, the agencies intend to take into consideration structural and product market developments, other relevant regulations, and potential issues with implementation across various product types.

Accordingly, as under the general risk-based capital rules, the final rule assigns exposures secured by one-to-four family residential properties to either the 50 percent or the 100 percent risk-weight category. Exposures secured by a first-lien on an owner-occupied or rented one-to-four family residential property that meet prudential underwriting standards, including standards relating to the loan amount as a percentage of the appraised value of the property, are not 90 days or more past due or carried on non-accrual status, and that are not restructured or modified receive a 50 percent risk weight. If a banking organization holds the first and junior lien(s) on a residential property and no other party holds an intervening lien, the banking organization must treat the combined exposure as a single loan secured by a first lien for purposes of determining the loan-to-value ratio and assigning a risk weight. A banking organization must assign a 100 percent risk weight to all other residential mortgage exposures. Under the final rule, a residential mortgage guaranteed by the federal government through the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA) generally will be risk-weighted at 20 percent.

Consistent with the general risk-based capital rules, under the final rule, a residential mortgage exposure may be assigned to the 50 percent risk-weight category only if it is not restructured or modified. Under the final rule, consistent with the proposal, a residential mortgage exposure modified or restructured on a permanent or trial basis solely pursuant to the U.S. Treasury's Home Affordable Mortgage Program (HAMP) is not considered to be restructured or modified. Several commenters from community banking organizations encouraged the agencies to broaden this exemption and not penalize banking organizations for participating in other successful loan modification programs. As described in greater detail in the proposal, the agencies believe that treating mortgage loans modified pursuant to HAMP in this manner is appropriate in light of the special and unique incentive features of HAMP, and the fact that the program is offered by the U.S. government to achieve the public policy objective of promoting sustainable loan Start Printed Page 62089modifications for homeowners at risk of foreclosure in a way that balances the interests of borrowers, servicers, and lenders.

8. Pre-Sold Construction Loans and Statutory Multifamily Mortgages

The general risk-based capital rules assign either a 50 percent or a 100 percent risk weight to certain one-to-four family residential pre-sold construction loans and to multifamily residential loans, consistent with provisions of the Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 (RTCRRI Act).[140] The proposal maintained the same general treatment as the general risk-based capital rules and clarified and updated the manner in which the general risk-based capital rules define these exposures. Under the proposal, a pre-sold construction loan would be subject to a 50 percent risk weight unless the purchase contract is cancelled.

The agencies are adopting this aspect of the proposal without change. The final rule defines a pre-sold construction loan, in part, as any one-to-four family residential construction loan to a builder that meets the requirements of section 618(a)(1) or (2) of the RTCRRI Act, and also harmonizes the agencies' prior regulations. Under the final rule, a multifamily mortgage that does not meet the definition of a statutory multifamily mortgage is treated as a corporate exposure.

9. High-Volatility Commercial Real Estate

Supervisory experience has demonstrated that certain acquisition, development, and construction loans (which are a subset of commercial real estate exposures) present particular risks for which the agencies believe banking organizations should hold additional capital. Accordingly, the agencies and the FDIC proposed to require banking organizations to assign a 150 percent risk weight to any HVCRE exposure, which is higher than the 100 percent risk weight applied to such loans under the general risk-based capital rules. The proposal defined an HVCRE exposure 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, or commercial real estate projects that meet certain prudential criteria, including with respect to the LTV ratio and capital contributions or expense contributions of the borrower.

Commenters criticized the proposed HVCRE definition as overly broad and suggested an exclusion for certain acquisition, development, or construction (ADC) loans, including: (1) ADC loans that are less than a specific dollar amount or have a debt service coverage ratio of 100 percent (rather than 80 percent, under the agencies' and the FDIC's lending standards); (2) community development projects or projects financed by low-income housing tax credits; and (3) certain loans secured by agricultural property for the sole purpose of acquiring land. Several commenters asserted that the proposed 150 percent risk weight was too high for secured loans and would hamper local commercial development. Another commenter recommended the agencies and the FDIC increase the number of HVCRE risk-weight categories to reflect LTV ratios.

The agencies have considered the comments and have decided to retain the 150 percent risk weight for HVCRE exposures (modified as described below), given the increased risk of these activities when compared to other commercial real estate loans.[141] The agencies believe that segmenting HVCRE by LTV ratio would introduce undue complexity without providing a sufficient improvement in risk sensitivity. The agencies have also determined not to exclude from the HVCRE definition ADC loans that are characterized by a specified dollar amount or loans with a debt service coverage ratio greater than 80 percent because an arbitrary threshold would likely not capture certain ADC loans with elevated risks. Consistent with the proposal, a commercial real estate loan that is not an HVCRE exposure is treated as a corporate exposure.

Many commenters requested clarification as to whether all commercial real estate or ADC loans are considered HVCRE exposures. Consistent with the proposal, the final rule's HVCRE definition only applies to a specific subset of ADC loans and is, therefore, not applicable to all commercial real estate loans. Specifically, some commenters sought clarification on whether a facility would remain an HVCRE exposure for the life of the loan and whether owner-occupied commercial real estate loans are included in the HVCRE definition. The agencies note that when the life of the ADC project concludes and the credit facility is converted to permanent financing in accordance with the banking organization's normal lending terms, the permanent financing is not an HVCRE exposure. Thus, a loan permanently financing owner-occupied commercial real estate is not an HVCRE exposure. Given these clarifications, the agencies believe that many concerns regarding the potential adverse impact on commercial development were, in part, driven by a lack of clarity regarding the definition of the HVCRE, and believe that the treatment of HVCRE exposures in the final rule appropriately reflects their risk relative to other commercial real estate exposures.

Commenters also sought clarification as to whether cash or securities used to purchase land counts as borrower-contributed capital. In addition, a few commenters requested further clarification on what constitutes contributed capital for purposes of the final rule. Consistent with existing guidance, cash used to purchase land is a form of borrower contributed capital under the HVCRE definition.

In response to the comments, the final rule amends the proposed HVCRE definition to exclude loans that finance the acquisition, development, or construction of real property that would qualify as community development investments. The final rule does not require a banking organization to have an investment in the real property for it to qualify for the exemption: Rather, if the real property is such that an investment in that property would qualify as a community development investment, then a facility financing acquisition, development, or construction of that property would meet the terms of the exemption. The agencies have, however, determined not to give an automatic exemption from the HVCRE definition to all ADC loans to businesses or farms that have gross annual revenues of $1 million or less, although they could qualify for another exemption from the definition. For example, an ADC loan to a small business with annual revenues of under $1 million that meets the LTV ratio and contribution requirements set forth in paragraph (3) of the definition would qualify for that exemption from the definition as would a loan that finances real property that: Provides affordable housing (including multi-family rental housing) for low to moderate income Start Printed Page 62090individuals; is used in the provision of community services for low to moderate income individuals; or revitalizes or stabilizes low to moderate income geographies, designated disaster areas, or underserved areas specifically determined by the federal banking agencies based on the needs of low- and moderate-income individuals in those areas. The final definition also exempts ADC loans for the purchase or development of agricultural land, which is defined as all land known to be used or usable for agricultural purposes (such as crop and livestock production), provided that the valuation of the agricultural land is based on its value for agricultural purposes and the valuation does not consider any potential use of the land for non-agricultural commercial development or residential development.

10. Past-Due Exposures

Under the general risk-based capital rules, the risk weight of a loan does not change if the loan becomes past due, with the exception of certain residential mortgage loans. The Basel II standardized approach provides risk weights ranging from 50 to 150 percent for exposures, except sovereign exposures and residential mortgage exposures, that are more than 90 days past due to reflect the increased risk of loss. Accordingly, to reflect the impaired credit quality of such exposures, the agencies and the FDIC proposed to require a banking organization to assign a 150 percent risk weight to an exposure that is not guaranteed or not secured (and that is not a sovereign exposure or a residential mortgage exposure) if it is 90 days or more past due or on nonaccrual.

A number of commenters maintained that the proposed 150 percent risk weight is too high for various reasons. Specifically, several commenters asserted that ALLL is already reflected in the risk-based capital numerator, and therefore an increased risk weight double-counts the risk of a past-due exposure. Other commenters characterized the increased risk weight as procyclical and burdensome (particularly for community banking organizations), and maintained that it would unnecessarily discourage lending and loan modifications or workouts.

The agencies have considered the comments and have decided to retain the proposed 150 percent risk weight for past-due exposures in the final rule. The agencies note that the ALLL is intended to cover estimated, incurred losses as of the balance sheet date, rather than unexpected losses. The higher risk weight on past due exposures ensures sufficient regulatory capital for the increased probability of unexpected losses on these exposures. The agencies believe that any increased capital burden, potential rise in procyclicality, or impact on lending associated with the 150 percent risk weight is justified given the overall objective of better capturing the risk associated with the impaired credit quality of these exposures.

One commenter requested clarification as to whether a banking organization could reduce the risk weight for past-due exposures from 150 percent when the carrying value is charged down to the amount expected to be recovered. For the purposes of the final rule, a banking organization must apply a 150 percent risk weight to all past-due exposures, including any amount remaining on the balance sheet following a charge-off, to reflect the increased uncertainty as to the recovery of the remaining carrying value.

11. Other Assets

Generally consistent with the general risk-based capital rules, the agencies have decided to adopt, as proposed, the risk weights described below for exposures not otherwise assigned to a specific risk weight category. Specifically, a banking organization must assign:

(1) A zero percent risk weight to cash owned and held in all of a banking organization's offices or in transit; gold bullion held in the banking organization's own vaults, or held in another depository institution's vaults on an allocated basis to the extent gold bullion assets are offset by gold bullion liabilities; and to exposures that arise from the settlement of cash transactions (such as equities, fixed income, spot foreign exchange and spot commodities) with a CCP where there is no assumption of ongoing counterparty credit risk by the CCP after settlement of the trade and associated default fund contributions;

(2) A 20 percent risk weight to cash items in the process of collection; and

(3) A 100 percent risk weight to all assets not specifically assigned a different risk weight under the final rule (other than exposures that would be deducted from tier 1 or tier 2 capital), including deferred acquisition costs (DAC) and value of business acquired (VOBA).

In addition, subject to the proposed transition arrangements under section 300 of the final rule, a banking organization must assign:

(1) A 100 percent risk weight to DTAs arising from temporary differences that the banking organization could realize through net operating loss carrybacks; and

(2) A 250 percent risk weight to the portion of MSAs and DTAs arising from temporary differences that the banking organization could not realize through net operating loss carrybacks that are not deducted from common equity tier 1 capital pursuant to section 22(d).

The agencies and the FDIC received a few comments on the treatment of DAC and VOBA. DAC represents certain costs incurred in the acquisition of a new contract or renewal insurance contract that are capitalized pursuant to GAAP. VOBA refers to assets that reflect revenue streams from insurance policies purchased by an insurance company. One commenter asked for clarification on risk weights for other types of exposures that are not assigned a specific risk weight under the proposal. Consistent with the proposal, under the final rule these assets receive a 100 percent risk weight, together with other assets not specifically assigned a different risk weight under the NPR.

Consistent with the general risk-based capital rules, the final rule retains the limited flexibility to address situations where exposures of a banking organization that are not exposures typically held by depository institutions do not fit wholly within the terms of another risk-weight category. Under the final rule, a banking organization may assign such exposures to the risk-weight category applicable under the capital rules for BHCs or covered SLHCs, provided that (1) the banking organization is not authorized to hold the asset under applicable law other than debt previously contracted or similar authority; and (2) the risks associated with the asset are substantially similar to the risks of assets that are otherwise assigned to a risk-weight category of less than 100 percent under subpart D of the final rule.

C. Off-Balance Sheet Items

1. Credit Conversion Factors

Under the proposed rule, as under the general risk-based capital rules, a banking organization would calculate the exposure amount of an off-balance sheet item by multiplying the off-balance sheet component, which is usually the contractual amount, by the applicable credit conversion factors (CCF). This treatment would apply to all off-balance sheet items, such as commitments, contingent items, guarantees, certain repo-style transactions, financial standby letters of credit, and forward agreements. The proposed rule, however, introduced Start Printed Page 62091new CCFs applicable to certain exposures, such as a higher CCF for commitments with an original maturity of one year or less that are not unconditionally cancelable.

Commenters offered a number of suggestions for revising the proposed CCFs that would be applied to off-balance sheet exposures. Commenters generally asked for lower CCFs that, according to the commenters, are more directly aligned with a particular off-balance sheet exposure's loss history. In addition, some commenters asked the agencies and the FDIC to conduct a calibration study to show that the proposed CCFs were appropriate.

The agencies have decided to retain the proposed CCFs for off-balance sheet exposures without change for purposes of the final rule. The agencies believe that the proposed CCFs meet the agencies' goals of improving risk sensitivity and implementing higher capital requirements for certain exposures through a simple methodology. Furthermore, alternatives proposed by commenters, such as exposure measures tied directly to a particular exposure's loss history, would create significant operational burdens for many small- and mid-sized banking organizations, by requiring them to keep accurate historical records of losses and continuously adjust their capital requirements for certain exposures to account for new loss data. Such a system would be difficult for the agencies to monitor, as the agencies would need to verify the accuracy of historical loss data and ensure that capital requirements are properly applied across institutions. Incorporation of additional factors, such as loss history or increasing the number of CCF categories, would detract from the agencies' stated goal of simplicity in its capital treatment of off-balance sheet exposures. Additionally, the agencies believe that the CCFs, as proposed, were properly calibrated to reflect the risk profiles of the exposures to which they are applied and do not believe a calibration study is required.

Accordingly, under the final rule, as proposed, a banking organization may apply a zero percent CCF to the unused portion of commitments that are unconditionally cancelable by the banking organization. For purposes of the final rule, a commitment means any legally binding arrangement that obligates a banking organization to extend credit or to purchase assets. Unconditionally cancelable means a commitment for which a banking organization may, at any time, with or without cause, refuse to extend credit (to the extent permitted under applicable law). In the case of a residential mortgage exposure that is a line of credit, a banking organization can unconditionally cancel the commitment if it, at its option, may prohibit additional extensions of credit, reduce the credit line, and terminate the commitment to the full extent permitted by applicable law. If a banking organization provides a commitment that is structured as a syndication, the banking organization is only required to calculate the exposure amount for its pro rata share of the commitment.

The proposed rule provided a 20 percent CCF for commitments with an original maturity of one year or less that are not unconditionally cancelable by a banking organization, and for self-liquidating, trade-related contingent items that arise from the movement of goods with an original maturity of one year or less.

Some commenters argued that the proposed designation of a 20 percent CCF for certain exposures was too high. For example, they requested that the final rule continue the current practice of applying a zero percent CCF to all unfunded lines of credit with less than one year maturity, regardless of the lender's ability to unconditionally cancel the line of credit. They also requested a CCF lower than 20 percent for the unused portions of letters of credit extended to a small, mid-market, or trade finance company with durations of less than one year or less. These commenters asserted that current market practice for these lines have covenants based on financial ratios, and any increase in riskiness that violates the contractual minimum ratios would prevent the borrower from drawing down the unused portion.

For purposes of the final rule, the agencies are retaining the 20 percent CCF, as it accounts for the elevated level of risk banking organizations face when extending short-term commitments that are not unconditionally cancelable. Although the agencies understand certain contractual provisions are common in the market, these practices are not static, and it is more appropriate from a regulatory standpoint to base a CCF on whether a commitment is unconditionally cancellable. A banking organization must apply a 20 percent CCF to a commitment with an original maturity of one year or less that is not unconditionally cancellable by the banking organization. The final rule also maintains the 20 percent CCF for self-liquidating, trade-related contingent items that arise from the movement of goods with an original maturity of one year or less. The final rule also requires a banking organization to apply a 50 percent CCF to commitments with an original maturity of more than one year that are not unconditionally cancelable by the banking organization, and to transaction-related contingent items, including performance bonds, bid bonds, warranties, and performance standby letters of credit.

Some commenters requested clarification regarding the treatment of commitments to extend letters of credit. They argued that these commitments are no more risky than commitments to extend loans and should receive similar treatment (20 percent or 50 percent CCF). For purposes of the final rule, the agencies note that section 33(a)(2) allows banking organizations to apply the lower of the two applicable CCFs to the exposures related to commitments to extend letters of credit. Banking organizations will need to make this determination based upon the individual characteristics of each letter of credit.

Under the final rule, a banking organization must apply a 100 percent CCF to off-balance sheet guarantees, repurchase agreements, credit-enhancing representations and warranties that are not securitization exposures, securities lending or borrowing transactions, financial standby letters of credit, and forward agreements, and other similar exposures. The off-balance sheet component of a repurchase agreement equals the sum of the current fair values of all positions the banking organization has sold subject to repurchase. The off-balance sheet component of a securities lending transaction is the sum of the current fair values of all positions the banking organization has lent under the transaction. For securities borrowing transactions, the off-balance sheet component is the sum of the current fair values of all non-cash positions the banking organization has posted as collateral under the transaction. In certain circumstances, a banking organization may instead determine the exposure amount of the transaction as described in section 37 of the final rule.

In contrast to the general risk-based capital rules, which require capital for securities lending and borrowing transactions and repurchase agreements that generate an on-balance sheet exposure, the final rule requires a banking organization to hold risk-based capital against all repo-style transactions, regardless of whether they generate on-balance sheet exposures, as described in section 37 of the final rule. One commenter disagreed with this treatment and requested an exemption from the capital treatment for off-balance sheet repo-style exposures. Start Printed Page 62092However, the agencies adopted this approach because banking organizations face counterparty credit risk when engaging in repo-style transactions, even if those transactions do not generate on-balance sheet exposures, and thus should not be exempt from risk-based capital requirements.

2. Credit-Enhancing Representations and Warranties

Under the general risk-based capital rules, a banking organization is subject to a risk-based capital requirement when it provides credit-enhancing representations and warranties on assets sold or otherwise transferred to third parties as such positions are considered recourse arrangements.[142] However, the general risk-based capital rules do not impose a risk-based capital requirement on assets sold or transferred with representations and warranties that (1) Contain early default clauses or similar warranties that permit the return of, or premium refund clauses covering, one-to-four family first-lien residential mortgage loans for a period not to exceed 120 days from the date of transfer; and (2) contain premium refund clauses that cover assets guaranteed, in whole or in part, by the U.S. government, a U.S. government agency, or a U.S. GSE, provided the premium refund clauses are for a period not to exceed 120 days; or (3) permit the return of assets in instances of fraud, misrepresentation, or incomplete documentation.[143]

In contrast, under the proposal, if a banking organization provides a credit-enhancing representation or warranty on assets it sold or otherwise transferred to third parties, including early default clauses that permit the return of, or premium refund clauses covering, one-to-four family residential first mortgage loans, the banking organization would treat such an arrangement as an off-balance sheet guarantee and apply a 100 percent CCF to determine the exposure amount, provided the exposure does not meet the definition of a securitization exposure. The agencies and the FDIC proposed a different treatment than the one under the general risk-based capital rules because of the risk to which banking organizations are exposed while credit-enhancing representations and warranties are in effect. Some commenters asked for clarification on what qualifies as a credit-enhancing representation and warranty, and commenters made numerous suggestions for revising the proposed definition. In particular, they disagreed with the agencies' and the FDIC's proposal to remove the exemptions related to early default clauses and premium refund clauses since these representations and warranties generally are considered to be low risk exposures and banking organizations are not currently required to hold capital against these representations and warranties.

Some commenters encouraged the agencies and the FDIC to retain the 120-day safe harbor from the general risk-based capital rules, which would not require holding capital against assets sold with certain early default clauses of 120 days or less. These commenters argued that the proposal to remove the 120-day safe harbor would impede the ability of banking organizations to make loans and would increase the cost of credit to borrowers. Furthermore, certain commenters asserted that removal of the 120-day safe harbor was not necessary for loan portfolios that are well underwritten, those for which put-backs are rare, and where the banking organization maintains robust buyback reserves.

After reviewing the comments, the agencies decided to retain in the final rule the 120-day safe harbor in the definition of credit-enhancing representations and warranties for early default and premium refund clauses on one-to-four family residential mortgages that qualify for the 50 percent risk weight as well as for premium refund clauses that cover assets guaranteed, in whole or in part, by the U.S. government, a U.S. government agency, or a U.S. GSE. The agencies determined that retaining the safe harbor would help to address commenters' confusion about what qualifies as a credit-enhancing representation and warranty. Therefore, consistent with the general risk-based capital rules, under the final rule, credit-enhancing representations and warranties will not include (1) Early default clauses and similar warranties that permit the return of, or premium refund clauses covering, one-to-four family first-lien residential mortgage loans that qualify for a 50 percent risk weight for a period not to exceed 120 days from the date of transfer; [144] (2) premium refund clauses that cover assets guaranteed by the U.S. government, a U.S. Government agency, or a GSE, provided the premium refund clauses are for a period not to exceed 120 days from the date of transfer; or (3) warranties that permit the return of underlying exposures in instances of misrepresentation, fraud, or incomplete documentation.

Some commenters requested clarification from the agencies and the FDIC regarding representations made about the value of the underlying collateral of a sold loan. For example, many purchasers of mortgage loans originated by banking organizations require that the banking organization repurchase the loan if the value of the collateral is other than as stated in the documentation provided to the purchaser or if there were any material misrepresentations in the appraisal process. The agencies confirm that such representations meets the “misrepresentation, fraud, or incomplete documentation” exclusion in the definition of credit-enhancing representations and warranties and is not subject to capital treatment.

A few commenters also requested clarification regarding how the definition of credit-enhancing representations and warranties in the proposal interacts with Federal Home Loan Mortgage Corporation (FHLMC), Federal National Mortgage Association (FNMA), and Government National Mortgage Association (GNMA) sales conventions. These same commenters also requested verification in the final rule that mortgages sold with representations and warranties would all receive a 100 percent risk weight, regardless of the characteristics of the mortgage exposure. First, the definition of credit-enhancing representations and warranties described in this final rule is separate from the sales conventions required by FLHMA, FNMA, and GNMA. Those entities will continue to set their own requirements for secondary sales, including representation and warranty requirements. Second, the risk weights applied to mortgage exposures themselves are not affected by the inclusion of representations and warranties. Mortgage exposures will continue to receive either a 50 or 100 percent risk weight, as outlined in section 32(g) of this final rule, regardless of the inclusion of representations and warranties when they are sold in the secondary market. If such representations and warranties meet the rule's definition of credit-enhancing representations and warranties, then the institution must maintain regulatory capital against the associated credit risk.

Some commenters disagreed with the proposed methodology for determining the capital requirement for Start Printed Page 62093representations and warranties, and offered alternatives that they argued would conform to existing market practices and better incentivize high-quality underwriting. Some commenters indicated that many originators already hold robust buyback reserves and argued that the agencies and the FDIC should require originators to hold adequate liquidity in their buyback reserves, instead of requiring a duplicative capital requirement. Other commenters asked that any capital requirement be directly aligned to that originator's history of honoring representation and warranty claims. These commenters stated that originators who underwrite high-quality loans should not be required to hold as much capital against their representations and warranties as originators who exhibit what the commenters referred to as “poor underwriting standards.” Finally, a few commenters requested that the agencies and the FDIC completely remove, or significantly reduce, capital requirements for representations and warranties. They argue that the market is able to regulate itself, as a banking organization will not be able to sell its loans in the secondary market if they are frequently put back by the buyers.

The agencies considered these alternatives and have decided to finalize the proposed methodology for determining the capital requirement applied to representations and warranties without change. The agencies are concerned that buyback reserves could be inadequate, especially if the housing market enters another prolonged downturn. Robust and clear capital requirements, in addition to separate buyback reserves held by originators, better ensure that representation and warranty claims will be fulfilled in times of stress. Furthermore, capital requirements based upon originators' historical representation and warranty claims are not only operationally difficult to implement and monitor, but they can also be misleading. Underwriting standards at firms are not static and can change over time. The agencies believe that capital requirements based on past performance of a particular underwriter do not always adequately capture the current risks faced by that firm. The agencies believe that the incorporation of the 120-day safe harbor in the final rule as discussed above addresses many of the commenters' concerns.

Some commenters requested clarification on the duration of the capital treatment for credit-enhancing representations and warranties. For instance, some commenters questioned whether capital is required for credit-enhancing representations and warranties after the contractual life of the representations and warranties has expired or whether capital has to be held for the life of the asset. Banking organizations are not required to hold capital for any credit-enhancing representation and warranty after the expiration of the representation or warranty, regardless of the maturity of the underlying loan.

Additionally, commenters indicated that market practice for some representations and warranties for sold mortgages stipulates that originators only need to refund the buyer any servicing premiums and other earned fees in cases of early default, rather than requiring putback of the underlying loan to the seller. These commenters sought clarification as to whether the proposal would have required them to hold capital against the value of the underlying loan or only for the premium or fees that could be subject to a refund, as agreed upon in their contract with the buyer. For purposes of the final rule, a banking organization must hold capital only for the maximum contractual amount of the banking organization's exposure under the representations and warranties. In the case described by the commenters, the banking organization would hold capital against the value of the servicing premium and other earned fees, rather than the value of the underlying loan, for the duration specified in the representations and warranties agreement.

Some commenters also requested exemptions from the proposed treatment of representations and warranties for particular originators, types of transactions, or asset categories. In particular, many commenters asked for an exemption for community banking organizations, claiming that the proposed treatment would lessen credit availability and increase the costs of lending. One commenter argued that bona fide mortgage sale agreements should be exempt from capital requirements. Other commenters requested an exemption for the portion of any off-balance sheet asset that is subject to a risk retention requirement under section 941 of the Dodd-Frank Act and any regulations promulgated thereunder.[145] Some commenters also requested that the agencies and the FDIC delay action on the proposal until the risk retention rule is finalized. Other commenters also requested exemptions for qualified mortgages (QM) and “prime” mortgage loans.

The agencies have decided not to adopt any of the specific exemptions suggested by the commenters. Although community banking organizations are critical to ensure the flow of credit to small businesses and individual borrowers, providing them with an exemption from the proposed treatment of credit-enhancing representations and warranties would be inconsistent with safety and soundness because the risks from these exposures to community banking organizations are no different than those to other banking organizations. The agencies also have not provided exemptions in this rulemaking to portions of off-balance sheet assets subject to risk retention, QM, and “prime loans.” The relevant agencies have not yet adopted a final rule implementing the risk retention provisions of section 941 of the Dodd-Frank Act, and the agencies, therefore, do not believe it is appropriate to provide an exemption relating to risk retention in this final rule. In addition, while the QM rulemaking is now final,[146] the agencies believe it is appropriate to first evaluate how the QM designation affects the mortgage market before requiring less capital to be held against off-balance sheet assets that cover these loans. As noted above, the incorporation in the final rule of the 120-day safe harbor addresses many of the concerns about burden.

The risk-based capital treatment for off-balance sheet items in this final rule is consistent with section 165(k) of the Dodd-Frank Act which provides that, in the case of a BHC with $50 billion or more in total consolidated assets, the computation of capital, for purposes of meeting capital requirements, shall take into account any off-balance-sheet activities of the company.[147] The final rule complies with the requirements of section 165(k) of the Dodd-Frank Act by requiring a BHC to hold risk-based capital for its off-balance sheet exposures, as described in sections 31, 33, 34 and 35 of the final rule.

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D. Over-the-Counter Derivative Contracts

In the Standardized Approach NPR, the agencies and the FDIC proposed generally to retain the treatment of OTC derivatives provided under the general risk-based capital rules, which is similar to the current exposure method (CEM) for determining the exposure amount for OTC derivative contracts contained in the Basel II standardized framework.[148] Proposed revisions to the treatment of the OTC derivative contracts included an updated definition of an OTC derivative contract, a revised conversion factor matrix for calculating the PFE, a revision of the criteria for recognizing the netting benefits of qualifying master netting agreements and of financial collateral, and the removal of the 50 percent risk weight cap for OTC derivative contracts.

The agencies and the FDIC received a number of comments on the proposed CEM relating to OTC derivatives. These comments generally focused on the revised conversion factor matrix, the proposed removal of the 50 percent cap on risk weights for OTC derivative transactions in the general risk-based capital rules, and commenters' view that there is a lack of risk sensitivity in the calculation of the exposure amount of OTC derivatives and netting benefits. A specific discussion of the comments on particular aspects of the proposal follows.

One commenter asserted that the proposed conversion factors for common interest rate and foreign exchange contracts, and risk participation agreements (a simplified form of credit default swaps) (set forth in Table 19 below), combined with the removal of the 50 percent risk weight cap, would drive up banking organizations' capital requirements associated with these routine transactions and result in much higher transaction costs for small businesses. Another commenter asserted that the zero percent conversion factor assigned to interest rate derivatives with a remaining maturity of one year or less is not appropriate as the PFE incorrectly assumes all interest rate derivatives always can be covered by taking a position in a liquid market.

The agencies acknowledge that the standardized matrix of conversion factors may be too simplified for some banking organizations. The agencies believe, however, that the matrix approach appropriately balances the policy goals of simplicity and risk-sensitivity, and that the conversion factors themselves have been appropriately calibrated for the products to which they relate.

Some commenters supported retention of the 50 percent risk weight cap for derivative exposures under the general risk-based capital rules. Specifically, one commenter argued that the methodology for calculating the exposure amount without the 50 percent risk weight cap would result in inappropriately high capital charge unless the methodology were amended to recognize the use of netting and collateral. Accordingly, the commenter encouraged the agencies and the FDIC to retain the 50 percent risk weight cap until the BCBS enhances the CEM to improve risk-sensitivity.

The agencies believe that as the market for derivatives has developed, the types of counterparties acceptable to participants have expanded to include counterparties that merit a risk weight greater than 50 percent. In addition, the agencies are aware of the ongoing work of the BCBS to improve the current exposure method and expect to consider any necessary changes to update the exposure amount calculation when the BCBS work is completed.

Some commenters suggested that the agencies and the FDIC allow the use of internal models approved by the primary Federal supervisor as an alternative to the proposal, consistent with Basel III. The agencies chose not to incorporate all of the methodologies included in the Basel II standardized framework in the final rule. The agencies believe that, given the range of banking organizations that are subject to the final rule in the United States, it is more appropriate to permit only the proposed non-models based methodology for calculating OTC derivatives exposure amounts under the standardized approach. For larger and more complex banking organizations, the use of the internal model methodology and other models-based methodologies is permitted under the advanced approaches rule. One commenter asked the agencies and the FDIC to provide a definition for “netting,” as the meaning of this term differs widely under various master netting agreements used in industry practice. Another commenter asserted that net exposures are likely to understate actual exposures and the risk of early close-out posed to banking organizations facing financial difficulties, that the conversion factors for PFE are inappropriate, and that a better measure of risk tied to gross exposure is needed. With respect to the definition of netting, the agencies note that the definition of “qualifying master netting agreement” provides a functional definition of netting. With respect to the use of net exposure for purposes of determining PFE, the agencies believe that, in light of the existing international framework to enforce netting arrangements together with the conditions for recognizing netting that are included in this final rule, the use of net exposure is appropriate in the context of a risk-based counterparty credit risk charge that is specifically intended to address default risk. The final rule also continues to limit full recognition of netting for purposes of calculating PFE for counterparty credit risk under the standardized approach.[149]

Other commenters suggested adopting broader recognition of netting under the PFE calculation for netting sets, using a factor of 85 percent rather than 60 percent in the formula for recognizing netting effects to be consistent with the BCBS CCP interim framework (which is defined and discussed in section VIII.E of this preamble, below). Another commenter suggested implementing a 15 percent haircut on the calculated exposure amount for failure to recognize risk mitigants and portfolio diversification. With respect to the commenters' request for greater recognition of netting in the calculation of PFE, the agencies note that the BCBS CCP interim framework's use of 85 percent recognition of netting was limited to the calculation of the hypothetical capital requirement of the QCCP for purposes of determining a clearing member banking organization's risk-weighted asset amount for its default fund contribution. As such, the final rule retains the proposed formula for recognizing netting effects for OTC derivative contracts that was set out in the proposal. The agencies expect to consider whether it would be necessary to propose any changes to the CEM once BCBS discussions on this topic are complete.

The proposed rule placed a cap on the PFE of sold credit protection, equal to the net present value of the amount of unpaid premiums. One commenter questioned the appropriateness of the proposed cap, and suggested that a seller's exposure be measured as the gross exposure amount of the credit Start Printed Page 62095protection provided on the name referenced in the credit derivative contract. The agencies believe that the proposed approach is appropriate for measuring counterparty credit risk because it reflects the amount a banking organization may lose on its exposure to the counterparty that purchased protection. The exposure amount on a sold credit derivative would be calculated separately under section 34(a).

Another commenter asserted that current credit exposure (netted and unnetted) understates or ignores the risk that the mark is inaccurate. Generally, the agencies expect a banking organization to have in place policies and procedures regarding the valuation of positions, and that those processes would be reviewed in connection with routine and periodic supervisory examinations of a banking organization.

The final rule generally adopts the proposed treatment for OTC derivatives without change. Under the final rule, as under the general risk-based capital rules, a banking organization is required to hold risk-based capital for counterparty credit risk for an OTC derivative contract. As defined in the rule, a derivative contract is a financial contract whose value is derived from the values of one or more underlying assets, reference rates, or indices of asset values or reference rates. A derivative contract includes an interest rate, exchange rate, equity, or a commodity derivative contract, a credit derivative, and any other instrument that poses similar counterparty credit risks. Derivative contracts also include unsettled securities, commodities, and foreign exchange transactions with a contractual settlement or delivery lag that is longer than the lesser of the market standard for the particular instrument or five business days. This applies, for example, to mortgage-backed securities (MBS) transactions that the GSEs conduct in the To-Be-Announced market.

Under the final rule, an OTC derivative contract does not include a derivative contract that is a cleared transaction, which is subject to a specific treatment as described in section VIII.E of this preamble. However, an OTC derivative contract includes an exposure of a banking organization that is a clearing member banking organization to its clearing member client where the clearing member banking organization is either acting as a financial intermediary and enters into an offsetting transaction with a CCP or where the clearing member banking organization provides a guarantee to the CCP on the performance of the client. The rationale for this treatment is the banking organization's continued exposure directly to the risk of the clearing member client. In recognition of the shorter close-out period for these transactions, however, the final rule permits a banking organization to apply a scaling factor to recognize the shorter holding period as discussed in section VIII.E of this preamble.

To determine the risk-weighted asset amount for an OTC derivative contract under the final rule, a banking organization must first determine its exposure amount for the contract and then apply to that amount a risk weight based on the counterparty, eligible guarantor, or recognized collateral.

For a single OTC derivative contract that is not subject to a qualifying master netting agreement (as defined further below in this section), the rule requires the exposure amount to be the sum of (1) the banking organization's current credit exposure, which is the greater of the fair value or zero, and (2) PFE, which is calculated by multiplying the notional principal amount of the OTC derivative contract by the appropriate conversion factor, in accordance with Table 19 below.

Under the final rule, the conversion factor matrix includes the additional categories of OTC derivative contracts as illustrated in Table 19. For an OTC derivative contract that does not fall within one of the specified categories in Table 19, the final rule requires PFE to be calculated using the “other” conversion factor.

Table 19—Conversion Factor Matrix for OTC Derivative Contracts 150

Remaining maturity 151Interest rateForeign exchange rate and goldCredit (investment- grade reference asset) 152Credit (non- investment- grade reference asset)EquityPrecious metals (except gold)Other
One year or less0.000.010.050.100.060.070.10
Greater than one year and less than or equal to five years0.0050.050.050.100.080.070.12
Greater than five years0.0150.0750.050.100.100.080.15

For multiple OTC derivative contracts subject to a qualifying master netting agreement, a banking organization must calculate the exposure amount by adding the net current credit exposure and the adjusted sum of the PFE amounts for all OTC derivative contracts subject to the qualifying master netting agreement. Under the final rule, the net current credit exposure is the greater of zero and the net sum of all positive and negative fair values of the individual OTC derivative contracts subject to the qualifying master netting agreement. The adjusted sum of the PFE amounts must be calculated as described in section 34(a)(2)(ii) of the final rule.

Under the final rule, to recognize the netting benefit of multiple OTC derivative contracts, the contracts must be subject to a qualifying master netting agreement; however, unlike under the general risk-based capital rules, under the final rule for most transactions, a banking organization may rely on sufficient legal review instead of an opinion on the enforceability of the netting agreement as described below.[153] The final rule defines a Start Printed Page 62096qualifying master netting agreement as any written, legally enforceable netting agreement that creates a single legal obligation for all individual transactions covered by the agreement upon an event of default (including receivership, insolvency, liquidation, or similar proceeding) provided that certain conditions set forth in section 3 of the final rule are met.[154] These conditions include requirements with respect to the banking organization's right to terminate the contract and liquidate collateral and meeting certain standards with respect to legal review of the agreement to ensure its meets the criteria in the definition.

The legal review must be sufficient so that the banking organization may conclude with a well-founded basis that, among other things, the contract would be found legal, binding, and enforceable under the law of the relevant jurisdiction and that the contract meets the other requirements of the definition. In some cases, the legal review requirement could be met by reasoned reliance on a commissioned legal opinion or an in-house counsel analysis. In other cases, for example, those involving certain new derivative transactions or derivative counterparties in jurisdictions where a banking organization has little experience, the banking organization would be expected to obtain an explicit, written legal opinion from external or internal legal counsel addressing the particular situation.

Under the final rule, if an OTC derivative contract is collateralized by financial collateral, a banking organization must first determine the exposure amount of the OTC derivative contract as described in this section of the preamble. Next, to recognize the credit risk mitigation benefits of the financial collateral, a banking organization could use the simple approach for collateralized transactions as described in section 37(b) of the final rule. Alternatively, if the financial collateral is marked-to-market on a daily basis and subject to a daily margin maintenance requirement, a banking organization could adjust the exposure amount of the contract using the collateral haircut approach described in section 37(c) of the final rule.

Similarly, if a banking organization purchases a credit derivative that is recognized under section 36 of the final rule as a credit risk mitigant for an exposure that is not a covered position under subpart F, it is not required to compute a separate counterparty credit risk capital requirement for the credit derivative, provided it does so consistently for all such credit derivative contracts. Further, where these credit derivative contracts are subject to a qualifying master netting agreement, the banking organization must either include them all or exclude them all from any measure used to determine the counterparty credit risk exposure to all relevant counterparties for risk-based capital purposes.

Under the final rule, a banking organization must treat an equity derivative contract as an equity exposure and compute its risk-weighted asset amount according to the simple risk-weight approach (SRWA) described in section 52 (unless the contract is a covered position under the market risk rule). If the banking organization risk weights a contract under the SRWA described in section 52, it may choose not to hold risk-based capital against the counterparty risk of the equity contract, so long as it does so for all such contracts. Where the OTC equity contracts are subject to a qualified master netting agreement, a banking organization either includes or excludes all of the contracts from any measure used to determine counterparty credit risk exposures. If the banking organization is treating an OTC equity derivative contract as a covered position under subpart F, it also must calculate a risk-based capital requirement for counterparty credit risk of the contract under this section.

In addition, if a banking organization provides protection through a credit derivative that is not a covered position under subpart F of the final rule, it must treat the credit derivative as an exposure to the underlying reference asset and compute a risk-weighted asset amount for the credit derivative under section 32 of the final rule. The banking organization is not required to compute a counterparty credit risk capital requirement for the credit derivative, as long as it does so consistently for all such OTC credit derivative contracts. Further, where these credit derivative contracts are subject to a qualifying master netting agreement, the banking organization must either include all or exclude all such credit derivatives from any measure used to determine counterparty credit risk exposure to all relevant counterparties for risk-based capital purposes.

Where the banking organization provides protection through a credit derivative treated as a covered position under subpart F, it must compute a supplemental counterparty credit risk capital requirement using an amount determined under section 34 for OTC credit derivative contracts or section 35 for credit derivatives that are cleared transactions. In either case, the PFE of the protection provider would be capped at the net present value of the amount of unpaid premiums.

Under the final rule, the risk weight for OTC derivative transactions is not subject to any specific ceiling, consistent with the Basel capital framework.

Although the agencies generally adopted the proposal without change, the final rule has been revised to add a provision regarding the treatment of a clearing member banking organization's exposure to a clearing member client (as described below under “Cleared Transactions,” a transaction between a clearing member banking organization and a client is treated as an OTC derivative exposure). However, the final rule recognizes the shorter close-out period for cleared transactions that are derivative contracts, such that a clearing member banking organization can reduce its exposure amount to its client by multiplying the exposure amount by a scaling factor of no less than 0.71. See section VIII.E of this preamble, below, for additional discussion.

E. Cleared Transactions

The BCBS and the agencies support incentives designed to encourage clearing of derivative and repo-style transactions [155] through a CCP wherever possible in order to promote transparency, multilateral netting, and robust risk-management practices.

Although there are some risks associated with CCPs, as discussed below, the agencies believe that CCPs generally help improve the safety and soundness of the derivatives and repo-style transactions markets through the multilateral netting of exposures, establishment and enforcement of collateral requirements, and the promotion of market transparency.

As discussed in the proposal, when developing Basel III, the BCBS recognized that as more transactions move to central clearing, the potential for risk concentration and systemic risk Start Printed Page 62097increases. To address these concerns, in the period preceding the proposal, the BCBS sought comment on a more risk-sensitive approach for determining capital requirements for banking organizations' exposures to CCPs.[156] In addition, to encourage CCPs to maintain strong risk-management procedures, the BCBS sought comment on a proposal for lower risk-based capital requirements for derivative and repo-style transaction exposures to CCPs that meet the standards established by the Committee on Payment and Settlement Systems (CPSS) and International Organization of Securities Commissions (IOSCO).[157] Exposures to such entities, termed QCCPs in the final rule, would be subject to lower risk weights than exposures to CCPs that did not meet those criteria.

Consistent with the BCBS proposals and the CPSS-IOSCO standards, the agencies and the FDIC sought comment on specific risk-based capital requirements for cleared derivative and repo-style transactions that are designed to incentivize the use of CCPs, help reduce counterparty credit risk, and promote strong risk management of CCPs to mitigate their potential for systemic risk. In contrast to the general risk-based capital rules, which permit a banking organization to exclude certain derivative contracts traded on an exchange from the risk-based capital calculation, the proposal would have required a banking organization to hold risk-based capital for an outstanding derivative contract or a repo-style transaction that has been cleared through a CCP, including an exchange.

The proposal also included a capital requirement for default fund contributions to CCPs. In the case of non-qualifying CCPs (that is, CCPs that do not meet the risk-management, supervision, and other standards for QCCPs outlined in the proposal), the risk-weighted asset amount for default fund contributions to such CCPs would be equal to the sum of the banking organization's default fund contributions to the CCPs multiplied by 1,250 percent. In the case of QCCPs, the risk-weighted asset amount would be calculated according to a formula based on the hypothetical capital requirement for a QCCP, consistent with the Basel capital framework. The proposal included a formula with inputs including the exposure amount of transactions cleared through the QCCP, collateral amounts, the number of members of the QCCP, and default fund contributions.

Following issuance of the proposal, the BCBS issued an interim framework for the capital treatment of bank exposures to CCPs (BCBS CCP interim framework).[158] The BCBS CCP interim framework reflects several key changes from the CCP consultative release, including: (1) A provision to allow a clearing member banking organization to apply a scalar when using the CEM (as described below) in the calculation of its exposure amount to a client (or use a reduced margin period of risk when using the internal models methodology (IMM) to calculate exposure at default (EAD) under the advanced approaches rule); (2) revisions to the risk weights applicable to a clearing member banking organization's exposures when such clearing member banking organization guarantees QCCP performance; (3) a provision to permit clearing member banking organizations to choose from one of two formulaic methodologies for determining the capital requirement for default fund contributions; and (4) revisions to the CEM formula to recognize netting to a greater extent for purposes of calculating the capital requirement for default fund contributions.

The agencies and the FDIC received a number of comments on the proposal relating to cleared transactions. Commenters also encouraged the agencies and the FDIC to revise certain aspects of the proposal in a manner consistent with the BCBS CCP interim framework.

Some commenters asserted that the definition of QCCP should be revised, specifically by including a definitive list of QCCPs rather than requiring each banking organization to demonstrate that a CCP meets certain qualifying criteria. The agencies believe that a static list of QCCPs would not reflect the potentially dynamic nature of a CCP, and that banking organizations are situated to make this determination on an ongoing basis.

Some commenters recommended explicitly including derivatives clearing organizations (DCOs) and securities-based swap clearing agencies in the definition of a QCCP. Commenters also suggested including in the definition of QCCP any CCP that the CFTC or SEC exempts from registration because it is deemed by the CFTC or SEC to be subject to “comparable, comprehensive supervision” by another regulator. The agencies note that such registration (or exemption from registration based on being subject to “comparable, comprehensive supervision”) does not necessarily mean that the CCP is subject to, or in compliance with, the standards established by the CPSS and IOSCO. In contrast, a designated FMU, which is included in the definition of QCCP, is subject to regulation that corresponds to such standards.

Another commenter asserted that, consistent with the BCBS CCP interim framework, the final rule should provide for the designation of a QCCP by the agencies in the absence of a national regime for authorization and licensing of CCPs. The final rule has not been amended to include this aspect of the BCBS CCP interim framework because the agencies believe a national regime for authorizing and licensing CCPs is a critical mechanism to ensure the compliance and ongoing monitoring of a CCP's adherence to internationally recognized risk-management standards. Another commenter requested that a three-month grace period apply for CCPs that cease to be QCCPs. The agencies note that such a grace period was included in the proposed rule, and the final rule retains the proposed definition without substantive change.[159]

With respect to the proposed definition of cleared transaction, some commenters asserted that the definition should recognize omnibus accounts because their collateral is bankruptcy-remote. The agencies agree with these commenters and have revised the operational requirements for cleared transactions to include an explicit reference to such accounts.

The BCBS CCP interim framework requires trade portability to be “highly likely,” as a condition of whether a trade satisfies the definition of cleared transaction. One commenter who encouraged the agencies and the FDIC to adopt the standards set forth in the BCBS CCP interim framework sought clarification of the meaning of “highly likely” in this context. The agencies clarify that, consistent with the BCBS CCP interim framework, if there is clear precedent for transactions to be transferred to a non-defaulting clearing member upon the default of another clearing member (commonly referred to as “portability”) and there are no indications that such practice will not continue, then these factors should be considered, when assessing whether client positions are portable. The Start Printed Page 62098definition of “cleared transaction” in the final rule is discussed in further detail below.

Another commenter sought clarification on whether reasonable reliance on a commissioned legal opinion for foreign financial jurisdictions could satisfy the “sufficient legal review” requirement for bankruptcy remoteness of client positions. The agencies believe that reasonable reliance on a commissioned legal opinion could satisfy this requirement. Another commenter expressed concern that the proposed framework for cleared transactions would capture securities clearinghouses, and encouraged the agencies to clarify their intent with respect to such entities for purposes of the final rule. The agencies note that the definition of “cleared transaction” refers only to OTC derivatives and repo-style transactions. As a result, securities clearinghouses are not within the scope of the cleared transactions framework.

One commenter asserted that the agencies and the FDIC should recognize varying close-out period conventions for specific cleared products, specifically exchange-traded derivatives. This commenter also asserted that the agencies and the FDIC should adjust the holding period assumptions or allow CCPs to use alternative methods to compute the appropriate haircut for cleared transactions. For purposes of this final rule, the agencies retained a standard close-out period in the interest of avoiding unnecessary complexity, and note that cleared transactions with QCCPs attract extremely low risk weights (generally, 2 or 4 percent), which, in part, is in recognition of the shorter close-out period involved in cleared transactions.

Another commenter requested confirmation that the risk weight applicable to the trade exposure amount for a cleared credit default swap (CDS) could be substituted for the risk weight assigned to an exposure that was hedged by the cleared CDS, that is, the substitution treatment described in sections 36 and 134 would apply. The agencies confirm that under the final rule, a banking organization may apply the substitution treatment of sections 36 or 134 to recognize the credit risk mitigation benefits of a cleared CDS as long as the CDS is an eligible credit derivative and meets the other criteria for recognition. Thus, if a banking organization purchases an eligible credit derivative as a hedge of an exposure and the eligible credit derivative qualifies as a cleared transaction, the banking organization may substitute the risk weight applicable to the cleared transaction under sections 35 or 133 of the final rule (instead of using the risk weight associated with the protection provider).[160] Furthermore, the agencies have modified the definition of eligible guarantor to include a QCCP.

Another commenter asserted that the final rule should decouple the risk weights applied to collateral exposure and those assigned to other components of trade exposure to recognize the separate components of risk. The agencies note that, if collateral is bankruptcy remote, then it would not be included in the trade exposure amount calculation (see sections 35(b)(2) and 133(b)(2) of the final rule). The agencies also note that such collateral must be risk weighted in accordance with other sections of the final rule as appropriate, to the extent that the posted collateral remains an asset on a banking organization's balance sheet.

A number of commenters addressed the use of the CEM for purposes of calculating a capital requirement for a default fund contribution to a CCP (Kccp).[161] Some commenters asserted that the CEM is not appropriate for determining the hypothetical capital requirement for a QCCP (Kccp) under the proposed formula because it lacks risk sensitivity and sophistication, and was not developed for centrally-cleared transactions. Another commenter asserted that the use of CEM should be clarified in the clearing context, specifically, whether the modified CEM approach would permit the netting of offsetting positions booked under different “desk IDs” or “hub accounts” for a given clearing member banking organization. Another commenter encouraged the agencies and the FDIC to allow banking organizations to use the IMM to calculate Kccp. Another commenter encouraged the agencies and the FDIC to continue to work with the BCBS to harmonize international and domestic capital rules for cleared transactions.

Although the agencies recognize that the CEM has certain limitations, the agencies consider the CEM, as modified for cleared transactions, to be a reasonable approach that would produce consistent results across banking organizations. Regarding the commenter's request for clarification of netting positions across “desk IDs” or “hub accounts,” the CEM would recognize netting across such transactions if such netting is legally enforceable upon a CCP's default. Moreover, the agencies believe that the use of models either by the CCP, whose model would not be subject to review and approval by the agencies, or by the banking organizations, whose models may vary significantly, likely would produce inconsistent results that would not serve as a basis for comparison across banking organizations. The agencies recognize that additional work is being performed by the BCBS to revise the CCP capital framework and the CEM. The agencies expect to modify the final rule to incorporate the BCBS improvements to the CCP capital framework and CEM through the normal rulemaking process.

Other commenters suggested that the agencies and the FDIC not allow preferential treatment for clearinghouses, which they asserted are systemically critical institutions. In addition, some of these commenters argued that the agency clearing model should receive a more favorable capital requirement because the agency relationship facilitates protection and portability of client positions in the event of a clearing member default, compared to the back-to-back principal model. As noted above, the agencies acknowledge that as more transactions move to central clearing, the potential for risk concentration and systemic risk increases. As noted in the proposal, the risk weights applicable to cleared transactions with QCCPs (generally 2 or 4 percent) represent an increase for many cleared transactions as compared to the general risk-based capital rules (which exclude from the risk-based ratio calculations exchange rate contracts with an original maturity of fourteen or fewer calendar days and derivative contracts traded on exchanges that require daily receipt and payment of cash variation margin),[162] in part to reflect the increased concentration and systemic risk inherent in such transactions. In regards to the agency clearing model, the agencies note that a clearing member banking organization that acts as an agent for a client and that guarantees the client's performance to the QCCP would have no exposure to the QCCP to risk weight. The exposure arising from the guarantee would be treated as an OTC derivative with a reduced holding period, as discussed below.

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Another commenter suggested that the final rule address the treatment of unfunded default fund contribution amounts and potential future contributions to QCCPs, noting that the treatment of these potential exposures is not addressed in the BCBS CCP interim framework. The agencies have clarified in the final rule that if a banking organization's unfunded default fund contribution to a CCP is unlimited, the banking organization's primary Federal supervisor will determine the risk-weighted asset amount for such default fund contribution based on factors such as the size, structure, and membership of the CCP and the riskiness of its transactions. The final rule does not contemplate unlimited default fund contributions to QCCPs because defined default fund contribution amounts are a prerequisite to being a QCCP.

Another commenter asserted that it is unworkable to require securities lending transactions to be conducted through a CCP, and that it would be easier and more sensible to make the appropriate adjustments in the final rule to ensure a capital treatment for securities lending transactions that is proportional to their actual risks. The agencies note that the proposed rule would not have required securities lending transactions to be cleared. The agencies also acknowledge that clearing may not be widely available for securities lending transactions, and believe that the collateral haircut approach (sections 37(c) and 132(b) of the final rule) and for advanced approaches banking organizations, the simple value-at-risk (VaR) and internal models methodologies (sections 132(b)(3) and (d) of the final rule) are an appropriately risk-sensitive exposure measure for non-cleared securities lending exposures.

One commenter asserted that end users and client-cleared trades would be disadvantaged by the proposal. Although there may be increased transaction costs associated with the introduction of the CCP framework, the agencies believe that the overall risk mitigation that should result from the capital requirements generated by the framework will help promote financial stability, and that the measures the agencies have taken in the final rule to incentivize client clearing are aimed at addressing the commenters' concerns. Several commenters suggested that the proposed rule created a disincentive for client clearing because of the clearing member banking organization's exposure to the client. The agencies agree with the need to mitigate disincentives for client clearing in the methodology, and have amended the final rule to reflect a lower margin period of risk, or holding period, as applicable, as discussed further below.

Commenters suggested delaying implementation of a cleared transactions framework in the final rule until the BCBS CCP interim framework is finalized, implementing the BCBS CCP interim framework in the final rule pending finalization of the BCBS interim framework, or providing a transition period for banking organizations to be able to comply with some of the requirements. A number of commenters urged the agencies and the FDIC to incorporate all substantive changes of the BCBS CCP interim framework, ranging from minor adjustments to more material modifications.

After considering the comments and reviewing the standards in the BCBS CCP interim framework, the agencies believe that the modifications to capital standards for cleared transactions in the BCBS CCP interim framework are appropriate and believe that they would result in modifications that address many commenters' concerns. Furthermore, the agencies believe that it is prudent to implement the BCBS CCP interim framework, rather than wait for the final framework, because the changes in the BCBS CCP interim framework represent a sound approach to mitigating the risks associated with cleared transactions. Accordingly, the agencies have incorporated the material elements of the BCBS CCP interim framework into the final rule. In addition, given the delayed effective date of the final rule, the agencies believe that an additional transition period, as suggested by some commenters, is not necessary.

The material changes to the proposed rule to incorporate the CCP interim rule are described below. Other than these changes, the final rule retains the capital requirements for cleared transaction exposures generally as proposed by the agencies and the FDIC. As noted in the proposal, the international discussions are ongoing on these issues, and the agencies will revisit this issue once the Basel capital framework is revised.

1. Definition of Cleared Transaction

The final rule defines a cleared transaction as an exposure associated with an outstanding derivative contract or repo-style transaction that a banking organization or clearing member has entered into with a CCP (that is, a transaction that a CCP has accepted).[163] Cleared transactions include the following: (1) A transaction between a CCP and a clearing member banking organization for the banking organization's own account; (2) a transaction between a CCP and a clearing member banking organization acting as a financial intermediary on behalf of its clearing member client; (3) a transaction between a client banking organization and a clearing member where the clearing member acts on behalf of the client banking organization and enters into an offsetting transaction with a CCP; and (4) a transaction between a clearing member client and a CCP where a clearing member banking organization guarantees the performance of the clearing member client to the CCP. Such transactions must also satisfy additional criteria provided in section 3 of the final rule, including bankruptcy remoteness of collateral, transferability criteria, and portability of the clearing member client's position. As explained above, the agencies have modified the definition in the final rule to specify that regulated omnibus accounts to meet the requirement for bankruptcy remoteness.

A banking organization is required to calculate risk-weighted assets for all of its cleared transactions, whether the banking organization acts as a clearing member (defined as a member of, or direct participant in, a CCP that is entitled to enter into transactions with the CCP) or a clearing member client (defined as a party to a cleared transaction associated with a CCP in which a clearing member acts either as a financial intermediary with respect to the party or guarantees the performance of the party to the CCP).

Derivative transactions that are not cleared transactions because they do not meet all the criteria, are OTC derivative transactions. For example, if a transaction submitted to the CCP is not accepted by the CCP because the terms of the transaction submitted by the clearing members do not match or because other operational issues are identified by the CCP, the transaction does not meet the definition of a cleared transaction and is an OTC derivative transaction. If the counterparties to the transaction resolve the issues and Start Printed Page 62100resubmit the transaction and it is accepted, the transaction would then be a cleared transaction. A cleared transaction does not include an exposure of a banking organization that is a clearing member to its clearing member client where the banking organization is either acting as a financial intermediary and enters into an offsetting transaction with a CCP or where the banking organization provides a guarantee to the CCP on the performance of the client. Under the standardized approach, as discussed below, such a transaction is an OTC derivative transaction with the exposure amount calculated according to section 34(e) of the final rule or a repo-style transaction with the exposure amount calculated according to section 37(c) of the final rule. Under the advanced approaches rule, such a transaction is treated as either an OTC derivative transaction with the exposure amount calculated according to sections 132(c)(8) or (d)(5)(iii)(C) of the final rule or a repo-style transaction with the exposure amount calculated according to sections 132(b) or (d) of the final rule.

2. Exposure Amount Scalar for Calculating for Client Exposures

Under the proposal, a transaction between a clearing member banking organization and a client was treated as an OTC derivative exposure, with the exposure amount calculated according to sections 34 or 132 of the proposal. The agencies acknowledged in the proposal that this treatment could have created disincentives for banking organizations to facilitate client clearing. Commenters' feedback and the BCBS CCP interim framework's treatment on this subject provided alternatives to address the incentive concern.

Consistent with comments and the BCBS CCP interim framework, under the final rule, a clearing member banking organization must treat its counterparty credit risk exposure to clients as an OTC derivative contract, irrespective of whether the clearing member banking organization guarantees the transaction or acts as an intermediary between the client and the QCCP. Consistent with the BCBS CCP interim framework, to recognize the shorter close-out period for cleared transactions, under the standardized approach a clearing member banking organization may calculate its exposure amount to a client by multiplying the exposure amount, calculated using the CEM, by a scaling factor of no less than 0.71, which represents a five-day holding period. A clearing member banking organization must use a longer holding period and apply a larger scaling factor to its exposure amount in accordance with Table 20 if it determines that a holding period longer than five days is appropriate. A banking organization's primary Federal supervisor may require a clearing member banking organization to set a longer holding period if the primary Federal supervisor determines that a longer period is commensurate with the risks associated with the transaction. The agencies believe that the recognition of a shorter close-out period appropriately captures the risk associated with such transactions while furthering the policy goal of promoting central clearing.

Table 20—Holding Periods and Scaling Factors

Holding period (days)Scaling factor
50.71
60.77
70.84
80.89
90.95
101.00

3. Risk Weighting for Cleared Transactions

Under the final rule, to determine the risk-weighted asset amount for a cleared transaction, a clearing member client banking organization or a clearing member banking organization must multiply the trade exposure amount for the cleared transaction by the appropriate risk weight, determined as described below. The trade exposure amount is calculated as follows:

(1) For a cleared transaction that is a derivative contract or a netting set of derivatives contracts, the trade exposure amount is equal to the exposure amount for the derivative contract or netting set of derivative contracts, calculated using the CEM for OTC derivative contracts (described in sections 34 or 132(c) of the final rule) or for advanced approaches banking organizations that use the IMM, under section 132(d) of the final rule), plus the fair value of the collateral posted by the clearing member client banking organization and held by the CCP or clearing member in a manner that is not bankruptcy remote; and

(2) For a cleared transaction that is a repo-style transaction or a netting set of repo-style transactions, the trade exposure amount is equal to the exposure amount calculated under the collateral haircut approach used for financial collateral (described in section 37(c) and 132(b) of the final rule) (or for advanced approaches banking organizations the IMM under section 132(d) of the final rule) plus the fair value of the collateral posted by the clearing member client banking organization that is held by the CCP or clearing member in a manner that is not bankruptcy remote.

The trade exposure amount does not include any collateral posted by a clearing member client banking organization or clearing member banking organization that is held by a custodian in a manner that is bankruptcy remote [164] from the CCP, clearing member, other counterparties of the clearing member, and the custodian itself. In addition to the capital requirement for the cleared transaction, the banking organization remains subject to a capital requirement for any collateral provided to a CCP, a clearing member, or a custodian in connection with a cleared transaction in accordance with section 32 or 131 of the final rule. Consistent with the BCBS CCP interim framework, the risk weight for a cleared transaction depends on whether the CCP is a QCCP. Central counterparties that are designated FMUs and foreign entities regulated and supervised in a manner equivalent to designated FMUs are QCCPs. In addition, a CCP could be a QCCP under the final rule if it is in sound financial condition and meets certain standards that are consistent with BCBS expectations for QCCPs, as set forth in the QCCP definition.

A clearing member banking organization must apply a 2 percent risk weight to its trade exposure amount to a QCCP. A banking organization that is a clearing member client may apply a 2 percent risk weight to the trade exposure amount only if:

(1) The collateral posted by the clearing member client banking organization to the QCCP or clearing member is subject to an arrangement that prevents any losses to the clearing member client due to the joint default or a concurrent insolvency, liquidation, or receivership proceeding of the clearing member and any other clearing member clients of the clearing member, and

(2) The clearing member client banking organization has conducted sufficient legal review to conclude with a well-founded basis (and maintains sufficient written documentation of that legal review) that in the event of a legal challenge (including one resulting from default or a liquidation, insolvency, or receivership proceeding) the relevant court and administrative authorities Start Printed Page 62101would find the arrangements to be legal, valid, binding, and enforceable under the law of the relevant jurisdiction.

If the criteria above are not met, a clearing member client banking organization must apply a risk weight of 4 percent to the trade exposure amount.

Under the final rule, as under the proposal, for a cleared transaction with a CCP that is not a QCCP, a clearing member banking organization and a clearing member client banking organization must risk weight the trade exposure amount to the CCP according to the risk weight applicable to the CCP under section 32 of the final rule (generally, 100 percent). Collateral posted by a clearing member banking organization that is held by a custodian in a manner that is bankruptcy remote from the CCP is not subject to a capital requirement for counterparty credit risk. Similarly, collateral posted by a clearing member client that is held by a custodian in a manner that is bankruptcy remote from the CCP, clearing member, and other clearing member clients of the clearing member is not be subject to a capital requirement for counterparty credit risk.

The proposed rule was silent on the risk weight that would apply where a clearing member banking organization acts for its own account or guarantees a QCCP's performance to a client. Consistent with the BCBS CCP interim framework, the final rule provides additional specificity regarding the risk-weighting methodologies for certain exposures of clearing member banking organizations. The final rule provides that a clearing member banking organization that (i) acts for its own account, (ii) is acting as a financial intermediary (with an offsetting transaction or a guarantee of the client's performance to a QCCP), or (iii) guarantees a QCCP's performance to a client would apply a two percent risk weight to the banking organization's exposure to the QCCP. The diagrams below demonstrate the various potential transactions and exposure treatment in the final rule. Table 21 sets out how the transactions illustrated in the diagrams below are risk-weighted under the final rule.

In the diagram, “T” refers to a transaction, and the arrow indicates the direction of the exposure. The diagram describes the appropriate risk weight treatment for exposures from the perspective of a clearing member banking organization entering into cleared transactions for its own account (T1), a clearing member banking organization entering into cleared transactions on behalf of a client (T2 through T7), and a banking organization entering into cleared transactions as a client of a clearing member (T8 and T9). Table 21 shows for each trade whom the exposure is to, a description of the type of trade, and the risk weight that would apply based on the risk of the counterparty.

Start Printed Page 62102

Table 21—Risk Weights for Various Cleared Transactions

Exposure toDescriptionRisk-weighting treatment under the final rule
T1QCCPOwn account2% risk weight on trade exposure amount.
T2ClientFinancial intermediary with offsetting trade to QCCPOTC derivative with CEM scalar.**
T3QCCPFinancial intermediary with offsetting trade to QCCP2% risk weight on trade exposure amount.
T4ClientAgent with guarantee of client performanceOTC derivative with CEM scalar.**
T5QCCPAgent with guarantee of client performanceNo exposure.
T6ClientGuarantee of QCCP performanceOTC derivative with CEM scalar.**
T7QCCPGuarantee of QCCP performance2% risk weight on trade exposure amount.
T8CMCM financial intermediary with offsetting trade to QCCP2% or 4%* risk weight on trade exposure amount.
T9QCCPCM agent with guarantee of client performance2% or 4%* risk weight on trade exposure amount.

4. Default Fund Contribution Exposures

There are several risk mitigants available when a party clears a transaction through a CCP rather than on a bilateral basis: The protection provided to the CCP clearing members by the margin requirements imposed by the CCP; the CCP members' default fund contributions; and the CCP's own capital and contribution to the default fund, which are an important source of collateral in case of counterparty default.[165] CCPs independently determine default fund contributions that are required from members. The BCBS therefore established, and the final rule adopts, a risk-sensitive approach for risk weighting a banking organization's exposure to a default fund.

Under the proposed rule, there was only one method that a clearing member banking organization could use to calculate its risk-weighted asset amount for default fund contributions. The BCBS CCP interim framework added a second method to better reflect the lower risks associated with exposures to those clearinghouses that have relatively large default funds with a significant amount unfunded. Commenters requested that the final rule adopt both methods contained in the BCBS CCP interim framework.

Accordingly, under the final rule, a banking organization that is a clearing member of a CCP must calculate the risk-weighted asset amount for its default fund contributions at least quarterly or more frequently if there is a material change, in the opinion of the banking organization or the primary Federal supervisor, in the financial condition of the CCP. A default fund contribution means the funds contributed or commitments made by a clearing member to a CCP's mutualized loss-sharing arrangement. If the CCP is not a QCCP, the banking organization's risk-weighted asset amount for its default fund contribution is either the sum of the default fund contributions multiplied by 1,250 percent, or in cases where the default fund contributions may be unlimited, an amount as determined by the banking organization's primary Federal supervisor based on factors described above.

Consistent with the BCBS CCP interim framework, the final rule requires a banking organization to calculate a risk-weighted asset amount for its default fund contribution using one of two methods. Method one requires a clearing member banking organization to use a three-step process. The first step is for the clearing member banking organization to calculate the QCCP's hypothetical capital requirement (KCCP), unless the QCCP has already disclosed it, in which case the banking organization must rely on that disclosed figure, unless the banking organization determines that a higher figure is appropriate based on the nature, structure, or characteristics of the QCCP. KCCP is defined as the capital that a QCCP is required to hold if it were a banking organization, and is calculated using the CEM for OTC derivatives or the collateral haircut approach for repo-style transactions, recognizing the risk-mitigating effects of collateral posted by and default fund contributions received from the QCCP clearing members.

The final rule provides several modifications to the calculation of KCCP to adjust for certain features that are unique to QCCPs. Namely, the modifications permit: (1) A clearing member to offset its exposure to a QCCP with actual default fund contributions, and (2) greater recognition of netting when using the CEM to calculate KCCP described below. Additionally, the risk weight of all clearing members is set at 20 percent, except when a banking organization's primary Federal supervisor has determined that a higher risk weight is appropriate based on the specific characteristics of the QCCP and its clearing members. Finally, for derivative contracts that are options, the PFE amount calculation is adjusted by multiplying the notional principal amount of the derivative contract by the appropriate conversion factor and the absolute value of the option's delta (that is, the ratio of the change in the value of the derivative contract to the corresponding change in the price of the underlying asset).

In the second step of method one, the final rule requires a banking organization to compare KCCP to the funded portion of the default fund of a QCCP, and to calculate the total of all the clearing members' capital requirements (K*cm). If the total funded default fund of a QCCP is less than KCCP, the final rule requires additional capital to be assessed against the shortfall because of the small size of the funded portion of the default fund relative to KCCP. If the total funded default fund of a QCCP is greater than KCCP, but the QCCP's own funded contributions to the default fund are less than KCCP (so that the clearing members' default fund contributions are required to achieve KCCP), the clearing members' default fund contributions up to KCCP are risk-weighted at 100 percent and a decreasing capital factor, between 1.6 percent and 0.16 percent, is applied to the clearing members' funded default fund contributions above KCCP. If the QCCP's own contribution to the default fund is greater than KCCP, then only the decreasing capital factor is applied to the clearing members' default fund contributions.

In the third step of method one, the final rule requires (K*cm) to be allocated back to each individual clearing member. This allocation is proportional to each clearing member's contribution to the default fund but adjusted to reflect the impact of two average-size clearing members defaulting as well as to account for the concentration of exposures among clearing members. A clearing member banking organization multiplies its allocated capital Start Printed Page 62104requirement by 12.5 to determine its risk-weighted asset amount for its default fund contribution to the QCCP.

As the alternative, a banking organization is permitted to use method two, which is a simplified method under which the risk-weighted asset amount for its default fund contribution to a QCCP equals 1,250 percent multiplied by the default fund contribution, subject to an overall cap. The cap is based on a banking organization's trade exposure amount for all of its transactions with a QCCP. A banking organization's risk-weighted asset amount for its default fund contribution to a QCCP is either a 1,250 percent risk weight applied to its default fund contribution to that QCCP or 18 percent of its trade exposure amount to that QCCP. Method two subjects a banking organization to an overall cap on the risk-weighted assets from all its exposures to the CCP equal to 20 percent times the trade exposures to the CCP. This 20 percent cap is arrived at as the sum of the 2 percent capital requirement for trade exposure plus 18 percent for the default fund portion of a banking organization's exposure to a QCCP.

To address commenter concerns that the CEM underestimates the multilateral netting benefits arising from a QCCP, the final rule recognizes the larger diversification benefits inherent in a multilateral netting arrangement for purposes of measuring the QCCP's potential future exposure associated with derivative contracts. Consistent with the BCBS CCP interim framework, and as mentioned above, the final rule replaces the proposed factors (0.3 and 0.7) in the formula to calculate Anet with 0.15 and 0.85, in sections 35(d)(3)(i)(A)(1) and 133(d)(3)(i)(A)(1) of the final rule, respectively.

F. Credit Risk Mitigation

Banking organizations use a number of techniques to mitigate credit risks. For example, a banking organization may collateralize exposures with cash or securities; a third party may guarantee an exposure; a banking organization may buy a credit derivative to offset an exposure's credit risk; or a banking organization may net exposures with a counterparty under a netting agreement. The general risk-based capital rules recognize these techniques to some extent. This section of the preamble describes how the final rule allows banking organizations to recognize the risk-mitigation effects of guarantees, credit derivatives, and collateral for risk-based capital purposes. In general, the final rule provides for a greater variety of credit risk mitigation techniques than the general risk-based capital rules.

Similar to the general risk-based capital rules, under the final rule a banking organization generally may use a substitution approach to recognize the credit risk mitigation effect of an eligible guarantee from an eligible guarantor and the simple approach to recognize the effect of collateral. To recognize credit risk mitigants, all banking organizations must have operational procedures and risk-management processes that ensure that all documentation used in collateralizing or guaranteeing a transaction is legal, valid, binding, and enforceable under applicable law in the relevant jurisdictions. A banking organization should conduct sufficient legal review to reach a well-founded conclusion that the documentation meets this standard as well as conduct additional reviews as necessary to ensure continuing enforceability.

Although the use of credit risk mitigants may reduce or transfer credit risk, it simultaneously may increase other risks, including operational, liquidity, or market risk. Accordingly, a banking organization should employ robust procedures and processes to control risks, including roll-off and concentration risks, and monitor and manage the implications of using credit risk mitigants for the banking organization's overall credit risk profile.

1. Guarantees and Credit Derivatives

a. Eligibility Requirements

Consistent with the Basel capital framework, the agencies and the FDIC proposed to recognize a wider range of eligible guarantors than permitted under the general risk-based capital rules, including sovereigns, the Bank for International Settlements, the International Monetary Fund, the European Central Bank, the European Commission, Federal Home Loan Banks (FHLB), Federal Agricultural Mortgage Corporation (Farmer Mac), MDBs, depository institutions, BHCs, SLHCs, credit unions, and foreign banks. Eligible guarantors would also include entities that are not special purpose entities that have issued and outstanding unsecured debt securities without credit enhancement that are investment grade and that meet certain other requirements.[166]

Some commenters suggested modifying the proposed definition of eligible guarantor to remove the investment-grade requirement. Commenters also suggested that the agencies and the FDIC potentially include as eligible guarantors other entities, such as financial guaranty and private mortgage insurers. The agencies believe that guarantees issued by these types of entities can exhibit significant wrong-way risk and modifying the definition of eligible guarantor to accommodate these entities or entities that are not investment grade would be contrary to one of the key objectives of the capital framework, which is to mitigate interconnectedness and systemic vulnerabilities within the financial system. Therefore, the agencies have not included the recommended entities in the final rule's definition of “eligible guarantor.” The agencies have, however, amended the definition of eligible guarantor in the final rule to include QCCPs to accommodate use of the substitution approach for credit derivatives that are cleared transactions. The agencies believe that QCCPs, as supervised entities subject to specific risk-management standards, are appropriately included as eligible guarantors under the final rule.[167] In addition, the agencies clarify one commenter's concern and confirm that re-insurers that are engaged predominantly in the business of providing credit protection do not qualify as an eligible guarantor under the final rule.

Under the final rule, guarantees and credit derivatives are required to meet specific eligibility requirements to be recognized for credit risk mitigation purposes. Consistent with the proposal, under the final rule, an eligible guarantee is defined as a guarantee from an eligible guarantor that is written and meets certain standards and conditions, including with respect to its enforceability. An eligible credit derivative is defined as a credit derivative in the form of a CDS, nth-to-default swap, total return swap, or any other form of credit derivative approved by the primary Federal supervisor, provided that the instrument meets the standards and conditions set forth in the definition. See the definitions of “eligible guarantee” and “eligible credit derivative” in section 2 of the final rule.

Under the proposal, a banking organization would have been permitted to recognize the credit risk mitigation Start Printed Page 62105benefits of an eligible credit derivative that hedges an exposure that is different from the credit derivative's reference exposure used for determining the derivative's cash settlement value, deliverable obligation, or occurrence of a credit event if (1) the reference exposure ranks pari passu with or is subordinated to the hedged exposure; (2) the reference exposure and the hedged exposure are to the same legal entity; and (3) legally-enforceable cross-default or cross-acceleration clauses are in place to assure payments under the credit derivative are triggered when the issuer fails to pay under the terms of the hedged exposure.

In addition to these two exceptions, one commenter encouraged the agencies and the FDIC to revise the final rule to recognize a proxy hedge as an eligible credit derivative even though such a transaction hedges an exposure that differs from the credit derivative's reference exposure. A proxy hedge was characterized by the commenter as a hedge of an exposure supported by a sovereign using a credit derivative on that sovereign. The agencies do not believe there is sufficient justification to include proxy hedges in the definition of eligible credit derivative because they have concerns regarding the ability of the hedge to sufficiently mitigate the risk of the underlying exposure. The agencies have, therefore, adopted the definition of eligible credit derivative as proposed.

In addition, under the final rule, consistent with the proposal, when a banking organization has a group of hedged exposures with different residual maturities that are covered by a single eligible guarantee or eligible credit derivative, it must treat each hedged exposure as if it were fully covered by a separate eligible guarantee or eligible credit derivative.

b. Substitution Approach

The agencies are adopting the substitution approach for eligible guarantees and eligible credit derivatives in the final rule without change. Under the substitution approach, if the protection amount (as defined below) of an eligible guarantee or eligible credit derivative is greater than or equal to the exposure amount of the hedged exposure, a banking organization substitutes the risk weight applicable to the guarantor or credit derivative protection provider for the risk weight applicable to the hedged exposure.

If the protection amount of the eligible guarantee or eligible credit derivative is less than the exposure amount of the hedged exposure, a banking organization must treat the hedged exposure as two separate exposures (protected and unprotected) to recognize the credit risk mitigation benefit of the guarantee or credit derivative. In such cases, a banking organization calculates the risk-weighted asset amount for the protected exposure under section 36 of the final rule (using a risk weight applicable to the guarantor or credit derivative protection provider and an exposure amount equal to the protection amount of the guarantee or credit derivative). The banking organization calculates its risk-weighted asset amount for the unprotected exposure under section 32 of the final rule (using the risk weight assigned to the exposure and an exposure amount equal to the exposure amount of the original hedged exposure minus the protection amount of the guarantee or credit derivative).

Under the final rule, the protection amount of an eligible guarantee or eligible credit derivative means the effective notional amount of the guarantee or credit derivative reduced to reflect any, maturity mismatch, lack of restructuring coverage, or currency mismatch as described below. The effective notional amount for an eligible guarantee or eligible credit derivative is the lesser of the contractual notional amount of the credit risk mitigant and the exposure amount of the hedged exposure, multiplied by the percentage coverage of the credit risk mitigant. For example, the effective notional amount of a guarantee that covers, on a pro rata basis, 40 percent of any losses on a $100 bond is $40.

c. Maturity Mismatch Haircut

The agencies are adopting the proposed haircut for maturity mismatch in the final rule without change. Under the final rule, the agencies have adopted the requirement that a banking organization that recognizes an eligible guarantee or eligible credit derivative must adjust the effective notional amount of the credit risk mitigant to reflect any maturity mismatch between the hedged exposure and the credit risk mitigant. A maturity mismatch occurs when the residual maturity of a credit risk mitigant is less than that of the hedged exposure(s).[168]

The residual maturity of a hedged exposure is the longest possible remaining time before the obligated party of the hedged exposure is scheduled to fulfil its obligation on the hedged exposure. A banking organization is required to take into account any embedded options that may reduce the term of the credit risk mitigant so that the shortest possible residual maturity for the credit risk mitigant is used to determine the potential maturity mismatch. If a call is at the discretion of the protection provider, the residual maturity of the credit risk mitigant is at the first call date. If the call is at the discretion of the banking organization purchasing the protection, but the terms of the arrangement at origination of the credit risk mitigant contain a positive incentive for the banking organization to call the transaction before contractual maturity, the remaining time to the first call date is the residual maturity of the credit risk mitigant. A banking organization is permitted, under the final rule, to recognize a credit risk mitigant with a maturity mismatch only if its original maturity is greater than or equal to one year and the residual maturity is greater than three months.

Assuming that the credit risk mitigant may be recognized, a banking organization is required to apply the following adjustment to reduce the effective notional amount of the credit risk mitigant to recognize the maturity mismatch:

Pm = E × [(t−0.25)/(T−0.25)],

where:

(1) Pm = effective notional amount of the credit risk mitigant, adjusted for maturity mismatch;

(2) E = effective notional amount of the credit risk mitigant;

(3) t = the lesser of T or residual maturity of the credit risk mitigant, expressed in years; and

(4) T = the lesser of five or the residual maturity of the hedged exposure, expressed in years.

d. Adjustment for Credit Derivatives Without Restructuring as a Credit Event

The agencies are adopting in the final rule the proposed adjustment for credit derivatives without restructuring as a credit event. Consistent with the proposal, under the final rule, a banking organization that seeks to recognize an eligible credit derivative that does not include a restructuring of the hedged exposure as a credit event under the derivative must reduce the effective notional amount of the credit derivative Start Printed Page 62106recognized for credit risk mitigation purposes by 40 percent. For purposes of the credit risk mitigation framework, a restructuring may involve forgiveness or postponement of principal, interest, or fees that result in a credit loss event (that is, a charge-off, specific provision, or other similar debit to the profit and loss account). In these instances, the banking organization is required to apply the following adjustment to reduce the effective notional amount of the credit derivative:

Pr = Pm × 0.60,

where:

(1) Pr = effective notional amount of the credit risk mitigant, adjusted for lack of a restructuring event (and maturity mismatch, if applicable); and

(2) Pm = effective notional amount of the credit risk mitigant (adjusted for maturity mismatch, if applicable).

e. Currency Mismatch Adjustment

Consistent with the proposal, under the final rule, if a banking organization recognizes an eligible guarantee or eligible credit derivative that is denominated in a currency different from that in which the hedged exposure is denominated, the banking organization must apply the following formula to the effective notional amount of the guarantee or credit derivative:

PC = Pr × (1−HFX),

where:

(1) Pc = effective notional amount of the credit risk mitigant, adjusted for currency mismatch (and maturity mismatch and lack of restructuring event, if applicable);

(2) Pr = effective notional amount of the credit risk mitigant (adjusted for maturity mismatch and lack of restructuring event, if applicable); and

(3) HFX = haircut appropriate for the currency mismatch between the credit risk mitigant and the hedged exposure.

A banking organization is required to use a standard supervisory haircut of 8 percent for HFX (based on a ten-business-day holding period and daily marking-to-market and remargining). Alternatively, a banking organization has the option to use internally estimated haircuts of HFX based on a ten-business-day holding period and daily marking-to-market if the banking organization qualifies to use the own-estimates of haircuts in section 37(c)(4) of the final rule. In either case, the banking organization is required to scale the haircuts up using the square root of time formula if the banking organization revalues the guarantee or credit derivative less frequently than once every 10 business days. The applicable haircut (HM) is calculated using the following square root of time formula:

where:

TM = equals the greater of 10 or the number of days between revaluation.

f. Multiple Credit Risk Mitigants

Consistent with the proposal, under the final rule, if multiple credit risk mitigants cover a single exposure, a banking organization may disaggregate the exposure into portions covered by each credit risk mitigant (for example, the portion covered by each guarantee) and calculate separately a risk-based capital requirement for each portion, consistent with the Basel capital framework. In addition, when a single credit risk mitigant covers multiple exposures, a banking organization must treat each hedged exposure as covered by a single credit risk mitigant and must calculate separate risk-weighted asset amounts for each exposure using the substitution approach described in section 36(c) of the final rule.

2. Collateralized Transactions

a. Eligible Collateral

Under the proposal, the agencies and the FDIC would recognize an expanded range of financial collateral as credit risk mitigants that may reduce the risk-based capital requirements associated with a collateralized transaction, consistent with the Basel capital framework. The agencies and the FDIC proposed that a banking organization could recognize the risk-mitigating effects of financial collateral using the “simple approach” for any exposure provided that the collateral meets certain requirements. For repo-style transactions, eligible margin loans, collateralized derivative contracts, and single-product netting sets of such transactions, a banking organization could alternatively use the collateral haircut approach. The proposal required a banking organization to use the same approach for similar exposures or transactions.

The commenters generally agreed with this aspect of the proposal; however, a few commenters encouraged the agencies and the FDIC to expand the definition of financial collateral to include precious metals and certain residential mortgages that collateralize warehouse lines of credit. Several commenters asserted that the final rule should recognize as financial collateral conforming residential mortgages (or at least those collateralizing warehouse lines of credit) and/or those insured by the FHA or VA. They noted that by not including conforming residential mortgages in the definition of financial collateral, the proposed rule would require banking organizations providing warehouse lines to treat warehouse facilities as commercial loan exposures, thus preventing such entities from looking through to the underlying collateral in calculating the appropriate risk weighting. Others argued that a “look through” approach for a repo-style structure to the financial collateral held therein should be allowed. Another commenter argued that the final rule should allow recognition of intangible assets as financial collateral because they have real value. The agencies believe that the collateral types suggested by the commenters are not appropriate forms of financial collateral because they exhibit increased variation and credit risk, and are relatively more speculative than the recognized forms of financial collateral under the proposal. For example, residential mortgages can be highly idiosyncratic in regards to payment features, interest rate provisions, lien seniority, and maturities. The agencies believe that the proposed definition of financial collateral, which is broader than the collateral recognized under the general risk-based capital rules, included those collateral types of sufficient liquidity and asset quality to recognize as credit risk mitigants for risk-based capital purposes. As a result, the agencies have retained the definition of financial collateral as proposed. Therefore, consistent with the proposal, the final rule defines financial collateral as collateral in the form of: (1) Cash on deposit with the banking organization (including cash held for the banking organization by a third-party custodian or trustee); (2) gold bullion; (3) short- and long-term debt securities that are not resecuritization exposures and that are investment grade; (4) equity securities that are publicly-traded; (5) convertible bonds that are publicly-traded; or (6) money market fund shares and other mutual fund shares if a price for the shares is publicly quoted daily. With the exception of cash on deposit, the banking organization is also required to have a perfected, first-priority security interest or, outside of the United States, the legal equivalent thereof, notwithstanding the prior security interest of any custodial agent. Even if a banking organization has the legal right, it still must ensure it monitors or has a freeze on the account to prevent a customer from withdrawing cash on deposit prior to defaulting. A banking organization is permitted to recognize partial collateralization of an exposure.Start Printed Page 62107

Under the final rule, the agencies require that a banking organization could recognize the risk-mitigating effects of financial collateral using the simple approach described below, where: The collateral is subject to a collateral agreement for at least the life of the exposure; the collateral is revalued at least every six months; and the collateral (other than gold) and the exposure is denominated in the same currency. For repo-style transactions, eligible margin loans, collateralized derivative contracts, and single-product netting sets of such transactions, a banking organization could alternatively use the collateral haircut approach described below. The final rule, like the proposal, requires a banking organization to use the same approach for similar exposures or transactions.

b. Risk-Management Guidance for Recognizing Collateral

Before a banking organization recognizes collateral for credit risk mitigation purposes, it should: (1) Conduct sufficient legal review to ensure, at the inception of the collateralized transaction and on an ongoing basis, that all documentation used in the transaction is binding on all parties and legally enforceable in all relevant jurisdictions; (2) consider the correlation between risk of the underlying direct exposure and collateral in the transaction; and (3) fully take into account the time and cost needed to realize the liquidation proceeds and the potential for a decline in collateral value over this time period.

A banking organization also should ensure that the legal mechanism under which the collateral is pledged or transferred ensures that the banking organization has the right to liquidate or take legal possession of the collateral in a timely manner in the event of the default, insolvency, or bankruptcy (or other defined credit event) of the counterparty and, where applicable, the custodian holding the collateral.

In addition, a banking organization should ensure that it (1) has taken all steps necessary to fulfill any legal requirements to secure its interest in the collateral so that it has and maintains an enforceable security interest; (2) has set up clear and robust procedures to ensure satisfaction of any legal conditions required for declaring the default of the borrower and prompt liquidation of the collateral in the event of default; (3) has established procedures and practices for conservatively estimating, on a regular ongoing basis, the fair value of the collateral, taking into account factors that could affect that value (for example, the liquidity of the market for the collateral and obsolescence or deterioration of the collateral); and (4) has in place systems for promptly requesting and receiving additional collateral for transactions whose terms require maintenance of collateral values at specified thresholds.

c. Simple Approach

The agencies are adopting the simple approach without change for purposes of the final rule. Under the final rule, the collateralized portion of the exposure receives the risk weight applicable to the collateral. The collateral is required to meet the definition of financial collateral. For repurchase agreements, reverse repurchase agreements, and securities lending and borrowing transactions, the collateral would be the instruments, gold, and cash that a banking organization has borrowed, purchased subject to resale, or taken as collateral from the counterparty under the transaction. As noted above, in all cases, (1) the collateral must be subject to a collateral agreement for at least the life of the exposure; (2) the banking organization must revalue the collateral at least every six months; and (3) the collateral (other than gold) and the exposure must be denominated in the same currency.

Generally, the risk weight assigned to the collateralized portion of the exposure must be no less than 20 percent. However, the collateralized portion of an exposure may be assigned a risk weight of less than 20 percent for the following exposures. OTC derivative contracts that are marked to fair value on a daily basis and subject to a daily margin maintenance agreement, may receive (1) a zero percent risk weight to the extent that contracts are collateralized by cash on deposit, or (2) a 10 percent risk weight to the extent that the contracts are collateralized by an exposure to a sovereign that qualifies for a zero percent risk weight under section 32 of the final rule. In addition, a banking organization may assign a zero percent risk weight to the collateralized portion of an exposure where the financial collateral is cash on deposit; or the financial collateral is an exposure to a sovereign that qualifies for a zero percent risk weight under section 32 of the final rule, and the banking organization has discounted the fair value of the collateral by 20 percent.

d. Collateral Haircut Approach

Consistent with the proposal, in the final rule, a banking organization may use the collateral haircut approach to recognize the credit risk mitigation benefits of financial collateral that secures an eligible margin loan, repo-style transaction, collateralized derivative contract, or single-product netting set of such transactions. In addition, the banking organization may use the collateral haircut approach with respect to any collateral that secures a repo-style transaction that is included in the banking organization's VaR-based measure under subpart F of the final rule, even if the collateral does not meet the definition of financial collateral.

To apply the collateral haircut approach, a banking organization must determine the exposure amount and the relevant risk weight for the counterparty or guarantor.

The exposure amount for an eligible margin loan, repo-style transaction, collateralized derivative contract, or a netting set of such transactions is equal to the greater of zero and the sum of the following three quantities:

(1) The value of the exposure less the value of the collateral. For eligible margin loans, repo-style transactions and netting sets thereof, the value of the exposure is the sum of the current market values of all instruments, gold, and cash the banking organization has lent, sold subject to repurchase, or posted as collateral to the counterparty under the transaction or netting set. For collateralized OTC derivative contracts and netting sets thereof, the value of the exposure is the exposure amount that is calculated under section 34 of the final rule. The value of the collateral equals the sum of the current market values of all instruments, gold and cash the banking organization has borrowed, purchased subject to resale, or taken as collateral from the counterparty under the transaction or netting set;

(2) The absolute value of the net position in a given instrument or in gold (where the net position in a given instrument or in gold equals the sum of the current market values of the instrument or gold the banking organization has lent, sold subject to repurchase, or posted as collateral to the counterparty minus the sum of the current market values of that same instrument or gold that the banking organization has borrowed, purchased subject to resale, or taken as collateral from the counterparty) multiplied by the market price volatility haircut appropriate to the instrument or gold; and

(3) The absolute value of the net position of instruments and cash in a currency that is different from the settlement currency (where the net position in a given currency equals the sum of the current market values of any instruments or cash in the currency the Start Printed Page 62108banking organization has lent, sold subject to repurchase, or posted as collateral to the counterparty minus the sum of the current market values of any instruments or cash in the currency the banking organization has borrowed, purchased subject to resale, or taken as collateral from the counterparty) multiplied by the haircut appropriate to the currency mismatch.

For purposes of the collateral haircut approach, a given instrument includes, for example, all securities with a single Committee on Uniform Securities Identification Procedures (CUSIP) number and would not include securities with different CUSIP numbers, even if issued by the same issuer with the same maturity date.

e. Standard Supervisory Haircuts

When determining the exposure amount, the banking organization must apply a haircut for price market volatility and foreign exchange rates, determined either using standard supervisory market price volatility haircuts and a standard haircut for exchange rates or, with prior approval of the agency, a banking organization's own estimates of volatilities of market prices and foreign exchange rates.

The standard supervisory market price volatility haircuts set a specified market price volatility haircut for various categories of financial collateral. These standard haircuts are based on the ten-business-day holding period for eligible margin loans and derivative contracts. For repo-style transactions, a banking organization may multiply the standard supervisory haircuts by the square root of 1/2 to scale them for a holding period of five business days. Several commenters argued that the proposed haircuts were too conservative and insufficiently risk-sensitive, and that banking organizations should be allowed to compute their own haircuts. Some commenters proposed limiting the maximum haircut for non-sovereign issuers that receive a 100 percent risk weight to 12 percent and, more specifically, assigning a lower haircut than 25 percent for financial collateral in the form of an investment-grade corporate debt security that has a shorter residual maturity. The commenters asserted that these haircuts conservatively correspond to the existing rating categories and result in greater alignment with the Basel framework.

In the final rule, the agencies have revised from 25.0 percent the standard supervisory market price volatility haircuts for financial collateral issued by non-sovereign issuers with a risk weight of 100 percent to 4.0 percent for maturities of less than one year, 8.0 percent for maturities greater than one year but less than or equal to five years, and 16.0 percent for maturities greater than five years, consistent with Table 22 below. The agencies believe that the revised haircuts better reflect the collateral's credit quality and an appropriate differentiation based on the collateral's residual maturity.

A banking organization using the standard currency mismatch haircut is required to use an 8 percent haircut for each currency mismatch for transactions subject to a 10 day holding period, as adjusted for different required holding periods. One commenter asserted that the proposed adjustment for currency mismatch was unwarranted because in securities lending transactions, the parties typically require a higher collateral margin than in transactions where there is no mismatch. In the alternative, the commenter argued that the agencies and the FDIC should align the currency mismatch haircut more closely with a given currency combination and suggested those currencies of countries with a more favorable CRC from the OECD should receive a smaller haircut. The agencies have decided to adopt this aspect of the proposal without change in the final rule. The agencies believe that the own internal estimates for haircuts methodology described below allows banking organizations appropriate flexibility to more granularly reflect individual currency combinations, provided they meet certain criteria.

Table 22—Standard Supervisory Market Price Volatility Haircuts 1

Residual maturityHaircut (in percent) assigned based on:Investment-grade securitization exposures (in percent)
Sovereign issuers risk weight under § _.32 2Non-sovereign issuers risk weight under § _.32
Zero20 or 501002050100
Less than or equal to 1 year0.51.015.01.02.04.04.0
Greater than 1 year and less than or equal to 5 years2.03.015.04.06.08.012.0
Greater than 5 years4.06.015.08.012.016.024.0
Main index equities (including convertible bonds) and gold15.0
Other publicly-traded equities (including convertible bonds)25.0
Mutual fundsHighest haircut applicable to any security in which the fund can invest.
Cash collateral heldZero
Other exposure types25.0
1 The market price volatility haircuts in Table 22 are based on a 10 business-day holding period.
2 Includes a foreign PSE that receives a zero percent risk weight.

The final rule requires that a banking organization increase the standard supervisory haircut for transactions involving large netting sets. As noted in the proposed rule, during the recent financial crisis, many financial institutions experienced significant delays in settling or closing-out collateralized transactions, such as repo-style transactions and collateralized OTC derivatives. The assumed holding period for collateral in the collateral haircut approach under Basel II proved to be inadequate for certain transactions and netting sets and did not reflect the difficulties and delays that institutions had when settling or liquidating Start Printed Page 62109collateral during a period of financial stress.

Thus, consistent with the proposed rule, for netting sets where: (1) The number of trades exceeds 5,000 at any time during the quarter; (2) one or more trades involves illiquid collateral posted by the counterparty; or (3) the netting set includes any OTC derivatives that cannot be easily replaced, the final rule requires a banking organization to assume a holding period of 20 business days for the collateral under the collateral haircut approach. The formula and methodology for increasing the haircut to reflect the longer holding period is described in section 37(c) of the final rule. Consistent with the Basel capital framework, a banking organization is not required to adjust the holding period upward for cleared transactions. When determining whether collateral is illiquid or whether an OTC derivative cannot be easily replaced for these purposes, a banking organization should assess whether, during a period of stressed market conditions, it could obtain multiple price quotes within two days or less for the collateral or OTC derivative that would not move the market or represent a market discount (in the case of collateral) or a premium (in the case of an OTC derivative).

One commenter requested the agencies and the FDIC clarify whether the 5,000-trade threshold applies on a counterparty-by-counterparty (rather than aggregate) basis, and only will be triggered in the event there are 5,000 open trades with a single counterparty within a single netting set in a given quarter. Commenters also asked whether the threshold would be calculated on an average basis or whether a de minimis number of breaches could be permitted without triggering the increased holding period or margin period of risk. One commenter suggested eliminating the threshold because it is ineffective as a measure of risk, and combined with other features of the proposals (for example, collateral haircuts, margin disputes), could create a disincentive for banking organizations to apply sound practices such as risk diversification.

The agencies note that the 5,000-trade threshold applies to a netting set, which by definition means a group of transactions with a single counterparty that are subject to a qualifying master netting agreement. The 5,000 trade calculation threshold was proposed as an indicator that a set of transactions may be more complex, or require a lengthy period, to close out in the event of a default of a counterparty. The agencies continue to believe that the threshold of 5,000 is a reasonable indicator of the complexity of a close-out. Therefore, the final rule retains the 5,000 trade threshold as proposed, without any de minimis exception.

One commenter asked the agencies to clarify how trades would be counted in the context of an indemnified agency securities lending relationship. In such transactions, an agent banking organization acts as an intermediary for, potentially, multiple borrowers and lenders. The banking organization is acting as an agent with no exposure to either the securities lenders or borrowers except for an indemnification to the securities lenders in the event of a borrower default. The indemnification creates an exposure to the securities borrower, as the agent banking organization could suffer a loss upon the default of a borrower. In these cases, each transaction between the agent and a borrower would count as a trade. The agencies note that a trade in this instance consists of an order by the borrower, and not the number of securities lenders providing shares to fulfil the order or the number of shares underlying such order.[169]

The commenters also addressed the longer holding period for trades involving illiquid collateral posted by the counterparty. Some commenters asserted that one illiquid exposure or one illiquid piece of collateral should not taint the entire netting set. Other commenters recommended applying a materiality threshold (for example, 1 percent) below which one or more illiquid exposures would not trigger the longer holding period, or allowing banking organizations to define “materiality” based on experience.

Regarding the potential for an illiquid exposure to “taint” an entire netting set, the final rule does not require a banking organization to recognize any piece of collateral as a risk mitigant. Accordingly, if a banking organization elects to exclude the illiquid collateral from the netting set for purposes of calculating risk-weighted assets, then such illiquid collateral does not result in an increased holding period for the netting set. With respect to a derivative that may not be easily replaced, a banking organization could create a separate netting set that would preserve the holding period for the original netting set of easily replaced transactions. Accordingly, the final rule adopts this aspect of the proposal without change.

One commenter asserted that the final rule should not require a banking organization to determine whether an instrument is liquid on a daily basis, but rather should base the timing of such determination by product category and on long-term liquidity data. According to the commenter, such an approach would avoid potential confusion, volatility and destabilization of the funding markets. For purposes of determining whether collateral is illiquid or an OTC derivative contract is easily replaceable under the final rule, a banking organization may assess whether, during a period of stressed market conditions, it could obtain multiple price quotes within two days or less for the collateral or OTC derivative that would not move the market or represent a market discount (in the case of collateral) or a premium (in the case of an OTC derivative). A banking organization is not required to make a daily determination of liquidity under the final rule; rather, banking organizations should have policies and procedures in place to evaluate the liquidity of their collateral as frequently as warranted.

Under the proposed rule, a banking organization would increase the holding period for a netting set if over the two previous quarters more than two margin disputes on a netting set have occurred that lasted longer than the holding period. However, consistent with the Basel capital framework, a banking organization would not be required to adjust the holding period upward for cleared transactions. Several commenters requested further clarification on the meaning of “margin disputes.” Some of these commenters suggested restricting “margin disputes” to formal legal action. Commenters also suggested restricting “margin disputes” to disputes resulting in the creation of an exposure that exceeded any available overcollateralization, or establishing a materiality threshold. One commenter suggested that margin disputes were not an indicator of an increased risk and, therefore, should not trigger a longer holding period.

The agencies continue to believe that an increased holding period is appropriate regardless of whether the dispute exceeds applicable collateral requirements and regardless of whether the disputes exceed a materiality threshold. The agencies expect that the determination as to whether a dispute constitutes a margin dispute for purposes of the final rule will depend solely on the timing of the resolution. That is to say, if collateral is not Start Printed Page 62110delivered within the time period required under an agreement, and such failure to deliver is not resolved in a timely manner, then such failure would count toward the two-margin-dispute limit. For the purpose of the final rule, where a dispute is subject to a recognized industry dispute resolution protocol, the agencies expect to consider the dispute period to begin after a third-party dispute resolution mechanism has failed.

For comments and concerns that are specific to the parallel provisions in the advanced approaches rule, reference section XII.A of this preamble.

f. Own Estimates of Haircuts

Under the final rule, consistent with the proposal, banking organizations may calculate market price volatility and foreign exchange volatility using own internal estimates with prior written approval of the banking organization's primary Federal supervisor. To receive approval to calculate haircuts using its own internal estimates, a banking organization must meet certain minimum qualitative and quantitative standards set forth in the final rule, including the requirements that a banking organization: (1) Uses a 99th percentile one-tailed confidence interval and a minimum five-business-day holding period for repo-style transactions and a minimum ten-business-day holding period for all other transactions; (2) adjusts holding periods upward where and as appropriate to take into account the illiquidity of an instrument; (3) selects a historical observation period that reflects a continuous 12-month period of significant financial stress appropriate to the banking organization's current portfolio; and (4) updates its data sets and compute haircuts no less frequently than quarterly, as well as any time market prices change materially. A banking organization estimates the volatilities of exposures, the collateral, and foreign exchange rates and should not take into account the correlations between them.

The final rule provides a formula for converting own-estimates of haircuts based on a holding period different from the minimum holding period under the rule to haircuts consistent with the rule's minimum holding periods. The minimum holding periods for netting sets with more than 5,000 trades, netting sets involving illiquid collateral or an OTC derivative that cannot easily be replaced, and netting sets involving more than two margin disputes over the previous two quarters described above also apply for own-estimates of haircuts.

Under the final rule, a banking organization is required to have policies and procedures that describe how it determines the period of significant financial stress used to calculate the banking organization's own internal estimates, and to be able to provide empirical support for the period used. These policies and procedures must address (1) how the banking organization links the period of significant financial stress used to calculate the own internal estimates to the composition and directional bias of the banking organization's current portfolio; and (2) the banking organization's process for selecting, reviewing, and updating the period of significant financial stress used to calculate the own internal estimates and for monitoring the appropriateness of the 12-month period in light of the banking organization's current portfolio. The banking organization is required to obtain the prior approval of its primary Federal supervisor for these policies and procedures and notify its primary Federal supervisor if the banking organization makes any material changes to them. A banking organization's primary Federal supervisor may require it to use a different period of significant financial stress in the calculation of the banking organization's own internal estimates.

Under the final rule, a banking organization is allowed to calculate internally estimated haircuts for categories of debt securities that are investment-grade exposures. The haircut for a category of securities must be representative of the internal volatility estimates for securities in that category that the banking organization has lent, sold subject to repurchase, posted as collateral, borrowed, purchased subject to resale, or taken as collateral. In determining relevant categories, the banking organization must, at a minimum, take into account (1) the type of issuer of the security; (2) the credit quality of the security; (3) the maturity of the security; and (4) the interest rate sensitivity of the security.

A banking organization must calculate a separate internally estimated haircut for each individual non-investment-grade debt security and for each individual equity security. In addition, a banking organization must estimate a separate currency mismatch haircut for its net position in each mismatched currency based on estimated volatilities for foreign exchange rates between the mismatched currency and the settlement currency where an exposure or collateral (whether in the form of cash or securities) is denominated in a currency that differs from the settlement currency.

g. Simple Value-at-Risk and Internal Models Methodology

In the NPR, the agencies and the FDIC did not propose a simple VaR approach to calculate exposure amounts for eligible margin loans and repo-style transactions or IMM to calculate the exposure amount for the counterparty credit exposure for OTC derivatives, eligible margin loans, and repo-style transactions. These methodologies are included in the advanced approaches rule. The agencies and the FDIC sought comment on whether to implement the simple VaR approach and IMM in the standardized approach. Several commenters asserted that the IMM and simple VaR approach should be implemented in the final rule to better capture the risk of counterparty credit exposures. The agencies have considered these comments and, have concluded that the increased complexity and limited applicability of these models-based approaches is inconsistent with the agencies' overall focus in the standardized approach on simplicity, comparability, and broad applicability of methodologies for U.S. banking organizations. Therefore, consistent with the proposal, the final rule does not include the simple VaR approach or the IMM in the standardized approach.

G. Unsettled Transactions

Under the proposed rule, a banking organization would be required to hold capital against the risk of certain unsettled transactions. One commenter expressed opposition to assigning a risk weight to unsettled transactions where previously none existed, because it would require a significant and burdensome tracking process without commensurate benefit. The agencies believe that it is important for a banking organization to have procedures to identify and track a delayed or unsettled transaction of the types specified in the rule. Such procedures capture the resulting risks associated with such delay. As a result, the agencies are adopting the risk-weighting requirements as proposed.

Consistent with the proposal, the final rule provides for a separate risk-based capital requirement for transactions involving securities, foreign exchange instruments, and commodities that have a risk of delayed settlement or delivery. Under the final rule, the capital requirement does not, however, apply to certain types of transactions, including: (1) Cleared transactions that are marked-to-market daily and subject to daily Start Printed Page 62111receipt and payment of variation margin; (2) repo-style transactions, including unsettled repo-style transactions; (3) one-way cash payments on OTC derivative contracts; or (4) transactions with a contractual settlement period that is longer than the normal settlement period (which the proposal defined as the lesser of the market standard for the particular instrument or five business days).[170] In the case of a system-wide failure of a settlement, clearing system, or central counterparty, the banking organization's primary Federal supervisor may waive risk-based capital requirements for unsettled and failed transactions until the situation is rectified.

The final rule provides separate treatments for delivery-versus-payment (DvP) and payment-versus-payment (PvP) transactions with a normal settlement period, and non-DvP/non-PvP transactions with a normal settlement period. A DvP transaction refers to a securities or commodities transaction in which the buyer is obligated to make payment only if the seller has made delivery of the securities or commodities and the seller is obligated to deliver the securities or commodities only if the buyer has made payment. A PvP transaction means a foreign exchange transaction in which each counterparty is obligated to make a final transfer of one or more currencies only if the other counterparty has made a final transfer of one or more currencies. A transaction is considered to have a normal settlement period if the contractual settlement period for the transaction is equal to or less than the market standard for the instrument underlying the transaction and equal to or less than five business days.

Consistent with the proposal, under the final rule, a banking organization is required to hold risk-based capital against a DvP or PvP transaction with a normal settlement period if the banking organization's counterparty has not made delivery or payment within five business days after the settlement date. The banking organization determines its risk-weighted asset amount for such a transaction by multiplying the positive current exposure of the transaction for the banking organization by the appropriate risk weight in Table 23. The positive current exposure from an unsettled transaction of a banking organization is the difference between the transaction value at the agreed settlement price and the current market price of the transaction, if the difference results in a credit exposure of the banking organization to the counterparty.

Table 23—Risk Weights for Unsettled DvP and PvP Transactions

Number of business days after contractual settlement dateRisk weight to be applied to positive current exposure (in percent)
From 5 to 15100.0
From 16 to 30625.0
From 31 to 45937.5
46 or more1,250.0

A banking organization must hold risk-based capital against any non-DvP/non-PvP transaction with a normal settlement period if the banking organization delivered cash, securities, commodities, or currencies to its counterparty but has not received its corresponding deliverables by the end of the same business day. The banking organization must continue to hold risk-based capital against the transaction until it has received the corresponding deliverables. From the business day after the banking organization has made its delivery until five business days after the counterparty delivery is due, the banking organization must calculate the risk-weighted asset amount for the transaction by risk weighting the current fair value of the deliverables owed to the banking organization, using the risk weight appropriate for an exposure to the counterparty in accordance with section 32. If a banking organization has not received its deliverables by the fifth business day after the counterparty delivery due date, the banking organization must assign a 1,250 percent risk weight to the current market value of the deliverables owed.

H. Risk-Weighted Assets for Securitization Exposures

In the proposal, the agencies and the FDIC proposed to significantly revise the risk-based capital framework for securitization exposures. These proposed revisions included removing references to and reliance on credit ratings to determine risk weights for these exposures and using alternative standards of creditworthiness, as required by section 939A of the Dodd-Frank Act. These alternative standards were designed to produce capital requirements that generally would be consistent with those under the BCBS securitization framework and were consistent with those incorporated into the agencies' and the FDIC's market risk rule.[171] They would have replaced both the ratings-based approach and an approach that permits banking organizations to use supervisor-approved internal systems to replicate external ratings processes for certain unrated exposures in the general risk-based capital rules.

In addition, the agencies and the FDIC proposed to update the terminology for the securitization framework, include a definition of securitization exposure that encompasses a wider range of exposures with similar risk characteristics, and implement new due diligence requirements for securitization exposures.

1. Overview of the Securitization Framework and Definitions

The proposed securitization framework was designed to address the credit risk of exposures that involve the tranching of credit risk of one or more underlying financial exposures. Consistent with the proposal, the final rule defines a securitization exposure as an on- or off-balance sheet credit exposure (including credit-enhancing representations and warranties) that arises from a traditional or synthetic securitization (including a resecuritization), or an exposure that directly or indirectly references a securitization exposure. Commenters expressed concerns that the proposed scope of the securitization framework was overly broad and requested that the definition of securitizations be narrowed to exposures that tranche the credit risk associated with a pool of assets. However, the agencies believe that limiting the securitization framework to exposures backed by a pool of assets would exclude tranched credit risk exposures that are appropriately captured under the securitization framework, such as certain first loss or other tranched guarantees provided to a single underlying exposure.

In the proposal a traditional securitization was defined, in part, as a transaction in which credit risk of one or more underlying exposures has been transferred to one or more third parties (other than through the use of credit derivatives or guarantees), where the credit risk associated with the underlying exposures has been separated into at least two tranches reflecting different levels of seniority. The definition included certain other conditions, such as requiring all or substantially all of the underlying exposures to be financial exposures. The agencies have decided to finalize the Start Printed Page 62112definition of traditional securitization largely as proposed, with some revisions (as discussed below), that reflect certain comments regarding exclusions under the framework and other modifications to the final rule.

Both the designation of exposures as securitization exposures (or resecuritization exposures, as described below) and the calculation of risk-based capital requirements for securitization exposures under the final rule are guided by the economic substance of a transaction rather than its legal form. Provided there is tranching of credit risk, securitization exposures could include, among other things, ABS and MBS, loans, lines of credit, liquidity facilities, financial standby letters of credit, credit derivatives and guarantees, loan servicing assets, servicer cash advance facilities, reserve accounts, credit-enhancing representations and warranties, and CEIOs. Securitization exposures also include assets sold with retained tranches.

The agencies believe that requiring all or substantially all of the underlying exposures of a securitization to be financial exposures creates an important boundary between the general credit risk framework and the securitization framework. Examples of financial exposures include loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities. Based on their cash flow characteristics, the agencies also consider asset classes such as lease residuals and entertainment royalties to be financial assets. The securitization framework is not designed, however, to apply to tranched credit exposures to commercial or industrial companies or nonfinancial assets or to amounts deducted from capital under section 22 of the final rule. Accordingly, a specialized loan to finance the construction or acquisition of large-scale projects (for example, airports or power plants), objects (for example, ships, aircraft, or satellites), or commodities (for example, reserves, inventories, precious metals, oil, or natural gas) generally would not be a securitization exposure because the assets backing the loan typically are nonfinancial assets (the facility, object, or commodity being financed).

Consistent with the proposal, under the final rule, an operating company does not fall under the definition of a traditional securitization (even if substantially all of its assets are financial exposures). Operating companies generally refer to companies that are established to conduct business with clients with the intention of earning a profit in their own right and generally produce goods or provide services beyond the business of investing, reinvesting, holding, or trading in financial assets. Accordingly, an equity investment in an operating company generally would be an equity exposure. Under the final rule, banking organizations are operating companies and do not fall under the definition of a traditional securitization. However, investment firms that generally do not produce goods or provide services beyond the business of investing, reinvesting, holding, or trading in financial assets, would not be operating companies under the final rule and would not qualify for this general exclusion from the definition of traditional securitization.

Under the proposed rule, paragraph (10) of the definition of traditional securitization specifically excluded exposures to investment funds (as defined in the proposal) and collective investment and pension funds (as defined in relevant regulations and set forth in the proposed definition of “traditional securitization”). These specific exemptions served to narrow the potential scope of the securitization framework. Investment funds, collective investment funds, pension funds regulated under ERISA and their foreign equivalents, and transactions registered with the SEC under the Investment Company Act of 1940 and their foreign equivalents would be exempted from the definition because these entities and transactions are regulated and subject to strict leverage requirements. The proposal defined an investment fund as a company (1) where all or substantially all of the assets of the fund are financial assets; and (2) that has no material liabilities. In addition, the agencies explained in the proposal that the capital requirements for an extension of credit to, or an equity holding in, these transactions are more appropriately calculated under the rules for corporate and equity exposures, and that the securitization framework was not intended to apply to such transactions.

Commenters generally agreed with the proposed exemptions from the definition of traditional securitization and requested that the agencies and the FDIC provide exemptions for exposures to a broader set of investment firms, such as pension funds operated by state and local governments. In view of the comments regarding pension funds, the final rule provides an additional exclusion from the definition of traditional securitization for a “governmental plan” (as defined in 29 U.S.C. 1002(32)) that complies with the tax deferral qualification requirements provided in the Internal Revenue Code. The agencies believe that an exemption for such government plans is appropriate because they are subject to substantial regulation. Commenters also requested that the agencies and the FDIC provide exclusions for certain products provided to investment firms, such as extensions of short-term credit that support day-to-day investment-related activities. The agencies believe that exposures that meet the definition of traditional securitization, regardless of product type or maturity, would fall under the securitization framework. Accordingly, the agencies have not provided for any such exemptions under the final rule.[172]

To address the treatment of investment firms that are not specifically excluded from the securitization framework, the proposed rule provided discretion to the primary Federal supervisor of a banking organization to exclude from the definition of a traditional securitization those transactions in which the underlying exposures are owned by an investment firm that exercises substantially unfettered control over the size and composition of its assets, liabilities, and off-balance sheet exposures. While the commenters supported the agencies' and the FDIC's recognition that certain investment firms may warrant an exemption from the securitization framework, some expressed concern that the process for making such a determination may present significant implementation burden.

To maintain sufficient flexibility to provide an exclusion for certain investment firms from the securitization framework, the agencies have retained this discretionary provision in the final rule without change. In determining whether to exclude an investment firm from the securitization framework, the agencies will consider a number of factors, including the assessment of the transaction's leverage, risk profile, and economic substance. This supervisory exclusion gives the primary Federal supervisor discretion to distinguish structured finance transactions, to which the securitization framework is designed to apply, from those of flexible investment firms, such as certain hedge funds and private equity funds. Only investment firms that can easily change the size and composition of their capital structure, as well as the size and composition of their assets and off-Start Printed Page 62113balance sheet exposures, are eligible for the exclusion from the definition of traditional securitization under this provision. The agencies do not consider managed collateralized debt obligation vehicles, structured investment vehicles, and similar structures, which allow considerable management discretion regarding asset composition but are subject to substantial restrictions regarding capital structure, to have substantially unfettered control. Thus, such transactions meet the definition of traditional securitization under the final rule.

The line between securitization exposures and non-securitization exposures may be difficult to identify in some circumstances. In addition to the supervisory exclusion from the definition of traditional securitization described above, the primary Federal supervisor may expand the scope of the securitization framework to include other transactions if doing so is justified by the economics of the transaction. Similar to the analysis for excluding an investment firm from treatment as a traditional securitization, the agencies will consider the economic substance, leverage, and risk profile of a transaction to ensure that an appropriate risk-based capital treatment is applied. The agencies will consider a number of factors when assessing the economic substance of a transaction including, for example, the amount of equity in the structure, overall leverage (whether on- or off-balance sheet), whether redemption rights attach to the equity investor, and the ability of the junior tranches to absorb losses without interrupting contractual payments to more senior tranches.

Under the proposal, a synthetic securitization was defined as a transaction in which: (1) All or a portion of the credit risk of one or more underlying exposures is transferred to one or more third parties through the use of one or more credit derivatives or guarantees (other than a guarantee that transfers only the credit risk of an individual retail exposure); (2) the credit risk associated with the underlying exposures has been separated into at least two tranches reflecting different levels of seniority; (3) performance of the securitization exposures depends upon the performance of the underlying exposures; and (4) all or substantially all of the underlying exposures are financial exposures (such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities). The agencies have decided to finalize the definition of synthetic securitization largely as proposed, but have also clarified in the final rule that transactions in which a portion of credit risk has been retained, not just transferred, through the use of credit derivatives is subject to the securitization framework.

In response to the proposal, commenters requested that the agencies and the FDIC provide an exemption for guarantees that tranche credit risk under certain mortgage partnership finance programs, such as certain programs provided by the FHLBs, whereby participating member banking organizations provide credit enhancement to a pool of residential mortgage loans that have been delivered to the FHLB. The agencies believe that these exposures that tranche credit risk meet the definition of a synthetic securitization and that the risk of such exposures would be appropriately captured under the securitization framework. In contrast, mortgage-backed pass-through securities (for example, those guaranteed by FHLMC or FNMA) that feature various maturities but do not involve tranching of credit risk do not meet the definition of a securitization exposure. Only those MBS that involve tranching of credit risk are considered to be securitization exposures.

Consistent with the 2009 Enhancements, the proposed rule defined a resecuritization exposure as an on- or off-balance sheet exposure to a resecuritization; or an exposure that directly or indirectly references a resecuritization exposure. A resecuritization would have meant a securitization in which one or more of the underlying exposures is a securitization exposure. An exposure to an asset-backed commercial paper (ABCP) program would not have been a resecuritization exposure if either: (1) The program-wide credit enhancement does not meet the definition of a resecuritization exposure; or (2) the entity sponsoring the program fully supports the commercial paper through the provision of liquidity so that the commercial paper holders effectively are exposed to the default risk of the sponsor instead of the underlying exposures.

Commenters asked the agencies and the FDIC to narrow the definition of resecuritization by exempting resecuritizations in which a minimal amount of underlying assets are securitization exposures. According to commenters, the proposed definition would have a detrimental effect on certain collateralized loan obligation exposures, which typically include a small amount of securitization exposures as part of the underlying pool of assets in a securitization. Specifically, the commenters requested that resecuritizations be defined as a securitization in which five percent or more of the underlying exposures are securitizations. Commenters also asked the agencies and the FDIC to consider employing a pro rata treatment by only applying a higher capital surcharge to the portion of a securitization exposure that is backed by underlying securitization exposures. The agencies believe that the introduction of securitization exposures into a pool of securitized exposures significantly increases the complexity and correlation risk of the exposures backing the securities issued in the transaction, and that the resecuritization framework is appropriate for applying risk-based capital requirements to exposures to pools that contain securitization exposures.

Commenters sought clarification as to whether the proposed definition of resecuritization would include a single exposure that has been retranched, such as a resecuritization of a real estate mortgage investment conduit (Re-REMIC). The agencies believe that the increased capital surcharge, or p factor, for resecuritizations was meant to address the increased correlation risk and complexity resulting from retranching of multiple underlying exposures and was not intended to apply to the retranching of a single underlying exposure. As a result, the definition of resecuritization in the final rule has been refined to clarify that resecuritizations do not include exposures comprised of a single asset that has been retranched. The agencies note that for purposes of the final rule, a resecuritization does not include pass-through securities that have been pooled together and effectively re-issued as tranched securities. This is because the pass-through securities do not tranche credit protection and, as a result, are not considered securitization exposures under the final rule.

Under the final rule, if a transaction involves a traditional multi-seller ABCP conduit, a banking organization must determine whether the transaction should be considered a resecuritization exposure. For example, assume that an ABCP conduit acquires securitization exposures where the underlying assets consist of wholesale loans and no securitization exposures. As is typically the case in multi-seller ABCP conduits, each seller provides first-loss protection by over-collateralizing the conduit to which it sells loans. To ensure that the commercial paper issued by each Start Printed Page 62114conduit is highly-rated, a banking organization sponsor provides either a pool-specific liquidity facility or a program-wide credit enhancement such as a guarantee to cover a portion of the losses above the seller-provided protection.

The pool-specific liquidity facility generally is not a resecuritization exposure under the final rule because the pool-specific liquidity facility represents a tranche of a single asset pool (that is, the applicable pool of wholesale exposures), which contains no securitization exposures. However, a sponsor's program-wide credit enhancement that does not cover all losses above the seller-provided credit enhancement across the various pools generally constitutes tranching of risk of a pool of multiple assets containing at least one securitization exposure, and, therefore, is a resecuritization exposure.

In addition, if the conduit in this example funds itself entirely with a single class of commercial paper, then the commercial paper generally is not a resecuritization exposure if, as noted above, either (1) the program-wide credit enhancement does not meet the definition of a resecuritization exposure or (2) the commercial paper is fully supported by the sponsoring banking organization. When the sponsoring banking organization fully supports the commercial paper, the commercial paper holders effectively are exposed to default risk of the sponsor instead of the underlying exposures, and the external rating of the commercial paper is expected to be based primarily on the credit quality of the banking organization sponsor, thus ensuring that the commercial paper does not represent a tranched risk position.

2. Operational Requirements

a. Due Diligence Requirements

During the recent financial crisis, it became apparent that many banking organizations relied exclusively on ratings issued by Nationally Recognized Statistical Rating Organizations (NRSROs) and did not perform internal credit analysis of their securitization exposures. Consistent with the Basel capital framework and the agencies' general expectations for investment analysis, the proposal required banking organizations to satisfy specific due diligence requirements for securitization exposures. Specifically, under the proposal a banking organization would be required to demonstrate, to the satisfaction of its primary Federal supervisor, a comprehensive understanding of the features of a securitization exposure that would materially affect its performance. The banking organization's analysis would have to be commensurate with the complexity of the exposure and the materiality of the exposure in relation to capital of the banking organization. On an ongoing basis (no less frequently than quarterly), the banking organization must evaluate, review, and update as appropriate the analysis required under section 41(c)(1) of the proposed rule for each securitization exposure. The analysis of the risk characteristics of the exposure prior to acquisition, and periodically thereafter, would have to consider:

(1) Structural features of the securitization that materially impact the performance of the exposure, for example, the contractual cash-flow waterfall, waterfall-related triggers, credit enhancements, liquidity enhancements, market value triggers, the performance of organizations that service the position, and deal-specific definitions of default;

(2) Relevant information regarding the performance of the underlying credit exposure(s), for example, the percentage of loans 30, 60, and 90 days past due; default rates; prepayment rates; loans in foreclosure; property types; occupancy; average credit score or other measures of creditworthiness; average LTV ratio; and industry and geographic diversification data on the underlying exposure(s);

(3) Relevant market data of the securitization, for example, bid-ask spread, most recent sales price and historical price volatility, trading volume, implied market rating, and size, depth and concentration level of the market for the securitization; and

(4) For resecuritization exposures, performance information on the underlying securitization exposures, for example, the issuer name and credit quality, and the characteristics and performance of the exposures underlying the securitization exposures.

Commenters expressed concern that many banking organizations would be unable to perform the due diligence necessary to meet the requirements and, as a result, would no longer purchase privately-issued securitization exposures and would increase their holdings of GSE-guaranteed securities, thereby increasing the size of the GSEs. Commenters also expressed concerns regarding banking organizations' ability to obtain relevant market data for certain exposures, such as foreign exposures and exposures that are traded in markets that are typically illiquid, as well as their ability to obtain market data during periods of general market illiquidity. Commenters also stated concerns that uneven application of the requirements by supervisors may result in disparate treatment for the same exposure held at different banking organizations due to perceived management deficiencies. For these reasons, many commenters requested that the agencies and the FDIC consider removing the market data requirement from the due diligence requirements. In addition, some commenters suggested that the due diligence requirements be waived provided that all of the underlying loans meet certain underwriting standards.

The agencies note that the proposed due diligence requirements are generally consistent with the goal of the agencies' investment permissibility requirements, which provide that banking organizations must be able to determine the risk of loss is low, even under adverse economic conditions. The agencies acknowledge potential restrictions on data availability and believe that the standards provide sufficient flexibility so that the due diligence requirements, such as relevant market data requirements, would be implemented as applicable. In addition, the agencies note that, where appropriate, pool-level data could be used to meet certain of the due diligence requirements. As a result, the agencies are adopting the due diligence requirements as proposed.

Under the proposal, if a banking organization is not able to meet these due diligence requirements and demonstrate a comprehensive understanding of a securitization exposure to the satisfaction of its primary Federal supervisor, the banking organization would be required to assign a risk weight of 1,250 percent to the exposure. Commenters requested that the agencies and the FDIC adopt a more flexible approach to due diligence requirements rather than requiring a banking organization to assign a risk weight of 1,250 percent for violation of those requirements. For example, some commenters recommended that the agencies and the FDIC assign progressively increasing risk weights based on the severity and duration of infringements of due diligence requirements, to allow the agencies and the FDIC to differentiate between minor gaps in due diligence requirements and more serious violations.

The agencies believe that the requirement to assign a 1,250 percent risk weight, rather than applying a lower risk weight, to exposures for violation of these requirements is appropriate given that such information is required to monitor appropriately the risk of the underlying assets. The agencies recognize the importance of Start Printed Page 62115consistent and uniform application of the standards across banking organizations and will endeavor to ensure that supervisors consistently review banking organizations' due diligence on securitization exposures. The agencies believe that these efforts will mitigate concerns that the 1,250 percent risk weight will be applied inappropriately to banking organizations' failure to meet the due diligence requirements. At the same time, the agencies believe that the requirement that a banking organization's analysis be commensurate with the complexity and materiality of the securitization exposure provides the banking organization with sufficient flexibility to mitigate the potential for undue burden. As a result, the agencies are adopting the risk weight requirements related to due diligence requirements as proposed.

b. Operational Requirements for Traditional Securitizations

The proposal outlined certain operational requirements for traditional securitizations that had to be met in order to apply the securitization framework. The agencies are adopting these operational requirements as proposed.

In a traditional securitization, an originating banking organization typically transfers a portion of the credit risk of exposures to third parties by selling them to a securitization special purpose entity (SPE).[173] Consistent with the proposal, the final rule defines a banking organization to be an originating banking organization with respect to a securitization if it (1) directly or indirectly originated or securitized the underlying exposures included in the securitization; or (2) serves as an ABCP program sponsor to the securitization.

Under the final rule, consistent with the proposal, a banking organization that transfers exposures it has originated or purchased to a securitization SPE or other third party in connection with a traditional securitization can exclude the underlying exposures from the calculation of risk-weighted assets only if each of the following conditions are met: (1) The exposures are not reported on the banking organization's consolidated balance sheet under GAAP; (2) the banking organization has transferred to one or more third parties credit risk associated with the underlying exposures; and (3) any clean-up calls relating to the securitization are eligible clean-up calls (as discussed below).[174]

An originating banking organization that meets these conditions must hold risk-based capital against any credit risk it retains or acquires in connection with the securitization. An originating banking organization that fails to meet these conditions is required to hold risk-based capital against the transferred exposures as if they had not been securitized and must deduct from common equity tier 1 capital any after-tax gain-on-sale resulting from the transaction.

In addition, if a securitization (1) includes one or more underlying exposures in which the borrower is permitted to vary the drawn amount within an agreed limit under a line of credit, and (2) contains an early amortization provision, the originating banking organization is required to hold risk-based capital against the transferred exposures as if they had not been securitized and deduct from common equity tier 1 capital any after-tax gain-on-sale resulting from the transaction.[175] The agencies believe that this treatment is appropriate given the lack of risk transference in securitizations of revolving underlying exposures with early amortization provisions.

c. Operational Requirements for Synthetic Securitizations

In general, the proposed operational requirements for synthetic securitizations were similar to those proposed for traditional securitizations. The operational requirements for synthetic securitizations, however, were more detailed to ensure that the originating banking organization has truly transferred credit risk of the underlying exposures to one or more third parties. Under the proposal, an originating banking organization would have been able to recognize for risk-based capital purposes the use of a credit risk mitigant to hedge underlying exposures only if each of the conditions in the proposed definition of “synthetic securitization” was satisfied. The agencies are adopting the operational requirements largely as proposed. However, to ensure that synthetic securitizations created through tranched guarantees and credit derivatives are properly included in the framework, in the final rule the agencies have amended the operational requirements to recognize guarantees that meet all of the criteria set forth in the definition of eligible guarantee except the criterion under paragraph (3) of the definition. Additionally, the operational criteria recognize a credit derivative provided that the credit derivative meets all of the criteria set forth in the definition of eligible credit derivative except for paragraph 3 of the definition of eligible guarantee. As a result, a guarantee or credit derivative that provides a tranched guarantee would not be excluded by the operational requirements for synthetic securitizations.

Failure to meet these operational requirements for a synthetic securitization prevents a banking organization that has purchased tranched credit protection referencing one or more of its exposures from using the securitization framework with respect to the reference exposures and requires the banking organization to hold risk-based capital against the underlying exposures as if they had not been synthetically securitized. A banking organization that holds a synthetic securitization as a result of purchasing credit protection may use the securitization framework to determine the risk-based capital requirement for its exposure. Alternatively, it may instead choose to disregard the credit protection and use Start Printed Page 62116the general credit risk framework. A banking organization that provides tranched credit protection in the form of a synthetic securitization or credit protection to a synthetic securitization must use the securitization framework to compute risk-based capital requirements for its exposures to the synthetic securitization even if the originating banking organization fails to meet one or more of the operational requirements for a synthetic securitization.

d. Clean-Up Calls

Under the proposal, to satisfy the operational requirements for securitizations and enable an originating banking organization to exclude the underlying exposures from the calculation of its risk-based capital requirements, any clean-up call associated with a securitization would need to be an eligible clean-up call. The proposed rule defined a clean-up call as a contractual provision that permits an originating banking organization or servicer to call securitization exposures before their stated maturity or call date. In the case of a traditional securitization, a clean-up call generally is accomplished by repurchasing the remaining securitization exposures once the amount of underlying exposures or outstanding securitization exposures falls below a specified level. In the case of a synthetic securitization, the clean-up call may take the form of a clause that extinguishes the credit protection once the amount of underlying exposures has fallen below a specified level.

The final rule retains the proposed treatment for clean-up calls, and defines an eligible clean-up call as a clean-up call that (1) is exercisable solely at the discretion of the originating banking organization or servicer; (2) is not structured to avoid allocating losses to securitization exposures held by investors or otherwise structured to provide credit enhancement to the securitization (for example, to purchase non-performing underlying exposures); and (3) for a traditional securitization, is only exercisable when 10 percent or less of the principal amount of the underlying exposures or securitization exposures (determined as of the inception of the securitization) is outstanding; or, for a synthetic securitization, is only exercisable when 10 percent or less of the principal amount of the reference portfolio of underlying exposures (determined as of the inception of the securitization) is outstanding. Where a securitization SPE is structured as a master trust, a clean-up call with respect to a particular series or tranche issued by the master trust meets criteria (3) of the definition of “eligible clean-up call” as long as the outstanding principal amount in that series or tranche was 10 percent or less of its original amount at the inception of the series.

3. Risk-Weighted Asset Amounts for Securitization Exposures

The proposed framework for assigning risk-based capital requirements to securitization exposures required banking organizations generally to calculate a risk-weighted asset amount for a securitization exposure by applying either (i) the simplified supervisory formula approach (SSFA), described in section VIII.H of the preamble, or (ii) if the banking organization is not subject to the market risk rule, a gross-up approach similar to an approach provided under the general risk-based capital rules. A banking organization would be required to apply either the SSFA or the gross-up approach consistently across all of its securitization exposures. However, a banking organization could choose to assign a 1,250 percent risk weight to any securitization exposure.

Commenters expressed concerns regarding the potential differences in risk weights for similar exposures when using the gross-up approach compared to the SSFA, and the potential for capital arbitrage depending on the outcome of capital treatment under the framework. The agencies acknowledge these concerns and, to reduce arbitrage opportunities, have required that a banking organization apply either the gross-up approach or the SSFA consistently across all of its securitization exposures. Commenters also asked the agencies and the FDIC to clarify how often and under what circumstances a banking organization is allowed to switch between the SSFA and the gross-up approach. While the agencies are not placing restrictions on the ability of banking organizations to switch from the SSFA to the gross-up approach, the agencies do not anticipate there should be a need for frequent changes in methodology by a banking organization absent significant change in the nature of the banking organization's securitization activities, and expect banking organizations to be able to provide a rationale for changing methodologies to their primary Federal supervisors if requested.

Citing potential disadvantages of the proposed securitization framework as compared to standards to be applied to international competitors that rely on the use of credit ratings, some commenters requested that banking organizations be able to continue to implement a ratings-based approach to allow the agencies and the FDIC more time to calibrate the SSFA in accordance with international standards that rely on ratings. The agencies again observe that in accordance with section 939A of the Dodd-Frank Act, they are required to remove any references to, or reliance on, ratings in regulations. Accordingly, the final rule does not include any references to, or reliance on, credit ratings. The agencies have determined that the SSFA is an appropriate substitute standard to credit ratings that can be used to measure risk-based capital requirements and may be implemented uniformly across institutions. Under the proposed securitization framework, banking organizations would have been required or could choose to assign a risk weight of 1,250 percent to certain securitization exposures. Commenters stated that the 1,250 percent risk weight required under certain circumstances in the securitization framework would penalize banking organizations that hold capital above the total risk-based capital minimum and could require a banking organization to hold more capital against the exposure than the actual exposure amount at risk. As a result, commenters requested that the amount of risk-based capital required to be held against a banking organization's exposure be capped at the exposure amount. The agencies have decided to retain the proposed 1,250 percent risk weight in the final rule, consistent with their overall goals of simplicity and comparability, to provide for comparability in risk-weighted asset amounts for the same exposure across institutions.

Consistent with the proposal, the final rule provides for alternative treatment of securitization exposures to ABCP programs and certain gains-on-sale and CEIO exposures. Specifically, similar to the general risk-based capital rules, the final rule includes a minimum 100 percent risk weight for interest-only mortgage-backed securities and exceptions to the securitization framework for certain small-business loans and certain derivatives as described below. A banking organization may use the securitization credit risk mitigation rules to adjust the capital requirement under the securitization framework for an exposure to reflect certain collateral, credit derivatives, and guarantees, as described in more detail below.Start Printed Page 62117

a. Exposure Amount of a Securitization Exposure

Under the final rule, the exposure amount of an on-balance sheet securitization exposure that is not a repo-style transaction, eligible margin loan, OTC derivative contract or derivative that is a cleared transaction is generally the banking organization's carrying value of the exposure. The final rule modifies the proposed treatment for determining exposure amounts under the securitization framework to reflect the ability of a banking organization not subject to the advanced approaches rule to make an AOCI opt-out election. As a result, the exposure amount of an on-balance sheet securitization exposure that is an available-for-sale debt security or an available-for-sale debt security transferred to held-to-maturity held by a banking organization that has made an AOCI opt-out election is the banking organization's carrying value (including net accrued but unpaid interest and fees), less any net unrealized gains on the exposure and plus any net unrealized losses on the exposure.

The exposure amount of an off-balance sheet securitization exposure that is not an eligible ABCP liquidity facility, a repo-style transaction, eligible margin loan, an OTC derivative contract (other than a credit derivative), or a derivative that is a cleared transaction (other than a credit derivative) is the notional amount of the exposure. The treatment for OTC credit derivatives is described in more detail below.

For purposes of calculating the exposure amount of an off-balance sheet exposure to an ABCP securitization exposure, such as a liquidity facility, consistent with the proposed rule, the notional amount may be reduced to the maximum potential amount that the banking organization could be required to fund given the ABCP program's current underlying assets (calculated without regard to the current credit quality of those assets). Thus, if $100 is the maximum amount that could be drawn given the current volume and current credit quality of the program's assets, but the maximum potential draw against these same assets could increase to as much as $200 under some scenarios if their credit quality were to improve, then the exposure amount is $200. An ABCP program is defined as a program established primarily for the purpose of issuing commercial paper that is investment grade and backed by underlying exposures held in a securitization SPE. An eligible ABCP liquidity facility is defined as a liquidity facility supporting ABCP, in form or in substance, which is subject to an asset quality test at the time of draw that precludes funding against assets that are 90 days or more past due or in default. Notwithstanding these eligibility requirements, a liquidity facility is an eligible ABCP liquidity facility if the assets or exposures funded under the liquidity facility that do not meet the eligibility requirements are guaranteed by a sovereign that qualifies for a 20 percent risk weight or lower.

Commenters, citing accounting changes that require certain ABCP securitization exposures to be consolidated on banking organizations balance sheets, asked the agencies and the FDIC to consider capping the amount of an off-balance sheet securitization exposure to the maximum potential amount that the banking organization could be required to fund given the securitization SPE's current underlying assets. These commenters stated that the downward adjustment of the notional amount of a banking organization's off-balance sheet securitization exposure to the amount of the available asset pool generally should be permitted regardless of whether the exposure to a customer SPE is made directly through a credit commitment by the banking organization to the SPE or indirectly through a funding commitment that the banking organization makes to an ABCP conduit. The agencies believe that the requirement to hold risk-based capital against the full amount that may be drawn more accurately reflects the risks of potential draws under these exposures and have decided not to provide a separate provision for off-balance sheet exposures to customer-sponsored SPEs that are not ABCP conduits.

Under the final rule, consistent with the proposal, the exposure amount of an eligible ABCP liquidity facility that is subject to the SSFA equals the notional amount of the exposure multiplied by a 100 percent CCF. The exposure amount of an eligible ABCP liquidity facility that is not subject to the SSFA is the notional amount of the exposure multiplied by a 50 percent CCF. The exposure amount of a securitization exposure that is a repo-style transaction, eligible margin loan, an OTC derivative contract (other than a purchased credit derivative), or derivative that is a cleared transaction (other than a purchased credit derivative) is the exposure amount of the transaction as calculated under section 34 or section 37 of the final rule, as applicable.

b. Gains-On-Sale and Credit-Enhancing Interest-Only Strips

Consistent with the proposal, under the final rule a banking organization must deduct from common equity tier 1 capital any after-tax gain-on-sale resulting from a securitization and must apply a 1,250 percent risk weight to the portion of a CEIO that does not constitute an after-tax gain-on-sale. The agencies believe this treatment is appropriate given historical supervisory concerns with the subjectivity involved in valuations of gains-on-sale and CEIOs. Furthermore, although the treatments for gains-on-sale and CEIOs can increase an originating banking organization's risk-based capital requirement following a securitization, the agencies believe that such anomalies are rare where a securitization transfers significant credit risk from the originating banking organization to third parties.

c. Exceptions Under the Securitization Framework

Commenters stated concerns that the proposal would inhibit demand for private label securitization by making it more difficult for banking organizations, especially community banking organizations, to purchase private label mortgage-backed securities. Instead of implementing the SSFA and the gross-up approach, commenters suggested allowing banking organizations to assign a 20 percent risk weight to securitization exposures that are backed by mortgage exposures that would be “qualified mortgages” under the Truth in Lending Act and implementing regulations issued by the CFPB.[176] The agencies believe that the proposed securitization approaches would be more appropriate in capturing the risks provided by structured transactions, including those backed by QM. The final rule does not provide an exclusion for such exposures.

Under the final rule, consistent with the proposal, there are several exceptions to the general provisions in the securitization framework that parallel the general risk-based capital rules. First, a banking organization is required to assign a risk weight of at least 100 percent to an interest-only MBS. The agencies believe that a minimum risk weight of 100 percent is prudent in light of the uncertainty implied by the substantial price volatility of these securities. Second, as required by federal statute, a special set of rules continues to apply to securitizations of small-business loans Start Printed Page 62118and leases on personal property transferred with retained contractual exposure by well-capitalized depository institutions.[177] Finally, if a securitization exposure is an OTC derivative contract or derivative contract that is a cleared transaction (other than a credit derivative) that has a first priority claim on the cash flows from the underlying exposures (notwithstanding amounts due under interest rate or currency derivative contracts, fees due, or other similar payments), a banking organization may choose to set the risk-weighted asset amount of the exposure equal to the amount of the exposure.

d. Overlapping Exposures

Consistent with the proposal, the final rule includes provisions to limit the double counting of risks in situations involving overlapping securitization exposures. If a banking organization has multiple securitization exposures that provide duplicative coverage to the underlying exposures of a securitization (such as when a banking organization provides a program-wide credit enhancement and multiple pool-specific liquidity facilities to an ABCP program), the banking organization is not required to hold duplicative risk-based capital against the overlapping position. Instead, the banking organization must apply to the overlapping position the applicable risk-based capital treatment under the securitization framework that results in the highest risk-based capital requirement.

e. Servicer Cash Advances

A traditional securitization typically employs a servicing banking organization that, on a day-to-day basis, collects principal, interest, and other payments from the underlying exposures of the securitization and forwards such payments to the securitization SPE or to investors in the securitization. Servicing banking organizations often provide a facility to the securitization under which the servicing banking organization may advance cash to ensure an uninterrupted flow of payments to investors in the securitization, including advances made to cover foreclosure costs or other expenses to facilitate the timely collection of the underlying exposures. These servicer cash advance facilities are securitization exposures.

Consistent with the proposal, under the final rule a banking organization must apply the SSFA or the gross-up approach, as described below, or a 1,250 percent risk weight to a servicer cash advance facility. The treatment of the undrawn portion of the facility depends on whether the facility is an eligible servicer cash advance facility. An eligible servicer cash advance facility is a servicer cash advance facility in which: (1) The servicer is entitled to full reimbursement of advances, except that a servicer may be obligated to make non-reimbursable advances for a particular underlying exposure if any such advance is contractually limited to an insignificant amount of the outstanding principal balance of that exposure; (2) the servicer's right to reimbursement is senior in right of payment to all other claims on the cash flows from the underlying exposures of the securitization; and (3) the servicer has no legal obligation to, and does not make, advances to the securitization if the servicer concludes the advances are unlikely to be repaid.

Under the proposal, a banking organization that is a servicer under an eligible servicer cash advance facility is not required to hold risk-based capital against potential future cash advanced payments that it may be required to provide under the contract governing the facility. A banking organization that provides a non-eligible servicer cash advance facility would determine its risk-based capital requirement for the notional amount of the undrawn portion of the facility in the same manner as the banking organization would determine its risk-based capital requirement for other off-balance sheet securitization exposures. The agencies are clarifying the terminology in the final rule to specify that a banking organization that is a servicer under a non-eligible servicer cash advance facility must hold risk-based capital against the amount of all potential future cash advance payments that it may be contractually required to provide during the subsequent 12-month period under the contract governing the facility.

f. Implicit Support

Consistent with the proposed rule, the final rule requires a banking organization that provides support to a securitization in excess of its predetermined contractual obligation (implicit support) to include in risk-weighted assets all of the underlying exposures associated with the securitization as if the exposures had not been securitized, and deduct from common equity tier 1 capital any after-tax gain-on-sale resulting from the securitization.[178] In addition, the banking organization must disclose publicly (i) that it has provided implicit support to the securitization, and (ii) the risk-based capital impact to the banking organization of providing such implicit support. The agencies note that under the reservations of authority set forth in the final rule, the banking organization's primary Federal supervisor also could require the banking organization to hold risk-based capital against all the underlying exposures associated with some or all the banking organization's other securitizations as if the underlying exposures had not been securitized, and to deduct from common equity tier 1 capital any after-tax gain-on-sale resulting from such securitizations.

4. Simplified Supervisory Formula Approach

The proposed rule incorporated the SSFA, a simplified version of the supervisory formula approach (SFA) in the advanced approaches rule, to assign risk weights to securitization exposures. Many of the commenters focused on the burden of implementing the SSFA given the complexity of the approach in relation to the proposed treatment of mortgages exposures. Commenters also stated concerns that implementation of the SSFA would generally restrict credit growth and create competitive equity concerns with other jurisdictions implementing ratings-based approaches. The agencies acknowledge that there may be differences in capital requirements under the SSFA and the ratings-based approach in the Basel capital framework. As explained previously, section 939A of the Dodd-Frank Act requires the agencies to use alternative standards of creditworthiness and prohibits the agencies from including references to, or reliance upon, credit ratings in their regulations. Any alternative standard developed by the agencies may not generate the same result as a ratings-based capital framework under every circumstance. However, the agencies have designed the SSFA to result in generally comparable capital requirements to those that would be required under the Basel ratings-based approach without undue complexity. The agencies will monitor implementation of the SSFA and, based Start Printed Page 62119on supervisory experience, consider what modifications, if any, may be necessary to improve the SSFA in the future.

The agencies have adopted the proposed SSFA largely as proposed, with a revision to the delinquency parameter (parameter W) that will increase the risk sensitivity of the approach and clarify the operation of the formula when the contractual terms of the exposures underlying a securitization permit borrowers to defer payments of principal and interest, as described below. To limit potential burden of implementing the SSFA, banking organizations that are not subject to the market risk rule may also choose to use as an alternative the gross-up approach described in section VIII.H.5 below, provided that they apply the gross-up approach to all of their securitization exposures.

Similar to the SFA under the advanced approaches rule, the SSFA is a formula that starts with a baseline derived from the capital requirements that apply to all exposures underlying the securitization and then assigns risk weights based on the subordination level of an exposure. The agencies designed the SSFA to apply relatively higher capital requirements to the more risky junior tranches of a securitization that are the first to absorb losses, and relatively lower requirements to the most senior exposures.

The SSFA applies a 1,250 percent risk weight to securitization exposures that absorb losses up to the amount of capital that is required for the underlying exposures under subpart D of the final rule had those exposures been held directly by a banking organization. In addition, the agencies are implementing a supervisory risk-weight floor or minimum risk weight for a given securitization of 20 percent. While some commenters requested that the floor be lowered for certain low-risk securitization exposures, the agencies believe that a 20 percent floor is prudent given the performance of many securitization exposures during the recent crisis.

At the inception of a securitization, the SSFA requires more capital on a transaction-wide basis than would be required if the underlying assets had not been securitized. That is, if the banking organization held every tranche of a securitization, its overall capital requirement would be greater than if the banking organization held the underlying assets in portfolio. The agencies believe this overall outcome is important in reducing the likelihood of regulatory capital arbitrage through securitizations.

The proposed rule required banking organizations to use data to assign the SSFA parameters that are not more than 91 days old. Commenters requested that the data requirement be amended to account for securitizations of underlying assets with longer payment periods, such as transactions featuring annual or biannual payments. In response, the agencies amended this requirement in the final rule so that data used to determine SSFA parameters must be the most currently available data. However, for exposures that feature payments on a monthly or quarterly basis, the final rule requires the data to be no more than 91 calendar days old.

Under the final rule, to use the SSFA, a banking organization must obtain or determine the weighted-average risk weight of the underlying exposures (KG), as well as the attachment and detachment points for the banking organization's position within the securitization structure. “KG,” is calculated using the risk-weighted asset amounts in the standardized approach and is expressed as a decimal value between zero and 1 (that is, an average risk weight of 100 percent means that KG would equal 0.08). The banking organization may recognize the relative seniority of the exposure, as well as all cash funded enhancements, in determining attachment and detachment points. In addition, a banking organization must be able to determine the credit performance of the underlying exposures.

The commenters expressed concerns that certain types of data that would be required to calculate KG may not be readily available, particularly data necessary to calculate the weighted-average capital requirement of residential mortgages according to the proposed rule's standardized approach for residential mortgages. Some commenters therefore asked to be able to use the risk weights under the general risk-based capital rules for residential mortgages in the calculation of KG. Commenters also requested the use of alternative estimates or conservative proxy data to implement the SSFA when a parameter is not readily available, especially for securitizations of mortgage exposures. As previously discussed, the agencies are retaining in the final rule the existing mortgage treatment under the general risk-based capital rules. Accordingly, the agencies believe that banking organizations should generally have access to the data necessary to calculate the SSFA parameters for mortgage exposures.

Commenters characterized the KG parameter as not sufficiently risk sensitive and asked the agencies and the FDIC to provide more recognition under the SSFA with respect to the credit quality of the underlying assets. Some commenters observed that the SSFA did not take into account sequential pay structures. As a result, some commenters requested that banking organizations be allowed to implement cash-flow models to increase risk sensitivity, especially given that the SSFA does not recognize the various types of cash-flow waterfalls for different transactions.

In developing the final rule, the agencies considered the trade-offs between added risk sensitivity, increased complexity that would result from reliance on cash-flow models, and consistency with standardized approach risk weights. The agencies believe it is important to calibrate capital requirements under the securitization framework in a manner that is consistent with the calibration used for the underlying assets of the securitization to reduce complexity and best align capital requirements under the securitization framework with requirements for credit exposures under the standardized approach. As a result, the agencies have decided to finalize the KG parameter as proposed.

To make the SSFA more risk-sensitive and forward-looking, the parameter KG is modified based on delinquencies among the underlying assets of the securitization. The resulting adjusted parameter is labeled K