The global financial crisis left an indelible mark on the nation’s banking industry. Whether the industry will be better for it remains to be seen. Though the overindulgences that once fanned the flames of the subprime mortgage lending bonanza have long since subsided, the compulsory regulatory cleansing that has ensued is of a magnitude never experienced by today’s banking professionals or their lawyers.
Nowhere have the manifestations of regulatory reform been more concentrated than in the areas of capital planning and capital adequacy. What follows is a brief discussion of some of the regulatory changes facing in-house counsel at banking institutions.
This past June, the federal banking agencies jointly published three proposed rules that would institute comprehensive reforms to the risk-based regulatory capital framework presently applicable to U.S. financial institutions. These rules were adapted from two sources: the international regulatory framework for banks (called Basel III), adopted in 2010 by the Basel Committee on Banking Supervision in response to the recent financial crisis, and provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).
Much of these rules’ substance applies to all banking organizations that are subject to the agencies’ minimum capital requirements — meaning all insured depository institutions and all bank holding companies with total consolidated assets of $500 million or more. Certain other rules would apply only to institutions subject to the agencies’ rules regarding advanced approaches and market risk (i.e. banking organizations with more than $50 billion in total consolidated assets).
Collectively, these proposed rules almost entirely supplant the existing Basel I-based regulatory capital regime implemented in 1989. One objective of the rules is to place a greater reliance on common equity (i.e. common stock and retained earnings) to absorb potential losses. Consistent with Basel III, the proposed rules redefine regulatory capital by splitting tier 1 capital into two separate components called “common equity tier 1 capital” and “additional tier 1 capital.” They also eliminate certain equity capital instruments from the elements of the new tier 1 capital components.
The proposed rules also revise the minimum capital requirements to incorporate new risk-based capital and leverage capital ratios, as well as a higher minimum tier 1 capital ratio. Similarly, the rules heighten the capital requirements in each of what are known as the prompt corrective action (PCA) capital categories (e.g. well capitalized, adequately capitalized, etc.); these PCA categories are meant to identify the level of an institution’s capitalization relative to its size, and limit or altogether prohibit certain activities as an institution’s capital levels decrease. Tightening of the PCA categories aligns them with the new minimum capital requirements proposed in the rules.
The proposed rules also introduce the concept of capital buffers intended to encourage banking organizations to maintain capital reserves well in excess of the minimum requirements.
The advanced-approaches and market-risk rules, which are applicable only to larger banking organizations, revise the advanced approaches risk-based capital rules to conform to Basel III and related provisions of Dodd-Frank.
Finally, the proposed rules aim to increase the risk sensitivity of the agencies’ general capital rules regarding the calculation of risk-weighted assets by incorporating aspects of the “standardized approach” espoused in Basel II. Generally, these rules increase the risk-weightings on certain classes of assets, such as residential mortgages and commercial real estate loans, while introducing greater recognition of credit-risk mitigation, such as financial collateral and eligible guarantors. They also propose alternatives to credit ratings for calculating the risk-weightings of certain asset classes consistent with Dodd-Frank.
The various rules will go into effect in stages; some are subject to phase-in periods, while others are not. Significantly, the new minimum capital requirements are to be phased in beginning Jan. 1, 2013, becoming completely effective by Jan. 1, 2015. All of the rules contain provisions permitting banks to opt-in early. This begs the question: Will the banking agencies adhere to the effective dates and phase-in periods, or will they pressure banks to opt-in early by restricting expansion activities or capital distributions? If history is any indication, the latter is a distinct possibility.
Advanced-approaches organizations have already begun preparing for the new capital requirements as part of their annual capital planning process, required under the Federal Reserve’s Comprehensive Capital Analysis Review (CCAR). Though the vast majority of banks are not subject to CCAR, all institutions nevertheless should begin making similar preparations right away.
Bank examiners will expect to see the minimum capital ratio provisions incorporated into banks’ capital plans beginning on Jan. 1, 2013. Indeed, as a precursor to the proposed capital rules, the Office of the Comptroller of the Currency released supervisory guidance for evaluating capital planning and adequacy.
Because of the wholesale changes that will result from these rules, the capital-planning process necessarily will involve additional preparation. The legal departments of banks will need to interpret the voluminous and frequently cryptic regulations. In-house counsel should endeavor not only to understand the regulations’ literal requirements but also how they apply to the bank individually, based on its specific circumstances and risk profile. From this exercise, management then should be able to identify certain key questions, the answers to which will help shape the organization’s capital plan.
For instance, cumulative perpetual preferred stock and trust preferred securities (TRUPS), both of which presently qualify as elements of restricted core capital for bank holding companies, will be phased out of Tier 1 capital treatment under the new rules. Even bank holding companies under $15 billion in total consolidated assets will see TRUPS phased out, albeit over a longer time horizon. Will this force the holding company to redeem these instruments and replace them with common equity? How will that impact a bank’s short- and/or long-term strategic objectives or the availability of alternative capital sources?
Also of considerable significance to the legal department are the new capital buffers. All banking organizations will be subject to capital-buffer requirements to one degree or another. An institution’s failure to maintain the applicable buffers will trigger restrictions on capital distributions and the payment of certain discretionary bonuses. If a bank becomes subject to dividend restrictions, how will that impact its holding company’s ability to meet its financial obligations? Or, if the organization is an S corporation, will dividend restrictions force the organization to convert to C corporation status?
Given the recent financial crisis, perhaps a comprehensive revision of the industry’s regulatory capital framework was appropriate — or perhaps not. Regardless, these proposed rules create a heightened emphasis on capital adequacy and planning. Whether and how quickly banks adapt and prosper under this new framework will largely depend on their lawyers’ ability to fully comprehend these rules and to ask the pertinent questions.