Bank Capital Rules: Federal Reserve Approves NPRs Addressing Basel III Implementation and Substantial Revisions to Basel I-Based Rules for all Banks and Finalizes Amendments to Market Risk Rules

Sullivan & Cromwell LLP - June 8, 2012

On Thursday, June 7, 2012, the Board of Governors of the Federal Reserve System (the “FRB”) approved for publication three notices of proposed rulemaking (the “NPRs”) substantially amending the risk-based capital rules for banks. The FRB also approved final amendments to the market risk rules (the “Market Risk Amendments”), often referred to as “Basel II.5”. The NPRs and Market Risk Amendments are meant to be joint rulemakings with the Office of the Comptroller of the Currency (the “OCC”) and the Federal Deposit Insurance Corporation (the “FDIC” and, together with the OCC and the Federal Reserve the “Agencies”) and will be published in the Federal Register after approval by the OCC and the FDIC, which is expected during the next several weeks.

The changes to the Agencies’ capital rules proposed in the NPRs and finalized in the Market Risk Amendments when implemented, taken together, will represent the most substantial revisions to the Agencies’ capital rules since the adoption in 1989 of risk-based capital standards based on the Basel Committee on Banking Supervision’s (“BCBS”) 1988 Accord, known as “Basel I”. Among other things:

  • Most of the Basel III provisions, including the application of a common equity Tier 1 (“CET1”) requirement, the revised definitions of other components of capital, and higher minimum capital ratios, would apply to all banks other than small bank holding companies (defined as those with $500 million or less in total assets), with phase-in periods that generally track Basel III. It remains to be seen whether the Agencies will actually follow these and other phase-in periods or will, as in the past, effectively accelerate them through restrictions on capital actions and expansion applications until the bank is fully compliant.
  • The standards in the Agencies’ existing Basel I-based capital rules, which the NPRs refer to as the “general risk-based capital requirements”, would be revised, effective January 1, 2015, to include a more risk sensitive risk-weighting approach based, in part, upon Basel II’s standardized approach, expanding the risk-weighting categories from the current four categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories, including many residential mortgages and certain commercial real estate. The NPRs refer to the general risk-based capital requirements as amended by the NPRs as the new “Standardized Approach”.
  • The Standardized Approach and the Market Risk Amendments would implement the requirement of Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) that regulations not use credit ratings by, where applicable, (i) for determining the risk weight of certain exposures to non-U.S. sovereigns and non-U.S. public sector entities, using the Organization for Economic Co-operation and Development’s (the “OECD”) country risk classification model (or “CRCs”), and (ii) for determining the risk weight of corporate exposures, adopting a definition of “investment grade” that is based on an approach that the OCC implemented in its investment securities regulations; namely, treating an exposure as investment grade if the obligor “has adequate capacity to meet financial commitments for the projected life of the asset or exposure”, with the “adequate capacity” test being met if “the risk of [the obligor’s] default is low and the full and timely repayment of principal and interest is expected”.
  • The FRB would apply capital rules to savings and loan holding companies when these proposed rules become effective as opposed to the July 22, 2015 outside date permitted by Section 171 of Dodd-Frank (the “Collins Amendment”).

The text of the NPRs and Market Risk Amendments, together with explanatory staff memos and preambles, is quite lengthy, running to more than 800 pages. We anticipate preparing more detailed memoranda to clients addressing them in the coming days. This memorandum serves only to highlight certain key features of the NPRs and the Market Risk Amendments.

The comment periods for each of the NPRs expire on September 7, 2012. The Market Risk Amendments become effective on January 1, 2013, and the NPRs contemplate that the Basel III requirements will become effective on January 1, 2013, subject to a phase-in period. The Standardized Approach is contemplated to become effective on January 1, 2015, with an option for early adoption.