Bank Capital Rules: Federal Reserve Approves Final Rules Addressing Basel III Implementation and, for All Banks, Substantial Revisions to Basel I-Based Rules

Sullivan & Cromwell LLP - July 3, 2013
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Yesterday, the Board of Governors of the Federal Reserve System (the “FRB”) unanimously approved final rules (the “Final Rules”) establishing a new comprehensive capital framework for U.S. banking organizations that would implement the Basel III capital framework as well as certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Final Rules largely adhere to the rules as initially proposed in June 2012 (the “Proposed Rules”), notwithstanding that the industry objected, sometimes strenuously to certain aspects of the Proposed Rules. Most of the changes made in response to the industry’s most fundamental concerns were effectively limited to community banks and other smaller banking organizations; the most stringent rules for “advanced approaches banking organizations”  ?  those with $250 billion or more in total consolidated assets or $10 billion or more in foreign exposures  ?  were maintained. For example:

  • All segments of the industry objected to the Proposed Rules’ elimination of the so-called “AOCI Filter”, which is a provision in existing capital rules that permits banking organizations to reverse fair-value adjustments to shareholders’ equity (for example, marks-to-market of available-for sale-securities recorded in accumulated other comprehensive income and loss) in regulatory capital calculations. Banking organizations are concerned that removing the AOCI Filter will create substantial earnings volatility and force banking organizations to address that risk by shortening the duration of their assets. Nevertheless, the Final Rules, like the Proposed Rules and Basel III, remove the AOCI Filter for advanced approaches banking organizations. However, the Final Rules permit a one-time permanent election by non-advanced approaches banking organizations to opt out of the provisions removing the AOCI Filter.
  • The Final Rules retain the existing rules’ risk-weightings for residential mortgage loans of 50% for high quality seasoned residential mortgage loans and 100% for all other residential mortgage loans instead of adopting the Proposed Rules’ provisions that would have applied risk-weightings to residential mortgages ranging from 35% to 150% depending, in the case of a particular mortgage loan, on its loan-to-value ratio and its particular terms (including its seniority). Concerns with the Proposed Rules’ treatment of residential mortgages were particularly important to regional and community banks, as acknowledged at yesterday’s FRB open meeting. FRB Governor Daniel Tarullo pointed out during the discussion of this issue that the application of the FRB’s stress test rules and capital planning rules (under which it administers its annual comprehensive capital adequacy review, or “CCAR”) to banking organizations with $50 billion or more in total consolidated assets has the practical effect of imposing a “higher capital expectation” with respect to higher risk mortgages held by those banking organizations notwithstanding the official risk-weighting.
  • For bank holding companies that had total consolidated assets of less than $15 billion at December 31, 2009, the Final Rules permanently grandfather as a component of Additional Tier 1 Capital trust preferred securities and other non-qualifying Tier 1 capital instruments (for example, cumulative perpetual preferred stock) that were issued prior to May 19, 2010. At yesterday’s open meeting, the FRB cited the more limited access of these banking organizations to the capital markets as the reason for including this grandfathering provision.

Governor Tarullo, in prepared remarks at yesterday’s open meeting, previewed an extensive, and potentially much more rigorous, set of additional capital requirements for the eight U.S. banking organizations already identified as having global systemic importance and potentially for an expanded group of large U.S. banking organizations. A separate Sullivan & Cromwell memorandum addressing those remarks and potential requirements is available at http://www.sullcrom.com/Bank_Capital_Rules_7_03_13/.

In addition to approving the Final Rules at yesterday’s meeting, the FRB approved a notice of proposed rulemaking regarding changes to the FRB’s, the Office of the Comptroller of the Currency’s (the “OCC”) and the Federal Deposit Insurance Corporation’s (the “FDIC” and, together with the OCC and the FRB, the “Agencies”) market risk capital rules (the “Market Risk NPR”) to align their treatment of foreign sovereigns and securitizations involving certain student and consumer loans for specific risk weighting purposes with the treatment of those items under the Final Rules and to make certain clarifying and technical amendments. Comments on the Market Risk NPR are due by September 3, 2013.

The Final Rules will be joint rulemakings of the Agencies. The OCC has indicated that it anticipates acting by July 9, 2013 to approve the Final Rules for publication. Yesterday, the FDIC provided notice that it will consider these rules, but as an interim final rule at its meeting on July 9, 2013 (presumably for procedural reasons relating to the FDIC’s intention also to consider an enhanced supplementary leverage ratio for the largest banking organizations, which is one of the initiatives Governor Tarullo mentioned in his prepared remarks referenced above).

Advanced approaches banking organizations will be required to comply with the Final Rules starting on January 1, 2014, subject to phase-in provisions that are generally consistent with Basel III. Other banking organizations as well as savings and loan holding companies that are not excluded from the Final Rules due to their insurance or commercial activities will be required to comply starting January 1, 2015.

The text of the Final Rules, together with explanatory staff memos and preambles, is extraordinarily lengthy, running to nearly 1,000 pages. This memorandum serves only to highlight certain key features of the Final Rules, focusing on changes as compared to the Proposed Rules and areas where the industry sought changes in the Proposed Rules that the Agencies rejected. We anticipate preparing a more detailed memorandum to clients addressing the Final Rules in the coming days.