On June 7, 2012, the Federal Reserve Board (“FRB”) released three proposed rules relating to minimum capital requirements for U.S. banking organizations¹. On June 12, the Federal Deposit Insurance Corporation (“FDIC”) and the Office of the Comptroller of the Currency (“OCC”), which jointly wrote the proposed regulations with the FRB, followed suit. The proposed requirements closely track the requirements put forth by the Basel Committee on Banking Supervision (“BCBS”) in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (“Basel III”). The proposed rules will require lenders to maintain higher capital reserves, primarily comprised of Common Equity capital meeting robust new standards. Additionally, the new rules would enact requirements found in sections 171 and 939A of the Dodd-Frank regulatory overhaul that banking organizations use alternative risk weighting, rather than “credit ratings,” for the calculation of risk-weighted assets. The third proposal embraces Basel III’s “Advanced Approaches” risk-based capital rule.

Comments regarding the proposals (which total 700 pages) must be submitted to the FRB, FDIC or OCC (collectively, “the Agencies”) on or before September 7, 2012. This Client Alert highlights a number of the key issues in the three proposed rulemakings.

Basel III and New Requirements for U.S. Banking Organizations

The Agencies’ actions are intended to implement the capital and disclosure requirements of Basel III. The BCBS created the new requirements in response to the recent financial crisis. The lack of adequate capitalization in U.S. banking organizations has had clear ramifications: Since September 2007, the FDIC lists 439 banking organizations as having failed. The Basel III requirements superseded a set of recommendations known as Basel II, which banking regulators suggested did not require a capital cushion substantial enough to ensure banking organizations’ resiliency in the event of a crisis. The oversight body of the Basel Committee approved the Basel III framework in 2010 and 2011, but each country adopting the framework must write its own rules. The proposed rules would begin implementation of some new requirements on January 1, 2013. The Agencies expect to fully phase in the requirements by January 1, 2019. According to Federal Reserve Chairman Ben Bernanke, the Agencies intend for the gradual timeline “to reduce compliance costs and minimize effects of higher capital on lending.”

Higher Quantity and Quality for Capital Requirements and Capital Buffers

Capital Requirements

The first of the Agencies’ proposed rules, titled “Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action,”2 would force banking organizations to adopt higher capital requirements. This has attracted a great deal of attention from the banking sector, due largely to its potential impact on banking organizations’ profitability. The rule would both expand the amount of high-quality “Tier 1” capital banking organizations are required to hold and create a requirement that banking organizations hold a specified amount of Common Equity capital.

The minimum Tier 1 capital requirement would increase from the current level of 4.0% to 6.0% by 2015. This is consistent with the BCBS recommendation and responds to concerns regarding banking organizations’ behavior during the financial crisis. The proposed rule notes that the crisis raised questions about banking organizations’ “ability to conserve capital during a stressful period or to cancel or defer interest payments on Tier 1 capital instruments.”

Likewise, the Common Equity capital requirement is designed to ensure that banking organizations have enough capital that can absorb large losses in the event of another crisis. The rule would require a ratio that 4.5% of risk-weighted assets are comprised of Common Equity capital, a more restrictive classification of capital than currently required for general Tier 1 capital. The new category of Common Equity capital seeks to avoid the inclusion of capital on a bank’s books that “would cause a banking organization’s condition to further weaken during periods of economic and market stress.” Common Equity capital satisfies the requirements of Tier 1 capital.

Additionally, the rule proposes two new capital “buffers”: (i) A Capital Conservation Buffer and (ii) a Countercyclical Capital Buffer. The Capital Conservation Buffer would serve to reinforce the strength of banking organizations throughout economic cycles and would apply to all banking organizations affected by the rule. It is separate from the minimum risk-based capital requirements. If the affected banking organization does not meet the requirement for the Capital Conservation Buffer, the organization would face limitations on capital distributions and discretionary bonus payments to executive officers based on a “maximum payout ratio.” The ratio would apply limitations on payouts based on the size of a banking organization’s Capital Conservation Buffer. For example, if a banking organization has a Capital Conservation Buffer of less than or equal to 0.625% during a previous quarter in 2018 (when the buffer requirement takes full effect), it would not be permitted to make any capital distributions or discretionary bonus payments during its current calendar quarter.

The Countercyclical Capital Buffer similarly would act to offset vulnerabilities that banks experience as a result of periods of expansionary growth and borrowing, but would impact only “Advanced Approaches” banking organizations. The Advanced Approaches guidelines, discussed in further detail in the Agencies’ third proposed rule, would generally apply to banking organizations that have $250 billion or more in total assets or total on-balance sheet foreign exposure equal to $10 billion or more. The Countercyclical Capital Buffer would begin at zero, and the Agencies would mandate its use only if financial markets are “experiencing a period of excessive aggregate credit growth that is associated with an increase in system-wide risk.” If invoked, it could reach a maximum of 2.5% by 2019. The Agencies would jointly decide whether to increase the countercyclical capital buffer based on a range of factors, and the agencies expect that the buffer would be the same at the depository institution and holding company levels. Both the capital conservation and Countercyclical Capital Buffers would have to be composed of Common Equity Tier 1 capital.

Federal and State Savings Associations

Thrift institutions, known sometimes as savings and loans and referred to in the proposed rules as “Federal and state savings associations,” would see a new set of requirements designed to better integrate them with national banks. Under current law, if a savings association makes “investments in and extensions of credit” to a subsidiary engaged in activity that is impermissible for a national bank3, such an investment must be deducted from the savings association’s assets and regulatory capital. Under the proposed rule, savings associations in most cases would have to deduct these investments from Common Equity Tier 1 capital.

Finally, the proposed rule subjects Federal and state savings associations to a tangible capital requirement of 1.5%. This requirement is separate from the Tier 1 capital requirement and could encompass a broader range of capital. It includes not only the amount of Tier 1 capital not included in previously tabulated Tier 1 capital totals, but also outstanding perpetual preferred stock.

To read the full alert, please click here.

Client Alert 2012-162