On June 7, 2012 the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Fed), and the Federal Deposit Insurance Corporation (FDIC) (collectively, the Agencies) released three notices of proposed rulemaking (NPRs) that suggest comprehensive revisions to the Agencies’ regulatory capital framework to incorporate the international Basel III standards and Basel capital framework as well as implement certain relevant provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).  To make it easier to understand the Agencies’ objectives, the overall proposal is divided into three separate NPRs: (1) Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action (Basel III NPR); (2) Regulatory Capital Rules: Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements (Standardized Approach NPR); and (3) Regulatory Capital Rules: Advanced Approaches Risk-based Capital Rule; Market Risk Capital Rule (Advanced Approaches and Market Risk NPR).  Each NPR is summarized below.


In this NPR the Agencies propose to revise their risk-based and leverage capital requirements to be consistent with 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).  The proposal implements aspects of Basel III such as higher minimum regulatory capital requirements, capital conservation buffers, and countercyclical buffers. The proposed rule would apply to all banking organizations currently subject to minimum capital requirements, including national banks, state banks, state and federal savings associations, top-tier bank holding companies (BHCs) domiciled in the United States, as well as top-tier savings and loan holding companies (SLHCs) domiciled in the United States.  It does not apply to BHCs subject to the Fed’s Small Bank Holding Company Policy Statement.  Certain proposals within the NPR, which are described below, would apply only to banking organizations subject to the advanced approaches.

Minimum Ratios:  The proposed rule would require banking organizations to meet minimum capital ratios consistent with Basel III.  The following proposed capital ratios would apply to banking organizations on a consolidated basis:

  • common equity Tier 1 capital ratio of 4.5 percent
  • Tier 1 capital ratio of 6 percent
  • total capital ratio of 8 percent
  • Tier 1 capital to average consolidated assets ratio of 4 percent
  • Tier 1 capital to total leverage exposure ratio of 3 percent (for banking organizations under the advanced approaches only).

Under this NPR all banking organizations would become subject to a 4 percent Tier 1 leverage ratio.  Currently, banking organizations with a supervisory composite rating of 1 are allowed a 3 percent Tier 1 leverage ratio, and an exception exists for BHCs with a supervisory composite rating of 1 that are subject to the market risk rule.  This NPR proposes to remove these exceptions.  The Tier 1 leverage ratio would be calculated by dividing a banking organization’s Tier 1 capital by its average consolidated assets, minus amounts deducted from Tier 1 capital.

In addition to increasing capital requirements, the proposed rule would establish more stringent eligibility criteria for instruments to be considered regulatory capital.  The Agencies propose a comprehensive set of criteria, consistent with Basel III, which effectively requires that voting common stockholder equity become the dominant element within Tier 1 capital.  Most existing common stock instruments previously issued by U.S. banks should fully satisfy the proposed criteria.  The proposed rule also includes criteria consistent with Basel III for qualifying additional Tier 1 capital instruments.  Under the proposed rule, trust preferred securities and cumulative perpetual preferred securities would not qualify as additional Tier 1 capital.  Additionally, though potentially allowed to be included in additional Tier 1 capital under Basel III, instruments classified as a liability under GAAP would not qualify as additional Tier 1 capital under the proposed rule.

Further, the proposed rule would require that most regulatory deductions and adjustments of regulatory capital be applied to common equity Tier 1 capital and that unrealized gains and losses on all available-for-sale securities and gains and losses associated with certain cash flow hedges flow through common equity Tier 1 capital.

Leverage Ratio:  The proposed rule also would require banking organizations under the advanced approaches to maintain a supplementary leverage ratio of Tier 1 capital to total leverage exposure of 3 percent.  Since these banking organizations tend to have significantly more balance sheet exposures that are not captured in the leverage ratio—and the denominator for this supplementary leverage ratio will use a broader exposure base including certain off-balance sheet exposures as the denominators—the Agencies believe a supplementary leverage ratio of this kind is appropriate.

The Agencies’ proposal would measure total leverage exposure as the sum of the following exposures:

  1. The balance sheet carrying value of all the banking organization’s on-balance sheet assets, minus amounts deducted from Tier 1 capital;
  2. The potential future exposure amount for each derivative contract to which the banking organization is a counterparty or each single-product netting set for such transactions;
  3. 10 percent of the notional amount of unconditional cancellable commitments made by the banking organization; and
  4. The notional amount of all other off-balance sheet exposures with certain exclusions.

Because international discussions on the most appropriate measurement of exposure for repo-style transactions are still ongoing, the Agencies propose maintaining the current on-balance sheet measurements of those transactions for purposes of calculating total leverage exposure.

Conservation Buffer:  Consistent with Basel III, the Agencies are proposing a capital conservation buffer to incentivize banking organizations holding enough capital to reduce the probability of their capital levels falling below minimum requirements in times of financial stress.  The proposal would require banking organizations to hold a buffer of greater than 2.5 percent of their risk-weighted assets (RWA).  Advanced approaches banking organizations would be required to hold an additional 100 percent of any applicable countercyclical capital buffer amount (described below).  The capital conservation buffer would be composed of common equity Tier 1 capital and would be separate from the minimum risk-based capital requirements.

 The Agencies propose measuring a banking organization’s capital conservation buffer as the lowest of the following:

1) common equity Tier 1 capital ratio minus minimum common equity Tier 1 capital ratio;

2) Tier 1 capital ratio minus minimum Tier 1 capital ratio; or

3)  total capital ratio minus minimum total capital ratio.

Banking organizations that are unable to maintain these buffers would face limits on their capital distributions (i.e., dividends) and certain discretionary bonuses.

Countercyclical Buffer:  Pursuant to Basel III, under this NPR advanced approaches banking organizations would be subject to an additional countercyclical capital buffer designed to take into account the macro-financial environment in which they operate and to protect the banking system from systemic vulnerabilities.  This additional buffer is limited to advanced approaches banking organizations in recognition of the heightened interconnectedness of large banking organizations with other institutions in the financial system.  The purpose of this buffer is to require banks to build up capital during periods of excessive credit growth in order to decrease their vulnerability to above normal losses during subsequent weakened credit conditions. Additionally, the buffer also may mitigate excessive credit growth by effectively increasing the cost of credit.  Under Basel III, national authorities, at their discretion, may increase the size of the capital conservation buffer by up to an additional 2.5 percent of RWA.  The countercyclical buffer amount would initially be set to zero in the United States.  Any increase in this buffer would be announced up to 12 months prior to its implementation to give banking organizations adequate time to adjust to any changes.

In order to align the proposed regulatory capital requirements with current Prompt Corrective Action (PCA) rules, the Agencies propose incorporating the revisions to the minimum capital requirements into their PCA framework.

The Basel III NPR would take effect on January 1, 2013, but most changes have phase-in schedules that would require full compliance ranging from 2015 to 2019.

Standardized Approach NPR

This proposed rulemaking revises the calculation of RWAs by incorporating the standardized approach set forth in “International Convergence of Capital Measurements and Capital Standards: A Revised Framework” (Basel II) (as modified by the 2009 “Enhancements to the Basel II Framework”) as well as other proposals addressed in recent consultative papers of the BCBS with the aim of enhancing the risk sensitivity of capital requirements.  Though some of the proposals in this NPR are not specifically included in the Basel capital framework, the Agencies believe that they are generally in keeping with the goals of Basel.  These proposals would apply to all banking organizations.  The primary proposed revisions to the methodologies for determining RWAs are outlined below.

 Exposures to Foreign Sovereigns, Foreign Banks, and Foreign Public Sector Entities: The risk weight would be determined using the Country Risk Classification (CRC) of the Organization for Economic Co-operation and Development (OECD).  The CRC is an assessment of a country’s credit risk, used to set interest rate charges for transactions covered by the OECD arrangement on export credit.  The Agencies note in the NPR that they do not believe the use of the CRC runs counter to section 939A of the Dodd-Frank Act which requires the review and modification of references to credit ratings in federal regulations. They conclude that because it neither provides the same evaluative and analytical services as credit ratings agencies, nor produces credit assessments for fee-paying clients, Section 939A was not meant to apply to organizations such as the OECD.

The proposal also would require banking organizations to apply a 150 percent risk weight to sovereign exposures if an event of default has occurred in the past five years or upon determination that an event of sovereign default has occurred.  Sovereigns that do not have a CRC would have a 100 percent risk weight.

Exposure to a foreign bank would receive a risk weight one category higher than the risk weight assigned to a direct exposure to the bank’s home country.

Exposures to Certain Supranational Entities and Multilateral Development Banks (MDBs): The Agencies propose reducing the risk weight for such entities from 20 percent under the general risk-based capital rules to zero percent.

Corporate Exposures: The proposed rule maintains the 100 percent risk weight assigned to corporate exposures under the general risk-based capital rules and would assign securities firms the same risk weight as corporate exposures.

Residential Mortgage Exposures: The NPR proposes a risk-weight framework that is different from both the Basel capital framework and the general risk-based capital rules.  Residential mortgages guaranteed by the U.S. government or its agencies would maintain their current risk-based capital treatment (zero percent risk weight for those unconditionally guaranteed and 20 percent risk-weight for those that are conditionally guaranteed).  All other residential mortgages would be divided into two categories depending on several characteristics intended to reflect the difference in risk.  Banking organizations would use the table below to determine the risk weight for a residential mortgage exposure using the loan-to-value (LTV) ratio of a loan as well as whether it is a category 1 or category 2 residential mortgage exposure.

Table 1 – Proposed Risk Weights for Residential Mortgage Exposures[1]

High Volatility Commercial Real Estate Exposures (HVCRE): Credit facilities that finance or have financed the acquisition, development, or construction of real property other than (1) one- to four-family residential property or (2) commercial real estate projects with certain LTV ratios and capital contributions will be assigned a 150 percent risk-weight.  All other commercial real estate will be treated as a corporate exposure and accordingly assigned a 100 percent risk-weight.

Past Due Exposures: Consistent with the Basel capital framework, the Agencies propose that a 150 percent risk weight be assigned to non-secured and non-guaranteed exposures that are 90 or more days past due or on nonaccrual.  This does not apply to sovereign exposures and residential mortgages.

Securitization Exposures: The Agencies propose replacing the current ratings-based approach with a formula-based approach for determining a securitization exposure’s risk weight based on the underlying assets and the exposure’s relative position in the securitization’s structure.

Among other things, the NPR also proposes changes to the treatment of off-balance exposures, over-the-counter (OTC) derivatives, and transactions cleared through central counterparties (CCPs).  Banking organizations must calculate the exposure amount of an off-balance sheet item by multiplying the off-balance sheet component by the applicable credit conversion factor (CCF).  Consistent with the Basel II standardized approach, the NPR proposes increasing the CCF from zero to 20 percent for most short term commitments and applying a CCF of 100 percent to off-balance sheet guarantees, repurchase agreements, securities lending or borrowing transactions, forward agreements, and other similar exposures.  Additionally, the NPR would require banking organizations to hold risk-based capital against all repo-style transactions, whether or not they generate on-balance sheet exposures.  Revisions to the treatment of OTC derivatives include updating the definition of derivatives contracts and the removal of the 50 percent risk weight limit for OTC derivatives contracts.  In order to incentivize the use of CCPs and to promote transparency and multilateral netting, the Agencies’ proposed changes to risk-based capital requirements for derivatives and repo-style transactions cleared through CCPs that are preferential to the requirements for non-cleared transactions.

The changes for the Standardized Approach NPR would take effect in January 2015 with an option for early adoption.

Advanced Approaches and Market Risk NPR

The Advanced Approaches and Market Risk NPR would amend the advanced approaches rule and integrate the Agencies’ revised market risk rules discussed here.  The proposed rule also would integrate Basel III, other revisions to the Basel capital framework published between 2009 and 2011, and additional consultative papers as well as attempt to achieve consistency with certain relevant provisions of the Dodd-Frank Act.  This NPR would apply to banking organizations currently subject to the advanced approaches rule—which are generally the largest and most complex financial institutions.  The Fed also proposes applying the advanced approaches rule to SLHCs, and the Fed, OCC, and FDIC propose applying the market risk rule to SLHCs and to federal and state savings associations, respectively.  The Advanced Approaches NPR primarily deals with counterparty credit risk, securitization exposures, and disclosure requirements.

Counterparty Credit Risk:  The Agencies propose changes to the treatment of counterparty credit risk exposure that generally are consistent with Basel III and are intended to ensure that all material on- and off-balance sheet counterparty risks are incorporated into risk-based capital ratios.

The proposed rule would modify the definition of “financial collateral” so that, under the advanced approaches rule, resecuritizations would no longer apply as eligible financial collateral and thus could not be used to adjust the exposure-at-default (EAD) of a given exposure.  The NPR defines a resecuritization as a securitization in which at least one of the underlying exposures is a securitization position.  The proposed rule also would exclude conforming residential mortgages and all non-investment grade debt securities from the definition of financial collateral.

Further, the proposal would remove references to ratings from standard supervisory haircuts for certain financial collateral and require them to be calculated based upon the risk weights described in the Standardized Approach NPR.  The proposal makes changes to the holding period in the collateral haircut and simple value-at-risk (VaR) approaches and the margin period of risk in the internal model methodology (IMM) to be consistent with Basel III.  Also consistent with Basel III, the Agencies propose that the advanced approaches rule be amended so that capital requirements for IMM exposures be caluculated using stress inputs. Banking organizations also would have to make adjustments to their internal models consistent with Basel III standards—including identifying, monitoring, and controlling wrong-way risk throughout the life of an exposure.

Moreover, the proposal would adopt the Basel III approaches for calculating credit valuation adjustments, but without references to credit ratings.

Securitization Exposures:  The Agencies propose broadening the definition of securitization exposures to include an exposure that directly or indirectly references a securitization exposure and also amend the definition of traditional securitization by excluding funds that are investment funds, pension funds, and companies regulated under the Investment Company Act of 1940 or a foreign equivalent.  The proposal also would revise the definition of an eligible guarantor to remove the existing references to ratings from the definition.

The advanced approaches rule currently does not include methods for calculating risk-weighted assets for guarantees or non-nth-to-default credit derivatives that reference a securitization exposure.  The proposed rule would require banking organizations to determine the risk-based capital requirements for guarantees or credit derivatives (other than an nth-to-default derivative) as if they directly hold the portion of the reference exposure covered by the guarantee or credit derivative.

Further, banking organizations would have to use the supervisory formula approach (SFA) and the simplified supervisory formula approach (SSFA) to determine the risk-weighted asset amounts for securitization exposures to comply with the proposal’s due diligence and disclosure requirements.

Additionally, instead of deducting certain exposures from total capital, as specified by Basel III, the Agencies propose generally assigning those exposures a 1,250 percent risk weight.  The exposures that would be subject to this change include securitization exposures such as credit-enhancing interest-only strips (CEIOs), low-rated securitization exposures, and high-risk securitization exposures subject to the SFA; credit reserve shortfalls; and certain failed capital market transactions.

Disclosure Requirements:  In regard to disclosure rules under the advanced approaches rule, the Agencies clarified the timing for certain quarterly and annual disclosures and proposed enhanced disclosure requirements for securitization exposures.

The Agencies also propose a number of changes to the current definitions in the advanced approaches that reference credit ratings in order to comply with Section 939A of the Dodd-Frank Act.  For example, they propose using an “investment grade” standard that does not rely on credit ratings as an alternative standard for several requirements under the advanced approaches and suggest modifying the hierarchy for risk weighting securitizations after eliminating the advanced approaches rule’s former ratings-based approach and internal assessment approach.


In connection with the changes proposed in the three NPRs discussed above, the Agencies intend to codify their current regulatory capital requirements under applicable statutory authority to promote consistency of capital rules across the various federal banking agencies and to make the rules easier to use.  Comments on the NPRs are due by September 7, 2012.

If you have any questions, please contact any of the following individuals within Weil’s Financial Institutions Regulatory practice group:

Derrick D.  Cephas, Partner                derrick.cephas@weil.com       +1 212 310 8797

Heath P.  Tarbert, Partner                   heath.tarbert@weil.com          +1 202 682 7177

Walter E.  Zalenski, Partner                 walter.zalenski@weil.com      +1 202 682 7120

Dimia E.  Fogam, Associate                 dimia.fogam@weil.com          +1 212 310 8187

Timothy C.  Welch, Associate              timothy.welch@weil.com       +1 202 682 7132

[1] Regulatory Capital Rules: Standardized Approach for Risk-weighted Assets; Market Discipline and Disclosure Requirements 33 (OCC joint proposed June 7, 2012) (to be codified at 12 C.F.R. Pt. 3) available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20120607a2.pdf.

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