Basel III Update: Federal Reserve Proposes New Bank
Capital Framework
June 8, 2012
The Board of Governors of the Federal Reserve System (the “Federal Reserve”) approved three
notices of proposed rulemaking (“NPRs”) that would revise the general risk-based capital rules
to make them consistent with heightened international capital standards agreed to by the BaselCommittee on Banking Supervision (“BCBS”)1 in a comprehensive reform package, known as
Basel III, as well as certain provisions of the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (the “Dodd-Frank Act”). Intended to strengthen the quality and quantityof capital of banking organizations of all sizes, the proposal was divided into three proposed
rules, each of which is summarized below. Comments on the proposal are due September 7,
2012.

NEW RISK-BASED AND LEVERAGE CAPITAL REQUIREMENTS
The first NPR (“Basel III NPR”) would revise the Board’s risk-based and leverage capitalrequirements to be consistent with those in Basel III. It includes a more restrictive definition ofregulatory capital, higher minimum regulatory capital requirements, and capital “buffers”
designed to increase the resiliency of banking organizations during periods of financial stress.
In addition, this NPR proposes a leverage ratio that incorporates certain off-balance sheet assets
in the denominator (supplementary leverage ratio) and includes transition periods for the
majority of the proposed requirements to give banking organizations ample time to adjust.
Introduction of CET1. The proposals in the Basel III NPR, which would apply to all depository
institutions, top-tier bank holding companies with total consolidated assets of $500 million or
more, and top-tier savings and loan holding companies2 (collectively, banking organizations)would establish a new minimum common equity tier 1 capital to total risk-weighted assets ratioof 4.5%. Common equity tier 1 capital (“CET1”) is a new regulatory capital component that is
predominantly made up of retained earnings and common stock instruments (that comply with

1

The BCBS is a committee of banking supervisory authorities, which was established by the central
bank governors of the G-10 countries in 1975. It currently consists of senior representatives of banksupervisory authorities and central banks from Argentina, Australia, Belgium, Brazil, Canada, China,
France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, theNetherlands, Russia, Saudi Arabia, Singapore, South Africa, Sweden, Switzerland, Turkey, theUnited Kingdom, and the United States.

2

The capital rule as proposed would apply to all top-tier savings and loan holding companies, which
would include commercial companies that own grandfathered saving associations, once the rule
becomes effective.

Memorandum – June 8, 2012

strict eligibility criteria), net of treasury stock, and net of certain regulatory capital deductions
and adjustments.3
Additional Capital Buffers. The Federal Reserve proposes to apply limits on a banking
organization’s capital distributions and certain discretionary bonus payments to executive
officers if the banking organization does not maintain a new “capital conservation buffer” of atleast 2.5% of total risk-weighted assets (on a fully phased-in basis). The capital conservationbuffer would be composed of CET1 capital and would be added to each of the minimum riskbased capital requirements.
For advanced approaches banking organizations,4 which typically include the largest, mostcomplex banking organizations, the capital conservation buffer may be expanded by up to an
additional 2.5% upon activation of a new “countercyclical capital buffer” comprised solely of
CET1. The countercyclical capital buffer may be triggered in the United States when the Federal
Reserve and other federal banking agencies determine that a period of excessive aggregate
credit growth is contributing to an increase in systemic risk. At the time the proposed rule
becomes effective, the countercyclical buffer amount in the United States would initially be set
to zero.
Basel III includes a CET1 capital surcharge of up to 3.5% for global systemically importantbanks (“G-SIBs”).5 The proposed rules do not address the G-SIB surcharge, although theagencies note that they plan to implement (on a phase-in basis) a surcharge for banks with $50
billion or more in total consolidated assets, in 2014.
Higher Capital Standards. In addition to these new capital measures, the proposed rule would
raise the minimum tier 1 capital ratio from 4% to 6% of risk-weighted assets. These new andrevised regulatory capital requirements also will be incorporated into the Prompt Corrective
Action (“PCA”) capital categories, which serve as a supervisory trigger as to inadequate capitalfor banks and thrifts (but generally not their holding companies). Banking organizations are
generally expected, as a prudential matter, to operate well above their minimum regulatory
ratios, with capital commensurate with the level and nature of the risks to which they are3

CET1 capital may also include limited amounts of common stock issued by consolidated subsidiaries
to third parties (minority interest).

4

In general, the advanced approaches risk-based capital rule applies to those banking organizations
with consolidated total assets of at least $250 billion or consolidated total on-balance sheet foreign
exposures of at least $10 billion (excluding insurance underwriting assets) and their depository
institution subsidiaries. The market risk capital rule generally applies to those banking organizations
with aggregate trading assets and trading liabilities equal to at least 10% of quarter-end total assets or$1 billion.

5

Although undefined in the proposal, the BCBS identifies G-SIBs based on their size,interconnectedness, lack of substitutes for the services they provide, complexity, and global (crossjurisdictional) activity.

Page 2

Memorandum – June 8, 2012

exposed. These expectations are reflected, in part, in the ratios applicable to “well-capitalized”
depository institutions under PCA.
Leverage Ratio: To constrain the degree to which a banking organization can leverage its equity
capital base, all banking organizations under the Basel III NPR would remain subject to a 4%
tier 1 leverage ratio. The leverage ratio is calculated by dividing an organization’s tier 1 capitalby its average consolidated assets (i.e. on-balance sheet assets as reported on the banking
organization’s regulatory report), minus amounts deducted from tier 1 capital. Advanced
approaches banking organizations would also be required to maintain a supplementary
leverage ratio of tier 1 capital to total leverage exposure of 3%. Total leverage exposure includes
both on- and off-balance sheet assets.
The new capital and leverage requirements under the Basel III NPR, as compared to current
requirements, are shown in Table 1, below:
Table 1: Current Minimum Requirements and Proposed Minimum Requirements
Under the Basel III NPR (When Fully Phased-In by January 1, 2019)
Current
Minimum
Requirement

Proposed
Minimum
Requirement*

Proposed Minimumfor WellCapitalized Under
PCA

Minimum CET1 capital ratio

N/A

4.5%

6.5%

Capital conservation buffer

N/A

2.5%

N/A

Minimum CET1 capital ratio plus
capital conservation buffer

N/A

7.0%

N/A

Minimum tier 1 capital ratio

4.0%

6.0%

8.0%

Minimum tier 1 capital ratio plus
capital conservation buffer

N/A

8.5%

N/A

Minimum total capital

8.0%

8.0%

10.0%

Minimum total capital plus capitalconservation buffer

N/A

10.5%

N/A

Leverage ratio

4.0% (or 3%)

4.0%

5.0%

*For depository institutions, the proposed minimum is the same as “adequately capitalized” under the PCA.

New Capital Components. In addition to raising the minimum capital requirements, the proposed
rule would establish more conservative standards for including an instrument in regulatory
capital. Trust preferred securities, cumulative preferred stock and other hybrid instruments, forPage 3

Memorandum – June 8, 2012

example, would not be included in tier 1 capital.6 Common stock and noncumulative perpetual
preferred stock would generally qualify, subject to a number of detailed criteria. These include,for preferred stock, a restriction on redemption within five years after issuance except for
regulatory events, a prohibition on dividend step-ups, and a prohibition on purchase priceresets or ratchets if new shares are subsequently issued at a lower price. The proposal also
notes that while hybrid debt instruments could potentially be included in additional tier 1
capital under Basel III, for U.S. purposes an instrument that is classified as a liability for GAAP
purposes would not qualify as tier 1 capital.
Capital Adjustments. Banking organizations would also be subject to stricter capital deductions(most of which are deducted from tier 1 capital) for assets such as mortgage servicing assets,deferred tax assets and certain investments in the capital of unconsolidated financial
institutions.7 Importantly, the proposal would remove the existing filter for unrealized gains
and losses accumulated from available for sale securities recorded in accumulated othercomprehensive income/loss (“AOCI”) from regulatory capital measurements, with removal
applied to CET1 capital.8 Recognizing that this could discourage organizations from holding
low-risk investment securities because of the potential capital volatility, the proposal requests
comment on whether unrealized gains and losses from interest rate changes should be excluded
from capital calculations.9

6

Consistent with Basel III and the Collins Amendment of the Dodd-Frank Act, the Basel III NPR
would require the phase-out from tier 1 capital of trust preferred securities and cumulative preferredstock over a 10-year period for all bank holding companies with total consolidated assets less than
$15 billion as of December 31, 2009, permitting the inclusion in capital up to the percentage of theoutstanding principal amount of such non-qualifying capital instruments as of December 31, 2013,
until the instruments are fully phased-out on January 1, 2022; and a phase-out of those instruments
over a 3-year period beginning on the same date for bank holding companies that had $15 billion ormore in total consolidated assets as of December 31, 2009.

7

The Basel III NPR follows Basel III in requiring that banks deduct from CET1 any of the following
assets to the extent that individually the asset category exceeds 10% of CET1 or, in the aggregate, 15%of CET1: (i) deferred tax assets arising from temporary differences that could not be realized throughnet operating loss carry-backs; (ii) mortgage servicing assets net of associated deferred tax liabilities;and (iii) significant investments in the capital of financial institutions in the form of common stock.
In addition, significant investments in non-common stock capital instruments of such entities are to
be deducted from the same tier of capital for which the instrument would qualify if issued by thebank itself.

8

Removal of the AOCI filter would be applied to CET1, with the impact of the filter’s removal being
phased-in 20% per year on an annual basis over five years commencing 2014.

9

The Agencies seek comment on an industry proposal that would exclude from the AOCI filter’s
removal unrealized gains and losses on debt securities whose valuations primarily change as a resultof fluctuations in benchmark interest rates (for example, U.S. government and agency debt
obligations, U.S. GSE debt obligations and other sovereign debt obligations that will qualify for a 0%risk weight under the Standardized Approach). The Agencies also seek comment on whether
unrealized gains and losses on general obligations issued by states or political subdivisions of the
Page 4

Memorandum – June 8, 2012

Effective Dates. While the rule would be effective as of January 1, 2013, full compliance withmost aspects would not be required until January 1, 2019. Transition periods apply in several
areas of the proposed rule, including the phase-out of certain non-qualifying capital
instruments (like trust preferred securities), the new minimum capital ratio requirements, thecapital conservation buffer, the regulatory capital adjustments and deductions, and thecalculation of risk-weighted assets. The new minimum regulatory capital ratios and changes tothe calculation of risk-weighted assets would be fully implemented by January 1, 2015.10 The
capital conservation buffer framework would phase-in between 2016 and 2018, with full
implementation by January 1, 2019. Advanced approaches organizations would be required to
calculate and report their supplementary leverage ratio beginning on January 1, 2015.
However, it would not be a requirement until 2018.
The proposed changes to the minimum PCA capital requirements would take effect January 1,
2015. The proposed amendments to the current PCA leverage measure for advanced
approaches depository institutions would take effect on January 1, 2018.

STANDARDIZED APPROACH FOR RISK-WEIGHTED ASSETS; MARKETDISCIPLINE AND DISCLOSURE REQUIREMENTS
The second NPR (the “Standardized Approach NPR”) would apply to all banking organizations(other than small bank holding companies with $500 million or less in total assets) and includes
proposed changes to the general risk-based capital requirements for determining risk-weighted
assets (that is, the calculation of the denominator of a banking organization’s risk-based capitalratios). The proposed rule would expand the risk-weighting categories from the current four
categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number ofcategories, depending on the nature of the assets. Generally ranging from 0% for U.S.
government securities to 600% for certain equity exposures, the Standardized Approach NPR
would apply higher risk weights for a variety of asset categories. Table 2, below, summarizes
key provisions of the Standardized Approach NPR.
Table 2: Proposed Treatment for Different Categories of Risk-Weighted Assets
Under the Standardized Approach NPR
Risk-Weighted Asset

Proposed Treatment

Residential mortgage
exposures

Applies a more risk-sensitive treatment that would risk-weightan exposure based on certain loan characteristics and loan-tovalue ratios

United States should receive similar treatment even though such gains or losses are more likely toresult from credit risk and not primarily from fluctuations in a benchmark rate.
10Consistent with the Dodd-Frank Act, a bank holding company subsidiary of a foreign banking
organization that is currently relying on the Federal Reserve’s Supervision and Regulation Letter (SR)01-1 would not be required to comply with the proposed capital requirements until July 21, 2015.

Page 5

Memorandum – June 8, 2012

Table 2: Proposed Treatment for Different Categories of Risk-Weighted Assets
Under the Standardized Approach NPR
Risk-Weighted AssetHigh volatility commercial
real estate
Past due exposures

Proposed Treatment
Assigns a higher risk weight (150%) for certain commercial realestate facilities that finance the acquisition, development, or
construction of real property
Assigns a higher risk weight (150%) for exposures that are morethan 90 days past due or on nonaccrual (excluding sovereign
and residential mortgage exposures)

Credit exposures toforeign sovereigns, foreignbanks, and foreign public
sector entities

Bases the risk weight for each exposure type on the country risk
classification of the sovereign

Derivative contracts

Removes the risk weight cap regardless of counterparties andprovide preferential capital treatment for centrally-cleared
derivatives and repo-style transactions

While the current risk-based capital requirements recognize guarantees and collateral as credit
risk mitigants to a limited extent, the Standardized Approach NPR would expand the scope of(i) eligible guarantors (to include, for example, investment grade corporate entities, subject tocertain limitations), and (ii) eligible collateral (to include, for example, corporate debt securities
that are investment grade, equity securities that are publicly traded and convertible bonds thatare publicly traded).
In the Standardized Approach NPR, the Federal Reserve also proposes alternatives to credit
ratings for calculating the risk-weighting assets for certain assets, consistent with Section 939Aof the Dodd-Frank Act.11 The proposed rule would also introduce disclosure requirements for
top-tier banking organizations domiciled in the United States with $50 billion or more in total
assets, including disclosures related to regulatory capital instruments.
The changes in the Standardized Approach rule are proposed to take effect on January 1, 2015,
with an option for early adoption.

11

For determining the risk weight of certain exposures to non-U.S. sovereigns and non-U.S. public
sector entities, the proposed rule uses the Organization for Economic Co-operation andDevelopment’s (the “OECD”) country risk classification model (or “CRCs”). And for determining therisk 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 riskof [the obligor’s] default is low and the full and timely repayment of principal and interest is
expected.”

Page 6

Memorandum – June 8, 2012

ADVANCED APPROACHES RISK-BASED CAPITAL RULE; MARKET RISKCAPITAL RULE
The third NPR (the “Advanced Approaches and Market Risk NPR”) would generally apply
only to advanced approaches banking organizations and proposes to revise the existing
advanced approaches risk-based capital rule to incorporate certain aspects of Basel III and theDodd-Frank Act. The changes are designed to increase the risk sensitivity of internationallyactive banks to counterparty risk and interconnectedness among financial institutions. These
revisions also include replacing references to credit ratings with alternative standards ofcreditworthiness consistent with Section 939A of the Dodd-Frank Act.
The Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation are
also expected to propose that the market risk capital rule be applicable to federal and statesavings associations, and the Federal Reserve is proposing that the advanced approaches andmarket risk capital rules apply to top-tier savings and loan holding companies domiciled in the
United States that meet the applicable thresholds.

FUTURE RULEMAKINGS?
While lauding the proposal as “major progress on the way to overhauling capitalrequirements,” Governor Daniel K. Tarullo, the governor largely responsible for the proposal,
cautioned that the proposal does not signify the end of that effort. In particular, Governor
Tarullo identified two areas for future reform. First, depending on the results of thefundamental review of the trading book currently underway in the BCBS, he would like to see
revisions made to the market risk capital requirements to standardize capital requirements formarket risk, as a “back-up” for model-derived risk weights. And, second, with regard tocontingent capital, which is part of Basel III but was not addressed in the proposal, Governor
Tarullo noted that regulators should consider changes in capital requirements to ensure that
there would be adequate subordinated debt or similar liabilities on the balance sheets of thelargest banking organizations to help ensure they could be successfully resolved through theconversion of debt to equity.
***

This memorandum serves only to highlight certain key features of the proposed rules. For
more information regarding the Federal Reserve’s proposal and its implications, please contact
any member of the Firm’s Financial Institutions Group.
This memorandum is for general information purposes and should not be regarded as legal advice. Pleasecontact your relationship partner if we can be of assistance regarding these important developments. The
names and office locations of all of our partners, as well as our recent memoranda, can be obtained fromour website, www.simpsonthacher.com.

The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

Page 7

Memorandum – June 8, 2012

UNITED STATESNew York
425 Lexington Avenue
New York, NY 10017+1-212-455-2000

Houston2 Houston Center
909 Fannin Street
Houston, TX 77010+1-713-821-5650

Los Angeles
1999 Avenue of the Stars
Los Angeles, CA 90067+1-310-407-7500

Palo Alto
2550 Hanover Street
Palo Alto, CA 94304+1-650-251-5000

ASIA
Beijing3919 China World Tower
1 Jian Guo Men Wai Avenue
Beijing 100004
China+86-10-5965-2999

Hong Kong
ICBC Tower
3 Garden Road, Central
Hong Kong+852-2514-7600

Tokyo
Ark Mori Building
12-32, Akasaka 1-Chome
Minato-Ku, Tokyo 107-6037
Japan+81-3-5562-6200

SOUTH AMERICA

Washington, D.C.

São Paulo

1155 F Street, N.W.
Washington, D.C. 20004+1-202-636-5500

Av. Presidente Juscelino Kubitschek, 1455
São Paulo, SP 04543-011
Brazil+55-11-3546-1000

EUROPE
LondonCityPoint
One Ropemaker Street
London EC2Y 9HUEngland+44-(0)20-7275-6500

www.simpsonthacher.com