Federal Reserve Adopts Final U.S. Bank Capital Standards
Under Basel III
July 8, 2013
The Federal Reserve Board has approved a final rule (the “Final Rule”) implementing therevised capital standards of the Basel Committee on Banking Supervision, commonly known as“Basel III,” 1 and addressing various requirements under the Dodd-Frank Wall Street Reformand Consumer Protection Act of 2010 (“Dodd-Frank”). It replaces the general risk-based capitalrules of the different banking agencies that currently apply to banking organizations with asingle integrated regulatory capital framework that emphasizes not only higher capital cushions
for banks to absorb losses but also more stringent criteria for what qualifies as regulatory
capital.
As discussed in this summary, the Final Rule makes important changes to the proposed rules
issued by the Federal Reserve Board and other banking agencies last summer (collectively, the“Proposed Rule”). 2 According to Governor Daniel K. Tarullo, who leads the Federal Reserve
Board’s bank regulatory reform efforts, the Final Rule marks the end of major modifications tocapital rules for the “vast majority of banks,” but there remain a number of other capital-related
initiatives for the eight U.S. banking organizations that have already been identified as having
global systemic importance (Bank of America, The Bank of New York Mellon Corporation,
Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street, and Wells Fargo).
A.

SCOPE OF APPLICATIONThe Final Rule generally applies to all U.S. banking organizations (including national and statechartered banks, federal and state-chartered thrifts, bank holding companies, and savings andloan holding companies), subject to the following notable exceptions:•

Insurance Companies and Grandfathered Unitary Thrift Holding Companies—The
Final Rule does not apply to top-tier savings and loan holding companies

1

Basel Committee, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems(Dec. 2010; revised June 2011), available at http://www.bis.org/publ/bcbs189.pdf.

2

The Proposed Rule, as published by the Federal Reserve Board, the Federal Deposit Insurance
Corporation, and the Office of the Comptroller of the Currency, 77 Fed. Reg. 52792 (Aug. 30, 2012),
comprised three separate proposals: (i) one relating to minimum capital ratios, capital buffers, anditems in the “numerator” of the regulatory capital ratios; (ii) another relating to risk-weighted assets
used in calculating the “denominator” for banking organizations; and (iii) another relating to riskweightings applicable only to internationally active banking organizations with significant trading
activities. The FDIC and OCC are expected to approve the Final Rule this week.

Memorandum – July 8, 2013(“SLHCs”) that: (i) have more than 25% of their consolidated assets derived
from insurance underwriting activities (other than credit risk insurance), (ii)are “insurance underwriting companies” (i.e., companies that engage ininsurance underwriting activities and are subject to state insurance
regulation), or (iii) are grandfathered unitary SLHCs with 50% or more of
their revenues on an enterprise-wide basis derived from nonfinancial
activities. 3 All other SLHCs are covered by the Final Rule (“covered
SLHCs”). The Federal Reserve Board was generally sympathetic toarguments by the insurance industry that the Proposed Rule’s capitalrequirements were “bank-centric” and inconsistent with insurancecompanies’ business models and risk profiles. A separate, “appropriate”
capital framework applicable to SLHCs not covered by the Final Rule isexpected to be implemented by the time covered SLHCs must comply with
the Final Rule in 2015. The Federal Reserve Board also noted that it plans torelease a proposal “in the near term” relating to the transfer by grandfathered
unitary SLHCs of their financial activities to an intermediate holding
company and the capital requirements for such intermediate holding
companies.

B.

•

Bank Holding Companies Relying on “SR 01-1”—U.S. bank holding company
subsidiaries of foreign banking organizations that are currently relying on
Supervision and Regulation Letter 01-1 are exempt from compliance until
July 21, 2015.

•

Small Bank Holding Companies—Top-tier bank holding companies that haveconsolidated assets of less than $500 million and are subject to the Federal
Reserve Board’s Small Bank Holding Company Policy Statement are exempt.
There is no comparable exemption for covered SLHCs that have consolidated
assets of less than $500 million.

GENERAL TIMING

There are two main start dates:•

3

January 1, 2014—For advanced approaches banking organizations (generally
those with consolidated total assets of at least $250 billion or consolidated
total on-balance sheet foreign exposures of at least $10 billion), this is the startdate for compliance with the revised minimum regulatory capital ratios andfor determining risk-weighted assets under the “advanced approach.”

The calculation of total consolidated assets for this purpose is generally based on GAAP, although theFederal Reserve Board recognizes that many SLHCs substantially engaged in insurance activities do
not calculate assets in such manner and, therefore, they will be permitted to use estimatedcalculations (subject to possible review and adjustment). Calculations must be as of June 30 of theprevious calendar year.

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Memorandum – July 8, 2013•

January 1, 2015—For non-advanced approaches banking organizations andcovered SLHCs, this is the start date for compliance with the revised
minimum regulatory capital ratios and for determining risk-weighted assets
under the “standardized approach.”

The Final Rule also provides transition periods for the phase-out of certain capital instrumentsthat no longer will be included in regulatory capital, as well as for certain required regulatory
capital deductions and adjustments, with the start date for such transition periods commencing
in 2014 or 2015, depending on whether the banking organization is subject to the advanced
approaches rules or not. Regardless of the size or complexity of a banking organization, thetransition period for the two special capital buffers under Basel III—the conservation buffer andthe countercyclical capital buffer, as discussed below—begins on January 1, 2016.
C.

HEIGHTENED CAPITAL RATIOS AND NEW BUFFERS

Consistent with Basel III and the Proposed Rule, the Final Rule sets out new minimum
regulatory capital requirements for U.S. banking organizations.
1.

Minimum Risk-Based Capital Ratios

All advanced approaches banking organizations, non-advanced approaches banking
organizations, and covered SLHCs (which are generally referred to as “banking organizations”
in this memorandum) will need to meet the following minimum capital ratios, expressed as apercentage of risk-weighted assets, by January 1, 2015:•

Common Equity Tier 1 Capital Ratio—a common equity Tier 1 (“CET1”) capitalratio of 4.5% (a new concept and requirement).

•

Tier 1 Capital Ratio (CET1 capital + Additional Tier 1 capital)—a Tier 1 capitalratio of 6.0% (increased from 4.0% under the current capital rules).

•Total Capital Ratio (Tier 1 capital + Tier 2 capital)—a total capital ratio of 8.0%
(unchanged from current capital rules).

For the year 2014 only, advanced approaches banking organizations that are not covered SLHCs
will need to have CET1 capital, Tier 1 capital, and total capital ratios of 4.0%, 5.5%, and 8.0%,
respectively.
As is the case under the existing capital rules, most banking organizations will be expected tomaintain capital levels well above the minimum capital ratios. In addition, for a bank holding
company to have the expanded activity authority attendant to “financial holding company”
status, it needs to be “well capitalized.” The Final Rule does not establish standards fordetermining whether a bank holding company is well capitalized, which under the current
rules are the same as the risk-weighted ratios required for well capitalized status under the
prompt corrective action rules.

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Memorandum – July 8, 2013

By 2019, all banking organizations will effectively be required to hold a minimum of 7% CET1
capital against total risk-weighted assets (taking into account the 4.5% CET1 capital ratio plus
the 2.5% capital conservation buffer). For the eight U.S. bank holding companies that have been
identified by the Financial Stability Board as being global systemically important banks (“GSIBs”), an additional common equity surcharge will apply on top of the 7% CET capital ratio(the highest G-SIB capital surcharge bucket has been set at 2.5% and will apply to Citigroup and
JPMorgan Chase). 4 The Final Rule does not address the G-SIB capital surcharge, but as noted in
Section G of this memorandum, the Federal Reserve Board is expected to issue a proposal later
this year to implement this additional capital requirement for the eight U.S. G-SIBs.
2.

Minimum Leverage Ratios

Under the Final Rule, all banking organizations will be subject to a leverage ratio of 4% (asbefore). The ratio is generally calculated by dividing Tier 1 capital by an organization’s average
total on-balance consolidated assets.
In addition, commencing January 1, 2018, advanced approaches banking organizations will be
subject to a minimum supplementary leverage ratio of 3%, although they will be required to
calculate and report this ratio beginning on January 1, 2015. This ratio is calculated as thesimple arithmetic mean of the ratio of a banking organization’s Tier 1 capital to total leverage
exposure as of the last day of each month in the reporting quarter. The term “total leverage
exposure” incorporates, among other things, the notional amount of certain off-balance sheet
exposures (such as 10% of the notional amount of unconditionally cancellable commitments
made by the banking organization and the potential future exposure amount for derivative
contracts) in addition to on-balance sheet assets.
It is important to note that the Final Rule implements the minimum leverage ratio requirement
under Basel III. As discussed in Section G of this memorandum, the Federal Reserve Board has
indicated it regards Basel III’s minimum leverage ratio as too low for the eight U.S. bankholding companies that have been identified as G-SIBs and, accordingly, may soon issue a
proposal to increase it.
3.

Capital Conservation Buffer and Countercyclical Capital Buffer

Consistent with Basel III and the Proposed Rule, the Final Rule adopts a “capital conservationbuffer” for all banking organizations, as well as another buffer, known as a “countercyclicalcapital buffer,” for advanced approaches banking organizations. Because noncompliance will4

See Financial Stability Board, Update of Group of Global Systemically Important Banks (G-SIBs) (Nov. 1,2012), available at http://www.financialstabilityboard.org/publications/r_121031ac.pdf. On July 3,
2013, the Basel Committee announced that it is in the process of updating its assessment
methodology for G-SIBs and that it intends to finalize its framework for assessing and identifying GSIBs by November 2013. See Basel Committee, Globally Systemically Important Banks: Updated
Assessment Methodology and the Higher Loss Absorbency Requirement (July 2013), available at
http://www.bis.org/publ/bcbs255.pdf.

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Memorandum – July 8, 2013

result in limitations on distributions and discretionary bonus payments, there are strong
incentives for banking organizations to hold more than the minimum required capital.
As noted above, the transition period for these two buffers begins on January 1, 2016. The
preamble to the Final Rule indicates that the maximum capital conservation buffer and the
maximum potential countercyclical capital buffer will each be 0.625% for 2016, 1.25% for 2017,1.875% for 2018, and 2.5% for 2019. This phase-in is consistent with both Basel III and the
Proposed Rule.

(i)

Capital Conservation Buffer

The capital conservation buffer will be composed exclusively of CET1 capital and would be
added on top of each of the minimum risk-based capital ratios discussed above. A banking
organization’s buffer will be calculated by taking the lowest of the following three ratios (ascalculated as of the last day of the previous calendar quarter): (i) its CET1 capital ratio minus its
minimum CET1 capital ratio requirement, (ii) its Tier 1 capital ratio minus its minimum Tier 1
capital ratio requirement, and (iii) its total capital ratio minus its minimum total risk-based
capital ratio requirement. Under the Final Rule, if any one of these ratios is less than or equal tothe applicable minimum requirement, then the capital conservation buffer is 0%.
The Final Rule provides a “maximum payout ratio” for distributions 5 and discretionary
bonuses 6 to executive officers 7 that increases in stringency as a banking organization dips
further into its buffer above the minimum ratios. As illustrated in the table below, themaximum dollar amount that a banking organization is permitted to pay during a calendar
quarter is equal to the maximum payout ratio multiplied by the banking organization’s eligible

5

The term “distribution” is defined generally as a repurchase or redemption of a Tier 1 or Tier 2
capital instrument or a dividend or interest payment on such instrument (except in the case of a Tier
2 instrument on which the banking organization does not have full discretion to suspend suchpayments without triggering an event of default). Significantly, the Final Rule provides that aredemption or repurchase of a capital instrument is not a “distribution” if the banking organization
fully replaces that capital instrument by issuing another capital instrument of the same or better
quality (that is, equally or more subordinate), based on the Final Rule’s eligibility criteria for capital
instruments, and provided that such issuance is completed within the same calendar quarter thebanking organization announces the repurchase or redemption.

6

The term “discretionary bonus” is defined relatively narrowly to include only payments where thebanking organization has discretion as to whether to make such payment and in what amount.
Payments pursuant to any contract or promise (express or implied) or prefunded bonus pool would
not be considered discretionary bonuses. In addition, non-cash payments that do not affect capitalor earnings would also be excluded.

7

The term “executive officer” means a person who holds the title or performs the function of one ormore of the following positions: president, chief executive officer, executive chairman, chief
operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending
officer, chief risk officer, or head of a major business line, and other staff that a banking
organization’s board of directors deems to have equivalent responsibility.
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Memorandum – July 8, 2013

retained income (generally, net income for the prior four calendar quarters, net of any capital
distributions).
Capital Conservation BufferGreater than 2.5%
Less than or equal to 2.5%
and greater than 1.85%
Less than or equal to 1.875%
and greater than 1.25%
Less than or equal to 1.25%
and greater than 0.625%
Less than or equal to 0.625%

Maximum Payout Ratio for Distributions
and Discretionary Bonus Payments
No payout limitation applies
60%
40%
20%
0%

To avoid these quantitative limits, a banking organization must hold a capital conservationbuffer in an amount greater than 2.5% of its total risk-weighted assets (plus, for advanced
approaches banking organizations, whatever is required under a countercyclical capital bufferthen in effect).
(ii)

Countercyclical Capital Buffer

The countercyclical capital buffer, also consisting of CET1 capital, applies only to advanced
approaches banking organizations. It would be on top of the capital conservation buffer andwould range from 0% to 2.5% of risk-weighted assets. For purposes of both buffers, advanced
approaches banking organizations will not be required to calculate them based on theiradvanced approaches total risk-weighted assets, as the Proposed Rule would have required.
Instead, they will generally calculate their buffers by using the lower of the standardized
approach and advanced approaches risk-based capital ratios. 8
Initially, the countercyclical capital buffer will be set to 0%, but the banking agencies have thediscretion to make upward adjustments, on a country-by-country exposures basis, based on a
range of “macroeconomic, financial, and supervisory information” (such as the ratio of credit toGDP, a variety of asset prices, funding spreads, credit condition surveys, and indices based on
CDS spreads) indicating an increase in systemic risk. An upward adjustment would generally
be announced 12 months prior to its effectiveness and remain in effect for 12 months unlessextended or adjusted by the banking agencies.

8This approach may be used by advanced approaches banking organizations that have completed theso-called “parallel run” process under Basel II. Basel II was never comprehensively implemented in
the United States, but a portion of it (relating to the “advanced approach”) was applied to thelargest, most complex U.S. banking organizations.

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Memorandum – July 8, 2013

4.

Updated Prompt Corrective Action Framework for Insured Depository
Institutions

The Final Rule updates the prompt corrective action (“PCA”) framework applicable to insured
depository institutions (but not their holding companies) under Section 38 of the Federal
Deposit Insurance Act. The general structure of the PCA framework—“well capitalized,”“adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “criticallyundercapitalized”—remains the same, but the Final Rule makes necessary adjustments toaccount for changes to the required capital levels made by the Final Rules, such as the new
CET1 capital requirement and the supplementary leverage ratio.
Effective January 1, 2015, all insured depository institutions must comply with the revised PCA
thresholds, as depicted below.
PCA Category
Well Capitalized
Adequately
Capitalized
Undercapitalized
Significantly
Undercapitalized
Critically
Undercapitalized
D.

Total
CapitalTier 1
CapitalCommonEquity Tier 1

≥ 10%

≥ 8%

≥ 6.5%

Leverage Measure
Leverage
Supplementary
Ratio
Leverage Ratio≥ 5%
Not applicable

≥ 8%

≥ 6%

≥ 4.5%

≥ 4%

≥ 3%

< 8%

< 6%

< 4.5%

< 4%

< 3%

< 6%

< 4%

< 3%

< 3%

Not applicable

Tangible Equity (defined as Tier 1 capital plus nonNot applicable
Tier 1 perpetual preferred stock) to Total Assets ≤ 2%

OTHER CHANGES TO THE NUMERATOR: REDEFINING THE COMPONENTS
OF REGULATORY CAPITAL

A central theme of Basel III, and of post-crisis capital regulatory reform in general, is that newcapital standards must not only address the quantity of capital but also the quality of capital heldby banking organizations. In the financial crisis, the U.S. banking agencies identified significant
weaknesses in the loss-absorbency of certain capital instruments, such as trust preferred
securities (“TruPS”), that ultimately led them to view such instruments as inappropriate forinclusion in Tier 1 capital. In the Proposed Rule from last summer, the banking agencies sought
to address these weaknesses. The Final Rule largely follows the Proposed Rule’s eligibility
criteria for the various components of capital, as well as the general approach to regulatory
adjustments and deductions, but with some notable differences.
1.

Capital Components

The Final Rule establishes the qualification criteria for the following three components thatcomprise a banking organization’s “regulatory capital”:

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Memorandum – July 8, 2013•

Common Equity Tier 1 Capital—As noted previously, CET1 capital is a newconcept under Basel III. CET1 capital is predominantly comprised ofretained earnings and common stock instruments (that meet strict delineatedcriteria), net of treasury stock, and after making necessary capital deductions
and adjustments. It will also include AOCI (for organizations that do notmake opt-out elections) and CET1 minority interests, which are subject torestrictions described below. Under the Final Rule, CET1 capital will be thelargest capital component for most banking organizations.

•

Additional Tier 1 Capital—Additional Tier 1 capital consists of non-cumulative
perpetual preferred stock and similar instruments meeting specified
eligibility criteria, related surplus, Tier 1 minority interests that are notincluded in a banking organization’s CET1 capital, 9 and “TARP” preferredstock and other instruments issued under the Emergency Economic
Stabilization Act of 2008. Among the eligibility criteria for both CET1 capitaland Additional Tier 1 capital instruments is the requirement (which beyond
what Basel III required) that any paid-in amount be classified as equity under
GAAP before the instruments may be included in regulatory capital. As
such, the banking agencies believe it will likely be difficult for any contingent
capital instrument to qualify prior to its conversion into an equity
instrument.

•

Tier 2 Capital—Tier 2 capital includes instruments such as subordinated debt
that has a minimum original maturity of at least five years and issubordinated to the claims of depositors and general creditors. 10 It will also
include total capital minority interest not included in Tier 1 capital andlimited amounts of a banking organization’s allowance for loan and leaselosses (ALLL), less applicable regulatory adjustments and deductions. The
Final Rule removes the existing limit on how much Tier 2 capital will countas regulatory capital and also removes the sublimit on the portion of Tier 2
capital that may be comprised of subordinated debt.

9

With respect to capital instruments issued by real estate investment trusts (“REITs”), which cancount toward Tier 1 capital under the current capital rules, the preamble to the Final Rule notes thatthe banking agencies do not expect REIT preferred stock to qualify as a Tier 1 minority interest
under the new capital framework, particularly if the issuer does not have the ability to declare aconsent dividend or otherwise cancel cash dividends. Also, the Final Rule clarifies that certain
REITs currently used by banking organizations will not qualify as “operating subsidiaries” under
the rule and, as a result, minority interests in such entities will not qualify as regulatory capital. For
REITs to be treated as operating subsidiaries, they must be actively managed for earning a profit intheir own right.

10

The Final Rule clarifies that for a subordinated debt instrument to qualify as Tier 2 capital, it mustalso be subordinated to the claims of trade creditors. Accordingly, subordinated debt issued bybanking organizations on or after May 19, 2010 with a carve-out for these creditors will not qualify
as Tier 2 capital.

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Memorandum – July 8, 20132.

Limitations on Minority Interests

During the recent financial crisis, the banking agencies found that minority interests in abanking organization’s consolidated subsidiaries were generally available to absorb losses atthe subsidiary level, but not always available to absorb losses at the consolidated parent
organization level. Under the Final Rule, minority interests in a parent banking organization’s
subsidiaries will be subject to limitations on their inclusion in the parent banking organization’s
regulatory capital based generally on the amount of capital held by the subsidiary and of thetype of interest held.
As a threshold matter, a minority interest in a consolidated subsidiary cannot be included in abanking organization’s regulatory capital if the subsidiary’s capital ratios are equal to or below
the level of capital necessary to meet the minimum capital requirements plus the capitalconservation buffer (or the equivalent standards of the subsidiary’s home country supervisor).
In other words, a subsidiary must have “surplus” capital for the banking organization to be able
to include its minority interest in such subsidiary as regulatory capital. However, the surplus
capital itself, to the extent it is attributable to third party investors, cannot be counted toward
the parent banking organization’s regulatory capital. For subsidiaries that are not subject to thecapital requirements of the Final Rule, or equivalent home country rules, the banking
organization will be required to make these calculations as if the subsidiary were subject to the
Final Rule.
As for the type of interest held, the particular capital instrument related to the minority interest
must satisfy the eligibility criteria for such instrument to be included in a particular class ofregulatory capital. Most importantly, only CET1 capital issued by a consolidated U.S.
depository institution subsidiary or foreign bank subsidiary of a parent banking organization tothird party investors may count under the Final Rule toward such parent’s CET1 capital.
3.

Phase-Out of Non-Qualifying Capital Instruments

As under Basel III, Dodd-Frank’s Collins Amendment, and the Proposed Rule, the Final Rulegenerally requires the phase-out of non-qualifying capital instruments—notably, TruPS andcumulative perpetual preferred stock—that were issued prior to a cut-off date and included inTier 1 capital. However, the Final Rule differs substantially from the Proposed Rule withrespect to timing and the treatment of certain instruments issued by smaller banking
organizations.
•

Depository Institution Holding Companies with Less than $15 Billion in Total
Consolidated Assets as of December 31, 2009—These companies may
permanently include non-qualifying instruments that were issued andincluded in Tier 1 or Tier 2 capital prior to May 19, 2010 in Additional Tier 1
or Tier 2 capital until they redeem such instruments or until the instruments
mature. This is a major change from the Proposed Rule, which would have
imposed a 10-year phase-out of these instruments and which disregarded thepermanent grandfathering treatment that Congress explicitly authorizedunder the Collins Amendment.
Page 9Memorandum – July 8, 2013•

4.

Depository Institution Holding Companies with $15 Billion or More in Total
Consolidated Assets as of December 31, 2009—These companies may include
non-qualifying instruments that were issued and included in Tier 1 or Tier 2
capital prior to May 19, 2010 in Additional Tier 1 or Tier 2 capital, subject to a
specified phase-out schedule. The Proposed Rule would have phased out
these instruments over a three-year period by capping the maximum amountincludible in Tier 1 and Tier 2 capital at 75% in 2013, 50% in 2014, 25% in
2015, and then 0% thereafter. The Final Rule effectively maintains the sameschedule once the Final Rule becomes effective: the Additional Tier 1 capitalphase-out schedule commences January 1, 2014 for advanced approaches
banking organizations (excluding SLHCs), when a 50% cap will apply, andon January 1, 2015 for non-advanced approaches banking organizations andcovered SLHCs, when a 25% cap will apply. By January 1, 2016, all nonqualifying instruments must be phased out of Additional Tier 1 capital. Nonadvanced approaches banking organizations may permanently include nonqualifying capital instruments in Tier 2 capital that have been phased out of
Additional Tier 1 capital pursuant to the schedule above. However,advanced approaches banking organizations may include non-qualifying
capital instruments in Tier 2 capital that have been phased out of Additional
Tier 1 capital pursuant to the schedule above up to a 60% cap for 2016, withthe cap declining progressively by 10% each year thereafter until the phaseout is completed at year-end 2021.
Capital Deductions and Adjustments

As a general matter, the revised capital framework imposes stricter regulatory capital
deductions from and adjustments to capital, with most deductions and adjustments taken
against CET1 capital. The Final Rule generally provides lengthy transition periods, except asotherwise noted below.
The following is a summary of how the Final Rule treats certain key deductions andadjustments:•

Mortgage Servicing Assets (“MSAs”), Deferred Tax Assets (“DTAs”), and Significant
Investments in Unconsolidated Financial Institutions—Consistent with Basel III and
the Proposed Rule, the Final Rule requires banking organizations to deduct thefollowing assets from CET1 capital to the extent they individually exceed 10% of
CET1 capital or, in the aggregate, 15% of CET1 capital: (i) DTAs that cannot berealized through net operating loss carrybacks, net of any related valuation
allowances and net of deferred tax liabilities (“DTLs”); (ii) MSAs, net of
associated DTLs; and (iii) “significant investments” (i.e., 10% or more ownership)in the capital (in the form of common stock, net of associated DTLs) ofunconsolidated “financial institutions” (defined broadly to include banking
organizations; nonbank banks, such as credit card banks and industrial banks;
insurance companies; nonbank companies designated as systemically importantby the Financial Stability Oversight Council (so-called “nonbank SIFIs”); and any
Page 10Memorandum – July 8, 2013

other company, of which the banking organization owns $10 million of GAAP
equity or more than 10% of the common stock, that is predominantly engaged incertain lending, securities underwriting, or certain insurance activities).
•

Unrealized Gains and Losses in Accumulated Other Comprehensive Income (“AOCI”)—
Under the Proposed Rule, unrealized gains and losses on AOCI (other than withrespect to certain cash flow hedges) would have been required to be included in
the CET1 capital of all banking organizations. Notably, the Final Rule gives
significant relief to community banks and many regional banks that had voiced
concerns during the comment period that the inclusion of unrealized gains andlosses on available-for-sale debt securities would have resulted in large andvolatile changes in their capital levels. Non-advanced approaches banking
organizations will be permitted to make a one-time election to opt-out of thisrequirement (and, in effect, retain the AOCI treatment under the current capitalrules) when they file their first call report after becoming subject to the Final Rule(i.e., the first quarter of 2015). If a top-tier depository institution holding
company makes an AOCI opt-out election, any subsidiary insured depository
institution that is consolidated by the depository institution holding company
also must make an AOCI opt-out election.
In the event of a merger or similar business combination between a banking
organization that has made an opt-out election and one that has not, thesurviving organization (if it is a non-advanced approaches banking organization)
will be permitted to make a new opt-out election by the first regulatory reporting
date after the completion of the transaction. This permitted election is notdependent upon the respective sizes of the merging organizations or which is thesurviving entity (assuming it is not an advanced approaches banking
organization). If a banking organization acquires less than substantially all of theassets or voting stock of a banking organization which had made a different optout election, the applicable banking agency may in its discretion allow theacquiror to make a new opt-out election.

•

Defined Benefit Pension Fund Assets—Depository institution holding companies(but not their bank or thrift subsidiaries) will need to deduct any defined pension
fund asset, net of any associated DTLs, from capital unless they have“unrestricted and unfettered access” to the assets of a particular fund.

•Goodwill and Other Intangibles (other than MSAs)—Goodwill and other intangible
assets of a banking organization (other than MSAs) are to be deducted from
CET1 capital. No transition period is provided for goodwill deductions.

•

Investments by a Banking Organization in its Own Regulatory Capital Instruments—
As in the Proposed Rule, the Final Rule requires a banking organization to
deduct the amount of its investments in its own capital instruments—including
direct, indirect, and synthetic exposures—to the extent such instruments are notalready excluded from regulatory capital. To avoid any double-counting ofPage 11

Memorandum – July 8, 2013

capital, a banking organization would have to look through its holdings of anindex security to deduct investments in its own capital.
•

Equity Investments in Financial Subsidiaries—National banks and insured statebanks that establish financial subsidiaries (generally subsidiaries that engage inactivities that are “financial in nature” for purposes of Section 4(k) of the Bank
Holding Company Act) will be required to deduct their equity investments insuch subsidiaries from CET1 capital. This is consistent with the deductions froma depository institution’s Tier 1 and Tier 2 capital and from its risk-weighted
assets under the current capital rules. There is no transition period.
5.

Treatment of Permitted Fund Investments Under the Volcker Rule

The Final Rule does not address the capital requirements that will apply in respect ofinvestments in private equity and hedge funds that are permitted under the Volcker Rule. We
expect this issue to be addressed in the long-awaited final regulations under the Volcker Rule.
E.

CHANGES TO THE DENOMINATOR: DETERMINING RISK-WEIGHTEDASSETS

Basel III generally gives banking organizations a choice between two methods for calculatingrisk-weighted assets, which comprise the denominator of a banking organization’s risk-based
capital ratios. One is a “standardized approach” that permits them to measure credit risk using
metrics and risk-weightings prescribed by regulation. Another is an “advanced approach” (orinternal ratings-based approach) that allows banking organizations to use their internal models
and ratings systems to measure credit risk, subject to regulatory approval. The Final Rulereflects changes in both approaches that are designed to address perceived shortcomings inrisk-based capital requirements identified by the U.S. banking agencies during the financial
crisis. To address criticisms that the advanced approach, which is generally used by the largest,
most complex financial institutions, could result in such institutions having lower capitalrequirements than smaller institutions, the standardized approach will serve as the “floor”
mandated by the Collins Amendment with respect to any leverage and risk-based capitalrequirements that the Federal Reserve Board may impose on banking organizations andnonbank SIFIs.
1.

The Standardized Approach

The standardized approach for calculating risk-weighting goes into effect on January 1, 2015
and will apply to all banking organizations. Until then, non-advanced approaches banking
organizations and covered SLHCs will remain subject to the current general risk-based capitalrules. From January 1, 2014 to December 31, 2014, advanced approaches banking organizations
will be required to use the current general risk-based capital rules, including the current
market-risk rule (which governs the market risk adjustment to the denominator), to calculate
their standardized total risk-weighted assets under the Final Rule.
The following is a summary of the key features of the standardized approach.

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Memorandum – July 8, 201311•

Expansion of Risk-Weight Categories—In general, the Final Rule changes therisk-weights used for certain on- and off-balance sheet asset categories tomore appropriately reflect their associated credit risks. The number of riskweighting categories is expanded from four (0%, 20%, 50%, and 100%) to amuch larger and more risk-sensitive number of categories that generally
range from 0% (for U.S. government and certain other sovereign exposures)to 600% (for certain equity exposures).

•

On-Balance Sheet Assets—Among other things, the Final Rule revises themethodologies for determining risk-weighted assets for certain on-balance
sheet items, such as:o certain commercial real estate credit facilities that finance theacquisition, development, or construction of real property, by
assigning a higher risk-weight (150%);o exposures that are more than 90 days past due or on nonaccrual(excluding sovereign and residential mortgage exposures), by
assigning a higher risk-weight (150%); ando exposures to foreign sovereigns, foreign banks, and foreign public
sector entities, by basing the risk-weight for each exposure type on the
Organization for Economic Co-operation and Development’s(“OECD”) country risk classification (“CRC”), rather than simply on
the basis of OECD membership. 11•

Residential Mortgage Exposures—Notably, the Final Rule did not adopt
proposed changes in the Proposed Rule on the risk-weightings for residential
mortgage exposures that would have applied a more granular, risk-sensitive
treatment to such exposures based on loan characteristics such as loan-tovalue ratios. Instead, the Federal Reserve Board opted to leave unchanged
the current risk-weightings for residential mortgages, which generally are
50% for performing, secured first-lien mortgage loans, and 100% for all otherfirst-lien residential mortgage loans. The Federal Reserve Board rejected theearlier proposal in view of potential implementation burdens, particularly forcommunity banks, as well as concerns regarding the cumulative impact ofother, recently-implemented residential mortgage regulations on U.S.
housing markets.

•

Off-Balance Sheet Exposures—The Final Rule also establishes risk-weights, bymeans of a credit conversion factor (“CCF”), for certain off-balance sheet
items, including guarantees and commitments. The Final Rule includes“credit enhancing representations and warranties” that are not securitization
exposures among the list of off-balance sheet exposures that will be subject toSince the release of the Proposed Rule, the OECD ceased rating certain high-income jurisdictions.
Accordingly, the Final Rule reflects this so that those OECD member countries, foreign banks
domiciled in OECD countries, or public sector entities that no longer receive a CRC are assigned to
the lowest applicable risk-weight (generally 0% to 20%).

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Memorandum – July 8, 2013

a CCF of 100%. However, the Federal Reserve Board retained the safe harborfrom capital requirements in the current risk-based capital rules for assets
sold with representations and warranties that contain certain early default
clauses or premium refund clauses that apply within 120 days of the sale.
Additionally, the Final Rule stipulates that banking organizations apply a
CCF of 20% to all short-term commitments of one year or less that are notunconditionally cancellable, as initially proposed.
•

OTC Derivatives—The Final Rule applies risk-weights to over-the-counter(“OTC”) derivative contracts. Exposure calculation methodologies vary,depending upon whether the contracts are single OTC contracts or multiple
contracts subject to qualifying master netting arrangements. The rule
generally recognizes credit risk mitigation benefits of financial collateral that
secures an OTC derivative contract. In addition to off-balance sheet exposure
related to the underlying contracts, counterparty credit risk for OTC credit
risk derivatives are addressed in the Final Rule, with regard to bothprotection purchasers and protection providers. In the case of counterparty
credit risk for OTC equity derivatives, banking organizations generally must
treat an OTC equity derivative contract as an equity exposure and compute arisk-weighted asset amount for the OTC equity derivative contract. In
addition, the organization must calculate a risk-based capital requirement forthe counterparty credit risk of an OTC equity derivative contract, as provided
in the Final Rule.
The Final Rule specifies applicable risk-weightings for a clearing bank’s
exposure for OTC derivative contracts, which apply whether the bank is
acting as direct financial intermediary or guarantor on behalf of its client.
The Final Rule introduces capital requirements for cleared transactions withcentral counterparties and for default fund contributions to central
counterparties (“CCPs”) by clearing member banking organizations, as
initially proposed. In general, the Final Rule recognizes that CCPs help
improve the safety and soundness of the derivative and repo-styletransaction markets through the multilateral netting of exposures,
establishment and enforcement of collateral requirements, and the promotionof market transparency, and the Final Rule provides preferential capitaltreatment for centrally-cleared derivatives and repo-style transactions.
Finally, the Final Rule specifies the methodologies to be used by banks thatare clearing member clients to calculate risk-weighted assets for cleared OTC
derivative transactions.

•Credit Risk Mitigants—The current capital rules recognize, to a very limited
extent, guarantees and collateral to mitigate credit risk. The Final Rule
specifies alternative methodologies for calculating such offsets and expands
the scope of (i) eligible guarantors (to include, for example, investment grade
corporate entities, subject to certain limitations) and (ii) eligible collateral (toinclude, for example, corporate debt securities that are investment grade,

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Memorandum – July 8, 2013

equity securities that are publicly traded and convertible bonds that are
publicly traded).

12•

Securitizations—Consistent with Basel III, the Final Rule specifies themethodologies for calculating risk-weighted assets for unsettled transactions
and for securitization exposures. Under the Final Rule, a banking
organization would determine the risk-based capital requirement for
securitization exposures by applying either (1) the gross-up approach fromthe general risk-based capital rules based on the subordination of asecuritization exposure; or (2) a simplified supervisory formula approach(“SSFA”), which is a simplified version of the supervisory formula approachin the advanced approaches rule and has been adopted by the agencies in themarket risk rule. The Final Rule modifies the SSFA to recognize common
deferral features associated with student and consumer loans unrelated tocredit risk.

•

Equities—Equity exposures are subject to alternative methods for calculatingrisk-weighted assets. Generally, banks must use a “simple risk-weightapproach,” which establishes risk-weights ranging from 0% to 600%,
depending upon the credit quality of the issuer, that are applied to theadjusted carrying value of the investment, in the case of on-balance sheet
equity exposures. Generally, non-significant equity exposures the carrying
value of which in the aggregate does not exceed 10% of a bank’s total capitalare subject to risk-weights of 100%, subject to certain exceptions. Equity
purchase commitments and other off-balance sheet equity exposures are
subject to conversion factors ranging from 20% to 100%, depending on theterm and conditionality of the commitments.

•

Fund Investments—With regard to investments by banking organizations in or
through investment funds, or separate accounts, the Final Rule offers three
options (i.e., full look-through, simple look-through, or alternative modified
look-through), each of which looks through the fund and establishes riskweights according to the types of investments permitted to be made by thefund or through the separate account. 12 Thus, the risk-based capitalrequirement for equity exposures to investment funds that hold only low-risk
assets would be relatively low, whereas high-risk exposures held throughinvestment funds would be subject to a higher capital requirement, with aminimum risk-weight for any equity exposure to an investment fund at 20%.

On July 5, 2013, the Basel Committee proposed further revisions to the treatment of banks’ equity
investments in funds. Among other things, the revisions address risks associated with banks’interaction with so-called “shadow banking entities,” or those credit intermediaries operating
outside the regular banking system, particularly where there are successive layers of funds (socalled “funds of funds”). In using the “look-through” approach, banks will be required to apply arisk-weight of 1,250% to a fund’s exposure to other funds. See Basel Committee, Consultative
Document: Capital Requirements for Banks’ Equity Investments in Funds (July 2013; comment period
expires Oct. 4, 2013), available at http://www.bis.org/publ/bcbs257.htm.
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Memorandum – July 8, 2013

An exposure to an investment fund that generally would meet the definitionof a “traditional securitization” 13 (as defined in the Final Rule) and that has“greater than immaterial leverage” (a phrase that is not defined) will be
subject to a risk-weight of 600%. Accordingly, investments in funds withmaterial amounts of leverage and that otherwise meet the definition of a
traditional securitization may be subject to higher capital requirements. Most
private equity funds should have immaterial leverage, particularly if debt
under so-called “subscription line facilities” (which involve debt that iscollateralized by uncalled capital commitments and eventually repaid out of
capital calls) is excluded from the analysis.
•

Alternatives to Credit Ratings—Consistent with the mandate of Dodd-Frank,
the Final Rule adopts alternatives to credit ratings for calculating the riskweighting for certain assets. 14 This is a significant departure from thereliance on credit ratings that had been sanctioned previously by regulators.

The Final Rule also introduces new quantitative and qualitative disclosure requirements for
top-tier banking organizations domiciled in the United States with $50 billion or more in total
assets. The required disclosures would be both quantitative and qualitative in nature, withquantitative disclosures to be made quarterly and qualitative disclosures to be made annually.
Banking organizations would have some flexibility in determining the appropriate medium andlocation of disclosure, but management is encouraged to provide all of the required disclosuresin one place on an entity’s public website.
The precise quantitative and qualitative disclosures to be made are outlined in 10 tables that areincluded in the Final Rule. Among other things, banking organizations would need tosummarize the main terms and conditions of their regulatory capital instruments, provide
details on capital adequacy (including specific capital ratios and disclosure of any limitations on
distributions and discretionary bonus payments resulting from the capital conservation buffer),
make disclosures related to counterparty risk and credit mitigation, and provide information on
securitization transactions and the management of interest rate risk.

13

The definition of “traditional securitization” specifically excludes exposures to an “investment
fund,” which is defined as a company (i) where all or substantially all of the assets of the fund arefinancial assets and (ii) that has no material liabilities.

14

For example, in determining the risk-weight of certain exposures to non-U.S. sovereigns and nonU.S. public sector entities, the Final Rule uses the OECD’s CRC model. And for determining therisk-weight of corporate exposures, it adopts a definition of “investment grade” that is based on an
approach that the OCC implemented in its investment securities regulations; namely, it treats 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.
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Memorandum – July 8, 2013

2.

The Advanced Approach

The advanced approach for calculating risk-weighted assets is revised under the Final Rule toincorporate certain aspects of Basel III and Dodd-Frank, including those related to thesecuritization framework, 15 treatment of counterparty credit risk, 16 and disclosure requirements
regarding capital instruments and securitization exposures. These modifications are designed
to ensure that advanced approaches banking organizations hold higher levels of capital forthese exposures and are more transparent about such exposures. To recognize the higher
correlation of financial institutions’ creditworthiness due to sensitivity to common risk factors,
and consistent with Basel III, the Final Rule increases capital requirements for exposures to nonregulated financial institutions and to regulated financial institutions with consolidated assets
greater than or equal to $100 billion. The changes are designed to increase the risk sensitivity ofinternationally active banks to counterparty risk and interconnectedness among financial
institutions.
F.

MARKET RISK CAPITAL RULE AND PROPOSED AMENDMENTS

The Final Rule also would integrate the banking agencies’ existing market risk capital rule into
the comprehensive capital framework and implement the market risk capital rule for savings
associations and covered SLHCs whose trading activity (the gross sum of its trading assets andtrading liabilities) is equal to 10% or more of its quarter-end total assets or $1 billion or more.
Contemporaneous with the release of the Final Rule, the Federal Reserve Board issued aproposal to amend the market risk capital rule by (i) revising the treatment under the current
market risk rule of the specific risk-weights for sovereign exposures, non-publicly tradedmutual funds, and certain student loans that are securitized and traded; and (ii) clarifying thetiming of disclosures required under the current market risk rule to better align the rule withtransition provisions of the new comprehensive capital framework.

15

These revisions also include replacing references to credit ratings with alternative standards ofcreditworthiness consistent with Section 939A of Dodd-Frank. The Final Rule removes the ratingsbased and the internal assessment approaches for securitization exposures from the rules currently
applicable to advanced approaches banking organizations. Instead, an advanced approaches
banking organization will calculate its capital requirement for securitization exposures using either
the supervisory formula approach (SFA) or the simplified supervisory formula approach (SSFA)
under the Final Rule.

16

To address shortcomings revealed by the financial crisis, the Final Rule includes a higher
counterparty credit risk capital requirement, consistent with Basel III, to account for credit valuation
adjustments (“CVA”). The CVA is the fair value adjustment that reflects counterparty credit risk inthe valuation of an over-the-counter derivative contract. The Final Rule also would make changes tothe internal models methodology under the advanced approach, requiring banking organizations to
consider stressed inputs when calculating their capital requirements for counterparty credit risk.

Page 17

Memorandum – July 8, 2013G.

ADDITIONAL CAPITAL-RELATED INITIATIVES AROUND THE CORNER

In his prepared remarks at the Federal Reserve Board’s meeting on July 2, 2013, Governor
Tarullo highlighted four additional capital-related initiatives, in “various stages ofdevelopment,” that will apply to the eight U.S. G-SIBs:•

G-SIB Capital Surcharge—A notice of proposed rulemaking, possibly “late thisyear,” to implement the G-SIB surcharge applicable to the eight U.S. banking
organizations identified as having global systemic importance.

•

Heightened Leverage Ratio—A notice of proposed rulemaking, which is “veryclose to completion,” that will establish a leverage ratio threshold above therequired minimum under Basel III. Governor Tarullo said the minimum
leverage ratio “seems to have been set too low to be an effective counterpart
to the combination of risk-weighted capital measures that have been agreed
internationally.”•

Total Equity and Long-Term Debt— A notice of proposed rulemaking “in thenext few months” concerning the combined amount of equity and long-term
debt that very large banking organizations should maintain in order tofacilitate orderly liquidation in appropriate circumstances.

•

Capital Charge Related to Short-Term Wholesale Funding—An advance notice ofproposed rulemaking that would require “additional measures that would
directly address risks related to short-term wholesale funding, including arequirement that large firms substantially dependent on such funding holdadditional capital.”**

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Memorandum – July 8, 2013

For more information, please contact a member of Simpson Thacher’s Financial Institutions
Group.
Lee Meyerson(212) 455-3675
lmeyerson@stblaw.com

Stacie McGinn(212) 455-2250
smcginn@stblaw.com

Andy Keller(212) 455-3577
akeller@stblaw.com

Maripat Alpuche(212) 455-3971
malpuche@stblaw.com

Mark Chorazak(212) 455-7613
mchorazak@stblaw.com

Elizabeth Cooper(212) 455-3407
ecooper@stblaw.com

Lesley Peng
(212) 455-2202
lpeng@stblaw.com

Roxane Reardon(212) 455-2758
rfreardon@stblaw.com

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 19

Memorandum – July 8, 2013

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