DODD-FRANK ACT

Hybrid Capital 

Instruments and Small 

Institution Access to 

Capital

Report to Congressional Committees

January 2012

GAO-12-237

United States Government Accountability Office

GAO
United States Government Accountability Office

Highlights of GAO-12-237, a report to 

congressional committees 

January 2012

DODD-FRANK ACT

Hybrid Capital Instruments and Small Institution 

Access to Capital

Why GAO Did This Study

Hybrid capital instruments are 

securities that have characteristics of

both equity and debt. The Federal 

Reserve allowed bank holding 

companies to include limited 

amounts of hybrid instruments

known as trust preferred securities in 

the highest level of required capital

(Tier 1), although other federal 

banking regulators never approved 

these or other hybrid instruments for 

this purpose. Responding to 

concerns that these instruments did 

not perform well during the 2007-

2009 financial crisis, in 2010 the 

Dodd-Frank Wall Street Reform and 

Consumer Protection Act (DoddFrank Act) required regulators to 

establish rules that will exclude the 

instruments from Tier 1 capital and 

required GAO to study the possible 

effects of this provision. This report 

addresses (1) the use, benefits, and 

risks of hybrid instruments as Tier 1 

capital; (2) the potential effects of the 

exclusion on banking institutions and 

the economy; and (3) options for 

smaller banking institutions to access 

regulatory capital. For this work, 

GAO analyzed data from financial 

regulatory filings and other sources, 

interviewed regulators and market 

participants, conducted economic 

analysis, and surveyed smaller 

banking institutions. 

GAO makes no recommendations in 

this report. GAO provided a draft to 

the banking regulators for their 

review and comment. FDIC and the 

Federal Reserve provided technical 

comments that were incorporated, as 

appropriate.

What GAO Found

Tier 1 hybrid capital instruments, particularly trust preferred securities, have been 

heavily used by bank holding companies because of their financial advantages, 

but they are not as effective in absorbing losses as traditional forms of Tier 1 

capital, such as common equity. As of December 31, 2010, almost two-thirds of 

all top-level bank holding companies that were subject to capital requirements 

included hybrid instruments in their Tier 1 capital, for a total value of $157 billion.

Hybrid instruments such as trust preferred securities have offered institutions the 

benefit of lower-cost capital, largely because of their debt-related features—

including tax-deductible dividends. These instruments also are accessible to a 

broader range of potential investors. However, trust preferred securities do not 

absorb losses like other Tier 1 instruments because of their obligation to repay 

principal and dividends. Trust preferred securities may provide limited financial 

flexibility in times of stress, but they may also hinder efforts to recapitalize

troubled banking institutions. 

Eliminating Tier 1 hybrid capital likely will have modest negative effects on the 

existing capital measures of individual banking institutions and lending and could 

improve institutions’ financial stability. Few institutions will fall below minimum 

regulatory capital levels without Tier 1 hybrid instruments, and banking 

institutions’ overall safety and soundness should improve with higher reliance on 

common equity. GAO’s analysis of the relationship between bank regulatory 

capital and lending activity suggests that any negative effects on the cost and 

availability of credit should be small, but the exact impact is unknown. Market 

participants said that losing access to tax-advantaged Tier 1 instruments could 

place U.S. institutions at a competitive disadvantage, as some foreign banks may 

still have access to such instruments. The international competitive effects are 

unclear, however, given the scope of ongoing worldwide regulatory reforms. 

Smaller banking institutions, which often had larger proportions of hybrid 

instruments as Tier 1 capital, have limited options for raising regulatory capital 

but indicated little unmet need for it. These smaller institutions now have access 

primarily to common equity raised from private sources. GAO’s survey results 

showed that smaller institutions consider their financial condition and 

performance as the most important factor affecting their ability to raise capital. 

Market participants identified challenges that could impact smaller institutions’ 

ability to raise capital, including limitations related to the size of capital raised,

liquidity, and return potential for investors. However, GAO estimated that most 

smaller institutions (65 percent) had not raised regulatory capital since January 1, 

2008, and of these, a large majority (88 percent) indicated that they had no need 

or interest in raising more. Further, most smaller institutions that had raised 

capital since 2008 were satisfied with the amount and terms involved. Only a 

small percentage of institutions (3 percent) that had attempted to raise capital 

since January 1, 2008, were unable to do so. Institutions with a stronger financial 

condition generally had a more favorable view of the capital raising environment. 

View GAO-12-237. For more information, 

contact Thomas McCool at (202) 512-2642 or 

mccoolt@gao.gov. 
Page i GAO-12-237 Hybrid Capital Instruments

Letter 1 

Background 5

Hybrid Instruments, While Popular with Holding Companies, Do 

Not Absorb Losses Well 12

Excluding Tier 1 Hybrid Capital Likely Will Have Limited Negative 

Effects 25

Smaller Banking Institutions Face Limited Capital-Raising Options 

but Report Little Unmet Capital Need 42

Agency Comments 52

Appendix I Objectives, Scope, and Methodology 53

Appendix II GAO Analysis of the Economic Effects of the Hybrid 

Capital Exclusion 59

Appendix III Responses to Questions from GAO’s Survey of Smaller Banking 

Institutions 67

Appendix IV GAO Contact and Staff Acknowledgments 80

Tables

Table 1: Capital Instruments 8

Table 2: Banking Institution Capital Requirements 26

Table 3: Tier 1 Ratio Capital Categories of Top-Level Bank Holding 

Companies with Tier 1 Hybrids, as of December 31, 2010 27

Table 4: Leverage Ratio Capital Categories of Top-Level Bank 

Holding Companies with Tier 1 Hybrid Instruments, as of 

December 31, 2010 29

Table 5: Effects of Implied Capital Deficits on Loan Volumes and 

Lending Spreads for Institutions with More Than $15 

Billion in Assets 34

Table 6: Estimates of Tier 1 Hybrid Exclusion on Loan Rates under 

Different Illustrative Scenarios 37

Contents
Page ii GAO-12-237 Hybrid Capital Instruments

Table 7: Population, Sample Size, and Respondent Information for 

GAO Survey 57

Table 8: Data Used in VAR Model 61

Table 9: Relevant Studies on the Impact of Capital on Lending 

Activity 64

Table 10: How Likely Is It That Your Institution Would Be Able to 

Raise the Following Types of Regulatory Capital at 

Acceptable Cost, Terms, and Conditions within the Next 

Year? 67

Table 11: How Important Are Each of the Following Factors in 

Determining Your Institution’s Ability to Successfully 

Raise Capital? 68

Table 12: If Your Institution Had to Replace 10 Percent of Its Tier 1 

Capital Within 2 Years, How Likely Is It That It Would Do 

Each of the Following? 70

Table 13: If Your Institution Had to Replace 10 Percent of Its Tier 1 

Capital Within 5 Years, How Likely Is It That It Would Do

Each of the Following? 72

Table 14: Has Your Institution Raised Regulatory Capital Since 

January 1, 2008? 73

Table 15: During Which of the Following Time Periods Did Your 

Institution Raise Capital? For the Time Period, Consider 

the Date of Offering or Issuance. 73

Table 16: Did the Amount of Regulatory Capital Your Institution 

Raised Meet Its Target/Goal? 74

Table 17: Did the Regulatory Capital Your Institution Raised Meet 

Its Initial Terms and Conditions? 74

Table 18: What Types of Regulatory Capital Has Your Institution 

Raised Since January 1, 2008? 74

Table 19: What Were the Reasons Your Institution Did Not Raise 

Regulatory Capital Since January 1, 2008? 75

Table 20: In Your Opinion, How Challenging, If at All, Is the Current 

Regulatory Capital-Raising Environment for Your 

Institution? 76

Table 21: How Challenging, If at All, Are Each of the Following 

Factors in Your Institution’s Ability to Raise Regulatory 

Capital? 76

Table 22: How Does the Current Ability of Your Institution to Raise 

Regulatory Capital Compare to the Ability to Raise 

Regulatory Capital Prior to the Recent Financial Crisis 

(Consider the Time Period before 2008)? 78
Page iii GAO-12-237 Hybrid Capital Instruments

Table 23: Prior to January 1, 2008, How Beneficial, If at All, to Your 

Institution’s Access to Regulatory Capital Was Its Ability to 

Issue Trust Preferred Securities (Including Pools of Trust 

Preferred Securities)? 78

Table 24: In Your View, How Will the Following Recent and 

Proposed Changes to Regulatory Capital Requirements 

Affect Your Institution’s Ability to Raise Regulatory 

Capital, If at All? 79

Figures 

Figure 1: Change in Tier 1 Eligibility of Capital Instruments 

Required by the Dodd-Frank Act 10

Figure 2: Framework of Trust Preferred Securities 11

Figure 3: Percentage of Top-Level Bank Holding Companies with 

Tier 1 Hybrid Instruments, 1997-2010 14

Figure 4: Value of Hybrid Instruments in Bank Holding Company 

Tier 1 Capital, 1997-2010 15

Figure 5: Average Percentage of Tier 1 Capital Held in Hybrid 

Instruments by Institutions Using Hybrid Capital, 1997-

2010 17

Figure 6: Amount of Trust Preferred Securities Eligible for Tier 1 

Capital Treatment under the Federal Reserve’s Rules for 

Bank Holding Companies, 1997-2010 19

Figure 7: Illustrative Cost-Benefit Example of Trust Preferred 

Securities 20

Figure 8: Smaller Banking Institutions’ Capital Offerings, 2000-2011 44

Figure 9: Perceived Ability of Smaller Institutions to Successfully 

Raise Capital, as of August 15, 2011 46

Figure 10: Capital-Raising Activity among Smaller Institutions since 

January 1, 2008, as of August 15, 2011 49

Figure 11: Smaller Institutions’ Views of the Capital-Raising 

Environment by Supervisory Rating, as of August 15, 2011 51
Page iv GAO-12-237 Hybrid Capital Instruments

Abbreviations

Basel Committee Basel Committee on Banking Supervision 

C&I commercial and industrial loans 

Dodd-Frank Act Dodd-Frank Wall Street Reform and Consumer 

Protection Act

FDIC Federal Deposit Insurance Corporation 

Federal Reserve Federal Reserve System 

GDP gross domestic product 

IRS Internal Revenue Service 

OCC Office of the Comptroller of the Currency 

OLS ordinary least squares 

OTS Office of Thrift Supervision 

REIT real estate investment trust 

SEC Securities and Exchange Commission 

TARP Troubled Asset Relief Program 

VAR vector autoregression

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Page 1 GAO-12-237 Hybrid Capital Instruments

United States Government Accountability Office 

Washington, DC 20548

January 18, 2012

The Honorable Tim Johnson

Chairman

The Honorable Richard C. Shelby

Ranking Member

Committee on Banking, Housing, 

 and Urban Affairs

United States Senate

The Honorable Spencer Bachus

Chairman

The Honorable Barney Frank

Ranking Member 

Committee on Financial Services

House of Representatives

Capital is critical to banking institutions’ ability to absorb unexpected 

losses and continue operating by making loans to businesses and 

consumers. Regulators require institutions to maintain certain levels of 

capital to promote stability across the banking industry and protect the 

nation’s financial system. One type of capital is hybrid instruments, which 

have characteristics of both equity and debt. In 1996, the Board of 

Governors of the Federal Reserve System (Federal Reserve) began 

allowing bank holding companies to count a limited amount of certain 

hybrid instruments—known as trust preferred securities—as a portion of 

their Tier 1, or highest quality, capital.1

 

1

Tier 1 capital is considered the most stable and readily available capital that a banking 

institution can have to support its operations by absorbing unexpected financial losses. It 

consists of core capital elements, such as common stockholder’s equity and 

noncumulative perpetual preferred stock. Other classes of capital include Tier 2, which 

consists of supplementary capital elements such as loan loss reserves, subordinated debt, 

and other instruments.

Trust preferred securities offer tax 

advantages that make them cheaper than other forms of Tier 1 capital 

and as a result have been the most popular type of hybrid capital 

 
 

Page 2 GAO-12-237 Hybrid Capital Instruments

instrument.2

However, regulators have not allowed depository institutions (banks and 

savings associations/thrifts) to use these types of hybrid instruments to 

meet Tier 1 capital requirements, including the Federal Reserve, the

Federal Deposit Insurance Corporation (FDIC), the Office of the 

Comptroller of the Currency (OCC), and the Office of Thrift Supervision 

(OTS).

At the end of 2009, their use was widespread, and bank 

holding companies held over $162 billion in hybrid instruments as part of 

required capital. In recent years, approximately two-thirds of bank holding 

companies and nearly all the largest bank holding companies have used 

hybrid instruments such as trust preferred securities to meet regulatory 

capital requirements. Smaller institutions have also relied on hybrid 

instruments issued jointly through pools to access needed capital.

3 FDIC in particular has argued that trust preferred securities do not 

provide a degree of capital support consistent with Tier 1 capital status. 

Further, following the 2007-2009 financial crisis, some market participants 

and observers raised concerns that trust preferred securities and other 

hybrid instruments did not perform as well as other forms of capital in 

helping institutions withstand financial stress. In response, the Dodd-Frank 

Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) of 2010 

directed regulators to implement requirements that will effectively exclude

most forms of hybrid instruments, including trust preferred securities, from 

Tier 1 capital for bank and thrift holding companies.

4

 

2

Trust preferred securities are cumulative preferred stock instruments issued by a specialpurpose entity (usually in the form of a trust) established by a bank holding company. The 

bank holding company issues subordinated debt to the special-purpose entity which uses 

the bank holding company’s interest payments on the debt to make payments to the 

preferred stock investors.

Specifically, Section 

171 of the Dodd-Frank Act, also known as the Collins Amendment, 

requires banking regulators to establish rules that will subject certain bank 

holding companies to the same capital requirements that apply to insured 

depository institutions. The Dodd-Frank Act includes grandfathering and 

phase-in provisions for existing instruments, but because of the exclusions, 

trust preferred securities and other hybrid instruments issued on or after 

May 19, 2010, will no longer be a viable source of new Tier 1 capital for 

bank holding companies subject to Tier 1 capital requirements. 

3

Section 313 of the Dodd-Frank Act abolished OTS, and section 312 distributed its 

regulatory functions among the Federal Reserve, FDIC, and OCC.

4

Pub. L. No. 111-203, 124 Stat. 1376 (2010).
 

Page 3 GAO-12-237 Hybrid Capital Instruments

Some observers have had concerns about the potential impact that 

excluding hybrid instruments from Tier 1 capital may have on the cost and 

availability of credit and the international competitiveness of U.S. banking 

institutions. Additionally, concerns exist that the hybrid capital exclusion 

may limit access to regulatory capital for smaller institutions, many of 

which relied on pooled offerings of trust preferred securities as a unique 

form of access to public capital markets.5

To describe the regulatory use of Tier 1 hybrid capital instruments, we 

analyzed banking institutions’ regulatory financial filings and reviewed the 

relevant federal banking regulations. To describe the benefits and risks of 

including hybrid instruments as Tier 1 capital, we reviewed studies from 

federal regulators, industry participants and observers, and academic 

sources. We conducted interviews with banking institutions, investment 

banks, credit rating agencies, law firms, industry associations, and each 

of the federal banking regulators. To evaluate the potential effects on 

banking institutions and the economy of prohibiting the use of hybrid 

instruments to meet Tier 1 capital requirements, we created a framework 

for our analysis that synthesized the findings and methodologies of 

existing studies on the economic and institutional effects of changes to 

bank capital requirements. We analyzed data on regulatory capital to 

determine the extent to which banking institutions may fall below 

minimum regulatory capital levels without Tier 1 hybrid instruments. We 

reviewed studies and compared U.S. regulatory policy with the 

international framework on hybrid capital proposed by the Basel 

Section 174 of the Dodd-Frank 

Act required GAO to study banking institutions’ use of hybrid capital 

instruments as a component of Tier 1 capital. In addition, Section 171 and 

Section 174 of the Dodd-Frank Act required us to study access to capital 

for smaller banking institutions. Accordingly, this report fulfills the two 

mandates by examining (1) the use of hybrid capital instruments as Tier 1 

capital and the benefits and risks of including them in this category, (2) 

the potential effects on banking institutions and the economy of 

prohibiting the use of hybrid instruments to meet Tier 1 capital 

requirements, and (3) options that exist for smaller banking institutions to 

access regulatory capital.

 

5

The securities created from this pooling process, or securitization, were in the form of 

collateralized debt obligations (CDO), complex structured financial products involving a

group of loans or debt securities that are pooled and used to issue securities in different 

tranches. These tranched CDO securities vary in risk and return depending on how the 

underlying cash flows produced by the pooled assets are allocated.
 

Page 4 GAO-12-237 Hybrid Capital Instruments

Committee on Banking Supervision. We also interviewed regulators, 

industry participants and observers, and European regulatory 

organizations to gather information on the possible effects of the hybrid 

capital exclusion on the international competitiveness of U.S. institutions. 

To examine the options that exist for smaller banking institutions to 

access capital, we conducted a nationally representative web-based 

survey of executives of banks, thrifts (savings associations), and bank 

and thrift holding companies with less than $10 billion in total assets. The 

survey identified their activities and experiences raising regulatory capital 

since January 1, 2008. The weighted response rate for this survey was 66 

percent. All percentage estimates based on these survey results included 

in this report have a margin of error of plus or minus 7 percentage points 

or less. We also interviewed regulators and industry participants and 

observers regarding smaller institutions’ options for and challenges 

associated with raising regulatory capital. To identify trends in the amount 

and types of regulatory capital raised since 2000, we analyzed Securities 

and Exchange Commission (SEC) data on public capital issuances. 

Appendixes I and II contain a more detailed discussion of our scope and 

methodology, and survey results can be found in appendix III.

For parts of our methodology that involved the analysis of computerprocessed data, we assessed the reliability of these data and determined 

that they were sufficiently reliable for our purposes. Specifically, we 

accessed Federal Reserve regulatory capital data for holding companies 

and SEC capital issuance data through SNL Financial, a private data 

provider that collects information from a variety of sources and enters it 

into a proprietary database using standardized accounting templates. We 

conducted reliability assessments on the SNL Financial data and on thrift 

holding company data collected from OTS. To assess the reliability of 

these data, we reviewed factors such as the timeliness, accuracy, and 

completeness of data. We conducted electronic testing and manual 

review to identify missing and out-of-range data and other anomalies, and 

compared computer-generated data to source documents for a selected 

sample of companies.

We conducted this performance audit from December 2010 to January 

2012 in accordance with generally accepted government auditing 

standards. Those standards require that we plan and perform the audit to 

obtain sufficient, appropriate evidence to provide a reasonable basis for 

our findings and conclusions based on our audit objectives. We believe 

that the evidence obtained provides a reasonable basis for our findings 

and conclusions based on our audit objectives.
 

Page 5 GAO-12-237 Hybrid Capital Instruments

Capital reassures an institution’s depositors, creditors, and counterparties 

that unanticipated losses or decreased earnings will not impair a financial 

institution’s ability to repay its creditors or protect the savings of 

depositors. In general, capital represents the share of an institution’s 

assets with no obligation for repayment, although this condition varies for 

less traditional forms of capital such as some hybrid instruments. 

Because capital generally does not have to be repaid, it can serve as a 

buffer against declines in asset values without subjecting an institution to 

default or insolvency. Capital typically is provided by a banking 

institution’s owners or through earnings that are retained by the firm. 

When institutions experience financial losses, the value of the firm 

represented by the owner’s stake (including retained earnings) is reduced 

first, thus protecting bank depositors and other creditors from loss.

Capital instruments vary in structure and their ability to absorb loss while 

preventing a banking institution from defaulting on its contractual 

repayment obligations. The strongest form of capital is common equity (or 

common stock), which carries no repayment obligation for principal or 

dividends, has the lowest payment priority in bankruptcy, and has no 

maturity date. Debt instruments are a weaker form of capital funding than 

common equity, as they require periodic interest payments and 

repayment of principal at maturity. Debt also has a higher claim than 

common equity in bankruptcy. Some debt instruments may qualify as 

capital if they contain certain equitylike characteristics such as a long 

maturity, subordination to other creditors, or ability to defer payments. 

Some hybrid instruments fall into this category, while others share more 

of the characteristics of common equity.

Three federal regulators oversee what we refer to as banking institutions 

in this report (that is, banks, savings associations (thrifts), and their 

holding companies). The Federal Reserve is the primary regulator for 

state-chartered member banks (i.e., state-chartered banks that are 

members of the Federal Reserve System) and bank and thrift holding 

companies. OCC is the primary regulator of federally chartered banks and 

thrifts, and FDIC is the primary regulator for state-chartered nonmember 

banks (i.e., state-chartered banks that are not members of the Federal 

Reserve System) and state-chartered thrifts. In addition, FDIC insures the 

deposits of all federally insured banks, generally up to $250,000 per 

depositor. Prior to July 21, 2011, OTS was the primary regulator of 

federally and state-chartered thrifts and thrift holding companies.

Because of capital’s important role in absorbing losses, promoting 

confidence, and protecting depositors, federal banking law requires 

Background
 

Page 6 GAO-12-237 Hybrid Capital Instruments

banking institutions to maintain adequate capital. Federal banking 

regulators set the minimum capital levels to ensure that the institutions 

they regulate maintain adequate capital. Federal law also authorizes 

banking regulators to take a variety of actions to ensure capital adequacy, 

including informal and formal enforcement actions. In implementing the 

statutory requirements, regulators generally expect institutions to hold 

capital at levels higher than regulatory minimums, with specific 

expectations based on institutions’ risk profiles.

The United States, along with nearly all other major economies, agrees to 

comply with international capital standards set by the Basel Committee on 

Banking Supervision (the Basel Committee). The Basel Committee, which 

comprises representatives of central banks and banking regulators from 

26 countries, issued its first set of international guidelines on bank capital 

(commonly known as “Basel I”) in 1988. These guidelines included 

standards for the amount of capital banks should hold and the nature of 

the capital instruments that banks could count toward meeting these 

amounts. In 1998, the Basel Committee specified the characteristics of 

instruments that would either qualify as the highest quality (Tier 1) capital 

or would not meet this standard but could be eligible as lesser-quality 

(Tier 2) regulatory capital. For example, in order for instruments to be 

considered Tier 1 capital, the Basel Committee stated that instruments

would need to meet certain criteria including deferability of dividends on a 

noncumulative basis, ability to absorb losses before the bank entered 

bankruptcy, permanence, and discretion over the amount and timing of 

distributions.

6 Common equity best meets all of the qualifications of Tier 1 

capital and thus should comprise the predominant share of Tier 1 under 

Basel guidelines. The Basel Committee standards have been revised 

several times since 1988, including most recently with the Basel III 

reforms released in 2010.7

 

6

Basel Committee on Banking Supervision press release, “Instruments eligible for 

inclusion in Tier 1 capital” (Oct. 27, 1998).

Banking institutions subject to the Basel 

agreements are due to begin implementing some of the recently revised 

standards in 2013.

7

For more information on prior revisions to Basel Committee capital standards, see GAO, 

Risk-Based Capital: New Basel II Rules Reduced Certain Competitive Concerns, but Bank 

Regulators Should Address Remaining Uncertainties, GAO-08-953 (Washington, D.C.: 

Sept. 12, 2008); and Risk-Based Capital: Bank Regulators Need to Improve Transparency 

and Overcome Impediments to Finalizing the Proposed Basel II Framework, GAO-07-253

(Washington, D.C.: Feb. 15, 2007). 
 

Page 7 GAO-12-237 Hybrid Capital Instruments

While definitions of hybrid capital vary, in this report we use “hybrid 

capital” and “hybrid instruments” to refer to those instruments that 

comprise what the Federal Reserve calls “restricted core capital 

elements”: cumulative perpetual preferred stock, trust preferred 

securities, certain types of minority interest, and mandatory convertible 

trust preferred securities (see table 1).8 These instruments include some 

but not all of the characteristics that the Basel Committee identified in 

1998 as necessary for Tier 1 capital. Nonetheless, the Federal Reserve

has allowed bank holding companies to include these instruments as Tier 

1 capital.9 Specifically, the Federal Reserve permits restricted core capital 

elements in Tier 1 capital in an amount of up to 25 percent of a bank 

holding company’s total core capital elements after deducting goodwill.

10

Other than these hybrid instruments, the Federal Reserve subjects bank 

holding companies to capital requirements that are generally similar to 

those for depository institutions.11

 

8

Restricted core capital also includes subordinated debt issued by bank holding 

companies electing to be taxed under Subchapter S of Chapter 1 of the Internal Revenue 

Code or bank holding companies organized in mutual form to the Department of the 

Treasury under the Troubled Asset Relief Program.

For example, in addition to common 

9

The 1988 Basel I framework—which federal banking regulators adopted in 1989—

introduced the Tier 1 capital category to internationally active banks. The Federal Reserve 

also voluntarily applied the standards to U.S. bank holding companies with the exception 

that holding companies could include the restricted core capital elements in Tier 1 capital 

on a limited basis. Although thrift holding companies also used hybrid capital instruments, 

OTS did not formally subject these institutions to uniform Tier 1 capital requirements but 

informally held them to similar standards as bank holding companies. For this purpose, 

OTS allowed thrift holding companies to include trust preferred securities in its proxy 

calculation of Tier 1 capital.

10The Federal Reserve defines core capital elements as common stockholders’ equity, 

noncumulative perpetual preferred stock, a certain type of minority interest related to 

common or noncumulative perpetual preferred stock issued by a depository institution, 

and restricted core capital elements. Tier 1 capital includes the sum of core capital 

elements less intangible assets and other items. The Federal Reserve applied a 15 

percent limit for large internationally active bank holding companies (generally those with 

greater than $250 billion in total assets), with an additional 10 percent allowed in the form 

of mandatory convertible trust preferred securities. Although the 15 percent restriction did 

not officially go into effect until 2011, agency officials said the Federal Reserve has 

informally requested that these large holding companies observe the limit since 1999.

11One type of restricted minority interest, known as Class C minority interest, relates to 

common equity and perpetual preferred shares issued by a nonbank consolidated 

subsidiary. Although the Federal Reserve considers this capital element as restricted core 

capital for bank holding companies, other bank regulators allow their supervised 

institutions to include this type of minority interest in Tier 1 if it relates to common equity 

and noncumulative perpetual preferred shares.

Regulatory Treatment of 

Hybrid Instruments
 

Page 8 GAO-12-237 Hybrid Capital Instruments

equity, all U.S. banking regulators recognize noncumulative perpetual 

preferred securities as a component of Tier 1 capital. Similarly, minority 

interests relating to common equity or noncumulative perpetual preferred 

securities are recognized as Tier 1 capital.

Table 1: Capital Instruments

Instrument Definition

Common stock Voting stock that represents ownership and does not have to be repaid. Dividend 

payments are not required unless declared and their amount is fully discretionary. 

Lowest priority in bankruptcy. 

Noncumulative perpetual preferred stock Nonvoting stock that represents ownership and does not have to be repaid. Entitles 

its holders to some preference or priority over the owners of common stock, usually 

regarding payment of dividends or asset distributions in a bankruptcy liquidation. 

Dividend payments are not required unless declared or made to holders of common 

stock. Dividend payment amounts are fixed but unpaid dividends do not 

accumulate. Lower bankruptcy priority than all capital instruments other than

common stock.

Minority interest relating to common stock or 

noncumulative perpetual preferred stock 

issued by a consolidated subsidiary

Ownership by third-party investors of common or noncumulative perpetual preferred 

stock issued by a banking institution’s subsidiary. The bank or bank holding 

company controls the subsidiary and consolidates the subsidiary on its balance 

sheet. The subsidiary may be a bank or nonbank entity.

Cumulative perpetual preferred stock Nonvoting stock that represents ownership and does not have to be repaid. Entitles 

its holders to some preference or priority over the owners of common stock, usually 

regarding payment of dividends or asset distributions in a bankruptcy liquidation. 

Dividend payments are not required unless declared and payments are fixed. No 

common stock dividends can be paid until accumulated dividends are paid. Lower 

bankruptcy priority than all capital instruments other than common stock.

Minority interest relating to cumulative 

perpetual preferred stock issued by a 

consolidated subsidiary

Ownership by third-party investors of cumulative perpetual preferred stock issued 

by a banking institution’s subsidiary. The bank or bank holding company controls 

the subsidiary and consolidates the subsidiary on its balance sheet. The subsidiary 

may be a bank or nonbank entity.

Trust preferred securities Cumulative preferred stock issued by a special-purpose entity (usually in the form of 

a trust) established by a bank holding company. The bank holding company issues 

subordinated debt to the special-purpose entity, which uses the bank holding 

company’s interest payments on the debt to make payments to the preferred stock 

investors. Dividends are required unless a negative declaration is made and unpaid 

dividends accrue.

Mandatory convertible trust preferred securities A bank holding company jointly issues to investors trust preferred securities and a 

forward purchase contract that obligates the investors to purchase a fixed amount 

of the bank holding company’s common stock, usually in 3 years. The investors 

place the trust preferred securities as collateral for the forward purchase contract. 

The common stock replaces the trust preferred securities as a component of the 

bank holding company’s Tier 1 capital, and the trust preferred securities are 

excluded from its regulatory capital.

Source: GAO analysis of regulatory documents and other information.
 

Page 9 GAO-12-237 Hybrid Capital Instruments

As figure 1 illustrates, provisions in the Dodd-Frank Act require banking 

regulators to establish rules that will effectively subject bank and thrift 

holding companies to regulatory capital requirements that are at least as 

stringent as those applicable to insured depository institutions, thereby 

effectively eliminating hybrid capital instruments from Tier 1 capital. The 

restrictions will apply immediately to capital instruments issued on or after 

May 19, 2010. Only bank holding companies with less than $500 million 

in total assets are exempt from the Dodd-Frank Act hybrid capital 

exclusion.12

 

12For the purposes of this report, total assets refers to a holding company’s total 

consolidated assets.

Bank holding companies with between $500 million and $15 

billion in total assets and thrift holding companies with less than $15 

billion in total assets will be allowed to continue including hybrid 

instruments issued prior to May 19, 2010, in Tier 1 capital but may not 

use any hybrid instruments issued on or after that date. Bank and thrift 

holding companies with more than $15 billion in total assets will be 

required to phase out all of their Tier 1 hybrid capital issued prior to May 

19, 2010, over a 3-year period from 2013 to 2016. The act subjects thrift 

holding companies to the same provisions as bank holding companies, 

except for thrift holding companies with less than $500 million in total 

assets. These institutions are treated the same as bank holding 

companies with between $500 million and $15 billion in total assets.
 

Page 10 GAO-12-237 Hybrid Capital Instruments

Figure 1: Change in Tier 1 Eligibility of Capital Instruments Required by the Dodd-Frank Act

Notes: Does not include instruments issued pursuant to the Department of the Treasury’s Troubled 

Asset Relief Program (TARP). 

a

Prior to July 21, 2011, the Office of Thrift Supervision (OTS) regulated thrift holding companies and 

did not formally subject these institutions to uniform capital requirements. However, OTS generally 

held thrift holding companies to similar standards as bank holding companies. On July 21, 2011, the 

Federal Reserve assumed regulatory responsibility for thrift holding companies. 

b

Prior to July 21, 2011, OTS was the primary regulator of federally and state-chartered thrifts. 

c

The amount eligible for Tier 1 capital is subject to limits if issued by a nondepository subsidiary. 

d

The amount eligible for Tier 1 capital is subject to limits. 

Trust preferred securities have been the most common form of Tier 1 

hybrid instrument among bank holding companies. The Internal Revenue 

Service (IRS) typically treats these securities as tax deductible, making 

them cheaper than other forms of Tier 1 capital. As figure 2 shows, the 

holding company establishes a special-purpose entity, usually in the form 
 

Page 11 GAO-12-237 Hybrid Capital Instruments

of a trust that holds all of the common equity. The trust issues undated 

cumulative preferred securities to outside investors and uses the 

proceeds to purchase a deeply subordinated unsecured note issued by 

the bank holding company.13

Figure 2: Framework of Trust Preferred Securities

Thus, the issuing trust serves as a conduit 

for exchanging funds between the bank holding company and the 

preferred equity investors. The subordinated note issued by the bank 

holding company is the trust’s sole asset and is senior only to the bank 

holding company’s common and preferred equity. The note has terms 

that generally replicate those of the trust preferred securities, except that 

the junior subordinated note has a fixed maturity of at least 30 years. 

Most trust agreements provide for the trust to terminate when the 

subordinated note matures. When the trust terminates, the trust preferred 

securities must be redeemed.

 

13A subordinated note is a debt instrument that has a claim on assets junior to other debt 

and receives payment only after other debt with a more senior claim has been repaid.
 

Page 12 GAO-12-237 Hybrid Capital Instruments

The trust collects interest payments on the subordinated note from the 

bank holding company that it uses to pay dividends to holders of the trust 

preferred securities. The bank holding company can treat the interest 

payments on the subordinated note as a tax-deductible interest expense. 

The terms of the trust preferred securities allow dividends to be deferred 

for at least 5 years without creating an event of default or acceleration of 

the principal and accrued interest. After the 5-year dividend deferral 

period, if the trust fails to pay the cumulative dividend amount owed to 

investors, an event of default and acceleration occurs, giving investors 

the right to take the subordinated note issued by the bank holding 

company. At the same time, the bank holding company’s obligation to pay 

principal and interest on the underlying junior subordinated note 

accelerates, and the note becomes immediately due and payable.

Many bank holding companies have used hybrid instruments—

predominantly trust preferred securities—to help meet Tier 1 capital 

requirements. In recent years, approximately two-thirds of all top-level 

bank holding companies that are subject to capital requirements 

(generally those with more than $500 million in total assets) have 

included hybrid instruments in their Tier 1 capital (see fig. 3).14

 

14For purposes of this report, top-level bank holding companies are defined as institutions 

that are not owned or controlled by other bank holding companies.

For 

example, December 2010 data filed with the Federal Reserve showed 

that 85 percent of bank holding companies with more than $10 billion in 

total assets and 100 percent of bank holding companies with over $100 

Hybrid Instruments, 

While Popular with 

Holding Companies, 

Do Not Absorb Losses 

Well

Bank Holding Companies 

Relied on Trust Preferred 

Securities for Tier 1 Hybrid 

Capital
 

Page 13 GAO-12-237 Hybrid Capital Instruments

billion in total assets included hybrid instruments in their Tier 1 capital.15

These hybrid instruments had a total value of $157 billion, representing 

13 percent of all bank holding company Tier 1 capital. Of the total $157 

billion in Tier 1 hybrid instruments, trust preferred securities accounted for 

$128 billion (82 percent).16

 

15All top-level bank holding companies with total consolidated assets of $500 million or 

more and select bank holding companies with less than $500 million in total assets file 

annual financial statements with the Federal Reserve on form FR Y-9C, “Consolidated 

Financial Statements for Bank Holding Companies.” Data from SNL Financial collected on 

July 11, 2011, showed that 973 top-level bank holding companies filed FR Y-9C regulatory 

capital data for 2010, of which 86 had less than $500 million in total assets. Additionally, 

the Federal Reserve has not required certain domestic subsidiaries of foreign banking 

institutions to meet capital requirements (for more on this policy, see GAO, Bank Capital 

Requirements: Potential Effects of New Changes on Foreign Holding Companies and U.S. 

Banks Abroad, 

Excluding the largest institutions with over 

$100 billion in total assets, trust preferred securities made up 97 percent 

of the total value of Tier 1 hybrid instruments.

GAO-12-160). These institutions, of which there were four by the end of 

2010, are not included in our analyses. When discussing the use of hybrid capital 

instruments, we assume that institutions included the maximum amount of their reported 

eligible hybrid instruments in Tier 1 up to the Federal Reserve’s limit for their institution 

size. 

16Mandatory convertible trust preferred securities, minority interest, and cumulative 

preferred securities accounted for the remaining 18 percent. See table 1 for descriptions 

of these instruments. 
 

Page 14 GAO-12-237 Hybrid Capital Instruments

Figure 3: Percentage of Top-Level Bank Holding Companies with Tier 1 Hybrid Instruments, 1997-2010

A few very large bank holding companies account for most of the value of 

all Tier 1 hybrid capital instruments. Specifically, the 20 largest bank 

holding companies with more than $100 billion in assets accounted for 85 

percent of bank holding companies’ Tier 1 hybrid capital as of December 

2010 and the four largest companies accounted for over 50 percent. As 

figure 4 shows, the amount of hybrid instruments included in Tier 1 capital 

has grown significantly since 1997. Although the total amount grew as 

institutions’ assets increased, the share of hybrid capital instruments in 

Tier 1 remained relatively consistent over time for the largest institutions. 

For example, in 1997, bank holding companies with more than $100 

billion in total assets that included hybrid instruments in Tier 1 had a total 

of $6 billion of these instruments, or an average of 16 percent of the 

companies’ total Tier 1 capital. By 2010, institutions of this size held $133 

billion in hybrid instruments, but the average percentage of their total Tier 

1 capital had fallen slightly to 14 percent.
 

Page 15 GAO-12-237 Hybrid Capital Instruments

Figure 4: Value of Hybrid Instruments in Bank Holding Company Tier 1 Capital, 1997-2010

As figure 5 shows, among institutions that included hybrid instruments in 

their Tier 1 capital, institutions with less than $10 billion in assets have 

held, on average, a greater percentage of Tier 1 hybrid instruments than 

larger institutions—between 19 percent and 22 percent—in every year 

since 2000. By comparison, for larger bank holding companies, the 

percent of Tier 1 hybrid instruments averaged between 12 percent and 15 

percent in all but 1 year over the same period.17

 

17In 2008, hybrid instruments comprised an average of 20 percent of larger institutions’ 

Tier 1 capital. This increase may be attributable to Troubled Asset Relief Program (TARP) 

investments in the largest banking institutions. Most of these investments in the largest 

institutions were made in the form of cumulative preferred securities. 

One explanation for this 

difference may be that in 2005 the Federal Reserve had imposed a lower 

limit on the percentage of Tier 1 hybrid instruments that large, 
 

Page 16 GAO-12-237 Hybrid Capital Instruments

internationally active institutions could hold than it imposed on smaller 

institutions.18

 

18Under a 2005 rule that came into effect in 2011, the Federal Reserve permitted large, 

internationally active institutions to include hybrid instruments in Tier 1 in the amount of up 

to 15 percent of total core capital elements after the deduction of goodwill. These 

institutions could also include up to an additional 10 percent in the form of mandatory 

convertible trust preferred securities. All other institutions were permitted to include hybrid 

instruments up to 25 percent of total core capital elements after the deduction of goodwill. 

Because under the prior rules the limits were calculated before the deduction of goodwill 

and because final Tier 1 capital generally includes additional deductions from total core 

capital elements for intangible assets and other items, some institutions included hybrid 

instruments at levels above 25 percent of Tier 1 capital. 

Although this lower limit did not formally go into effect until 

March 2011, the Federal Reserve has informally requested that these 

institutions observe this limit since 1999, according to agency officials. As 

of December 2010, none of these institutions were using the maximum 

level of hybrid instruments allowed by the Federal Reserve for institutions 

of their size. By contrast, smaller institutions more frequently used the 

maximum amount of Tier 1 hybrid instruments allowed by the Federal 

Reserve. In 2010, 131 of the 558 smaller bank holding companies that 

included hybrid instruments in their Tier 1 capital included the maximum 

amount.
 

Page 17 GAO-12-237 Hybrid Capital Instruments

Figure 5: Average Percentage of Tier 1 Capital Held in Hybrid Instruments by 

Institutions Using Hybrid Capital, 1997-2010

Compared to bank holding companies, fewer thrift holding companies 

have used trust preferred securities. Prior to the transfer of supervisory 

authority under the Dodd-Frank Act, thrift holding companies were 

supervised by OTS and were not subject to a uniform Tier 1 capital 

requirement. However, OTS examiners did consider use of trust preferred 

securities when monitoring thrift holding companies’ capital adequacy. 

For example, examiners used a proxy calculation that included trust 

preferred securities to approximate a Tier 1 capital measure and, 

Fewer Thrift Holding 

Companies Have Used 

Trust Preferred Securities
 

Page 18 GAO-12-237 Hybrid Capital Instruments

consistent with Federal Reserve rules, generally recognized only a 

portion of these securities as the highest-quality capital.19 The number of 

thrift holding companies using trust preferred securities peaked in 2006 at 

132 of 473, or 28 percent of all thrift holding companies.20

Unlike bank holding companies, whose use of trust preferred securities 

has remained relatively consistent since 2008, the amount of trust 

preferred securities that thrift holding companies have used has declined 

substantially in recent years (see fig. 6). Specifically, thrift holding 

companies’ use of trust preferred securities peaked at $21 billion in 2007 

but had declined to $3 billion by the end of 2010. In part, this decline 

came about because many of the largest users of trust preferred 

securities had failed or reorganized. As with bank holding companies, a 

small number of institutions accounted for a large share of the total 

amount of trust preferred securities held by thrift holding companies, with 

just five institutions accounting for more than 70 percent in 2007. By 

2010, all of these companies were no longer thrift holding companies due 

to failure or reorganization.

By comparison, 

in the same year, 64 percent of bank holding companies included trust 

preferred securities in their Tier 1 capital. As of December 31, 2010, only 

95 of 434 thrift holding companies (22 percent) used trust preferred 

securities.

 

19We are considering only thrift holding companies’ use of trust preferred securities rather 

than hybrid instruments more generally. The Thrift Financial Report schedule for holding 

companies did not include a separate line item for cumulative preferred instruments prior 

to 2009. OTS did include minority interest in its proxy Tier 1 capital calculation, but OTS 

data do not distinguish between minority interest that would have been restricted by the 

Federal Reserve for bank holding companies and minority interest that would have been 

unrestricted and still included as Tier 1 capital under the Dodd-Frank Act. 

20We consider thrift holding companies to have used trust preferred securities in a given 

year if the companies reported them on their Thrift Financial Report holding company 

schedule for that year. Amounts of trust preferred securities listed for thrift holding 

companies include only the amount that would be eligible for Tier 1 capital treatment 

under the Federal Reserve’s rules for bank holding companies. 
 

Page 19 GAO-12-237 Hybrid Capital Instruments

Figure 6: Amount of Trust Preferred Securities Eligible for Tier 1 Capital Treatment 

under the Federal Reserve’s Rules for Bank Holding Companies, 1997-2010

Note: Data on thrift holding company use of trust preferred securities is not available prior to 2004, 

when OTS added the field for trust preferred securities in its Thrift Financial Report. 

Hybrid capital instruments have provided financial advantages to the 

banking institutions that have used them but are a lower-quality form of 

Tier 1 capital than other financial instruments. Trust preferred securities, 

the predominant form of Tier 1 hybrid capital, offered institutions a lowcost form of capital primarily because of their debtlike features, including 

tax-deductible payments. Unlike dividends on traditional preferred and 

common stock, dividends on trust preferred securities are treated as tax 

deductible because the bank holding company makes interest payments 

on the subordinated note held by the trust. Deducting dividend or interest 

payments for tax purposes can lower an institution’s overall capital cost 

and increase after-tax earnings (see fig. 7). In addition, trust preferred 

securities generally offered a cheaper source of Tier 1 capital than 

common or noncumulative preferred equity because of other debtlike 

features, including an effective maturity date, cumulative dividend 

payments, and a superior repayment claim in case of bankruptcy or 

liquidation.

Hybrid Instruments Offer 

Financial Advantages but 

Are a Weaker Form of Tier 

1 Capital
 

Page 20 GAO-12-237 Hybrid Capital Instruments

Figure 7: Illustrative Cost-Benefit Example of Trust Preferred Securities

Note: The cost of capital figures for common stock and trust preferred securities are hypothetical 

assumptions and are not based on observed prices. Cost of capital refers to the amount an institution 

must pay the owners of capital for its use, including the costs of interest payments on debt and 

dividends generated for shareholders. 

Banking institutions also have used trust preferred securities to increase 

financial returns to existing shareholders. For example, because trust 

preferred securities are not equity of the banking institution and do not 

dilute the ownership stakes of existing common shareholders, bank 

holding companies have leveraged these instruments by using them as a 

capital source to fund lending and other activity. As a result, the holding 

companies could increase returns on common equity and earnings per 

common share—two important measures for investors. These effects are 

similar to those that can be achieved with debt financing or by issuing 

preferred stock. However, because payments on trust preferred securities 

are tax deductible, they are a more efficient means for achieving these 
 

Page 21 GAO-12-237 Hybrid Capital Instruments

effects. Also, trust preferred securities’ debtlike features have allowed 

institutions to raise capital from a larger group of potential investors that 

faced restrictions on investments in other Tier 1 capital instruments. For 

example, market participants said that trust preferred securities offered 

banking institutions access to investors in fixed-income assets that make 

up a larger market than equity investors. Finally, according to one market 

participant, trust preferred securities were attractive to investors who did 

not want to face bank holding company restrictions by exceeding 

ownership limits, because they did not include the ownership rights of 

directly issued equity instruments such as common and preferred stock.

However, trust preferred securities lack many characteristics of higherquality capital, such as common equity. Common equity is the highestquality capital instrument for absorbing losses and maintaining the 

ongoing financial viability of banking institutions. Market participants and 

bank regulators generally recognize common equity as the strongest form 

of capital, and regulators require banking institutions to have most of their 

Tier 1 capital as common equity. In the stressed market conditions of the 

recent financial crisis, market participants focused on common equity 

when assessing the strength of banking institutions. Several 

characteristics make common equity such an effective capital instrument 

for absorbing unexpected financial losses that could otherwise threaten 

the ongoing viability of a banking institution. These include an unrestricted 

ability to absorb losses while the institution continues to operate as a 

going concern, full discretion over payments to holders, and permanence. 

Other Tier 1 instruments share these attributes to a varying extent. For 

example, noncumulative preferred shares eligible for Tier 1 status have a 

perpetual maturity and no obligation to make dividend payments. 

However, these instruments are more limited in their ability to absorb 

losses as they may do so only after losses reduce the sum of common 

stock and surplus and retained earnings below zero. 

In contrast, trust preferred securities do not contain features that allow 

them to absorb financial losses outside of bankruptcy. Issuers of the 

instruments have a contractual obligation to repay the full principal 

amount and all dividends, and failure to repay at the maturity of the note 

may result in default. Market participants said that some large institutions 

had been able to absorb financial losses by exchanging existing 
 

Page 22 GAO-12-237 Hybrid Capital Instruments

securities, but at a discount, and not as a feature of the instruments.21

Trust preferred securities also do not allow for complete discretion over 

dividend or principal payments, although they may provide some limited 

financial flexibility in times of stress. Institutions’ ability to defer dividend 

payments for up to 5 years may help institutions withstand financial stress 

by preserving cash for other purposes.

However, the instruments do not contain any contractual rights to such 

transactions, and any discount depends on a voluntary renegotiation of 

the security in light of an institution’s financial distress, as investors 

cannot be forced to exchange them. As a result, credit rating agencies 

identify some exchanges as distressed, which they consider to be a

default event that could threaten a banking institution’s viability. According 

to one market participant, exchanges were an option for only relatively 

strong troubled banks because investors received common equity and 

would agree to convert only if they were reasonably confident that the 

banking institution would survive.

22

Troubled institutions are often reluctant to defer dividend payments.

However, institutions face limits 

on the benefits they receive from dividend deferrals. For example, missed 

dividend payments accumulate and the issuer has a contractual 

obligation to pay the missed amounts in full by the end of the deferral 

period or be subject to default. Thus, dividend deferrals cannot increase 

an institution’s earnings or the amount of its equity capital but instead 

offer only temporary flexibility in the use of its cash funds. This flexibility is 

limited by the relatively small size of dividend payments, which constitute 

only a small share of an instrument’s principal value, so that realizing 

significant benefits from deferring dividend payments is difficult.

23

 

21If an investor exchanges existing trust preferred securities for a discounted amount of 

another capital instrument, such as common equity, issued by the same institution or sells 

the trust preferred securities back to the institution for less than the investor paid for them, 

the transaction increases the institution’s capital by extinguishing a liability.

Market participants and some regulators we interviewed identified the 

22For inclusion in Tier 1 capital, the Federal Reserve has required trust preferred 

securities to allow for the deferral of dividend payments for up to a minimum of 20 

consecutive quarters without an event of default. Although the dividend deferral period 

could be longer, 5 years was the typical time frame included in the securities’ contracts. 

23Banking regulators also can force institutions to defer dividends on trust preferred 

securities if they believe it is necessary to help preserve the institution’s safety and 

soundness. 
 

Page 23 GAO-12-237 Hybrid Capital Instruments

negative consequences for institutions that defer dividends on their trust 

preferred securities. Investors’ expectations about receiving dividends 

can place pressure on institutions to keep paying. An institution’s decision 

to defer dividends on trust preferred securities, as with common stock and 

other instruments, can send additional negative signals to investors and 

other market participants about its financial strength. To the extent that 

investors view deferral as a sign of financial weakness, deferring 

dividends can limit an institution’s ability to raise capital and increase the 

cost of any subsequent capital-raising efforts. According to market 

participants, some banking institutions that could have benefited from 

deferring payments during the financial crisis did not do so because of 

such concerns. Market participants also said that larger, publicly traded 

institutions have been more reluctant to defer dividends than smaller 

institutions. One reason for their reluctance is that these institutions may 

decide that the consequences of deferral for their common stock prices 

would be too detrimental. Larger institutions also tend to rely more heavily 

on access to capital markets as a source of funding and can be more 

reluctant than smaller institutions to jeopardize their access to these 

markets in the future. According to Federal Reserve officials, these 

consequences are secondary to the consequences of an institution 

eliminating common stock dividends, a step an institution must take

before it can defer dividends on perpetual preferred stock or trust 

preferred securities and one that has significant market implications for 

the institution. 

Few institutions that have deferred dividend payments have recovered 

and paid the accumulated amount of the deferrals. Some market 

participants said that the length of the dividend deferral period is long 

enough for an institution to either recover or fail by the time all accrued 

payments become due. Available data on the outcome of deferring 

dividends on trust preferred securities indicate that most banking 

institutions have not recovered but remain in deferral or have defaulted. 

According to a leading credit rating agency, of the 605 banking institutions 

in pooled trust preferred securities that have deferred dividends since 

January 1, 2007, some 62 percent are still deferring, 29 percent have 

defaulted, and 7 percent had repaid all missed dividends as of September 
 

Page 24 GAO-12-237 Hybrid Capital Instruments

30, 2011.24 Another leading credit rating agency found a similar trend.25

Trust preferred securities also differ from stronger Tier 1 capital 

instruments because they are not a permanently available capital source. 

A perpetual maturity is a strong feature because it helps ensure that 

capital will be available to absorb losses when needed and that the 

institution will not have to repay or replace funds used as capital. Unlike 

common equity and other Tier 1 instruments, trust preferred securities 

have an effective maturity date when the principal amount must be 

repaid. In the typical trust preferred security structure, the subordinated 

note issued by the bank holding company has a maturity of at least 30 

years, and maturity cannot be perpetual in order to qualify for tax 

deductibility. In most cases, the trust terminates at the maturity of the 

subordinated note, and the trust preferred securities must be redeemed.

However, limited historical data exist on such deferrals, because most 

institutions issued the securities after 2000, and banking institutions 

operated in a favorable economic environment until the 2007-2009 

financial crisis.

Finally, trust preferred securities can hinder the recapitalization of 

troubled banking institutions. Some market participants and regulators 

said that the existence of trust preferred securities can act as an 

impediment to improving an institution’s capital structure—or 

recapitalization. An institution that is deferring dividends on trust preferred 

securities cannot pay dividends to common or preferred stockholders until 

all accumulated dividends have been paid. As a result, investors may 

require an exchange of trust preferred securities for equity or a reduction 

in their principal amount before investing new equity, and reaching 

agreement on such an exchange or reduction can be difficult. Any funds 

 

24Seven of the institutions (about 1 percent) had their deferring securities sold or 

otherwise disposed of by the pooled entity. Data are from Fitch Ratings’ Bank Default and 

Deferral Index, which tracks defaults and deferrals by banking institutions whose 

securities make up the 85 pooled trust preferred securities rated by Fitch (originated value 

of $37.7 billion for around 1,800 institutions). The Bank Default and Deferral Index data 

also include a very small amount of senior and subordinated debt, but Fitch officials said 

that essentially all of the deferral data was for trust preferred securities. Fitch typically 

characterizes a deferral as a banking institution that has elected to defer payments on its 

trust preferred securities or similar debt instrument and considers defaulted institutions 

those that have been closed by bank regulators or that have filed for bankruptcy.

25Moody’s Investors Service, TRUP CDOs: 2011 Outlook and 2010 Year in Review (New 

York, NY: Jan. 13, 2011).
 

Page 25 GAO-12-237 Hybrid Capital Instruments

from new equity investments would first be used to pay the accumulated 

dividends before paying dividends on common stock or other equity. 

Holders of trust preferred securities have reduced incentives to 

subordinate their position in a recapitalization because they have legal 

rights to cumulative dividends and the repayment of principal. Also, the 

structure of pooled trust preferred securities—typically a collateralized 

debt obligation (CDO)—can impede the approval of transactions to 

exchange the securities for equity or repurchase them at a discounted 

price. For example, market participants said it can be difficult to identify 

and gain approval for recapitalization transactions from the ultimate CDO 

investors. If a trustee represents the CDO investors, the trustee often will 

not agree to a proposed transaction or will require a very high percentage 

of the investors to agree because of concerns about potential legal 

liability.

With the exclusion of hybrid instruments from Tier 1, few banking 

institutions will fall below minimum amounts of regulatory capital, and 

greater reliance on common equity should improve the overall safety and 

soundness of banking institutions. To identify and resolve problems at 

banks and thrifts, the prompt corrective action provisions require 

depository institution regulators to classify insured depository institutions 

into one of five capital categories—well capitalized, adequately 

capitalized, undercapitalized, significantly undercapitalized, and critically 

undercapitalized—using different capital measures. Among these are the 

Tier 1 risk-based capital ratio (Tier 1 ratio), which measures Tier 1 capital 

as a share of risk-weighted assets and the Tier 1 leverage ratio (leverage 

ratio), which measures Tier 1 capital as a share of average total 

consolidated assets.26 Well-capitalized banks have a Tier 1 ratio of 6 

percent or more, adequately capitalized banks a ratio of 4 percent or 

more, and undercapitalized banks a ratio of less than 4 percent.27

 

26Risk-weighted assets are on- and off-balance sheet assets adjusted for their risk 

characteristics. The other measures are the total risk-based capital ratio and a fourth 

measure that regulators use to identify critically undercapitalized institutions. We use the 

Tier 1 risk-based and leverage ratios to measure institutions’ capital adequacy, as these 

ratios would be most directly affected by the Tier 1 hybrid capital restrictions. 

The 

minimum leverage ratio is 4 percent for most banks, and well-capitalized 

27To be well capitalized, a bank must meet the criteria for all three capital measures, and 

banks may be considered undercapitalized if they fail to meet adequately capitalized 

criteria for any of the measures. 

Excluding Tier 1 

Hybrid Capital Likely 

Will Have Limited 

Negative Effects
 

Page 26 GAO-12-237 Hybrid Capital Instruments

banks have a leverage ratio of 5 percent or more. The Federal Reserve 

applies similar minimum levels when assessing the capital adequacy of 

bank holding companies but generally does not identify specific criteria for 

adequately or well-capitalized institutions or use the term undercapitalized 

(see table 2).28

Table 2: Banking Institution Capital Requirements

Tier 1 risk-based capital ratio Tier 1 leverage ratio

Banks and thrifts

Well capitalized 6% or more 5% or more

Adequately capitalized 4% or more 4% or morea

Undercapitalized Less than 4% Less than 4%a

Bank holding companies

Above minimum capital 4% or more 4% or moreb

Below minimum capital Less than 4% Less than 4%

Sources: FDIC—12 C.F.R. § 325.103 and § 390.453; Federal Reserve—12 C.F.R. § 208.43 and 12 C.F.R. Part 225, appendixes A and 

D; and OCC—12 C.F.R. § 6.4 and § 165.4.

Notes: As noted, the Dodd-Frank Act transfers to OCC the functions of OTS relating to federal 

savings associations and transfers to FDIC the functions of OTS relating to state savings 

associations. Section 316 of the Dodd-Frank Act requires that OCC and the FDIC identify those 

regulations of the OTS that are continued and that they will enforce. Both OCC and OTS listed OTS’s 

prompt corrective action regulations, 12 C.F.R. Part 565, as among the regulations that they will 

enforce. See 75 Fed. Reg. 39246, 39247-39248. 

a

The minimum leverage ratio is 3 percent for banks or thrifts that have the strongest supervisory 

examination ratings and that generally are not experiencing or anticipating significant growth. 

b

The minimum leverage ratio is 3 percent for bank holding companies with the strongest supervisory 

examination ratings and those that are subject to a risk-based capital measure for market risk. 

We evaluated the impact of the Tier 1 hybrid capital exclusion on bank 

holding companies’ capital levels using the explicit criteria for well 

capitalized that apply to banks and thrifts and found that most bank 

holding companies would experience a reduction in Tier 1 capital but 

maintain well-capitalized status without Tier 1 hybrids. Of the 969 toplevel bank holding companies filing consolidated regulatory financial 

 

28The minimum leverage ratio is 3 percent for bank holding companies with the strongest 

examination ratings and those that have implemented a risk-based capital measure for 

market risk. For all other bank holding companies, the minimum leverage ratio is 4 

percent. We evaluated all bank holding companies using the higher minimum requirement. 

The Federal Reserve defines well capitalized for certain bank holding companies, 

including those under $500 million in total assets that are subject to its Small Bank 

Holding Company Policy Statement. 
 

Page 27 GAO-12-237 Hybrid Capital Instruments

reports for 2010, 615 had hybrid instruments that the Dodd-Frank Act 

would exclude from Tier 1 capital.29 However, the amount of other Tier 1 

capital instruments was large enough that 587 (95 percent) of these 

institutions would see no change in the capital adequacy category of their 

Tier 1 ratio without those instruments. As table 3 shows, 554 (90 percent) 

would maintain a Tier 1 ratio of well capitalized.30

Table 3: Tier 1 Ratio Capital Categories of Top-Level Bank Holding Companies with Tier 1 Hybrids, as of December 31, 2010

The average Tier 1 ratio 

of all top-level bank holding companies would fall from 13.5 percent to 

12.2 percent after excluding Tier 1 hybrid instruments, and the average 

ratio of institutions with Tier 1 hybrids would decrease by around 2 

percentage points but remain considerably higher than the minimum level 

for the well-capitalized category.

Total asset size

Number of 

institutions

Tier 1 hybrid 

instruments

Average 

Tier 1 ratio

Well 

capitalized

Above 

minimuma Below 

minimum

More than $15 billion 44 Included 13.1% 44 0 0 

Excluded 11.6% 44 0 0 

Between $500 million 

and $15 billionb 526 Included 12.7% 500 11 15

Excluded 10.6% 485 20 21

Less than $500 millionc 45 Included 9.0% 30 6 9 

Excluded 7.1% 25 9 11

Total 615 Included 12.5% 574 17 24

Excluded 10.4% 554 29 32

Source: GAO analysis of Federal Reserve data obtained from SNL Financial.

a

The above minimum category does not include institutions in the category we refer to as well 

capitalized. 

b

Tier 1 hybrid instruments excluded for illustrative purposes. Institutions with less than $15 billion of 

total assets can continue including hybrid instruments issued prior to May 19, 2010, in Tier 1 capital. 

c

Tier 1 hybrid instruments excluded for illustrative purposes. Institutions with less than $500 million of 

total assets are largely exempt from the Dodd-Frank Act exclusion of Tier 1 hybrid capital. 

While the Dodd-Frank Act includes exemptions from the Tier 1 hybrid 

capital exclusion for the two categories of smaller institutions, our analysis 

 

29Our analyses do not include four top-level holding companies that are subsidiaries of 

foreign banking institutions and were exempt from Tier 1 regulatory capital requirements in 

2010. 

30Of the 941 that would have no change in their capital adequacy category, 587 had Tier 1 

hybrid instruments as of December 31, 2010.
 

Page 28 GAO-12-237 Hybrid Capital Instruments

revealed that some smaller institutions with Tier 1 hybrid instruments 

would not fare as well as larger institutions if they had to exclude hybrid 

instruments from Tier 1 capital. Specifically, 20 institutions would see the 

capital category of their Tier 1 ratio fall below the well-capitalized criteria

but remain above the minimum level, and an additional 8 would fall to 

below the minimum level. All of these institutions had less than $2.5 

billion in total assets and 7 had less than $500 million as of December 31, 

2010. The average Tier 1 ratio of these 28 institutions, including Tier 1 

hybrid instruments, was well below the overall average at 6.3 percent and 

would fall to 4.7 percent without Tier 1 hybrid instruments.

Our analysis also found that more institutions would not meet the higher 

minimum Tier 1 ratio under Basel III, particularly smaller firms. However, 

how U.S. regulators will implement Basel III is unclear, including how they 

will determine which institutions will have to meet the higher standards or 

set the time frames for implementation. The Basel III capital framework—

which all member countries, including the United States, have 

approved—increases the Tier 1 capital ratio and excludes the same 

hybrid instruments from Tier 1 as the Dodd-Frank Act.

Effects of the hybrid capital exclusion on institutions’ leverage ratio capital 

categories would also be modest, although more institutions would fall 

below minimum levels. Almost all of the 615 institutions with Tier 1 hybrid 

capital would be in the same category of leverage ratio capital without 

those instruments. For example, about the same number of institutions 

would maintain Tier 1 and leverage ratios of well capitalized (see table 4). 

However, leverage ratios for 20 institutions would fall below the minimum 

level.31

 

31We used a leverage ratio requirement of 4 percent for all institutions. However, the 

Federal Reserve allows some bank holding companies to meet the leverage ratio 

requirement with a ratio of 3 percent based on their examination ratings and other factors. 

All of the institutions that would see their leverage ratio capital 

categories fall had less than $4 billion in total assets and 9 had less than 

$500 million as of December 31, 2010. After excluding Tier 1 hybrid 

instruments, the average leverage ratio for all top-level bank holding 

companies would fall from 9.2 percent to 8.2 percent. The average ratio 

of institutions with Tier 1 hybrids would decrease from 8.9 percent to 7.3 

percent, also considerably higher than the minimum level for the wellcapitalized category.
 

Page 29 GAO-12-237 Hybrid Capital Instruments

Table 4: Leverage Ratio Capital Categories of Top-Level Bank Holding Companies with Tier 1 Hybrid Instruments, as of 

December 31, 2010

Total asset size

Number of 

institutions

Tier 1 hybrid 

instruments

Average 

leverage ratio

Well 

capitalized

Above 

minimuma Below minimum

More than $15 billion 44 Included 9.0% 44 0 0 

Excluded 8.0% 44 0 0 

Between $500 million 

and $15 billionb 526 Included 9.0% 493 11 22

Excluded 7.5% 472 19 35

Less than $500 millionc 45 Included 6.6% 26 6 13

Excluded 5.2% 23 2 20

Total 615 Included 8.9% 563 17 35

Excluded 7.3% 539 21 55

Source: GAO analysis of Federal Reserve data obtained from SNL Financial.

a

The above minimum category does not include institutions in the category we refer to as well 

capitalized. 

b

Tier 1 hybrid instruments excluded for illustrative purposes. Bank holding companies with less than 

$15 billion of total assets can continue including hybrid instruments issued prior to May 19, 2010, in 

Tier 1 capital. 

c

Tier 1 hybrid instruments excluded for illustrative purposes. Bank holding companies with less than 

$500 million of total assets are largely exempt from the Dodd-Frank Act exclusion of Tier 1 hybrid 

capital. 

Exceptions to the hybrid exclusion will help limit potential negative effects 

on institutions’ capital levels. For example, as discussed earlier, the 

Dodd-Frank Act includes grandfathering provisions for bank holding 

companies with less than $15 billion in total assets that will allow these 

institutions to continue including hybrid instruments issued before May 19, 

2010, in Tier 1 capital. Thus, all of these institutions that would have had 

their capital adequacy categories reduced based on their year-end 2010 

Tier 1 or leverage ratios will not experience a reduction in Tier 1 levels as

a result of the hybrid capital exclusion.32

 

32This finding assumes that institutions had not issued Tier 1 hybrid capital between May 

19, 2010, and December 31, 2010. The Senate adopted the Collins Amendment in May 

2010, and it became law when the Dodd-Frank Act was passed in July 2010. 

Furthermore, as discussed 

earlier, the Dodd-Frank Act largely exempts institutions with less than 
 

Page 30 GAO-12-237 Hybrid Capital Instruments

$500 million in total assets from the exclusion of Tier 1 hybrid capital.33

Further, increased reliance on stronger forms of capital should increase 

institutions’ financial stability. Some institutions may have difficulty 

replacing hybrid instruments or choose not to replace them with other 

forms of Tier 1 capital. But to the extent that banking institutions replace 

hybrid capital instruments with capital that has a higher capacity to absorb 

unexpected losses—such as common equity—institutions’ financial 

resiliency should improve. Some market participants identified likely 

safety and soundness benefits for banking institutions that increase their 

share of common equity or other stronger capital sources. A few market 

participants noted that some institutions may respond to increased capital 

costs by increasing lending and investment risks, including activities for 

which increased risk may not require additional capital under existing riskbased capital requirements, to generate higher returns. However, bank 

regulators have the discretion to require higher levels of capital for 

institutions with heightened risk profiles, and recent Basel Committee 

reforms include enhancing the risk coverage of the capital framework by 

strengthening capital requirements for trading activities, complex 

securitization exposures, and counterparty credit exposures. 

In 

addition, although none of the larger bank holding companies not subject 

to the grandfathering provisions would fall below minimum capital levels 

or experience a reduction in capital categories based on the Tier 1 ratio or 

leverage ratio, a phase-in period will help limit the immediate effects of 

the hybrid capital exclusion. For institutions with $15 billion or more in 

total assets, hybrid capital deductions from Tier 1 must be phased in over 

3 years beginning on January 1, 2013, almost 2-1/2 years after passage 

of the Dodd-Frank Act.

One market participant argued that the safety and soundness effects 

could be negative if institutions decided to hold less capital overall rather 

than increasing the share of common equity. Another market participant 

noted that the hybrid capital exclusion limits institutions’ options for raising 

 

33The Collins Amendment provisions in the Dodd-Frank Act do not apply to any institutions 

subject to the Federal Reserve’s Small Bank Holding Company Policy Statement that was 

in effect on May 19, 2010. This statement generally applies to all bank holding companies 

with less than $500 million in total assets that (1) are not engaged in significant 

nonbanking activities, (2) do not conduct significant off-balance sheet activities, and (3) do 

not have a material amount of debt or equity securities outstanding (other than trust 

preferred securities) that are registered with the Securities and Exchange Commission. 

The Dodd-Frank Act did not similarly exempt small thrift holding companies. 
 

Page 31 GAO-12-237 Hybrid Capital Instruments

capital in times of financial distress. However, institutions that decide not 

to replace Tier 1 hybrid capital could retain the instruments in their capital 

structure, and the hybrid capital may qualify as Tier 2 capital. 

Furthermore, institutions will still be required to have capital levels 

sufficient to support safety and soundness, and this capital will be higher 

quality that will better absorb unexpected losses and improve institutions’ 

ability to withstand periods of financial distress.

The exclusion of hybrid instruments from Tier 1 capital likely will have 

modest immediate and long-term effects on the cost and availability of 

credit. In general, the hybrid capital exclusion could negatively affect the 

cost and availability of credit in two ways. First, if institutions view their Tier 

1 capital positions as insufficient without existing hybrid instruments, they 

may take actions to maintain consistent regulatory capital levels, creating a 

negative capital shock that empirical studies suggest could have an impact 

on lending activity. For example, institutions could choose to replace 

excluded hybrid capital with other Tier 1 instruments such as common 

equity, increase capital through retained earnings, or reduce risk-weighted 

assets. Second, regardless of whether institutions take such actions, those 

that had previously relied on Tier 1 hybrid instruments as a cheaper form of 

capital could experience higher overall capital costs when raising Tier 1 

capital in the future. Loan rates could increase if institutions choose to and 

are able to pass on any increased capital costs to borrowers.

The terms of the hybrid capital exclusion and the relationship between 

lending activity and changes to capital levels will limit the exclusion’s 

immediate consequences for institutions’ lending decisions. As previously 

discussed, most bank holding companies would not experience 

reductions in capital levels from the Tier 1 hybrid capital exclusion 

because the Dodd-Frank Act exempted existing hybrid instruments for 

most smaller institutions and gradually introduced the exclusions for the 

remaining institutions with $15 billion or more in assets. Also, institutions 

with more than $15 billion in assets generally have Tier 1 capital in 

excess of regulatory minimums, potentially further limiting their need for 

Effects on the Cost and 

Availability of Credit Likely 

Will Be Small

Short-Term Effects of 

Maintaining Tier 1 Capital 

Positions without Hybrid 

Instruments
 

Page 32 GAO-12-237 Hybrid Capital Instruments

an immediate response to the hybrid capital exclusion.34 Finally, 

institutions generally will be able to include excluded Tier 1 hybrid 

instruments in Tier 2 capital up to allowable limits, potentially minimizing 

effects on their total capital positions.35

Some institutions may still seek to maintain a target level of Tier 1 capital 

that exceeds regulatory minimums and is consistent with the level they 

had with Tier 1 hybrids. These institutions may prefer to maintain a capital 

buffer in excess of the minimum levels to satisfy regulators or investors 

and other market participants. In such cases, the institutions would 

experience a negative capital shock that could impact lending activity. To 

determine the potential impact of such an occurrence on lending activity, 

we designed a modified version of an established econometric model to 

estimate the effect of a change in Tier 1 capital levels on key credit 

market variables.36

 

34All bank holding companies with assets greater than $15 billion will continue to have Tier 

1 risk-based capital and leverage ratios that exceed 6 percent and 4 percent, respectively, 

and therefore will meet the well-capitalized criteria we used in our analysis. A very small 

number of domestic subsidiaries of foreign banking institutions do not meet these 

standards, but the Federal Reserve generally has not required them to meet capital 

requirements. For more information on this policy, see GAO, Bank Capital Requirements: 

Potential Effects of New Changes on Foreign Holding Companies and U.S. Banks Abroad, 

Specifically, we used the model to evaluate the 

dynamic responses of loan volume growth, lending spreads, and other 

important variables to temporary negative capital shocks representing the 

industry’s potential responses to the hybrid capital exclusion. For 

example, if institutions wish to maintain the same Tier 1 leverage ratio, 

the capital deficit is the full difference between the capital ratios with and 

GAO-12-160 (Washington, D.C.: Jan. 18, 2012). 

35Bank holding companies face an overall limit on the amount of allowable Tier 2 capital 

equal to the amount of their Tier 1 capital.

36Specifically, the dynamic framework we use is known as a vector autoregression (VAR) 

methodology. Following Cara Lown and Donald P. Morgan, “The Credit Cycle and the 

Business Cycle: New Findings Using the Loan Officer Opinion Survey,” Journal of Money, 

Credit, and Banking, vol. 38, (2006): 1575–97; and Jose M. Berrospide and Rochelle M. 

Edge, “‘The Effects of Bank Capital on Lending: What Do We Know, and What Does It 

Mean?,’’ International Journal of Central Banking, vol. 6 (December 2010), our model is a 

version of existing VAR models extended to include a banking sector. Our model includes 

four variables that capture supply, demand, output, and prices that comprise the 

“macroeconomy.” We extend the model to include the credit market using various proxies 

for loan volumes, bank capital, loan spreads, and information on lending standards. The 

econometric approach has specific limitations but is considered a reasonable alternative 

to other types of models, including more sophisticated models. See appendix II for a fuller 

discussion of the methodology, assumptions, and limitations.
 

Page 33 GAO-12-237 Hybrid Capital Instruments

without the excluded Tier 1 hybrid instruments. Alternatively, institutions 

that are satisfied with a lower Tier 1 leverage ratio after the exclusions will 

have a smaller perceived capital deficit. As a result, we were able to 

analyze the impact under various assumptions about the institutions’ 

collective desire to rebuild capital buffers.37

Although considerable uncertainty exists, our model suggests that the 

immediate effects of the Tier 1 hybrid exclusion on the cost and 

availability of credit likely will be modest. In the model, a negative capital 

shock related to implementation of the hybrid capital exclusion causes 

loan volumes to fall, lending standards to tighten, and lending spreads to 

rise. However, the implied shocks are relatively small, and the sensitivity 

of lending activity to changes in capital levels is moderate. Our results are 

generally consistent with other studies we identified in our review.38 As 

table 5 shows, in the scenario in which institutions restore 100 percent of 

excluded hybrid capital to maintain consistent Tier 1 capital ratios, our 

model estimates an average 1.12 percentage point peak decline in loan 

growth between two quarters and a year after the exclusion goes into 

effect.39 For lending spreads in this scenario, the model estimates an 

average 0.15 percentage point peak increase occurring about two to 

three quarters after the hybrid exclusion goes into effect. These effects on 

the cost and availability of credit are relatively modest and are even more 

so under less extreme scenarios that consider the amount of excluded 

hybrid capital that institutions replace.

 

37The hybrid capital exclusion results in a negative capital shock reducing the Tier 1 

leverage ratio by around 1 percentage point at the aggregate level at most. Note that the 

negative shock to capital is designed to be temporary with all variables expected to return 

to normal levels over time. In general, the impulse response functions from the VAR 

system should return to zero if the system is stable.

38See appendix II for a complete list of studies we identified in our review.

39Estimates are based on impulse response functions from GAO’s VAR model. The 

estimates assume an immediate negative shock to capital. The responses have very wide 

confidence intervals and should be interpreted with caution.
 

Page 34 GAO-12-237 Hybrid Capital Instruments 

Table 5: Effects of Implied Capital Deficits on Loan Volumes and Lending Spreads for Institutions with More Than $15 Billion 

in Assets 

Capital shock scenario 

Peak change in 

loan growth 

(percentage points) 

Peak change in 

lending spreads

(percentage points)

Implied replacement rate of 

hybrid instruments 

Implied change in Tier 1 

leverage ratio 

(percentage points)

100% -0.94 -1.12 0.15

70% -0.66 -0.78 0.10

50% -0.47 -0.56 0.07

25% -0.23 -0.28 0.04

0% 0 0 0

Source: GAO analysis of Federal Reserve data. 

Note: The model uses the Tier 1 leverage ratio for the capital target, although the Tier 1 risk-based 

ratio would produce generally similar results. “Implied replacement rate of hybrid instruments” refers 

to actions institutions take to restore their Tier 1 capital ratio to the level that would be equivalent to 

the direct replacement of the hybrid instruments. Impact estimates are based on impulse response 

function from GAO’s VAR model. The estimates assume an immediate negative shock with no 

transition period. The effects of the shock to capital are traced out of 12 quarters that by design return 

to zero. Estimates in the table represent the peak effects based on two different modeling 

specifications. See appendix II for further information. 

Our results assume that banking institutions immediately address capital 

reductions resulting from Tier 1 hybrid exclusions. Given that these 

institutions would continue to meet minimum capital requirements and 

expect the change to the use of Tier 1 hybrid capital, they are more likely to 

replace—if they elected to do so—any hybrid instruments slowly over a 

number of years. The Dodd-Frank Act excludes existing Tier 1 hybrid 

instruments over 3 years beginning in 2013 (for institutions with more than 

$15 billion in assets), also implying more limited effects on lending activity. 

However, the immediate effects on overall lending activity may be more 

significant for certain loan types. For example, the hybrid capital exclusion 

could affect volumes of commercial and industrial loans more significantly 

than other types of loans because markets for these loans appear more 

sensitive to changes in bank capital. The peak decline in loan growth from 

a negative capital shock is roughly 2.26 percentage points for commercial 

and industrial loans or about two times larger than the impact suggested 

for aggregate loan volumes (1.12 percentage points). Other studies also 

have found that commercial and industrial loans are more strongly 
 

Page 35 GAO-12-237 Hybrid Capital Instruments

affected by capital ratios than other types of loans.40

Although other studies found similar results, our estimates generally 

should be interpreted with caution, given the methodological and other 

limitations inherent in this type of analysis. For example, many of the 

specific estimates are not statistically significant with respect to the actual 

size of the hybrid capital exclusion’s effects, if any—meaning that they 

are not statistically different from zero.

Moreover, the model 

parameters are aggregate estimates and may not generalize to the 

specific circumstances of some banks. For example, our model suggests 

that banks will adjust lending spreads and loan volumes in response to 

the hybrid restriction. However some banks may not be able to raise rates 

and would likely have to take other actions, including reducing loan 

volumes by more than is suggested here.

41 Given the limitations, we 

compared the results of our model to a wider body of empirical 

literature.42 In general, these sources also found small to moderate 

effects on lending activity from changes to bank capital.43

Applying estimates of the impact of capital on lending activity from 

available studies to the potential deficit created by the hybrid capital 

 

40See, for example, Diana Hancock, Andrew J. Laing, and James A. Wilcox, “Bank Capital 

Shocks: Dynamic Effects on Securities, Loans, and Capital,” Journal of Banking and 

Finance (1995): 661-77.

41For example, our estimates have wide confidence intervals suggesting considerable 

uncertainty in the results (see app. II for limitations).

42See, for example, Berrospide and Edge, “The Effects of Bank Capital”; Mark A. Carlson, 

Hui Shan, and Missaka Warusawitharana, “Capital Ratios and Bank Lending: A Matched 

Bank Approach,” Federal Reserve Board working paper No. 2011-34 (July 1, 2011); and 

Thomas Cosimano and Dalia Hakura, “Bank Behavior in Response to Basel III: A CrossCountry Analysis,” IMF working paper No. 11/119 (Washington, D.C., 2011).

43Responses to the Federal Reserve’s Senior Loan Officer Opinion Survey suggest that 

deterioration in banks’ capital positions ranked as the least important reason behind banks 

decision to tighten lending standards during the most recent financial crisis. See 

Berrospide and Edge (2010).
 

Page 36 GAO-12-237 Hybrid Capital Instruments

exclusion results in a range of effects.44 For example, when we assume 

that institutions target capital ratios equivalent to replacing 70 percent of 

excluded hybrid instruments, estimates range from a decline of 0.13 to 

1.81 percentage points for loan volumes and from an increase of 0.06 to 

0.43 percentage points for lending spreads. Although exact comparisons 

are not always possible, the averages of the estimates are generally 

consistent with our model results.45

Long-term effects of the hybrid capital exclusion on loan rates will likely 

also be small, although the exact impact is unknown. Without Tier 1 

hybrid instruments, loan rates could increase if capital costs rise for 

institutions that have relied on these instruments as a cheaper source of 

regulatory capital. To assess the potential impact on loan rates for these 

institutions, we used a modified version of an existing loan pricing

model.

Like our own analysis, some of the 

studies examine the impact of a generalized shock to capital. However, in 

the case of the Tier 1 hybrid capital exclusion, the capital shock is specific 

to bank holding companies with assets of $15 billion or more. Given the 

large number of banking institutions with assets of less than $15 billion, 

the ability of affected institutions to raise loan rates significantly may be 

limited by competitive forces, and the decline in loan growth may be 

mitigated by substitution across institutions.

46

 

44The studies included in these estimates are reported in appendix II. Each study allowed 

us to determine the impact of a 1 percentage point change in capital on loan volumes and

lending rates. (For example, our model implies that a 1 percentage point shock to capital 

results in a decline in aggregate loan growth of 1.2 percentage points and an increase in 

lending spreads of roughly 0.16 percentage points.) We then scaled the estimates by the 

size of the expected capital deficit as a result of the hybrid restriction. Because most of the 

other studies are focused on specific episodes of credit contraction or on Basel III, they 

make different assumptions that make strict comparisons difficult, including about the time 

period over which the impact is measured.

Banking institutions have multiple options for adjusting to more 

costly forms of Tier 1 capital—such as shifting lending activity to lowerrisk borrowers, reducing returns to shareholders, increasing efficiency, or 

raising lending rates—and the loan pricing model allowed us to consider 

45For example some studies look at peak effects, while others examine long-run effects. 

These studies represent a variety of different methodologies ranging from regression 

techniques to large-scale macroeconomic and general equilibrium models, each with its 

own limitations. General equilibrium models attempt to model various aspects of the 

economy when bank balance sheets and credit markets can be modeled explicitly and 

allow for consistent counterfactual experiments with different policy scenarios.

46For information on our model and the model we modified, see appendix II. 

Long-Term Effects of Raising 

Tier 1 Capital without Less 

Costly Hybrid Instruments
 

Page 37 GAO-12-237 Hybrid Capital Instruments

these different scenarios. For all of the scenarios we examined, our 

model indicated minimal potential loan rate increases from institutions’ 

use of higher cost and quality Tier 1 capital and, as a result, modest 

effects on loan volumes (table 6). Even if institutions are assumed to 

adjust solely by raising lending rates, rates would increase by 0.12 

percentage points. Other scenarios assuming that institutions’ 

adjustments also occurred in other areas led to smaller increases in 

lending rates. The long-term effects on lending rates may be more 

significant for certain institutions. For example, customers of smaller 

institutions could experience larger increases in loan rates, but even 

these effects likely will remain modest.47

Table 6: Estimates of Tier 1 Hybrid Exclusion on Loan Rates under Different Illustrative Scenarios

Again, the effects on lending 

rates would likely be mitigated since it may be difficult for the impacted 

institutions to pass the higher cost on to borrowers without losing market 

share.

Key values Starting values Scenario 1a Scenario 2b Scenario 3c Scenario 4d

All banking institutions

Loan rate 5.59% 5.71% 5.61% 5.61% 5.63%

Return on equity 15.00% 15.00% 14.75% 15.00% 15.00%

Yield on debt 2.57% 2.57% 2.55% 2.57% 2.57%

Credit spread 1.05% 1.05% 1.05% 1.00% 1.05%

Administrative costs 1.03% 1.03% 1.03% 1.03% 1.00%

Increase in loan rate (percentage points) 0.12 0.03 0.02 0.04

Smaller banking institutionse

Loan rate 6.61% 6.82% 6.68% 6.67% 6.69%

Return on equity 15.00% 15.00% 14.80% 15.00% 15.00%

Yield on debt 3.38% 3.38% 3.36% 3.38% 3.38%

Credit spread 0.90% 0.90% 0.90% 0.85% 0.90%

Administrative costs 1.32% 1.32% 1.32% 1.32% 1.29%

Increase in loan rate (percentage points) 0.21 0.07 0.06 0.08

Sources: GAO and The Brookings Institution.

 

47For the illustrative purposes of our model, we defined smaller institutions as those with 

between $1 billion and $10 billion in total assets. 
 

Page 38 GAO-12-237 Hybrid Capital Instruments

Notes: The Brookings Institution sources are Douglas J. Elliott, “Quantifying the Effects on Lending of 

Increased Capital Requirements,” Brookings briefing paper (Washington, D.C., 2009); and Douglas J. 

Elliott, “A Further Exploration of Bank Capital Requirements: Effects of Competition from Other 

Financial Sectors and Effects of Size of Bank or Borrower and Loan Types,” Brookings briefing paper 

(Washington, D.C., 2010). 

Scenarios are based on a loan pricing equation in which the loan rate equals the weighted cost of 

capital. We assumed that the yield on hybrids reflects the yield on trust preferred securities, which is 

assumed to be slightly higher for small banking institutions. The actual cost of trust preferred 

securities and noncumulative perpetual preferred securities will vary according to the issuing 

institution and market conditions. See appendix II for details, assumptions, and limitations. 

a

Scenario 1 illustrates the effects of banking institutions adjusting to the hybrid exclusion solely by 

raising loan rates to increase their retained earnings. 

b

Scenario 2 illustrates the effects of banking institutions raising rates but also having investors view 

the institution as less risky. We assume that the return on equity decreases by 0.25 percentage points 

and that the yield on debt decreases by 0.02 percentage points. 

c

Scenario 3 illustrates the effects of banking institutions raising rates and also shifting their lending 

activity toward loans with less risk. By reducing the amount of risk, we assume that the credit spread 

of the institutions’ assets, which is equal to the probability-weighted expected loss, declines by 0.05 

percentage points. 

d

Scenario 4 illustrates the effects of banking institutions raising rates and also taking steps to lower 

administrative cost associated with loans by 0.03 percentage points. 

e

For the illustrative purposes of our model, we defined smaller institutions as those with between $1 

billion and $10 billion in total assets.

The lack of tax-deductible Tier 1 hybrid capital instruments could result in 

a cost disadvantage for U.S. institutions relative to their foreign peers, 

although the overall competitive effects are unclear.48 Hybrid capital 

instruments, in particular trust preferred securities and real estate 

investment trust (REIT) preferred securities, generally have been the 

primary Tier 1 capital instruments for which U.S. institutions have 

received tax-deductible treatment.49

 

48For the purposes of this section, hybrid generally refers to capital instruments other than 

common equity rather than to the specific instruments that the Federal Reserve classifies 

as restricted core capital elements.

In the United States, debt 

instruments receive favorable tax treatment compared to equity. The tax 

code generally allows interest expenses on debt instruments to be 

deducted from income, but not dividends or other payments to equity 

49REIT preferred securities are noncumulative preferred shares issued by a specialpurpose entity established by a bank as a wholly owned subsidiary that qualifies for REIT 

tax status. The REIT uses proceeds from the sale of the preferred shares to purchase 

qualifying real estate assets from its parent bank and pays dividends on the preferred 

shares using income from the real estate assets. A bank can deduct from its income 

dividends paid by its REIT subsidiary as long as the REIT complies with federal income 

tax rules.

Some U.S. Institutions May 

Face a Tax Disadvantage 

Relative to Foreign Peers
 

Page 39 GAO-12-237 Hybrid Capital Instruments

holders. According to market participants, other Tier 1 capital instruments 

such as preferred stock generally have not qualified for tax advantages 

because their equitylike features, such as a perpetual maturity or 

noncumulative dividends, disqualify them from IRS consideration as debt 

instruments. Market participants said that a favorable tax treatment is one 

of the primary reasons banking institutions use hybrid capital. In addition, 

the Federal Reserve has identified the importance of trust preferred 

securities’ tax advantages to the competitiveness of U.S. banking 

institutions as a reason for allowing the instruments as Tier 1 capital.

Changes to the definition of Tier 1 capital resulting from the Dodd-Frank 

Act and Basel III effectively eliminate hybrid capital instruments that 

qualify for tax-deductible status in the United States. Both the Dodd-Frank 

Act and Basel III prevent the use of trust preferred securities in Tier 1 

capital, and Basel III restricts the use of REIT preferred securities for 

large banking institutions. In addition to the Dodd-Frank Act’s exclusion of 

trust preferred securities, Basel III contains provisions that would 

eliminate the instruments’ use as Tier 1 capital, although over a longer 

period.50 The Basel III framework requires Tier 1 instruments that are not 

common equity to meet certain criteria—including having a perpetual 

maturity and discretionary, noncumulative dividends—that effectively 

exclude trust preferred securities. Furthermore, Basel III limits the amount 

of Tier 1 capital credit for instruments such as REIT preferred, hindering 

their use as a tax-advantaged source of Tier 1 capital, according to 

market participants. The Basel III standards provide a single global 

definition of bank regulatory capital, but how those standards are adopted 

and implemented depends on statutory and regulatory action by national 

authorities.51

However, some foreign jurisdictions have tax codes that may allow tax 

advantages for hybrid instruments that would still qualify as Tier 1 under 

To promote complete and globally consistent 

implementation, the Basel Committee established a framework to monitor 

and review implementation of Basel III capital requirements. 

 

50The Dodd-Frank Act allows institutions with less than $15 billion in total assets to 

continue including existing hybrid instruments in Tier 1 and phases out Tier 1 treatment of 

such instruments for institutions over $15 billion from 2013 through 2016. Basel III phases 

out Tier 1 treatment of hybrid (noncommon equity) Tier 1 instruments for all internationally 

active banking institutions from 2013 through 2022.

51Basel III requires member countries to complete implementation by translating the rules 

into national laws and regulations prior to January 1, 2013.
 

Page 40 GAO-12-237 Hybrid Capital Instruments

the new Basel III definition, potentially leaving U.S. institutions with a 

cost-of-capital disadvantage. The tax treatment of capital instruments—

such as the ability to deduct interest or dividend payments—differs across 

countries based on their domestic tax regimes, potentially resulting in 

varied after-tax costs of Tier 1 instruments across countries. According to 

market participants, some foreign jurisdictions—particularly in Europe—

allow tax deductibility of some perpetual, noncumulative capital 

instruments that would still meet Basel III Tier 1 criteria. For example, a 

2006 report by the Committee of European Bank Supervisors indicated 

that European countries such as France, Germany, Spain, and the United 

Kingdom allow tax deductibility of some types of noncumulative, perpetual 

instruments that are not tax deductible in the United States.52 In a 2007 

report on the use of hybrid capital instruments in Europe, the same 

organization found that almost all Tier 1 hybrid instruments in Europe 

were perpetual (95 percent) and noncumulative (93 percent).53

The international competitive effects of any such disadvantage for U.S. 

institutions are uncertain given the scope and significance of other 

regulatory reforms occurring domestically and globally. Basel III and the 

Dodd-Frank Act include many significant changes to capital requirements 

and financial regulation that may have consequences for the international 

competitiveness of U.S. banking institutions—consequences that are 

equal to or greater than the consequences of the changes to Tier 1 hybrid 

Market 

participants indicated that the lack of tax-deductible Tier 1 capital could 

result in a cost of capital disadvantage for U.S. institutions relative to their 

international peers. The longer time frame for excluding trust preferred 

securities and other Tier 1 hybrid instruments under Basel III rules also 

could present a cost-of-capital disadvantage for U.S. banking institutions 

during the extended phase-out period.

 

52Committee of European Banking Supervisors, Survey of the Implementation of the 

Current Rules on Own Funds Across Member States: Annex 8—Overview of Hybrid 

Instruments Eligible as Original Own Funds (London, UK: June 23, 2006).

53Committee of European Banking Supervisors, Report on a Quantitative Analysis of the 

Characteristics of Hybrids in the European Economic Area (London, UK: Mar. 13, 2007). 

The definition of Tier 1 hybrid instruments used by the Committee of European Bank 

Supervisors differs from the definition used in our report, which is based on the Federal 

Reserve’s restricted core capital elements and does not include noncumulative preferred 

stock. The Committee of European Bank Supervisors uses a broader definition that 

includes (1) innovative instruments with an incentive to redeem such as step-up features; 

(2) noninnovative instruments that do not have incentives to redeem, and (3) 

noncumulative perpetual preference shares.
 

Page 41 GAO-12-237 Hybrid Capital Instruments

capital rules. For example, Basel III increases required capital levels; 

introduces additional capital buffers; expands its coverage of risks, 

including those from securitizations and trading counterparties; and 

introduces a leverage ratio requirement and liquidity standards. The 

Dodd-Frank Act introduced fundamental reforms across the banking and 

financial regulatory systems, including changes to the regulation of 

systemic risks, the trading and investment activities of banking 

institutions, the use and trading of derivatives, securities regulation, and 

the structure of bank supervision. The extent to which these regulatory 

reforms may interact to present additional competitive advantages or 

disadvantages to U.S. banking institutions relative to their foreign peers 

will determine the ultimate significance of any tax disadvantage from 

hybrid instruments.

In addition, market participants identified other factors that might affect any 

international competitiveness implications of not permitting tax-deductible 

Tier 1 hybrid instruments. First, U.S. regulators have not yet proposed rules 

for implementing Basel III, and their decisions on how, when, and for which 

institutions the provisions will apply may limit potential tax disadvantages. 

For example, one banking institution said that U.S. regulators could choose 

not to apply Basel III minority interest deductions to REIT preferred 

securities because regulators can require that the instruments be converted 

to preferred shares when necessary to absorb financial losses more 

effectively. Second, concerns about a cost-of-capital disadvantage would 

apply only to the largest U.S. banks that compete globally rather than to the 

many smaller banking institutions that compete with each other 

domestically. Third, institutions in some foreign jurisdictions may face 

competitive disadvantages from a more stringent application of Basel III 

rules for hybrid instruments. For example, European authorities said that 

draft rules for European institutions require an explicit loss absorption 

mechanism—such as the ability to write down or convert the hybrid 

instrument to equity—for all Tier 1 hybrid instruments, while the Basel III 

rules require such features only for some instruments (not including 

preferred shares). Finally, hybrid instruments will have a more limited role 

than in the past because of increased regulatory requirements for the 

amount of common equity in Tier 1, potentially moderating any competitive 

disadvantages from differences in the cost of Tier 1 hybrid capital. For 

example, the common equity requirement under Basel III represents over 

80 percent of the overall Tier 1 capital requirement, and the share is higher 
 

Page 42 GAO-12-237 Hybrid Capital Instruments

for systemically important institutions.54 A higher requirement for common 

equity results in a smaller scope for using hybrid instruments to meet 

overall Tier 1 levels. Previous Basel guidelines called for common equity to 

make up only the predominant share of overall Tier 1—effectively 51 

percent.55 Thus, any cost of capital disadvantages from Tier 1 hybrid 

instruments may be relatively less significant than under prior international 

regulatory capital frameworks.

Smaller banking institutions generally had limited options for raising capital, 

and one important form of capital—trust preferred securities—is now 

largely unavailable to these banks.56

Trust preferred securities quickly became a popular option for smaller 

institutions to access capital. Available data show that, from 2000 to 

2007, trust preferred securities accounted for over half of all regulatory 

capital offerings made by smaller institutions and totaled more than $23 

According to market participants we 

interviewed, around 2000 or earlier, smaller institutions had little to no 

access to public capital markets, in part because their offerings were not 

large enough to attract investors. Starting in 2000, investment banks began 

pooling the trust preferred securities of many smaller institutions and selling 

shares of those pools to investors. This pooling of trust preferred securities 

expanded smaller institutions’ access to capital by removing many of the 

previous obstacles to attracting investors. For example, the pooled 

structures received combined credit ratings for all of the underlying issuers, 

while many smaller institutions did not receive individual ratings. As a 

result, for the first time, smaller institutions were able to access significant 

amounts of capital from investors who required credit ratings.

 

54Basel III requires systemically important banking institutions to meet a minimum 

additional Tier 1 capital requirement comprised entirely of common equity and ranging 

from 1 percent to 2.5 percent depending on the institution’s systemic importance. 

55Basel Committee on Banking Supervision press release, “Instruments eligible for 

inclusion in Tier 1 capital” (Oct. 27, 1998).

56Smaller banking institutions are defined as banks, thrifts, and bank and thrift holding 

companies with less than $10 billion in total assets. For the purposes of this section, 

capital generally refers to capital instruments that an institution’s primary federal regulator 

has permitted as Tier 1 or Tier 2 regulatory capital.

Smaller Banking 

Institutions Face 

Limited CapitalRaising Options but 

Report Little Unmet 

Capital Need
 

Page 43 GAO-12-237 Hybrid Capital Instruments

billion (see fig. 8).57 Based on our nationally representative survey, we 

estimate that 30 percent of smaller institutions considered that prior to 

January 1, 2008, their ability to issue trust preferred securities (including 

pools of trust preferred securities) had been beneficial to their ability to 

access regulatory capital.58 About half of institutions did not issue any 

trust preferred securities, and 10 percent considered their ability to issue 

trust preferred securities not at all beneficial.59

 

57These data include offerings of capital instruments that may be counted as Tier 1 or Tier 

2 regulatory capital: common stock, preferred stock, trust preferred securities, and 

subordinated debt. These data are from SNL Financial, which obtains information on 

capital offerings from SEC filings and press releases. While these data include public and 

private offerings, they do not reflect capital raises by institutions that do not file with SEC, 

do not have parent companies that file with SEC, and are not publicly traded, such as 

some small institutions that may receive equity investments from board members or the 

local community. Comprehensive data on private capital raises were unavailable.

58GAO conducted a nationwide representative web-based survey of banks, thrifts, and 

holding companies with less than $10 billion in total assets from June to August 2011. We 

received valid responses from 510 (64 percent) out of the 794 sampled banking 

institutions. The weighted response rate was 66 percent. All percentage estimates have a 

95 percent confidence level of ± 7 percentage points or less. This estimate represents 

those respondents who answered either “greatly beneficial” or “moderately beneficial” to 

the survey question. For more details on the survey methodology and questions, see 

appendixes I and III.

59The remaining respondents reported “no opinion.” 
 

Page 44 GAO-12-237 Hybrid Capital Instruments

Figure 8: Smaller Banking Institutions’ Capital Offerings, 2000-2011

Note: Figures for 2011 represent only the first two quarters. 

During and following the financial crisis, however, offerings of trust 

preferred securities dropped considerably. According to market 

participants, investors were no longer interested in purchasing trust 

preferred securities, partly because of their performance during the 

financial crisis and concerns about new regulatory restrictions such as 

those under the Dodd-Frank Act. Specifically, many investors in trust 

preferred securities found that the instruments did not meet their 

expectations during the crisis. For example, more institutions deferred 

dividends than investors had expected, particularly smaller institutions. 

Additionally, pools of trust preferred securities did not prove to be as 

diversified as anticipated. After 2007, trust preferred securities accounted 

for a much smaller share of smaller institutions’ regulatory capital 

offerings—just 3 percent from 2008 through 2010—and no smaller 

institutions offered trust preferred securities in the first half of 2011. Based 
 

Page 45 GAO-12-237 Hybrid Capital Instruments

on our survey, an estimated 12 percent of smaller institutions would likely 

be able to raise trust preferred securities within the next year.60

With trust preferred securities largely unavailable, smaller institutions 

increased their reliance on other types of preferred shares as a capital 

source, largely through investments from the Treasury Department’s 

Troubled Asset Relief Program (TARP). Prior to the financial crisis, 

smaller banking institutions rarely issued preferred shares that were not 

pooled into trust preferred securities. For example, between 2000 and 

2007, preferred shares accounted for 4 percent of the number of 

regulatory capital offerings of smaller institutions. However, in 2008 and 

2009, when TARP made its investments in hundreds of banking 

institutions, over half (58 percent) of smaller institutions’ capital offerings 

were in the form of preferred shares. Of these, 82 percent were offered 

through TARP. As the federal government is no longer making new 

capital investments in banking institutions, smaller institutions will likely 

face more limited access to preferred shares in the future. For example, 

preferred shares accounted for only 17 percent of smaller institutions’ 

capital offerings in the first half of 2011.

Common equity now predominates, and the most available source of 

capital for smaller institutions is equity investments from board members or 

the local community. In 2010 and 2011, most capital offerings by smaller 

institutions (70 percent) were in the form of common equity. In 2010, 

smaller institutions raised more common equity—$7 billion—than in any 

year between 2000 and 2009, a period when the average amount raised 

annually was $3.4 billion. Based on our survey results, we estimate that 70 

percent of smaller institutions would likely be able to raise equity capital 

from board members or their local community within the next year. 

However, smaller institutions were considerably less likely to be able to 

raise capital in other forms during this time. For example, we estimate that 

about 30 percent of institutions would likely be able to raise preferred equity 

from a private placement, subordinated debt, or common equity from a 

public offering, and the estimated percentages are lower for preferred 

equity from a public offering and trust preferred securities (see fig. 9).

 

60The percentage estimates of smaller institutions that would likely be able to raise capital 

reflect the “very likely” and “somewhat likely” responses to the survey question.
 

Page 46 GAO-12-237 Hybrid Capital Instruments

Figure 9: Perceived Ability of Smaller Institutions to Successfully Raise Capital, as 

of August 15, 2011

Notes: Estimates reflect “very likely” and “somewhat likely” responses to the survey question “How 

likely is it that your institution would be able to raise the following types of regulatory capital at 

acceptable cost, terms, and conditions within the next year?” 

Percentages are estimates based on the results of our nationally 

representative sample of smaller banking institutions. All estimates have 

a margin of error of less than 7 percentage points.

Smaller institutions consider their financial condition and performance (for 

example, profitability, debt and capital levels, and asset quality) as the 

most important factor in their ability to successfully access capital. Based 

on our survey results, we estimate that 87 percent of smaller institutions 

consider financial condition and performance as a very important factor in 

their ability to raise capital. Market participants noted that investors may 

be concerned about smaller institutions’ loan portfolios and 

concentrations in commercial real estate. They explained that smaller 

institutions tend to have greater geographic concentration and fewer 

business lines and tend also to focus on traditional lending, which has not 

been profitable recently. Management quality was the second most 

important factor, with 74 percent considering it as very important to 

raising capital. One smaller institution with less than $100 million in total 

assets noted that it could raise capital fairly easily from existing investors 

and local customers but added that they would have to perceive the 

bank’s performance and management as satisfactory. Smaller institutions 

rated several other factors as important to their ability to successfully 

Smaller Institutions’ 

Ability to Raise Capital 

Varies by Financial 

Condition and Other 

Factors
 

Page 47 GAO-12-237 Hybrid Capital Instruments

raise capital, including growth potential, the economic environment in 

their lending area, and familiarity with investors.

Additionally, results from our survey showed that smaller banking 

institutions’ ability to raise different forms of capital varied somewhat by 

factors such as asset size, ownership type (public or private), institution 

type (bank or thrift), and organization structure (holding company or 

stand-alone). For example, we estimate that a larger proportion of public

institutions and institutions with total assets of between $500 million and 

$10 billion were likely to be able to raise common equity from a private 

capital offering than were private institutions and institutions with less 

than $500 million in total assets. Also, a larger proportion of banks and 

holding companies were likely to be able to raise subordinated debt than 

were thrifts and stand-alone institutions without a holding company. 

However, most of these groups saw equity investments from board 

members or the local community as the most available form of capital.

The current regulatory capital-raising environment was described as very 

challenging for an estimated 44 percent of smaller banking institutions 

and moderately challenging for an additional 32 percent, for several 

reasons. Smaller institutions most often considered the economic climate 

and laws and regulations as challenges to their institutions’ ability to raise 

capital. Specifically, 89 percent of smaller institutions found the economic 

climate, market conditions, or both to be challenging to their ability to 

raise capital, and 86 percent found laws and regulations to be 

challenging.61 Several respondents identified SEC rules that apply 

additional reporting requirements to institutions exceeding 500 

shareholders as a constraint on their ability to raise capital from new 

investors.62

 

61The percentage estimates of smaller institutions that considered certain factors as 

challenging reflect the “very challenging” and “moderately challenging” response options 

to the survey question.

Other factors that the majority of smaller institutions identified 

as challenging included the transaction costs of conducting a public 

offering, lack of access to public capital markets, and investors’ 

preference for large offerings.

62Under Securities Exchange Act Section 12(g), an issuer with 500 or more holders of a 

class of its equity securities and assets in excess of $10 million generally must register 

that class of security with the Securities and Exchange Commission. See 15 U.S.C. § 

78l(g)(1)(B); 17 C.F.R. § 240.12g-1.
 

Page 48 GAO-12-237 Hybrid Capital Instruments

Market participants also identified several factors that inhibited smaller 

institutions’ access to public capital markets. For example, some 

investors have minimum investment requirements and cannot make 

investments below a certain size. At the same time, limitations on the 

share of ownership of banks—beyond which investors would have to 

register as a bank holding company—restrict the share of equity 

securities that most investors are willing to purchase. According to some 

market participants, the minimum investment size requirements, along 

with ownership limitations, eliminate many investors as a potential capital 

source for small institutions. Additionally, market participants said that 

potential investors generally were not willing to devote resources to 

researching offerings of relatively small banks because the research 

required for a small offering was nearly the same as it would be for a 

larger offering that would provide more potential for a higher absolute 

return. Also, market participants noted that investors generally required 

that the securities they purchased be liquid—that is, easily resold at a 

reasonable price. The capital offerings of smaller institutions typically 

have less liquidity than those of larger institutions because a more limited 

group of investors is able and willing to purchase the instruments, and 

they are traded less frequently. Finally, market participants reported that 

credit rating agencies generally did not rate the offerings of smaller 

institutions, which can restrict access to public capital markets.

Most smaller institutions have not raised capital since January 1, 2008, 

and the majority of those reported no need for or interest in additional 

capital (see fig. 10). Specifically, we estimate that 65 percent of smaller 

institutions have not raised capital since January 1, 2008, and 88 percent 

of those did not need or want to raise more regulatory capital. Only 3 

percent of smaller institutions that had not raised capital since January 1, 

2008, attempted to raise capital but were unable to do so.

A Majority of Smaller 

Institutions Report No 

Unmet Capital Need
 

Page 49 GAO-12-237 Hybrid Capital Instruments

Figure 10: Capital-Raising Activity among Smaller Institutions since January 1, 2008, as of August 15, 2011

Note: Percentages are estimates based on the results of our nationally representative sample of 

smaller banking institutions. All estimates have a margin of error of less than 7 percentage points. 

The smaller institutions that had raised capital since January 1, 2008, 

were generally satisfied with the capital they had raised. We estimate that 

35 percent of smaller institutions had raised regulatory capital since 

January 1, 2008. Of these institutions, 82 percent reported that the 

amount of regulatory capital raised met their goal, and 93 percent 

reported that it met their initial terms and conditions.

Institutions whose financial condition was relatively strong generally had a 

more favorable view of the capital-raising environment. Supervisory 

examination ratings assigned by a banking institution’s primary regulator 
 

Page 50 GAO-12-237 Hybrid Capital Instruments

generally assess the institutions’ financial condition and performance.63

 

63The federal banking agencies assign a supervisory rating when they conduct 

examinations of a bank or thrift’s safety and soundness. The numerical ratings range from 

1 to 5, with 1 being the strongest and 5 the weakest. The ratings—referred to as 

CAMELS—assess six components of an institution’s financial health: capital, asset quality, 

management, earnings, liquidity, and sensitivity to market risk. The Federal Reserve also 

uses ratings to measure the overall condition of bank and thrift holding companies. 

According to our survey results, institutions that found the current 

regulatory capital-raising environment challenging had weaker 

supervisory ratings on average than institutions that did not find the 

environment challenging (see fig. 11). Furthermore, among smaller 

institutions that raised capital, the institutions that met their initial targets 

had significantly stronger supervisory ratings than institutions that did not 

meet their target amounts. Consistent with our survey results, market 

participants noted that capital was available for relatively healthy 

institutions that sought capital to support growth opportunities but was 

largely unavailable to weaker institutions seeking capital to address 

problems with their financial condition and performance.
 

Page 51 GAO-12-237 Hybrid Capital Instruments

Figure 11: Smaller Institutions’ Views of the Capital-Raising Environment by 

Supervisory Rating, as of August 15, 2011

Note: Percentages are estimates based on the results of our nationally representative sample of 

smaller banking institutions. All estimates have a margin of error of less than 7 percentage points. 
 

Page 52 GAO-12-237 Hybrid Capital Instruments

We provided a draft of this report to FDIC, the Federal Reserve, and OCC 

for their review and comment. FDIC and the Federal Reserve provided 

technical comments that were incorporated, as appropriate.

We are sending copies of this report to appropriate congressional 

committees, FDIC, the Federal Reserve, OCC, and other interested 

parties. In addition, the report is available at no charge on the GAO 

website at http://www.gao.gov. 

If you or your staff have any questions about this report, please contact 

me at (202) 512-2642 or mccoolt@gao.gov. Contact points for our Offices 

of Congressional Relations and Public Affairs may be found on the last 

page of this report. GAO staff who made key contributions to this report 

are listed in appendix IV. 

Thomas J. McCool

Director

Center for Economics,

Applied Research and Methods

Agency Comments
Appendix I: Objectives, Scope, and 

Methodology

Page 53 GAO-12-237 Hybrid Capital Instruments

The objectives of our report were to examine (1) the use of hybrid capital 

instruments as Tier 1 capital and the benefits and risks of including them 

in this category, (2) the potential effects on banking institutions and the 

economy of prohibiting the use of hybrid instruments to meet Tier 1 

capital requirements, and (3) options that exist for smaller banking 

institutions to access regulatory capital.

To describe the use of Tier 1 hybrid capital instruments, we analyzed data 

from banking institutions’ regulatory financial filings and reviewed relevant 

federal banking regulations. To determine the instruments that were 

eligible for Tier 1 capital treatment for various banking institutions, we 

reviewed the statutes and regulations concerning capital requirements for 

banks (including national banks, state member banks, and state 

nonmember banks), thrifts, and bank and thrift holding companies. We 

also interviewed federal banking regulators—specifically, from the 

Federal Deposit Insurance Corporation (FDIC), the Board of Governors of 

the Federal Reserve System (Federal Reserve), the Office of the 

Comptroller of the Currency (OCC), and the Office of Thrift Supervision 

(OTS)—to determine the regulatory treatment of hybrid capital 

instruments for different banking institutions. We defined the scope of this 

report to focus on instruments that the Federal Reserve made eligible for 

limited inclusion in Tier 1 capital for bank holding companies but were not

allowed for other types of banking institutions. These instruments—

defined by the Federal Reserve as restricted core capital elements—will 

be excluded from Tier 1 capital by the Dodd-Frank Wall Street Reform 

and Consumer Protection Act (Dodd-Frank Act) and include trust 

preferred securities, which are widely recognized as the most common 

hybrid capital instrument. Because federal banking regulators did not 

allow these instruments as Tier 1 capital for depository institutions—

banks and thrifts—our review focused on the use of hybrid instruments by 

holding companies.

To assess the use of hybrid instruments by bank holding companies, we 

analyzed data that these institutions report to the Federal Reserve 

annually on form FR Y-9C, “Consolidated Financial Statements for Bank 

Holding Companies.” This report is filed by all top-level bank holding 

companies with $500 million or more in consolidated total assets and by 

select institutions with less than $500 million in total assets. The Federal 

Reserve supervises approximately 5,000 top-level bank holding 

companies, although most of these do not file form FR Y-9C and are not 

subject to Tier 1 capital requirements because of their small asset size. 

For December 31, 2010, our data included 969 top-level bank holding 

Appendix I: Objectives, Scope, and 

Methodology 

Use of Tier 1 Hybrid 

Capital Instruments and 

Their Benefits and Risks
Appendix I: Objectives, Scope, and 

Methodology

Page 54 GAO-12-237 Hybrid Capital Instruments

companies. We removed a small number of institutions from our data that 

reported “NA” for total assets. We also removed a small number of 

domestic subsidiaries of foreign banking institutions that the Federal 

Reserve exempted from Tier 1 capital requirements. We analyzed yearend data from 1997—the first full year following the Federal Reserve’s 

decision to allow trust preferred securities as Tier 1 capital—through 

2010, the most recent year with complete data available. We collected the 

FR Y-9C data using SNL Financial, a private data provider, and 

calculated the amount of hybrid instruments eligible for inclusion in Tier 1 

in consultation with the Federal Reserve.

We also assessed the use of hybrid capital instruments by thrift holding 

companies. Although thrift holding companies were not subject to uniform 

Tier 1 capital requirements, they were informally assessed under rules 

similar to the Federal Reserve’s rules for bank holding companies, 

according to OTS officials.1 As such, we included thrift holding companies 

in our analysis using a proxy Tier 1 calculation described in the OTS 

examiner’s handbook for thrift holding companies. We obtained data on 

thrift holding companies from the holding company schedule in the Thrift 

Financial Report filed by OTS-supervised institutions. The data included 

some institutions that were not top-level consolidated thrift holding 

companies, and we removed them from our analysis after discussions 

with a former OTS official who is now at FDIC.2

To describe the benefits and risks of including hybrid instruments as Tier 

1 capital, we collected and reviewed studies and other documentary 

evidence from federal regulators, industry participants and observers, and 

academic sources. We conducted interviews with market participants, 

We used SNL Financial 

and the Federal Reserve’s National Information Center to determine 

which records to remove from our analysis. Because data from the Thrift 

Financial Report includes fewer fields than the FR Y-9C, we limited our 

analysis to thrift holding companies’ use of trust preferred securities from 

year-end 2004 to year-end 2010. Data on thrift holding companies’ use of 

trust preferred securities was not available prior to 2004.

 

1

As a result of the Dodd-Frank Act, thrift holding companies will be subject to uniform 

capital requirements in the future and will face the same restrictions on hybrid capital as 

bank holding companies.

2

Most OTS staff were reassigned to other federal banking regulators, including FDIC, in 

the summer of 2011. 
Appendix I: Objectives, Scope, and 

Methodology

Page 55 GAO-12-237 Hybrid Capital Instruments

including banking institutions, investment banks, credit rating agencies, 

law firms, industry associations, and each of the federal banking 

regulators. We also reviewed data on the recent default and dividend 

deferral activity of trust preferred securities provided to us by a major 

credit rating agency.

To assess the effects of excluding Tier 1 hybrid capital on the capital 

adequacy of financial institutions, we analyzed regulatory capital data to 

determine the extent to which bank holding companies may fall below 

minimum regulatory capital levels without Tier 1 hybrid instruments. We 

used year-end 2010 data from the FR Y-9C regulatory filing discussed 

previously as a baseline to compare institutions’ Tier 1 capital levels 

before and after the hybrid capital exclusion. We assessed potential 

reductions in institutions’ capital categories based on the Tier 1 riskbased capital ratio and Tier 1 leverage ratio. For the risk-based capital 

and leverage ratios, we used the capital adequacy category of well 

capitalized based on the levels that FDIC has identified for depository 

institutions under prompt corrective action standards. For the minimum 

capital levels for these ratios, we used benchmarks based on the Federal 

Reserve’s bank holding company capital adequacy regulations. To 

consider the most significant potential effects, our analysis removed all 

Tier 1 hybrid instruments from all bank holding companies’ Tier 1 capital. 

In reality, any effects will be mitigated by grandfathering, exemptions, and 

phase-in periods. We also collected information from interviews with 

regulators and industry participants and observers on the potential effects 

of the hybrid capital exclusion on the safety and soundness of banking 

institutions.

To evaluate the potential implications for international competitiveness of 

restricting Tier 1 hybrid capital, we reviewed studies and other 

documentary evidence and compared international rules on hybrid capital 

proposed by the Basel Committee on Banking Supervision with U.S. 

regulatory policy, including the Dodd-Frank Act. We also reviewed 

proposed rules to implement the new Basel Committee standards in 

Europe and reports by the Committee of European Banking Supervisors 

on the use of hybrid capital in Europe. We interviewed regulators, industry 

participants and observers, and European regulatory organizations to 

gather information on the effects of the hybrid capital exclusion on the 

international competitiveness of U.S. institutions.

For information on our analysis of the hybrid capital exclusion’s potential 

effects on the cost and availability of credit, see appendix II.

Effects of Excluding Tier 1 

Hybrid Instruments on 

Capital Adequacy and 

International 

Competitiveness
Appendix I: Objectives, Scope, and 

Methodology

Page 56 GAO-12-237 Hybrid Capital Instruments

To address our third objective, we conducted a nationally representative 

web-based survey of executives of banks, thrifts, and bank and thrift 

holding companies with less than $10 billion in total assets. Based on 

information on banking institutions provided by FDIC, OTS, and the 

Federal Reserve, we identified 6,733 institutions with less than $10 billion 

in total assets that would serve as the population for this survey. This 

population included all stand-alone banks and thrifts (banks and thrifts 

that do not have a holding company), as well as all top-level consolidated 

bank and thrift holding companies. We included top-level holding 

companies in our population rather than the subsidiary banks or thrifts 

because industry participants and regulators said that the holding 

company typically raised capital for its subsidiaries. We selected a 

stratified random sample of 794 institutions from the population of 6,733. 

We divided the population into four strata based on the amount of assets 

and the entity’s status—that is, whether it was part of a holding company 

or a stand-alone bank or thrift. We designed the sample size to produce a 

proportion estimate within each stratum that would achieve a precision of 

plus or minus 7 percentage points or less at the 95-percent confidence 

level. We then inflated the sample size for an expected response rate of 

50 percent. Because of the small number of banks and holding 

companies with assets greater than $5 billion and less than $10 billion, 

we selected all of these with certainty.

We received valid responses from 510 (64 percent) of the 794 sampled 

banking institutions. The weighted response rate, which accounts for the 

differential sampling fractions within strata, is 66 percent. We identified 

eight banking institutions in our sample that were either closed or were 

improperly included in the sampling frame. We classified these as out-ofscope institutions and adjusted our estimates so that they were 

generalized only to the 6,659 (+/- 58) institutions estimated to be in-scope 

institutions in the population.

Smaller Banking 

Institution Access to 

Regulatory Capital
Appendix I: Objectives, Scope, and 

Methodology

Page 57 GAO-12-237 Hybrid Capital Instruments

Table 7: Population, Sample Size, and Respondent Information for GAO Survey

Stratum 

Population 

size

Sample 

size

Out of 

scope

Respondents 

within scope

1. Holding company $5 billion-

$10 billion

63 63 2 30

2. Holding company less than 

$5 billion

5,118 378 5 249

3. Banks $5 billion-$10 billion 5 5 0 4 

4. Banks less than $5 billion 1,547 348 1 219

Total 6,733 794 8 502

Source: GAO survey of smaller banking institutions.

We analyzed our survey results to identify potential sources of 

nonresponse bias using two methods. First, we examined the response 

propensity of the sampled banking institutions by several demographic 

characteristics, including asset size, type of institution, region, regulator, 

and ownership status. Second, we compared weighted estimates from 

respondents and nonrespondents to known population values for four 

measures that were related to the survey outcomes we were most 

interested in. We conducted statistical tests of differences, at the 95-

percent confidence level, between estimates and known population 

values, and between respondents and nonrespondents. We determined 

that weighting adjustments within strata would be sufficient to mitigate 

any potential nonresponse bias. We did not observe any significant 

differences between weighted estimates and known population values or 

between respondents and nonrespondents.

The web-based survey was administered from June 15, 2011 to August 

15, 2011. We sent banking institution executives an e-mail invitation to 

complete the survey on a GAO web server using a unique username and 

password. Nonrespondents received several reminder e-mails and a 

letter from GAO asking them to complete the survey. The practical 

difficulties of conducting any survey may introduce additional 

nonsampling errors, such as difficulties interpreting a particular question, 

which can introduce unwanted variability into the survey results. We took 

steps to minimize nonsampling errors by pretesting the questionnaire with 

four banks in April 2011. We conducted pretests to make sure that the 

questions were clear and unbiased and that the questionnaire did not 

place an undue burden on respondents. An independent reviewer within 

GAO also reviewed a draft of the questionnaire prior to its administration. 

We made appropriate revisions to the content and format of the 

questionnaire after the pretests and independent review. All data analysis 
Appendix I: Objectives, Scope, and 

Methodology

Page 58 GAO-12-237 Hybrid Capital Instruments

programs were independently verified for accuracy. See appendix III for 

responses to survey questions. We also collected information on 

supervisory examination ratings from the Federal Reserve and FDIC to 

supplement information from our survey.

To identify trends in the amount and types of regulatory capital raised by 

smaller banking institutions since 2000, we analyzed data on capital 

issuances. We obtained data from SNL Financial, which collects capital 

issuance data from Securities and Exchange Commission filings and press 

releases. We limited our review to the issuance of instruments that may be 

counted as Tier 1 or Tier 2 regulatory capital by an institution’s primary 

federal regulator. These included common equity, preferred stock, trust 

preferred securities, and subordinated debt. We discussed the data with SNL 

Financial representatives to confirm our understanding of what the data 

represented and what types of capital issuances were not included. The data 

included offerings on public and private exchanges but did not reflect capital 

raises that were not publicly offered, such as equity investments in small 

institutions made by board members or local communities. Comprehensive 

data on the raising of private capital were unavailable.

We also interviewed market participants, including banking institutions, 

investment banks, industry associations, and federal banking regulators, 

to collect information on how smaller banking institutions access 

regulatory capital and challenges they face in raising capital.

For parts of our methodology that involved the analysis of computerprocessed data, we assessed the reliability of these data and determined 

that they were sufficiently reliable for our purposes. Specifically, we 

conducted reliability assessments on the SNL Financial data and on data 

from OTS’s Thrift Financial Reports. To assess the reliability of these data, 

we reviewed factors such as the timeliness, accuracy, and completeness. 

We conducted electronic testing and manual review to identify missing and 

out-of-range data and other anomalies and compared computer-generated 

data to source documents for a selected sample of companies.

We conducted this performance audit from December 2010 to January 

2012 in accordance with generally accepted government auditing 

standards. Those standards require that we plan and perform the audit to 

obtain sufficient, appropriate evidence to provide a reasonable basis for 

our findings and conclusions based on our audit objectives. We believe 

that the evidence obtained provides a reasonable basis for our findings 

and conclusions based on our audit objectives.
Appendix II: GAO Analysis of the Economic 

Effects of the Hybrid Capital Exclusion 

Page 59 GAO-12-237 Hybrid Capital Instruments

To assess the effects on banking institutions and the economy of 

prohibiting the use of hybrid instruments to meet Tier 1 capital 

requirements, we analyzed the potential impact of this change on the cost 

and availability of credit. Specifically, we designed a modified version of 

an established econometric model to estimate the effect of a change in 

Tier 1 capital levels on key credit market variables, including loan volume 

growth and lending spreads. We also used a modified version of an 

existing loan pricing model to assess the impact on loan rates of banking 

institutions’ inability to include newly issued hybrid securities as Tier 1 

capital.

To estimate the effect of changes to banking institutions’ capital ratios on 

the cost and availability of credit, we estimated a modified version of a 

vector autoregression (VAR) model commonly used in macroeconomic 

and monetary research. Our VAR model consists of eight variables, 

including variables that serve as a proxy for the banking sector. We 

conducted analysis known as “innovation accounting” to trace a 

temporary shock to bank capital through the banking system. These 

techniques allowed us to form estimates of the impact of changes in 

capital ratios on loan growth, loan spreads, and lending standards. Our 

model closely follows similar analysis by Berrospide and Edge (2010), 

Lown and Morgan (2006), and Bernanke and Gertler (1997). We found 

that a negative 1 percentage point decrease in the capital ratio results in 

a 1.2 percentage point decline in loan volume growth and a 0.16 

percentage point (16 basis points) increase in loan spreads. We 

calibrated these estimates to the capital shock resulting from the hybrid 

capital exclusion, assuming that banks have a particular capital target.

The VAR methodology provides a systematic method to capture 

dynamics in multiple time series and provide empirical evidence on the 

response of macroeconomic variables to various exogenous changes 

(called shocks or impulses within the framework). In contrast to structural 

models, VARs do not rely on detailed ex ante modeling of the 

relationships among the variables of interest. So long as they are present 

in the data during the period over which the model is estimated, many of 

the factors that need to be modeled separately by other estimation 

approaches—including international spillovers, impacts of competition or 

market power, and the stabilizing role of monetary policy—are 

incorporated implicitly.

The VAR methodology advanced by Sims (1980) treats all variables 

symmetrically and as potentially endogenous. That is, each variable in the 

Appendix II: GAO Analysis of the Economic 

Effects of the Hybrid Capital Exclusion

Vector Autoregression 

Model
Appendix II: GAO Analysis of the Economic 

Effects of the Hybrid Capital Exclusion 

Page 60 GAO-12-237 Hybrid Capital Instruments

model is treated as if it is influenced by other variables in the system. No 

structure is imposed on the variables in the model, and instead any 

existing causal relations are determined purely by the data itself. Each 

variable is expressed as a linear function of its own past values and the 

past values of all other variables included in the system. The equations 

are estimated by ordinary least squares (OLS) with the error terms 

representing surprise/unexpected movements in the variables after taking 

past values into account.1

The VAR methodology can be transformed to examine the dynamic 

reaction of each of the endogenous variables to shocks to the system.2

Our VAR model consists of eight variables. The core variables that 

represent the macroeconomy are (1) real gross domestic product (GDP) 

growth, (2) GDP price inflation, (3) federal funds rate, and (4) commodity 

price index growth. As Lown and Morgan (2006) discuss, these four 

variables potentially make up a complete economy with output, price, 

demand, and supply all represented. We captured the banking sector with 

This technique is often referred to as innovation accounting and involves 

the construction of impulse response functions. Impulse responses trace 

the effects of shocks or innovations to one variable through the system 

and examine their impacts on the other included variables. In tracing out 

the response of current and future values of each of the variables to a 

shock in the current value of one of the VAR errors, we assume that this 

error returns to zero in subsequent periods and that all other errors are 

equal to zero. Consequently, the shock is designed to be temporary. To 

exploit the innovation accounting framework and identify the impulse 

response function, we must impose some structure on the model that 

takes the form of simplifying restrictions. These restrictions result in 

causal priority given to some variables over others and are generally 

driven by theory. As a result, although the system incorporates feedback 

between all of the variables, some variables are expected to impact on 

others without contemporaneous feedback. As we discuss later, the 

ordering of variables is critically important and can impact the results in 

material ways.

 

1

For more on the VAR methodology, see C.A Sims. “Macroeconomics and Reality,” 

Econometica, vol. 48 (1980), 1-48.

2

The residuals obtained from each of the estimated OLS regressions in the VAR system 

are combinations of underlying structural innovations.
Appendix II: GAO Analysis of the Economic 

Effects of the Hybrid Capital Exclusion 

Page 61 GAO-12-237 Hybrid Capital Instruments

four variables: (1) real loan volume growth—commercial bank and thrift 

loan growth in our base models, (2) changes in lending spreads—

commercial and industrial loan rate relative to a benchmark, (3) lending 

standards as measured by the net fraction of loan officers at commercial 

banks reporting a tightening of credit standards for commercial and 

industrial loans (C&I) in the Federal Reserve’s Senior Loan Officer 

Opinion Survey, and (4) the aggregate capital-to-assets ratio for the 

commercial banking sector. The addition of the latter four variables allows 

us to investigate the dynamic interaction between banks and the 

macroeconomy. We assembled the data from Thomson Reuters 

Datastream and the Federal Reserve System (table 8). We have relied on 

this data in our past reports and neither Thomson Reuters Datastream 

nor the Federal Reserve has changed their methods for collecting or 

reporting data since we relied on it last. We consider this data to be 

reliable for our purposes.

Table 8: Data Used in VAR Model

Variable Source

Real gross domestic product (GDP) Thomson Reuters Datastream

GDP price inflation Thomson Reuters Datastream

Federal funds rate Thomson Reuters Datastream

Spot commodity price index Thomson Reuters Datastream

Lending spreads Board of Governors of the Federal 

Reserve System

Real loan volumes

Total commercial bank loans Board of Governors of the Federal 

Reserve System

Total savings institution loans Board of Governors of the Federal 

Reserve System

Capital-to-assets ratio (commercial bank sector) Federal Reserve Bank of St. Louis

Lending standards Thomson Reuters Datastream

Source: GAO.

We transformed all of the variables into growth rates except for the capital 

ratio and lending standards in our base models. We adjusted loan 

volumes for inflation as suggested by the Basel Committee on Banking 

Supervision’s Macroeconomic Assessment Group. Using the estimated 

VAR system for the third quarter of 1990 through the fourth quarter of 

2010, we traced out the dynamic responses of loan volumes, lending 

spreads, and other macroeconomic variables to shocks to the bank 
Appendix II: GAO Analysis of the Economic 

Effects of the Hybrid Capital Exclusion 

Page 62 GAO-12-237 Hybrid Capital Instruments

capital ratio. As a result, we can obtain quantitative estimates of how 

bank “innovations” or “shocks” affect the cost and availability of credit.

To model the relationship as validly as possible, we

• transformed the variables to ensure that they were stationary,

• selected the appropriate lag length using a formal test,

• tested formally for the stability of the system,

• determined a reasonable ordering of the variables, and

• conducted sensitivity tests.

Our base results rely on impulse response functions using the following 

causal ordering of the variables: GDP, GDP deflator (inflation), federal 

funds rate, commodity spot prices, loan volumes, capital ratio, loan 

spreads, and lending standards. However, we also obtained impulse 

response functions using an alternative ordering that gave causal priority 

to the banking sector variables. Although these are two extremely 

different ordering schemes, we found that the results were only mildly 

sensitive to the decision to give causal priority to the macroeconomic 

variables. For example, using the standard ordering of the variables, we 

found a 1 percentage point increase in the capital ratio yields peak effects 

on loan volumes and lending spreads of 0.96 percentage points and 14 

basis points, while the alternative order produced peak effects of 1.4 

percentage points and 17 basis points, respectively. Nevertheless, our 

base estimates use the average of the outcomes for the two different 

orderings of the variables: (1) where the macro variables are given causal 

priority and (2) where the bank variables are given causal priority.

We also varied the functional form in some sensitivity tests, including 

changing the time period analyzed and using different proxies for loan 

volumes and bank capital. In some sensitivity tests, we excluded the 

effects of the global financial crisis by running the model on the time 

period from the third quarter of 1990 to the third quarter of 2008. The 

estimated parameters from these estimates generally resulted in smaller 

effects on loans but larger effects on loan spreads. One finding in the 

literature is that C&I loans are more sensitive to changes in capital. As a 

result, we looked directly at the response of C&I loans to a capital shock. 

Our results were consistent with the literature, and we found an impact of 

capital changes on C&I loan volumes of about twice the size as the 
Appendix II: GAO Analysis of the Economic 

Effects of the Hybrid Capital Exclusion 

Page 63 GAO-12-237 Hybrid Capital Instruments

impact for aggregate loans. Specifically, for C&I loans, we found that a 

negative 1 percentage point increase in the capital ratio results in a 2.4 

percentage point decline in loan volume growth and a 21 basis point 

increase in loan spreads.

The VAR methodology, while containing some advantages over other 

modeling techniques, has particular limitations, and therefore results 

using this approach should be interpreted with caution. First, the 

methodology potentially overstates the quantitative effects of shocks on 

the economy and can be difficult to interpret. Second, the results are 

heavily influenced by market and macroeconomic conditions in place 

during past periods of large changes in the modeled variables, so they 

may not be informative if similar shifts take place under different 

circumstances. Also, because the statistical relationships are estimated 

from aggregate historical data, the model may not be fully informative 

about how economic actors will respond to future policy changes. Third, 

the model parameters are aggregate estimates and may not generalize to 

the specific circumstances of some banks. Fourth, causal priority is given 

to some variables over others in order to conduct meaningful 

assessments of the impacts of shocks to the system. Our results, 

however, are not particularly sensitive to this ordering, although we do 

obtain larger impacts of bank capital on lending activity with some 

alternative orderings. To minimize this limitation, our estimates are an 

average of a model where causal priority is given to the macroeconomic 

variables and a model where causal priority is given to the bank variables. 

It should also be noted that VAR shocks reflect omitted variables. If the 

omitted variables (factors or information) correlate with included variables, 

then the estimates will contain omitted variable bias. Lastly, in our 

particular case, the impulse response functions have wide confidence 

intervals, suggesting considerable uncertainty in the results. Despite 

these limitations, the VAR approach is considered to be a reasonable 

alternative to other types of models. Users of the report should be aware 

that the VAR methodology represents one approach to analyzing the 

effect of bank capital on lending activity. As a result, we believe the 

results should be analyzed in the context of the wider body of literature on 

the issue. Table 9 identifies studies that we used to compare our results 

for reliability and consistency.
Appendix II: GAO Analysis of the Economic 

Effects of the Hybrid Capital Exclusion 

Page 64 GAO-12-237 Hybrid Capital Instruments

Table 9: Relevant Studies on the Impact of Capital on Lending Activity

Bank for International Settlements, “Basel III: Long-term impact on economic 

performance and fluctuations,” BIS working paper, No. 338, Monetary and Economic 

Department (2011). 

Bank for International Settlements, “Assessing the macroeconomic impact of the 

transition to stronger capital and liquidity requirements,” interim report, Macroeconomic 

Assessment Group (August 2010).

B. Bernanke and C. Lown, “The Credit Crunch,” Brookings Papers on Economic Activity 

2: 205–47 (1991).

J. M. Berrospide and R. M. Edge, “The Effects of Bank Capital on Lending: What Do We 

Know? And What Does It Mean?,” Finance and Economics Discussion Series No. 44 

(Washington, D.C.: Federal Reserve Board, 2010).

Mark A. Carlson, H. Shan, and M. Warusawitharana, “Capital Ratios and Bank Lending: 

A Matched Bank Approach,” Federal Reserve Board working paper No. 2011-34 

(July 1, 2011).

T. Cosimano and D. Hakura, “Bank Behavior in Response to Basel III: A Cross-Country 

Analysis,” IMF working paper, WP/11/119, International Monetary Fund (2011).

Douglas J. Elliott, “A Further Exploration of Bank Capital Requirements,” Brookings 

briefing paper (Washington, D.C.: Brookings Institution, 2010).

Douglas J. Elliott, “Quantifying the Effects on Lending of Increased Capital 

Requirements,” Brookings briefing paper (Washington, D.C.: Brookings Institution, 2009).

M. King, “Mapping Capital and Liquidity Requirements to Bank Lending Spreads,” 

BIS working paper, No 324, Bank of International Settlements (2010).

C. Lown and D. Morgan, “The Credit Cycle and the Business Cycle: New Findings Using 

the Loan Officer Opinion Survey,” Journal of Money, Credit, and Banking 38 (6): 

1575–97 (2006).

Jan Vlcek and S. Roger, “Macroeconomic Costs of Higher Bank Capital and Liquidity 

Requirements,” IMF working paper 11/103, International Monetary Fund (2011).

P. Slovik and B. Cournede, “Macroeconomic Impact of Basel III,” OECD Economics 

Department Working Papers, No. 844, (Paris: Organization for Economic Cooperation 

and Development Publishing, 2011).

Source: GAO.

To assess the impact of the inability of banking institutions with greater 

than $500 million in assets to include newly issued hybrid securities as 

Tier 1 capital, we utilized a modified version of a loan pricing model 

following Elliott (2009, 2010). This methodology is designed to illustrate 

that banking institutions have multiple options for adjusting to more costly 

forms of Tier 1 capital and allows us to consider these different scenarios 

and show the implied change in lending rates. Given the variety of ways 

that banks can adjust and the degree of competition in loan markets, we 

found that the impact on lending rates will likely be modest.

Loan Pricing Model
Appendix II: GAO Analysis of the Economic 

Effects of the Hybrid Capital Exclusion 

Page 65 GAO-12-237 Hybrid Capital Instruments

Our framework is a simple mathematical model that is based on a loan 

pricing equation where the price of the loan is such that it must at least 

cover the weighted cost of capital, expected credit losses, and 

administrative expenses. We augment the equation found in Elliott (2009, 

2010) by decomposing equity into common equity and equitylike 

instruments (hybrid capital) that qualify as Tier 1 capital. Assuming that 

the loan is priced so that the rate charged at least covers the weighted 

cost of capital and that institutions hold common equity and hybrid capital 

as equity, we can write the following:

L*(1-t) >= (E*(EK*rce + EH*rtps(1-t))+((D*rd)+C+A-O)*(1-t) 

Where:

L = effective interest rate on the loan

t = marginal tax rate for the bank

E = proportion of equity backing the loan

rtps = required rate of return (yield) on the marginal hybrid securities (trust 

preferred securities)

rce = required rate of return (yield) on the marginal common equity

EK = proportion of equity held as common equity

EH = proportion of equity held as hybrid securities (trust preferred 

securities)

D = Proportion of debt and deposits funding the loan

rd = Effective marginal interest rate on D

C = the credit spread (equal to probability weighted expected loss on the 

loan portfolio)

A = administrative and other expenses related to the loan

O = other offsetting benefits to the bank of making the loan

This formula is used to capture the lower cost of hybrid securities, 

including the associated tax benefits (EH*rtps(1-t)). In practice these 

instruments are largely trust preferred securities. As a result, we use the 

yield on trust preferred securities as our proxy for the yield on the class of 

hybrid instruments. We assume that the yield on hybrid capital is 8.65 

percent based on our review of a small sample of actual trust preferred 

securities. For smaller banking institutions, we increase the yield on 

hybrid capital slightly to 9 percent. For the aggregate banking sector, we 
Appendix II: GAO Analysis of the Economic 

Effects of the Hybrid Capital Exclusion 

Page 66 GAO-12-237 Hybrid Capital Instruments

assume that institutions hold 12 percent of their Tier 1 equity in the form 

of hybrid securities based on our analysis of banking data from SNL 

Financial. Similarly, based on our analysis, we assume that smaller 

institutions hold a larger percentage of hybrid securities as equity—19 

percent. We initiated our model using the assumptions laid out in Elliott 

(2009, 2010) but then made modest adjustments to calibrate the loan rate 

to the actual yield on loans for the commercial banking sector (5.6 

percent). For smaller banking institutions, we used Elliott’s (2010) 

assumptions for banks with $1 billion to 10 billion in assets with minor 

modifications. For example, we assumed that smaller institutions had a 

higher probability-weighted loss on loan portfolios. The remaining 

assumptions not discussed here are contained in table 6.

Our scenario analysis is designed to illustrate how the loan rate might be 

affected given various assumptions about banking institutions’ responses 

and other mitigating factors. However, because there is limited empirical 

foundation for many of our initial values, the assumptions underlying the 

analysis and estimates for the loan rate should not be considered 

definitive. Our analysis is designed to illustrate how the cost of credit 

might change given various assumptions about institutions’ responses

and other factors, rather than arrive at precise estimates for the level of 

loan rates. Moreover, because we focused our analysis on the aggregate 

banking sector, the actual impact on and response by individual 

institutions can differ depending on a number of dynamics. For example, 

we have assumed that banking institutions have the ability to pass on 

higher costs to borrowers in the form of higher lending rates, to some 

degree. However, some institutions may have to resort to asset sales, 

thereby reducing the total amount of their risk-weighed assets or 

undertaking other actions due to the inability to pass on the higher cost of 

capital to customers.
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 67 GAO-12-237 Hybrid Capital Instruments

We sampled 794 stand-alone banks and thrifts (those with no holding 

company) and top-level bank holding companies and thrift holding 

companies with total assets of less than $10 billion from the population of 

6,733 to examine the options these smaller institutions have for raising 

capital. We received valid responses from 510 (64 percent) out of the 794 

sampled institutions. Tables 10-24 show the responses to questions from 

the survey. Because we followed a probability procedure based on 

random selections, our sample is only one of a large number of samples 

that we might have drawn. Since each sample could have provided 

different estimates, we also provide the lower and upper bound estimates 

at a 95 percent confidence interval. The weighted response rate, which 

accounts for the differential sampling fractions within strata, is 66 percent. 

For more information about our methodology for designing and 

distributing the survey, see appendix I.

Table 10: How Likely Is It That Your Institution Would Be Able to Raise the Following Types of Regulatory Capital at 

Acceptable Cost, Terms, and Conditions within the Next Year? 

Responses

Estimated 

percentage

95 percent 

confidence interval—

lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

Equity investments from board members or 

local community

Very likely 32 28 37

Somewhat likely 38 33 43

Not likely 23 19 27

No basis to judge 6 4 9 

Common equity from public offering Very likely 8 5 11

Somewhat likely 19 16 23

Not likely 57 52 61

No basis to judge 16 13 20

Common equity from private placement Very likely 12 9 16

Somewhat likely 34 29 38

Not likely 39 34 44

No basis to judge 15 12 18

Preferred equity from public offering Very likely 4 3 7 

Somewhat likely 13 10 17

Not likely 60 55 64

No basis to judge 23 19 27

Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 68 GAO-12-237 Hybrid Capital Instruments

Responses

Estimated 

percentage

95 percent 

confidence interval—

lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

Preferred equity from private placement Very likely 6 4 9 

Somewhat likely 24 20 28

Not likely 48 43 53

No basis to judge 22 18 26

Trust preferred securities Very likely 2 1 4 

Somewhat likely 10 7 13

Not likely 66 62 71

No basis to judge 22 18 26

Subordinated debt Very likely 6 4 9 

Somewhat likely 23 19 27

Not likely 51 46 56

No basis to judge 20 16 23

Other Very likely 4 2 8 

Somewhat likely 4 2 8 

Not likely 31 25 38

No basis to judge 61 54 67

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Note: Examples of “Other” responses included the U.S. Treasury Department’s Small Business 

Lending Fund and mutual institutions that raise capital exclusively through profits. 

Table 11: How Important Are Each of the Following Factors in Determining Your Institution’s Ability to Successfully Raise 

Capital? 

Responses

Estimated 

percentage

95 percent 

confidence interval—

lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

Financial condition and performance (e.g., 

profitability, debt and capital levels, asset 

quality)

Very important 87 83 90

Somewhat 

important

9 7 12

Not important 1 0 2 

No basis to judge 3 2 5 

Growth potential Very important 49 44 54

Somewhat 

important

41 37 46

Not important 6 4 9 
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions

Page 69 GAO-12-237 Hybrid Capital Instruments

Responses

Estimated 

percentage

95 percent 

confidence interval—

lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

No basis to judge 4 2 6 

Management quality Very important 74 70 78

Somewhat 

important

19 15 23

Not important 2 1 4 

No basis to judge 4 3 6 

Size of institutions/offering Very important 28 24 33

Somewhat 

important

51 47 56

Not important 12 9 16

No basis to judge 8 6 11

Liquidity of capital instrument Very important 30 26 35

Somewhat 

important

51 46 56

Not important 11 8 15

No basis to judge 7 5 10

Economic environment in lending area Very important 47 42 52

Somewhat 

important

45 40 50

Not important 4 2 6 

No basis to judge 5 3 7 

Capital market conditions Very important 39 34 44

Somewhat 

important

43 38 48

Not important 10 7 13

No basis to judge 8 6 11

Familiarity with investors Very important 45 40 50

Somewhat 

important

39 34 44

Not important 7 5 10

No basis to judge 9 7 12
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 70 GAO-12-237 Hybrid Capital Instruments

Responses

Estimated 

percentage

95 percent 

confidence interval—

lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

Ability to conduct public offerings Very important 18 14 21

Somewhat 

important

27 22 31

Not important 33 28 37

No basis to judge 23 19 27

Other Very important 6 3 11

Somewhat 

important

4 2 9 

Not important 14 9 21

No basis to judge 75 68 82

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Note: Examples of “Other” responses included the regulatory environment and structure as a mutual 

institution. 

Table 12: If Your Institution Had to Replace 10 Percent of Its Tier 1 Capital Within 2 Years, How Likely Is It That It Would Do 

Each of the Following? 

Responses

Estimated 

percentage

95 percent 

confidence interval—

lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

Issue new equity Very likely 32 27 36

Somewhat likely 34 29 39

Not likely 29 25 34

No basis to judge 5 3 7 

Reduce dividend payments Very likely 39 34 43

Somewhat likely 16 13 20

Not likely 29 25 34

No basis to judge 15 13 18

Increase operating efficiency, including by 

reducing compensation or other costs

Very likely 38 33 43

Somewhat likely 44 40 49

Not likely 16 13 20

No basis to judge 1 0 3 
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 71 GAO-12-237 Hybrid Capital Instruments

Responses

Estimated 

percentage

95 percent 

confidence interval—

lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

Raise average margins between borrowing 

and lending rates

Very likely 26 21 30

Somewhat likely 48 43 53

Not likely 26 22 30

No basis to judge 1 0 2 

Increase non-interest income Very likely 22 18 26

Somewhat likely 49 44 54

Not likely 28 23 32

No basis to judge 1 0 2 

Lower the size of loan portfolios Very likely 18 14 21

Somewhat likely 36 31 40

Not likely 46 41 51

No basis to judge 1 0 2 

Reduce or sell non-loan assets Very likely 13 10 17

Somewhat likely 32 28 37

Not likely 51 46 56

No basis to judge 3 2 5 

Shift balance sheet composition toward less 

risky assets

Very likely 15 12 19

Somewhat likely 48 43 53

Not likely 33 28 37

No basis to judge 4 2 6 

Other Very likely 6 3 12

Somewhat likely 3 1 8 

Not likely 13 7 20

No basis to judge 78 70 85

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Note: Examples of “Other” responses included retain earnings and increase borrowing. 
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 72 GAO-12-237 Hybrid Capital Instruments

Table 13: If Your Institution Had to Replace 10 Percent of Its Tier 1 Capital Within 5 Years, How Likely Is It That It Would Do 

Each of the Following? 

Responses

Estimated 

percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

Issue new equity Very likely 31 26 35

Somewhat likely 34 30 39

Not likely 32 27 36

No basis to judge 4 2 6 

Reduce dividend payments Very likely 29 25 34

Somewhat likely 21 17 25

Not likely 36 31 40

No basis to judge 14 11 16

Increase operating efficiency, including by 

reducing compensation or other costs

Very likely 34 30 39

Somewhat likely 47 42 52

Not likely 17 14 21

No basis to judge 1 0 3 

Raise average margins between borrowing 

and lending rates

Very likely 30 26 34

Somewhat likely 45 40 50

Not likely 24 20 28

No basis to judge 1 0 2 

Increase non-interest income Very likely 26 22 30

Somewhat likely 51 46 56

Not likely 22 18 26

No basis to judge 1 0 2 

Lower the size of loan portfolios Very likely 10 7 13

Somewhat likely 34 29 38

Not likely 55 50 60

No basis to judge 1 0 2 

Reduce or sell non-loan assets Very likely 10 7 13

Somewhat likely 36 31 41

Not likely 52 47 57

No basis to judge 2 1 4 
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions

Page 73 GAO-12-237 Hybrid Capital Instruments

Responses

Estimated 

percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

Shift balance sheet composition towards less 

risky assets

Very likely 12 9 15

Somewhat likely 49 44 54

Not likely 36 31 40

No basis to judge 4 2 6 

Other Very likely 7 3 14

Somewhat likely 4 1 9 

Not likely 15 9 23

No basis to judge 73 64 81

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Note: Examples of “Other” responses included retain earnings and increase borrowing. 

Table 14: Has Your Institution Raised Regulatory Capital Since January 1, 2008?

Responses Estimated percentage

95 percent confidence interval—

lower bound (percentage)

95 percent confidence interval—

upper bound (percentage)

Yes 35 31 40

No 65 60 69

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Table 15: During Which of the Following Time Periods Did Your Institution Raise Capital? For the Time Period, Consider the 

Date of Offering or Issuance. 

Responses

Estimated 

percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent 

confidence interval—

upper bound 

(percentage)

January 1, 2011—present Raised capital 35 27 43

Did not raise capital 65 57 73

January 1, 2010—December 31, 2010 Raised capital 50 41 59

Did not raise capital 50 41 59

January 1, 2009—December 31, 2009 Raised capital 54 45 63

Did not raise capital 46 37 55

January 1, 2008—December 31, 2008 Raised capital 39 30 47

Did not raise capital 61 53 70

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Note: Results reflect the responses of those that answered “Yes” to the question “Has your institution 

raised regulatory capital since January 1, 2008?” 
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 74 GAO-12-237 Hybrid Capital Instruments

Table 16: Did the Amount of Regulatory Capital Your Institution Raised Meet Its Target/Goal? 

Responses Estimated percentage

95 percent confidence interval—

lower bound (percentage)

95 percent confidence interval—

upper bound (percentage)

Yes 82 74 88

No 18 12 26

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Note: Results reflect the responses of those that answered “Yes” to the question “Has your institution 

raised regulatory capital since January 1, 2008?” 

Table 17: Did the Regulatory Capital Your Institution Raised Meet Its Initial Terms and Conditions? 

Responses Estimated percentage

95 percent confidence interval—

lower bound (percentage)

95 percent confidence interval—

upper bound (percentage)

Yes 93 87 96

No 7 4 13

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Note: Results reflect the responses of those that answered “Yes” to the question “Has your institution 

raised regulatory capital since January 1, 2008?” 

Table 18: What Types of Regulatory Capital Has Your Institution Raised Since January 1, 2008? 

Responses

Estimated 

percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent 

confidence 

interval—upper 

bound (percentage)

Equity instruments from board members or 

local community

Raised capital 58 50 67

Did not raise capital 42 33 50

Common equity from public offering Raised capital 11 6 17

Did not raise capital 89 83 94

Common equity from private offering Raised capital 29 22 37

Did not raise capital 71 63 78

Preferred equity from public offering Raised capital 1 0 5 

Did not raise capital 99 95 100

Preferred equity from private offering Raised capital 5 2 10

Did not raise capital 95 90 98

Trust preferred securities Raised capital 4 1 8 

Did not raise capital 97 92 99

Subordinated debt Raised capital 14 8 22

Did not raise capital 86 78 92
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 75 GAO-12-237 Hybrid Capital Instruments

Responses

Estimated 

percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent 

confidence 

interval—upper 

bound (percentage)

Federal government capital programs (such 

as the Capital Purchase Program and 

Community Development Capital Initiative)

Raised capital 28 21 36

Did not raise capital 72 64 79

Other Raised capital 25 15 36

Did not raise capital 75 64 85

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Note: Results reflect the responses of those that answered “Yes” to the question “Has your institution 

raised regulatory capital since January 1, 2008?” Examples of “Other” responses included operating 

income and the exercise of stock options. 

Table 19: What Were the Reasons Your Institution Did Not Raise Regulatory Capital Since January 1, 2008?

Responses

Estimated 

percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent 

confidence 

interval—upper 

bound (percentage)

No need for or interest in raising additional 

regulatory capital?

A reason 88 84 92

Not a reason 12 8 16

Lack of capital raising options (for reasons 

including: unfavorable market conditions, 

lack of investor interest, etc.)

A reason 20 15 26

Not a reason 80 74 85

Tried to raise capital but was unable to do so A reason 3 1 6 

Not a reason 97 94 99

Other A reason 18 10 27

Not a reason 82 73 90

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Note: Results reflect the responses of those that answered “No” to the question “Has your institution 

raised regulatory capital since January 1, 2008?” Examples of “Other” responses included institutions 

that are already well capitalized and mutual institutions that are not allowed to raise capital except 

through retained earnings.
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 76 GAO-12-237 Hybrid Capital Instruments

Table 20: In Your Opinion, How Challenging, If at All, Is the Current Regulatory Capital-Raising Environment for Your 

Institution? 

Responses Estimated percentage

95 percent confidence interval—

lower bound (percentage)

95 percent confidence interval—

upper bound (percentage)

Very challenging 44 39 49

Moderately challenging 32 28 37

Not challenging 12 9 16

No opinion 11 9 15

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Table 21: How Challenging, If at All, Are Each of the Following Factors in Your Institution’s Ability to Raise Regulatory 

Capital? 

Responses

Estimated 

percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent 

confidence 

interval—upper 

bound (percentage)

Lack of rating by credit rating 

agency

Very challenging 6 4 9 

Moderately challenging 20 16 24

Not challenging 31 26 35

No opinion / not applicable 43 38 48

Lack of equity analyst coverage Very challenging 8 5 11

Moderately challenging 17 13 21

Not challenging 31 26 35

No opinion / not applicable 44 40 49

Lack of access to public capital 

markets 

Very challenging 16 12 20

Moderately challenging 25 20 29

Not challenging 22 18 26

No opinion / not applicable 38 33 42

Investor preference for larger 

offering size

Very challenging 16 13 20

Moderately challenging 19 15 23

Not challenging 27 23 31

No opinion / not applicable 38 33 42

Transaction costs of conducting a 

public offering (including 

underwriting costs)

Very challenging 22 18 26

Moderately challenging 26 22 30

Not challenging 19 15 23
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 77 GAO-12-237 Hybrid Capital Instruments

Responses

Estimated 

percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent 

confidence 

interval—upper 

bound (percentage)

No opinion / not applicable 34 29 38

Economic climate and/or market 

conditions

Very challenging 46 41 51

Moderately challenging 28 24 33

Not challenging 9 7 13

No opinion / not applicable 16 13 19

Investor perception of your 

institution’s financial condition (for 

example, based on factors including 

amount of debt or non-performing 

assets) 

Very challenging 19 15 23

Moderately challenging 25 21 29

Not challenging 37 32 41

No opinion / not applicable 19 16 23

Composition of your institution’s 

existing capital structure (for 

example, existence of trust 

preferred securities)

Very challenging 5 3 8 

Moderately challenging 15 12 19

Not challenging 48 44 53

No opinion / not applicable 31 27 35

Laws and regulations Very challenging 33 28 38

Moderately challenging 36 31 40

Not challenging 11 8 15

No opinion / not applicable 20 16 24

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 78 GAO-12-237 Hybrid Capital Instruments

Table 22: How Does the Current Ability of Your Institution to Raise Regulatory Capital Compare to the Ability to Raise 

Regulatory Capital Prior to the Recent Financial Crisis (Consider the Time Period before 2008)?

Responses Estimated percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent confidence 

interval—upper bound 

(percentage)

Much more difficult than before 41 36 45

Somewhat more difficult than before 26 21 30

Equally as easy or difficult as before 10 7 13

Somewhat easier than before 1 0 2 

Much easier than before 0 0 2 

Uncertain 7 5 10

No opinion 15 12 19

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.

Table 23: Prior to January 1, 2008, How Beneficial, If at All, to Your Institution’s Access to Regulatory Capital Was Its Ability 

to Issue Trust Preferred Securities (Including Pools of Trust Preferred Securities)? 

Responses Estimated percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent confidence 

interval—upper bound 

(percentage)

Greatly beneficial 20 16 24

Moderately beneficial 9 7 13

Not at all beneficial 10 7 13

No opinion 10 7 13

Not applicable: my institution did not 

issue any trust preferred securities. 

50 46 55

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.
Appendix III: Responses to Questions from 

GAO’s Survey of Smaller Banking Institutions 

Page 79 GAO-12-237 Hybrid Capital Instruments

Table 24: In Your View, How Will the Following Recent and Proposed Changes to Regulatory Capital Requirements Affect 

Your Institution’s Ability to Raise Regulatory Capital, If at All? 

Responses

Estimated 

percentage

95 percent confidence 

interval—lower bound 

(percentage)

95 percent 

confidence 

interval—upper 

bound (percentage)

The Dodd-Frank Act’s prohibition 

on hybrid capital instruments, such 

as trust preferred securities, from 

consideration as Tier 1 regulatory 

capital

Greatly decrease 24 20 29

Somewhat decrease 17 14 21

No change 29 24 33

Somewhat increase 4 3 7 

Greatly increase 3 1 5 

No opinion 23 19 27

Basel III (changes to the definition 

of capital (including Tier 1 capital), 

changes to the calculation of riskweighted assets, and changes to 

capital ratio requirements)

Greatly decrease 18 15 22

Somewhat decrease 22 18 26

No change 21 17 25

Somewhat increase 7 5 11

Greatly increase 3 2 5 

No opinion 28 24 32

Source: GAO survey of smaller banking institutions from June 15, 2011, to August 15, 2011.
Appendix IV: GAO Contact and Staff 

Acknowledgments

Page 80 GAO-12-237 Hybrid Capital Instruments

Thomas J. McCool, (202) 512-2642 or mccoolt@gao.gov

In addition to the contact named above, Daniel Garcia-Diaz (Acting 

Director), James Ashley, Kevin Averyt, Emily Chalmers, William R.

Chatlos, Rachel DeMarcus, M’Baye Diagne, Lawrance Evans Jr., Richard 

Krashevski, Jill Lacey, Courtney LaFountain, Marc Molino, Patricia Moye, 

Michael Pahr, and Maria Soriano made key contributions to this report.

Appendix IV: GAO Contact and Staff 

Acknowledgments 

GAO Contact

Staff 

Acknowledgments

(250579)
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