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 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. 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. Banking institutions subject to the Basel agreements are due to begin implementing some of the recently revised standards in 2013. 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). 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. 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. Other than these hybrid instruments, the Federal Reserve subjects bank holding companies to capital requirements that are generally similar to those for depository institutions. For example, in addition to common 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. 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. 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. 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 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. 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. 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). 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 billion in total assets included hybrid instruments in their Tier 1 capital. 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).$100 billion in total assets, trust preferred securities made up 97 percent of the total value of Tier 1 hybrid instruments. 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. 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.minimum leverage ratio is 4 percent for most banks, and well-capitalized The 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). 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 top- level bank holding companies filing consolidated regulatory financial reports for 2010, 615 had hybrid instruments that the Dodd-Frank Act would exclude from Tier 1 capital. 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. 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. While the Dodd-Frank Act includes exemptions from the Tier 1 hybrid capital exclusion for the two categories of smaller institutions, our analysis 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. 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 well- capitalized category. 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.earlier, the Dodd-Frank Act largely exempts institutions with less than Furthermore, as discussed $500 million in total assets from the exclusion of Tier 1 hybrid capital. 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. 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 risk- based 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. 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 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 an immediate response to the hybrid capital exclusion. 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. Specifically, 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. 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. 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. 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. 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. See appendix II for a complete list of studies we identified in our review. Implied change in Tier 1 leverage ratio (percentage points) Peak change in loan growth (percentage points) Peak change in lending spreads (percentage points) 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 affected by capital ratios than other types of loans.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. 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. compared the results of our model to a wider body of empirical literature. In general, these sources also found small to moderate effects on lending activity from changes to bank capital. For example, our estimates have wide confidence intervals suggesting considerable uncertainty in the results (see app. II for limitations). exclusion results in a range of effects. 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.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. 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. Banking institutions have multiple options for adjusting to more costly forms of Tier 1 capital—such as shifting lending activity to lower- risk borrowers, reducing returns to shareholders, increasing efficiency, or raising lending rates—and the loan pricing model allowed us to consider 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. 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. 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. 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.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 In the United States, debt 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. 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. To promote complete and globally consistent implementation, the Basel Committee established a framework to monitor and review implementation of Basel III capital requirements. However, some foreign jurisdictions have tax codes that may allow tax advantages for hybrid instruments that would still qualify as Tier 1 under 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. 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). 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. 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 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 for systemically important institutions. 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. 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. 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. 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 billion (see fig. 8). 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. 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. 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 on our survey, an estimated 12 percent of smaller institutions would likely be able to raise trust preferred securities within the next year. 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). 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 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. 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. 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. 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. 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 generally assess the institutions’ financial condition and performance.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. 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. 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 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 year- end 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. 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. 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. 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, 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 risk- based 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. 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-of- scope 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. 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 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 computer- processed 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. 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 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. The VAR methodology can be transformed to examine the dynamic reaction of each of the endogenous variables to shocks to the system. 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. The residuals obtained from each of the estimated OLS regressions in the VAR system are combinations of underlying structural innovations. 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. 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 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 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. 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. 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*r)+C+A-O)*(1-t) 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 r = 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 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. 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. 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.

Summary: 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 (Dodd-Frank 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. 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.