Publications

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The US Department of the Treasury has announced its “Principles for Reforming the US and International Regulatory Capital Framework for Banking Firms.” To review the document, released on September 3, 2009, please click here. 

Although the statement, by its own terms, is one of “high-level principles and does not, for example, contain specific numerical recommendations for risk weights on particular exposure types or for the level of minimum capital ratios,” it nevertheless provides key insights into proposals for reformed rules for capital adequacy that Treasury is discussing with relevant banking regulators in the US as well as with its overseas counterparts. The goal of these recommendations is to reach a comprehensive international agreement on a new global capital adequacy framework by December 31, 2010, with international implementation of the resulting reforms effective December 31, 2012.

Existing Capital Regulations: Basel I. The Treasury’s proposals on reforming the rules pertaining to bank capital arises against the back-drop of the perceived inadequacies of the current regulatory regime in effect for measuring capital adequacy for banks and financial institutions in the US and elsewhere in the developed world. Under present standards, bank capital requirements are dependent, in turn, on the categorization of assets and capital that are entitled to receive standardized risk-weighting, in accordance with international norms as promulgated by the Basel Committee on Banking Supervision under the auspices of the Bank for International Settlements. Based on principles originally announced in 1988, the first of these international set of bank regulatory requirements, known as Basel I, laid the foundation for an elaborate system of capital calculations predicated on the maintenance of a capital ratio that reflected the percentage of a bank’s capital to its risk-weighted assets. The weights to be provided to each asset varied based upon risk-sensitivity ratios as defined under the Basel I Accord.

The Types of Capital and Acceptable Ratios under Basel I Formulations. The Basel I set of definitions distinguishes types of capital into two fundamental categories: Tier 1, which consists primarily of shareholders’ equity and other equity-like instruments, including, for certain purposes and amounts, perpetual preferred stock; and Tier 2, or “supplementary” capital, which generally consists of undisclosed reserves, revaluation reserves, loan loss provisions, hybrid instruments and subordinated term debt. As an example of these rules in operation, a bank in the US must maintain a Tier 1 capital ratio of at least 4 percent, a combined Tier 1 and Tier 2 capital ratio of at least 8 percent, and a leverage ratio (which measures capital as a function of consolidated assets) of at least 4 percent. A well-capitalized bank must maintain a Tier 1 capital ratio of at least 6 percent, a combined Tier 1 and Tier 2 capital ratio of at least 10 percent, and a leverage ratio of at least 5 percent.

Basel II and its Particularistic Approach. The second, and most recent, of the Basel requirements on capital adequacy is the so-called Basel II Accord. It was initially published by the Basel Committee in June 2004. US banking regulators issued final guidance in July 2008, implementing the new capital adequacy framework set forth in this standard. Basel II adopted a “three pillars” concept: (1) minimum capital requirements based on risk assessments; (2) supervisory review; and (3) market discipline. However, most significantly, in calculating the three major components of risk that a bank faces---credit risk, operational risk and market risk---Basel II encourages specific banks to develop and use internal measurement approaches, based on particular judgments about the risks involved made by the relevant bank in question.

Concerns with the Basel II Framework. As noted, Basel II anticipated a move away from the standardized requirements contained in Basel I, towards a more specific and individualistic range of requirements developed for each risk category by each particular bank. However, the experience of the global credit crisis of 2007-2009 revealed serious shortcomings in the methodological approach fostered by Basel II, including problems caused by the arbitraging of risk definitions and related weighting experience by individual banks, in an apparent attempt by these banks to lower overall capital requirements. This unfortunate exploitation of the Basel II regulatory standards led to many banks becoming seriously undercapitalized at the time of the credit crisis---a disturbing tendency further encouraged by the failure, under Basel II’s risk methodologies, to incorporate off-balance sheet investment vehicles into the requirements implemented for calculating the overall consolidated capital amounts for many financial institutions.

The Treasury’s New Proposals. The perceived inadequacies of Basel II and the current capital adequacy system, which allowed many financial institutions to fail to have adequate amounts of capital available as a cushion during the tumultuous market events of the past few years, has led Treasury to reevaluate and reformulate the entire capital requirements regime so as to encourage and mandate institutions to maintain more adequate reservoirs of ready capital, based on a system of clearly applicable and non-exploitable provisions. The Treasury initiative is organized into eight core principles, each of which is significant in prescribing certain fundamental changes to the current methodology used for calculating capital adequacy. The eight principles are as follows:

• Capital requirements should be designed to protect the stability of the overall financial system, as well as the solvency of individual banking firms: the Principles decry “narrow micro-prudential concern for the solvency of individual firms,” and emphasize, instead, how the behavior of particular firms may affect systemically the operations and activities of other institutions throughout the broader economy. To this end, the Principles introduce themes that will be repeated throughout elements of the specific recommendations that are made in the document, stressing the importance of encouraging banking firms to build larger capital cushions “in good times,” as a buffer against peril in leaner periods, while imposing even greater capital obligations on the largest banking entities, known as Tier 1 Financial Holding Companies (FHCs) in the Treasury’s regulatory proposals, in order to insulate the economy from any downward pressures that may be caused should such firms become troubled;
• Capital requirements for all banking firms should be higher, and capital requirements for Tier 1 Financial Holding Companies should be even higher than those for other firms: as already observed, to insulate the larger economy from the dangers that may be caused by an insolvency in a Tier 1 FHC, all such institutions, as well as FHCs more broadly, will be required to achieve and maintain well-capitalized and well-managed status on a consolidated basis;
• The regulatory capital framework should put greater emphasis on higher quality forms of capital: the Treasury’s proposals state that, during good economic conditions, common equity should constitute a large majority of a banking firm’s Tier 1 capital and, at the same time, Tier 1 capital should constitute a “large majority” of a banking firm’s total regulatory capital. The Treasury goes on to suggest that voting common equity should represent a large majority of a banking firm’s Tier 1 capital, since such investors will have a greater stake in the success or failure of the firm’s activities. All these proposals represent a significant attempt to strengthen the amount and the type of capital that will be available to a financial institution in the event of crisis, beyond the more limited obligations imposed under Basel II ;
• Risk-based capital requirements should be a function of the relative risk of a banking firm’s exposures, and risk-based capital ratios should better reflect a banking firm’s current financial condition: in general, Treasury proposes that risk-weighting should be a function of the asset-specific risk of the various exposure types a firm has assumed, as well as the systemic importance of the various exposure types. For example, exposures to off-balance sheet vehicles, proprietary and trading positions, equity investments, structured asset-backed and mortgage-backed securities and to other financial firms, all deserve special consideration and focused weighting given their relative importance and significant systemic role. In limiting the scope of individualistic measurements of risk, and in expressly incorporating off-balance sheet and other positions into the overall calculations of risk and capital, the new Treasury proposals aim to rectify some of the serious shortfalls experienced under the Basel II approach;
• The “procyclicality” of the existing regulatory capital and accounting regimes should be reduced and consideration should be given to introducing countercyclical elements into the regulatory capital regime: Treasury suggests a close review of accounting, capitalization and loan loss policies and regulations to introduce “countercyclicality” as an important goal, whereby a firm will build its reserves and equity positions at times that are positive from an economic perspective, to insulate itself better for those periods during which market pressures and economic downturns may adversely affect the ability of an institution to bolster its equity position;
• Banking firms should be subject to a simple, non-risk based leverage constraint: in addition to sophisticated, and perhaps more malleable, risk-based weighting models as the sole drivers for capital adequacy, the Treasury urges the adoption of an additional, more simple, leverage ratio which, in conjunction with a risk-based approach, “is much more difficult to arbitrage.” In this way, the Treasury Proposals attempt to establish clear standards that will not be subject to exploitation or micro-management by affected banks and financial firms in their attempt to avoid otherwise legitimate capital requirements;
• Banking firms should be subject to a conservative, explicit liquidity standard: liquidity regulations would be designed to enhance the short-term resiliency of banking firms by requiring them to hold a pool of unencumbered, liquid assets sufficient to cover likely funding shortfalls in the event of an acute liquidity stress scenario, and to reduce “longer-term structural asset-liability mismatches” at banking firms; and
• Stricter capital requirements for the banking system should not result in the re-emergence of an under-regulated nonbank financial sector that poses a threat to financial stability: Treasury makes clear that it will continue to push for legislative enactment of its regulatory reform agenda, including, presumably, by establishing a systemic risk regulator as well as a Consumer Financial Protection Agency. The adoption of more sophisticated and all-encompassing capital and liquidity rules is not, in Treasury’s view, a substitute for the regulatory reform proposals that it is also advocating, as analyzed in a recent Client Alert, prepared at the time of the publication by Treasury of its White Paper outlining these proposed regulatory reform changes.

Possible Next Steps. The proposal to increase pertinent bank capital requirements has already been the subject of ministerial discussions at the Group of 20 level, and is expected to be on the agenda for consideration at the forthcoming G-20 Summit scheduled to take place in the US on September 23 and 24, 2009. The effect of these recommendations could be far-reaching, not only in requiring banks and financial institutions doing business in the US to develop new methodologies for the measurement of risk, the raising of capital and the calculation of acceptable leverage and liquidity ratios, but also in affecting related regulatory proposals, such as the recent Statement of Policy on Qualifications for Failed Bank Acquisitions issued by the Federal Deposit Insurance Corporation (FDIC), in which the FDIC imposed a 10 percent capital adequacy ratio on proposed acquirers of troubled financial institutions. It remains to be seen whether this Statement of Policy will be affected by the new Proposals on the types and amounts of capital that may be prudentially required, and what steps banking regulators such as the FDIC, the Federal Reserve Board and the Office of the Comptroller of the Currency will pursue in the actual implementation of these standards by regulation aimed at those institutions under their regulatory jurisdiction.

We will continue to monitor developments on these capital proposals, and advise our clients on significant steps that may take place, both in this area as well as on the related topic of financial services legislative reform.

For more information on the impact of these developments in your business, please contact:

Rusty Conner

Richard Coll

Andrew Eskin

James Kaplan

Megan Kraai

David Krohn

Bob Pratt

Michael Reed