On June 8, 2012, the Federal Reserve Board (Board) approved three notices of proposed rulemaking (NPRs) that would significantly revise the regulatory capital requirements for all US banking organizations by, among other things, implementing the Basel III capital reforms and incorporating various Dodd-Frank-related capital provisions. In addition, the Board approved a final rule implementing a new market risk capital rule (Market Risk Rule) that incorporates various changes to the capital standards for market risk developed by the Basel Committee from 2005 to 2010. 

The three NPRs and the final Market Risk Rule are expected to be published jointly by the Board, the FDIC, and the Comptroller of the Currency after each agency has completed its approval process. Board staff has suggested a 90-day comment period for the NPRs.

Taken together, the NPRs and the Market Risk Rule total over 800 pages and will take considerable time to review and analyze in detail. We provide below a preliminary overview of select aspects of the rules. A more detailed analysis of the rules will follow in due course. Board staff memos summarizing each NPR and the final Market Risk Rule are available, together with the text of the draft Federal Register notices, at: http://www.federalreserve.gov/aboutthefed/boardmeetings/20120607openmaterials.htm.

Scope of the NPRs. The first two NPRs apply to all US depository institutions, bank holding companies (except those with less than $500 million in consolidated assets) and savings and loan holding companies (collectively, “banking organizations”). The third NPR applies only to banking organizations that are subject to either the advanced approaches risk-based capital rule or the Market Risk Rule (i.e., the largest internationally active banking organizations and those with significant trading activities). 

First NPR—Basel III Regulatory Capital Minimums, Definition of Capital and Capital Buffers. The first NPR focuses primarily on the numerator of the capital ratio and would subject all banking organizations to the Basel III minimum regulatory capital requirements, including the new 4.5 percent common equity tier 1 (CET1) requirement. It also would adopt the Basel III capital conservation buffer and countercyclical capital buffer, although the latter is proposed to apply only to advanced approaches banking organizations and would initially be set at zero. In addition to increasing numerical capital requirements, the first NPR would impose Basel III’s more restrictive definitions of capital and stricter capital deductions (including deductions for mortgage servicing rights and certain deferred tax assets, as well as inclusion of unrealized losses on available-for-sale securities), which generally are applied against CET1. This NPR also would retain a modified version of the existing leverage requirement for all US banks, but also apply a supplemental Basel III-based leverage requirement (including off-balance sheet items) to advanced approaches banking organizations.

Second NPR—Standardized Approach for Risk-Weighted Assets. The second NPR focuses on the denominator of the risk-based capital ratio. It would essentially replace the existing Modified Basel I risk-based capital requirements with a new risk-based capital regime (somewhat similar in approach to the agencies’ 2008 proposal that was never adopted) that would make significant changes to the calculation of risk-weighted assets, including through the adoption of additional (i.e., more granular) risk-weight categories and incorporation of certain aspects of the Basel II standardized approach. This NPR also would establish calculations for risk-weighted assets using alternatives to credit ratings, as required by section 939A of the Dodd-Frank Act. Specific proposed changes include (i) using the OECD’s country credit risk classifications (CRCs) to assign risk weights to exposures to sovereign entities and non-US banks; (ii) applying a 150 percent risk-weight to acquisition, development and construction loans, and to any loan 90 days or more past due; and (iii) adopting a range of risk-weights for residential mortgages from 35 to 200 percent depending on various characteristics, including loan-to-value ratios. It generally would retain the treatment of OTC derivatives currently in place under Modified Basel I, with some modifications to the conversion factors for computing potential future exposure and the netting criteria, as well as removal of the existing 50 percent risk-weight cap. The NPR would provide greater recognition of collateral and guaranties than the current Modified Basel I requirements.

The second NPR’s standardized approach (as well as the third NPR on Advanced Approaches and Market Risk) would have potentially significant implications for the treatment of securitizations. Not surprisingly, the rules include a “default” 1250 percent risk-weighting if gross-up treatment or the simplified supervisory formula approach (SSFA) is not used (under the standardized approach) or if the supervisory formula approach (SFA) or SSFA is not used (under the Advanced Approaches and Market Risk NPR). However (and perhaps borrowed from CRD 122a applicable to EU banks), both standardized and advanced approaches banks investing in securitizations would be subject to a punitive (1250 percent) risk-weight if they failed to perform and maintain adequate diligence of both the securitization exposure and the underlying exposures. The NPR also would exclude exposures to fully supported asset-backed commercial paper conduits from the definition of resecuritization exposure.

Advanced approaches banking organizations would use the risk-weights in the second NPR to calculate their Collins Amendment floor.

Third NPR—Advanced Approaches and Market Risk. The third NPR, which generally would apply only to the largest US banking organizations, would amend the existing US Basel II advanced approaches rule to incorporate various recent changes to the international capital standards, including those related to securitizations, treatment of counterparty credit risk and disclosure requirements regarding capital instruments and securitization exposures. Consistent with Basel III, this NPR includes (i) a higher counterparty credit risk capital requirement to account for credit valuation adjustments (CVA), (ii) capital requirements for cleared transactions with central counterparties and (iii) increased capital requirements for exposures to non-regulated financial institutions and to regulated financial institutions with consolidated assets of more than $100 billion. The third NPR would incorporate similar alternatives to credit ratings as are included in the standardized approach under the second NPR and in the Market Risk Rule. The third NPR would also integrate the Market Risk Rule into the agencies’ comprehensive capital framework.  

Transition Arrangements. Most of the new capital requirements will take effect January 1, 2013, but are subject to lengthy transition arrangements consistent with the Basel III framework. Thus, full compliance with most aspects of the new capital requirements would not be required until January 1, 2019. Notably, the second NPR, which contains the standardized approach, would not take effect until January 1, 2015, although banks could elect to apply it earlier.  

Issues Not Addressed in the NPRs. The Basel III liquidity standards—i.e., the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)—are not included in the NPRs, but will be addressed through separate proposals at a later date (presumably after the Basel Committee releases expected modifications to its version of the LCR). In addition, this package of proposed capital reforms does not address the capital surcharge for systemically important financial institutions (SIFIs), which the agencies intend to address as part of the pending enhanced prudential standards rulemaking under section 165 of the Dodd-Frank Act.

Final Market Risk Rule. This action finalizes earlier proposals designed largely to implement Basel 2.5 in the United States. Consistent with the current market risk capital rule, the final Market Risk Rule will apply to any banking organization with aggregate trading assets and liabilities that exceed either 10 percent of its total assets or $1 billion. 

Among other things, the final Market Risk Rule: (i) modifies the definition of “covered position” to ensure that less liquid or difficult-to-value positions, and positions not held with the ability to trade, are subject to the credit risk-based capital rules, regardless of where held; (ii) enhances the value-at-risk (VaR)-based measures, including stricter internal modeling requirements and required use of a stressed VaR measure; (iii) incorporates the earlier proposed incremental risk measure; (iv) implements the Dodd-Frank Act’s ban on the use of credit ratings by establishing alternative standards of creditworthiness for sovereign, bank (both based on CRCs) and corporate (based on a qualitative non-ratings-based “investment grade” approach) debt; and (v) requires the use of a standardized method (a modified version of the earlier proposed SSFA, but retaining the proposed 20 percent floor) to calculate specific risk capital requirements for certain debt positions and all securitization positions—other than “correlation trading positions” or tranched credit products with corporate debt positions as the underlying assets for which internal models can be used, subject to an 8 percent (rather than earlier proposed 15 percent) comprehensive risk measure surcharge. Advanced approaches banks subject to the Market Risk Rule may continue to use the supervisory formula approach under the advanced approaches rule. The final rule also incorporates a slightly revised version of earlier proposed enhanced disclosure requirements.

For more information about any of the issues raised in this Legal Update, please contact Scott Anenberg at +1 202 263 3303, Carol Hitselberger at +1 704 444 3522, Jason Kravitt at +1 212 506 2622, or Donald Waack at +1 202 263 3165.