Financial Services Alert - July 9, 2013 July 09, 2013
In This Issue

Analysis of Banking Agencies’ Rule to Implement Basel III and Dodd-Frank Capital Reforms

On July 2, 2013, the FRB approved a 972-page final rule (the “Final Capital Rule”), briefly described in the July 2, 2013 Financial Services Alert, that enhances bank regulatory capital requirements and implements certain elements of the Basel III capital accords (“Basel III”) in the U.S. as well as certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  The FRB also issued for public comment a notice of proposed rulemaking (the “Market Risk NPR”) that would modify the FRB’s market risk rule.  The FRB, OCC and FDIC (the “Agencies”) had previously issued three joint proposed rules (the “Proposed Capital Rules”) regarding enhanced capital requirements and have received thousands of public comment letters on the Proposed Capital Rules.  Please see the June 12, 2012 Financial Services Alert for prior coverage of the Proposed Capital Rules.  Earlier today, the Agencies issued a notice of proposed rulemaking (the “Supplementary Leverage Ratio NPR”) that would increase the supplementary leverage ratio for certain very large banking organizations.  In addition, earlier today, the OCC announced that it had approved the Final Capital Rule.  Moreover, the FDIC announced that it had approved the Final Capital Rule as an interim final rule.  The interim final rule approved by the FDIC is identical to the Final Capital Rule except that it seeks comment on the interaction between the Final Capital Rule and the Supplementary Leverage Ratio NPR.  The Final Capital Rule will be jointly issued by the Agencies and published in the Federal Register.  Comments to the FDIC regarding the interaction between the Final Capital Rule and the Supplementary Leverage Ratio NPR are due 60 days after its publication in the Federal Register.

The Final Capital Rule makes significant changes to the U.S. bank regulatory capital framework, generally increases capital requirements for banking organizations, and requires banking organizations to increase the level of “high quality” capital they hold, such as common equity and retained earnings.  In addition, the Final Capital Rule modifies many of the definitions and elements of bank regulatory capital and significantly revises the risk weightings for banking assets.  As part of these changes, the Final Capital Rule requires increased levels of capital to mitigate the types of risks incurred by banking organizations (and in particular larger banking organizations) during the recent financial crisis in connection with securitization transactions and counterparty exposures.

The scope of the Final Capital Rule is broad.  It applies to all depository institutions, all top-tier bank holding companies other than bank holding companies that are subject to the FRB’s Small Bank Holding Company Policy Statement (generally, those with less than $500 million in consolidated assets) and all top-tier savings and loan holding companies other than savings and loan holding companies substantially engaged in insurance underwriting or commercial activities.  In response to the many comments received by the federal banking agencies from community banks, the Final Capital Rule directly addresses concerns about, among other things,  trust preferred securities, unrealized gains and losses on available-for-sale securities in accumulated other comprehensive income (“AOCI”) and mortgage risk weights.

Banking organizations that are not subject to the advanced approach for risk-weighted assets (which applies to large banking organizations or organizations with large trading portfolios) must begin to be in compliance with the Final Capital Rule by January 1, 2014.  The Final Capital Rule, however, grants community banking organizations (and savings and loan holding companies, even if they use advanced approaches)  an additional year, until January 1, 2015, to begin compliance with its requirements.  Moreover, the Final Capital Rule provides an overlay of transition, phase-in and phase-out periods for specific requirements so that all of the elements of the Final Capital Rule are not expected to be fully implemented until January 1, 2019.

Although the Final Capital Rule, the Market Risk NPR, and the Supplementary Leverage Ratio NPR reflect substantial modifications to the bank regulatory capital framework, the federal banking agencies are expected to issue additional capital-related regulations in the future (all of which will be covered in the Alert) concerning enhanced, short-term wholesale funding, and combined equity and long-term debt.

The balance of this Article provides a discussion in some detail of the major elements of the Final Capital Rule and a brief summary of the changes proposed in the Market Risk NPR and the Supplementary Leverage Ratio NPR.

I.  Minimum Capital Requirements

A.  Minimum Capital Ratios for All Banking Organizations

The minimum capital ratios set forth in the Final Capital Rule are unchanged from the Proposed Capital Rules and require banking organizations to hold more capital with an emphasis on common equity.  Under the Final Capital Rule, all banking organizations must maintain the following minimum capital requirements:

  • a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5%;
  • a tier 1 capital ratio of 6% (increased from 4%);
  • a total capital ratio of 8% (unchanged from the current requirement);
  • a leverage ratio of 4% (unchanged except for banking organizations with the highest supervisory composite rating); and
  • a new capital conservation buffer of 2.5% of risk-weighted assets in addition to the minimum common equity tier 1, tier 1 and total capital ratios.

B.  Supplementary Leverage Ratio for Advanced Approaches Banking Organizations

Banking organizations subject to the advanced approach (“Advanced Approaches Banking Organizations”) are also subject to a minimum supplementary leverage ratio of 3%.  The calculation of the supplementary leverage ratio includes both on- and off-balance sheet exposures, including exposures to funded and unfunded loan commitments, derivative contracts, and repurchase transactions.  Under the Final Capital Rule, total leverage exposure equals the sum of:

  • the balance sheet carrying value of all of the banking organization’s on-balance sheet assets less amounts deducted from tier 1 capital;
  • the potential future exposure amount for each derivative contract to which the banking organization is a counterparty (or each single-product netting set of such transactions);
  • 10% of the notional amount of unconditionally cancellable commitments made by the banking organization; and
  • the notional amount of all other off-balance sheet exposures of the banking organization (excluding securities lending, securities borrowing, reverse repurchase transactions, derivatives and unconditionally cancellable commitments).

The supplementary leverage ratio set forth in the Final Capital Rule was not modified from the Proposed Capital Rules.  The Final Capital Rule implements the supplementary leverage ratio for reporting purposes for Advanced Approaches Banking Organizations on January 1, 2015 and Advanced Approaches Banking Organizations must comply with the minimum supplementary leverage ratio starting on January 1, 2018.

The Supplementary Leverage Ratio NPR would increase the supplementary leverage ratio requirement for bank holding companies with more than $700 billion in consolidated total assets or $10 trillion in assets under custody.  Such bank holding companies would be required to maintain a tier 1 capital leverage buffer of at least 2% above the minimum supplementary leverage ratio requirement of 3%, for a total of 5%.  Additionally, the insured depository institution subsidiaries of such bank holding companies would be required to maintain a supplementary leverage ratio of at least 6% to be considered “well capitalized” for prompt corrective action purposes.  Failure to maintain the required supplementary leverage ratio would result in limitations on distributions and discretionary bonus payments.

Comments on the Supplementary Leverage Ratio NPR are due 60 days after its publication in the Federal Register.

C.  Capital Conservation Buffer

The capital conservation buffer set forth in the Final Capital Rule is largely unchanged from the Proposed Capital Rules.  Under the Final Capital Rule, all banking organizations must maintain a capital conservation buffer of common equity tier 1 capital in an amount greater than 2.5% of total risk-weighted assets in addition to the minimum common equity tier 1, tier 1 and total capital ratios.  A banking organization’s capital conservation buffer is the lowest of the following ratios: (i) the banking organization’s common equity tier 1 capital ratio minus its minimum common equity tier 1 capital ratio; (ii) the banking organization’s tier 1 capital ratio minus its minimum tier 1 capital ratio; and (iii) the banking organization’s total capital ratio minus its minimum total capital ratio.  If the banking organization’s common equity tier 1, tier 1 or total capital ratio is less than or equal to its minimum common equity tier 1, tier 1 or total capital ratio, respectively, the banking organization’s capital conservation buffer is zero.

Unlike the Proposed Capital Rules, the Final Capital Rule does not treat a redemption or repurchase of a capital instrument as a distribution, provided that the banking organization fully replaces that capital instrument by issuing another capital instrument of the same or better quality (i.e., equally or more subordinate) and the issuance of the replacement capital instrument is completed within the same calendar quarter in which the banking organization announces the repurchase or redemption.

Banking organizations that do not maintain a sufficient capital conservation buffer are subject to the following limitations on distributions and discretionary bonuses to executive officers as a percentage of eligible retained income:

Capital Conservation Buffer  Maximum Payout Ratio 
Greater than 2.5%  No payout ratio limitation applies 
Less than or equal to 2.5%, and greater than 1.875%  60% 
Less than or equal to 1.875%, and greater than 1.25%  40% 
Less than or equal to 1.25%, and greater than 0.625%  20% 
Less than or equal to 0.625%  0% 
 

Under the Final Capital Rule, the maximum payout ratio is the percentage of eligible retained income that a banking organization is allowed to pay out in the form of distributions and discretionary bonus payments to executives during the current calendar quarter.  The maximum payout ratio is determined by the banking organization’s capital conservation buffer as calculated as of the last day of the previous quarter.  A banking organization that becomes subject to a maximum payout ratio remains subject to restrictions on distributions and discretionary bonus payments to executives until it is able to build up its capital conservation buffer through retained earnings, raising additional capital, or reducing its risk-weighted assets.  A banking organization’s primary federal banking supervisor may permit the banking organization to make a distribution or discretionary bonus payment if the supervisor determines the distribution or discretionary bonus payment would not be contrary to the purpose of the capital conservation buffer or the safety and soundness of the organization.

The capital conservation buffer requirement of the Final Capital Rules will effectively require banking organizations to maintain their risk-based capital ratios at least 50 basis points above well capitalized levels in order to avoid restrictions on distributions and discretionary bonus payments to executives.

D.  Countercyclical Capital Buffer

Advanced Approaches Banking Organizations must also maintain a countercyclical capital buffer that would expand the banking organization’s capital conservation buffer by up to an additional 2.5% of risk-weighted assets.  The national banking supervisors of the jurisdictions that adopt Basel III will establish a countercyclical capital buffer amount as a percentage of risk-weighted assets that should be held by banking organizations with credit exposures in that jurisdiction.  The amount of the Advanced Approaches Banking Organization’s countercyclical buffer is determined by calculating the weighted average of the countercyclical capital buffer amounts established for the national jurisdictions where the Advanced Approaches Banking Organization has private sector credit exposures.  The contributing weight assigned to a jurisdiction’s countercyclical capital buffer amount is calculated by dividing the total risk-weighted assets for the Advanced Approaches Banking Organization’s private sector credit exposures located in the jurisdiction by the total risk-weighted assets for all of the Advanced Approaches Banking Organization’s private sector credit exposures.  The Advanced Approaches Banking Organization is required to hold this amount of common equity tier 1  capital in addition to the 2.5% capital conservation buffer.  An Advanced Approaches Banking Organization will become subject to the restrictions on distributions and discretionary bonuses described above with respect to the capital conservation buffer if it does not hold the required minimum amount of the combined capital conservation buffer and countercyclical capital buffer.

E.  Prompt Corrective Action Requirements

The Final Capital Rule increases the thresholds for a banking organization to be considered “adequately capitalized” to be equal to the minimum capital requirements discussed above, including the addition of the common equity tier 1  ratio.  The risk-based capital ratios for “well capitalized” banking organizations would continue to be two percentage points higher than the ratios for adequately capitalized banking organizations, and the leverage ratio for well capitalized banking organizations would be one percentage point higher than for adequately capitalized banking organizations.  Thus, to be well capitalized under the Final Capital Rule, a banking organization must maintain a total risk-based capital ratio of 10% or more; a tier 1 capital ratio of 8% or more; a common equity tier 1 capital ratio of 6.5% or more; and a leverage ratio of 5% or more.  Advanced Approaches Banking Organizations also would be required to satisfy a supplementary leverage ratio of 3% in order to be considered adequately capitalized.  The capital conservation buffer is not included in the definition of the capitalization categories under the prompt corrective action rules because the Agencies believe it is appropriate for a banking organization to be able to reduce its capital conservation buffer without being considered less than well capitalized for prompt corrective action purposes.  As discussed above in Section I.B., the Supplementary Leverage Ratio would require the insured depository institution subsidiaries of certain very large bank holding companies to maintain a supplementary leverage ratio of at least 6% to be considered “well capitalized” for prompt corrective action purposes.

F.  Overall Capital Adequacy

Certain of the comment letters submitted in response to the Proposed Capital Rules expressed a concern that banking organizations that currently operate with a buffer over the minimum capital ratios will be expected by federal and state regulatory agencies to maintain the same additional levels of capital over the new minimum requirements.  In response, the Agencies stated that banking organizations are expected to hold capital commensurate with the banking organization’s size, sophistication, and risk profile, which may result in maintaining capital levels well above the minimum capital requirements.  The Agencies further stated that they will continue to evaluate a banking organization’s capital adequacy in light of such factors.

G.  Changes for Federal and State Savings Associations

In connection with the Final Capital Rule, the OCC will integrate its prompt corrective action rules for national banks and federal savings associations.  Federal savings association will be subject to the same prompt corrective action rules as national banks.  As part of the integration of these rules, federal savings associations will calculate tangible equity based on average total assets rather than period-end total assets.  Additionally, the OCC revised the definition of “tangible capital” for purposes of maintaining the minimum amount of tangible capital under the Home Owners Loan Act to mirror the definition of “tangible equity” for prompt corrective action purposes.  For state savings associations, the FDIC has also revised the definition of “tangible capital” to mirror the definition of “tangible equity.”  Similar to federal savings associations, state savings associations will calculate tangible equity based on average total assets rather than period-end total assets.

H.  Additional Requirements for Global Systemically Important Financial Institutions

Additionally, the FRB has indicated that the federal banking agencies are expected to propose three additional capital requirements for U.S. banking organizations that are identified as global systemically important financial institutions (“G-SIFIs”) beyond those proposed in the Final Capital Rule and the Supplementary Leverage Ratio NPR.  Currently there are eight U.S. banking organizations that have been designated as G-SIFIs.  These additional requirements are expected to be  (i) a proposed rule concerning the combined amount of equity and long-term debt these firms should maintain in order to facilitate orderly resolution in appropriate circumstances; (ii) a proposal to implement a framework of capital surcharges on U.S. G-SIFIs; and (iii) additional measures that would directly address risks related to short-term wholesale funding, including a requirement that large firms substantially dependent on such funding hold additional capital.

II.  Definition of capital

Under the Final Capital Rule, a banking organization’s regulatory capital components consist of (i) common equity tier 1 capital, (ii) additional tier 1 capital and (iii) tier 2 capital, in each case net of certain regulatory adjustments and deductions.  In most respects, the Final Capital Rule defines these elements of regulatory capital without significant change from the Proposed Capital Rules; however, as explained below, the Final Capital Rule includes several important changes and clarifications in response to concerns raised by commenters.

A.  Common Equity Tier 1 Capital

The Final Capital Rule defines a banking organization’s common equity tier 1 capital as qualifying common stock instruments issued by the banking organization (plus any related surplus, but net of treasury stock), qualifying capital instruments issued by mutual banking organizations, retained earnings, the amount of accumulated other comprehensive income (“AOCI”) as reported under generally accepted accounting principles (“GAAP”) (subject to an opt-out election addressed below), and common equity tier 1 minority interests (subject to certain limitations).  To qualify as common equity tier 1 capital, common stock issued by a banking organization and interests issued by a mutual banking organization must satisfy the following criteria:

  • The instrument must be paid-in, issued directly by the banking organization and represent the most subordinate claim in a receivership, insolvency, liquidation or similar proceeding of the issuing banking organization.
  • The holder of the instrument must be entitled to a claim on the residual assets of the issuing banking organization that is proportional with the holder’s share of the organization’s issued capital after all senior claims have been satisfied in a receivership, insolvency, liquidation or similar proceeding.
  • The instrument must have no maturity date, may only be redeemed via discretionary repurchase with the prior approval of the appropriate federal banking agency and may not contain any term or feature that creates an incentive to redeem.  This restriction need not be included explicitly in the capital instrument’s documentation provided the banking organization is required to obtain regulatory approval prior to redemption.
  • The issuing banking organization may not create at issuance of the instrument through any action or communication an expectation that it will buy back, cancel or redeem the instrument, and the instrument may not contain any term or feature that may create such an expectation.
  • The issuing banking organization must have full discretion to refrain from paying any dividends and making other distributions on the instrument without triggering an event of default, a requirement to make a payment-in-kind, or imposition of any other restrictions.  This requirement should not prevent a banking organization from paying a dividend on common equity tier 1 capital where it has incurred operational obligations in the normal course of business that are not yet due or that are subject to minor delays for reasons unrelated to the financial condition of the issuing banking organization.
  • Dividend payments and any other distributions on the instrument may be paid only after all legal and contractual obligations of the issuing banking organization have been satisfied, including payments due on more senior claims.  A banking organization must comply with this limitation even if state corporate law or other law would permit payment of dividends out of surplus when the organization does not have current or retained earnings.
  • The holders of the instrument must bear losses as they occur equally, proportionally, and simultaneously with the holders of all other common stock instruments before any losses are borne by holders of claims on the issuing banking organization with greater priority in a receivership, insolvency, liquidation or similar proceeding.
  • The paid-in amount must be classified as equity under GAAP.
  • The issuing banking organization or an entity that it controls must not purchase or directly or indirectly fund the instrument.
  • The instrument must be issued in accordance with applicable laws and regulations.
  • The instrument must be reported on the issuing banking organization’s financial statements separately from other capital instruments.

Nonvoting common stock will also qualify as common equity tier 1 capital; however, the preamble to the Final Capital Rule explains that voting common stockholders’ equity should be the dominant element within common equity tier 1 capital.  Further, to the extent a banking organization issues non-voting common stock or common stock with limited voting rights, the stock must be identical, except for voting rights, to voting common stock to be included in common equity tier 1 capital.  The Final Capital Rule permits a banking organization to include in common equity tier 1 capital stock held in trust for the benefit of employees under an employee stock ownership plan notwithstanding the fact that the plan may be an affiliate and notwithstanding any requirement in the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), that the issuer agree to repurchase stock that is not publicly traded in certain circumstances.

B.  Additional Tier 1 Capital

Under the Final Capital Rule, additional tier 1 capital consists of qualifying additional tier 1 capital elements and any related surplus, less regulatory adjustments and deductions, tier 1 minority interest (subject to limitations) and instruments that qualify as tier 1 capital under current general risk-based capital rules and that were issued under the Small Business jobs Act of 2010 (the “Jobs Act”) or prior to October 4, 2010 under the Emergency Economic Stabilization Act of 2008 (“TARP Instruments”).  To qualify as additional tier 1 capital, an instrument must meet the following requirements:

  • The instrument must be issued and paid-in.
  • The instrument must be subordinated to depositors, general creditors, and subordinated debt holders of the issuing banking organization in a receivership, insolvency, liquidation, or similar proceeding.
  • The instrument may not be secured, covered by a guarantee of the issuing banking organization or of an affiliate of the issuing banking organization, and may not be subject to any other arrangement that legally or economically enhances the seniority of the instrument.
  • The instrument must have no maturity date and may not contain a dividend step-up or any other term or feature that creates an incentive to redeem.
  • If callable by its terms, the instrument may be called by the issuing banking organization only after a minimum of five years following issuance, except that the terms of the instrument may allow it to be called earlier than five years upon the occurrence of a regulatory event that precludes the instrument from being included in additional tier 1 capital, a tax event, or if the issuing entity is required to register as an investment company pursuant to the Investment Company Act of 1940.  In addition, (i) the issuing banking organization must receive prior approval from its appropriate federal banking agency to exercise a call option on the instrument, (ii) the issuing banking organization may not create at issuance of the instrument, through any action or communication, an expectation that the call option will be exercised, and (iii) prior to exercising a call option, or immediately thereafter, the issuing banking organization must either replace the instrument to be called with an equal amount of common equity tier 1 capital or additional tier 1 equity or demonstrate to the satisfaction of its appropriate federal banking agency that, following redemption, the issuing banking organization will continue to hold capital commensurate with its risk.
  • Redemption or repurchase of the instrument must be subject to prior approval from the issuing banking organization’s appropriate federal banking agency.
  • The issuing banking organization must have full discretion at all times to cancel dividends or other distributions on the instrument without triggering an event of default, a requirement to make a payment-in-kind, or an imposition of other restrictions on the issuing banking organization except in relation to any distributions to holders of common stock or instruments that are pari passu with the instrument.  This exception responds to requests from commenters to clarify that the Final Capital Rule would not preclude so-called “dividend stopper” provisions that preclude payment of dividends on instruments that are parri passu with or junior to a capital instrument unless dividends are also declared and paid on the instrument containing the limitation.
  • Any distributions on the instrument must be paid out of the issuer’s net income, retained earnings, or surplus related to other additional tier 1 capital instruments.  As noted, a banking organization must comply with this limitation even if corporate law or other applicable law is more permissive.
  • The instrument may not have a credit-sensitive feature, such as a dividend rate that is reset periodically based in whole or in part on the issuing banking organization’s credit quality, but may have a dividend rate that is adjusted periodically independent of the issuer’s credit quality, in relation to general market interest rates or similar adjustments.
  • The paid-in amount must be classified as equity under GAAP.  This requirement will preclude so-called contingent capital instruments that are classified as liabilities for GAAP purposes as qualifying for additional tier 1 capital treatment.
  • The issuing banking organization, or an entity that its controls, may not purchase or directly or indirectly fund the purchase of the instrument.
  • The instrument must not have any features that would limit or discourage additional issuance of capital by the issuing banking organization, such as provisions that require the issuer to compensate holders of the instrument if a new instrument is issued at a lower price during a specified time frame.
  • If the instrument is not issued directly by the banking organization or by a subsidiary of the banking organization that is an operating entity, the only asset of the issuing entity may be its investment in the capital of the banking organization, and proceeds must be immediately available without limitation to the banking organization or its top-tier holding company in a form which meets or exceeds all of the other criteria for additional tier 1 capital instruments.
  • On a prospective basis, for an Advanced Approaches Banking Organization, the governing agreement, offering circular, or prospectus for the instrument must disclose that the holders of the instrument may be fully subordinated to interests held by the U.S. government in the event that the banking organization enters into a receivership, insolvency, liquidation, or similar proceeding.

The Final Capital Rule provides that an instrument issued by a banking organization and held in trust for an employee stock ownership plan may qualify for inclusion in additional tier 1 capital notwithstanding the fact that the plan may be an affiliate and notwithstanding any requirement of ERISA that the issuer agree to repurchase stock that is not publicly traded in certain circumstances.  Similarly, an instrument that provides that it may be called earlier than five years from issuance upon the occurrence of a rating agency event may continue to qualify as additional tier 1 capital if it was issued and included in the issuing banking organization’s tier 1 capital as of the effective date of the Final Capital Rule and if it otherwise meets the requirements for inclusion in additional tier 1 capital.

C.  Tier 2 Capital

The Final Capital Rule defines tier 2 capital as qualifying tier 2 capital instruments and any related surplus, total capital minority interest (subject to limitations), allowance for loan and lease losses (up to 1.25% of the banking organization’s total-risk weighted assets, not including allowance for loan and lease losses and market risk assets), instruments that qualify as tier 2 capital under the current general risk-based capital rules and were issued under the Jobs Act or that are TARP instruments, and (for a bank that makes an AOCI opt-out election, as discussed below in Section II.G) 45% of pretax net unrealized gains on available for sale preferred stock classified as an equity security under GAAP and equity exposures, less regulatory adjustments and deductions.

A tier 2 capital instrument must meet the following requirements:

  • The instrument must be issued and paid-in.
  • The instrument must be subordinated to depositors and general creditors of the issuing banking organization.  An instrument need not expressly state that it is subordinate to general creditors as long as it is clear from the governing agreement, offering circular or prospectus that the instrument is subordinated to general creditors.
  • The instrument must not be secured or covered by a guarantee of the issuing banking organization or of an affiliate of the issuing banking organization, and may not be subject to any other arrangement that legally or economically enhances the seniority of the instrument in relation to more senior claims.
  • The instrument must have a minimum original maturity of at least five years.  At the beginning of each of the last five years of the life of the instrument, the amount that is eligible to be included in tier 2 capital is reduced by 20% of the original amount of the instrument (net of redemptions) and is excluded from regulatory capital when the remaining maturity is less than one year.  In addition, the instrument must not have any terms or features that require, or create significant incentives for, the issuing banking organization to redeem the instrument prior to maturity.  Notwithstanding this requirement, a banking organization may treat a debt instrument that automatically converts to an equity instrument within five years as tier 2 capital if the instrument otherwise satisfies the requirements for inclusion in tier 2 capital.  If a banking organization defers interest payments on an existing trust preferred instrument includable in tier 2 capital, the organization must treat the instrument as having a five year maturity at that point, even if the instrument allows acceleration after five years or interest deferral.
  • The instrument, by its terms, may be called by the issuing banking organization only after a minimum of five years following issuance, except that the terms of the instrument may allow it to be called sooner upon the occurrence of an event that would preclude the instrument from being included in tier 2 capital, a tax event, or if the issuing entity is required to register as an investment company pursuant to the Investment Company Act of 1940.
  • The issuing banking organization must receive the prior approval of the responsible federal banking agency to exercise a call option on the instrument.
  • The issuing banking organization may not create at issuance, through action or communication, an expectation that the call option will be exercised.
  • Prior to exercising the call option, or immediately thereafter, the issuing banking organization must either: replace any amount called with an equivalent amount of an instrument that meets the criteria for regulatory capital, or demonstrate to the satisfaction of the responsible federal banking agency that, following redemption, the issuing banking organization would continue to hold an amount of capital that is commensurate with its risk.
  • The holder of the instrument must have no contractual right to accelerate payment of principal or interest on the instrument, except in the event of a receivership, insolvency, liquidation, or similar proceeding of the issuing banking organization.
  • The instrument may not have any credit-sensitive feature, such as a dividend or interest rate that is reset periodically based in whole or in part on the issuing banking organization’s credit standing, but may have a dividend rate that is adjusted periodically independent of the issuing banking organization’s credit standing, in relation to general market interest rates or similar adjustments.
  • The issuing banking organization, or an entity that the issuing banking organization controls, must not purchase or directly or indirectly fund the purchase of the instrument.
  • If the instrument is not issued directly by the banking organization or by a subsidiary of the banking organization that is an operating entity, the only asset of the issuing entity may be its investment in the capital of the banking organization, and proceeds must be immediately available without limitation to the banking organization or the banking organization’s top-tier holding company in a form that meets or exceeds all the other criteria for tier 2 capital instruments.
  • The issuing banking organization may only redeem the instrument prior to maturity or repurchase with the prior approval of its responsible federal banking agency.
  • On a going forward basis, for an Advanced Approaches Banking Organization, the governing agreement, offering circular, or prospectus must disclose that the holders of the instrument may be fully subordinated to interests held by the U.S. government in the event that the issuing banking organization enters into a receivership, insolvency, liquidation, or similar proceeding.

D.  Treatment of Trust Preferred

In response to comments from community banking organizations, the Final Capital Rule permits banking organizations with less than $15 billion of total assets as of December 31, 2009 and banking organizations that were mutual holding companies as of May 19, 2010 to include in tier 1 capital nonqualifying trust preferred securities and cumulative preferred stock issued prior to May 19, 2010, subject to a limit of 25% of tier 1 capital elements (excluding the nonqualifying instruments).  The excess above this limit may be included in tier 2 capital.  Other banking organization would be required to phase out non-qualifying capital instruments according to a timetable set forth in the Final Capital Rule.  However, the Final Capital Rule permits holding companies that are not Advanced Approaches Banking Organizations with $15 billion or more of total consolidated assets to include in tier 2 capital trust preferred instruments that are phased out of tier 1 capital.  Advanced Approaches Banking Organizations, however, would not qualify for this treatment.

E.  Treatment of Minority Interest

Under the Final Capital Rule, a banking organization may include minority interest in a consolidated subsidiary in capital if the interest qualifies as common equity tier 1, additional tier 1 or tier 2 capital, as appropriate.  Common equity tier 1 minority interest is limited to instruments issued by a depository institution or foreign bank that is a subsidiary of the banking entity.  As previously noted, to qualify for inclusion in additional tier 1 or tier 2 capital, the instrument must be issued by a subsidiary of the banking organization that is an operating entity or an entity whose only asset is its investment in the capital of the banking organization.  Institutions that currently include real estate investment trust preferred stock in capital will need to evaluate whether the issuer is an operating entity and whether it is able to comply with all of the requirements of the Final Capital Rule, including canceling dividends (or issuing consent dividends that do not involve distribution of assets).  If the consolidated subsidiary has more capital than it needs to meet minimum capital requirements plus a capital conservation buffer, the banking organization may not include in its capital the portion of such surplus capital that is attributable to third party investors.

F.  Deductions from and Adjustments to Capital

The Final Capital Rule requires banking organizations to make the following deductions from and adjustments to its common equity tier 1 capital:

  • Goodwill, net of associated deferred tax liabilities (“DTLs”).  This deduction includes goodwill that is embedded in the value of a significant investment in the capital of an unconsolidated financial institution in the form of common stock and that is reflected in the consolidated financial statement of the banking organization.
  • Intangible assets (other than mortgage servicing assets), net of associated DTLs.
  • Gain on sale associated with securitization exposures.
  • Holding companies must deduct defined benefit pension fund net assets unless the holding company has unrestricted and unfettered access to the assets.
  • Advanced Approaches Banking Organizations that have completed the parallel run process must deduct the amount of expected credit loss that exceeds its eligible credit reserves.
  • Investments by a bank in a financial subsidiary.
  • Certain adjustments related to AOCI.
  • A banking organization must deduct any net gain and add any net loss related to changes in the fair value of liabilities that are due to changes in the bank’s own credit risk.  An Advanced Approaches Banking Organization must also deduct the credit spread premium over the risk free rate for derivatives that are liabilities.

A banking organization must deduct an investment in the banking organization’s own common stock from its common equity tier 1 capital, and similar deductions are also required with respect to investments in tier 1 and tier 2 instruments.  The Final Capital rule requires banking organizations to deduct investments in the capital of other financial institutions it holds reciprocally, where such reciprocal cross-holdings result from a formal or informal arrangement to swap, exchange or otherwise intend to hold each other’s capital instruments.  In general, the banking organization must make the deduction from the component of capital for which the underlying instrument would qualify if it were issued by the banking organization itself (the “corresponding deduction approach”).

The Final Capital Rule requires a banking organization to deduct its non-significant investments in the capital of unconsolidated financial institutions that, in the aggregate, exceed 10% of its common equity tier 1 capital, net of required deductions and adjustments, using the corresponding deduction approach.  An investment is non-significant when it represents 10% or less of the issued and outstanding common stock of the unconsolidated financial institution.  In general, a financial institution includes a bank holding company, a savings and loan holding company, a nonbank financial institution supervised by the FRB under Title 1 of the Dodd-Frank Act, a depository institution, a foreign bank, an industrial loan company (or industrial bank or similar institution), a national association or state member or nonmember bank that is not a depository institution, an insurance company, a securities holding company, a broker dealer than is registered under Section 15 of the Securities Exchange Act, a futures commission merchant, a swap dealer or a security-based swap dealer.  The term financial institution also includes a designated financial market utility, and any non-U.S. entity that is supervised and regulated in a manner similar to any of the entities described above.  The Final Capital Rule also treats an entity as a financial institution if the banking organization owns an investment in GAAP equity instruments of the entity with an adjusted carrying value or exposure of $10 million or more or that represents more than 10% of the company’s issued and outstanding common shares, if the entity is predominantly engaged in lending, insurance, underwriting and dealing in securities and other financial instruments, or asset management (other than investment or financial advisory activities).  However, the term financial institution excludes small business investment companies, community development financial institutions, registered investment companies and foreign equivalents, certain employee benefit plans and governmental plans, and certain entities to the extent an investment in such entities would qualify as community development investments for a national bank.

A banking organization must deduct its significant investments in the capital stock of unconsolidated financial institutions that are not in the form of common stock by applying the corresponding deduction approach.

A banking organization must deduct from its common equity tier 1 capital the amount of each of the following items that, individually, exceeds 10% of its common equity tier 1 elements (less adjustments and deductions):

  • Certain deferred tax assets.
  • Mortgage servicing assets net of associated DTLs.
  • Significant investments in the capital of unconsolidated financial institutions in the form of common stock, net of DTLs.

To the extent the aggregate amount of these items not deducted as described above exceeds 17.65% of the banking organization’s common equity tier 1 capital (net of deductions), the excess must be deducted from common equity tier 1 capital.

The Final Capital Rule includes transition provisions that address the time table on which banking organizations would be required to be begin making these deductions and adjustments.

G.  AOCI Opt Out Election

As noted, the Final Capital Rule generally requires banking organizations to include AOCI in common equity tier 1.  However, in response to comments from the banking industry, the Final Capital Rules would permit banking organizations other than Advanced Approaches Banking Organizations to make a one-time, permanent election to continue excluding AOCI from capital.  Generally, banking organizations would be required to make this election when filing the first call report for financial statement after the date on which they become subject to the Final Capital Rule.  The opt-out election would generally be permanent except in instances of a merger or acquisition transactions between two banking organizations of which only once made an AOCI opt-out election.

H.  Approval of Capital Instruments

The Final Capital Rule requires that a banking organization receive its primary federal supervisor’s prior approval to include a capital element in its common equity tier 1 capital, additional tier 1 capital, or tier 2 capital unless that element: (i) was included in the banking organization’s tier 1 capital or tier 2 capital prior to May 19, 2010 in accordance with that supervisor’s risk-based capital rules that were effective as of that date and the underlying instrument continues to be includable under the criteria set forth in the Final Capital Rule; or (ii) is equivalent, in terms of capital quality and ability to absorb credit losses with respect to all material terms, to a regulatory capital element determined by that supervisor to be includable in regulatory capital in a publicly available decision.

III.  Denominator changes related to regulatory capital

The Final Capital Rule makes certain changes to the denominator of the risk-based and leverage ratios relating to regulatory capital changes.  Generally, amounts deducted from capital are also excluded from risk weighted assets and leverage exposure.  In addition, the Final Capital Rule requires banking organizations to assign a 250% risk weight to mortgage servicing assets, deferred tax assets arising from temporary differences that a banking organization could not realize through net loss operating carrybacks (net of related valuation allowances and net of DTLs) and any significant investments in the capital of unconsolidated financial institutions that are not deducted from capital.

IV.  Standardized Approach for Risk – Weighted Assets

Beginning on January 1, 2015, all banking organizations will be required to calculate risk-weighted assets under the standardized approach of the Final Capital Rule.  In response to the substantial number of comment letters regarding the standardized approach, the standardized approach set forth in the Final Capital Rule contains significant changes from the Proposed Capital Rules.

Under the Final Capital Rule, a banking organization determines its standardized total risk-weighted assets by calculating the sum of (i) its risk-weighted assets for general credit risk, cleared transactions, default fund contributions, unsettled transactions, securitization exposures, and equity exposures plus (ii) market risk-weighted assets, if applicable, minus (iii) the amount of the banking organization’s allowance for loan and lease losses that is not included in tier 2 capital, and any amounts of allocated transfer risk reserves.

A.  Risk-Weighted Assets for General Credit Risk

Sovereign Exposures.  Under the Final Capital Rule, exposures to the U.S. government, its central bank, or a U.S. government agency and the portion of an exposure that is directly and unconditionally guaranteed by the U.S. government, the U.S. central bank, or a U.S. government agency (including exposures guaranteed by the FDIC or NCUA) receive a 0% risk weight.  An exposure conditionally guaranteed by the U.S. government, its central bank, or a U.S. government agency receives a 20% risk weight.  Foreign sovereign exposures receive a risk weight of 0% to 150% based on the Organization for Economic Co-operation and Development (“OECD”) country risk classifications.  Because the OECD ceased assigning country risk classifications to certain countries after the release of the Proposed Capital Rules, under the Final Capital Rule countries without a country risk classification are assigned either a 0% or 100% risk weight depending on whether the country is a member of the OECD.  Consistent with the Proposed Capital Rules, the Final Capital Rule provides that if a banking supervisor in a sovereign jurisdiction allows banking organizations in that jurisdiction to apply a lower risk weight to an exposure to the sovereign than under the Final Capital Rule, a U.S. banking organization may assign the lower risk weight to an exposure to the sovereign, provided the exposure is denominated in the sovereign’s currency and the U.S. banking organization has at least an equivalent amount of liabilities in that foreign currency.

Supranational Entity and Multilateral Development Bank Exposures.  Under the Final Capital Rule, exposures to the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund and certain defined multilateral development banks receive a 0% risk weight.

Government-Sponsored Entity (“GSE”) Exposures.  The Final Capital Rule assigns a 20% risk weight to exposures to GSEs that are not equity exposures and assigns a 100% risk weight to preferred stock issued by a GSE.  This is unchanged from the risk weights of the current capital rules of the FRB and the FDIC.  The OCC currently assigns a 20% risk weight to GSE preferred stock.

Depository Institution, Foreign Bank and Credit Union Exposures.  Under the Final Capital Rule, exposures to U.S. depository institutions and credit unions are assigned a 20% risk weight and an exposure to a foreign bank is assigned a risk weight one category higher than the risk weight assigned to a sovereign exposure to the foreign bank’s home country.  A 150% risk weight is assigned to an exposure to a foreign bank from a country in default or that has defaulted in the last five years.  Exposures to a financial institution that are included in the regulatory capital of such financial institution receive a risk weight of 100%, with certain exceptions, and self-liquidating, trade-related contingent items that arise from the movement of goods and that have a maturity of three months or less are assigned a risk weight of 20%.  Exposures to bank holding companies, savings and loan holding companies, securities firms and other financial institutions that are not insured depository institutions or credit unions are assigned a 100% risk weight.

Public Sector Entity Exposures.  The Final Capital Rule defines a public sector entity as a state, local authority, or other governmental subdivision below the level of a sovereign, including U.S. states and municipalities.  Under the Final Capital Rule, general obligation exposures to a public sector entity that is organized under the laws of the United States or any state or political subdivision thereof are assigned a 20% risk weight and revenue obligation exposures to such a public sector entity are assigned a 50% risk weight.  Exposures to non-U.S. public sector entities are assigned risk weights based on OECD country risk classification of the public sector entity’s home country.

Corporate Exposures.  Under the Final Capital Rule all corporate exposures receive a 100% risk weight, as they do under the current capital rules.  Corporate exposures include bonds, loans and any exposure not otherwise included in another exposure category but do not include an exposure to a sovereign, the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, an multilateral development bank, a depository institution, a foreign bank, a credit union, a public sector entity, a GSE, a residential mortgage exposure, a pre-sold construction loan, a statutory multifamily mortgage, a high-volatility commercial real estate exposure, a cleared transaction, a default fund contribution, a securitization exposure, an equity exposure, or an unsettled transaction.

Mortgage Exposures.  The Proposed Capital Rules would have divided mortgages into two categories based on the product features of the mortgage and then would have assigned risk weights to mortgage exposures based on the risk weight and loan-to-value ratio of the mortgage.  This proposed treatment was heavily criticized in the comment letters, both for its complexity and its potential effect on the mortgage market.  In response to these comments, the Final Capital Rule retains the current risk weights for residential mortgages under the general risk-based capital rules, which assign a risk weight of either 50% (for most first-lien exposures) or 100% for all other residential mortgage exposures.

Pre-Sold Construction Loan and Statutory Multifamily Mortgage Exposures.  Under the Final Capital Rule, a banking organization must assign a 50% risk weight to a pre-sold construction loan unless the purchase contract is cancelled, in which case the banking organization must assign a 100% risk weight. Exposures to statutory multifamily mortgages are assigned a 50% risk weight.  A multifamily mortgage that does not meet the definition of a statutory multifamily mortgage is treated as a corporate exposure.

High-Volatility Commercial Real Estate (“HVCRE”) Exposures.  Consistent with the Proposed Capital Rules, under the Final Capital Rules HVCRE exposures are assigned a 150% risk weight.  This is higher than the current 100% risk weight for such exposures.  HVCRE exposures include any credit facility that finances or has financed the acquisition, development, or construction of real property, unless the facility finances one- to four-family residential mortgage property, community development investments, agricultural development for agricultural purposes or commercial real estate projects that meet certain prudential criteria.  The Agencies clarified that a loan permanently financing owner-occupied commercial real estate is not an HVCRE exposure.

Past Due Exposures.  Under the Final Capital Rule, exposures more than 90 days past due or on nonaccrual that are not guaranteed or secured (and are not a sovereign or residential mortgage exposure) are increased to 150%.

Other Assets.  The Final Capital Rule assigns the following risk weights to certain other exposures not otherwise assigned to a specific risk weight category, which are generally consistent with the current capital rules:

  • 0% risk weight for cash, gold bullion held by the banking organization, and exposures from the settlement of cash transactions;
  • 20% risk weight for cash items in process of collection;
  • 100% risk weight to all assets not specifically assigned a different risk weight (other than exposures that would be deducted from tier 1 or tier 2 capital), including deferred acquisition costs and value of business acquired;
  • 100% risk weight to deferred tax assets arising from temporary differences that the banking organization could realize through net operating loss carrybacks; and
  • 250% risk weight to the portion of mortgage servicing assets and deferred tax assets arising from temporary differences that the banking organization could not realize through net operating loss carrybacks that are not deducted from common equity tier 1.

B.  Off-Balance Sheet Exposures

Credit Conversion Factors.  Under the Final Capital Rule, exposures to off-balance sheet items are calculated by multiplying the off-balance sheet component by the applicable credit conversion factor, similar to the requirement under the current capital rules.  This treatment applies to all off-balance sheet items, such as commitments, contingent items, guarantees, certain repo-style transactions, financial standby letters of credit, and forward agreements.  Consistent with the Proposed Capital Rules, new credit conversion factors apply to certain exposures, such as a higher credit conversion factor for commitments with an original maturity of one year or less that are not unconditionally cancelable.  A 0% credit conversion factor applies to the unused portion of commitments that are unconditionally cancelable by the banking organization.  A 20% credit conversion factor applies to commitments with an original maturity of one year or less that are not unconditionally cancelable by a banking organization, and for self-liquidating, trade-related contingent items that arise from the movement of goods with an original maturity of one year or less.  A 50% credit conversion factor applies to commitments with an original maturity of more than one year that are not unconditionally cancelable by the banking organization, and to transaction-related contingent items, including performance bonds, bid bonds, warranties, and performance standby letters of credit.  A 100% credit conversion factor applies to off-balance sheet guarantees, repurchase agreements, credit-enhancing representations and warranties that are not securitization exposures, securities lending or borrowing transactions, financial standby letters of credit, and forward agreements, and other similar exposures.

Credit-Enhancing Representations and Warranties.  The Proposed Capital Rules would have eliminated the 120-day safe harbor for certain early default or premium refund clauses.  In response to comments critical of this proposal, the Final Capital Rule does not require capital to be held for assets sold with representations and warranties that contain certain early default clauses or premium refund clauses that apply within 120 days of the sale.  Therefore, consistent with the current capital rules, under the Final Capital Rule, credit-enhancing representations and warranties do not include (i) early default clauses and similar warranties that permit the return of, or premium refund clauses covering, one-to-four family first-lien residential mortgage loans that qualify for a 50% risk weight for a period not to exceed 120 days from the date of transfer; (ii) premium refund clauses that cover assets guaranteed by the U.S. government, a U.S. government agency, or a GSE, provided the premium refund clauses are for a period not to exceed 120 days from the date of transfer; or (iii) warranties that permit the return of underlying exposures in instances of misrepresentation, fraud, or incomplete documentation.

C.  Over-the-Counter Derivative (“OTC”) Contracts 

Under the Final Capital Rule, the Agencies generally retain the treatment of OTC derivatives provided under the current capital rules.Revisions to the treatment of the OTC derivative contracts included an updated definition of an OTC derivative contract, a revised conversion factor matrix for calculating the potential future exposure, a revision of the criteria for recognizing the netting benefits of qualifying master netting agreements and of financial collateral, and the removal of the 50% risk weight cap for OTC derivative contracts.  Under the Final Capital Rule, as under the current capital rules, a banking organization is required to hold risk-based capital for counterparty credit risk for an OTC derivative contract.  As defined in the Final Capital Rule, a derivative contract is a financial contract whose value is derived from the values of one or more underlying assets, reference rates, or indices of asset values or reference rates.  A derivative contract includes an interest rate, exchange rate, equity, or a commodity derivative contract, a credit derivative, and any other instrument that poses similar counterparty credit risks. Derivative contracts also include unsettled securities, commodities, and foreign exchange transactions with a contractual settlement or delivery lag that is longer than the lesser of the market standard for the particular instrument or five business days.  To determine the risk-weighted asset amount for an OTC derivative contract under the Final Capital Rule, a banking organization must first determine its exposure amount for the contract and then apply to that amount a risk weight based on the counterparty, eligible guarantor, or recognized collateral.

D.  Cleared Transactions

Under the Final Capital Rule, a banking organization must hold risk-based capital for outstanding derivative contracts or repo-style transactions that have been cleared through a central counterparty, including an exchange.  The Final Capital Rules incorporate changes to the Proposed Capital Rules based on the interim central counterparty capital framework adopted by the Basel Committee on Banking Supervision.  The Agencies indicated that the international discussions are ongoing on the framework, and that the Agencies will revisit this issue once the final central counterparty capital framework is revised.  Changes from the Proposed Capital Rule include revisions with respect to the definition of a “cleared transaction,” the exposure amount scalar for calculating client exposures, risk weighting for cleared transactions, and default fund contribution exposures.

E.  Credit Risk Mitigation

Guarantees and Credit Derivatives.  Under the Final Capital Rule, guarantees and credit derivatives are required to meet specific eligibility requirements to be recognized for credit risk mitigation purposes.  The Agencies adopted the substitution approach, maturity mismatch haircut, adjustment for credit derivatives without restructuring as a credit event, currency mismatch adjustment and multiple credit risk mitigations in the Final Capital Rule without change from the Proposed Capital Rules.

Collateralized Transactions.  The Final Capital Rule recognizes an expanded range of financial collateral as credit risk mitigants that may reduce the risk-based capital requirements associated with a collateralized transaction.  Under the Final Capital Rule, the Agencies require that a banking organization recognize the risk-mitigating effects of financial collateral using the simple approach where (i) the collateral is subject to a collateral agreement for at least the life of the exposure; (ii) the collateral is revalued at least every six months; and (iii) the collateral (other than gold) and the exposure is denominated in the same currency.  For repo-style transactions, eligible margin loans, collateralized derivative contracts, and single-product netting sets of such transactions, a banking organization could alternatively use the collateral haircut approach.  The final rule, like the proposal, requires a banking organization to use the same approach for similar exposures or transactions.

Under the simple approach, the collateralized portion of the exposure receives the risk weight applicable to the collateral.  Under the collateral haircut approach, a banking organization may use the collateral haircut approach to recognize the credit risk mitigation benefits of financial collateral that secures an eligible margin loan, repo-style transaction, collateralized derivative contract, or single-product netting set of such transactions.

When determining the exposure amount, the banking organization must apply a haircut for price market volatility and foreign exchange rates, determined either using standard supervisory market price volatility haircuts and a standard haircut for exchange rates or, with prior approval of the agency, a banking organization’s own estimates of volatilities of market prices and foreign exchange rates.

Unsettled Transactions.  The Final Capital Rule provides for a separate risk-based capital requirement for transactions involving securities, foreign exchange instruments, and commodities that have a risk of delayed settlement or delivery.  Under the Final Capital Rule, the capital requirement does not, however, apply to certain types of transactions, including: (i) cleared transactions that are marked-to-market daily and subject to daily receipt and payment of variation margin; (ii) repo-style transactions, including unsettled repo-style transactions; (iii) one-way cash payments on OTC derivative contracts; or (iv) transactions with a contractual settlement period that is longer than the normal settlement period (which the proposal defined as the lesser of the market standard for the particular instrument or five business days).  In the case of a system-wide failure of a settlement, clearing system, or central counterparty, the banking organization’s primary federal supervisor may waive risk-based capital requirements for unsettled and failed transactions until the situation is rectified.  The final rule provides separate treatments for delivery-versus-payment and payment-versus-payment transactions with a normal settlement period, and non- delivery-versus-payment or non- payment-versus-payment transactions with a normal settlement period.  If a banking organization has not received its deliverables by the fifth business day after the counterparty delivery due date, the banking organization must assign a 1,250% risk weight to the current market value of the deliverables owed.

F.  Risk-Weighted Assets for Securitization Exposures

The Final Capital Rule significantly revises the risk-based capital framework for securitization exposures.  In accordance with the Dodd-Frank Act, the Final Capital Rule removes references to and reliance on credit ratings to determine risk weights for these exposures and using alternative standards of creditworthiness.  The Final Capital Rule defines a securitization exposure as an on- or off-balance sheet credit exposure (including credit-enhancing representations and warranties) that arises from a traditional or synthetic securitization (including a resecuritization), or an exposure that directly or indirectly references a securitization exposure.

Definition of Traditional Securitization.  A traditional securitization is generally defined as a transaction in which credit risk of one or more underlying exposures has been transferred to one or more third parties (other than through the use of credit derivatives or guarantees), where the credit risk associated with the underlying exposures has been separated into at least two tranches reflecting different levels of seniority.  An operating company does not fall under the definition of a traditional securitization even if substantially all of its assets are financial exposures.  The definition of traditional securitization also excludes exposures to investment funds, collective investment funds and pension funds.

Definition of Synthetic Securitization.  A synthetic securitization is defined as a transaction in which: (i) all or a portion of the credit risk of one or more underlying exposures is transferred to one or more third parties through the use of one or more credit derivatives or guarantees (other than a guarantee that transfers only the credit risk of an individual retail exposure); (ii) the credit risk associated with the underlying exposures has been separated into at least two tranches reflecting different levels of seniority; (iii) performance of the securitization exposures depends upon the performance of the underlying exposures; and (iv) all or substantially all of the underlying exposures are financial exposures (such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities).  The Agencies clarified that transactions in which a portion of credit risk has been retained, not just transferred, through the use of credit derivatives is subject to the securitization framework.

Due Diligence Requirements.  The Final Capital Rule requires a banking organization to demonstrate, to the satisfaction of its primary federal supervisor, a comprehensive understanding of the features of a securitization exposure that would materially affect its performance.  The banking organization’s analysis to satisfy this requirement must be commensurate with the complexity of the exposure and the materiality of the exposure in relation to capital of the banking organization.  On an ongoing basis and no less frequently than quarterly, the banking organization must evaluate, review, and update as appropriate such analysis required for each securitization exposure.  If a banking organization is not able to meet these due diligence requirements and demonstrate a comprehensive understanding of a securitization exposure to the satisfaction of its primary federal supervisor, the banking organization would be required to assign a risk weight of 1,250% to the exposure.

Operational Requirements.  The Final Capital Rule establishes certain operational requirements for securitization transactions.  Under the final rule, consistent with the proposal, a banking organization that transfers exposures it has originated or purchased to a securitization special purpose entity or other third party in connection with a traditional securitization can exclude the underlying exposures from the calculation of risk-weighted assets only if each of the following conditions are met: (i) the exposures are not reported on the banking organization’s consolidated balance sheet under GAAP; (ii) the banking organization has transferred to one or more third parties credit risk associated with the underlying exposures; and (iii) any clean-up calls relating to the securitization are eligible clean-up calls as defined under the Final Capital Rule.  In general, the proposed operational requirements for synthetic securitizations are similar to those for traditional securitizations.  Additionally, an originating banking organization may recognize for risk-based capital purposes the use of a credit risk mitigant to hedge underlying exposures only if each of the conditions in the proposed definition of “synthetic securitization” is satisfied.  The Final Capital Rule permits a banking organization to recognize guarantees and credit derivatives that meet certain criteria set forth in the definition of eligible guarantee and eligible credit derivative, respectively.

Risk-Weighted Asset Amounts for Securitization Exposures.  To assign risk-based capital requirements to securitization exposures, banking organizations generally must calculate a risk-weighted asset amount for a securitization exposure by applying either (i) the simplified supervisory formula approach or (ii) if the banking organization is not subject to the market risk rule, a gross-up approach similar to an approach provided under the current capital rules. A banking organization must apply either the simplified supervisory formula approach or the gross-up approach consistently across all of its securitization exposures.  However, a banking organization may choose to assign a 1,250% risk weight to any securitization exposure.

The simplified supervisory formula approach is a simplified version of the supervisory formula approach set forth in the advanced approaches rule.  The simplified supervisory formula has a baseline derived from the capital requirements that apply to all exposures underlying the securitization and then assigns risk weights based on the subordination level of an exposure.  It is intended to apply relatively higher capital requirements to the more risky junior tranches of a securitization that are the first to absorb losses, and relatively lower requirements to the most senior exposures.  A 1,250% risk weight is applied to securitization exposures that absorb losses up to the amount of capital that is required for the underlying exposures under the Final Capital Rule had those exposures been held directly by a banking organization.  Additionally, the Final Capital Rule establishes a minimum risk weight for a given securitization of 20%.  Thus, at the inception of a securitization, the simplified supervisory formula approach requires more capital on a transaction-wide basis than would be required if the underlying assets had not been securitized.

Banking organizations that that are not subject to the market risk rule may assign risk-weighted asset amounts to securitization exposures by implementing the gross-up approach, which is similar to an existing approach provided under the current risk-based capital rules.  The gross-up approach assigns risk-weighted asset amounts based on the full amount of the credit-enhanced assets for which the banking organization directly or indirectly assumes credit risk.  Under the gross-up approach, a banking organization is required to calculate the credit equivalent amount, which equals the sum of (i) the exposure of the banking organization’s securitization exposure and (ii) the par value of the banking organization’s exposure as a percentage of the par value of the tranche in which the securitization exposure resides multiplied by the par value of all the tranches that are more senior to the tranche in which the exposure resides. To calculate risk-weighted assets for a securitization exposure under the gross-up approach, a banking organization is required to assign the applicable risk weight to the gross-up credit equivalent amount. However, the minimum risk weight for securitization exposures is 20% applies to securitizations under the gross-up approach.

Alternative Treatments for Certain Types of Securitization Exposures.  Under the Final Capital Rule, a banking organization generally would assign a 1,250% risk weight to any securitization exposure to which the banking organization does not apply the simplified supervisory formula approach or the gross-up approach.  However, the Final Capital Rule provides for alternative treatments for eligible asset-backed commercial paper liquidity facilities and securitization exposures in a second-loss position or better to an asset-backed commercial paper program, provided that the banking organization knows the composition of the underlying exposures at all times.

Credit Risk Mitigation for Securitization Exposures.  A banking organization that purchases credit protection for securitization exposures must use the approach for collateralized transactions or the substitution treatment for guarantees and credit derivatives.  In cases of maturity or currency mismatches, or, if applicable, lack of a restructuring event trigger, the banking organization must make any applicable adjustments to the protection amount of an eligible guarantee or credit derivative as required for any hedged securitization exposure.  For synthetic securitizations, when an eligible guarantee or eligible credit derivative covers multiple hedged exposures that have different residual maturities, the banking organization is required to use the longest residual maturity of any of the hedged exposures as the residual maturity of all the hedged exposures.  The Agencies clarified that a banking organization is not required to compute a counterparty credit risk capital requirement for the credit derivative provided that this treatment is applied consistently for all of its OTC credit derivatives, unless the OTC credit derivative is a covered position under the market risk rule.  Under the Final Capital Rule, the capital requirement for credit protection provided through an nth-to-default credit derivative is determined either by using the simplified supervisory formula approach or applying a 1,250% risk weight.

V.  Equity Exposures

The Final Capital Rule significantly revises the treatment of equity exposures.  The Final Capital Rule sets forth the methods for determining the adjusted carrying value for each equity security depending on whether the banking organization has made an AOCI opt-out election.  The Final Capital Rule also sets forth calculations for determining the adjusted carrying value of commitments to acquire an equity exposure and off-balance sheet equity exposures.  Under the Final Capital Rule, a banking organization determines the risk-weighted asset amount for each equity exposure, other than an equity exposure to an investment fund, by multiplying the adjusted carrying value of the equity exposure (or the effective portion and ineffective portion of a hedge pair) by the lowest applicable risk weight.  The proposed risk weights for equity exposures are as follows:

  • 0% risk weight for an equity exposure to a sovereign, the Bank of International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, an multilateral development bank or any other entity whose credit exposures receive a 0% risk weight under the Final Capital Rule;
  • 20% risk weight for an equity exposure to a public sector entity (e.g., states, municipalities), Federal Home Loan Bank or Federal Agricultural Mortgage Corporation;
  • 100% risk weight for an equity exposure to community development equity exposures, the effective portion of a hedge pair, and non-significant equity exposures (to the extent that the aggregate adjusted carrying value of the exposures does not exceed 10% of tier 1 capital plus tier 2 capital).
  • 250% risk weight for a significant investment in the capital of a non-deducted unconsolidated financial institution in the form of common stock;
  • 300% risk weight for publicly traded equity exposures (other than an equity exposure that receives a 600% risk weight and including the ineffective portion of a hedge pair);
  • 400% risk weight for non-publicly traded equity exposures (other than an equity exposure that receives a 600% risk weight); and
  • 600% risk weight for an equity exposure to an investment firms that does not meet the definition of a traditional securitization and has greater than immaterial leverage.

Under the Final Capital Rule, a banking organization may apply a 100% risk weight to certain non-significant equity exposures for which the aggregate adjusted carrying value of the exposures does not exceed 10% of the banking organization’s total capital.  The definition of equity exposure and the equity exposure risk weights set forth in the Final Capital Rule did not change from the Proposed Capital Rules.

A banking organization may determine the effectiveness of a hedge pair for calculating its risk weight by using one of three methods set forth in the Final Capital Rule: the dollar-offset method, the variability-reducing method or the regression method.  A banking organization may select one of three methods set forth in the Final Capital Rule to calculate the risk-weight asset amount for equity exposures to investment funds: the full-look through approach, the simple modified look-through approach or the alternative modified look-through approach.  Under the Final Capital Rule, the risk weight for an equity exposure to an investment fund must be no less than 20%.  A banking organization must treat an investment in a separate account, such as bank-owned life insurance, as if it were an equity exposure to an investment fund. 

VI.  Insurance – Related Activities

The Final Capital Rule applies to top-tier savings and loan holding companies (“SLHCs”) other than top-tier SLHCs that are insurance companies or that are grandfathered under the Gramm-Leach-Bliley Act and that engage in a significant amount of commercial activities.  With respect to insurance companies, a top-tier SLHC that is an insurance underwriting company or that, as of June 30 of the previous year, held 25% or more of its total consolidated assets in subsidiaries that are insurance underwriting companies will not be subject to the Final Capital Rule.  For purposes of determining the amount of its consolidated assets related to insurance underwriting activities, an SLHC must calculate its total consolidated assets in accordance with GAAP or, if the company does not calculate its total consolidated assets under GAAP for any regulatory purpose, the company may estimate its total consolidated assets (subject to review and adjustment by the FRB).  With respect to grandfathered companies, the Final Capital Rule excludes from its coverage any top-tier SLHC that is a grandfathered unitary SLHC under Section 10(c)(9)(A) of the Home Owners’ Loan Act and, as of June 30 of the previous year, derived 50% or more of its total consolidated assets or 50% or more of its total revenues on an enterprise-wide basis (as calculated under GAAP) from activities that are not financial in nature under Section 4(k) of the Bank Holding Company Act.

For bank or savings and loan holding companies subject to the Final Capital Rule that engage in insurance underwriting activities, the Final Capital Rule includes provisions that address the risk-weights for certain insurance related exposures.  Specifically, the Final Capital Rule requires such companies to assign a 20% risk weight to policy loans.  The Final Capital Rule also provides for preferential treatment for non-guaranteed separate accounts by assigning a 0% risk weight to assets held in such an account where all losses are passed on to the policy holder.  However, assets held in a separate account where the insurance company guarantees a minimum return or account value would be risk weighted in the same manner as other on balance sheet assets.

In addition, a bank holding company or SLHC engaged in insurance underwriting activities must deduct an amount equal to the regulatory capital requirement for insurance underwriting risks established by the regulator of any insurance underwriting activities of the company. The bank holding company or SLHC must take the deduction 50% from tier 1 capital and 50% from tier 2 capital.  If the amount deductible from tier 2 capital exceeds the amount of tier 2 capital, the institution must deduct the excess from tier 1 capital.

VII.  Market Discipline and Disclosure Requirements

The Final Capital Rule requires banking organizations with $50 million or more in total assets to make certain quantitative and qualitative disclosures on a quarterly and annual basis beginning on January 1, 2015. Generally speaking, quantitative disclosures must be made quarterly, while qualitative disclosures that typically do not change each quarter may be disclosed annually.

In addition, the Final Capital Rule requires banking organizations subject to the disclosure requirements to have a formal disclosure policy approved by the board of directors that addresses the banking organization’s approach for determining the disclosures it makes. The policy must address the associated internal controls, disclosure controls, and procedures. One or more senior officers of the banking organization must attest that the disclosures meet the requirements of the Final Capital Rule.

The Agencies note in commentary to the Final Capital Rule that a banking organization must determine the information to include in its disclosures based on the materiality of that information. Information is material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information for the purpose of making an investment decision.

A.  Public Disclosure Requirements

A banking organization subject to the disclosure provisions of the Final Capital Rule must make the disclosures described in Tables 1 through 10 included in Section 63 of the Final Capital Rule and summarized below:

  • Table 1, “Scope of Application” – Name of top corporate entity in the group to which the Final Capital Rule applies; brief description of the differences in the basis for consolidating entities for accounting and regulatory purposes, as well as a description of any restrictions, or other major impediments, on transfer of funds or total capital within the group.
  • Table 2, “Capital Structure” – Summary information about the terms and conditions of the main features of regulatory capital instruments; total amount of common equity tier 1, tier 1 and total capital, with separate disclosures for deductions and adjustments to capital.
  • Table 3, “Capital Adequacy” – Information on the banking organization’s approach for categorizing and risk weighting its exposures, as well as the amount of total risk-weighted assets. The table also includes common equity tier 1, and tier 1 and total risk-based capital ratios for the top consolidated group, and for each depository institution subsidiary.
  • Table 4, “Capital Conservation Buffer,” – Disclose the capital conservation buffer, the eligible retained income and any limitations on capital distributions and certain discretionary bonus payments, as applicable.
  • Table 5, “Credit Risk: General Disclosures,” Table 6, “General Disclosure for Counterparty Credit Risk-Related Exposures,” and Table 7, “Credit Risk Mitigation,” relate to credit risk, counterparty credit risk and credit risk mitigation, respectively.
  • Table 8, “Securitization” – Provide information on the amount of credit risk transferred and retained by a banking organization through securitization transactions, the types of products securitized by the organization, the risks inherent in the organization’s securitized assets, the organization’s policies regarding credit risk mitigation, and the names of any entities that provide external credit assessments of a securitization.
  • Table 9, “Equities Not Subject to Subpart F of this Part” – Types of equity securities held by the banking organization and how they are valued.
  • Table 10, “Interest Rate Risk for Non-trading Activities” – Provide certain quantitative and qualitative disclosures regarding the banking organization’s management of interest rate risks.

B.  Frequency of Disclosures

For calendar quarters that do not correspond to a fiscal year end, the Agencies consider disclosures that are made within 45 days of the end of the calendar quarter (or within 60 days for the banking organization’s first reporting period in which it is subject to the Final Capital Rule’s disclosure requirements) as timely.

Where a banking organization’s fiscal year-end coincides with the end of a calendar quarter, the Agencies will consider qualitative and quantitative disclosures to be timely if they are made no later than the applicable SEC disclosure deadline for the corresponding Annual Report on Form 10-K.

C.  Location of Disclosures

The disclosures must be publicly available (for example, included on a public website) for each of the last three years or such shorter time period beginning when the banking organization became subject to the disclosure requirements. Management has some discretion to determine the appropriate medium and location of the disclosure. Furthermore, a banking organization has flexibility in formatting its public disclosures. The Agencies encourage management to provide all of the required disclosures in one place on the entity’s public website. However, a banking organization may provide the disclosures in more than one public financial report or other regulatory reports, provided that the banking organization publicly provides a summary table specifically indicating the location(s) of all such disclosures.

VIII.  Modifications to the Advanced Approaches Rule for Risk-Weighted Assets

Beginning on January 1, 2014, Advanced Approaches Banking Organizations will be required to calculate risk-weighted assets using the modifications incorporated into the Final Capital Rule. The Agencies noted that they took a consistent approach toward addressing comments with respect to the standardized approach and the advanced approaches rule.

The Final Capital Rule incorporates certain aspects of Basel III into the advanced approaches rule, in particular to require Advanced Approaches Banking Organizations to hold more capital for counterparty credit risk, credit valuation adjustments, and wrong-way risk. The Final Capital Rule also revises the treatment of securitization exposures, removing the rating-based approach and internal assessment approach and instead instituting due diligence requirements.

In addition, the Final Capital Rule includes a higher counterparty credit risk capital requirement, consistent with Basel III, to account for credit valuation adjustments (“CVA”). CVA is the fair value adjustment that reflects counterparty credit risk in the valuation of an over-the-counter derivative contract. The capital requirement reflects the significant amount of counterparty credit risk losses due to CVA during the financial crisis. The Final Capital Rule also makes changes to the advanced approaches’ internal models methodology, requiring banking organizations to consider stressed inputs when calculating their capital requirements for counterparty credit risk.

Moreover, the Final Capital Rule increases capital requirements for exposures to non-regulated financial institutions and to regulated financial institutions with consolidated assets of greater than or equal to $100 billion.

Furthermore, the Final Capital Rule removes the ratings-based and the internal assessment approaches for securitization exposures from the current advanced approaches rule. They would be replaced by the use of either the supervisory formula approach or the simplified supervisory formula approach for an Advanced Approaches Banking Organization to calculate its capital requirement for securitization exposures. The final advanced approaches capital requirements also include requirements for cleared transactions with central counterparties and for default fund contributions parallel to those in the standardized approach, discussed above under Section IV – “Standardized Approach for Risk – Weighted Assets.”  Advanced Approaches Banking Organizations are also subject to enhanced disclosure requirements similar to the disclosure requirements discussed above under Section VII – “Market Discipline and Disclosure Requirements.”

IX.       Market Risk NPR and Market Risk Section of Final Capital Rule

A.  Overview of the Market Risk Rule.  

The current market risk capital rule as adopted by the Agencies as a “final rule” on August 30, 2012 and effective as of January 1, 2013 (the “Market Risk Rule”) applies to U.S. banking organizations that have aggregate trading assets and liabilities of at least $1 billion, or 10% of total assets (“Market Risk Banking Organizations”).  The Market Risk Rule determines capital requirements for trading assets based on general market risks as well as on specific market risks associated with a particular asset.  The Agencies describe general market risk as the risk of loss in the market value of positions resulting from broad market movements, e.g., changes in interest rates or equity or commodity prices.  Specific market risks are those risks of loss derived from changes in value due to factors other than general market movements, e.g., from changes due to unexpected events or a change in the financial strength of a particular obligor.  The Market Risk Rule supplements and adjusts the Agencies’ other risk-based capital requirements, and the Agency that is the principal federal banking regulator of a Market Risk Banking Organization may require that institution to hold an amount of capital greater than otherwise required under the Market Risk Rule if it deems it is appropriate to reflect safety and soundness concerns.  In general, a Market Risk Banking Organization excludes covered positions (other than certain foreign exchange and commodities positions) when it calculates its risk-weighted assets under the risk-based capital rules other than the Market Risk Rule and, instead, determines the appropriate capital requirement for these covered positions using the methods described in the Market Risk Rule.  The Market Risk Banking Organization is then required to multiply the market risk capital requirement for the applicable positions by 12.5 to determine the risk-weighted asset amount for its market risk exposures.  The Market Risk Banking Organization must then include the risk-weighted assets amounts it has calculated in its standardized approach risk-weighted assets (or, for an advanced approaches Market Risk Banking Organization, in its advanced approaches risk-weighted assets). 

The FRB stated that the revisions to the Market Risk Rule that became effective on January 1, 2013 reflect changes required by the Dodd-Frank Act that were designed to better capture positions subject to market risk, reduce pro-cyclicality in market risk capital requirements, enhance the Market Risk Rule’s sensitivity to requirements that were not previously adequately captured and enhance disclosure requirements.

In the Final Capital Rule, the FRB stated that application of the Market Risk Rule to Market Risk Banking Organizations is particularly important at this time because it appears to the FRB that over the course of the recent financial crisis these large banking organizations generally increased their respective exposures “to traded credit products, such as collateralized debt instruments, asset-backed securities and other structured products, as well as other less liquid products.”

B.  The Market Risk NPR. 

The FRB issued the Market Risk NPR (1) to revise the treatment under the Market Risk Rule of specific risk weights for sovereign exposures, non-publicly traded mutual funds, and (specifically to avoid an unintended disincentive for banking organizations to invest in securitizations of federally-guaranteed student loans) certain student loans that are securitized and traded, and (2) to clarify the timing of disclosures required under the Market Risk Rule. 

With respect to determination of risk weights for sovereign exposures, Section 939A of the Dodd-Frank Act (“Section 939A”) requires the Agencies to remove references to requirements of reliance on credit ratings from their regulations and “to substitute in such regulations such standard of creditworthiness as each respective agency shall determine is appropriate for such regulations.”  In the Market Risk NPR the FRB proposes to revise the Market Risk Rule to reflect recent changes to the country risk classifications published by the Organization for Economic Cooperation and Development (because these classifications are not “ratings” whose use would be prohibited under Section 939A).

Comments on the Market Risk NPR are due by September 3, 2013.

C.  The Market Risk Section of the Final Capital Rule.

In a complementary change, the market risk section of the Final Capital Rule integrates the Agencies’ Market Risk Rule into the Agencies’ comprehensive capital framework and expands the coverage of the Market Risk Rule so that it would apply to federal savings associations and certain savings and loan holding companies as of January 1, 2015.

X.  Next Steps

With the issuance of the Final Capital Rule it appears as if the Agencies have reached a consensus as to the minimum capital levels and the appropriate capital measures at least for those smaller banking organizations that use the standardized approach.  As noted above in Section II.H of this Article, the FRB has signaled that the Agencies are likely to propose three additional capital requirements for U.S. banking organizations that are identified as global systemically important financial institutions.  We recommend that banking organizations, if they are not already deeply into the process, use the Final Capital Rule as the basis for initiating, at the Board of Directors and senior management level, detailed deliberations of the respective banking organization’s capital plan, funding needs and strategic allocation of capital resources.  The Alert will continue to follow closely regulatory developments in this area.

Employee Benefits Update - DOMA’s Demise in Supreme Court’s Windsor Decision Affects Employee Benefits

Goodwin Procter issued a client alert that examines the implications for retirement, health and other employee benefit plans of the Supreme Court’s recent ruling in the Windsor case that struck down Section 3 of the Defense of Marriage Act.  The client alert identifies some steps employers should consider taking to ascertain and address the impact the Windsor decision will have on their employee benefit arrangements while awaiting guidance from the relevant federal agencies.

Goodwin Procter Alert – SEC Forecasts an Increase in Whistleblower Cases and Awards

Goodwin Procter issued a client alert that (1) discusses the SEC’s announcement of its second-ever Dodd-Frank whistleblower award, (2) reviews  public statements by SEC officials and data from the first full year of the SEC’s new Dodd-Frank whistleblower program that suggest an upward trend in cases and awards over the next 6 to 12 months, and (3) reviews key benchmarks for companies to consider in ensuring that they have an effective whistleblower program.

July 10 SEC Meeting Agenda Includes Action on Proposed Rule Changes Implementing JOBS Act Mandate to Remove General Solicitation Prohibition for Rule 506 and Rule 144A Offerings

The SEC’s proposed agenda for its July 10, 2013 meeting includes final action on proposed amendments to eliminate the general solicitation/advertising prohibitions in Regulation D and Rule 144A under the Securities Act of 1933, as mandated by the Dodd-Frank Act.  The proposed amendments were discussed in the September 4, 2012 Financial Services Alert.  The agenda also includes consideration of whether to (1) issue a proposal to amend Regulation D, Form D, and Rule 156 under the Securities Act to facilitate SEC monitoring of changes in offering practices under the Rule 506 registration exemption in Regulation D and (2) adopt final rule amendments that would foreclose reliance on the Rule 506 exemption for a securities offering involving certain “bad actors,” as mandated by the Dodd- Frank Act.  The SEC’s proposal relating to “bad actor” disqualification under Rule 506 was discussed in the May 31, 2011 Financial Services Alert.  The meeting, which is scheduled for 10 a.m. Washington, DC time, will be webcast here.

IOSCO Releases Final Report on Principles for ETF Regulation

In June 2013 the Board of the International Organization of Securities Commissions (IOSCO) published its Final Report on Principles for the Regulation of Exchange Traded Funds (the “Final Report”), which articulates nine high level principles designed to provide both the industry and regulators with the means to assess across multiple jurisdictions the quality of regulation and industry practices concerning exchange-traded funds (ETFs).  The Final Report generally defines ETFs as open-ended collective investment schemes (CIS) that seek to replicate the performance of a target index (but may be actively managed) and trade throughout the day like a stock in the secondary market (i.e., an exchange).  The Final Report addresses only ETFs, and its recommendations do not apply to other forms of exchange traded products (ETPs) not organized as CIS, such as exchange-traded commodities (ETCs), exchange-traded notes (ETNs), exchange-traded instruments (ETIs), and exchange-traded vehicles (ETVs).

In a related release, IOSCO noted that numerous consultations among IOSCO’s member regulators and repeated engagements with representatives of the global ETF industry have led to the Final Report and, as a result, it reflects a shared consensus within the global regulatory community about an approach to ETF regulation.

The nine principles are set forth below.  The Final Report also includes commentary for each set of principles discussing various means of implementation.

Disclosure - differentiation among ETFs, and from other CIS and ETPs

  1. Regulators should encourage disclosure that helps investors to clearly differentiate ETFs from other ETPs.
  2. Regulators should seek to ensure a clear differentiation between ETFs and other CIS as well as appropriate disclosure for index-based ETFs and non index-based ETFs.
  3. Index tracking and portfolio transparency

  4. Regulators should require appropriate disclosure with respect to the manner in which an index-based ETF will track the index it references.
  5. Regulators should consider imposing requirements regarding the transparency of an ETF’s portfolio and other appropriate measures in order to provide adequate information concerning: 
     
    • Any index referenced and its composition; and
    • The operation of performance tracking.
  6. Disclosure - costs, expenses and offsets

  7. Regulators should encourage the disclosure of fees and expenses for investing in ETFs in a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a particular level of costs.
  8. Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to the material lending and borrowing of securities (e.g., disclosure on related costs).
  9. Disclosure – strategies and related risks

  10. Regulators should encourage all ETFs, in particular those that use or intend to use more complex investment strategies, to assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner and whether it addresses the nature of risks associated with the ETF’s strategies.
  11. Conflicts of interest

  12. Regulators should assess whether the securities laws and applicable rules of securities exchanges within their jurisdiction appropriately address potential conflicts of interests raised by ETFs (e.g., arising out of the involvement of an index provider, authorized participant, or swap counterparty affiliated with an ETF’s sponsor).
  13. Managing counterparty risks

  14. Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management in the contexts of both physical EFTs (in which the assets tracked by the ETF are owned by the ETF) and synthetic ETFs (in which the performance of the assets tracked by the ETF may be obtained with the use of derivative instruments).

A concluding section of the Final Report briefly addresses several issues that ETFs share with other financial products, such as the role of intermediaries in the marketing and sale of ETFs and the potential for ETFs to affect market stability, and references separate IOSCO recommendations relating to those issues.