Financial Services Alert - December 28, 2010

The FRB, OCC and FDIC (the "agencies") announced that they are seeking comment on a notice of proposed rulemaking that would revise the market risk capital rules for banking organizations with significant trading activity (the "NPR").  The Agencies believe that the proposed revisions would better capture positions for which the market risk capital rules are appropriate, reduce procyclicality in market risk capital requirements, enhance the rules’ sensitivity to risks that are not adequately captured by the current regulatory measurement methodologies, and increase market discipline through enhanced disclosures.

The NPR is based on a previous proposal (from September 2006) by the Agencies to revise the market risk rules as well as a series of publications by the Basel Committee on Banking Supervision (the “Basel Committee”) intended to enhance the market risk capital framework, particularly in light of the deficiencies revealed during the recent financial crisis.  The Agencies are not currently proposing to use credit ratings for the assignment of standardized charges for securitization and re-securitization positions as published by the Basel Committee in July 2009; however, the NPR indicates that the Agencies intend to implement these standardized charges in a subsequent rulemaking in a way that achieves the results intended by the Basel Committee’s proposed revisions, and that appropriately reflects the requirements of Section 939A of the Dodd-Frank Act.

Similar to the Basel II capital framework for credit risk, the NPR is based on three pillars: minimum regulatory capital (Pillar 1), supervisory review (Pillar 2), and market discipline through enhanced public disclosure (Pillar 3).  Below is a general description of the market risk capital rules, with special attention to the material proposed modifications.

Scope of the Market Risk Capital Rules

The market risk capital rules supplement and adjust the Agencies’ credit risk capital rules.  The applicability of the NPR would remain unchanged from the existing market risk capital rule in that it would apply to banking organizations with aggregate trading assets and trading liabilities equal to at least 10% of total assets or $1 billion.  The primary federal supervisor of a banking organization also may generally apply the market risk capital rule to a banking organization, or exempt a banking organization from application of the rule, if, consistent with safe and sound banking practices, the supervisor deems that it is appropriate based on the banking organization’s level of market risk.  In addition, the NPR contains a reservation of authority provision permitting a banking organization’s primary federal supervisor to increase or decrease capital requirements as appropriate in specific circumstances.  Furthermore, the NPR would authorize a regulator to include specific positions or portfolios in the market risk rules, or the credit risk rules, as applicable, to more appropriately reflect the risks of the positions.

Definition of Covered Position

The NPR requires banking organizations to maintain capital against the market risk of their “covered positions.”  In order to address the concern that banking organizations can arbitrage the capital standards for market and credit risk by calculating capital for a given position under the framework that resulted in the lowest capital requirement, the NPR establishes more explicit eligibility criteria for which positions can be designated as covered positions.

The NPR modifies the definition of a covered position to include trading assets and trading liabilities that are “trading positions” (i.e., positions held for the purpose of short-term resale or with the intent of benefiting from actual or expected short-term price movements, or to lock in arbitrage profits).  A banking organization’s covered positions also would include trading assets and trading liabilities that hedge covered positions, but only if those hedges are within the scope of the banking organization’s hedging strategy.  The Agencies expressed concern in the NPR that a banking organization could craft its hedging strategies in order to bring non-trading positions that are more appropriately treated under the credit risk capital rules into a banking organization’s covered positions.  Accordingly, the Agencies noted that they will scrutinize each banking organization’s hedging strategies to ensure that they are not being manipulated in this manner. 

As under the existing market risk rule, the NPR also would include as a covered position any foreign exchange or commodity position regardless of whether it is a trading asset or trading liability.  Also consistent with the current market risk rule, liquidity facilities for asset-backed commercial paper would be excluded from the definition of a covered position.  In addition, the definition of covered position under the NPR would exclude all intangible assets, including servicing assets, because their risks are explicitly addressed in the credit risk capital rules, often through a deduction from capital.

The NPR would require a banking organization to have clearly defined policies and procedures for determining which of its trading assets and trading liabilities are trading positions, as well as which of its trading positions are “correlation trading positions” (as defined below).  These policies and procedures must take into account (i) the extent to which positions and their related hedges can be marked-to-market daily by references to a two-way market, and (ii) possible impairments to the liquidity of a position or its hedge. 

In addition, the NPR requires a bank to have clearly defined policies and procedures for actively managing all covered positions, which policies and procedures must require, among other things, daily monitoring by senior management (including daily marking to market and daily risk assessment).  Senior management also must reassess established limits on positions at least annually.  Moreover, as a result of the Agencies’ concerns about deficiencies in banking organizations’ valuation of less liquid trading positions, the NPR introduces new requirements for the prudent valuation of covered positions that include maintaining policies and procedures for valuation, marking positions to market or to model, independent price verification, and valuation adjustments or reserves.

Internal Model Requirements

Unlike the existing market risk rule, the NPR proposes that a banking organization must receive the prior written approval of its primary federal supervisor before using any internal model to calculate its market risk capital requirement.  The NPR also would require a banking organization to promptly notify such regulator when it plans to extend the use of such model to an additional business line or product type, or if it makes any change to the internal model that would result in a material change in the risk-weighted asset amount for a portfolio of covered positions.  The banking organization also must notify its primary federal supervisor if it makes any material change to its modeling assumptions.  Such primary federal supervisor may rescind its approval, in whole or in part, of the use of any internal model and determine an appropriate capital requirement for the applicable covered positions.

Under the NPR, a banking organization must incorporate its internal models into its risk management process and integrate the internal models used for calculating its VaR-based measure into its daily risk management process.  The level of sophistication of a banking organization’s models must be commensurate with the complexity and amount of its covered positions.  In addition, the NPR expands upon the current market risk rule’s stress-testing requirement by requiring a banking organization to stress test the market risk of its covered positions at a frequency appropriate to each portfolio, and in no case less frequently than quarterly.

Market Risk Capital Requirements

As under the existing market risk rule, the NPR would require a banking organization to calculate its risk-based capital ratio denominator as the sum of its adjusted risk-weighted assets and market risk equivalent assets.  To calculate market risk equivalent assets, a banking organization must multiply its measure for market risk by 12.5.

The NPR would require a bank to capture a broader set of risks than under the current market risk rule.  In addition to the VaR-based capital requirement, any specific risk add-ons, and any capital requirement for de minimis exposures, as required under the current market risk rule, the NPR would also require calculation of: (a) a stressed VaR-based capital requirement; (b) any incremental risk capital requirement; and (c) any comprehensive risk capital requirement.  No adjustments would be permitted to address potential double counting among any of the components of a banking organization’s measure for market risk.

a. VaR-based Capital Requirement.  Consistent with the current rule, the NPR requires a banking organization to use one or more internal models to calculate a daily VaR-based measure that reflects general market risk for all covered positions.  The quantitative requirements for this VaR model remain consistent with those in the current rules: a one-tailed, 99.0% confidence level with a ten business day holding period, and a historical observation period of at least one year.  The daily VaR-based measure may also reflect the banking organizations specific risk for one or more portfolios of debt or equity positions and must reflect the specific risk for any portfolios of correlation trading positions that are modeled as described below.

In addition to interest rate risk, equity price risk, foreign exchange rate risk, and commodity price risk, the NPR adds credit spread risk to the list of risk categories a banking organization must include in its VaR-based measure.  Furthermore, the NPR would allow a banking organization to include certain term repo-style transactions in its VaR-based measure even though these positions may not meet the definition of a covered position, provided the banking organization includes all such term repo-style transactions consistently over time.

Consistent with the current rule, a banking organization’s VaR-based capital requirement under the NPR would equal the greater of (i) the previous day’s VaR-based measure, or (ii) the average of the daily VaR-based measures for each of the preceding 60 business days multiplied by three, or such higher multiplication factor required based on backtesting results.

b. Stressed VaR-based Capital Requirement.  Pursuant to the NPR, a banking organization would have to calculate at least weekly a stressed VaR-based measure using the same internal model(s) used to calculate its VaR-based measure, but with model inputs calibrated to reflect historical data from a continuous 12-month period that reflects a period of significant financial stress appropriate to the banking organization’s current portfolio.  The stressed VaR-based measure, which is intended to reduce the procyclicality of the minimum capital requirements for market risk and ensure banks hold enough capital to survive a period of financial distress, would equal the greater of (i) the most recent stressed VaR-based measure; or (ii) the average of the weekly VaR-based measures for each of the preceding 12 weeks multiplied by three, or a higher multiplication factor based on backtesting results.

c. Revised Modeling Standards for Specific Risk.  Compared to the current market risk rule, the NPR more clearly specifies the modeling standards for specific risk and eliminates the current option for a bank to model some but not all material aspects of specific risk for an individual portfolio of debt or equity positions.  Under the current market risk rule, if a banking organization incorporates specific risk in its internal model but fails to demonstrate to its primary federal supervisor that its internal model adequately measures all aspects of specific risk for a portfolio of debt or equity positions, the banking organization is subject to an internal models-based specific risk add-on for that portfolio.  In contrast, the NPR, in order to create an incentive for more robust risk modeling, requires a banking organization that does not have an approved internal model that captures all material aspects of specific risk for a particular portfolio of debt, equity, or correlation trading positions to use the standardized measurement method described below to calculate a specific risk add-on for that portfolio.

d. Standardized Specific Risk Capital Requirement.  The NPR would require a banking organization to calculate a total specific risk add-on for each portfolio of debt and equity positions for which the bank’s VaR-based measure does not capture all material aspects of specific risk and for each of its securitization positions that are not modeled with respect to the comprehensive risk capital requirement described below.  The standardized specific risk capital requirements for securitization positions are left unchanged from the current market risk rule due to the Dodd-Frank Act’s prohibition on the Agencies’ requiring the use of external credit ratings to compute capital requirements.  The Agencies noted that they plan to develop an alternative treatment for securitizations that does not require reliance on external ratings at a later date and request comment on alternative creditworthiness standards for purposes of the market risk capital rules.

e. Incremental Risk Capital Requirement.  As a result of banking organizations including certain types of positions in the market risk capital framework that contain significant levels of credit risk, which was not envisioned when the market risk rule was first implemented, the NPR establishes a new capital requirement: the incremental risk charge.  Pursuant to the NPR, a banking organization that measures the specific risk of a portfolio of debt positions using internal models would calculate an incremental risk measure for that portfolio using an internal model (an “incremental risk model”).  As stated in the NPR, incremental risk “consists of the default risk of a position (that is, the risk of loss on the position upon an event of default (for example, the failure of the obligor to make timely payments of principal or interest), including bankruptcy, insolvency, or similar proceeding) and the credit migration risk of a position (that is, price risk that arises from significant changes in the underlying credit quality of the position).”

The NPR also allows a banking organization, with the prior approval of its primary federal supervisor, to include portfolios of equity positions in its incremental risk model, provided that it consistently includes such equity positions in a manner that is consistent with how the bank internally measures and manages the incremental risk for such positions at the portfolio level.  A banking organization may not include correlation trading positions or securitization positions in its incremental risk model.  With respect to the applicable quantitative requirements, the NPR would require an incremental risk model to measure incremental risk over a one-year time horizon and at a one-tail, 99.9% confidence level, either under the assumption of a constant level of risk, or under the assumption of constant positions.

A banking organization that calculates an incremental risk measure would be required to do so at least weekly, with the capital requirement being the greater of: (i) the average of the incremental risk measures over the previous 12 weeks; or (ii) the most recent incremental risk measure.

f. Comprehensive Risk Capital Requirement.  The NPR would permit a banking organization, with the approval of its primary federal supervisor, to measure all material price risk of one or more portfolios of correlation trading positions using an internal model (a “comprehensive risk model”).  A correlation trading position is defined as (i) a securitization position for which all or substantially all of the value of the underlying exposures is based on the credit quality of a single company for which a two-way market exists, or on commonly traded indices based on such exposures for which a two-way market exists on the indices; or (ii) a position that is not a securitization position and that hedges a position described in clause (i). 

Similar to the incremental risk model, a banking organization’s comprehensive risk model would be required to measure comprehensive risk consistent with a one-year time horizon and at a one-tail, 99.9% confidence level, under the assumption of either a constant level of risk or constant positions.  A banking organization approved to measure comprehensive risk for one or more portfolios of correlation trading positions must calculate at least weekly a comprehensive risk measure, which equals the sum of the output from the bank’s approved comprehensive risk model plus a surcharge on the modeled correlation trading positions. 

The Agencies are proposing an initial capital surcharge of 15.0% of the total specific risk add-on that would apply to the banking organization’s modeled correlation trading positions under the standardized measurement method for specific risk.  Over time, however, with approval from its primary federal supervisor, a banking organization may be permitted to use a floor approach to calculate its capital requirement for correlation trading positions.  This floor would be the higher of (i) the output of the banking organization’s approved comprehensive risk model, or (2) 8.0% of the total specific risk add-on for such positions.

The comprehensive risk capital requirement would be the greater of (i) the average of the comprehensive risk measures over the previous 12 weeks; or (ii) the most recent comprehensive risk measure.

If a banking organization does not use a comprehensive risk model to calculate the price risk of a portfolio of correlation trading positions, it must calculate the specific risk add-on for the portfolio using the standardized measurement method, which is the higher of (i) the standardized specific risk charges for all long correlation trading positions and (ii) the standardized specific risk charges for all short correlation trading positions.

Supervisory Review Process

The proposed supervisory review process stresses the need for banking organizations to assess their capital adequacy positions relative to risk, and for primary federal supervisors to take appropriate actions in response to those assessments.  The NPR would require banking organizations to have an internal capital adequacy program to address their capital needs for market risk and capture these and all material risks.  The NPR also provides requirements for the control, oversight, validation mechanisms, and documentation of internal models.  In addition, the NPR requires a banking organization’s primary federal supervisor to evaluate the robustness and appropriateness of its stress tests through the supervisory review process. 

Disclosure Requirements

With respect to Pillar 3 adjustments to the market risk rule, the NPR would impose quantitative and qualitative disclosure requirements designed to increase transparency and improve market discipline on the top-tier consolidated legal entity that is subject to the market risk capital rule.  Under the NPR, a banking organization would have to disclose certain components of its market risk capital requirement, information on its modeling approaches, and information relating to its securitization activities.

More specifically, the NPR would require a banking organization, at least quarterly, to disclose publicly for each portfolio of covered positions the high, low, median, and mean: (i) VaR-based measures over the reporting period and the measure at period-end; (ii) stressed VaR-based measures over the reporting period and the measure at period-end; (iii) incremental risk capital requirements over the reporting period and at period-end; and (iv) comprehensive risk capital requirements over the reporting period and at period-end.  Banking organizations would also have to disclose at least quarterly separate measures for interest rate risk, credit spread risk, equity price risk, foreign exchange rate risk, and commodity price risk used to calculate the VaR-based measure, and a comparison of VaR-based measures with actual results and an analysis of important outliers.  In addition, banking organizations would have to publicly disclose at least quarterly: (a) the aggregate amount of on-balance sheet and off-balance sheet securitization positions, by exposure type; and (b) the aggregate amount of correlation trading positions.

Furthermore, a top-level banking organization would have to make certain qualitative disclosures at least annually, or more frequently in the event of material changes, on each portfolio of covered positions.  These qualitative disclosures would include, among other things, information on: (i) portfolio composition; (ii) valuation policies, procedures and methodologies; (iii) internal model characteristics; (iv) model validation approaches; and (v) stress test descriptions.

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Comments on the NPR will be due within 90 days of its publication in the Federal Register.

The Treasury has launched a website to provide further details on its Small Business Lending Fund (the “SBLF”), including term sheets and the application forms.  The SBLF was created under the Small Business Jobs Act of 2010 to encourage lending to small businesses by providing Tier 1 capital to qualified community banks with assets of less than $10 billion.

Under the SBLF, the Treasury will provide capital by purchasing Tier 1-qualifying preferred stock or equivalents from participating institutions.  The dividend rate for such capital will initially be set no higher than 5%.  If a participating institution’s small business lending increases by 10% or more, then the dividend rate for such institution will be reset to as low as 1%.  If the participating institution’s small business lending does not increase over the first two years of its participation in the SBLF, however, the dividend rate for such institution will increase to 7%.  After 4.5 years, the dividend rate will increase to 9% if the participating institution has not already repaid its SBLF funding.  Qualified small-business lending under the SBLF includes certain loans of up to $10 million to businesses with up to $50 million in annual revenues. Such loans include commercial and industrial loans; owner-occupied nonfarm, nonresidential real estate loans; loans to finance agricultural production and other loans to farmers; and loans secured by farmland. With the approval of its regulator, a participating institution may exit the SBLF at any time by repaying the funding provided along with any accrued dividends.  If the participating institution wishes to repay its SBLF funding in partial payments, each partial payment must be at least 25% of the original funding amount.

The SBLF also provides an option to refinance preferred stock issued to the Treasury through the Capital Purchase Program (“CPP”) or the Community Development Capital Initiative (“CDCI”) under certain conditions.  Simultaneous participation in the CPP or the CDCI and the SBLF is not permitted.  In order to refinance CPP or CDCI securities through the SBLF, an institution must be current on its dividend payments to the Treasury, cannot have previously missed more than one dividend payment, and must fully refinance or repay its CPP or CDCI securities.  Any warrants issued to the Treasury in connection with the CPP would remain outstanding until repurchased by the institution.  Compensation restrictions and other limitations imposed as a condition of participating in the TARP or the CPP do not apply to the SBLF. 

To participate in the SBLF, eligible banks must have assets of $10 billion or less and meet certain other requirements.  Institutions are not eligible if they are on the FDIC problem bank list (or similar list) or have been removed from that list in the previous 90 days.  The Treasury noted that generally this will include any bank with a CAMELS rating of 4 or 5. If an institution is controlled by a holding company, the combined assets of the holding company determine eligibility, and the holding company must apply for capital under the SBLF.  Institutions with total assets of $1 billion or less, may apply for SBLF funding in an amount equal to up to 5% of risk-weighted assets. Institutions with total assets of more than $1 billion, but less than $10 billion, may apply for SBLF funding in an amount that equals up to 3% of risk-weighted assets.  The minimum investment amount under the SBLF for all eligible institutions is 1% of risk-weighted assets.

Separately, the FDIC issued a Financial Institution Letter, FIL-90-2010, providing guidance to FDIC-insured institutions concerning prudent underwriting standards for small business loans made by FDIC-insured depository institutions using SBLF funds.

The Department of Labor (“DOL”) announced that it will hold a public hearing in Washington D.C. on March 1, 2011 and, if necessary, March 2, 2011, on the proposed rule amending the definition of the term “fiduciary” under the Employee Retirement Income Security Act of 1974, as amended.  The DOL expects to issue details through formal notice in the Federal Register in early January 2011.

The Department also extended the deadline for public comments on the proposed rule an additional two weeks, to Feb. 3, 2011.  Details on the proposed rule were reported in the November 23, 2010 Alert.

The FRB, FDIC, OCC and OTS jointly released their annual Community Reinvestment Act (“CRA”) asset-size threshold adjustments for small and intermediate small depository institutions.  The annual adjustments are based upon changes in the average of the Consumer Price Index for Urban Wage Earners and Clerical Workers (not seasonally adjusted, for each twelve-month period ending in November, with rounding to the nearest million).  Effective January 1, 2011, a “small bank” or “small savings association” is one that as of December 31 of either of the prior two calendar years  had assets of less than $1.122 billion.  An “intermediate small bank” or “intermediate small savings association” is one that had assets of at least $280 million as of December 31 of both of the prior two calendar years and less than $1.122 billion as of December 31 of either of the prior two calendar years.

The CFTC issued a release proposing rules related to (a) establishing the regulatory standards for compliance by derivatives clearing organizations (“DCOs”) with core principles related to reporting, recordkeeping,  public information, and information sharing, (b) technical amendments to existing regulations required by the proposed regulations, and (c) delegating to the Director of the Division of Clearing and Intermediary Oversight the CFTC’s authority to require reports by certain persons for positions cleared on a DCO.  Comments on the proposals are due by February 14, 2011.

The CFTC issued a release proposing rules related to external business standards for swap dealers and major swap participants with counterparties.  Among other things, the proposed regulations contain provisions (a) prohibiting “swap dealers” and “major swap participants” from engaging in fraud, manipulation and other abusive practices, (b) requiring verification of counterparty eligibility, (c) requiring disclosure of material risks, characteristics, material incentives and conflicts of interest regarding a swap, and (d) special provisions related to conduct of “swap dealers” and “major swap participants” when dealing with “special entities.” 

Comments on the proposals are due by February 22, 2011.

The CFTC issued a release proposing new and amended rules, guidance and acceptable practices related to the designation and operation of contract markets.  The proposals are designed to implement the provisions Section 735 of the Dodd-Frank Act by (a) eliminating the stand-alone designation criteria for designation as a contract market, (b) revising the existing core principles, including incorporating therein most of the substantive elements of the former designation criteria, and (c) adding new core principles related to (i) disciplinary procedures, (ii) system safeguards, (iii) financial resources, (iv) diversity of boards of directors, and (v) the Securities and Exchange Commission, thereby requiring applicants and designated contract markets to comply with a total of 23 core principles as a condition of obtaining and maintaining designation as a contract market.  Comments on the proposals are due by February 22, 2011.

The CFTC issued a release proposing rules related to the registration and regulation of “Swap Data Repositories” as required by Section 728 of the Dodd-Frank Act.  The proposed rules include provisions related to (a) registering and maintaining the registration of a Swap Data Repository, (b) prescribing specific duties of a Swap Data Repository, (c) designating a Chief Compliance Officer, and (d) implementing the core principles that are applicable to a Swap Data Repository.  Comments on the proposals are due by February 22, 2011.

The CFTC issued a release proposing rules designed to implement the elective end-user exception to the mandatory clearing requirements for swap contracts created under the Dodd-Frank Act (the “End User Exception”), and seeking comments regarding whether to except small banks, savings associations and credit unions (“Small Banks”) from the definition of “financial entity” so that Small Banks can make use of the End User Exception.  The End User Exception is generally available where one party to the swap is not a “financial entity”, the non-”financial entity” is using swaps to hedge or mitigate commercial risk, and the non-”financial entity” notifies the CFTC of how it generally meets its financial obligations associated with entering into noncleared swaps.

The proposed rules establish the requirements for (a) the non-”financial entity” to make the required notice to the CFTC, and (b) determining whether a swap is used to hedge or mitigate commercial risk.  The CFTC is seeking comments on all aspects of the rule proposal, including specifically with regards to:

• Whether to limit swaps qualifying as hedging or risk mitigating to swaps where the underlying hedged item is a non-financial commodity; and
• whether to adopt a definition of ‘‘hedge or mitigate commercial risk’’ that is different from the definition of ‘‘hedging or mitigating commercial risk’’ contained in the “major swap participant” definitions rule, and that is specifically designed to address the circumstances of the End User Exception, and if so, in what way the definitions should differ?

Comments on the proposals, including whether to include Small Banks from the definition of “financial entity,” are due by February 22, 2011.

The FDIC’s Winter 2010 edition of its publication, Supervisory Insights, which reviews issues related to bank regulatory supervision, includes an article entitled “Trust Preferred Securities and the Capital Strength of Banking Organizations.” The article analyzes the role of trust preferred securities (“TPS”) during the recent financial crisis and concludes, among other things, that the inclusion of TPS in bank holding companies’ (“BHC”) Tier 1 capital enabled BHCs, “as a group, to operate with substantially less loss-absorbing capital than permitted for [FDIC] insured banks.”  The article in Supervisory Insights notes that Section 171 of the Dodd-Frank Act (the so-called “Collins Amendment”) prohibits BHCs (with certain exceptions) from holding TPS (issued on or after May 19, 2010)  as an element of the BHC’s Tier 1 capital.  The article concludes that “moving away from reliance on [TPS] and toward real loss-absorbing capital will be manageable for most institutions, will challenge some, but will in the end result in a stronger U.S. banking industry.”