Financial Services Alert - July 2, 2013

The FRB approved a final rule (the “Final Capital Rule”) that enhances bank regulatory capital requirements and implements certain elements of the Basel III capital reforms in the U.S. as well as certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The FRB also issued a notice of proposed rulemaking that would modify the FRB’s market risk rule.  The FRB, OCC and FDIC had previously issued three joint proposed rules (the “Proposed Capital Rules”) regarding enhanced capital requirements.  Please see the June 12, 2012 Financial Services Alert for prior coverage of the Proposed Capital Rules.

The FRB received over 2,600 comment letters regarding the Proposed Capital Rules, many of which raised concerns that the Proposed Capital Rules were unduly burdensome or inappropriate for community banking organizations.  Many community banking organizations sought to be exempted from the Final Capital Rule.

The Final Capital Rule 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.  The Final Capital Rule, however, directly addresses concerns raised by community banking organizations with respect to trust preferred securities, unrealized gains and losses on available-for-sale securities in accumulated other comprehensive income (“AOCI”) and mortgage risk weights.  Additionally, the Final Capital Rule grants community banking organizations an additional year, until January 1, 2015, to comply with its requirements.

The following are some of the key points of the Final Capital Rule:

• Banking organizations which are not subject to the advanced approach for risk-weighted assets (which applies to large banking organizations or banking organizations with large trading portfolios) must be in compliance with the Final Capital Rule by January 1, 2015.   Banking organizations subject to the advanced approach must comply with the Final Capital Rule by January 1, 2014.
• All banking organizations must maintain the following minimum capital requirements:
  • a new minimum ratio of common equity tier 1 (“CET1”) 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 CET1, tier 1 and total capital ratios.
• Banking organizations subject to the advanced approach are also subject to a minimum supplemental leverage ratio of 3%.  The denominator of the supplemental leverage ratio incorporates certain off-balance sheet exposures.
• Banking organizations subject to the advanced approach 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.
• Trust preferred securities issued before May 19, 2010 by banking organizations with less than $15 billion in assets as of December 31, 2009 or those organized in mutual form as of May 19, 2010 are grandfathered for inclusion in tier 1 capital subject to a limit of 25% of tier 1 capital elements.
• Banking organizations (other than banking organizations subject to the advanced approach) may make a one-time election to opt-out of the requirement to include most AOCI components in the calculation of CET1, effectively retaining the treatment of AOCI in the current capital rules.  This one-time election must be made on the first regulatory reporting period under the Final Capital Rule and may only be changed in very limited circumstances.
• The mortgage risk weights set forth in the Proposed Capital Rules were not adopted.  Instead, 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.
• Mortgage servicing assets and certain deferred tax assets are subject to more stringent limits and a 250% risk weight, as set forth in the Proposed Capital Rules.  Amounts above the limits are deducted from CET1 capital.
• The risk weight for high-volatility commercial real estate exposures and exposures more than 90 days past due or on nonaccrual (other than sovereign or residential mortgage exposures) are increased to 150%, as proposed in the Proposed Capital Rules.
• Capital is not required 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.  The Proposed Capital Rules had proposed to remove the 120-day safe harbor.

The FDIC has provided notice that it will consider the Final Capital Rule as an interim final rule on July 9, 2013.  The OCC has stated that it expects to review and consider the Final Capital Rule as a final rule by July 9, 2013.

The Alert will cover the Final Capital Rule in greater detail in future issues.  The implications of the Final Capital Rule will vary for different institutions.  We regularly provide advice to our clients concerning the capital requirements of bank regulatory agencies and other regulatory and capital matters and encourage you to reach out to your Goodwin Procter contact for specific advice regarding the Final Capital Rule and its implications for your organization.

Goodwin Procter’s ERISA Litigation Practice published its latest quarterly ERISA Litigation Update.  The update discusses (1) the U.S. Supreme Court’s decision in U. S. Airways, Inc. v. McCutchen regarding enforcement of a plan reimbursement provision, (2) the Seventh Circuit’s decision in Leimkuehler v. Am. United Life Ins. Co. affirming dismissal of claims against an insurer concerning revenue sharing payments received with respect to mutual funds offered to retirement plans through a platform created and maintained by the insurer in which the funds were held in separate accounts within group annuity contracts, and (3) the Second Circuit’s decision in PBGC. v. Morgan Stanley Investment Management, Inc. affirming dismissal of an ERISA complaint asserting imprudence regarding excessive plan investments in subprime mortgages prior to the subprime real estate crash in 2007 and 2008.

On June 26, 2013 the Basel Committee on Banking Supervision of the Bank for International Settlements (the “Basel Committee”) issued a Consultative Document entitled “Revised Basel III leverage ratio framework and disclosure requirements” (the “Consultative Document”).  The Basel Committee states that an important factor that led to the recent financial crisis was the build-up of excessive on-and-off-balance sheet leverage in the banking system.  During the crisis, banks were required to reduce their leverage “in a manner that amplified downward pressure on asset prices.”  The Basel Committee has concluded that these risks can be better addressed by employing a straightforward non-risk-based leverage ratio as a “credible supplementary measure to the risk-based capital requirements.”

The Basel Committee defines the leverage ratio, applicable to those banks subject to the Basel III framework, as a Capital Measure (as defined, the numerator) divided by an Exposure Measure (as defined, the denominator) with the resulting ratio expressed as a percentage.  The Capital Measure in the revised Basel III leverage ratio continues to be a bank’s Tier 1 capital.  The significant revisions to the Basel III leverage ratio proposed in the Consultation Document are to the Exposure Measure, which is the sum of a bank’s (i) on-balance sheet exposures, (ii) derivative exposures, (iii) securities financing transaction exposures, and (iv) other off-balance sheet exposures.  The Basel Committee stated in the Consultative Document that the key changes it has made, which are reflected in the Exposure Measure of the Revised Basel III leverage ratio, are:

• specification of a broad scope of consolidation for the inclusion of exposures;
• clarification of the general treatment of derivatives and related collateral;
• enhanced treatment of written credit derivatives; and
• enhanced treatment of securities financing transactions (e.g., repurchase agreements).

In the Consultative Document, the Basel Committee also proposed new public disclosure requirements concerning banks’ leverage ratios.  The Basel Committee states that the proposed disclosure requirements would take effect on January 1, 2015, subject to implementation by national supervisors.  The public disclosures requirements include:

• A summary comparison table that compares a bank’s total accounting assets and its leverage ratio exposures;
• A common disclosure template that discloses the breakdown of a bank’s main leverage ratio regulatory elements;
• A reconciliation of the material differences between a bank’s on-balance-sheet exposures in the common disclosure template and its total on-balance sheet assets in its financial statements; and
• Certain other disclosures described in the Consultative Document.

The Basel Committee said that it will undertake a Quantitative Impact Study to make certain that the calibration of the leverage ratio and its relationship with the risk-based capital requirements are appropriate.

Comments on the Consultative Document are due by September 20, 2013.  Final changes to the definition and method of calculation of the leverage ratio are expected to be completed in 2017, with the changes effective on January 1, 2018, and, as noted above, the public disclosure requirements are expected to take effect on January 1, 2015.

On June 27, 2013, the Basel Committee on Banking Supervision (the “Basel Committee”) issued proposed guidelines (the “Proposed Guidelines”) entitled “Sound Management of Risks Related to Money Laundering and Financing of Terrorism,” with the goal of describing “how banks should include money laundering and financing of terrorism risks within their overall risk management.”  The Proposed Guidelines are intended to support countries’ implementation of the revised “International Standards on Combating Money Laundering and the Financing of Terrorism and Proliferation,” issued by the Financial Action Task Force in February 2012, and merge and supersede two of the Basel Committee’s prior publications on money laundering (“ML”) and financing of terrorism (“FT”) risk management, issued in October 2001 and October 2004.

The Proposed Guidelines outline six “essential elements” of sound ML and FT risk management, including (i) assessment, understanding and mitigation of risks, (ii) customer acceptance policy, (iii) customer and beneficial owner identification, verification and risk profiling, (iv) ongoing monitoring, (v) management of information and (vi) reporting of suspicious transactions and asset freezing.

The Proposed Guidelines focus heavily on customer due diligence procedures, stating that a bank should establish a systematic procedure for identifying and verifying its customers and, where applicable, any beneficial owner(s) or persons acting on behalf of customers.  Reliable, independent source documents, data and/or information should be used prior to account opening and before a banking transaction, such as a wire transfer, is carried out on behalf of a non-customer.  Additionally, a bank should also have policies and procedures in place to conduct due diligence on its customers sufficient to develop customer risk profiles either for particular customers or categories of customers, based on, for instance, the purpose of a banking relationship, the level of assets or size of transactions, and the regularity and duration of a relationship, in order to detect abnormal activity for a particular customer or customer category and to determine whether such customer or customer category requires enhanced customer due diligence measures and controls.

The Proposed Guidelines also address ML/FT risk management in a group-wide and cross-border context, recommending group-wide information sharing and the consistent application of group-wide policies and procedures that reflect the strictest applicable standard.  Additionally, the Proposed Guidelines discuss reliance on a third-parties to perform customer due diligence, specific considerations for correspondent banking, and include recommendations for banking supervisors.

Comments on the Proposed Guidelines are due by September 27, 2013.

On Tuesday, June 25, 2013, the U.S. Court of Appeals for the District of Columbia Circuit affirmed the decision of the United States District Court for the District of Columbia to dismiss a lawsuit brought by the U.S. Chamber of Commerce (the “Chamber”) and Investment Company Institute (“ICI”) against the CFTC challenging amendments to CFTC Regulations 4.5 and 4.27 adopted in 2012 (the “Amendments”).  The Amendments, which were described in the February 14, 2012 Financial Services Alert (the “February 2012 Alert”), imposed (1) additional trading and marketing limitations as conditions of the exclusion from the definition of commodity pool operator (“CPO”) available with respect to registered investment companies (“RICs”) under CFTC Regulation 4.5, and (2) quarterly reporting requirements for CPOs under CFTC Regulation 4.27.   The Chamber and ICI alleged, among other things, that the Amendments did not meet the requirements of the Commodity Exchange Act (“CEA”) relating to cost-benefit analysis and were arbitrary and capricious under the Administrative Procedure Act.  In dismissing the lawsuit brought by the Chamber and ICI, the Court of Appeals upheld the District Court’s finding that the CFTC’s amendments to Regulation 4.5 and 4.27 were not arbitrary and capricious.

The Amendments were not stayed pending the resolution of the suit brought by Chamber and ICI.  Compliance with the changes to Regulation 4.5 was generally required beginning January 1, 2013.  CPOs that were already registered were required to comply with Regulation 4.27 by September 15, 2012 or December 15, 2012, depending upon their assets under management.  CPOs required to register because of the changes to Regulation 4.5 are not yet subject to recordkeeping, reporting, and disclosure requirements pursuant to part 4 of the CFTC’s regulations, including Regulation 4.27, but will be 60 days following the effectiveness of a final rule adopted as result of the CFTC’s ongoing rulemaking initiative to harmonize CFTC and SEC compliance requirements for RICs, as discussed below.

CFTC Harmonization Proposal for RICs.  When it adopted the Amendments, the CFTC also proposed a number of amendments to its regulations (the “Harmonization Proposal”) that are designed to harmonize CFTC compliance obligations for CPOs of RICs with those imposed on RICs by the SEC.  The Harmonization Proposal focuses on three principal areas: (a) delivery of disclosure documents and periodic reports; (b) recordkeeping; and (c) disclosure content.  See the February 2012 Alert for additional detail on the Harmonization Proposal.  The comment period for the Harmonization Proposal closed on April 24, 2012.  It is anticipated that the CFTC will vote on adoption of the Harmonization Proposal later this year.