Financial Services Alert - December 21, 2010 December 21, 2010
In This Issue

FDIC Board Approves Interagency Proposal to Set Risk-Based Capital Floor for Large Financial Institutions

On December 14, 2010, the Board of Directors of the FDIC approved a Joint Notice of Proposed Rulemaking titled “ Risk-Based Capital Standards: Advanced Capital Adequacy Framework-Basel II; Establishment of a Risk-Based Capital Floor”(the “Proposed Rule”).  The Proposed Rule implements certain provisions of Section 171 of the Dodd-Frank Act, which is more commonly known as the Collins Amendment. Section 171 of the Dodd‑Frank Act requires, in part, the risk-based capital rules that are applicable to all insured banks, regardless of international exposure or total asset size (the “generally applicable risk-based capital requirements”), to serve as a minimum for any capital requirements that the Federal banking agencies (the “Agencies”) may establish, including for large, internationally active banks and bank holding companies, as well as non-bank financial companies supervised by the FRB.  The Proposed Rule, which implements Section 171(b)(2) of the Dodd-Frank Act, would, if adopted, remove the transitional floor periods set forth in the “advanced approaches rule” of Basel II, as implemented in the United States, and would set the generally applicable risk-based capital requirements as a permanent floor for the advanced approaches.  The Proposed Rule would also amend the Agencies' general risk-based capital rules to allow banks to use the Bank Holding Company capital rules in certain situations to determine the capital requirements for low-risk assets that are not traditionally held by banks.

In 2007, the Agencies adopted the “advanced approaches rule” of Basel II in order to employ an advanced risk-based capital framework for certain large, internationally active banking institutions in the United States.  The “advanced approaches rule” establishes a series of transitional floors to provide a smooth transition to the advanced approaches rule and to limit temporarily the amount by which a banking organization’s risk-based capital requirements could decline relative to the generally applicable risk-based capital requirements.  Each transitional floor equals the lesser of the bank's (i) risk-based capital ratios calculated under the advanced approaches rule, and (ii) risk-based capital ratios calculated under the generally applicable risk-based capital requirements, with risk‑weighted assets multiplied by transitional floor percentages of 95% (for the first transitional floor period), 90% (for the second transitional floor period), and 85% (for the third transitional floor period).

As a result, the “advanced approaches rule” expressly allows for the possibility that the risk-based capital requirements of an institution subject to the “advanced approaches rule” could be lower than if such institution calculated its capital requirements solely under the generally applicable risk-based capital requirements.  Accordingly, the transitional floors under the “advanced approaches rule” do not comply with Section 171 of the Dodd-Frank Act.  Therefore, the Agencies are proposing in the Proposed Rule to replace the transitional floors set forth under the “advanced approaches rule” with a permanent floor, which would be equal to the minimum capital requirement computed using the generally applicable risk-based capital requirements.

Furthermore, Section 171 of the Dodd-Frank Act provides that the Agencies are not allowed to establish capital requirements that are “quantitatively lower” than the generally applicable capital requirements for insured depository institutions that were in effect on July 21, 2010 when the Dodd-Frank Act was signed into law.  The Proposed Rule notes that, to comply with this provision, the Agencies propose to perform a quantitative analysis of the likely effect on capital requirements as part of developing future amendments to the capital rules to ensure that any new capital framework is not quantitatively lower than the requirements in effect as of July 21, 2010.

The Proposed Rule also notes that certain institutions that are subject to the requirements of Section 171 of the Dodd-Frank Act (including non-bank financial companies supervised by the FRB and savings and loan holding companies) have not previously been subject to consolidated risk-based capital requirements.  While some of these entities may be similar in nature to depository institutions and bank holding companies subject to the generally applicable risk-based capital requirements, other such institutions may be different and have types of exposures and risks that were not considered or contemplated when the generally applicable risk-based capital requirements were established.  As a result, certain situations may arise where the FRB will need to evaluate the risk-based capital treatment of specific exposures not traditionally held by depository institutions, and which do not have a specific risk weight under the generally applicable risk-based capital requirements.  The Agencies are proposing to amend the generally applicable risk-based capital requirements to allow banks to use the bank holding company capital requirements for such assets, in order to permit a suitable capital requirement for low risk non-bank assets.  The circumstances would be limited to situations where a bank holds an asset under special authority and the asset poses substantially similar risks to an asset with a risk-weight lower than 100%.

Comments on the Proposed Rule will be due 60 days from its publication in the Federal Register.

Basel Committee Issues Final Basel III Rules and Publishes Results of its Quantitative Impact Study

The Basel Committee on Banking Supervision (the “Basel Committee”) issued the final version of its new Basel III capital rules on December 16, 2010.  Basel III is intended to protect financial stability and promote sustainable economic growth by setting out higher and better capital requirements, requiring better risk coverage, introducing a leverage ratio as a backstop to the risk-based requirement, instituting measures to promote the build up of capital that can be drawn down in periods of stress, and introducing a global liquidity framework.  In particular, the December 16, 2010 release provides details on the application of the two new liquidity standards under Basel III, the Liquidity Coverage Ratio (“LCR”) and the Net Stable Funding Ratio (“NSFR”).  Future editions of the Alert will provide additional information regarding the details of the LCR and the NSFR, as well as the remainder of the final Basel III rules.

The Basel Committee also released on December 16, 2010 the results of its comprehensive quantitative impact study (“QIS”) regarding the Basel III capital standards announced in July 2009 and the capital and liquidity proposals released in December 2009.  A total of 263 banks from 23 jurisdictions participated in the QIS, including 94 “Group 1 banks” (i.e., those banks with Tier 1 capital in excess of €3 billion (approximately $4 billion) that are considered well diversified and internationally active) and 169 Group 2 banks (i.e., all other banks).  The QIS did not take into account any transitional arrangements and instead assumed full implementation of the final Basel III rules, based on data as of year-end 2009.  Furthermore, the QIS did not take into account banks’ profitability or behavioral responses, such as changes in bank capital or balance sheet composition.

Including the effect of all changes to the definition of capital and risk-weighted assets, as well as assuming full implementation as of December 31, 2009, the average common equity Tier 1 capital ratio (“CET1”) of Group 1 banks was 5.7%, and the average CET1 of Group 2 banks was 7.8%.  The new minimum CET1 requirement under Basel III is 4.5%, plus a 2.5% capital conservation buffer, for a total of 7%.  The Basel Committee estimated that Group 1 banks in the aggregate would have had a shortfall of €577 billion (approximately $760 billion) from such requirement at the end of 2009.  Group 2 banks with CET1 ratios less than 7% would have required an additional €25 billion (approximately $33 billion).

With respect to the new liquidity requirements, the average LCR for Group 1 banks was 83%, while the average for Group 2 banks was 98%.  The average NSFR for Group 1 banks was 93%, and the average for Group 2 banks was 103%.  Banks will have until 2015 to meet the 100% LCR requirement, and until 2018 to meet the 100% NSFR requirement.  The Basel Committee noted that banks that are below the 100% required minimum thresholds can meet these standards by lengthening the term of their funding or restructuring business models.  Banks may also increase their holdings of liquid assets.  The Basel Committee also noted that the shortfalls in the LCR and the NSFR are not additive, as decreasing the shortfall in one standard may also result in a decrease in the shortfall in the other standard.

The QIS results also showed Group 1 banks having a weighted average leverage ratio of 2.8% at the end of 2009, and Group 2 banks having a weighted average leverage ratio of 3.8%.

The Basel Committee also published additional guidance for national authorities operating the countercyclical capital buffer, which is intended to protect the banking sector from periods of excess aggregate credit growth that have often been associated with the build-up of system-wide risk.  The Basel Committee noted that “in addition to providing guidance for national authorities, this document should help banks understand and anticipate the buffer decisions in the jurisdictions to which they have credit exposures.”  For additional information regarding the Basel III countercyclical capital buffer, please see the July 20, 2010 Alert.

Finally, the Basel Committee reiterated that it is continuing work related to systemic banks and contingent capital in coordination with the Financial Stability Board, and that it expects to issue a consultation paper on the capitalization of bank exposures to central counterparties soon.  The Alert will continue to monitor further developments and provide updates on material developments as they occur.

FDIC Board Sets Two Percent Designated Reserve Ratio under Insurance Fund Management Plan

The FDIC Board of Directors approved a final rule (the “Rule”) setting the designated reserve ratio (“DRR”) for the deposit insurance fund (“DIF”) at 2% of estimated insured deposits.  The Rule allows the FDIC to build reserves in excess of its current level.  The FDIC said the Rule allows the FDIC to prepare for the future and build DIF reserves during good economic times.  The FDIC further noted that its analysis of historic losses led it to conclude that a 2% DRR was needed as a long-term, minimum goal “in order to maintain a positive [DIF] balance [in a banking crisis] and steady, predictable assessment rates.”

The Dodd-Frank Act (“DFA”) gave the FDIC greater authority to manage the DIF, including where to set the DRR.  Among other things, the DFA raised the minimum DRR (which the FDIC must set annually) to 1.35% from 1.15%, eliminated the upper limit on the DRR, and requires that the DIF reserves reach 1.35% by September 30, 2020.  The FDIC said that the Rule is part of a comprehensive fund management plan that is meant to provide insured depository institutions with moderate, steady assessment rates throughout economic cycles.  The Rule will become effective on January 1, 2011.

IRS Issues Revenue Ruling Modifying Rules for Group Trusts

On December 16, 2010, the Internal Revenue Service (the “IRS”) issued Revenue Ruling 2011-1 (the “Ruling”), modifying the rules for group trusts as described in Revenue Ruling 81-100 (as clarified and modified by Revenue Ruling 2004-67, “Rev. Rul. 81-100”).  The Ruling (i) revises the generally applicable rules for group trusts set forth in Rev. Rul. 81‑100 and (ii) permits the participation in group trusts by custodial accounts under Section 403(b)(7) of the Internal Revenue Code of 1986, as amended (the “Code”), retirement income accounts under Section 403(b)(9) of the Code, and governmental retiree benefit plans under Section 401(a)(24) of the Code, if certain requirements are met.  The Ruling also extends the transition relief provided in Revenue Ruling 2008-40 relating to plans qualifying under section 1165 of the Puerto Rico Internal Revenue Code through January 1, 2012.

The assets of qualified plans under Section 401(a) of the Code, individual retirement accounts (“IRAs”), and eligible governmental plans under Section 457(b) of the Code may be pooled in a group trust with the assets of custodial accounts under Section 403(b)(7), retirement income accounts under Section 403(b)(9) and Section 401(a)(24) governmental plans (each such entity, a “Plan”) without affecting the tax status of the Plan or the group trust, if the requirements set forth in the Ruling are met.  The requirements under the Ruling generally mirror the requirements set forth in Rev. Rul. 81-100, with the addition of the following new requirements:

  • Each Plan which adopts the group trust is itself a trust, a custodial account, or a similar entity that is tax-exempt under Sections 408(e) or 501(a) of the Code (or is treated as tax-exempt under Section 501(a)). A Section 401(a)(24) governmental plan is treated as meeting this requirement if it is not subject to Federal income taxation.
  • Each Plan which adopts the group trust expressly and irrevocably provides in its governing document that it is impossible for any part of the corpus or income of that Plan to be used for, or diverted to, purposes other than for the exclusive benefit of the plan participants and their beneficiaries.
  • The group trust instrument expressly limits the assets that may be held by the group trust to assets that are contributed by, or transferred from, a Plan to the group trust (and the earnings thereon), and the group trust instrument expressly provides for separate accounts (and appropriate records) to be maintained to reflect the interest which each adopting Plan has in the group trust.

It should be noted that the Ruling is limited to the tax-exempt status of group trusts and does not extend to the treatment of group trusts under other laws, including the securities laws which generally do not provide an exemption for IRAs or Section 403(b) plans.  For example, Section 403(b) plans are not eligible for purposes of the securities law exemptions for bank-maintained collective funds.

The Ruling is scheduled to take effect on January 10, 2011, and a sponsor of a group trust that satisfies Rev. Rul. 81-100, but that does not currently provide for separate accounts, must generally amend its group trust instrument by January 10, 2012.  The Ruling provides a model amendment for this purpose, as well as a model amendment to reflect the Ruling in general, that may be adopted by group trusts that received favorable determination letters from the IRS prior to January 10, 2011.

District Court in Gallus v. Ameriprise Financial Reinstates its Dismissal of Mutual Fund Excessive Fee Case

In a 2007 decision in Gallus v. Ameriprise Financial (“Gallus”), the District Court for the District of Minnesota granted the defendants’ motion for summary judgment dismissing plaintiffs’ claims in a shareholder suit brought against an investment adviser which alleged excessive advisory fees in violation of Section 36(b) of the Investment Company Act.  The district court based its decision on an analysis of the factors cited in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982), and held that the plaintiffs had failed to establish a genuine issue of material fact regarding whether the fees charged were so disproportionately large that they bear no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.

On appeal, the Eighth Circuit applied a different Section 36(b) standard, and the United States Supreme Court accepted Gallus for review after agreeing to review another Section 36(b) case, Jones v. Harris Associates, 537 F.3d 728 (7th Cir. 2008) (“Harris Associates”).  The Supreme Court then vacated Gallus and remanded the case to the Eighth Circuit for further proceedings in accordance with the Supreme Court’s decision in Harris Associates.  (For a more detailed discussion of the prior decisions in Gallus, see the April 14, 2009 Alert and the April 6, 2010 Alert.)  The Eighth Circuit, in turn, remanded the Gallus case to the district court.

On December 9, 2010, the district court reinstated its order granting summary judgment to defendants.  It found that such a holding was “appropriate,” given the Supreme Court’s decision in Harris Associates which “adopted the Gartenberg framework and reasoning” that the district court used in granting summary judgment.  The action thus was dismissed with prejudice.

Federal Banking Agencies Revise Regulations Expanding Scope of Community Reinvestment Act to Encourage Support for HUD Neighborhood Stabilization Program Activities

The FRB, FDIC, OCC and OTS (the “Agencies”) issued a joint final rule (the “Rule”) amending their Community Reinvestment Act (“CRA”) regulations to support stabilization of communities adversely affected by high foreclosure levels.  The Rule encourages depository institutions to support eligible development activities in areas designated under the Neighborhood Stabilization Program (the “Program”) administered by the Department of Housing and Urban Development (“HUD”).  Under the Program, HUD has provided funds to state and local governments and nonprofit organizations for the purchase and redevelopment of abandoned and foreclosed properties.  Specifically, in the Rule, the Agencies revised the term “community development” to include loans, investments and services by financial institutions “that support, enable or facilitate projects or activities that meet the ‘eligibility uses’ criteria described in Section 2301(c) of the Housing and Economic Recovery Act of 2008” and are conducted in designated target areas identified in plans approved by HUD under the Program.  The Rule provides consideration for the award of CRA credit by the Agencies for depository institutions under the Program that benefit low-, moderate- and middle-income individuals and geographic Program target areas designated as “areas of greatest need.”  In addition, the Rule provides that a financial institution that has adequately aided the community development needs of its own assessment area may receive CRA credit for Program eligible activities outside of its assessment area.  The Rule will become effective 30 days after its publication in the Federal Register.

SEC and CFTC Seek Comment on Definitions in Dodd-Frank Act Derivatives Regulatory Framework

The SEC and CFTC published a joint notice of proposed rulemaking requesting comment from interested parties on rulemaking by the agencies to further define certain key definitions that are part of the comprehensive scheme for regulating swaps and security‑based swaps set forth in Title VII of the Dodd-Frank Act.  The key definitions at issue are the definitions of “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.”  The joint notice also includes guidance on how the agencies propose to interpret these definitions.  For further discussion of Title VII of the Dodd-Frank Act, please see the August 2, 2010 Special Edition of the Alert.  Comments on the proposal are due by February 22, 2011.

CFTC Issues Interim Final Rule Regarding Reporting Certain Post Enactment Swap Transactions

The CFTC issued a release adopting and seeking comment on an interim final rule for the reporting of certain post-enactment swap transactions entered into on or after July 21, 2010.  The proposal is designed to implement Section 723 of the Dodd‑Frank Act.  The interim final rule was effective December 17, 2010 and will remain in effect until the operative date for permanent recordkeeping and reporting rules for swap transactions to be adopted by the CFTC.  The CFTC is seeking comment on all aspects of the interim final rule; comments are due on or before January 18, 2011.

CFTC Issues Rule Proposals Regarding Derivatives Clearing Organizations

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 compliance, rule enforcement, anti-trust considerations and legal risk, (b) amending and clarifying rules related to submission of DCO applications, transferring DCO registrations and submission of DCO rules to establish a portfolio margining program, (c) codifying the statutory requirements contained in Section 725(b) of the Dodd‑Frank Act for chief compliance officers (“CCOs”) and setting forth additional provisions relating to CCOs and (d) updating the definitions of “clearing member” and “clearing organization” and adding definitions for certain other terms.  Comments on the proposals are due by February 11, 2011.

SEC Proposes Review Process for Mandatory Clearing of Security-Based Swaps and Proposes Requirements for End-User Exception from Mandatory Clearing of Security Based Swaps

The SEC issued rule proposals related to the mandatory clearing of security-based swaps pursuant to the Dodd-Frank Act.  The first proposal relates primarily to the processes by which a clearing agency submits to the SEC a proposal for a security-based swap that the clearing agency intends to clear, but also addresses the filing responsibilities of clearing agencies that are designated as systemically important and the process by which self-regulatory organizations seek approval of rule changes from the SEC.  The second proposal relates to the “end-user clear exception” from mandatory clearing of security-based swaps that applies where one party to a security-based swap is not a financial entity, is using security-based swaps to hedge or mitigate commercial risk, and notifies the SEC how it generally meets its financial obligations associated with entering into non-cleared security-based swaps.  Comments on the first proposal are due 45 days after its publication in the Federal Register.  Comments on the second proposal are due by February 4, 2011.