Alert February 15, 2011

FDIC Adopts Amendments to Deposit Insurance Assessment Regulations

The FDIC adopted rules that amend the FDIC’s deposit insurance assessment regulations.  The first rule (the “Asset Based Rule“) implements a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd‑Frank Act”) that changes the assessment base for insured depository institutions (“IDIs”) from domestic deposits to assets. The second rule (the “Large Bank Rule“) adopts changes for the deposit insurance assessment system for large institutions given the Dodd-Frank Act’s changes to the assessment base.  The proposals for each of these rules were discussed in the November 16, 2010 Alert.  The regulations adopted by the FDIC also incorporate rules regarding assessment dividends and assessment rates; the proposal for those rules was described in the October 26, 2010 Alert.

I.  Asset Based Rule

The Asset Based Rule defines the assessment base as “average consolidated total assets minus average tangible equity,” as required by Section 331 of the Dodd-Frank Act (which was discussed in the July 28, 2010 Special Edition of the Alert); permits certain reductions for “banker’s banks” and “custodial banks”; makes conforming changes to the unsecured debt adjustment and brokered deposit adjustment, eliminates the secured liability adjustment and creates a new adjustment for an institution that holds long-term unsecured debt issued by another IDI; and revises deposit insurance rate schedules in light of the changes to the assessment base.

a.         Assessment Base.  The Asset Based Rule changes the assessment base to average consolidated assets minus average tangible equity.  All IDIs must report their average total assets using the accounting methodology for reporting total assets as applied to Line 9 of Schedule RC-K of the Call Report (that is, the methodology established by Schedule RC-K regarding when to use amortized cost, historical cost, or fair value, and how to treat deferred tax effects).  The final rule differs from the proposed rule, however, by allowing certain institutions to report average consolidated total assets on a weekly, rather than daily, basis.  The final rule requires institutions with total assets of at least $1 billion and all institutions that are newly insured after March 31, 2011, to average their balances as of the close of business for each day during the calendar quarter.  Institutions with less than $1 billion in quarter-end consolidated total assets on their March 31, 2011 Call Report or Thrift Financial Report (“TFR”) may report an average of their balances as of the close of business on each Wednesday during the calendar quarter or may, at any time, permanently opt to calculate average consolidated total assets on a daily basis.

There is no existing definition of “tangible equity” for IDI reporting purposes.  In an effort to minimize new reporting requirements, the FDIC will use Tier 1 capital as the definition of tangible equity.  In the FDIC’s view, defining tangible equity as Tier 1 capital not only avoids an increase in regulatory burden that a new definition of capital would cause, but also provides a clearly understood capital buffer for the Deposit Insurance Fund (“DIF”) in the event of the IDI’s failure.  The FDIC will define the averaging period for tangible equity to be monthly, except that IDIs that report less than $1 billion in quarter-end total consolidated assets on their March 31, 2011 Call Report or TFR may report average tangible equity using an end-of-quarter balance or may at any time opt permanently to report average tangible equity using a monthly average balance.

b.         Reductions for Banker’s Banks and Custodial Banks

            (i)  Banker’s banks

Banker’s banks, which are defined by 12 U.S.C. § 24, must be owned exclusively by IDIs or IDI holding companies and the IDI or holding company and all subsidiaries thereof must be engaged exclusively in providing services to or for other IDIs, their holding companies, and the officers, directors, and employees thereof.  The Asset Based Rule requires a banker’s bank to self-certify on its Call Report or TFR that it meets the definition of “banker’s bank” set forth in 12 U.S.C. § 24.  The self-certification is subject to verification by the FDIC.  The final rule clarifies that banker’s banks that have funds from government capital infusion programs (such as TARP and the Small Business Lending Fund), stock owned by the FDIC resulting from bank failures or stock that is issued as part of an equity compensation program will not be excluded from the definition of banker’s bank solely for these reasons.

For an IDI that meets the definition of banker’s bank, the FDIC will exclude from its assessment base the daily average amount of reserve balances “passed through” to the Federal Reserve Board (the “FRB”), the daily average amount of reserve balances held at the FRB for its own account, and the daily average amount of its federal funds sold.  The collective amount of this exclusion, however, may not exceed the sum of the IDI’s daily average amount of total deposits of commercial banks and other IDIs in the United States and the daily average amount of its federal funds purchased.  The assessment base adjustment applicable to a banker’s bank will only be available to an IDI that conducts 50 percent or more of its business with non-affiliated entities (as defined under the Bank Holding Company Act or the Home Owners’ Loan Act).

            (ii)  Custodial Banks

The Dodd-Frank Act instructed the FDIC to consider whether certain assets should be deducted from the assessment base of custodial banks, but left it to the FDIC to define custodial banks “based on factors including the percentage of total revenues generated by custodial businesses and the level of assets under custody.”  Under the final rule, the FDIC will define custodial banks as those IDIs with previous calendar year-end trust assets (consisting of fiduciary and custody and safekeeping assets ) of at least $50 billion or those IDIs that derived more than 50 percent of their revenue from trust activities over the previous calendar year.  This definition is revised slightly from the definition in the proposed rule in that it expands the definition to include fiduciary assets and revenue in addition to custody and safekeeping assets and revenue.  As a result, more IDIs will qualify as custodial banks.

The assessment base for custodial banks will be the daily average or weekly average – in accordance with the way the IDI reports its average consolidated total assets – of a certain amount of low risk assets – designated as assets with a Basel risk weighting of 0 percent, regardless of maturity, plus 50 percent of those assets with a Basel risk weighting of 20 percent, regardless of maturity – subject to the limitation that the daily or weekly average value of these assets cannot exceed the daily or weekly average value of those deposits classified as transaction accounts and identified by the IDI as being directly linked to a fiduciary or custody and safekeeping account.

There are certain differences between the adjustment for custodial banks in the final rule from the adjustment that would have been provided under the proposed rule.  First, the final rule allows a deduction of all 0 percent risk-weighted assets and 50 percent of 20 percent risk-weighted assets without regarding to a specific maturity.  In addition, the final rule allows a deduction up to the daily or weekly average value of those deposits classified as transaction accounts that are identified by the IDI as being linked to a fiduciary or custodial and safekeeping account.  The final rule also limits the deduction to transaction accounts, rather than all deposit accounts, because deposits generated in the course of providing custodial services are used for payments and clearing purposes, as opposed to deposits held in non-transaction accounts, which may be part of a wealth management strategy.

c.         Changes to Other Adjustments.  In March 2009, the FDIC issued a final rule incorporating three adjustments into the risk-based pricing system – the unsecured debt adjustment, the secured liability adjustment, and the brokered deposit adjustment.  In light of the Dodd-Frank Act’s changes to the deposit insurance assessment base, the FDIC is revisiting these adjustments.

            (i)  Unsecured Debt Adjustment

The Asset Based Rule revises the unsecured debt adjustment to ensure that IDIs continue to have the same incentive to issue more long-term unsecured debt than they otherwise would.  The unsecured debt adjustment will be scaled to the new assessment base and will be increased to 40 basis points plus an IDI’s initial base assessment rate (“IBAR”) times the amount of long-term unsecured liabilities divided by the amount of the new assessment base.  The cap on the unsecured debt adjustment will be the lesser of 5 basis points or 50 percent of an IDI’s IBAR.  Unsecured debt will no longer include any Tier 1 capital.

The final rule, unlike the proposed rule, slightly alters the definition of long-term unsecured debt.  Currently, long-term unsecured debt is defined as long-term if the unsecured debt has at least one year remaining until maturity.  Under the final rule, long-term unsecured debt is long-term if the debt has at least one year remaining until maturity, unless the investor or holder of the debt has a redemption option that is exercisable within one year of the reporting date.

            (ii)  Depository Institution Debt Adjustment

Although issuance of unsecured debt by an IDI lessens the potential loss to the DIF in the event of an IDI’s failure, the FDIC noted that when this debt is held by other IDIs, the overall risk to the DIF is not reduced.  The Asset Based Rule includes a new adjustment, the depository institution debt adjustment (“DIDA”), which is meant to offset the benefit received by IDIs that issue long-term, unsecured liabilities when those liabilities are held by other IDIs.  In response to comments on the proposed rule, the final rule allows an IDI to exclude from the unsecured debt amount used in calculating the DIDA an amount equal to up to 3 percent of the IDI’s Tier 1 capital as posing de minimis risk.  Therefore, the final rule will apply a 50 basis point DIDA to every dollar (above 3 percent of an IDI’s Tier 1 capital) of long-term unsecured debt held by an IDI when that debt is issued by another IDI.

            (iii)  Secured Liability Adjustment

The Asset Based Rule eliminates the secured liability adjustment.  The FDIC believes that with the change in the assessment base, the relative cost advantage of funding with secured liabilities will disappear, thus eliminating the differential that led to the FDIC’s introduction of the adjustment.

            (iv)  Brokered Deposit Adjustment

The brokered deposit adjustment will be scaled to the new assessment base.  The new formula for brokered deposits will become:  BDA = ((Brokered deposits – (Domestic deposits*10%)/New assessment base)*25 basis points.  In response to comments on the proposed rule, however, the final rule provides an exemption from the brokered deposit adjustment for large institutions that are well-capitalized and have a composite CAMELS rating of 1 or 2.  For small institutions, the brokered-deposit adjustment will continue to apply to those in risk categories II, III, and IV when the ratio of brokered deposits to domestic deposits exceeds 10 percent, but does not apply to small institutions that are well-capitalized and have a composite CAMELS rating of 1 or 2.  The final rule maintains a cap on the brokered deposit adjustment of 10 basis points.

d.         Assessment Dividends.  Pursuant to the Dodd-Frank Act, the FDIC has the authority to declare dividends when the DIF reserve ratio at the end of a calendar year is at least 1.5% and to suspend or limit declaration or payment of dividends from the DIF.  Accordingly, the final rule provides that dividends be suspended permanently when the DIF reserve ratio exceeds 1.5%, which would increase the probability that the DIF will reach a level sufficient to withstand a future crisis.  As discussed in further detail below, as an alternative to declaring dividends to prevent the DIF from becoming unnecessarily large, the FDIC will apply progressively lower assessment rate schedules when the reserve ratio exceeds 2% and 2.5%.  These lower rate assessment schedules serve much the same function as dividends in preventing the DIF from growing unnecessarily large but provide more stable and predictable effective assessment rates.

e.         Assessment Rate Schedule.  The assessment rate schedule will be changed so that approximately the same amount of revenue would be collected under the new assessment base as would be collected under the current rate schedule and the schedules proposed by the FDIC in October 2010.  The range of IBARs is the same for all sizes of IDIs (5 basis points to 35 basis points).  For IDIs with less than $10 billion in total assets, the assessment rate under the schedule will depend on the risk category assigned to the IDI.  Risk Category I institutions, for example, will pay IBARs between 5 and 9 basis points.  IDIs with at least $10 billion in assets will not be assigned to risk categories, and may be subject to any assessment rate within the applicable range.

Under the final rule, assessment rates also may be reduced based on the DIF reserve ratio as follows:

  • When the DIF reserve ratio reaches 1.15%, assessment rates will be lowered significantly. Risk Category I institutions, for example, will pay IBARs between 3 and 7 basis points;
  • When the DIF reserve ratio reaches 2.00%, assessment rates will be lowered by approximately 25%. Risk Category I institutions, for example, would pay IBARs between 2 and 6 basis points; and
  • When the DIF reserve ratio reaches 2.50%, assessment rates will be lowered by approximately 50% below the rates that will take effect when the reserve ratio reaches 1.15%. Risk Category I institutions, for example, will pay IBARs between 1 and 5 basis points.

The FDIC believes that the progressively lower assessment rate schedules will serve to provide more stable and predictable assessment rates.

f.          FDIC Adjustments to Assessment Rates.  The Asset Based Rule retains the FDIC Board’s ability to adopt actual assessment rates that are higher or lower than total base assessment rates without the necessity of further notice-and-comment rulemaking, provided that (1) the FDIC Board may not increase or decrease rates from one quarter to the next by more than 2 basis points (rather than the current and proposed 3 basis points), and (2) cumulative increases and decreases cannot be more than 2 basis points higher or lower than the total base assessment rates.  The reduction from 3 to 2 basis points was prompted by an industry trade group, which noted that 2 basis points of the new assessment base is approximately equal to 3 basis points of the domestic deposit assessment base.

g.         Effective Date for the Asset Based Rule.  The rate schedule and other revisions to the assessment rules will become effective on April 1, 2011, and will be used to calculate the June 30, 2011, invoices for assessments, which will be due on September 30, 2011. 

II.  Large Bank Rule

The Large Bank Rule will revise the risk-based assessment system for all large IDIs.  The final rule eliminates risk categories and the use of long-term debt issuer ratings when calculating the initial base assessment for large IDIs.  Instead, the FDIC will use a scorecard method to calculate assessment rates for all large IDIs.  The assessment system for large IDIs will combine CAMELS ratings and certain financial measures into two scorecards – one for most large IDIs and another for the remaining very large IDIs that are structurally and operationally complex or that pose unique challenges and risks in the case of failure (highly complex IDIs). 

a.         Large Institution Scorecard and Base Assessment Rate.  Under the Large Bank Rule, the assessment rate for large IDIs will be calculated using a scorecard which is based on institution performance and financial measures as potentially modified by discretionary adjustments available to the FDIC or as a result of the unsecured debt adjustment, IDI debt adjustment, or the brokered deposit adjustment under the Asset Based Rule.

A large IDI will continue to be defined as it currently is – generally, an IDI with at least $10 billion in total assets for at least four consecutive quarters.  Insured branches of foreign banks will not be included within the definition of a large IDI. 

The scorecard for large IDIs assesses certain risk measures to produce two scores – a performance score (the “Performance Score”) and a loss severity score (the “Loss Severity Score”) – that will ultimately be combined and converted to an initial assessment rate. 

(i)  Performance Score

The Performance Score measures a large IDI’s financial performance and its ability to withstand stress.  The Performance Score for large IDIs is the weighted average of three inputs:  (1) weighted average CAMELS ratings; (2) ability to withstand asset-related stress measures, and (3) ability to withstand funding-related stress measures.  The scorecard combines these weighted measures into a single Performance Score between 0 and 100.

                        (A)  Weighted Average CAMELS Score

A weighted average of a large IDI’s CAMELS score constitutes 30% of the large IDI’s Performance Score.  Due to a non-linear conversion, the Performance Score will increase at an increasing rate as the weighted average CAMELS rating increases.   

                        (B)  Asset-Related Stress Component

The ability to withstand stress constitutes 50% of such IDI’s Performance Score and is based on a weighted calculation combining the following financial measures:

      • Tier 1 leverage ratio;
      • Concentration measure (the higher of the ratio of higher-risk assets to the sum of Tier 1 capital and reserves or the growth-adjusted portfolio concentrations measure);
      • The ratio of core earnings to average quarter-end total assets; and
      • Credit quality measure (the higher of the ratio of criticized and classified items to the sum of Tier 1 capital and reserves measure).

Each of the measures used in calculating the asset-related stress component is described in detail in Appendix A to the Large Bank Rule.  Each of the measures is also subject to a minimum and maximum cutoff, meaning that to the extent that such measures produce values that are very low or very high, the effect of such value on the Performance Score is limited.

                        (C)  Funding-Related Stress Component

The ability of a large IDI to withstand funding-related stress constitutes 20% of the IDI’s Performance Score and is based on a weighted calculation combining two financial measures:  a core deposits to total liabilities ratio, and a balance sheet liquidity ratio, which measures the amount of highly liquid assets to cover potential cash outflows in the event of stress. 

Each of the measures used in calculating the funding-related stress component is described in detail in Appendix A to the Large Bank Rule.  Like the measures in the asset-related stress component, each of the measures in the funding-related stress component is also subject to a minimum and maximum cutoff, meaning that to the extent such measures produce values that are very low or very high, the effect of such value on the Performance Scorecard is limited.

            (ii)  Loss Severity Score

The Loss Severity Score quantifies the relative magnitude of potential losses to the FDIC in the event of the IDI’s failure.  It is based on a loss severity measure that the FDIC considers most relevant to assessing an IDI’s potential losses.  (Appendix D to the proposal describes the calculation of the loss severity measure in detail).

The loss severity measure applies a standardized set of assumptions based on recent failures regarding liability runoffs and the recovery value of asset categories to calculate possible losses to the FDIC.  In the proposed rule, the FDIC proposed including a noncore funding ratio in the Loss Severity Score as a potential proxy for franchise value.  The FDIC continues to believe that franchise value is an important factor to consider in the overall assessment of loss severity, but, given that liability composition is considered in the loss severity measure, the final rule eliminates the noncore funding ratio from the Loss Severity Score.  Instead, qualitative factors that affect an IDI’s franchise value will be considered in determining whether to apply a large bank adjustment.

The Loss Severity Score cannot be less than 0 or more than 100.

            (iii)  Total Score and Base Assessment Rate

Once the Performance and Loss Severity Scores are calculated, these scores will be converted to a total score by multiplying the Performance Score by the Loss Severity Score.  An IDI’s score may not be less than 30 or more than 90.

A large IDI with a total score of 30 will pay the minimum base assessment rate, and an IDI with a total score of 90 will pay the maximum IBAR.  For total scores between 30 and 90, the IBAR will rise an increasing rate as the total score increased.

The IBAR can be adjusted as a result of the unsecured debt adjustment, the depository institution debt adjustment, or the brokered deposit adjustment, in accordance with the Asset Based Rule, or through a discretionary adjustment by the FDIC, as described below.

b.         Highly Complex Institution Scorecard and Base Assessment Rate.  IDIs that meet the definition of “highly complex” will be subject to a more complex scorecard than ordinary large IDIs.  A highly complex IDI is defined as an IDI (other than a credit card bank) with more than $50 billion in total assets that is controlled by a parent or intermediate holding company with more than $500 billion in total assets.  The designation also applies to a processing bank or trust company with at least $10 billion in total assets.  The scorecards for highly complex IDIs and relevant adjustments thereto are identical to the scorecard and adjustments for large IDIs, with certain exceptions described below.

            (i)  Performance Score

The Performance Score for highly complex IDIs will be based on the same factors – the weighted average CAMELS score, the asset-related stress component and the ability to withstand funding-related stress component – as the Performance Score for large IDIs.  The weighted average CAMELS score for highly complex IDIs will be calculated in the same manner as in the scorecard for large IDIs.  However, the calculations of the asset-related stress component and the ability to withstand funding-related stress component will be modified for highly complex IDIs as discussed below.

Two of the four measures used to assess a highly complex IDI’s ability to withstand asset-related stress (the Tier 1 leverage ratio and the core earnings to average quarter-end total assets ratio) will be determined in the same manner used for other large IDIs.  However, the concentration measure for highly complex IDIs considers the top 20 counterparty exposures to Tier 1 capital and reserves ratio instead of the growth-adjusted portfolio concentrations used in the scorecard for large IDIs because recent experience shows that the concentration of a highly complex IDI’s exposures to a small number of counterparties – either through lending or derivatives activities – significantly increases a highly complex IDI’s vulnerability to unexpected market events.  In addition, the ability to withstand asset-related stress includes a credit quality measure like the scorecard for large IDIs, but the highly complex IDI scorecard also includes a market risk measure that consists of three risk measures – trading revenue volatility, market risk capital, and level 3 trading assets.

Two of the measures (the core deposits to total liabilities ratio and the balance sheet liquidity ratio) in the ability to withstand funding-related stress component are determined in the same manner as in the scorecard for large for large IDIs, although their weights differ.  However, the ability to withstand funding-related stress component in the highly complex IDI scorecard adds an additional measure – the average short-term funding to average total assets ratio – because experience during the recent financial crisis shows that heavy reliance on short-term funding significantly increases a highly complex IDI’s vulnerability to unexpected adverse developments in the funding market.

            (ii)  Loss Severity Score

The Loss Severity Score for highly complex IDIs is calculated the same way as the Loss Severity Score for other large IDIs, as described above.

            (iii)  Total Score and Base Assessment Rate

The total score and the base assessment for highly complex IDIs will be calculated in the same manner as for other large IDIs, as described above.

c.         FDIC Discretionary Adjustment to the Total Score.  Similar to the current system, the FDIC will have the ability to adjust a large IDI’s or highly complex IDI’s total score by a maximum of 15 points, up or down, based upon significant risk.  The FDIC will any such adjustment to the total score.

In determining whether to make a discretionary adjustment, the FDIC will consider such information as financial performance and condition information and other market or supervisory information.  The FDIC also must consult with an IDI’s primary federal regulator and, for state chartered institutions, state banking supervisor.

The FDIC will notify a large or highly complex IDI before making an upward adjustment to the IDI’s assessment rate so that the IDI has an opportunity to respond to or address the FDIC’s rationale for proposing an upward adjustment.

In adopting the final rule, the FDIC acknowledged the need to clarify its processes for making adjustments to ensure fair treatment and accountability and plans to propose and seek comment on updated guidelines.  Accordingly, the FDIC will not adjust assessment rates until the updated guidelines are published for comments and approved by the FDIC.  In addition, the FDIC will publish aggregate statistics on adjustments each quarter.

d.         Updating the Scorecard

The FDIC will have the ability to update the minimum and maximum cutoff values used in the scorecard annually without further rulemaking as long as the method of selecting cut-off values remains unchanged.  In particular, the FDIC can add new data from each year to its analysis and could, from time to time, exclude data from some earlier years from its analysis.

On the other hand, if the FDIC concludes that additional or alternative measures should be used to determine risk-based assessments, that the method of selecting cutoff values should be revised, that the weights assigned to the scorecard measures should be recalibrated, or that a new method should be used to differentiate among large IDIs and highly complex IDIs, such changes can be made through a future rulemaking.

e.         Effective Date for the Large Bank Rule.  The changes under the Large Bank Rule will be effective on April 1, 2011.  Accordingly, the scorecard method will be used to calculate assessments for large and highly complex IDIs beginning with the second quarter assessment period of 2011.