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Introduction | Spotlight: New Regulatory Capital Framework | Spotlight: The Dodd-Frank Act: Third Anniversary Implementation Status | State of the District | National Banking Trends

New Regulatory Capital Framework

On July 2, 2013, the Federal Reserve issued a final rule implementing new capital standards for all bank organizations with $500 million or more in total consolidated assets. The rule incorporates both Basel III and certain requirements of the Dodd-Frank Act. The new capital requirements increase the quality and quantity of regulatory capital and will improve firms' ability to absorb losses. Changes include

  • Revised definitions of regulatory capital;
  • New minimum capital and supplemental leverage ratios;
  • Consistent minimum leverage ratio requirements for all banking organizations;
  • The introduction of capital buffers;
  • New risk-weights for determining risk-based capital ratios; and
  • A revised prompt corrective action (PCA) framework which reflects new regulatory capital requirements.

The requirements are tailored to the risk profile of institutions and increase according to size and complexity. The final rule minimizes the burden on smaller, less complex firms. Bank holding companies with less than $500 million in total consolidated assets are exempt (though their subsidiary banks would still be subject to the new capital rules). For firms with greater than $500 million, but less than $15 billion in assets, the rule permanently grandfathers nonqualifying capital instruments, such as trust preferred securities, into Tier 1 capital. Advanced approaches firms (generally defined as banking organizations with consolidated total assets of $250 billion or more or consolidated total on-balance sheet foreign exposures of at least $10 billion) are subject to additional leverage and buffer requirements.

The rule is effective on January 1, 2014, for advanced approaches organizations and on January 1, 2015, for all other supervised financial institutions. There is a multistep phase-in period for all banking organizations to come into compliance with the new requirements. The phase-in period for the capital conservation buffer requirement begins in 2016 runs until 2019.

Measures to improve the quantity of capital
The final rule includes several measures to improve the quantity of capital held by all supervised financial institutions (see table 1), including:

  • The introduction of a new capital ratio, Common Equity Tier 1 (CET1), with a minimum requirement of 4.5 percent;
  • An increase in the tier 1 capital ratio requirement from 4 percent to 6 percent;
  • A requirement for a capital conservation buffer of 2.5 percent for all supervised financial institutions. Failure to maintain the 2.5 percent buffer will result in limits being placed on capital distributions (including dividend payments, discretionary bonus payments, and share buybacks);
  • A minimum leverage ratio for all organizations of 4 percent, which eliminates the lower leverage ratio of 3 percent previously allowed for institutions with a composite rating of "1"; and
  • For advanced approaches organizations, a new supplementary leverage ratio of 3 percent that considers off-balance sheet items and a countercyclical buffer requirement of a maximum of 2.5 percent, which will be used when regulators identify increased systemic risk. The initial buffer is set at zero.

RCF table 1

The prompt corrective action (PCA) rules have been revised to reflect the framework, including the CET1 ratio and new minimum capital and leverage requirements.

Measures to improve the quality of capital
In addition to requirements to improve the quantity of capital, the final rule also includes measures to improve the quality of capital. The new rule redefines regulatory capital, emphasizing CET1 capital—the most loss-absorbing form of capital—and implements strict eligibility criteria for regulatory capital instruments. For example:

  • The rule requires the bulk of regulatory capital deductions, such as goodwill and deferred tax assets, to be deducted from CET1 capital elements.
  • The rule also limits the amount of minority interests, mortgage servicing assets, and certain investments in unconsolidated financial institutions that may be included in regulatory capital.
  • Organizations are also required to include certain unrealized gains and losses in tier 1 capital. Non-advanced approaches organizations are permitted a one-time "opt-out" of this treatment.
  • In keeping with the Collins Amendment of the Dodd-Frank Act, supervised financial institutions must phase out nonqualifying capital instruments, including trust preferred securities, from tier 1 capital. For firms with less than $15 billion in total assets, the final rule permanently grandfathers the treatment of nonqualifying capital instruments, issued before May 19, 2010, into tier 1 capital. Firms with $15 billion or more in consolidated assets, that are not advanced approaches firms, are required to phase out nonqualifying capital instruments from tier 1 capital but allowed to include nonqualifying instruments in tier 2 capital, subject to certain limits. Advanced approaches firms may not include nonqualifying instruments in regulatory capital.

The final rule also includes changes to the risk-weighting of assets and expands the number of risk-weight categories to increase risk sensitivity. There are three primary risk-weighting changes that affect the majority of banks:

  • The risk weight for exposures past due for more than 90 days or on nonaccrual is increased to 150 percent;
  • High-volatility commercial real estate exposures are also risk-weighted at 150 percent (more information is available here); and
  • The conversion factor for commitments with an original maturity of one year or less is increased from 0 percent to 20 percent.

Notably, however, in response to public comments, the Board of Governors decided to maintain the existing treatment of residential mortgages, which allows prudently underwritten first-lien mortgages to be risk-weighted at 50 percent and assigns all other residential mortgages a risk weight of 100 percent. In the proposal, residential mortgages would have been assigned different risk weights, topping out at 200 percent, based on the borrower's financial condition and the terms of the mortgage.

Elimination of credit ratings
As required by the Dodd-Frank Act, the final rule also removes references to credit ratings and provides for the use of alternative standards to determine creditworthiness for sovereign, public sector, bank, and securitization exposures. The alternative standards include: a country risk classification established by the Organization for Economic Cooperation and Development: an analysis based on the seniority of securitizations; and an analysis of leverage, cash flow and stock volatility over a 12-month period for public debt. Banking institutions must exercise the required due diligence on securitization exposures or face a risk weight of 1,250 percent.

New rules for larger banks
The rule incorporates additional requirements for advanced-approach banking organizations. The more significant requirements address the treatment of counterparty credit risk, the computation of risk-weighted assets for securitization exposures, and changes to the risk weights for exposures to central counterparties. The final rule also removes the current ratings-based and internal assessment treatments for securitization exposures allowed under existing advanced approach rules (see table 2).

RCF table 2

Conclusion
The new regulatory capital framework integrates existing capital guidance with new requirements mandated by Basel III and the Dodd-Frank Act. It strengthens capital requirements for all supervised banking organizations, making them more resilient in times of stress and is scaled to reduce the burden on smaller institutions and to respond appropriately to the increased systemic risk posed by the largest, most complex organizations. A lengthy phase-in period is provided to allow all organizations to comply with the new capital and leverage ratio and buffer requirements. Based on the Federal Reserve Board's analysis of March 30, 2013 data, nine of ten community banks already meet or exceed the new CET1 minimum requirements.

Additional information on the new regulatory capital rules is available here.

This article was written by Robert Canova, a senior financial analyst in the Risk Analysis Unit of the Atlanta Fed's Supervision and Regulation Division.