Basel III: Dodd Frank Implementation

Transcription

1 Basel III: Dodd Frank Implementation Association of Corporate Counsel Jerome Walker Partner, Financial Institutions Regulation New York, New York August 22,

2 What Is the Current Status of the Dodd Frank Implementation of Basel III? On June 4, 2012, the Board of Governors of the Federal Reserve System (the Federal Reserve ), the Office of the Comptroller of the Currency (the OCC ) and the Federal Deposit Insurance Corporation (the FDIC ) issued three joint notice of proposed rulemakings designed primarily to implement the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd Frank ), and the December 2010, Basel Committee on Bank Supervision (the Basel Committee ) approvals set forth in Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems, constituting the Basel III framework, which is scheduled to be implemented from January 1, 2013, with full compliance in the US by January 1, The rulemakings would make changes to 12 C.F.R. 208, 217 and 225, in the case of the Federal Reserve, 12 C.F.R. 3, 5, 6, 165 and 167, in the case of the OCC, and 12 C.F.R. 324 and 325, in the case of the FDIC. 2

3 What Is the Current Status of the Dodd Frank Implementation of Basel III? Those proposed rulemakings include: 1. Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action (the Minimum Regulatory Capital NPR ), which is designed to implement Section 171 of Dodd Frank; 2. Regulatory Capital Rules: Standardized Approach for Risk-weighted Assets; Market Discipline and Disclosure Requirements (the Standardized Approach NPR ), which is designed to implement Sections 171 and 939A of Dodd Frank; 3. Regulatory Capital Rules: Advanced Approaches Risk-based Capital Rule; Market Risk Capital Rule, which is designed to implement Sections 171 and 939A of Dodd Frank (the Advanced Approaches NPR ). The Advanced Approaches NPR would also apply the market risk capital rule to savings and loan associations and savings and loan association holding companies. 3

4 What Is the Current Status of the Dodd Frank Implementation of Basel III? According to a memorandum dated June 4, 2012, from Federal Reserve Governor Tarullo to the Federal Reserve the proposed rulemakings are designed to revise the current minimum risk-based and leverage capital rules of the Federal banking agencies to introduce a minimum common equity risk-based capital ratio and, for internationally active banking organizations, a supplementary leverage ratio. The Minimum Regulatory Capital NPR would apply to all depository institutions, bank holding companies with consolidated assets of $500 million or more, and savings and loan holding companies. 4

5 What Is the Current Status of the Dodd Frank Implementation of Basel III? The Standardized Approach NPR would apply to all depository institutions, bank holding companies with consolidated assets of $500 million or more, and savings and loan holding companies. This NPR is designed to enhance risk sensitivity and incorporate aspects of the Basel II standardized approach. The Advanced Approaches NPR would ONLY apply to banking organizations which are subject to the advanced approaches risk-based capital rule or the market risk capital rule. The original comment period was set to expire on September 7, On August 8, 2012, the comment period was extended to October 22,

6 What Is the Immediate Impact of the Minimum Regulatory Capital NPR? The most immediate impact of the Minimum Regulatory Capital NPR is to raise the amount and quality of capital on all banking organizations. To achieve this goal, the Federal banking agencies created a new common equity tier 1 ratio of 4.5%, increased the minimum tier 1 capital ratio from 4% to 6%, kept the total capital ratio of 8% of riskweighted assets, modified the tier 1 leverage ratio of 4% based upon a new definition of tier 1 capital, substantially changed the definition of capital, and established limitations on capital distributions, and certain discretionary bonuses if a banking organization does not hold enough capital. Page 18 of Minimum Regulatory Capital NPR. To avoid restrictions on capital distributions and discretionary bonuses to executives, banking organization would also be required to hold an additional buffer of common equity tier 1 capital in an amount above 2.5% of total risk-weighted assets. If the buffer is less than 2.5%, then the Federal banking agencies would restrict the distributions and discretionary bonuses. If the buffer is zero, then the Federal banking agencies would prohibit the distributions or discretionary bonuses. Page 18 of Minimum Regulatory Capital NPR. 6

7 What Is the Immediate Impact of the Minimum Regulatory Capital NPR? With respect to the definition of capital, the goal is to require more loss absorbing capital and capital that creates confidence in investors. Thus, for example, cumulative preferred and trust preferred-like instruments would be excluded from tier 1 capital because they do neither. There would also be deductions from common equity tier 1 capital: 1. Goodwill would be deducted from common equity tier 1 capital; 2. Deferred tax assets arising from operating losses and tax credit carry forwards would be deducted from common equity tier 1 capital; 3. Mortgage servicing assets and deferred tax assets arising from temporary differences that an organization could not realize through net operating loss carry backs, and investments in the common stock of unconsolidated financial institutions each would be individually limited to 10% of common equity tier 1, and, in the aggregate, 15% of common equity tier 1 capital; 7

8 What Is the Immediate Impact of the Minimum Regulatory Capital NPR? There would also be deductions from common equity tier 1 capital: 4. The amount of minority interests permitted in capital would be limited; 5. Unrealized gains and losses on all available-for-sale securities and gains and losses associated with certain cash flow hedges would flow through to common equity tier 1 capital; 8

9 What Is the Immediate Impact of the Standardized Approach NPR? The most immediate impact of the Standardized Approach NPR is to force banking organization to improve their credit underwriting and due diligence. To achieve this goal, the Federal banking agencies limit reliance on credit ratings and provide alternatives that banking organizations must use. The Standardized Approach NPR also increases the required capital for certain assets such as higher risk residential mortgages (currently, typically 50%; proposed to range from 35% to 200% based upon the loan to value ratio of the mortgage and certain product features), higher risk construction and commercial real estate lending (150%) and certain securitization exposures (must use a gross up approach or a simplified supervisory formula approach). There is also a new Country Risk Classification used for credit exposures to certain foreign entities. Pages 15 and 16 of Standardized Approaches NPR. 9

10 What Is the Immediate Impact of the Standardized Approach NPR? Exposures that are more than 90 days past due or on nonaccrual would have a risk weight of 150% (up from the typical 100%). Pages 15 and 16 of Standardized Approaches NPR. The Standardized Approach NPR creates incentives for trading and clearing derivatives through central counterparties by granting better capital treatment. This NPR proposes that beginning on January 1, 2015, a banking organization would be required to calculate risk-weighted assets using the new methodologies. Credit exposures to US governments and its agencies, US government-sponsored entities, US depository institutions and credit unions and US public sector entities such as states and municipalities would remain the same. Credit exposure to corporate entities would have a 100% risk weight. The credit conversion factor for most short term off-balance sheet commitments would increase from 0% to 20%. The 50% risk weight cap for derivative contracts would be eliminated. 10

11 What Is the Immediate Impact of the Advanced Approaches NPR? The most immediate impact of the Advanced Approaches NPR is to force the largest and most internationally active banking organizations to better address risk sensitivity. To achieve this goal, the Federal banking agencies make changes to better address counterparty credit risk and interconnectedness. There would also be a minimum supplementary tier 1 leverage ratio of 3% (disclosure beginning January 1, 2015; meet requirement by January 1, 2018). The 2.5% buffer required by the Minimum Regulatory Capital NPR may be increased by a countercyclical capital buffer. This buffer would be triggered when the Federal banking agencies determine that a period of excessive aggregate credit growth is contributing to an increase in systemic risk. The maximum amount of the buffer would be 2.5% of the riskweighted assets of the banking organization. The Advanced Approaches NPR requires banking organizations to use the risk weights in the Standardized Approach NPR. 11

12 Why are Basel I and Basel II Insufficient? The financial crisis showed that this concentrated, almost all-consuming regulatory focus on refining bank capital requirements in Basel II had come at the expense of attention to other risks in the financial system. In particular, banking regulators failed to appreciate fully the implications of the growth--in size, leverage, and maturity transformation levels-- of the shadow banking system for the balance sheets of commercial banks and for overall financial stability. The crisis showed that liquidity problems can be an independent source of severe stress, perhaps even for firms that might otherwise have remained solvent. But it was also evident that the specifics of pre-crisis capital regulation fell far short of what this prudential instrument can achieve. Federal Reserve Governor Daniel K. Tarullo, November 9,

13 Why are Basel I and Basel II insufficient? Basel I and Basel II capital requirements relied almost exclusively on capital ratios that were essentially snapshots of balance sheets and thus all too often a lagging indicator of a bank's condition. Declines in asset values--particularly of non-traded assets--were often not reflected in capital calculations for some time. Though already well-known before the crisis, this phenomenon was particularly problematic as asset values declined rapidly, causing both markets and supervisors alike to regard regulatory capital ratios as providing only limited information about a firm's current financial condition. Federal Reserve Governor Daniel K. Tarullo, November 9,

14 Why are Basel I and Basel II insufficient? In addition, minimum capital levels had simply been set too low, in general and with respect to particular assets. One of the most obvious examples was the capital requirement for asset-backed securities in the trading books of banks. The requirement was based on returns over a 10-day holding period, used a one-year observation period that had been characterized by unusually low price volatility, and did not adequately account for the credit risks inherent in these traded instruments. Federal Reserve Governor Daniel K. Tarullo, November 9,

15 Why are Basel I and Basel II insufficient? Furthermore, at least some of the instruments that qualified as "Tier 1 capital" for regulatory purposes were not reliable buffers against losses, at least not on a going concern basis. It is instructive that during the height of the crisis, counterparties and other market actors looked almost exclusively to the amount of tangible common equity held by financial institutions in evaluating the creditworthiness and overall stability of those institutions. They essentially ignored the Tier 1 and total risk-based capital ratios in regulatory requirements. In the fall of 2008, there was widespread doubt in markets that the common equity of some of our largest institutions was sufficient to withstand the losses that those firms appeared to be facing. This doubt made investors and counterparties increasingly reluctant to deal with those firms, contributing to the severe liquidity strains that characterized financial markets at the time. Federal Reserve Governor Daniel K. Tarullo, November 9,

16 What are Basel I and Basel II insufficient? Finally, the crisis validated the concerns expressed by some academics and by policy staff at the Bank for International Settlements that the effectiveness of capital regulation was limited by its exclusively microprudential focus. Capital requirements had been set with reference solely to the balance sheet of a specific firm. The risk weights assigned to the firm's assets were calculated with reference to ordinary times, whether through a supervisory determination or a combination of supervisory formulas and a firm's own modeling. This microprudential focus did not take into account the potential impact of a shock to the value of widely-held assets--whether exogenous, caused by the distress sales of such assets by a large firm suffering particularly severe problems, or, as in the financial crisis, a lethal interaction between these two factors. Federal Reserve Governor Daniel K. Tarullo, November 9,

17 What is Basel III? The purpose of Basel III is to strengthen microprudential regulation and supervision, and add a macroprudential overlay that includes capital buffers Pillar 1: Capital Quality and level of Capital Greater focus on common equity. The minimum will be raised to 4.5% of riskweighted assets, after deductions. Capital loss absorption at the point of non-viability Contractual terms of capital instruments will include a clause that allows at the discretion of the relevant authority write-off or conversion to common shares if the bank is judged to be non-viable. This principle increases the contribution of the private sector to resolving future banking crises and thereby reduces moral hazard. 17

18 What is Basel III? The purpose of Basel III is to strengthen microprudential regulation and supervision, and add a macroprudential overlay that includes capital buffers Pillar 1: Capital Capital conservation buffer Comprising common equity of 2.5% of risk-weighted assets, bringing the total common equity standard to 7%. Constraint on a bank s discretionary distributions will be imposed when banks fall into the buffer range. Countercyclical buffer Imposed within a range of 0-2.5% comprising common equity, when authorities judge credit growth is resulting in an unacceptable build up of systematic risk. 18

19 What is Basel III? The purpose of Basel III is to strengthen microprudential regulation and supervision, and add a macroprudential overlay that includes capital buffers Pillar 1: Risk Coverage Securitizations Strengthens the capital treatment for certain complex securitizations. Requires banks to conduct more rigorous credit analyses of externally rated securitization exposures. Trading book Significantly higher capital for trading and derivatives activities, as well as complex securitizations held in the trading book. Introduction of a stressed value-at-risk framework to help mitigate procyclicality. A capital charge for incremental risk that estimates the default and migration risks of unsecuritized credit products and takes liquidity into account. 19

20 What is Basel III? The purpose of Basel III is to strengthen microprudential regulation and supervision, and add a macroprudential overlay that includes capital buffers Pillar 1: Risk Coverage Counterparty credit risk Substantial strengthening of the counterparty credit risk framework. Includes: more stringent requirements for measuring exposure; capital incentives for banks to use central counterparties for derivatives; and higher capital for inter-financial sector exposures. Bank exposures to central counterparties (CCPs) The Committee has proposed that trade exposures to a qualifying CCP will receive a 2% risk weight and default fund exposures to a qualifying CCP will be capitalized according to a risk-based method that consistently and simply estimates risk arising from such default fund. 20

21 What is Basel III? The purpose of Basel III is to strengthen microprudential regulation and supervision, and add a macroprudential overlay that includes capital buffers Pillar 1: Containing Leverage Leverage ratio A non-risk-based leverage ratio that includes off-balance sheet exposures will serve as a backstop to the risk-based capital requirement. Also helps contain system wide build up of leverage. 21

22 What is Basel III? The purpose of Basel III is to strengthen microprudential regulation and supervision, and add a macroprudential overlay that includes capital buffers Pillar 2: Risk management and supervision Supplemental Pillar 2 requirements Address firm-wide governance and risk management; capturing the risk of offbalance sheet exposures and securitization activities; managing risk concentrations; providing incentives for banks to better manage risk and returns over the long term; sound compensation practices; valuation practices; stress testing; accounting standards for financial instruments; corporate governance; and supervisory colleges. 22

23 What is Basel III? The purpose of Basel III is to strengthen microprudential regulation and supervision, and add a macroprudential overlay that includes capital buffers Pillar 3: Market discipline Revised Pillar 3 disclosure requirements The requirements introduced relate to securitization exposures and sponsorship of off-balance sheet vehicles. Enhanced disclosures on the detail of the components of regulatory capital and their reconciliation to the reported accounts will be required, including a comprehensive explanation of how a bank calculates its regulatory capital ratios. 23

24 What is Basel III? Basel III introduces a global liquidity standard and supervisory monitoring. Liquidity Liquidity coverage ratio The liquidity coverage ratio will require banks to have sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario that is specified by supervisors. Net stable funding ratio The net stable funding ratio is a longer-term structural ratio designed to address liquidity mismatches. It covers the entire balance sheet and provides incentives for banks to use stable sources of funding. 24

25 What is Basel III? Basel III introduces a global liquidity standard and supervisory monitoring. Liquidity Principles for sound liquidity risk management and supervision The Committee s 2008 guidance Principles for Sound Liquidity Risk Management and Supervision takes account of lessons learned during the crisis and is based on a fundamental review of sound practices for managing liquidity risk in banking organizations. Supervisory monitoring The liquidity framework includes a common set of monitoring metrics to assist supervisors in identifying and analyzing liquidity risk trends at both the bank and system-wide level. 25

26 What is Basel III? Globally systemically important financial institutions ( G-SIFIs ) will have additional requirements. In addition to meeting the Basel III requirements, G-SIFIs must have higher loss absorbency capacity to reflect the greater risks that they pose to the financial system. The Committee has developed a methodology that includes both quantitative indicators and qualitative elements to identify global systemically important banks ( G-SIBs ). The additional loss absorbency requirements are to be met with a progressive Common Equity Tier 1 capital requirement ranging from 1% to 2.5%, depending on a bank s systemic importance. For banks facing the highest G-SIB surcharge, an additional loss absorbency of 1% could be applied as a disincentive to increase materially their global systemic importance in the future. A consultative document was published in cooperation with the Financial Stability Board, which is coordinating the overall set of measures to reduce the moral hazard posed by G-SIFIs. 26

27 About SNR Denton Financial Institutions and Funds Practice Group Jerome Walker Partner New York Office T jerome.walker@snrdenton.com Former Senior Attorney for the Office of the Comptroller of the Currency under the US Department of Treasury Former General Counsel and Chief Compliance Officer for the US operations of HongkongBank (HSBC) Former Managing Director and Head of Bank Regulatory Compliance for Deutsche Bank Americas Focusing on regulation, supervision and compliance activities of commercial banks, investment banks, and the US operations of international banks Over 20 years experiences in representing internationally active banks 27