Today, more than ever, capital adequacy is a key strategic priority for banks and bank holding companies ("BHCs"). Capital affects the ability of a BHC to elect financial holding company ("FHC") status and thus take full advantage of the expanded authorities provided by the Gramm-Leach-Bliley Act of 1999. In addition to FHC status, capital governs, among other things, the (1) extent to which a BHC can engage in stock repurchases, (2) level of deposit insurance assessments, (3) efficiency with which banks and BHCs can engage in new activities, and (4) ease of geographic expansion. Furthermore, the US federal bank regulators have indicated that capital will become even more important as financial institutions seek to expand into new activities, and as highly publicized and criticized bank failures (such as Superior Bank) occur.
Regulatory proposals are pending that would fundamentally alter the foundations and frameworks upon which the risk capital rules are currently based. Because of the critical importance of capital, this Alert is intended to assist institutions to identify, understand and evaluate the possible ramifications of these proposals on their organizations. These new proposals have implications not only for effective balance sheet management and strategic development, but also for internal risk management procedures and documentation. These types of considerations should be kept in focus as institutions seek to comment upon the regulatory proposals and to respond most effectively to these regulatory initiatives.
I. Background
.The current system, which focuses solely on setting a regulatory minimum for capital, is based upon the 1988 Capital Accord (the "1988 Accord") developed by the Basel Committee on Banking Supervision (the "Basel Committee"). The Basel Committee (so named because it meets in Basel, Switzerland) is a committee of banking supervisory authorities consisting of representatives of the bank regulatory agencies and central banks of the US, Canada, Japan, and European countries.
The Basel Committee’s purpose is to establish uniform international standards that promote safety and soundness and prevent banks of one country from gaining a competitive advantage over those of another. Although the Basel Committee does not itself have the authority to set capital standards in a particular country, its capital accords have been adopted by regulators in over 100 countries (including the four US federal bank regulators). Nonetheless, there often is a significant delay between the Basel Committee’s publication of a capital accord and its adoption by a country’s regulators. For example, as discussed in the December 19, 2000 Alert, although the Basel Committee has recommended a 20% capital charge on claims against specified broker-dealers since 1998, the US regulators still impose a 100% charge for such claims. (The comment period on regulations proposing to reduce the charge to 20% ended January 22, 2001.)
The Basel Committee has determined that the mechanistic, four bucket (0%, 20%, 50%, 100%) risk-capital approach of the 1988 Accord is insufficient (both in terms of flexibility and risk sensitivity) to address the complex instruments, transactions, and technologies of the modern financial services marketplace. Accordingly, in 1999 the Basel Committee began publishing a modified approach to more accurately calculate risk and the capital which must be held against it (the "New Accord"). Substantial industry criticism of the 1999 proposal led to a new proposal in January 2001. Comments on aspects of the new proposal are due by October 31, 2001. The Basel Committee has indicated it will publish another comprehensive proposal in February 2002, with the New Accord to be finalized by the end of next year. To provide time to adjust to the requirements of the New Accord, each country’s bank regulators are not expected to make it effective until 2005.
The most recent version of the New Accord and its supporting material extends over several hundred pages. See, http://www.bis.org/publ/bcbsca.htm. Section II of this Alert summarizes principal tenets of the New Accord so that affected financial institutions, particularly large and international banking organizations, can comment and begin to prepare for its implementation. Section III highlights a proposal issued by US federal bank regulators to provide special capital treatment for the smaller institutions in the system. Finally, Section IV discusses certain other capital rules. As a general matter, it should be pointed out that the New Accord, as well as several capital proposals by US federal bank regulators, have been criticized as overly burdensome and capital intensive.
II. The New Accord
A.
Applicability.The New Accord will apply only to banks and, on a consolidated basis, to holding companies of entities that engage predominantly in banking. Accordingly, while the New Accord is expected to apply to BHCs and FHCs, it may not apply to holding companies that have only limited purpose banks as subsidiaries (although it will be relevant to those subsidiaries). However, it must be emphasized that the exact scope of the application of the New Accord has not yet been developed. In addition, while large institutions will be encouraged to comply with the New Accord, smaller institutions may have other alternatives, as discussed in Section III below.
B.
The Three Pillars of the New Accord.Whereas the current regime focuses solely on capital, the New Accord is comprised of three highly interdependent pillars: (1) the new capital standard itself ("Minimum Capital Requirements"); (2) an increased supervisory review of a bank’s internal assessment of its own capital adequacy ("Regulatory Supervisory Review Process"); and (3) additional public disclosure of bank risk profiles ("Market Discipline").
1. Minimum Capital Requirements
.The first pillar establishes a new risk weighting process for the risk capital calculation (i.e., the denominator). Notably, the New A ccord does not propose to modify the definition of eligible regulatory capital (i.e., the numerator of the risk capital calculation), the minimum benchmark for adequate risk-capital (8%, of which at least 4% must be Tier 1 capital) or, to a large extent, the current approach to market risk. Moreover, the current version of the New Accord recommends deducting from capital (1) investments in insurance subsidiaries, and (2) significant investments in commercial entities.
Credit Risk Alternative
s. The most fu ndamental change inherent in the New Accord is the approach to credit risk. The New Accord establishes three alternative approaches for evaluating credit risk, depending upon the demonstrable sophistication and systems of the institution: (1) Standardized; (2) Internal Ratings-Based ("IRB")-Foundation; and (3) IRB-Advanced. The Basel Committee notes that the Standardized approach is the closest to the current system and is the easiest to implement. However, the Basel Committee believes the more sophisticated, risk sensitive IRB approaches are more desirable, and the New Accord will contain capital incentives (i.e., less capital required for equivalent circumstances) and other incentives for institutions to seek the necessary regulatory approval to migrate toward the IRB-Foundation and, ultimately, IRB-Advanced approaches. Indeed, in an October 15, 2001 speech, FRB Governor Meyer stated that the Foundation approach is designed to address banks in the "early stages of developing their risk-management systems" and ultimately the regulators "expect virtually all [large complex banking organizations ("LCBOs")] to choose -- or to be induced to choose -- the Advanced approach." As to the size of the capital incentives, Governor Meyer further stated that if "the revised Standardized approach is calibrated to yield capital similar to that of the [1988] Accord and Advanced requirements are far below Standardized requirements, in the United States there may well be a very large reduction in capital requirements relative to today’s levels for the banking system as a whole." However, numerous industry commentators have expressed concern that the current version of the New Accord is too cautious and would impose inappropriately large total capital requirements.Standardized
. The Standardized approach to the minimum capital requirements largely relies on the risk bucket approach employed under the current system, but with greater risk differential (i.e., more buckets) and more reliance on third-party credit assessments to establish risk weights. The Standardized approach sets forth grids of credit risk weightings for various types of counterparties (e.g., governments, banks, and corporations), with the risk weightings increasing as the external ratings become more unfavorable. For example, under the current system, a 100% risk-weighting applies to virtually all claims (e.g., claims from a loan) against a corporation. Under the Standardized approach of the New Accord, generally a 20% risk weight would apply to claims against the highest rated (AAA to AA-) corporations, a 150% risk weight would apply to claims against the lowest rated corporations (below BB-), and a 100% risk weight would apply to unrated corporations. The current framework would largely be retained for off-balance sheet transactions.As to asset securitizations under the Standardized approach, originating and sponsoring banks generally would have to deduct "first-loss" credit enhancements from capital, and investor banks would apply varying risk weights depending upon external credit ratings (with deductions for unrated or very low rated (B+ or below) tranches). All securitizations would have to satisfy "clean break criteria," or a bank would be required to treat the securitized assets as if they were on-balance sheet exposures and hold capital accordingly.
The New Accord also emphasizes the use of credit risk mitigation ("CRM") techniques, such as collateral, obtaining credit derivatives or third-party guarantees, and netting, and permits a wider range o f collateral mitigants (such as highly rated corporate securities, certain mutual fund investments and Undertakings for Collective Investment in Transferable Securities) than the current approach. The Standardized approach permits two approaches to CRM, with a "simple approach" that largely uses the substitution approach of the current system and a "comprehensive approach" that places more burden on institutions to account for changes in the value of their exposures and collateral, but also permits the use of an even broader range of collateral. In response to industry comment, in September 2001 the Basel Committee eliminated a special additional capital charge set forth in the New Accord (the so-called w factor) that would have reflected the "residual ris ks" with CRM techniques (e.g ., imperfect guarantees), and instead made evaluation of such risks a component of the Regulatory Supervisory Review Process. Moreover, in response to industry comment, the September release also notes that, while its CRM techniques generally are applied on a transaction by transaction basis, the Basel Committee is considering providing more favorable treatment to master netting agreements with respect to repo-style transactions.
IRB-Foundation
. The IRB approach (including the Advanced approach discussed below) is the centerpiece of the New Accord. In contrast to the current system, or even the Standardized approach, under the IRB approach the minimum capital requirement would largely be based on a bank’s own internal assessment of each borrower’s creditworthiness. In other words, rather than relying on uniform supervisory risk buckets, the IRB approach provides a greater differentiation of risk weightings based upon the institution’s own internal assessments. Moreover, in response to industry comment, in June 2001 the Basel Committee announced that it "anticipates the need for reductions in the basic calibration of the foundation IRB approach."It must be emphasized, however, that an institution must obtain regulatory authority to use the IRB approach, and to obtain that authorization the institution must meet minimum supervisory requirements that demonstrate the rigor of its assessment. For example, as discussed in an October 2001 release with respect to asset securitizations, an institution would not be able to use only external ratings (as in the Standardized approach) to establish the appropriate risk weight, but also would have to have the capability to evaluate information about the securitized assets themselves. CRM techniques under the IRB-Foundation approach would be substantially similar to the Standardized approach.
The IRB approach functionally divides credit exposures into two separate frameworks: (1) corporation, bank, and sovereign exposures ("Framework One"); and (2) retail, specialized lending, and equity exposures ("Framework Two"). With respect to Framework One, under the IRB-Foundation approach, institutions must be able to effectively determine the probability of default ("PD") of each of their borrowers. Moreover, in addition to PD, credit risk depends on how much an institution will lose if a default occurs, which in turn depends on (1) the loss given the default ("LGD") of the borrower (which is expressed as a percentage of exposure), and the exposure to the borrower at the time of default ("EAD"). Under the IRB-Foundation approach, supervisory rules estimate the LGD and EAD in determining appropriate risk capital charges.
As to Framework Two, retail credit exposures are defined as consisting of homo geneous portfolios comprising a large number of low value loans with either a consumer or business focus (e.g ., credit cards and installment loans) and where the incremental risk of any single exposure is small. In contrast to the per entity exposures des cribed under Framework One, with retail credit exposures institutions would divide the exposures into various segments. As a result of the data banks have available to them, no "IRB-Foundation" approach is provided, but rather banks will be required to supply more of the PD, EAD, and LGD inputs. In October 2001, the Basel Committee first published guidance on the IRB approach to "specialized lending" (defined to address corporate exposures where the cash flow generated by the collateral, rather than the ongoing operations of the borrowers, is a loan’s principal source of repayment), which includes project finance, income-producing real estate, object finance, and commodities finance (collectively, "SL Exposures").
The October release declares that while institutions are able to order SL Exposures by level of risk, they are not generally able to engage in the same rigorous credit analysis as with the exposures contained in Framework One. As a result, in contrast to retail exposures, the October release anticipates that supervisory rules will initially provide more of the PD, LGD, and EAD components to determine risk capital charges for SL Exposures, with institutions providing more of these factors as their systems become more advanced.
Evidencing the particular importance of asset securitization to financial institutions, the Basel Committee dedicated a special publication on its IRB treatment (as well as the treatment of synthetic securitizations) of these transactions in October 2001. As a general matter, the Basel Committee is seeking to make the IRB approach revenue neutral so banks have neither an incentive nor a disincentive to engage in securitizations. The availability of external ratings and the amount of information the bank has about the securitized asset pool are primary determinants of IRB treatment. If an external rating is available and/or the bank does not have the information to calculate the IRB capital requirement for the underlying assets (KIRB), it must use the risk weights outlined in the issuance (ranging from 14% for an Aaa rating to 522% for a Ba3 rating, with tranches of ratings less than Ba3 deducted from regulatory capital). However, originating banks (but not investing banks) would still have to deduct rated positions when treating positions that fall below KIRB. The October release also provides a mechanism for "inferring" ratings for otherwise unrated tranches if a subordinate tranche in a pool has a rating. As to truly unrated securitizations, if a bank is able to calculate KIRB, then, while it would have to deduct tranches falling below KIRB, it would be able to rely on a supervisory formula for all positions above KIRB. Revolving securitizations (e.g., credit card receivables) receive special treatment.
IRB-Advanced
. In addition to PD, to be eligible for the IRB-Advanced approach, an institution must be able to demonstrate that it can calculate LGD, EAD, and/or treatment of guarantees/credit derivatives. While an institution would be eligible for advanced treatment when it has demonstrated the ability to calculate any one of these elements, supervisors will expect the bank to proceed to be able to calculate all components within a reasonably short period of time (perhaps pursuant to an implementation plan). As suggested above under the IRB-Foundation description, institutions with systems enabling them to obtain regulatory authorization to use the IRB-Advanced approach will be better able to use internal assessments to define capital requirements (e.g., with respect to credit exposure, CRM, and asset securitizations), which is anticipated to allow them to hold less capital than similarly situated institutions using the Standardized or IRB-Foundation approach. In this regard, discussing the benefits and burdens of this approach, FRB Governor Meyer noted in a speech on March 5, 2001 that "[b]anks using the [A]dvanced approach will have more freedom, but their methodologies for deriving loss given default statistics and effective exposures will be closely reviewed. In all cases, supervisors will require a rigorous analysis supporting their estimates, whether they are based on internal or vendor data."Operational Risk
. In addition to credit risk (as described above) and market risk, the New Accord would add a third component to the denominator of the risk-capital calculation--operational risk. A September 2001 Basel Committee publication narrowed the definition of operational risk from the January 2001 proposal to be "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events." Strategic and reputational risks are not included in the definition. Moreover, in light of industry criticism, the Basel Committee reduced the standard weight of operational risk from 20% of minimum regulatory capital to 12%. As with the risk capital measurements, varying levels of sophistication also exist with operational risk (Basic Indicator Approach, Standardized Approach, and Advanced Measurement Approaches), with incentives to move toward the more sophisticated approaches. FRB Governor Meyer has stated that regulators and the industry will work to develop by 2005 operational charges "better linked" to each bank.2. Regulatory Supervisory Review Process
.As stated above, whereas the current regime only provides minimum risk capital standards, the New Accord has two additional pillars. The second pillar is the Regulatory Supervisory Review Process, which is based on four principles.
Principle 1 is that "[b]anks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels." This requires oversight by an institution’s board and senior management, establishment of a capital assessment process, rigorous, looking forward stress-testing, and internal control review.
Principle 2 is that supervisors should review the processes described in Principle 1, and take appropriate action if they are not satisfied with that review.
Principle 3 is that supervisors should expect banks to operate above the regulatory capital minimums.
Finally, Principle 4 is that supervisors should intervene quickly if adequate capital is not maintained and require rapid remedial action (e.g ., restricting dividends or requiring a capital restoration plan). More generally, this element is intended to encourage institutions to establish a strong, internal control environment that uses risk management techniques to monitor and manage credit and operational risks.
3. Market Discipline
.The third pillar of the new Accord is Market Discipline, which the Basel Committee declares "imposes strong incentives on banks to conduct their business in a safe, sound, and effective manner" by making an institution’s risk and capital position more transparent to third parties. In response to industry criticism, in September 2001 the Basel Committee sought to substantially reduce the amount of public disclosure required in its January 2001 release, and also provide further clarification as to the disclosures required. Required disclosure includes detailed discussions about such topics as (1) capital; (2) the allocation of capital; and (3) risk exposure and assessment, including: credit risk exposures, both general and specific as to the credit risk alternative used by the institution, CRM techniques, asset securitizations, market risk, operational risk, and interest rate risk.
As to frequency, the Basel Committee declares that the detailed disclosures should generally be made at least semi-annually, with capital ratios discussed quarterly. Although the September 2001 release reduces disclosures, several commentators still believe that the required disclosures are too extensive.
III. Simpler Standards for Community Banks
.As described in detail in the November 7, 2000 Alert, the four US federal banking agencies also have issued an advance notice of proposed rulemaking ("ANPR") for a simpler capital framework for non-complex institutions (i.e., relatively small size and simple balance sheet). The ANPR seeks comment on a variety of approaches, including reliance on a combined leverage/risk-capital ratio, reliance solely on a leverage ratio, or use of a modified leverage ratio approach. However, the ANPR also states that the trade off for a simpler approach would likely be a slightly higher capital charge.
As FRB Governor Meyer stated in a March 15, 2001 speech, most commentators have indicated that they do not wish to pursue such a trade off, and thus "[r]emaining on the current standard (with or without some minor modifications) is an option we will need to consider for community banks. And we need to hear your views."
IV. Other Capital Rule
s. As discussed in the March 6, 2001 Alert, it should be highlighted that the US federal banking agencies proposed rules imposing Tier 1 capital charges on nonfinancial investments by banks and BHCs, with the capital charge increasing commensurately with the aggregate amount of these investments. The comment period on these proposals ended early this year, meaning that these agencies could implement those charges in the near future. Finally, the Basel Committee equalized the treatment of domestic and non-domestic government public sector entities.Conclusion
. The capital rules are varied, complex and evolving. However, given their fundamental importance, it is critical that management understand their possible application to its particular institution so that it can comment to seek to improve the rules’ ramifications, and prepare for their implementation.
The contents of this publication are intended for informational purposes only and should not be construed as legal advice or legal opinion, which can be rendered properly only when related to specific facts. This document may be considered advertising under rules of the Supreme Judicial Court of Massachusetts.
© Goodwin Procter LLP 2001
