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Commercial Bank Examination Manual, Section 3000

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Commercial Bank Examination Manual, Section 3000 3000—CAPITAL, EARNINGS, LIQUIDITY, AND SENSITIVITY TO MARKET RISK The 3000 series of sections address the super- asset quality (see the 2000 series major head- visory assessment of a state member bank’s ing), the CELS components represent the key Capital, Earnings, Liquidity, and Sensitivity to areas that examiners review in assessing the market risk (CELS). In addition to the review of overall financial condition of the bank. Commercial Bank Examination Manual May 2021 Page 1 Assessment of Capital Adequacy Effective date November 2020 Section 3000.1 PURPOSE OF CAPITAL financial crisis by helping to ensure that the banking system is better able to absorb losses Although both bankers and bank regulators look and continue to lend in future periods of eco- carefully at the quality of bank assets and nomic stress. In addition, Regulation Q imple- management and at the ability of the bank to ments certain federal laws related to capital control costs, evaluate risks, and maintain proper requirements and international regulatory capi- liquidity, capital adequacy is the area that trig- tal standards adopted by the Basel Committee gers the most supervisory action, especially in on Banking Supervision (BCBS). view of the prompt-corrective-action (PCA) pro- vision of section 38 of the Federal Deposit Applicability of Regulation Q Insurance Act (FDIA), 12 U.S.C. 1831o. The primary function of capital is to fund the bank’s Regulation Q applies on a consolidated basis to operations, act as a cushion to absorb unantici- every Board-regulated institution (referred to as pated losses and declines in asset values that a “banking organization” in this section) that is may otherwise lead to material bank distress or failure, and provide protection to uninsured • a state member bank; depositors and debt holders if the bank were to • a bank holding company (BHC) domiciled in be placed in receivership. A bank’s solvency the United States that is not subject to 12 CFR promotes public confidence in the bank and the part 225, appendix C,2 or banking system as a whole by providing contin- • a covered savings and loan holding company ued assurance that the bank will continue to (SLHC) domiciled in the United States. honor its obligations and provide banking ser- vices. By exposing stockholders to a larger Regulation Q does not apply to SLHCs sub- percentage of any potential loss, higher capital stantially engaged in insurance underwriting or levels reduce the subsidy provided to banks by commercial activities, or to SLHCs that are the federal safety net. insurance underwriting companies. Capital regulation is particularly important because deposit insurance and other elements of Components of Capital the federal safety net provide banks with an incentive to increase their leverage beyond what Regulation Q provides a definition of capital and the market—in the absence of depositor a framework for calculating risk-weighted assets protection—would permit. Additionally, banks’ higher capital levels can reduce the need for certain supervisory activities, thereby lowering “Frequently Asked Questions on the Regulatory Capital Rule” the regulatory burden on supervised institutions. and the “New Capital Rule: Community Bank Guide” (July 2013). 2. 12 CFR part 225, appendix C is the “Small Bank Holding Company and Savings and Loan Holding Company Policy Statement,” and it applies to BHCs with pro forma OVERVIEW OF REGULATION Q consolidated assets of less than $3 billion that (1) are not (12 CFR Part 217) engaged in significant nonbanking activities either directly or through a nonbank subsidiary; (2) do not conduct significant In 2013, the Federal Reserve Board, the Federal off-balance-sheet activities (including securitization and asset management or administration) either directly or through a Deposit Insurance Corporation (FDIC), and the nonbank subsidiary; and (3) do not have a material amount of Office of the Comptroller of the Currency (OCC) debt or equity securities outstanding (other than trust preferred (collectively the agencies) adopted a rule replac- securities) that are registered with the Securities and Exchange ing their general risk-based capital require- Commission. The Board may, in its discretion, exclude any BHC, regardless of asset size, from the policy statement if ments, advanced approaches capital require- such action is warranted for supervisory purposes. With some ments, market risk capital requirements, and exceptions, the policy statement applies to SLHCs as if they leverage capital requirements.1 The Federal were BHCs. See the Bank Holding Company Supervision Reserve’s capital rule, Regulation Q, addresses Manual for more information on the Small Bank Holding Company and Savings and Loan Holding Company Policy weaknesses highlighted during the 2008–09 Statement. The Board may, by order, apply any or all of Regulation Q to any BHC, based on an institution’s asset size, 1. See 12 CFR part 217 (Regulation Q). For more infor- level of complexity, risk profile, scope of operations, or mation on the implementation of Regulation Q, see SR-15-6, financial condition. Commercial Bank Examination Manual November 2020 Page 1 3000.1 Assessment of Capital Adequacy by assigning assets and off-balance-sheet items Additional Tier 1 Capital to broad categories of credit risk. A banking organization’s risk-based capital ratio is calcu- Additional tier 1 capital includes instruments lated by dividing its qualifying capital (the that satisfy the criteria set forth in Regulation Q numerator of the ratio) by its risk-weighted (12 CFR 217.20(c)). Additional tier 1 capital assets (the denominator). A summary of the also includes surplus related to the issuance of components of qualifying capital is outlined additional tier 1 capital instruments, and limited below, as are the procedures for calculating amounts of tier 1 minority interest that are not risk-weighted assets. For more comprehensive included in a banking organization’s common information on the definition of capital and risk equity tier 1 capital, less applicable regulatory weighted assets, see the Federal Reserve’s Regu- adjustments and deductions. The eligibility cri- lation Q. teria for additional tier 1 capital instruments are The risk-based capital requirements of Regu- designed to ensure that additional tier 1 capital lation Q are designed to be sensitive to differ- instruments would be available to absorb losses ences in credit-risk profiles among banking on a going-concern basis. Given the strict crite- organizations; factor off-balance-sheet expo- ria, in the United States the only instrument sures into the assessment of capital adequacy; includable in additional tier 1 capital is non- minimize disincentives to holding liquid, low- cumulative perpetual preferred stock. Cumula- risk assets; and achieve consistency in the evalu- tive preferred stock and trust preferred securities ation of the capital adequacy of major banking are generally not included in additional tier 1 organizations worldwide. capital. The three components of regulatory capital are (1) common equity tier 1 capital, (2) addi- tional tier 1 capital, and (3) tier 2 capital. Tier 2 Capital Tier 2 capital consists of instruments that satisfy Common Equity Tier 1 Capital the criteria set forth in Regulation Q (12 CFR 217.20(d)). Tier 2 capital also includes Common equity tier 1 capital is defined as the surplus related to the issuance of tier 2 capital sum of a banking organization’s outstanding instruments; limited amounts of total capital common equity tier 1 capital instruments that minority interest not included in a banking satisfy the criteria set forth in Regulation Q (12 organization’s tier 1 capital; and limited amounts CFR 217.20(b)). Common equity tier 1 capital of the allowance for loan and lease losses represents the highest-quality and most loss (ALLL),3 or adjusted allowances for credit losses absorbing form of capital. The criteria for com- (AACL),4 as applicable, less applicable regula- mon equity tier 1 capital are designed to ensure that common equity tier 1 capital is available to 3. ALLL means valuation allowances that have been estab- absorb losses as they occur and that common lished through a charge against earnings to cover estimated equity tier 1 instruments do not possess features credit losses on loans, lease financing receivables, or other that would cause a banking organization’s con- extensions of credit as determined in accordance with GAAP. dition to weaken further during periods of eco- ALLL excludes “allocated transfer risk reserves.” For pur- poses of Regulation Q, ALLL includes allowances that have nomic and market stress. Common equity tier 1 been established through a charge against earnings to cover capital is primarily composed of common stock estimated credit losses associated with off-balance-sheet credit and retained earnings, plus limited amounts of exposures as determined in accordance with GAAP. minority interest in the form of common stock, 4. AACL means, with respect to a Board-regulated insti- tution that has adopted current expected credit losses (CECL) less certain regulatory adjustments and deduc- methodology, valuation allowances that have been established tions (e.g., goodwill). through a charge against earnings or retained earnings for Under the standardized approach of Regula- expected credit losses on financial assets measured at amor- tion Q, banking organizations are not required to tized cost and a lessor’s net investment in leases that have been established to reduce the
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