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The New Basel III Definition of Capital: Understanding the Deductions for Investments in Unconsolidated Financial Institutions

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The New Basel III Definition of Capital: Understanding the Deductions for Investments in Unconsolidated Financial Institutions The New Basel III Definition of Capital: Understanding the Deductions for Investments in Unconsolidated Financial Institutions n July 9, 2013, the FDIC Board of Directors approved Background on Basel III Othe Basel III interim final rule (new capital rule or rule). The An important goal of the new capital new capital rule, which takes effect rule is to strengthen the definition of for community banks in January regulatory capital to ensure it consists 2015, is intended to strengthen the of elements that can absorb loss. Begin- quality and increase the required ning with the Call Report dated March level of regulatory capital in order to 31, 2015, community banks will report promote a more stable and resilient a new regulatory capital measure, banking system.1 This article is part common equity tier 1 (CET1), which of the FDIC’s effort to provide techni- is limited to capital elements of the cal assistance to community banks highest quality. Some banks may have on the new capital rule. It focuses other capital elements such as noncu- on a specific aspect of the rule that mulative perpetual preferred stock; changes the treatment for certain these, if any, may be recognized as capital investments that community “additional tier 1 capital,” which when banks may hold: the deductions from added to CET1 equals tier 1 capital. regulatory capital for investments in Finally, a bank’s total regulatory capi- the capital instruments of unconsoli- tal may also include certain tier 2 dated financial institutions. elements (see Table 1). Table 1 – Components of Regulatory Capital Common Equity tier Composed of common stock and surplus, retained earnings, accu- 1 capital (CET1) mulated other comprehensive income (unless an opt-out is chosen*) and qualifying minority interest Additional tier 1 Noncumulative perpetual preferred stock and related surplus, and Tier 1 capital capital qualifying minority interest Total capital Tier 2 capital Subordinated debt, qualifying minority interest, limited amounts of gains on available-for-sale equity securities, and the allowable portion of the allowance for loan and lease losses *All banks, other than advanced approaches banks, are given a one-time irrevocable option to continue to treat certain accumulated other comprehensive income (AOCI) components as they are treated under the current general risk-based capital rules. The AOCI opt-out election must be made on the Call Report filed as of March 31, 2015. 1 The rule, which is substantively identical to the rule issued by the Federal Reserve and the Office of the Comp- troller of the Currency, is described in FIL-31-2013. Additional resources are available at http://www.fdic.gov/ regulations/capital/index.html. 27 Supervisory Insights Winter 2013 New Basel III Definition of Capital continued from pg. 27 The new rule includes a series of The Call Report instructions will adjustments and deductions to arrive also be available to walk banks step at the final value of reported CET1 by step through these calculations. used to meet the regulatory capital It is expected that the once a bank requirements (see Table 2). Some has identified its investments that are adjustments and deductions are subject to the threshold deductions (if straightforward and longstanding, such any), the calculation of those deduc- as the deduction of goodwill. Others tions and applicable transitions will be are conceptually straightforward but performed within Call Report software. new. For example, certain types of It should also be noted that the exam- deferred tax assets are automatically ples in this article involve relatively deducted, and all intangible assets are large capital deductions and a rela- deducted except a limited amount of tively large proportion of additional tier mortgage servicing assets. In addition, 1 capital within the example bank’s tier there are threshold deductions, which 1 capital. The amounts in the examples are new and not quite as straightfor- are to help explain the calculations ward. The remainder of this article and are not viewed as representative of will describe the threshold deduc- typical banks. tions and work through an extended example to demonstrate the deduction calculations. Table 2 – Regulatory Capital Deductions and Adjustments Deduction or Common Items for Community Banks* Adjustment Regulatory Capital Goodwill Deductions from CET1 capital Intangible assets (other than mortgage servicing assets (MSAs)) Deferred Tax Assets (DTAs) that arise from Net Operating Losses and tax credit carryforwards Regulatory Adjust- Unrealized Gains and Losses included in Accumulated Other Comprehen- ments to CET1 sive Income (if the opt-out election is not chosen) capital Threshold Deduc- Non-significant investments in the capital of unconsolidated financial insti- tions to CET1 capital tutions exceeding 10% of the bank’s CET1, after regulatory capital deduc- tions and adjustments Items subject to the 10% and 15% CET1 capital deduction thresholds: DTAs arising from temporary differences that could not be realized through net operating loss carrybacks MSAs Significant investments in the capital of unconsolidated financial institu- tions in the form of common stock * This chart does not include all the deductions or adjustments a community bank may be required to make and only includes a few of the more common deductions or adjustments for illustrative purposes. See 12 CFR § 324.22(a)-(d) for a complete list of items subject to deduction or adjustment. 28 Supervisory Insights Winter 2013 Reasons for these threshold B. What is the definition of a deductions financial institution? First and foremost, the purpose of If certain investments in financial the threshold deductions for invest- institutions are to be deducted, the ments in financial institutions is to first question must be, for what types limit the double counting of capital of financial institutions? The answer in the financial system. When banks is in the definition of financial institu- invest in capital instruments of other tion in the Basel III regulation, which financial institutions, problems at determines whether any of a bank’s one institution can directly affect the capital investments may be subject financial health of other banks invest- to the threshold deductions. In brief, ing in its capital instruments. A good “financial institutions” include banks example is the losses some banks (including bankers’ banks), bank experienced on their investments in holding companies, savings and loan collateralized debt obligations (CDOs) holding companies, and other insti- of trust preferred securities of other tutions cited in the definition. For banking organizations. This type of purposes of the threshold deductions, interdependence among banks can financial institutions do not include exacerbate a financial crisis. government-sponsored enterprises (for example, Federal Home Loan Banks), small business investment compa- A. What is the starting point nies, community development finan- for the threshold deductions? cial institutions, mutual funds, and employee benefit plans. If a bank has investments in the capi- tal instruments of a financial institu- The definition also includes a tion, then these investments may be predominantly engaged test as a subject to the threshold deductions. catch-all for types of financial institu- The threshold deductions are made to tions not expressly listed. Investments CET1 after regulatory capital deduc- in the capital instruments of such tions and regulatory adjustments (see companies would also be subject to the the first two panels of Table 2). threshold deduction. If a community bank owns more than 10 percent of a potential unconsolidated financial institution’s common stock, the bank would have to apply this test. 29 Supervisory Insights Winter 2013 New Basel III Definition of Capital continued from pg. 29 perpetual preferred stock owned by C. What is the amount of my the bank also would be considered a investment? significant investment. Once a bank determines it has an A non-significant investment in investment in the capital instrument the capital of an unconsolidated of an unconsolidated financial institu- financial institution refers to all tion, it must determine the amount of investments in the capital instru- the investment. A bank may have such ments of an unconsolidated financial an investment through either a direct, institution where the bank owns 10 indirect, or synthetic exposure (see percent or less of the common stock Table 3). of the unconsolidated financial insti- tution (including situations in which the bank owns no common stock). For example, if a bank only owns D. Is my investment significant noncumulative perpetual preferred or non-significant? stock in an unconsolidated financial institution, its investment is non- The bank needs to determine significant regardless of the amount whether its investment is significant or of preferred stock owned. non-significant as this directly affects the calculation of the deduction: Banks must evaluate investments in the capital instruments of each A significant investment in the capi- unconsolidated financial institution to tal of an unconsolidated financial which they are exposed to determine institution refers to all investments whether the exposure is significant or in the capital instruments of an non-significant. Once this analysis is unconsolidated financial institution completed, the resulting significant and where the bank owns more than 10 non-significant investments are aggre- percent
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