• Bank/Thrift Regulatory Agencies Propose Optional Framework for Risk Based Capital Regulations
  • August 11, 2008
  • Law Firm: Kilpatrick Stockton LLP - Atlanta Office
  • The Office of the Comptroller of the Currency, Federal Reserve Board, Federal Deposit Insurance Corporation and Office of Thrift Supervision (the “Agencies”) recently issued a Notice of Proposed Rulemaking (“NPR”) that would establish an optional framework for most banks, savings associations and bank holding companies to calculate their risk-based capital ratios. The optional framework would join the final rule adopted in December, 2007, generally applicable to banking organizations with consolidated total assets of $250 billion or greater, in implementing the BASEL II Accord of 2004. The NPR represents the second attempt of the Agencies to implement BASEL II as to smaller institutions replacing an earlier proposal which had been withdrawn.

    The expressed goal of the optional risk-based capital framework is to increase the risk sensitivity of the capital requirement. It is also intended to address complaints that banking organizations with consolidated total assets of $250 billion or greater may have a competitive advantage over smaller institutions through the applicability of the more risk sensitive BASEL II capital framework now applicable to them if smaller institutions do not have a similar framework. The NPR would not modify how a banking organization calculates its leverage ratio and would not affect capital classifications and regulatory responses under the prompt corrective action regulations. As is the case now, the Agencies would retain the authority to require additional capital in individual cases depending upon the circumstances.

    A qualifying banking organization could use the optional framework by providing its primary federal regulator with notice of its intention at least 60 days before the beginning of the calendar quarter in which it would start to use the optional framework. It could switch back to the existing risk-based framework by providing a similar notice. However, the NPR indicates that the Agencies do not expect banking organizations to alternate between the optional and existing frameworks. The Agencies would retain general authority to disallow or require use of the optional framework in individual circumstances. Whichever approach is chosen would generally apply to both a holding company (excluding savings and loan holding companies, which are not subject to risk-based capital requirements) and subsidiary institutions within the organization, although the Agencies would allow for exceptional situations where an organization could receive approval to use both approaches within the organization.

    The optional framework would maintain the same minimum risk-based capital ratios and the existing framework and the elements of tier 1 and tier 2 capital would not change. However, additional deductions from capital, such as for after tax gains on sales resulting from securitizations, would be implemented. Consequently, the optional framework would have a different definition of tier 1, tier 2 and total capital from the existing framework.

    The optional framework would change the calculation of certain risk weights, particularly securitizations and equity exposures. It would expand the ability to use external ratings by qualifying ratings organizations to determine risk weights for various items. The types of financial collateral and guarantors eligible to mitigate risk-weightings would be broadened. The number of risk categories would be significantly increased. For example, the risk-weights for first-lien 1- to 4-family mortgages would range from 20% to 150% depending upon loan-to-value ratio. Junior lien mortgage exposure would also be weighted, based on loan- to-value ratio, on a scale of 75% to 150%. Mortgages and other loans that are 90 days or more past due or on nonaccrual would be subject to an additional risk weighting.

    The proposed rule would also risk weight exposures from securitizations, primarily based on external ratings. Off-balance sheet items would be converted to their on-balance sheet credit equivalent, as with the existing framework, but certain of the credit conversion factors would be modified. Unlike the existing framework, the optional framework would contain a capital charge for organizational risk. Risk weighting for operational risk would be equal to 15% of average positive annual gross income over the previous three years multiplied by 12.5.

    The existing framework only requires the disclosure of capital information in the quarterly financial reports that are filed with the Agencies. However, the optional framework would require enhanced public disclosures of capital and other financial information. The disclosures are intended to recognize the importance of market discipline in encouraging sound risk management practices and fostering financial stability. Generally, the top tier legal entity of a banking organization would be required to adopt a formal disclosure policy that addresses the organization’s public financial disclosures, including the associated internal controls and review procedures. In particular, the NPR encourages that the disclosure be made in one place on the banking organization’s website. The NPR notes that some of the contemplated disclosure could be fulfilled by relying on disclosures based on GAAP or applicable Securities Exchange Commission requirements.