On November 21, 2018, the Federal Reserve, Office of Comptroller of the Currency and the FDIC jointly published a notice of proposed rulemaking (the “NPR”) to provide an alternative capital system for qualifying banking organizations.  Specifically, the regulators have proposed a new, alternative, simplified capital regime for qualifying institutions that will deem an institution to be well-capitalized so long as it maintains a leverage ratio of at least 9% and adequately capitalized so long as it maintains a leverage ratio of at least 7.5%.

The NPR seeks to implement the community bank leverage ratio (CBLR) mandated by Section 201 of the Economic Growth, Regulatory Relief and Consumer Protection Act (“EGRRCPA”).  EGRRCPA requires the regulatory agencies to develop a CBLR of not less than 8 percent and not more than 10 percent for qualifying community banking organizations, and provides that organizations that meet such CBLR will deemed well capitalized for all purposes.  EGRRCPA further provides that a qualifying community banking organization to be a depository institution or depository institution holding company with total consolidated assets of less than $10 billion.

Summary of the NPR

The NPR establishes five criteria for an depository institution or holding company to be deemed a Qualifying Community Banking Organization:

  • Total consolidated assets of less than $10 billion;
  • Total off-balance sheet exposures of 25% or less of total consolidated assets;
  • Total trading assets and trading liabilities of 5% or less of total consolidated assets;
  • MSAs of 25% or less of CBLR tangible equity; and
  • Temporary difference DTAs of 25% or less of CBLR tangible equity.

Under the NPR, the numerator of the CBLR would be CBLR tangible equity.  CBLR tangible equity would be equal to total equity capital, determined in accordance with Call Report or Form Y-9C instructions, prior to including any minority interests, less (i) accumulated other comprehensive income (AOCI), (ii) all intangible assets (other than MSAs) including goodwill and core deposit intangibles, and (iii) DTA’s arising from net operating loss and tax credit carryforwards.

The CBLR denominator would be average total consolidated assets, calculated in accordance with Call Report or Form Y-9C instructions, less the items deducted from the CBLR numerator, except AOCI.  The NPR notes that the calculation is similar to the one used in determining the denominator of the tier 1 leverage ratio.

Under the NPR, a Qualifying Community Banking Organization may elect to use the CBLR framework at any time, so long as it has a CBLR greater than 9% at the time of the election.  Under the CBLR framework, the Qualifying Community Banking Organization will be considered well capitalized so long as it has a CBLR greater than 9%. A qualifying depository institution that previously elected to use the CBLR framework but has fallen below 9% will not be required to convert back to the regular capital system.  Instead, the following CBLR leves will serve as proxies for the PCA categories:

  • Adequately Capitalized – CBLR of 7.5% or greater;
  • Undercapitalized – CBLR of less than 7.5%; and
  • Significantly Undercapitalized – CBLR of less than 6%.

The framework for Critically Undercapitalized would remain unchanged at a ratio of tangible equity to total assets of 2% or below.  Any institution that would be deemed Significantly Undercapitalized under the CBLR framework would be required to promptly provide its appropriate regulators sufficient information to calculate the PCA tangible equity ratio.

If an institution ceases to be a Qualifying Community Banking Organization (generally by growing above $10 billion in consolidated assets), the institution will generally be provided two quarters to begin reporting under the traditional capital ratio framework.

Only a Proposed Rule

The NPR is exactly that… a notice of proposed rulemaking.  While institutions should consider the impact of the NPR if adopted on their respective institutions, and certainly consider commenting if the NPR contains either particularly advantageous or disadvantageous provisions, we would not recommend locking in a longer term strategy based on the NPR.  We suspect at least certain provisions will be modified significantly prior to adoption.

A Voluntary Framework

As established by the NPR, the CBLR framework is completely voluntary.  To the extent their are provisions of the CBLR that negatively affect a particular institution’s situation, that institution will remain free to remain in the current capital framework.  Moreover, the NPR contemplates that institutions will be free to move in and out of the CBLR framework without restriction (other than having to have a greater than 9% CBLR at the time of any election into the framework).  The NPR contemplates that such changes will be rare and typically driven by a change in business activities, but that flexibility is warranted. The regulators would expect, however, an institution opting out of the CBLR framework to be able to provide a rationale for doing so.

Could Impact a Lot of Banks

The NPR indicates there were 5,408 insured depository institutions and 4,261 holding companies with less than $10 billion in assets.  However, the number of holding companies directly impacted will be significantly less. As noted in the NPR, more than 95% of such holding companies will not be subject to the capital rule because they have less than $3 billion in total consolidated assets and otherwise meet the criteria under the Federal Reserve’s small bank holding company policy statement.  The NPR provides than 151 holding companies had total assets between $3 and $10 billion.

The NPR indicates that approximately 83% of potentially eligible depository institutions and 56% of the affected holding companies would both (i) satisfy the requirements to be a Qualifying Community Banking Organization and (ii) satisfy the proposed 9% CBLR to be deemed well-capitalized.

Not Just for Highly Capitalized Qualifying Banks

While EGRRCPA, and the legislative history and proposals that preceded it, contemplated that the community bank leverage ratio framework would only be available to highly capitalized institutions, the NPR takes a different approach.  While a CBLR of more than 9% is necessary to elect into the CBLR framework, once in, the CBLR framework offers a complete alternative framework for institutions under $10 billion. This would eliminate the risk of needing to re-implement potentially burdensome capital ratio calculations at a time of economic stress for the institution.  It also provides the potential to fundamentally alter (or at least create a parallel system) the capital rules for all smaller institutions.

Elimination of Risk Weighting

Although not discussed in the NPR, one of the more significant impacts of the CBLR framework would be the elimination of risk weighting of the bank assets.  We suspect that most institutions that exceed a 9% CBLR would also easily exceed the various risk weighted capital ratios, but the elimination of the need to calculate those ratios would still be a welcome relief.

The CBLR framework’s elimination of risk-weighted capital ratios could also have substantive benefits to the qualifying institutions, including the elimination of the effects (and limitations imposed by) the HVCRE rules, and also potentially provide a structural pricing advantage on higher risk-weighted loans, at least based on cost of capital constructs.

Elimination of Tier 1/Tier 2 Requirements

The NPR acknowledges that, prior to 2012, the capital rules required that voting common stock be the “dominant” form of tier 1 capital and that banking organizations should avoid “undue reliance” on nonvoting equity and preferred stock.  (Note: we’ve generally found the regulators have continued these expectations since 2012, notwithstanding that they’re no longer found in the regulations.) The NPR also acknowledges that cumulative perpetual preferred stock have generally not qualified as tier 1 capital.

However, “consistent with the intention to maintain a simple definition of CBLR tangible equity,” the NPR does not include such restrictions and is intended to provide more flexibility with respect to the types of capital instruments that could qualify for CBLR tangible equity.

Assuming the NPR is adopted as proposed, the impact of this elimination is uncertain.  Regulators may still, based on safety and soundness concerns, assert implicit or explicit preferences for certain terms.  However, the ability to have greater flexibility in capital terms could provide for some creative alternatives to the traditional reliance on voting common stock.  To the extent an institution already qualifies under the small bank holding company policy statement, this freedom is arguably already present, but we have generally seen minimal use of such flexibility.

Another Nail in Trust Preferred Securities?

Under the existing instructions for Form FR Y-9C, subordinated notes payable to unconsolidated trusts issuing trust preferred securities, and trust preferred securities issued by consolidated special purpose entities, are each entered as liabilities on Schedule HC.   As such, trust preferred securities would not be included within the definition of CBLR tangible equity, notwithstanding their grandfathered tier 1 treatment for institutions under $15 billion in total assets.

For institutions under $3 billion, the small bank holding company policy statement would make this distinction irrelevant.  However, for those institutions between $3 billion and $10 billion with trust preferred securities, the elimination of capital treatment for such securities could be a fatal omission for electing the CBLR framework.  Given the debate over the need to preserve tier 1 capital treatment in connection with the passage of Dodd-Frank (and the Collins Amendment to preserve such treatment for institutions under $15 billion), this is one area of the NPR that may certainly draw further comment.

SubDebt Market Impacted?

Although not as dramatic as the impact on trust preferred securities (where they go from tier 1 treatment to debt), the CBLR framework may also impact the tier 2 subordinated note market.  Under the existing capital ratio frameworks, subordinated notes can be a cost efficient means for institutions to raise tier 2 (and total) capital, particularly for compliance with the risk-weighted capital ratios.  While many of these institutions qualify under the small bank holding company policy statement already (and thus tier 2 treatment isn’t required), as larger institutions look towards a CBLR framework future, the market for such subordinated notes may fundamentally change.