Sullivan & Cromwell discusses Bank Capital Plans and Stress Tests

On July 17, the Board of Governors of the Federal Reserve System (the “FRB”) released a notice of proposed rulemaking (the “NPR” and the rules set forth therein, the “Proposed Rule”) that would modify certain aspects of the FRB’s capital plan rule (the “Capital Plan Rule”)[1] and Dodd-Frank Act stress test rules (the “DFAST Stress Test Rules”)[2] applicable to large bank holding companies (“BHCs”)[3] and certain banking organizations with total consolidated assets of more than $10 billion. The NPR would also affect elements of the FRB’s supervisory Comprehensive Capital Analysis and Review (“CCAR”) process. The proposed changes would apply beginning with the 2016 capital planning and stress testing cycles, and include:

  • Suspension of incorporation of the advanced approaches for capital plan and stress test purposes: For advanced approaches banking organizations that must calculate their minimum regulatory capital requirements using both the standardized and advanced approaches, the Proposed Rule would delay “until further notice” the use of the advanced approaches for calculating risk-based capital requirements for purposes of the capital plan and stress testing framework. Responding to industry concerns that incorporating the advanced approaches into stress testing “would require significant resources and introduce complexity and opacity,” the FRB is proposing to delay this requirement, pending a “broader review” of the interaction of the Capital Plan and DFAST Stress Test Rules with the regulatory capital rules.
  • Elimination of Tier 1 common ratio calculation and minimum requirement: The 2013 revisions to the U.S. regulatory capital rules[4] include a new minimum common equity tier 1 (“CET1”) capital requirement of 4.5 percent of risk-weighted assets. This CET1 ratio requirement was fully phased in as of January 1, 2015, making the 2016 capital plan and stress test cycle the first cycle for which banking organizations will be fully subject to the CET1 ratio. The CET1 ratio requirement is generally expected to be more binding on subject banking organizations than the former tier 1 common ratio under the severely adverse scenario. As a result, the Proposed Rule would eliminate the requirement that a banking organization demonstrate its ability to also maintain a pro forma tier 1 common capital ratio of 5 percent of risk-weighted assets under baseline and stressed scenarios.
  • Delayed implementation of the S. supplementary leverage ratio (“SLR”) requirement: The SLR applies only to advanced approaches banking organizations and becomes effective as a minimum capital requirement on January 1, 2018. The Proposed Rule would delay the incorporation of the SLR into the capital plan and stress testing framework for one year. As a result, subject banking organizations would not be required to include an estimate of the SLR for capital plan and stress test cycle beginning on January 1, 2016. This change is proposed to provide additional time for subject banking organizations to develop the systems necessary to project the SLR in light of the October 2014 revisions to the Capital Plan and DFAST Stress Test Rules, which changed the commencement date of the capital plan and stress test cycles and would otherwise have required the inclusion of SLR estimates for the ninth quarter of the 2016 capital planning and stress testing horizon.
  • Modification of capital action assumptions: The DFAST Stress Test Rules currently require large BHCs (that is, those with consolidated total assets of $50 billion or more) to assume that they do not issue capital or redeem instruments in the second through ninth quarters of the planning horizon. However, (i) the October 2014 revisions to the Capital Plan and Stress Test Rules provided an exception to this assumption for issuances related to employee compensation, and (ii) assumptions relating to business plan changes require large BHCs to project the effects of any planned mergers or acquisitions in balance sheet projections. To better align the capital action assumptions with these provisions, the Proposed Rule would (x) make a technical change to require a firm to assume that it pays dividends equal to the quarterly average dollar amount of common stock dividends that the company paid in the previous year on any issuance of stock related to expensed employee compensation, and (y) permit a large BHC to assume that it issues capital associated with funding a planned acquisition to the extent it is required to include an assumption in its balance sheet projections regarding such planned acquisition.
  • Elimination of fixed dividend payment assumptions: The Proposed Rule would eliminate the fixed dividend payment assumptions for BHCs with more than $10 billion but less than $50 billion of consolidated assets and savings and loan holding companies (“SLHCs”) with total consolidated assets of more than $10 billion. The DFAST Stress Test Rules currently require subject BHCs and SLHCs to make the same capital action assumptions in their stress tests that apply to large BHCs by assuming that they (i) maintain their common stock dividend at a steady rate over the planning horizon, (ii) continue payments on other regulatory capital instruments at their stated dividend rate, and (iii) do not repurchase or issue shares during each of the second through ninth quarters of the planning horizon. The Proposed Rule would eliminate the requirement to incorporate fixed assumptions regarding dividends in stress tests for BHCs with total consolidated assets of more than $10 billion but less than $50 billion and SLHCs with total consolidated assets of more than $10 billion, instead requiring these banking organizations to incorporate their own dividend payment assumptions consistent with internal capital needs and projections. However, the Proposed Rule would maintain the required assumption that there will be no repurchases, redemptions or issuances of regulatory capital instruments.

Notably, the NPR states that the FRB does not anticipate any further changes that would impact the 2016 capital plan and stress test cycle beyond those outlined therein. As such, capital buffers (including the GSIB capital surcharge buffer)[5] will not be incorporated into CCAR for the 2016 cycle. The FRB continues to consider “a broad range of issues” related to the capital plan and stress testing framework—including their interaction with other elements of the capital rules—and it would propose any further changes in a separate rulemaking that would take effect no earlier than the 2017 cycle. In addition, in his opening remarks on the final rule implementing the GSIB capital surcharge buffer on July 20, Governor Tarullo indicated that the FRB “will need to consider whether and, if so, how to incorporate the surcharges into the post-stress minimum capital levels required in [CCAR].”

Furthermore, the Proposed Rule would also delay, for one stress test cycle, the company-run stress test requirement for SLHCs with total consolidated assets of more than $10 billion, making the requirement applicable for the first time beginning on January 1, 2017. This change is being proposed to reinstate the originally intended transition period for these SLHCs in light of the October 2014 revisions to the DFAST Stress Test Rules that effectively shortened the transition period from the original two years to one year.

Finally, the NPR also includes technical amendments to the Capital Plan and DFAST Stress Test Rules meant to incorporate changes related to other rulemakings, most notably by (i) amending the definition of minimum regulatory capital ratios to replace references to the risk-based capital rules in 12 C.F.R. part 225 (which are no longer operative as of January 1, 2015) with references to the revised risk-based capital rules in 12 C.F.R. part 217, and (ii) to incorporate the deduction of aggregate investments in covered funds from tier 1 capital as required under the Volcker Rule,[6] which is not currently reflected in the regulatory text of 12 C.F.R. part 217.

Comments on the Proposed Rule must be received by the FRB on or before September 24, 2015.

ENDNOTES

[1]           12 C.F.R. § 225.8. For a discussion of the Capital Plan Rule and related stress test requirements for large BHCs, see our memorandum to clients, Bank Capital Plans: Federal Reserve Board Issues Final Rule Regarding Capital Plan and Formal Stress Test Requirements for Certain Large Bank Holding Companies (Nov. 29, 2011), available at https://www.sullcrom.com/Bank-Capital-Plans-11-29-2011/. For a discussion of the requirements and expectations for capital planning for large BHCs, see our memoranda to clients, Bank Capital Plans: Federal Reserve Board Issues Guidance Outlining Supervisory Expectations for Capital Planning at Large Bank Holding Companies and Bank Capital Plans (Sept. 11, 2013), available at https://www.sullcrom.com/Bank-Capital-Plans, and Bank Capital Plans and Stress Tests: Federal Reserve Issues Instructions and Guidance for the 2015 Comprehensive Capital Analysis and Review Program (Oct. 29, 2014), available at https://sullcrom.com/bank-capital-plans-and-stress-tests-10-29-2014.

[2]           12 C.F.R. § 252, Subparts B, E and F. For a discussion of the Stress Test Rules of the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (together, the “Agencies”) and certain actions taken by the Agencies following approval of their final Stress Test Rules, see our memoranda to clients, Stress Test Rules: Federal Banking Agencies Publish Final Stress Test Rules on Supervisory and Company-Run Stress Test Requirements Imposed by Dodd-Frank (Oct. 26, 2012), available at http://www.sullcrom.com/Stress_Test_Rules/, and Dodd-Frank Stress Tests: Federal Banking Agencies Propose Company-Run Stress Test Data Reporting Templates and Related Documentation for Financial Institutions with Over $10 Billion but Less Than $50 Billion in Assets (Apr. 19, 2013), available at http://www.sullcrom.com/Dodd-Frank-Stress-Tests.

[3]           Bank holding companies with total consolidated assets of $50 billion or more. The changes in the NPR would also apply to nonbank financial companies supervised by the FRB that ultimately become subject to the capital planning and stress test requirements, as well as to U.S. intermediate holding companies of foreign banking organizations in accordance with the transition provisions of the final rule incorporating enhanced prudential standards for U.S. bank holding companies and foreign banking organizations with total consolidated assets of $50 billion or more. (79 FR 17240 (March 27, 2014)).

[4]           The 2013 revised risk-based regulatory capital rules are codified at 12 C.F.R. part 217. For a discussion of the revised capital rules, see our memorandum to clients, Bank Capital Rules: Federal Reserve Board Approves Final Rules Addressing Basel III Implementation and, for All Banks, Substantial Revisions to Basel I-Based Rules (Jul. 3, 2013), available at https://sullcrom.com/Bank_Capital_Rules_Basel_III_7_3_13.

[5]           Capital “buffers” were implemented as part of the Basel III-based revised regulatory capital rules now codified at 12 C.F.R. part 217. The FRB adopted a final rule implementing a capital surcharge “buffer” applicable to global systemically important BHCs (“GSIBs”) on July 20, 2015.

[6]           See 12 C.F.R. § 248.10(b).

The preceding post comes to us from Sullivan & Cromwell LLP and is based on their recent memo that was published on July 22, 2015, and is available here.