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This week The Institutional Risk Analyst is on the road. We were in Merriville, IN last night to give a talk entitled "A New Deal for the American Economy." The well-attended event was sponsored by the School of Business at Indiana State University and City Securities in Indianapolis. Tomorrow the IRA is traveling to Washington, D.C. to participate in a roundtable sponsored by the Federal Reserve Board to talk about implementing the provisions of Dodd-Frank that deal with rating agencies. Click here �to read our written comment on the ANPR OCC-2010-0016.
This week we republish�an�article written by our friend Linda Lowell which was published last month�in Housing Wire magazine.� Linda one of the few members of the media who actually understands structured finance, a fact that is probably attributable to her several decades of work as an analyst in this sector of Wall Street. Next week, we'll be providing a blow-by-blow analysis of the discussion at the Fed regarding the role of rating agencies in the financial markets.
While many observers correctly noted the increase in the powers of the Fed as the result of Dodd-Frank, few have bothered to notice the even greater increase in the regulatory powers of the FDIC. Linda's article is just one reminder that if you are not a subscriber to Housing Wire, you are missing the point when it comes to many aspects of mortgage banking and�origination, servicing and REO disposal.
The FDIC ambushes the Fed, and gains a beachhead in Basel: How a little-noticed amendment in the Dodd-Frank financial reform legislation might put the FDIC into the regulatory driver's seat
Housing Wire�
By Linda Lowell
I should write about Basel III rulemaking. By the time this column overflows onto your desk, the Committee should have digested a round of comments on amendments approved last July. By the time you read this, they will likely be preparing the final package of international bank capital and liquidity reforms, complete with design and calibration, just in time for the November 2010 G20 leaders summit in Seoul.
The subject does have mild entertainment value: the proposals contain some potential stink bombs from the banking industry's point of view, and a couple of pills (more or less bitter) depending on an institution's jurisdiction. Some contentious issues here have banks leaning in public and private on their regulators, and their regulators pushing for their national interests in the Committee.
Messing with mortgage servicing rights, and other new standards
For instance, a global liquidity standard has raised a flurry of speculation that it could cut margins and transform bank balance sheets by tilting investment preference from loans and less liquid securities towards highly-liquid, highest-quality securities, like U.S. Treasuries.
I detailed this standard in a previous column, along with a roundup of research analyzing its potential impact. The buzz it aroused is exemplified by a late June report from Barclays Capital MBS analysts, who called it the "real regulatory reform." In fact, "while fixed income investors parse through the final version of the financial reform bill," Barclays contended, the slower-moving Basel liquidity rules might ultimately be more important for securitized asset markets.
Then there are the capital reforms in Basel III. They do not alter the Basel II model-bound Advanced Approach (which lowered capital levels just as the disaster began to unfold) or the Standard Approach tying risk weights to too-often bogus rating agency credit quality assessments. Instead, among other things, the Committee has honed in on capital quality, tightening the definition of qualifying capital instruments.
Most annoying - for U.S. banks, at least - the July amendments would limit the amount of mortgage servicing rights that can be included in the calculation of capital to just 10% of common equity (they currently go up to 50%). Press reports have put the price tag for U.S. banks with massive mortgage banking businesses in the billions of dollars.
This provision only impinges on U.S. banks, too, as mortgage servicing rights exist only in America. Other countries do not issue residential mortgages at a premium, trading securities and placing chunks of the price premium and excess interest into lenders' pockets.. But banks in other countries - notably Japan - do get a hickey from a 10% limit on deferred tax assets. The July amendments would also limit unconsolidated investments in more than 10% of the issued shares of financial institutions.
The July amendments also finally put a number on the minimum Tier 1 leverage ratio promised in the December 2009 Consultative Document (ur-Basel III): 3%. Further details regarding calibration and calculation were provided as well.
In many of Basel's constituent jurisdictions, a floor on leverage is anathema, so there's bound to be a battle. Indeed, if you read on, you will see that Sheila Bair - chairman of the Federal Deposit Insurance Corporation and U.S. banking's own Joan of Arc - has already moved to the ramparts to support the rule. But it is how she did it that is the real story here.
Dodd-Frank, and the Collins Amendment
Attending to the Basel rulemaking process is like watching paint dry. So while all the Basel watchers parse amendments to consultative documents, we are going to deconstruct a real coup on home turf: the culmination of years of struggle by the FDIC to protect the insurance fund from the Fed's efforts to dilute (in the FDIC's view) bank capital requirements.
What follows is a magnificent end run around the entire fractious bank regulatory apparatus and the heavily lobbied Congressional leadership, in which the ball is passed to the one lawmaker Democrats couldn't say no to, moderate Senator Susan Collins (R-ME).
That ball was a couple of pages of capital provisions horse-traded into the Dodd-Frank Act known as the Collins Amendment. It is said by knowledgeable banking lawyers to have been originally drafted by the Federal Deposit Insurance Corporation staff. Regardless, these few pages embody views that chairman Sheila Bair has been expressing in speeches and testimony ever since she first took office.
The Collins Amendment is designed to impose the same leverage and risk-based capital requirements applied to insured banks upon the bank holding companies and systemically non-bank financial companies regulated by the Federal Reserve. It also requires that bank holding companies calculate leverage and risk-based capital using the regulatory capital components defined for insured institutions. The effect is to eliminate the use of trust preferred securities (TruPS), previously approved by regulation for inclusion in Tier 1 capital by bank holding companies (BHC).
Why? Here's how Bair explained it January 14, 2010 before the Financial Crisis Inquiry Commission: "BHC capital requirements are less stringent, qualitatively and quantitatively, than those applied to insured banks. For instance, bank holding companies may include TruPS and subordinated debt as regulatory Tier 1 capital. As a result of such differences, certain large bank holding companies had significantly more leverage on a consolidated basis than is permitted banks themselves."
Bair ventured that the policy rationale for this inequity was a belief that holding companies did not enjoy an explicit federal safety net.
But, clearly, the financial crisis of 2007 and 2008 has proven otherwise. As Bair noted in a May 7, 2010 letter supporting the amendment, insured subsidiary banks became "a source of support both to the holding companies and holding company affiliates. Far from being a source of strength to banks as Congress intended, holding companies became a source of weakness requiring federal support."
So, via the Collins Amendment, FDIC rules now apply to the Fed's big fish.
The best part is that these requirements overlap Basel III, a source of no little consternation for the U.S. regulators who thought they led the charge in the international arena and led at against home in implementing international accords. (They also overlap the regulatory scope of the newly established Financial Stability Oversight Council, chaired by the Secretary of the Treasury, but let's let that pungent prospect simmer for future discussion.)
Dodd-Frank Act, Section 171
The Collins Amendment requires federal banking regulators to establish minimum leverage capital and risk-based capital requirements on a consolidated basis across the board for insured depositories, depository institution holding companies and nonbank financial companies supervised by the Fed (as newly-authorized by the Dodd-Frank Act). It also applies to certain BHC subsidiaries of foreign banking organizations.
Two floors are set:
* Not "less than the generally applicable" requirements for leverage capital and risk-based capital
* Not "quantitatively lower than the generally applicable" requirements that were in effect at the date of enactment
Generally applicable requirements are defined as those already set by the agencies (under the Prompt Corrective Action regulations implementing section 38 of the FDIC) "regardless of total consolidated asset size or foreign financial exposure."
The emphatic italics are mine, as that phrase sweeps in some twenty of the largest and internationally active institutions for which model-based advanced Basel II risk-based capital rules were intended, and also which - had the rules been fully implemented in the U.S. - would have rewarded them with significantly slashed capital requirements for using black boxes to quantify risk exposures.
They have not yet been implemented, largely because the FDIC insisted, when it capitulated to the adoption of advanced Basel II rules in 2007, on a very slow transition process. On more than one occasion since, the FDIC's Bair has credited the agency's stubbornness with preserving U.S. banking system capital during the extreme stresses of 2008 and 2009.
In effect, the Collins Amendment precludes the possibility of any international banking regulation accords - be it Basel II, Basel III, Basel to the Future - of lowering capital requirements for U.S. banks below levels established under authorities that date to the resolution of the thrift and bank crises of the 1980s.
Generally applicable?
What are those "generally applicable" requirements in the Collins Amendment?
To understand these words means understanding some of the basic regulatory framework for banking. For example, to be considered "well capitalized," an insured depository must hold at least 6% of risk-weighted assets in Tier 1 capital components, and 10% in total Tier 1 and Tier 2 combined. To be "adequately capitalized," those%ages fall to 4% and 8% respectively.
Additionally, the minimum leverage ratio (Tier 1 capital divided by average total assets) is currently 3% for institutions not anticipating or experiencing significant growth, having well-diversified risk (and other qualifications), and rated number one under the CAMELS rating system. Otherwise, to be considered well capitalized, that ratio moves to 5%, and adequately capitalized at 4%.
The Collins Amendment goes further. It calls on the banking agencies to develop requirements that reflect banking activities that pose risks not only to the institution, but also to other public and private stakeholders. Those rules would address such activities as:
Significant volumes of activity in derivatives, securitized products purchased and sold, financial guarantees purchased and sold, securities borrowing and lending, and repurchase agreements and reverse repurchase agreements Concentrations in assets for which the values presented in financial reports are based on models rather than historical cost or prices deriving from deep and liquid two-way markets
Concentrations in market share for any activity that would substantially disrupt financial markets if the institution were forced to unexpectedly cease the activity
The rationale for this change, again, can be found in Bair's January 14 testimony. She reminded the FCIC that, in the mid-1990s, the Basel Committee introduced capital requirements for banks' trading activities that "were generally much lower than the requirements for traditional lending, under the theory that banks' trading-book exposures were liquid, marked-to-market, mostly hedged, and could be liquidated at close to their market values within a short interval - for example, 10 days".
These market risk rules opened the door to regulatory arbitrage as institutions shifted assets from loans to trading assets, including a growing amount of instruments that were not marked-to-market but "marked-to-model." Many of these positions proved to be so complex, opaque and illiquid that they could not be sold quickly without a loss. Write-downs of trading assets in late 2007 and through 2008 weakened the capital positions of some large commercial and investment banks.
Who could forget the ensuing credit freeze? The smell of panic on the breeze?
Thou shalt not leverage
Bair has been firm in support of retaining the U.S. leverage requirement and promulgating it internationally, almost from the moment she was confirmed as chairman in June 2006 (picking up her predecessor, Donald Powell's opposition to advanced approaches).
In October 2006, at a meeting of the Basel Committee in Merida, Mexico, she put a leverage standard on the committee's agenda. The gesture received a chilly reception and only slight coverage from the financial press.
The reception to Bair's notion of bank capital shifted, however, as the financial crisis unfolded. In February 2008, speaking to the Global Association of Risk Professionals, she cited a "Lex" column in the Financial Times observing that some of the largest European banks had tangible capital ratios as low as 1%. She quoted Lex to her audience: "Right now, many investors want Basel 0" and noted that the column ended with a call on regulators to adopt the U.S. style "back-to-basics" reliance on several capital metrics.
"Dare I," Bair proclaimed, "revive my call for an international leverage ratio?"
That call is an actual proposal now, of course, with a long, long deadline and ratification still pending in November. On July 22, Bloomberg reporter Yalman Onaran, punning on "Bair's leverage," noted how far the world had come since Merida. Indeed, committee chairman (and president of the Dutch central bank) Nout Wellink himself reminded the committee of Bair's 2006 speech and acknowledged attitudes toward a leverage requirement had reversed.
Bair is not resting on those laurels. She is campaigning hard against calls to water down Basel III reforms before they are ratified later this year. In an August 23, 2010, Financial Times article she wrote at length against claims by some industry representatives that stronger capital requirements would raise the cost of borrowing and stifle the recovery.
One trade group, for instance, has argued that capital reforms will raise the cost of loans in industrialized countries by an average of 132 basis points, resulting in a loss of 3.1% in gross domestic product and 9.7 million jobs between 2011 and 2015. Bair counters with studies - from Harvard and Chicago University economists - that raising capital requirements by even 10%age points would raise the cost of capital by just 25 to 35 basis points. She also has pointed to a separate study from the Bank for International Settlements that suggests GDP would be dinged by no more than 0.3% over four years. Finally, the Basel Committee's own study anticipates long run benefits from capital reforms in terms of global economic output.
The difference between the pro and con studies? For one thing, Bair says the negative studies ignore the fact that debt holders demand compensation for the extra risk in more thinly capitalized institutions, a crucial fact that should significantly equalize the relative cost of equity versus debt. Second, the cons ignore costs (i.e., taxpayer bailouts) when risks are borne by the government and not the shareholders. Finally, they ignore the ultimate costs of oversupplying property markets and misallocating capital during leverage-fed booms.
There is more? There is TruPS?
Plucking TruPS out of BHC Tier 1 capital marked a victory in an even older conflict between the FDIC and the Federal Reserve. Trust preferred securities (TruPS) are a product of financial engineering with characteristics of both debt and equity - hence the label "hybrid" used by Bair and others to refer to them. They are structured securities, too. The sponsor (a bank holding company) creates a special-purpose vehicle (a business trust, hence "trust preferred"), to which it issues junior subordinated debt. Simultaneously, the subsidiary issues common stock to its parent, and preferred stock to investors (the preferred sale funding the sub debt purchase).
To the moralists engendered by the financial crisis, TruPS will appear to be a quintessential example of a structured product up to no good. Accounting professor Anne Beatty (in an academic paper "Do Accounting Changes Affect the Economic Behavior of Financial Firms?" October 17, 2005) turned up a 2002 Wall Street Journal article, "How the Treasury Department Lost A Battle Against a Dubious Security," that reports TruPS were invented in 1993 by Goldman Sacks to provide an "irresistible combination" of debt and equity.
"For the tax man, it resembled a loan, so that interest payments could be deducted from taxable income," the Journal story said. "For shareholders and rating agencies, who look askance at overleveraged companies, it resembled equity."
In October 1996, the Federal Reserve Board made it possible for bank holding companies to include TruPS in Tier 1 capital, something the FDIC did not allow for regulated depositories. The financing vehicle took off. According to Todd Eveson and John Schramm ("Bank Holding Company Trust Preferred Securities: Recent Developments," February 25, 2007), within a year, nearly 100 bank holding companies had issued TruPS, and by December 31, 1999 approximately $31 billion were outstanding.
Beatty notes that two accounting changes in 2003 eliminated the structure's accounting advantages: SFAS 150 required reclassification of mandatorily redeemable capital securities, such as TruPS, from equity to liability. Dividends on the preferred stock, previously classified as a noninterest expense, were required to be treated as an interest expense. Secondly, FIN 46R, which became effective December 31, 2003, required the deconsolidation of trusts that issued trust-preferred securities. Leverage provided by the vehicles was no longer concealed by an accounting sleight-of-hand.
Tax and regulatory capital treatment was unaffected, though, by the accounting changes. Furthermore, the advent of pooling in collateralized debt obligations and private placement TruPS issues opened the market to smaller BHCs. According to a report by the Federal Research Bank of Philadelphia, at the end of 2008, almost 1,400 companies had approximately $148.8 billion in outstanding TruPS.
TruPS were a win-win while the banking industry was expanding from 2000 to 2006. BHCs used the proceeds from TruPS to fund mergers and acquisitions, support growth in subsidiary banks with capital contributions, repurchase common stock and reduce the overall cost of capital.
However, when a BHC or its subsidiary bank's financial condition (especially capital levels) deteriorates, the amount of TruPS that can be included in regulatory capital declines, accelerating the ratio's downward trend. When the rules changed to include goodwill in core capital as of Q1 2009, this problem was exacerbated for BHCs that had made acquisitions and have significant amounts of goodwill.
It is debt, not equity
The FDIC has long opposed counting TruPS toward regulatory capital requirements. In 2004, the Federal Reserve issued a proposed rule for comment that would retain Tier 1 treatment for TruPS, but subject them to tighter standards and stricter quantitative limits.
At the time it adopted the rule in March 2005, the Fed admitted that of the 38 comments received, only one (from the FDIC) opposed continuing the treatment - primarily on the grounds that instruments accounted as liabilities under generally accepted accounting principals should not be included in Tier 1 capital.
Such reasoning may carry more weight now, but at the time the Fed rejected the FDIC's arguments. "The Board does not believe that the change in GAAP accounting for trust preferred securities has changed the prudential characteristics that led the Board in 1996 to include trust preferred securities in the Tier 1 capital of BHCs," the Fed said at the time. "In arriving at this decision, the Board also considered its generally positive supervisory experience with trust-preferred securities, domestic and international competitive equity issues, and supervisory concerns with alternative tax-efficient instruments."
The market for dubious TruPS effectively collapsed in 2008 with the financial crisis. Likewise, the market for CDOs of TruPS evaporated. The Philly Fed's research found that only 48 TruPS issues amounting to $19.2 billion were completed in 2008, compared to 210 deals for $40.5 billion in 2007.
And this market will not likely have a second life. The Collins Amendment should nail the coffin shut on this market.
Banks have time, however, to replace their TruPS with more substantial capital. For TruPS issued before May 19, 2010, there is a three-year phase-out period, beginning January 2013, to allow institutions to replace their TruPS with qualifying Tier 1 regulatory capital. Subsidiaries of foreign banks would have a five-year transition period. Finally, BHCs that are not mutual holding companies (e.g. savings banks) or have less than $15 billion of total consolidated assets as of year-end 2009 are exempt.
In your face, big boys
It will not surprise fans of extreme regulatory infighting that the Treasury and Fed did their utmost to kill the Collins amendment. Or so the Wall Street Journal and American Banker reported.
Said Damian Paletta in a May 19 Journal story, "Practically, it sets into law standards for how much capital large bank holding companies should be required to hold, upending precedent that gives wide discretion to regulators to set those standards."
"Regulators," in this case, would be the Fed. According to Paletta, government officials and bankers were "scurrying" to "try to have [the amendment] stripped out." Opponents were so shocked it was voted into the Senate package, in fact, that some believed the Senate simply didn't understand what it meant. Edward Yingling, president and CEO of the American Bankers Association, argued, "I don't believe that the senators understood the full implications of this amendment. It would cause a severe capital crunch for many banks, resulting in the major decrease in lending capability."
Sen. Collins has said Treasury Secretary Timothy Geithner asked her to change the amendment. But, said Collins, Bair had convinced her that it addressed the root cause of the financial crisis. She was standing pat.
A week later, Donna Borak wrote in American Banker that the battle over the Collins amendment resulted from a "long-standing feud" between the two regulators. Plain and simple, the FDIC does not believe TruPS absorb losses. Jason Cave, deputy for supervision issues, pointed to last year's stress tests as proof.
Although one of Borak's sources suggested the Fed, founder of the TruPS feast, never admitted to a mistake, its substantive complaint was apparently that the amendment undermined its ability to negotiate Basel III with international regulators. What this means is that the Committee had already proposed eliminating TruPS from Tier 1 capital last year, and by capitulating this year, the Fed hoped to extract other concessions (such as maybe a higher limit on MSRs included in capital calculations?).
Now that Bair - oops, I mean Collins - has butt in, that strategy is no longer available.
The Treasury, in the meantime, was coming around. According to Borak, Michael Barr, assistant secretary for financial institutions, told reporters in late May, "we" share the goal of the Collins Amendment 100%. Given the importance of Sen. Collins to moving the Senate's reform legislation to the floor for a vote, one can imagine the Treasury sucked it up - bitter though it was.
Questions? Comments?info@institutionalriskanalytics.com
This week we republish�an�article written by our friend Linda Lowell which was published last month�in Housing Wire magazine.� Linda one of the few members of the media who actually understands structured finance, a fact that is probably attributable to her several decades of work as an analyst in this sector of Wall Street. Next week, we'll be providing a blow-by-blow analysis of the discussion at the Fed regarding the role of rating agencies in the financial markets.
While many observers correctly noted the increase in the powers of the Fed as the result of Dodd-Frank, few have bothered to notice the even greater increase in the regulatory powers of the FDIC. Linda's article is just one reminder that if you are not a subscriber to Housing Wire, you are missing the point when it comes to many aspects of mortgage banking and�origination, servicing and REO disposal.
The FDIC ambushes the Fed, and gains a beachhead in Basel: How a little-noticed amendment in the Dodd-Frank financial reform legislation might put the FDIC into the regulatory driver's seat
Housing Wire�
By Linda Lowell
I should write about Basel III rulemaking. By the time this column overflows onto your desk, the Committee should have digested a round of comments on amendments approved last July. By the time you read this, they will likely be preparing the final package of international bank capital and liquidity reforms, complete with design and calibration, just in time for the November 2010 G20 leaders summit in Seoul.
The subject does have mild entertainment value: the proposals contain some potential stink bombs from the banking industry's point of view, and a couple of pills (more or less bitter) depending on an institution's jurisdiction. Some contentious issues here have banks leaning in public and private on their regulators, and their regulators pushing for their national interests in the Committee.
Messing with mortgage servicing rights, and other new standards
For instance, a global liquidity standard has raised a flurry of speculation that it could cut margins and transform bank balance sheets by tilting investment preference from loans and less liquid securities towards highly-liquid, highest-quality securities, like U.S. Treasuries.
I detailed this standard in a previous column, along with a roundup of research analyzing its potential impact. The buzz it aroused is exemplified by a late June report from Barclays Capital MBS analysts, who called it the "real regulatory reform." In fact, "while fixed income investors parse through the final version of the financial reform bill," Barclays contended, the slower-moving Basel liquidity rules might ultimately be more important for securitized asset markets.
Then there are the capital reforms in Basel III. They do not alter the Basel II model-bound Advanced Approach (which lowered capital levels just as the disaster began to unfold) or the Standard Approach tying risk weights to too-often bogus rating agency credit quality assessments. Instead, among other things, the Committee has honed in on capital quality, tightening the definition of qualifying capital instruments.
Most annoying - for U.S. banks, at least - the July amendments would limit the amount of mortgage servicing rights that can be included in the calculation of capital to just 10% of common equity (they currently go up to 50%). Press reports have put the price tag for U.S. banks with massive mortgage banking businesses in the billions of dollars.
This provision only impinges on U.S. banks, too, as mortgage servicing rights exist only in America. Other countries do not issue residential mortgages at a premium, trading securities and placing chunks of the price premium and excess interest into lenders' pockets.. But banks in other countries - notably Japan - do get a hickey from a 10% limit on deferred tax assets. The July amendments would also limit unconsolidated investments in more than 10% of the issued shares of financial institutions.
The July amendments also finally put a number on the minimum Tier 1 leverage ratio promised in the December 2009 Consultative Document (ur-Basel III): 3%. Further details regarding calibration and calculation were provided as well.
In many of Basel's constituent jurisdictions, a floor on leverage is anathema, so there's bound to be a battle. Indeed, if you read on, you will see that Sheila Bair - chairman of the Federal Deposit Insurance Corporation and U.S. banking's own Joan of Arc - has already moved to the ramparts to support the rule. But it is how she did it that is the real story here.
Dodd-Frank, and the Collins Amendment
Attending to the Basel rulemaking process is like watching paint dry. So while all the Basel watchers parse amendments to consultative documents, we are going to deconstruct a real coup on home turf: the culmination of years of struggle by the FDIC to protect the insurance fund from the Fed's efforts to dilute (in the FDIC's view) bank capital requirements.
What follows is a magnificent end run around the entire fractious bank regulatory apparatus and the heavily lobbied Congressional leadership, in which the ball is passed to the one lawmaker Democrats couldn't say no to, moderate Senator Susan Collins (R-ME).
That ball was a couple of pages of capital provisions horse-traded into the Dodd-Frank Act known as the Collins Amendment. It is said by knowledgeable banking lawyers to have been originally drafted by the Federal Deposit Insurance Corporation staff. Regardless, these few pages embody views that chairman Sheila Bair has been expressing in speeches and testimony ever since she first took office.
The Collins Amendment is designed to impose the same leverage and risk-based capital requirements applied to insured banks upon the bank holding companies and systemically non-bank financial companies regulated by the Federal Reserve. It also requires that bank holding companies calculate leverage and risk-based capital using the regulatory capital components defined for insured institutions. The effect is to eliminate the use of trust preferred securities (TruPS), previously approved by regulation for inclusion in Tier 1 capital by bank holding companies (BHC).
Why? Here's how Bair explained it January 14, 2010 before the Financial Crisis Inquiry Commission: "BHC capital requirements are less stringent, qualitatively and quantitatively, than those applied to insured banks. For instance, bank holding companies may include TruPS and subordinated debt as regulatory Tier 1 capital. As a result of such differences, certain large bank holding companies had significantly more leverage on a consolidated basis than is permitted banks themselves."
Bair ventured that the policy rationale for this inequity was a belief that holding companies did not enjoy an explicit federal safety net.
But, clearly, the financial crisis of 2007 and 2008 has proven otherwise. As Bair noted in a May 7, 2010 letter supporting the amendment, insured subsidiary banks became "a source of support both to the holding companies and holding company affiliates. Far from being a source of strength to banks as Congress intended, holding companies became a source of weakness requiring federal support."
So, via the Collins Amendment, FDIC rules now apply to the Fed's big fish.
The best part is that these requirements overlap Basel III, a source of no little consternation for the U.S. regulators who thought they led the charge in the international arena and led at against home in implementing international accords. (They also overlap the regulatory scope of the newly established Financial Stability Oversight Council, chaired by the Secretary of the Treasury, but let's let that pungent prospect simmer for future discussion.)
Dodd-Frank Act, Section 171
The Collins Amendment requires federal banking regulators to establish minimum leverage capital and risk-based capital requirements on a consolidated basis across the board for insured depositories, depository institution holding companies and nonbank financial companies supervised by the Fed (as newly-authorized by the Dodd-Frank Act). It also applies to certain BHC subsidiaries of foreign banking organizations.
Two floors are set:
* Not "less than the generally applicable" requirements for leverage capital and risk-based capital
* Not "quantitatively lower than the generally applicable" requirements that were in effect at the date of enactment
Generally applicable requirements are defined as those already set by the agencies (under the Prompt Corrective Action regulations implementing section 38 of the FDIC) "regardless of total consolidated asset size or foreign financial exposure."
The emphatic italics are mine, as that phrase sweeps in some twenty of the largest and internationally active institutions for which model-based advanced Basel II risk-based capital rules were intended, and also which - had the rules been fully implemented in the U.S. - would have rewarded them with significantly slashed capital requirements for using black boxes to quantify risk exposures.
They have not yet been implemented, largely because the FDIC insisted, when it capitulated to the adoption of advanced Basel II rules in 2007, on a very slow transition process. On more than one occasion since, the FDIC's Bair has credited the agency's stubbornness with preserving U.S. banking system capital during the extreme stresses of 2008 and 2009.
In effect, the Collins Amendment precludes the possibility of any international banking regulation accords - be it Basel II, Basel III, Basel to the Future - of lowering capital requirements for U.S. banks below levels established under authorities that date to the resolution of the thrift and bank crises of the 1980s.
Generally applicable?
What are those "generally applicable" requirements in the Collins Amendment?
To understand these words means understanding some of the basic regulatory framework for banking. For example, to be considered "well capitalized," an insured depository must hold at least 6% of risk-weighted assets in Tier 1 capital components, and 10% in total Tier 1 and Tier 2 combined. To be "adequately capitalized," those%ages fall to 4% and 8% respectively.
Additionally, the minimum leverage ratio (Tier 1 capital divided by average total assets) is currently 3% for institutions not anticipating or experiencing significant growth, having well-diversified risk (and other qualifications), and rated number one under the CAMELS rating system. Otherwise, to be considered well capitalized, that ratio moves to 5%, and adequately capitalized at 4%.
The Collins Amendment goes further. It calls on the banking agencies to develop requirements that reflect banking activities that pose risks not only to the institution, but also to other public and private stakeholders. Those rules would address such activities as:
Significant volumes of activity in derivatives, securitized products purchased and sold, financial guarantees purchased and sold, securities borrowing and lending, and repurchase agreements and reverse repurchase agreements Concentrations in assets for which the values presented in financial reports are based on models rather than historical cost or prices deriving from deep and liquid two-way markets
Concentrations in market share for any activity that would substantially disrupt financial markets if the institution were forced to unexpectedly cease the activity
The rationale for this change, again, can be found in Bair's January 14 testimony. She reminded the FCIC that, in the mid-1990s, the Basel Committee introduced capital requirements for banks' trading activities that "were generally much lower than the requirements for traditional lending, under the theory that banks' trading-book exposures were liquid, marked-to-market, mostly hedged, and could be liquidated at close to their market values within a short interval - for example, 10 days".
These market risk rules opened the door to regulatory arbitrage as institutions shifted assets from loans to trading assets, including a growing amount of instruments that were not marked-to-market but "marked-to-model." Many of these positions proved to be so complex, opaque and illiquid that they could not be sold quickly without a loss. Write-downs of trading assets in late 2007 and through 2008 weakened the capital positions of some large commercial and investment banks.
Who could forget the ensuing credit freeze? The smell of panic on the breeze?
Thou shalt not leverage
Bair has been firm in support of retaining the U.S. leverage requirement and promulgating it internationally, almost from the moment she was confirmed as chairman in June 2006 (picking up her predecessor, Donald Powell's opposition to advanced approaches).
In October 2006, at a meeting of the Basel Committee in Merida, Mexico, she put a leverage standard on the committee's agenda. The gesture received a chilly reception and only slight coverage from the financial press.
The reception to Bair's notion of bank capital shifted, however, as the financial crisis unfolded. In February 2008, speaking to the Global Association of Risk Professionals, she cited a "Lex" column in the Financial Times observing that some of the largest European banks had tangible capital ratios as low as 1%. She quoted Lex to her audience: "Right now, many investors want Basel 0" and noted that the column ended with a call on regulators to adopt the U.S. style "back-to-basics" reliance on several capital metrics.
"Dare I," Bair proclaimed, "revive my call for an international leverage ratio?"
That call is an actual proposal now, of course, with a long, long deadline and ratification still pending in November. On July 22, Bloomberg reporter Yalman Onaran, punning on "Bair's leverage," noted how far the world had come since Merida. Indeed, committee chairman (and president of the Dutch central bank) Nout Wellink himself reminded the committee of Bair's 2006 speech and acknowledged attitudes toward a leverage requirement had reversed.
Bair is not resting on those laurels. She is campaigning hard against calls to water down Basel III reforms before they are ratified later this year. In an August 23, 2010, Financial Times article she wrote at length against claims by some industry representatives that stronger capital requirements would raise the cost of borrowing and stifle the recovery.
One trade group, for instance, has argued that capital reforms will raise the cost of loans in industrialized countries by an average of 132 basis points, resulting in a loss of 3.1% in gross domestic product and 9.7 million jobs between 2011 and 2015. Bair counters with studies - from Harvard and Chicago University economists - that raising capital requirements by even 10%age points would raise the cost of capital by just 25 to 35 basis points. She also has pointed to a separate study from the Bank for International Settlements that suggests GDP would be dinged by no more than 0.3% over four years. Finally, the Basel Committee's own study anticipates long run benefits from capital reforms in terms of global economic output.
The difference between the pro and con studies? For one thing, Bair says the negative studies ignore the fact that debt holders demand compensation for the extra risk in more thinly capitalized institutions, a crucial fact that should significantly equalize the relative cost of equity versus debt. Second, the cons ignore costs (i.e., taxpayer bailouts) when risks are borne by the government and not the shareholders. Finally, they ignore the ultimate costs of oversupplying property markets and misallocating capital during leverage-fed booms.
There is more? There is TruPS?
Plucking TruPS out of BHC Tier 1 capital marked a victory in an even older conflict between the FDIC and the Federal Reserve. Trust preferred securities (TruPS) are a product of financial engineering with characteristics of both debt and equity - hence the label "hybrid" used by Bair and others to refer to them. They are structured securities, too. The sponsor (a bank holding company) creates a special-purpose vehicle (a business trust, hence "trust preferred"), to which it issues junior subordinated debt. Simultaneously, the subsidiary issues common stock to its parent, and preferred stock to investors (the preferred sale funding the sub debt purchase).
To the moralists engendered by the financial crisis, TruPS will appear to be a quintessential example of a structured product up to no good. Accounting professor Anne Beatty (in an academic paper "Do Accounting Changes Affect the Economic Behavior of Financial Firms?" October 17, 2005) turned up a 2002 Wall Street Journal article, "How the Treasury Department Lost A Battle Against a Dubious Security," that reports TruPS were invented in 1993 by Goldman Sacks to provide an "irresistible combination" of debt and equity.
"For the tax man, it resembled a loan, so that interest payments could be deducted from taxable income," the Journal story said. "For shareholders and rating agencies, who look askance at overleveraged companies, it resembled equity."
In October 1996, the Federal Reserve Board made it possible for bank holding companies to include TruPS in Tier 1 capital, something the FDIC did not allow for regulated depositories. The financing vehicle took off. According to Todd Eveson and John Schramm ("Bank Holding Company Trust Preferred Securities: Recent Developments," February 25, 2007), within a year, nearly 100 bank holding companies had issued TruPS, and by December 31, 1999 approximately $31 billion were outstanding.
Beatty notes that two accounting changes in 2003 eliminated the structure's accounting advantages: SFAS 150 required reclassification of mandatorily redeemable capital securities, such as TruPS, from equity to liability. Dividends on the preferred stock, previously classified as a noninterest expense, were required to be treated as an interest expense. Secondly, FIN 46R, which became effective December 31, 2003, required the deconsolidation of trusts that issued trust-preferred securities. Leverage provided by the vehicles was no longer concealed by an accounting sleight-of-hand.
Tax and regulatory capital treatment was unaffected, though, by the accounting changes. Furthermore, the advent of pooling in collateralized debt obligations and private placement TruPS issues opened the market to smaller BHCs. According to a report by the Federal Research Bank of Philadelphia, at the end of 2008, almost 1,400 companies had approximately $148.8 billion in outstanding TruPS.
TruPS were a win-win while the banking industry was expanding from 2000 to 2006. BHCs used the proceeds from TruPS to fund mergers and acquisitions, support growth in subsidiary banks with capital contributions, repurchase common stock and reduce the overall cost of capital.
However, when a BHC or its subsidiary bank's financial condition (especially capital levels) deteriorates, the amount of TruPS that can be included in regulatory capital declines, accelerating the ratio's downward trend. When the rules changed to include goodwill in core capital as of Q1 2009, this problem was exacerbated for BHCs that had made acquisitions and have significant amounts of goodwill.
It is debt, not equity
The FDIC has long opposed counting TruPS toward regulatory capital requirements. In 2004, the Federal Reserve issued a proposed rule for comment that would retain Tier 1 treatment for TruPS, but subject them to tighter standards and stricter quantitative limits.
At the time it adopted the rule in March 2005, the Fed admitted that of the 38 comments received, only one (from the FDIC) opposed continuing the treatment - primarily on the grounds that instruments accounted as liabilities under generally accepted accounting principals should not be included in Tier 1 capital.
Such reasoning may carry more weight now, but at the time the Fed rejected the FDIC's arguments. "The Board does not believe that the change in GAAP accounting for trust preferred securities has changed the prudential characteristics that led the Board in 1996 to include trust preferred securities in the Tier 1 capital of BHCs," the Fed said at the time. "In arriving at this decision, the Board also considered its generally positive supervisory experience with trust-preferred securities, domestic and international competitive equity issues, and supervisory concerns with alternative tax-efficient instruments."
The market for dubious TruPS effectively collapsed in 2008 with the financial crisis. Likewise, the market for CDOs of TruPS evaporated. The Philly Fed's research found that only 48 TruPS issues amounting to $19.2 billion were completed in 2008, compared to 210 deals for $40.5 billion in 2007.
And this market will not likely have a second life. The Collins Amendment should nail the coffin shut on this market.
Banks have time, however, to replace their TruPS with more substantial capital. For TruPS issued before May 19, 2010, there is a three-year phase-out period, beginning January 2013, to allow institutions to replace their TruPS with qualifying Tier 1 regulatory capital. Subsidiaries of foreign banks would have a five-year transition period. Finally, BHCs that are not mutual holding companies (e.g. savings banks) or have less than $15 billion of total consolidated assets as of year-end 2009 are exempt.
In your face, big boys
It will not surprise fans of extreme regulatory infighting that the Treasury and Fed did their utmost to kill the Collins amendment. Or so the Wall Street Journal and American Banker reported.
Said Damian Paletta in a May 19 Journal story, "Practically, it sets into law standards for how much capital large bank holding companies should be required to hold, upending precedent that gives wide discretion to regulators to set those standards."
"Regulators," in this case, would be the Fed. According to Paletta, government officials and bankers were "scurrying" to "try to have [the amendment] stripped out." Opponents were so shocked it was voted into the Senate package, in fact, that some believed the Senate simply didn't understand what it meant. Edward Yingling, president and CEO of the American Bankers Association, argued, "I don't believe that the senators understood the full implications of this amendment. It would cause a severe capital crunch for many banks, resulting in the major decrease in lending capability."
Sen. Collins has said Treasury Secretary Timothy Geithner asked her to change the amendment. But, said Collins, Bair had convinced her that it addressed the root cause of the financial crisis. She was standing pat.
A week later, Donna Borak wrote in American Banker that the battle over the Collins amendment resulted from a "long-standing feud" between the two regulators. Plain and simple, the FDIC does not believe TruPS absorb losses. Jason Cave, deputy for supervision issues, pointed to last year's stress tests as proof.
Although one of Borak's sources suggested the Fed, founder of the TruPS feast, never admitted to a mistake, its substantive complaint was apparently that the amendment undermined its ability to negotiate Basel III with international regulators. What this means is that the Committee had already proposed eliminating TruPS from Tier 1 capital last year, and by capitulating this year, the Fed hoped to extract other concessions (such as maybe a higher limit on MSRs included in capital calculations?).
Now that Bair - oops, I mean Collins - has butt in, that strategy is no longer available.
The Treasury, in the meantime, was coming around. According to Borak, Michael Barr, assistant secretary for financial institutions, told reporters in late May, "we" share the goal of the Collins Amendment 100%. Given the importance of Sen. Collins to moving the Senate's reform legislation to the floor for a vote, one can imagine the Treasury sucked it up - bitter though it was.
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