Download Bank Investment in Other Financial Institution Debt

January 29, 2016
FAQs: Bank Investment in Other Financial Institution Debt and Capital
1. Can banks invest in senior and sub debt issued by other depository institutions?
Yes. Banks and BHCs can invest in other depository institution senior debt and capital securities. But Basel
III (Regulation Q) limits the amount that banks and BHCs with $1 billion or more in assets can invest in
capital securities issued by other financial institutions in the aggregate to 10% or less of the investing bank’s
Common Equity Tier 1 Capital (CET1). Investment amounts in excess of that 10% limit are deducted from the
same form of capital using the corresponding deduction approach as explained below. For additional
details, see http://www.gpo.gov/fdsys/pkg/FR-2013-10-11/pdf/2013-21653.pdf
The Total Loss Absorbing Capacity (TLAC) Notice of Proposed Rulemaking (NPR) issued on October 30, 2015,
adds senior BHC debt issued by 8 U.S. Global Systemically Important Banks (GSIBs) (covered BHCs) to the list
of instruments potentially deducted from the investing financial institution’s regulatory capital (pursuant to
regulation Q). These 8 covered BHCs include: JPM, C, BAC, GS, MS, WFC, SST, and BK. Senior BHC debt
issued by non-GSIBs would not face this regulation Q restriction. Under the proposed TLAC NPR, the
deduction for GSIB senior BHC debt begins on January 1, 2019 and is fully phased in on January 1, 2022. The
comment period for this NPR ends on February 1, 2016, and the final rule may differ from the NPR.
The chart on the following page summarizes the application of capital deductions for bank investments due
to TLAC and Basel III rules as well as the imposition of additional FDIC charges for bank level investment in
long term bank debt issued by other depository institutions.
The decision on where to hold the investment in other bank senior debt or capital securities is a function of
the total asset size of the banking entity making the investment as well as the current amount of other bank
investments. Bank level investments of more than 3% of the investing bank’s tier 1 capital will cause a 50 BP
increase in risk assessments (see #5 below for more detail). BHC investments in the senior debt of other
depository institutions do not require this adjustment. BHCs with less than $1 billion in total assets are not
subject to the Basel III rules and requirements at the BHC level. (see question #6 for more details)
For additional details, see https://www.gpo.gov/fdsys/pkg/FR-2015-11-30/pdf/2015-29740.pdf and
http://www.sandleroneill.com/Collateral/Documents/English-US/TLAC%20%20Repercussions%20and%20Disruptions%20for%20U.S.%20Banks%20and%20Investors.pdf
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2. How is the amount to be deducted using the Corresponding Deduction Approach
calculated?
In Column A, the sample bank’s investment portfolio currently includes senior BHC GSIB debt and
subordinated debt totaling $125 million. Under current Basel III rules, the $75 million of senior BHC GSIB
covered debt is not included in the calculation of investments subject to the Basel III deduction, and the
sample bank would face no capital deduction.
In Column B, the sample bank’s investment portfolio includes the $75 million in senior BHC GSIB covered debt
under the proposed Total Loss Absorbing Capital (TLAC) rules and would create an excess investment of $75
million that would be deducted from Tier 2 capital. Since the amount of Tier 2 capital at the sample bank of
$25 million is less than the deduction amount of $75 million, the $50 million balance is deducted from
preferred stock which is the next highest form of capital and then common equity until the full $75 million
deduction is taken. This results in a $75 million reduction in total capital with $25 million being deducted
from subordinated debt, $25 million from preferred stock and $25 million from common equity. This
deduction eliminates 100% of the subordinated debt and preferred stock that the investing bank can count as
regulatory capital. Overall, the 13.64% reduction in capital would not be required under current Basel III
capital rules but would be triggered under the proposed TLAC NPR.
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Case Study: Impact of Capital Deduction for Covered Debt on Sample Bank
A
B
Total Assets = $5 Billion
Total CET1 = $.500 Billion
Corresponding
Deduction Approach
Under Current Rules
Corresponding
Deduction Approach
Under TLAC NPR
Non-significant
Investment Type
Investment Amt. ($)
Investment Amt. ($)
Senior BHC Covered Debt (GSIB)
Subordinated Debt
Trust Preferred Stock
Preferred Stock
Common Stock
Total Bank Investments
Subject to Basel III Deduction
$
$
75.0
50.0
50.0
$
$
$
$
$
$
$
75.0
50.0
125.0
$
$
$
$
Common Equity Tier 1
$
500.0
$
500.0
> 10% CET1
$
50.0
$
50.0
Excess Bank Investments
$
-
$
75.0
Deduction Amount:
Senior BHC Covered Debt (GSIB)
Subordinated Debt
Trust Preferred
Preferred Stock
Common Stock
Current Capital Structure
Subordinated Debt
Preferred Stock
Common Stock
Total Regulatory Capital
$
$
$
$
$
$
$
$
$
$
Before Deduction
25.0
25.0
500.0
550.0
$
$
$
$
$
$
(45.0)
(30.0)
(75.0)
Deduction
$
$
$
$
(25.0)
(25.0)
(25.0)
(75.0)
% Total
60%
40%
0%
0%
0%
100%
Adjusted $ (%) Change
-100.00%
$
$
-100.00%
-5.00%
$ 475.0
$ 475.0
-13.64%
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3. How should banks underwrite their investment in senior and sub debt?
The OCC, Fed and FDIC issued guidance in October 2013 on the definitions of “investment grade”, “sub
investment grade” and “doubtful”, which specifies the criteria that insured depository institutions can use to
support their determination of classification. An investment grade issuer will generally not be adversely
classified if the issuer has adequate capacity to meet its financial commitments and if the risk of default is
low and the full and timely repayment of principal and interest is expected. If there is any question about
payment of the obligation in full, it is no longer considered investment grade and should be classified. For
more detail refer to the OCC bulletin at http://www.federalreserve.gov/bankinforeg/srletters/sr1318a1.pdf
4. What is the risk weighting applicable to an investment in senior or sub bank debt?
For U.S. community banks subject to the standardized approach, an investment in senior or sub debt would
carry a risk weighting of 100%, as shown in the chart below. If the investing bank has $250 billion or more
in assets and subject to the Advance Approaches risk-weighting methodology, the BIS requirement is 250%
for sub debt and 30% to 300% for senior debt based on rating. This would obviously not apply directly to
community banks but could impact the market pricing for such securities. All acquisition, development and
construction (ADC) commercial real estate loans are risk weighted at 150% except: (i) one- to- four family
residential ADC loans and (ii) commercial real estate ADC loans that meet applicable regulatory LTV
requirements; the borrower has contributed cash to the project of at least 15 percent of the real estate’s
“appraised as completed” value prior to the advancement of funds by the bank; and the borrower
contributed capital is contractually required to remain in the project until the credit facility is converted to
permanent financing, sold or paid in full. Non-performing loans are risk weighted at 150%.
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5.
How does the purchase at the bank level of another bank’s term debt impact
risk assessments of the purchasing bank?
The depository institution debt adjustment increases the risk assessments by 50 BP for the amount of the
investment in the other insured depository institution’s debt above 3% of the investing bank’s Tier 1
capital. As illustrated in the chart below, the excess investment amount of $88 million x 50 BP =
$440,000 penalty. This penalty is paid through an increase in the bank’s FDIC assessment rate from 14
BP below to 14.96 BP.
50 BP penalty on investment
in other bank debt
DIDA Adjustment
increases FDIC risk
assessments
Depository Institution Debt Adjustment (DIDA):
LT senior unsecured debt
88,000,000
3% of Tier 1 Capital
12,000,000
Amount of LT IDI debt > 3% Limit
DIDA adjustment factor
88,000,000
0.500%
Adjusted average total assets
Tangible equity (including qualifying tier 1)
Current FDIC Assessment Base
Current FDIC Assessment Rate (from step 4 above)
Plus: Depository Institution Debt Adjustment
Revised FDIC Assesstment Rate
Revised FDIC Risk Assessment Premiums
Savings/(Expense) After DIDA
*
0.5000%
100,000,000
/
4,600,000,000
DIDA adjustment
0.0096%
5,000,000,000
400,000,000
4,600,000,000
0.1400%
0.0096%
0.1496%
6,880,000
(440,000) Cost of DIDA adjustment of $440,000
For more information on the calculation methodology for FDIC risk assessments for small, large and
highly complex banking organizations, see https://www.fdic.gov/deposit/insurance/calculator.html
6.
Are BHCs with less than $1 billion in assets subject to the Basel III deductions for
investment in other bank capital securities?
Pursuant to the Small Bank Holding Company Policy Statement effective May of 2015, a banking
institution with less than $1 billion in assets can potentially avoid deductions on investments in capital
securities by moving assets at fair market value (and consistent with section 23A and 23B restrictions)
from its bank, where BIII capital rules apply, to its BHC, where the Basel III capital rules do not apply,
until the BHC reaches $1 billion in assets. In December 2015, the House Financial Services Committee
approved a bill (H.R. 3791) to increase the consolidated BHC assets size threshold applicable to the Policy
Statement form $1 billion to $5 billion which, if adopted as law, would significantly expand the number
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of BHCs that could explicitly benefit. Effective January 1, 2019, investments by Federal Reserve Board
regulated institutions with assets of $1 billion or more in senior BHC debt issued by GSIBs are subject to
deduction from capital using the corresponding deduction approach. For more information, see
http://www.gpo.gov/fdsys/pkg/FR-2015-04-15/pdf/2015-08513.pdf and
http://www.gpo.gov/fdsys/pkg/FR-2013-10-11/pdf/2013-21653.pdf
7.
Should banks classify an investment in bank debt, sub debt or other forms of
hybrid capital as a loan or as a security?
The OCC provided guidance on a similar issue in its bank advisory accounting series in October 2014. See
http://www.occ.gov/publications/publications-by-type/other-publications-reports/baas.pdf
Facts: A bank purchases [capital] securities using its legal lending limit authority.
Question 12:
statements?
Should these securities be reported as loans or securities on the bank’s financial
Staff Response: The [capital] securities should be classified and reported as securities on the bank’s
financial statements, including call reports. The legal means for acquiring the security is not relevant for
the accounting treatment. The financial statement classification is governed by GAAP, not the legal
authority under which the assets are purchased. The [capital] securities are debt securities subject to the
accounting requirements of ASC 320.
Additional References:
1. Source: OCC
http://www.federalreserve.gov/bankinforeg/srletters/sr1215a1.pdf
2. Source: FDIC
https://www.fdic.gov/news/conferences/chicago_region/2014-04-24.pdf
3. Source: OCC Investment securities handbook
http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/investsecurities1.pdf
The following excerpt is instructive:
“Occasionally, examiners will have difficulty distinguishing between a loan and a security. Loans result
from direct negotiations between a borrower and a lender. A bank will refuse to grant a loan unless the
borrower agrees to its terms. A security, on the other hand, is usually acquired through a third party, a
broker or dealer in securities. Most securities have standardized terms that can be compared to the
terms of other market offerings. Because the terms of most loans do not lend themselves to such
comparison, the average investor may not accept the terms of the lending arrangement. Thus, an
individual loan cannot be regarded as a readily marketable security.
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National banks are governed in their security investments by the seventh paragraph of 12 USC 24 and by
the investment securities regulation of the Comptroller of the Currency (12 CFR 1). The investment
securities regulation defines investment securities; political subdivision; general obligation; and Type I, II,
and III securities, and establishes limitations on the bank’s investment in those securities. The law, 12
USC 24, requires that for a security to qualify as an investment security, it be marketable and not
predominantly speculative.
For its own account, a bank may purchase Type I securities, which are obligations of the U.S.
government or its agencies and general obligations of states and political subdivisions (see 12 USC
24(7)), subject to no limitations, other than the exercise of prudent banking judgment. The purchase of
Type II and III securities (see 12 CFR 1.3(d) and (e)) is limited to 10 percent of capital and surplus for each
obligor when the purchase is based on adequate evidence of the maker’s ability to perform. That
limitation is reduced to 5 percent of capital and surplus for all obligors in the aggregate where the
purchase judgment is predicated on “reliable estimates.” The term “reliable estimates” refers to
projections of income and debt service requirements or conditional ratings when factual credit
information is not available and when the obligor does not have a record of performance. Securities
purchased subject to the 5 percent limitation may, in fact, become eligible for the 10 percent limitation
once a satisfactory financial record has been established. There are additional limitations on specific
securities ruled eligible for investment by the OCC that are detailed in 12 CFR 1.3. The par value, not the
book value or purchase price, of the security is the basis for computing the limitations. However, the
limitations do not apply to securities acquired through debts previously contracted.”
Thomas W. Killian
Principal
212-466-7709
[email protected]
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General Information and Disclaimers
These FAQs have been prepared and issued by Sandler O’Neill + Partners, L.P., a registered brokerdealer and a member of the Financial Industry Regulatory Authority, Inc. The information contained in
these FAQs (except information regarding Sandler O’Neill and its affiliates) was obtained from various
sources
that
completeness.
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believe
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but
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Additional information is available upon request.
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accuracy
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The information and opinions
contained in these FAQs speak only as of the date of these FAQs and are subject to change without
notice.
Contact information for Sandler O’Neill and the author of these FAQs is available at
www.sandleroneill.com.
These FAQs have been prepared and circulated for general information only and presents the author’s
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intended to and does not provide a recommendation with respect to any security. These FAQs do not
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investors. Investors must make their own determinations of the appropriateness of an investment
strategy and an investment in any particular securities based upon the legal, tax, regulatory and
accounting considerations applicable to such investors and their own investment objective.
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