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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 2 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. 3 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% 4 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%. 5 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 6 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. 7 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] 8 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. we believe to be reliable, but we do not Additional information is available upon request. guarantee its accuracy or 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 views of regulatory matters affecting banks and bank holding companies. These FAQs are not intended to and does not provide a recommendation with respect to any security. These FAQs do not take into account the financial position or particular needs or investment objectives of any individual or entity. The investment strategies, if any, discussed in these FAQs may not be suitable for all 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. These FAQs do not constitute an offer, or a solicitation of an offer, to buy or sell any securities or other financial instruments, including any securities mentioned in these FAQs. Nothing in these FAQs constitutes or should be construed to be accounting, tax, regulatory, investment or legal advice. Neither these FAQs, nor any portion thereof, may be reproduced or redistributed by any person for any purpose without the written consent of Sandler O’Neill. © 2016 Sandler O'Neill + Partners, L.P. All rights reserved. 9