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From Banking and Finance Law Daily, February 27, 2014

Basel III amendments applied to subordinated debt and capital limits

By Andrew A. Turner, J.D.

In making regulations governing national banks and federal savings associations consistent with the recently adopted Basel III Capital Framework, the Office of the Comptroller of the Currency has revised subordinated debt rules to clarify requirements and procedures. The interim rule amendments are effective March 31, 2014.

The OCC also noted that one consequence of revising the cross-references to the definitions of tier 1 and tier 2 capital in the new Basel III capital framework is that new definitions of tier 1 and tier 2 capital will be applicable with respect to the calculation of various statutory and regulatory limits in other rules that referenced the risk-based capital requirements in 12 C.F.R. Part 3. As part of the revisions to those cross-references, the OCC has looked at the effect that the changes in the risk-based capital would have on numerical limits in other regulations that are based on regulatory capital. The OCC believes that the new definitions of capital in the Basel III Capital Framework are appropriate measures for the calculation of other various statutory and regulatory limits. However, the OCC is aware of the possibility of indirect effects of these regulatory changes and has requested comment on this aspect of the new definition of capital.

Technical and conforming amendments. Apart from its role in establishing minimum regulatory capital requirements for the purposes of capital adequacy, regulatory capital historically also has served as a useful measure for numerous statutory and regulatory limits used as supervisory tools for safety and soundness purposes. Examples of such measures are the legal lending limits (12 C.F.R. Part 32) and limits on investment securities (12 C.F.R. Part 1). As a result, the major revisions to capital adequacy rules included in the Basel III capital framework, introduced a level of complexity to the conforming and technical amendments beyond changing cross references in rules.

The Basel III capital framework provided different mandatory compliance dates for advanced approaches national banks and federal savings associations and non-advanced approaches national banks and federal savings associations. Accordingly, the amendments replaced cross references to the current regulatory capital rules with cross-references to both the Basel III final rule and the current regulatory capital rules, where appropriate.

Subordinated debt. The OCC’s rules governing subordinated debt have been amended to be consistent with the Basel III capital framework. Unlike the current regulatory capital rules, the Basel III capital framework does not identify specific types of instruments that are included in regulatory capital. Instead, the Basel III capital framework lists criteria that an instrument must satisfy to be included in regulatory capital. While the OCC acknowledges that a national bank or federal savings association may want to issue subordinated debt for liquidity or reasons other than raising regulatory capital, the OCC expects that most subordinated debt generally would qualify as tier 2 capital.

The OCC currently has separate rules for subordinated debt issued by national banks and federal savings associations In order to minimize confusion, the amendments do not integrate those rules. Instead, integration of those rules into a single subordinated debt rule applicable to both national banks and federal savings associations may occur as part of a future rulemaking.

The interim final rule retains current procedures for the issuance of subordinated debt, including the distinction between eligible and non-eligible banks, while the OCC added new procedures for prepayment of subordinated debt included in tier 2 capital and prepayment in the form of a call option.

Limitations based on capital. The OCC’s rules cross-reference definitions of tier 1 and tier 2 regulatory capital as the basis for limits in other regulations that are based on capital. Examples of such limits are the lending limit and the limit applicable to investment securities. The OCC’s overall assessment of the effect of these changes is that for most FDIC-insured institutions, it does not expect reliance on the Basel III capital framework to have a significant impact on lending limits or other components of a bank’s or savings association’s activities that are linked to the amount of a bank’s or savings association’s capital and surplus.

The OCC believes that under the Basel III capital framework, banks and savings associations holding capital at minimum required amounts generally will be holding more capital than under current rules, and thus, their lending limits and other limits tied to the amount of their capital and surplus will be unambiguously higher. Even with respect to national banks and federal savings associations that experience decreasing capital-linked limits because of the Basel III changes, the OCC does not expect this to be a problem for most institutions. To assist the OCC in information gathering, comments are sought on the impact of changes in the definition of capital on a bank’s or savings association’s limits based on capital.

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