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From Banking and Finance Law Daily, September 24, 2013

Fed rules explain Basel III effects on stress tests, capital plans

By Richard A. Roth, J.D.

The Federal Reserve Board has adopted two interim rules that are intended to clarify how the Basel III capital rules will affect bank and holding company stress tests and capital plans during the next cycle. The rules are necessary, the Fed says, because the Basel III capital reforms will take effect in 2014 and 2015, and the planning horizon for the next cycle runs through the end of 2015, resulting in an overlap.

The capital plan process and stress test process are two tools used by the federal financial regulatory agencies to examine the capital adequacy of the institutions they regulate. The Fed’s capital plan rule requires each holding company with more than $50 billion in total consolidated assets to file an annual capital plan that provides estimates of the company’s minimum regulatory capital ratios and tier 1 common ratio under expected conditions and under a range of stressed scenarios over a nine-quarter planning horizon. The plan also must describe how the company would maintain a tier 1 common ratio of higher than 5 percent under those scenarios. A company that fails to secure Fed approval of its plan is subject to restrictions on its ability to pay dividends or take other actions that affect capital.

The Fed’s stress test rules require covered companies to conduct stress tests to examine whether they have enough capital to withstand the losses that could result from adverse economic conditions. The largest holding companies must carry out semi-annual company stress tests and annual supervisory stress tests, while smaller companies need conduct only annual company stress tests.

Both the capital plan and stress test rules require the companies to calculate their tier 1 common ratio for each quarter of a nine-quarter planning horizon. However, the capital rules adopted in July 2013 to implement Basel III include a new methodology for computing the common equity tier 1 capital ratio and a new minimum common equity tier 1 capital ratio, and the changes will be phased in during the nine-quarter period to be covered in the current cycles.

Institutions affected. The two rules affect organizations of different sizes. One applies to bank holding companies with $50 billion or more in total consolidated assets, while the other applies to banks and holding companies with assets of at least $10 billion but no more than $50 billion. One provision applies to both categories, the Fed says—companies will not be required to use the Basel III advanced approaches to calculate their risk-weighted assets unless they have been notified by September 30 of the year, before the stress test and capital plan cycle has begun.

Large holding companies. The interim rule that applies to the largest holding companies will require them to calculate their tier 1 common ratio under the existing capital guidelines, not the guidelines set by the regulation adopted in July 2013. However, the Fed says that companies are to project their regulatory capital ratios and minimum capital requirements for each quarter of the planning horizon in accordance with the minimum capital requirements that are in effect during that quarter. Thus, those requirements will change during the planning horizon.

Smaller institutions. Holding companies and Fed-supervised banks in the $10 billion to $50 billion total consolidated assets range are being given a one-year transition period to incorporate the revised capital framework into their company-run stress tests. This means that in the stress test cycle beginning Oct. 1, 2013, the institutions will estimate their capital levels and ratios using the capital rules now in effect.

According to the Fed, requiring the companies to comply with the changed rules during the next cycle of tests would add complexity and increase the likelihood of errors. This could compromise the usefulness of the stress test results without providing any corresponding benefit.

The transition period does not apply to state member banks that are subsidiaries of holding companies that exceed the $50 billion threshold. These banks are to project their regulatory capital ratios for each quarter of the planning horizon in accordance with the minimum capital requirements that will be in effect during that quarter.

Deadlines. Both rules are effective on Sept. 30, 2013. Comments must be submitted by Nov. 25, 2013.

RegulatoryActivity: CapitalBaselAccords DoddFrankAct FederalReserveSystem FinancialStability

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