Federal Banking Agencies Propose to Simplify Capital Regulations … or Did They?
On October 27, 2017, the federal banking agencies issued a joint notice of proposed rulemaking (NPR) covering changes to certain provisions of their respective capital regulations. The NPR is a result of the banking agencies’ stated goal in their March 2017 report to Congress to meaningfully reduce regulatory burden. One aspect in particular that was highlighted for potential revision was the capital rules that resulted from the implementation of Basel III. Despite the stated goal, for some organizations this NPR may have no impact, and for others it may in fact increase the burden associated with calculating and complying with its regulatory capital requirements.
What Institutions May Be Affected. Most of the proposed changes would apply only to institutions that are subject to the “standardized approach” methodology for calculating risk-based capital, as opposed to those institutions that are subject to the “advanced approaches” capital rule established by Basel III; in other words, these proposals would primarily affect banking institutions other than those with more than $250 billion in total assets or foreign exposure greater than $10 billion.
Proposed Changes to Risk-Based Capital Treatment of Certain Acquisition, Development, and Construction Loans. Under current regulations, certain loans that meet the definition of being a “high volatility commercial real estate exposure” (HVCRE) are assigned a 150 percent weight for purposes of risk-based capital requirements. An HVCRE is defined as a credit facility, prior to conversion to permanent financing, the purpose of which was to finance the acquisition, development, or construction of real property. Loans to finance one-to four-family residential properties, certain agricultural or community development loans, and commercial real estate loans where the borrower met certain contributed capital requirements were exempt from the definition and therefore subject to a lesser risk weighting. In practice, certain aspects of the definition have proven to be challenging, such as the classification of a loan with multiple purposes—a portion real estate and the remainder not—or determining whether some types of residential development truly met the one-to-four-family exemption. Bankers have also found the contributed capital exemption less than clear and sought a definition of the term “permanent financing.”
In response to these concerns, the NPR proposes to introduce a new exposure category called high volatility acquisition, development, or construction exposure (HVADC). This new category addresses the contributed capital concerns by eliminating it all together as an exemption. A multipurpose loan would be deemed an HVADC if the loan primarily finances the acquisition, development, or construction project; i.e., if more than 50 percent of the loan proceeds go toward these efforts. With respect to the definition of residential properties, the NPR establishes a bright-line test; while town homes or row houses might be exempt, condominium or cooperative projects would not unless the project contained fewer than five individual dwelling units. The NPR defines the term “permanent loan” to be a prudently underwritten loan that has a clearly identified source of repayment sufficient for serving the loan, aside from the sale of the property.
In recognition that the new definition may in fact encompass more loans than the definition of an HVCRE, the banking agencies are proposing to reduce the risk weighting on HVADCs from 150 to 130 percent. However, the new category and risk weighting would apply only to loans originated after the effective date of the final regulations. As such, if the rules are finalized as proposed, financial institutions will need to track both HVCREs and HVADCs until all HVCREs are off their books.
Other Proposed Changes. The NPR also proposes to change the treatment of mortgage servicing rights, temporary deferred tax assets, and investments in unconsolidated subsidiaries. Under current rules, the amount of any such investment that individually exceeds 10 percent of the institution’s common equity tier 1 capital must be deducted from common equity tier 1 capital for capital compliance purposes. In addition, any amount not deducted as a result of the 10 percent individual investment requirement must be deducted if, in the aggregate, the investments exceed 15 percent of common equity tier 1 capital. The NPR proposes to increase the individual investment threshold to 25 percent and eliminate the aggregate threshold in its entirety. Any amounts not deducted would be subject to a 250 percent risk weighting.
Comment Period Ends Soon. The comment period on the NPR ends on December 26, 2017. Institutions that may be affected should closely review the NPR to see whether there are individual aspects not highlighted here that may affect them. A copy of the NPR along with the instructions for submitting comments can be found at www.regulations.gov by entering “Docket ID OCC-2017-0018” in the Search box. This docket ID should be used regardless of your institution’s primary federal regulator.