The proposed rule maintains the minimum risk-based capital ratio requirements of 4.0 percent tier 1 capital to total risk-weighted assets and 8.0 percent total qualifying capital to total risk-weighted assets. Under the proposed rule, a bank's total qualifying capital is the sum of its tier 1 (core) capital elements and tier 2 (supplemental) capital elements, subject to various limits and restrictions, minus certain deductions (adjustments). The agencies are not restating the elements of tier 1 and tier 2 capital in this proposed rule. Those capital elements generally remain as they are currently in the general risk-based capital rules.³⁰ The agencies have provided proposed regulatory text for, and the following discussion of, proposed adjustments to the capital elements for purposes of the advanced approaches.

The agencies are considering restating the elements of tier 1 and tier 2 capital, with any necessary conforming and technical amendments, in any final rules that are issued regarding this proposed framework so that a bank using the advanced approaches would have a single, comprehensive regulatory text that describes both the numerator and denominator of the bank's minimum risk-based capital ratios. The agencies decided not to set forth the capital elements in this proposed rule so that commenters would be able to focus attention on the parts of the risk-based capital framework that the agencies propose to amend. Question 21: Commenters are encouraged to provide views on the proposed adjustments to the components of the risk-based capital numerator as described below. Commenters also may provide views on numerator-related issues that they believe would be useful to the agencies' consideration of the proposed rule.

After identifying the elements of tier 1 and tier 2 capital, a bank would make certain adjustments to determine its tier 1 capital and total qualifying capital (that is, the numerator of the total risk-based capital ratio). Some of these adjustments would be made only to the tier 1 portion of the capital base. Other adjustments would be made 50 percent from tier 1 capital and 50 percent from tier 2 capital.³¹ Under the proposed rule, a bank must still have at least 50 percent of its total qualifying capital in the form of tier 1 capital.

The bank would continue to deduct from tier 1 capital goodwill, other intangible assets, and deferred tax assets to the same extent that those assets are currently required to be deducted from tier 1 capital under the general risk-based capital rules. Thus, all goodwill would be deducted from tier 1 capital. Qualifying intangible assets – including mortgage servicing assets, non-mortgage servicing assets, and purchased credit card relationships – that meet the conditions and limits in the general risk-based capital rules would not have to be deducted from tier 1 capital. Likewise, deferred tax assets that are dependent upon future taxable income and that meet the valuation requirements and limits in the general risk-based capital rules would not have to be deducted from tier 1 capital.³²

Under the general risk-based capital rules, a bank also must deduct from its tier 1 capital certain percentages of the adjusted carrying value of its nonfinancial equity investments. An advanced approaches bank would no longer be required to make this deduction. Instead, the bank's equity exposures would be subject to the equity treatment in part VI of the proposed rule and described in section V.F. of this preamble.³³

Under the general risk-based capital rules, a bank is allowed to include in tier 2 capital its ALLL up to 1.25 percent of risk-weighted assets (net of certain deductions). Amounts of ALLL in excess of this limit, as well as allocated transfer risk reserves, may be deducted from the gross amount of risk-weighted assets.

Under the proposed framework, as noted above, the ALLL is treated differently. The proposed rule includes a methodology for adjusting risk-based capital requirements based on a comparison of the bank's eligible credit reserves to its ECL. The proposed rule defines eligible credit reserves as all general allowances, including the ALLL, that have been established through a charge against earnings to absorb credit losses associated with on- or off-balance sheet wholesale and retail exposures. Eligible credit reserves would not include allocated transfer risk reserves established pursuant to 12 U.S.C. 3904³⁴ and other specific reserves created against recognized losses.

The proposed rule defines a bank's total ECL as the sum of ECL for all wholesale and retail exposures other than exposures to which the bank has applied the double default treatment (described below). The bank's ECL for a wholesale exposure to a non-defaulted obligor or a non-defaulted retail segment is the product of PD, ELGD, and EAD for the exposure or segment. The bank's ECL for a wholesale exposure to a defaulted obligor or a defaulted retail segment is equal to the bank's impairment estimate for ALLL purposes for the exposure or segment.

The proposed method of measuring ECL for non-defaulted exposures is different than the proposed method of measuring ECL for defaulted exposures. For non-defaulted exposures, ECL depends directly on ELGD and hence would reflect economic losses, including the cost of carry and direct and indirect workout expenses. In contrast, for defaulted exposures, ECL is based on accounting measures of credit loss incorporated into a bank's charge-off and reserving practices.

The agencies believe that, for defaulted exposures, any difference between a bank's best estimate of economic losses and its impairment estimate for ALLL purposes is likely to be small. As a result, the agencies are proposing to use a bank's ALLL impairment estimate in the determination of ECL for defaulted exposures to reduce implementation burden for banks. The agencies recognize that this proposed treatment would require a bank to specify how much of its ALLL is attributable to defaulted exposures, and that a bank still would need to capture all material economic losses on defaulted exposures when building its databases for estimating ELGDs and LGDs for non-defaulted exposures. Question 22: The agencies seek comment on the proposed ECL approach for defaulted exposures as well as on an alternative treatment, under which ECL for a defaulted exposure would be calculated as the bank's current carrying value of the exposure multiplied by the bank's best estimate of the expected economic loss rate associated with the exposure (measured relative to the current carrying value), that would be more consistent with the proposed treatment of ECL for non-defaulted exposures. The agencies also seek comment on whether these two approaches would likely produce materially different ECL estimates for defaulted exposures. In addition, the agencies seek comment on the appropriate measure of ECL for assets held at fair value with gains and losses flowing through earnings.

A bank must compare the total dollar amount of its ECL to its eligible credit reserves. If there is a shortfall of eligible credit reserves compared to total ECL, the bank would deduct 50 percent of the shortfall from tier 1 capital and 50 percent from tier 2 capital. If eligible credit reserves exceed total ECL, the excess portion of eligible credit reserves may be included in tier 2 capital up to 0.6 percent of credit-risk-weighted assets. The proposed rule defines credit-risk-weighted assets as 1.06 multiplied by the sum of total wholesale and retail risk-weighted assets, risk-weighted assets for securitization exposures, and risk-weighted assets for equity exposures.

A bank must deduct from tier 1 capital any increase in the bank's equity capital at the inception of a securitization transaction (gain-on-sale), other than an increase in equity capital that results from the bank's receipt of cash in connection with the securitization. The agencies have designed this deduction to offset accounting treatments that produce an increase in a bank's equity capital and tier 1 capital at the inception of a securitization - for example, a gain attributable to a CEIO that results from Financial Accounting Standard (FAS) 140 accounting treatment for the sale of underlying exposures to a securitization special purpose entity (SPE). Over time, as the bank, from an accounting perspective, realizes the increase in equity capital and tier 1 capital that was booked at the inception of the securitization through actual receipt of cash flows, the amount of the required deduction would shrink accordingly.

Under the general risk-based capital rules,³⁵ a bank must deduct CEIOs, whether purchased or retained, from tier 1 capital to the extent that the CEIOs exceed 25 percent of the bank's tier 1 capital. Under the proposed rule, a bank must deduct CEIOs from tier 1 capital to the extent they represent gain-on-sale, and must deduct any remaining CEIOs 50 percent from tier 1 capital and 50 percent from tier 2 capital.

Under the proposed rule, certain other securitization exposures also would be deducted from tier 1 and tier 2 capital. These exposures include, for example, securitization exposures that have an applicable external rating (defined below) that is more than one category below investment grade (for example, below BB) and most subordinated unrated securitization exposures. When a bank must deduct a securitization exposure (other than gain-on-sale) from regulatory capital, the bank must take the deduction 50 percent from tier 1 capital and 50 percent from tier 2 capital. Moreover, a bank may calculate any deductions from regulatory capital with respect to a securitization exposure (including after-tax gain-on-sale) net of any deferred tax liabilities associated with the exposure.

The proposed rule also requires a bank to deduct the bank's exposure on certain unsettled and failed capital markets transactions 50 percent from tier 1 capital and 50 percent from tier 2 capital, as discussed in more detail below in section V.D. of the preamble.

The agencies note that investments in unconsolidated banking and finance subsidiaries and reciprocal holdings of bank capital instruments would continue to be deducted from regulatory capital as described in the general risk-based capital rules. Under the agencies' current rules, a national or state bank that controls or holds an interest in a financial subsidiary does not consolidate the assets and liabilities of the financial subsidiary with those of the bank for risk-based capital purposes. In addition, the bank must deduct its equity investment (including retained earnings) in the financial subsidiary from regulatory capital – at least 50 percent from tier 1 capital and up to 50 percent from tier 2 capital.³⁶ A BHC generally does not deconsolidate the assets and liabilities of the financial subsidiaries of the BHC's subsidiary banks and does not deduct from its regulatory capital the equity investments of its subsidiary banks in financial subsidiaries. Rather, a BHC generally fully consolidates the financial subsidiaries of its subsidiary banks. These treatments would continue under the proposed rule.

For BHCs with consolidated insurance underwriting subsidiaries that are functionally regulated (or subject to comparable supervision and minimum regulatory capital requirements in their home jurisdiction), the following treatment would apply. The assets and liabilities of the subsidiary would be consolidated for purposes of determining the BHC's risk-weighted assets. However, the BHC must deduct from tier 1 capital an amount equal to the insurance underwriting subsidiary's minimum regulatory capital requirement as determined by its functional (or equivalent) regulator. For U.S. regulated insurance subsidiaries, this amount generally would be 200 percent of the subsidiary's Authorized Control Level as established by the appropriate state insurance regulator.

This approach with respect to functionally-regulated consolidated insurance underwriting subsidiaries is different from the New Accord, which broadly endorses a deconsolidation and deduction approach for insurance subsidiaries. The Board believes a full deconsolidation and deduction approach does not fully capture the risk in insurance underwriting subsidiaries at the consolidated BHC level and, thus, has proposed the consolidation and deduction approach described above. Question 23: The Board seeks comment on this proposed treatment and in particular on how a minimum insurance regulatory capital proxy for tier 1 deduction purposes should be determined for insurance underwriting subsidiaries that are not subject to U.S. functional regulation.

A March 10, 2005, final rule issued by the Board defined restricted core capital elements for BHCs and generally limited restricted core capital elements for internationally active banking organizations to 15 percent of the sum of all core capital elements net of goodwill less any associated deferred tax liability.³⁷ Restricted core capital elements are defined as qualifying cumulative perpetual preferred stock (and related surplus), minority interest related to qualifying cumulative perpetual preferred stock directly issued by a consolidated DI or foreign bank subsidiary, minority interest related to qualifying common or qualifying perpetual preferred stock issued by a consolidated subsidiary that is neither a DI nor a foreign bank, and qualifying trust preferred securities. The final rule defined an internationally active banking organization to be a BHC that (i) as of its most recent year-end FR Y-9C reports total consolidated assets equal to $250 billion or more or (ii) on a consolidated basis, reports total on-balance sheet foreign exposure of $10 billion or more in its filing of the most recent year-end FFIEC 009 Country Exposure Report. The Board intends to change the definition of an internationally active banking organization in the Board's capital adequacy guidelines for BHCs to make it consistent with the definition of a core bank. This change would be less restrictive on BHCs because the BHC threshold in this proposed rule uses total consolidated assets excluding insurance rather than total consolidated assets including insurance.

30. See 12 CFR part 3, Appendix A, § 2 (national banks); 12 CFR part 208, Appendix A, § II (state member banks); 12 CFR part 225, Appendix A, § II (bank holding companies); 12 CFR part 325, Appendix A (state non-member banks); and 12 CFR 567.5 (savings associations).  Return to text
31. If the amount deductible from tier 2 capital exceeds the bank's actual tier 2 capital, however, the bank must deduct the shortfall amount from tier 1 capital.  Return to text
32. See 12 CFR part 3, § 2 (national banks); 12 CFR part 208, Appendix A, § II (state member banks); 12 CFR part 225, Appendix A, § II (bank holding companies); 12 CFR part 325, Appendix A, § II (state non-member banks). OTS existing rules are formulated differently, but include similar deductions. Under OTS rules, for example, goodwill is included within the definition of "intangible assets" and is deducted from tier 1 (core) capital along with other intangible assets. See 12 CFR 567.1 and 567.5(a)(2)(i). Similarly, purchased credit card relationships and mortgage and non-mortgage servicing assets are included in capital to the same extent as the other agencies' rules. See 12 CFR 567.5(a)(2)(ii) and 567.12. The deduction of deferred tax assets is discussed in Thrift Bulletin 56.  Return to text
33. By contrast, OTS rules require the deduction of equity investments from total capital. 12 CFR 567.5(c)(2)(ii). "Equity investments" are defined to include (i) investments in equity securities (other than investments in subsidiaries, equity investments that are permissible for national banks, indirect ownership interests in certain pools of assets (for example, mutual funds), Federal Home Loan Bank stock and Federal Reserve Bank stock); and (ii) investments in certain real property. 12 CFR 567.1. Savings associations applying the proposed rule would not be required to deduct investments in equity securities. Instead, such investments would be subject to the equity treatment in part VI of the proposed rule. Equity investments in real estate would continue to be deducted to the same extent as under the current rules.  Return to text
34. 12 U.S.C. 3904 does not apply to savings associations regulated by the OTS. As a result, the OTS rule will not refer to allocated transfer risk reserves.  Return to text
35. See 12 CFR part 3, Appendix A, § 2(c)(4) (national banks); 12 CFR part 208, Appendix A, § I.B.1.c. (state member banks); 12 CFR part 225, Appendix A, § I.B.1.c. (bank holding companies); 12 CFR part 325, Appendix A, § I.B.5. (state non-member banks); 12 CFR 567.5(a)(2)(iii) (savings associations).  Return to text
36. See 12 CFR 5.39(h)(1) (national banks); 12 CFR 208.73(a) (state member banks); 12 CFR part 325, Appendix A, § I.B.2. (state non-member banks). Again, OTS rules are formulated differently. For example, OTS rules do not use the terms "unconsolidated banking and finance subsidiary" or "financial subsidiary." Rather, as required by section 5(t)(5) of the Home Owners' Loan Act (HOLA), equity and debt investments in non-includable subsidiaries (generally subsidiaries that are engaged in activities that are not permissible for a national bank) are deducted from assets and tier 1 (core) capital. 12 CFR 567.5(a)(2)(iv) and (v). As required by HOLA, OTS will continue to deduct non-includable subsidiaries. Reciprocal holdings of bank capital instruments are deducted from a savings association's total capital under 12 CFR 567.5(c)(2).  Return to text
37. 70 FR 11827 (Mar. 10, 2005). The final rule also allowed internationally active banking organizations to include restricted core capital elements in their tier 1 capital up to 25 percent of the sum of all core capital elements net of goodwill less associated deferred tax liability so long as any amounts of restricted core capital elements in excess of the 15 percent limit were in the form of mandatory convertible preferred securities.  Return to text