Federal Register: September 27, 2000 (Volume 65, Number 188)
DOCID: FR Doc 00-24203
DEPARTMENT OF THE TREASURY
Thrift Supervision Office
CFR Citation: 12 CFR Part 3
Docket ID: [Docket No. 00-17]
RIN ID: RIN 1557-AB14
NOTICE: PROPOSED RULES
DOCUMENT ACTION: Notice of proposed rulemaking.
SUBJECT CATEGORY:
FEDERAL RESERVE SYSTEM
DATES: Comments must be received by December 26, 2000.
DOCUMENT SUMMARY:
The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) (collectively, the Agencies) propose to amend their capital adequacy standards for banks, bank holding companies and thrifts (collectively, banking organizations) concerning the treatment of certain residual interests in asset securitizations or other transfers of financial assets. Residual interests are defined as those onbalance sheet assets that represent interests (including beneficial interests) in the transferred financial assets retained by a seller (or transferor) after a securitization or other transfer of financial assets; and are structured to absorb more than a pro rata share of credit loss related to the transferred assets through subordination provisions or other credit enhancement techniques (credit enhancement). Examples of residual interests include, but are not limited to, interest only strips receivable (I/O strips), spread accounts, cash collateral accounts, retained subordinated interests, and other similar forms of onbalance sheet assets that function as a credit enhancement. Residual interests as defined in the proposed rule do not include interests purchased from a third party.
Generally, these residual interests are noninvestment grade or unrated assets retained by the issuing institution in order to provide ``firstloss'' credit support for the senior positions in a securitization or other financial asset transfer. They generally lack an active market through which a readily available market price can be obtained. In addition, many of these residual interests are exposed, on a leveraged basis, to a significant level of credit and interest rate risk that make their valuation extremely sensitive to changes in the underlying credit and prepayment assumptions. As a result, such residual interests present valuation and liquidity concerns. High concentrations of such illiquid and volatile assets in relation to capital can threaten the safety and soundness of banking organizations.
This proposed rule is intended to better align regulatory capital requirements with the risk exposure of these types of residual interests, encourage conservative valuation methods, and restrict excessive concentrations in these assets. The proposed rule would require that riskbased capital be held in an amount equal to the amount of the residual interest that is retained on the balance sheet by a banking organization in a securitization or other transfer of financial assets, even if the capital charge exceeds the full risk based capital charge typically held against the transferred assets. The proposed rule also would restrict excessive concentrations in residual interests by limiting the amount that may be included in Tier 1 capital for both leverage and riskbased capital purposes. When aggregated with nonmortgage servicing assets and purchased credit card relationships (PCCRs), the balance sheet amount of residual interests would be limited to 25 percent of Tier 1 capital, with any amount in excess of this limitation deducted in determining the amount of a banking organization's Tier 1 capital.
SUMMARY:
See Committee for the Implementation of Textile Agreements; Capital; leverage and risk-based capital and captial adequacy guidelines, capital maintenance, residual interests, etc.,
DOCUMENT BODY 2:
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R1080]
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN 3064AC34
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Part 565 and 567
[Docket No. 200070]
RIN 1550AB11
Capital; Leverage and RiskBased Capital Guidelines; Capital
Adequacy Guidelines; Capital Maintenance: Residual Interests in Asset
Securitizations or Other Transfers of Financial Assets
SUPPLEMENTAL INFORMATION
This preamble consists of the following sections:
I. Introduction
II. Nature of Supervisory Concerns
III. Current Capital Treatment for Residual Interests
IV. Residual Interests Subject to the Proposal
V. Proposed Amendments to the Capital Standards
VI. Request for Public Comment
VII. Plain Language
VIII. Regulatory Analysis
I. Introduction
The proposed rule addresses the supervisory concerns arising from the illiquid and volatile nature of residual interests that are retained by the securitizer or other seller of financial assets, when those residual interests are used as a credit enhancement to support the financial assets transferred. The proposal also reduces the risk from excessive concentrations in these residual interests, including those situations where large residual interests are retained in connection with the sale or securitization of low quality, higher risk loans. As discussed in more detail in section V, the proposed rule would (1) require capital to be maintained in an amount equal to the amount of the residual interest that is retained on the balance sheet for riskbased capital purposes, and (2) require the amount of any such residual interests to be included in the 25 percent of Tier 1 capital sublimit that currently applies to nonmortgage servicing assets and purchased credit card relationships (PCCRs), with any amounts in excess of this limit deducted from Tier 1 capital for both leverage and risk based capital purposes.
II. Nature of Supervisory Concerns
Securitizations and other financial asset transfers provide an efficient mechanism for banking organizations to sell loan assets or credit exposures. The benefits of these transactions must be balanced against the significant risks that such activities can pose to banking organizations and to the deposit insurance funds. Recent examinations have disclosed significant weaknesses in the risk management processes related to securitization activities at certain institutions. The most frequently encountered problems stem from: (1) The failure to recognize recourse obligations that frequently accompany securitizations and to hold sufficient capital against such obligations; (2) the excessive or inadequately supported valuation of residual interests; (3) the liquidity risk associated with over reliance on asset securitization as a funding source; and (4) the absence of adequate independent risk management and audit functions.
The Agencies addressed these concerns in the Interagency Guidance
on Asset Securitization (Securitization Guidance) issued in December
1999.\1\ The Securitization Guidance highlighted some of the risks
associated with asset securitization and emphasized the Agencies'
concerns with certain residual interests generated from the securitization and sale of assets.
\1\ See OCC Bulletin 9946 (December 14, 1999) (OCC); FDIC FIL
10999 (December 13, 1999) (FCIC); SR 9937(SUP) (December 13, 1999)
(FRB); and CEO LTR 99119 (December 14, 1999) (OTS). See this
guidance for a more detailed discussion of the risk management processes applicable to securitization activities.
The Securitization Guidance addressed the fundamental risk management practices that should be in place at institutions that engage in securitization activities and stressed the need for bank management to implement policies and procedures that include limits on the amount of residual interests that may be carried as a percentage of capital. In particular, the Securitization Guidance set forth the supervisory expectation that the value of a residual interest in a securitization must be supported by objectively verifiable documentation of the asset's fair market value utilizing reasonable, conservative valuation assumptions. Under this guidance, residual interests that do not meet this expectation, or that fail to meet the supervisory standards set forth in the Securitization Guidance, should be classified as ``loss'' and disallowed as assets of the banking organization for regulatory capital purposes.
Moreover, the Agencies indicated in this guidance that institutions
found lacking effective risk management programs or engaging in
practices that present safety and soundness concerns would be subject
to more frequent supervisory review, limitations on residual interest
holdings, more stringent capital requirements, or other supervisory
response. The Securitization Guidance further advised the industry that
given the risks presented by securitization activities, and the
illiquidity and potential volatility of residual interests, the
Agencies were actively considering the establishment of regulatory
restrictions that would limit or eliminate the amount of certain residual interests that
[[Page 57995]]
may be recognized in determining the adequacy of regulatory capital.
The Agencies have identified three areas of continuing supervisory concern:
(1) Inappropriate or aggressive valuations of residual interests;
(2) Inadequate capital in relation to the risk exposure of the organization retaining residual interests; and
(3) Excessive concentrations of residual interests in relation to capital.
The Statement of Financial Accounting Standards No. 125,
``Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities'' (FAS 125) \2\ governs the recognition
of a residual interest in a securitization as an asset of the
sponsoring institution. Under these generally accepted accounting
principles (GAAP), when a transfer of assets is treated as a sale, the
securitizing or selling institution carries any residual interests as
an asset on its books at an estimate of fair value.\3\ Retaining this
residual interest on the balance sheet in connection with a sale
generally has the effect of increasing the amount of current earnings generated by the gains from the sale.
\2\ FAS 125 establishes certain transfer of control, accounting,
and valuation criteria surrounding the transfer of financial assets
as a benchmark for determining whether a transfer is recorded as a
``sale'' and, if so, at what value it is recorded. Under FAS 125,
the transferring financial institution generally will immediately
recognize gains from the sale of the transferred assets and record
retained interests in a manner that captures all of the financial
components of, including the residual interests that arise in
connection with, the securitization or other asset transfer.
\3\ The fair value reflects the expected future cash flows
discounted in an appropriate market interest rate, and is calculated
using assumptions regarding estimated credit loss rates and prepayment speeds.
The Agencies have become increasingly concerned with fair value estimates that are based on unwarranted assumptions of expected cash flows. No active market exists for many residual interests. As a result, there is no marketplace from which an arm's length market price can readily be obtained to support the residual interest valuation. Recent examinations have highlighted the inherent uncertainty and volatility regarding the initial and ongoing valuation of residual interests. A banking organization that securitizes assets may overvalue its residual interests and thereby inappropriately generate ``paper profits'' (or mask actual losses) through incorrect cash flow modeling, flawed loss assumptions, inaccurate prepayment estimates, and inappropriate discount rates. Residual interests are exposed to a significant level of credit and interest rate risk that make their valuation extremely sensitive to changes in the underlying assumptions. Market events can affect the discount rate or performance of assets supporting residual interests and can swiftly and dramatically alter their value. Should the institution hold an excessive concentration of such assets in relation to capital, the safety and soundness of the institution may be threatened.
The Agencies believe that the current regulatory capital
requirements do not adequately reflect the risk of unexpected losses
associated with these transactions. The booking of a residual interest
using gainonsale accounting can increase the selling institution's
capital and thereby allow the bank to leverage the capital created from
the securitization. This increased leverage resulting from the current
recognition of uncertain future cash flows is a supervisory concern.
Accordingly, the proposed rule focuses on those transfers of financial assets treated as sales under GAAP.\4\
\4\ When the securitization or other transfer of financial
assets is treated as a financing, under GAAP and for regulatory
capital purposes, rather than a sale, the assets continue to be
reflected on the balance sheet of the transferring institution. In
these circumstances, the assets continue to be subject to the
minimum capital requirement (generally 8 percent). The level of
supervisory concern is diminished in these circumstances because
there is no residual interest created to pose valuation or liquidity
concerns. Importantly, a financing transaction does not generate
earnings leading to the creation of capital. For this reason, the
proposal only changes the regulatory capital requirements for
banking organizations when they securitize or otherwise transfer
financial assets and treat the transactions as sales under GAAP.
A related concern is the adequacy of capital held by institutions that securitize or sell assets and retain residual interests. First, the lack of liquidity of residual interests and the potential volatility of residual interests arising from their leveraged credit and interest rate risk limits their ability to support the institution, especially in times of stress. Second, any weaknesses in the valuation of the residual interest can translate into weaknesses in the quality of capital available to support the institution. Liberal or unsubstantiated assumptions can result in material inaccuracies in financial statements. Even when such residual interests have been appropriately valued, relatively small changes in the underlying assumptions can lead to material changes in the residual interest's fair value. Inaccuracies in the initial valuation of residual interests, as well as changes in the underlying assumptions over time, can result in substantial writedowns of residual interests. If these generally illiquid and volatile residual interests represent an excessive concentration of the sponsoring institution's capital, they can contribute to the ultimate failure of the institution.
The concerns regarding excessive concentration and adequacy of capital are heightened where the residual interests are generated from the securitization of certain assets, such as lowquality or high loan tovalue loans. Recent examinations have shown that in order to provide adequate credit enhancement to the senior positions in securitizations involving low quality assets, institutions generally must retain relatively greater credit risk exposure. In such transactions, the sponsoring institutions may retain residual interests in amounts that exceed the riskbased capital that would have been associated with the loans had they not been transferred.
Because of these continuing supervisory concerns, the Agencies
believe it is appropriate to propose these revisions to their
respective capital adequacy rules in order to limit the amount of
residual interests that are retained by banking organizations and require adequate capital for the risk exposure created.
III. Current Capital Treatment for Residual Interests
Assets Sold ``With Recourse'' \5\
\5\ Consolidated Reports of Condition and Income (Call Report) instructions issued by the Federal Financial Institutions
Examination Council provide examples of transfers of assets that
involve recourse arrangements. See the Call Report Glossary entry
for ``Sales of Assets for RiskBased Capital Purposes.'' These
examples address the risk of loss retained in connection with
transfers of assets. OTS currently defines the term ``recourse''
more broadly in its capital rules at 12 CFR 567.1 to include the
``acceptance, assumption or retention'' of the risk of loss. The
Agencies have issued a separate proposal that, among other things,
would provide a uniform definition of ``recourse.'' See 65 FR 12319 (March 8, 2000).
Under current riskbased capital guidelines, banking organizations
that retain ``recourse'' on assets sold generally are required to hold
capital as though the loans remained on the institution's books,\6\ up to the ``full capital charge''.\7\ For regulatory capital
[[Page 57996]]
purposes, recourse is generally defined as an arrangement in which a
banking organization retains the risk of credit loss in connection with
an asset transfer, if the risk of credit loss exceeds a pro rata share of the institution's claim on the assets.\8\
\6\ Under the Agencies' current capital rules, assets
transferred with recourse in a transaction that is reported as a
sale under generally accepted accounting principles (GAAP) are
removed from the balance sheet and are treated as offbalance sheet
exposures for riskbased capital purposes. For transactions reported
as a sale, the entire amount of the assets sold (not just the
contractual amount of the recourse obligation) is normally converted
into an onbalance sheet credit equivalent amount using a 100
percent conversion factor. This credit equivalent amount is then risk weighted for riskbased capital calculation purposes.
\7\ For assets that are assigned to the 100 percent riskweight
category, the full capital charge is 8 percent of the amount of
assets transferred, and institutions are required to hold 8 cents of
capital for every dollar of assets transferred with recourse. For
assets that are assigned to the 50 percent riskweight category, the
full capital charge is 4 cents of capital for every dollar of assets transferred with recourse.
\8\ The riskbased capital treatment for sales with recourse can
be found at 12 CFR 3, appendix A, section (3)(b)(1)(iii) (OCC); 12
CFR 208, appendix A, section III.D.1 and 12 CFR 225, appendix A,
section III.D.1 (FRB); 12 CFR 325, appendix A, section II.D.1 (FDIC); and 12 CFR 567.6(a)(2)(i)(C) (OTS).
As required by statute,\9\ the Agencies have adopted rules that
provide ``lowlevel recourse'' treatment for those institutions that
securitize or sell assets and retain recourse in dollar amounts less
than the full capital charge.\10\ Before the issuance of the lowlevel
recourse rules, these institutions could have been required to hold a
greater level of capital than their maximum contractual exposure to
loss on the transferred assets. The lowlevel recourse treatment
applies to transactions accounted for as sales under FAS 125 in which a
banking organization contractually limits its recourse exposure to less than the full capital charge for the assets transferred.
\9\ Lowlevel recourse treatment is mandated by section 350 of
the Riegle Community Development and Regulatory Improvement Act, 12
U.S.C. 4808, which generally provides that: ``the amount of risk
based capital required to be maintained * * * by any insured
depository institution with respect to assets transferred with
recourse by such institution may not exceed the maximum amount of
recourse for which such institution is contractually liable under the recourse agreement.''
\10\ The Agencies' lowlevel resourse rules appear at: 12 CFR 3,
appendix A, section 3(d) (OCC); 12 CFR 208, appendix A, section
III.D.1.g and 225, appendix A, section III.D.1.g (FRB); 12 CFR 325,
appendix A, section II.D.1 (FDIC); and 12 CFR 567.6(a)(2)(i)(C)
(OTS). A brief explanation is also contained in the instructions for
regulatory reporting in section RCR for the Call Report or schedule CCR for the Thrift Financial Report.
Under the lowlevel recourse rule, a banking organization generally holds capital on a dollarfordollar basis up to the amount of the maximum contractual exposure. In the absence of any other recourse provisions, the onbalance sheet amount of the residual interests represents the maximum contractual exposure. For example, assume that a banking organization securitizes $100 million of credit card loans and records a residual interest on the balance sheet of $5 million that serves as a credit enhancement for the assets transferred. Before the lowlevel recourse rule was issued, the institution would be required to hold $8 million of riskbased capital against the $100 million in loans sold, as though the loans had not been sold. Under the lowlevel recourse rule, the institution would be required to hold $5 million in capital, that is, ``dollarfordollar'' capital up to the institution's maximum contractual exposure.
Existing regulatory capital rules, however, do not require institutions to hold ``dollarfordollar'' capital against residual interests that exceed the full capital charge ($8 million in the above example). Typically, institutions that securitize and sell higher risk assets are required to retain a large residual interest (often greater than the full capital charge of 8 percent on 100 percent riskweighted assets) in order to ensure that the more senior positions in the securitization or other asset sale can receive the desired investment ratings. Writedowns of the recorded value of the residual interest, due to unrealistic (or changing) loss or prepayment assumptions, can result in residual losses that exceed the amount of capital held against these assets, thereby impairing the safety and soundness of the institution.
For example, assume that a banking organization securitizes $100 million of subprime credit card loans and records a residual interest on the balance sheet of $15 million that serves as a credit enhancement for the securitization. Under the current riskbased capital rules, the transferred loans would be treated as sold with recourse, and an 8 percent riskbased capital charge for these 100 percent riskweighted loans would be required; that is, $8 million in riskbased capital would be required to be held against the $100 million of transferred loans. In this hypothetical example, however, the amount of residual interests retained on the balance sheet ($15 million) exceeds the full equivalent riskbased capital charge held against the assets transferred ($8 million). Accordingly, the amount of the residual interest is not fully covered by dollarfordollar riskbased capital; only $8 million in capital is required to be held by the institution against the $15 million residual interest exposure.
This example demonstrates that, for residual interests that exceed
the dollar amount of the full capital charge on the assets transferred,
current capital standards do not require dollarfordollar capital
protection for the full contractual exposure to loss retained by the
selling institution. Any losses in excess of the full capital charge (8
percent in the example above) could negatively affect the capital
adequacy of the institution. Should the asset be written down from $15
million to $5 million, the $8 million of required capital would be insufficient to absorb the full loss of $10 million.
B. Prior Consideration of Concentration Limits on Residual Interests
In 1998, the Agencies amended their capital rules to change the regulatory capital treatment of servicing assets.\11\ This rulemaking increased from 50 percent to 100 percent the amount of mortgage servicing assets that could be included in Tier 1 capital. The Agencies imposed more restrictive limits on the amount of nonmortgage servicing assets and PCCRs that could be included in Tier 1 capital. These stricter limitations were imposed due to the lack of depth and maturity of the marketplace for such assets, and related concerns about their valuation, liquidity, and volatility.
\11\ See 63 FR 42668 (August 10, 1998).
At the time the Agencies issued the final rule on servicing assets,
the Agencies declined to adopt similar capital limits for I/O strips, a
form of residual interest, notwithstanding that certain I/O strips
possessed cash flow characteristics similar to servicing assets and
presented similar valuation, liquidity, and volatility concerns. At
that time, the Agencies chose not to impose such limitations in
recognition of the ``prudential effects of banking organizations
relying on their own risk assessment and valuation tools, particularly
their interest rate risk, market risk, and other analytical models.''
\12\ The Agencies expressly indicated that they would continue to
review banking organizations' valuation of I/O strips and the
concentrations of these assets relative to capital. Moreover, the
Agencies noted that they ``may, on a casebycase basis, require
banking organizations that the Agencies determine have high
concentrations of these assets relative to their capital, or are
otherwise at risk from these assets, to hold additional capital
commensurate with their risk exposures''.\13\ In addition, most of the
residual interests at that time that were used as credit enhancements
did not exceed the full capital charge on the transferred assets and
thus were subject to ``dollarfordollar'' capital requirements under
the Agencies'' existing lowlevel recourse rules. However, a trend
toward the securitization of higher risk loans has now resulted in
residual interests that exceed the full capital charge and for which
``dollarfordollar'' capital is not required under the current risk
based capital rules. This trend has also resulted in certain banking organizations engaged in such
[[Page 57997]]
securitization transactions having large concentrations in residual interests as a percentage of capital.
\12\ Id. at 42672.
\13\ Id.
IV. Residual Interests Subject to the Proposal
Included in this proposal are residual interests that are structured to absorb more than a pro rata share of credit loss related to the securitized or sold assets through subordination provisions or other credit enhancement techniques. Such residual interests can take many forms. Generally, these residual interests are noninvestment grade or unrated ``firstloss'' positions that provide credit support for the senior positions of the securitization or other asset sale. A key aspect of such residual interests is that they reflect an arrangement in which the institution retains risk of credit loss in connection with an asset transfer. In addition to recourse provisions that may require the selling institution to support a securitization, residual interests can take the form of spread accounts, over collateralization, subordinated securities, cash collateral accounts, or other similar forms of onbalance sheet assets that function as a credit enhancement. Servicing assets that function as credit enhancements would be subject to the proposed rule.
The definition of residual interests excludes those interests that do not serve as credit enhancements. In this regard, highly rated, liquid, marketable residual interests where the institution assumes only the interest rate risk associated with the assets transferred in the securitization (e.g., Fannie Mae or Freddie Mac I/O strips) do not serve as a credit enhancement for the transferred assets and thus do not expose the institution to a concentrated level of credit risk. Further, such instruments are traded in a currently active marketplace and thus do not present the same degree of liquidity and valuation concerns.
The residual interests covered by the proposed rule are generally
retained by the securitizing institution rather than sold because they
are generally illiquid and volatile in nature and thus present
liquidity and valuation concerns. The proposed rule extends only to
residual interests that have been retained by a banking organization as
a result of a securitization or other sale transaction and does not
cover residual interests that a banking organization has purchased from another party.\14\
\14\ The proposed rule would extend to all residual interests as
defined, whether included in the banking book or included in the trading book and subject to the market risk rules.
Purchased residual interests can present the same degree of concentrated credit risk associated with retained residual interests. The exclusion of purchased residual interests from the proposed rule could establish a different capital treatment for the same asset, depending on whether the interest is purchased from a third party or retained in connection with the transfer of financial assets to a third party. The Agencies are particularly concerned about the possible ``swapping'' of residual interests, where there is otherwise limited breadth and depth of the market for these residual interests, and both parties stand to gain from accommodation valuations of each asset.
However, residual interests purchased in an arm's length transaction may not pose the same degree of liquidity risk as interests that are retained. In addition, purchased interests do not present the same opportunity to create capital as do interests that are originated and retained by a securitizing institution. Further, unlike retained residual interests where an overvaluation of the residual interest can lead to a higher gain on sale and the creation of additional capital, there is a marketplace discipline on the initial amount at which a purchased residual interest is recorded (that is, it is limited to the purchase price), and there is no incentive on the part of the purchaser to pay a price above market because such a purchase does not create any capital for the purchaser.
The Agencies are considering including such purchased interests within the scope of the rule and are requesting comment on this issue. V. Proposed Amendments to the Capital Standards
A. Proposed Treatment of Residual Interests
The Agencies propose to amend the regulatory riskbased capital standards by eliminating the distinction between the treatment of low level recourse obligations and the treatment of assets securitized or sold with recourse in those cases where the amount of the residual interest retained on balance sheet exceeds the full capital charge for the assets transferred. The current rules essentially place a ceiling on the ``dollarfordollar'' capital requirement for recourse obligations. Removal of this ``cap'' will ensure that all residual interests are subject to the same ``dollarfordollar'' capital standard that is applied to residual interests in lowlevel recourse transactions and that capital is held for the organization's total contractual exposure to loss.
In addition to modifying the riskbased capital treatment for residual interests, the Agencies propose limiting the amount of residual interests that can be recognized in determining Tier 1 capital under the Agencies' leverage and riskbased capital standards. The purpose of the limit is to prevent excessive concentrations in holdings of residual interests. The Agencies propose including residual interests within the 25 percent of Tier 1 capital sublimit already placed upon nonmortgage servicing assets and PCCRs. Under this restriction, any amounts of residual interests, when aggregated with nonmortgage servicing assets and PCCRs, that exceed of 25 percent of Tier 1 capital, would be deducted from Tier 1 capital for purposes of calculating both the riskbased and leverage capital ratios.\15\ \15\ The unrealized gains that may be recorded by an institution with respect to residual interests that are accounted for as availableforsale securities are presently not included in Tier 1 capital and would not be subject to further deduction under this rule.
In addition to including residual interests in the sublimit currently applied to PCCRs and nonmortgage servicing assets, residual interests would also be included in the calculation of the overall 100 percent limit on servicing assets. Under this proposal, the maximum allowable amount of mortgage servicing assets, PCCRs, nonmortgage servicing assets, and residual interests, in the aggregate, would be limited to 100 percent of the amount of Tier 1 capital that exists before the deduction of any disallowed mortgage servicing assets, any disallowed PCCRs, any disallowed nonmortgage servicing assets, any disallowed residual interests, and any disallowed deferred tax assets. The residual interests, however, would not be subject to the 90 percent of fair value limitation that applies to servicing assets and PCCRs. Under the proposed rule, residual interests would already be subject to a ``dollarfordollar'' capital requirement. Any residual interests deducted in determining the Tier 1 capital numerator for the leverage and riskbased capital ratios also would be excluded from the denominators of these ratios.
In summary, under the proposed rule, institutions generally would
be required to hold ``dollarfordollar'' capital for residual
interests and additionally would be required to deduct from Tier 1
capital the amount of any residual interests (when aggregated with
nonmortgage servicing assets and PCCRs) that exceed the established 25
percent sublimit. In combination, the proposal is intended to ensure that all
[[Page 57998]]
residual interests are supported by ``dollarfordollar'' capital and
that excessive concentrations (over 25 percent) in residual interests relative to capital are avoided.\16\
\16\ The Agencies are also proposing minor technical changes.
For example, this proposal does not effect the calculation of
tangible equity the under prompt corrective action regulations.
However, because the Agencies define tangible equity using different
core capital concepts (i.e., ``core capital'' vs. ``core capital
elements''), the OTS is proposing a technical revision to its
definition of tangible equity (12 CFR 565.2(f)) to ensure that this calculation is not effected by the proposal.
In addition, the FDIC is also amending its regulations to remove an obsolete provision concerning the transitional 7.25 percent risk based capital standard that was only effective until December 31, 1992. This provision currently appears in section III.B of appendix A to part 325. Similarly, OTS is making technical revisions to related regulatory provisions at 12 CFR 565.2(f).
B. NetofTax Treatment
The Agencies propose to extend the current netoftax treatment permitted in their existing capital standards to residual
interests.\17\ Thus, the proposed rule would permit: (1) Disallowed
amounts of residual interests (that is, those amounts in excess of the
25 percent of Tier 1 capital sublimit) to be determined on a basis that
is net of any associated deferred tax liability, and (2) any amounts of
residual interests that are subject to the ``dollarfordollar''
capital requirement (that is, those amounts included in the 25 percent
of Tier 1 capital sublimit) to be determined on a basis that is net of
any associated deferred tax liability. In instances where there is no
difference between the book basis and the tax basis of the residual
interest, no deferred tax liability would be created. Any deferred tax
liability used to reduce the capital requirement for a residual
interest would not be available for the organization to use in
determining the amount of net deferred tax assets that may be included in the calculation of Tier 1 capital.\18\
\17\ The proposed treatment is consistent with that permitted
for lowlevel recourse exposures, disallowed servicing assets, and
disallowed intangible assets in nontaxable business combinations.
\18\ For example, see Sec. 325.5(g) of the FDIC's capital
regulations (12 CFR 325.5(g)), which sets forth the limitations on
the amount of deferred tax assets that state nonmember banks can
recognize for purposes of calculating Tier 1 capital under the leverage and riskbased capital rules.
The following example helps illustrate the proposed tax treatment. Assume residual interests of $100 with an associated deferred tax liability of $35 and Tier 1 capital (before the deduction of any disallowed residual interests) of $200. In this example, the 25 percent concentration limit on residual interests (when combined with nonmortgage servicing assets and PCCRs) would be $50 (i.e., 25 percent times $200). The amount of disallowed residual interests (before considering the associated deferred tax liability) would have been $50. The deferred tax liability associated with the otherwise disallowed residual interests of $50 would be $17.50 (a $35 associated deferred tax liability against $100 in residual interests drives a 35 percent tax effect against the $50 disallowed residual interest). Thus, the amount of disallowed residual interests to be deducted in determining Tier 1 capital under the leverage and riskbased capital standards net of the associated deferred tax liability would be $32.50 (i.e., the $50 in disallowed residual interests minus the $17.50 tax effect associated with the disallowed residual interests).
In determining riskweighted assets, the remaining $50 amount of residual interests allowable in Tier 1 would be subject to a ``dollar fordollar'' capital on a basis that is also net of the deferred tax liability associated with the $50 residual interest. The deferred tax liability associated with the $50 not deducted from Tier 1 capital would be $17.50 (i.e., the 35 percent tax effect as calculated above times $50). Thus, the amount of residual interests that would be subjected to ``dollarfordollar'' treatment would be $32.50 ($50 less the $17.50 in deferred tax liabilities). Calculation of this ``dollar fordollar'' capital charge is consistent with the ``dollarfor dollar'' capital requirements that are currently required for lowlevel recourse transactions.
Other alternative calculations are possible and will be considered
by the Agencies.\19\ The Agencies seek comment on whether the
complexity of a ``netoftax'' approach is necessary and justified, and
if so, what, if any, alternative calculations should be allowed.
\19\ Two additional treatments are possible. Under the first
approach, the amount of residual interests subject to a ``dollar
fordollar'' deduction for riskbased capital purposes, and a
concentration limit for leverage capital purposes, would be the
``atrisk'' amount; that is, the residual interests reduced by any
associated deferred tax liability. For example, assume residual
interests of $100 with an associated deferred tax liability of $35.
Under this approach, the amount of residual interests subject to a
``dollarfordollar'' capital charge and a concentration limit is
$65 ($100$35). In a worstcase scenario, if the value of the
residual interests drops to zero, then the corresponding deferred
tax liability would also drop to zero, and therefore capital would decline by $65the netoftax amount. If the 25% of Tier 1
concentration limitation is $50, then the deduction would be $15
($65$50). Under the second approach, the amount of residual
interests subject to the ``dollarfordollar'' capital requirement
and 25% of Tier 1 capital concentration limit would be determined on
a gross basis, that is, without netting the associated deferred tax liability.
C. Reservation of Authority
While this proposal should help remedy some of the major concerns
associated with the generally illiquid and volatile nature of residual
interests, the Agencies are also proposing to add language to the risk
based capital standards that will provide greater flexibility in
administering the standards. Institutions are developing novel
transactions that do not fit well into the riskweight categories set
forth in the standards. Institutions are also devising novel
instruments that nominally fit into a particular riskweight category,
but that impose risks on the banking organization at levels that are
not commensurate with the nominal riskweight for the asset, exposure,
or instrument. Accordingly, the Agencies are proposing to add language
to the standards to clarify the Agencies' authority, on a casebycase
basis, to determine the appropriate riskweight asset amount in these
circumstances. Exercise of this authority by the Agencies may result in
a higher or lower risk weight for an asset. This reservation of
authority explicitly recognizes the Agencies' retention of sufficient
discretion to ensure that institutions, as they develop novel financial
assets, will be treated appropriately under the riskbased capital standards.
D. Relationship of This Residual Interest Proposal to the March 2000 Securitization Proposal
This proposed rule regarding residual interests (residual interest
proposal) and the March 2000 notice of proposed rulemaking on the risk
based capital treatment of recourse arrangements, direct credit
substitutes, and asset securitizations (the securitization proposal)
are interrelated in that both proposals would address the regulatory
capital treatment for residual interests that are retained in
connection with securitizations and other transfers of financial
assets.\20\ The capital treatment of residual interests under the
securitization proposal differs in certain respects from the treatment
proposed in this residual interest proposal. In any final rule that
addresses the regulatory capital treatment of residual interests, the
Agencies will ensure that any regulatory capital treatment of residual [[Page 57999]]
interests resulting from these two proposals will be consistent.
\20\ See 65 FR 12320 (March 8, 2000) for the text of the
proposed revisions to the riskbased capital treatment of recourse
arrangements, direct credit substitutes, and asset securitizations.
In the securitization proposal, the Agencies propose using external credit ratings to match the riskbased capital requirement more closely to the relative risk of loss in asset securitizations. Highly rated investmentgrade positions in securitizations would receive a favorable (less than 100 percent) riskweight. Belowinvestment grade or unrated positions in securitizations would receive a less favorable riskweight (greater than 100 percent riskweight or grossup treatment). A residual interest retained by an institution in an asset securitization (as well as residual interests that are purchased) would be subject to this capital framework under the securitization proposal.
The residual interest proposal differs from the securitization proposal in several respects. For example, under the residual interest proposal, all residual interests that are retained by the institution and that fall within the 25 percent of Tier 1 capital limit would be subject to ``dollarfordollar'' capital treatment regardless of rating (and comment is sought on whether purchased interests should be treated similarly). To date, the Agencies believe that residual interests in asset securitizations generally are unrated and illiquid interests; however, as the market evolves, residual interests may in the future take the form of rated, liquid, certificated securities. If the rating provided to such a residual interest were investment grade (or no more than one category below investment grade) the securitization proposal would afford that residual interest more favorable capital treatment than the dollarfordollar capital requirement set forth in this residual interest proposal. In addition, the riskbased capital requirement for unrated residual interests that are subject to grossup treatment under the securitization proposal would not exceed the full riskbased capital charge for the underlying assets that are being supported by the residual interest. Under this residual interest proposal, however, ``dollarfordollar'' capital would be required for the amount of the residual interest that is retained and falls within the 25 percent of Tier 1 capital limit, even if this amount exceeds the full capital charge typically held against the underlying assets that have been transferred with recourse. Also, unlike the residual interest proposal, the securitization proposal does not establish any concentration limit for residual interests as a percentage of capital.
These differences between the residual interest proposal and the securitization proposal will be taken into account in any final rule published under either proposal. In developing a final rule on residual interests, the Agencies specifically invite comment on how the capital treatment for residual interests under this residual interest proposal should be reconciled with the capital treatment set forth in the securitization proposal.
E. Effective Date
The Agencies intend to apply this proposal to existing as well as future transactions. Because banking organizations may need additional time to adapt to any new capital treatment, the Agencies may delay the effective date for a specific period of time (transition period). The Agencies view this transition period as an opportunity for institutions to consider the proposal's impact on their balance sheet structure and capital position. The Agencies invite comment on the need for and duration of a transition period.
VI. Request for Public Comment
The Agencies invite public comment on all aspects of the proposed rule. In particular, the Agencies request comment on the definition of residual interest, the treatment of residual interests in determining compliance with minimum capital requirements, the conditions established in the proposal, and the implementation of the proposal. The Agencies also specifically request comment on the ``dollarfor dollar'' riskbased capital charge for residual interests, the 25 percent of Tier 1 capital concentration limit on the amount of residual interests that can be recognized for leverage and riskbased capital purposes, and the issue of whether a ``netofassociated deferred tax liability'' approach is appropriate in determining the capital requirements for residual interests.
VII. Plain Language
Section 722 of the GrammLeachBliley (GLB) Act (12 U.S.C. 4809)
requires federal banking agencies to use ``plain language'' in all
proposed and final rules published after January 1, 2000. We invite
your comments on how to make this proposed rule easier to understand. For example:
(1) Have we organized the material to suit your needs?
(2) Are the requirements in the rule clearly stated?
(3) Does the rule contain technical language or jargon that isn't clear?
(4) Would a different format (grouping and order of sections, use
of headings, paragraphing) make the rule easier to understand? (5) Would more (but shorter) sections be better?
(6) What else could we do to make the rule easier to understand? VIII. Regulatory Analysis
A. Regulatory Flexibility Act Analysis
Board: Pursuant to section 605(b) of the Regulatory Flexibility Act, the Board has determined that this proposal will not have a significant impact on a substantial number of small business entities within the meaning of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.). The Board's comparison of the applicability section of this proposal with Call Report data on all existing banks shows that application of the proposal to small entities will be rare. Accordingly, a regulatory flexibility analysis is not required. In addition, because the riskbased capital standards generally do not apply to bank holding companies with consolidated assets of less than $150 million, this proposal will not affect such companies''.