January 29, 2016

FAQs: Bank Investment in Other Financial Institution Debt and Capital

1. Can banks invest in senior and sub debt issued by other depository institutions?

Yes. Banks and BHCs can invest in other depository institution senior debt and capital securities. But Basel

III (Regulation Q) limits the amount that banks and BHCs with $1 billion or more in assets can invest in

capital securities issued by other financial institutions in the aggregate to 10% or less of the investing bank’s

Common Equity Tier 1 Capital (CET1). Investment amounts in excess of that 10% limit are deducted from the

same form of capital using the corresponding deduction approach as explained below. For additional

details, see http://www.gpo.gov/fdsys/pkg/FR-2013-10-11/pdf/2013-21653.pdf

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The Total Loss Absorbing Capacity (TLAC) Notice of Proposed Rulemaking (NPR) issued on October 30, 2015,

adds senior BHC debt issued by 8 U.S. Global Systemically Important Banks (GSIBs) (covered BHCs) to the list

of instruments potentially deducted from the investing financial institution’s regulatory capital (pursuant to

regulation Q). These 8 covered BHCs include: JPM, C, BAC, GS, MS, WFC, SST, and BK. Senior BHC debt

issued by non-GSIBs would not face this regulation Q restriction. Under the proposed TLAC NPR, the

deduction for GSIB senior BHC debt begins on January 1, 2019 and is fully phased in on January 1, 2022. The

comment period for this NPR ends on February 1, 2016, and the final rule may differ from the NPR.

The chart on the following page summarizes the application of capital deductions for bank investments due

to TLAC and Basel III rules as well as the imposition of additional FDIC charges for bank level investment in

long term bank debt issued by other depository institutions.

The decision on where to hold the investment in other bank senior debt or capital securities is a function of

the total asset size of the banking entity making the investment as well as the current amount of other bank

investments. Bank level investments of more than 3% of the investing bank’s tier 1 capital will cause a 50 BP

increase in risk assessments (see #5 below for more detail). BHC investments in the senior debt of other

depository institutions do not require this adjustment. BHCs with less than $1 billion in total assets are not

subject to the Basel III rules and requirements at the BHC level. (see question #6 for more details)

For additional details, see https://www.gpo.gov/fdsys/pkg/FR-2015-11-30/pdf/2015-29740.pdf and

http://www.sandleroneill.com/Collateral/Documents/English-US/TLAC%20-

%20Repercussions%20and%20Disruptions%20for%20U.S.%20Banks%20and%20Investors.pdf

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2. How is the amount to be deducted using the Corresponding Deduction Approach

calculated?In Column A, the sample bank’s investment portfolio currently includes senior BHC GSIB debt and

subordinated debt totaling $125 million. Under current Basel III rules, the $75 million of senior BHC GSIB

covered debt is not included in the calculation of investments subject to the Basel III deduction, and the

sample bank would face no capital deduction.

In Column B, the sample bank’s investment portfolio includes the $75 million in senior BHC GSIB covered debt

under the proposed Total Loss Absorbing Capital (TLAC) rules and would create an excess investment of $75

million that would be deducted from Tier 2 capital. Since the amount of Tier 2 capital at the sample bank of

$25 million is less than the deduction amount of $75 million, the $50 million balance is deducted from

preferred stock which is the next highest form of capital and then common equity until the full $75 million

deduction is taken. This results in a $75 million reduction in total capital with $25 million being deducted

from subordinated debt, $25 million from preferred stock and $25 million from common equity. This

deduction eliminates 100% of the subordinated debt and preferred stock that the investing bank can count as

regulatory capital. Overall, the 13.64% reduction in capital would not be required under current Basel III

capital rules but would be triggered under the proposed TLAC NPR.

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Case Study: Impact of Capital Deduction for Covered Debt on Sample Bank

A BTotal Assets = $5 Bil lion Corresponding CorrespondingTotal CET1 = $.500 Bill ion Deduction Approach Deduction Approach

Under Current Rules Under TLAC NPR

Non-significant Investment Amt. ($) Investment Amt. ($)Investment Type

Senior BHC Covered Debt (GSIB) 75.0$ 75.0$Subordinated Debt 50.0$ 50.0$Trust Preferred Stock -$Preferred Stock -$ -$Common Stock -$ -$Total Bank Investments -$ -$Subject to Basel III Deduction 50.0$ 125.0$

Common Equity Tier 1 500.0$ 500.0$

> 10% CET1 50.0$ 50.0$

Excess Bank Investments -$ 75.0$

Deduction Amount: % TotalSenior BHC Covered Debt (GSIB) -$ (45.0)$ 60%Subordinated Debt -$ (30.0)$ 40%Trust Preferred -$ -$ 0%Preferred Stock -$ -$ 0%Common Stock -$ -$ 0%

-$ (75.0)$ 100%

Current Capital Structure Before Deduction Deduction Adjusted $ (%) ChangeSubordinated Debt 25.0$ (25.0)$ -$ -100.00%Preferred Stock 25.0$ (25.0)$ -$ -100.00%Common Stock 500.0$ (25.0)$ 475.0$ -5.00%Total Regulatory Capital 550.0$ (75.0)$ 475.0$ -13.64%

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3. How should banks underwrite their investment in senior and sub debt?

The OCC, Fed and FDIC issued guidance in October 2013 on the definitions of “investment grade”, “subinvestment grade” and “doubtful”, which specifies the criteria that insured depository institutions can use tosupport their determination of classification. An investment grade issuer will generally not be adverselyclassified if the issuer has adequate capacity to meet its financial commitments and if the risk of default islow and the full and timely repayment of principal and interest is expected. If there is any question aboutpayment of the obligation in full, it is no longer considered investment grade and should be classified. Formore detail refer to the OCC bulletin at http://www.federalreserve.gov/bankinforeg/srletters/sr1318a1.pdf

4. What is the risk weighting applicable to an investment in senior or sub bank debt?

For U.S. community banks subject to the standardized approach, an investment in senior or sub debt wouldcarry a risk weighting of 100%, as shown in the chart below. If the investing bank has $250 billion or morein assets and subject to the Advance Approaches risk-weighting methodology, the BIS requirement is 250%for sub debt and 30% to 300% for senior debt based on rating. This would obviously not apply directly tocommunity banks but could impact the market pricing for such securities. All acquisition, development andconstruction (ADC) commercial real estate loans are risk weighted at 150% except: (i) one- to- four familyresidential ADC loans and (ii) commercial real estate ADC loans that meet applicable regulatory LTVrequirements; the borrower has contributed cash to the project of at least 15 percent of the real estate’s“appraised as completed” value prior to the advancement of funds by the bank; and the borrowercontributed capital is contractually required to remain in the project until the credit facility is converted topermanent financing, sold or paid in full. Non-performing loans are risk weighted at 150%.

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5. How does the purchase at the bank level of another bank’s term debt impact

risk assessments of the purchasing bank?

The depository institution debt adjustment increases the risk assessments by 50 BP for the amount of the

investment in the other insured depository institution’s debt above 3% of the investing bank’s Tier 1

capital. As illustrated in the chart below, the excess investment amount of $88 million x 50 BP =

$440,000 penalty. This penalty is paid through an increase in the bank’s FDIC assessment rate from 14

BP below to 14.96 BP.

For more information on the calculation methodology for FDIC risk assessments for small, large and

highly complex banking organizations, see https://www.fdic.gov/deposit/insurance/calculator.html

6. Are BHCs with less than $1 billion in assets subject to the Basel III deductions for

investment in other bank capital securities?

Pursuant to the Small Bank Holding Company Policy Statement effective May of 2015, a banking

institution with less than $1 billion in assets can potentially avoid deductions on investments in capital

securities by moving assets at fair market value (and consistent with section 23A and 23B restrictions)

from its bank, where BIII capital rules apply, to its BHC, where the Basel III capital rules do not apply,

until the BHC reaches $1 billion in assets. In December 2015, the House Financial Services Committee

approved a bill (H.R. 3791) to increase the consolidated BHC assets size threshold applicable to the Policy

Statement form $1 billion to $5 billion which, if adopted as law, would significantly expand the number

50 BP penalty on investment Depository Institution Debt Adjustment (DIDA): 88,000,000 * 0.5000%

in other bank debt LT senior unsecured debt 100,000,000

3% of Tier 1 Capital 12,000,000 / 4,600,000,000

Amount of LT IDI debt > 3% Limit 88,000,000

DIDA adjustment factor 0.500% DIDA adjustment 0.0096%

DIDA Adjustment Adjusted average total assets 5,000,000,000

increases FDIC risk Tangible equity (including qualifying tier 1) 400,000,000

assessments Current FDIC Assessment Base 4,600,000,000

Current FDIC Assessment Rate (from step 4 above) 0.1400%

Plus: Depository Institution Debt Adjustment 0.0096%

Revised FDIC Assesstment Rate 0.1496%

Revised FDIC Risk Assessment Premiums 6,880,000

Savings/(Expense) After DIDA (440,000) Cost of DIDA adjustment of $440,000

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of BHCs that could explicitly benefit. Effective January 1, 2019, investments by Federal Reserve Board

regulated institutions with assets of $1 billion or more in senior BHC debt issued by GSIBs are subject to

deduction from capital using the corresponding deduction approach. For more information, see

http://www.gpo.gov/fdsys/pkg/FR-2015-04-15/pdf/2015-08513.pdf and

http://www.gpo.gov/fdsys/pkg/FR-2013-10-11/pdf/2013-21653.pdf

7. Should banks classify an investment in bank debt, sub debt or other forms of

hybrid capital as a loan or as a security?

The OCC provided guidance on a similar issue in its bank advisory accounting series in October 2014. See

http://www.occ.gov/publications/publications-by-type/other-publications-reports/baas.pdf

Facts: A bank purchases [capital] securities using its legal lending limit authority.

Question 12: Should these securities be reported as loans or securities on the bank’s financial

statements?

Staff Response: The [capital] securities should be classified and reported as securities on the bank’sfinancial statements, including call reports. The legal means for acquiring the security is not relevant forthe accounting treatment. The financial statement classification is governed by GAAP, not the legalauthority under which the assets are purchased. The [capital] securities are debt securities subject to theaccounting requirements of ASC 320.

Additional References:

1. Source: OCC

http://www.federalreserve.gov/bankinforeg/srletters/sr1215a1.pdf

2. Source: FDIC

https://www.fdic.gov/news/conferences/chicago_region/2014-04-24.pdf

3. Source: OCC Investment securities handbook

http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/investsecurities1.pdf

The following excerpt is instructive:

“Occasionally, examiners will have difficulty distinguishing between a loan and a security. Loans resultfrom direct negotiations between a borrower and a lender. A bank will refuse to grant a loan unless theborrower agrees to its terms. A security, on the other hand, is usually acquired through a third party, abroker or dealer in securities. Most securities have standardized terms that can be compared to theterms of other market offerings. Because the terms of most loans do not lend themselves to suchcomparison, the average investor may not accept the terms of the lending arrangement. Thus, anindividual loan cannot be regarded as a readily marketable security.

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National banks are governed in their security investments by the seventh paragraph of 12 USC 24 and bythe investment securities regulation of the Comptroller of the Currency (12 CFR 1). The investmentsecurities regulation defines investment securities; political subdivision; general obligation; and Type I, II,and III securities, and establishes limitations on the bank’s investment in those securities. The law, 12USC 24, requires that for a security to qualify as an investment security, it be marketable and notpredominantly speculative.

For its own account, a bank may purchase Type I securities, which are obligations of the U.S.government or its agencies and general obligations of states and political subdivisions (see 12 USC24(7)), subject to no limitations, other than the exercise of prudent banking judgment. The purchase ofType II and III securities (see 12 CFR 1.3(d) and (e)) is limited to 10 percent of capital and surplus for eachobligor when the purchase is based on adequate evidence of the maker’s ability to perform. Thatlimitation is reduced to 5 percent of capital and surplus for all obligors in the aggregate where thepurchase judgment is predicated on “reliable estimates.” The term “reliable estimates” refers toprojections of income and debt service requirements or conditional ratings when factual creditinformation is not available and when the obligor does not have a record of performance. Securitiespurchased subject to the 5 percent limitation may, in fact, become eligible for the 10 percent limitationonce a satisfactory financial record has been established. There are additional limitations on specificsecurities ruled eligible for investment by the OCC that are detailed in 12 CFR 1.3. The par value, not thebook value or purchase price, of the security is the basis for computing the limitations. However, thelimitations do not apply to securities acquired through debts previously contracted.”

Thomas W. KillianPrincipal212-466-7709tkillian@sandleroneill.com

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