"Dodd-Frank Capital Requirements for Financial Institutions"
Peter J. Rivas
Jones Walker Banking & Financial Services E*lert, October 14, 2010

The Dodd-Frank Act Wall Street Reform and Consumer Protection Act (the "Act") imposes a series of more onerous capital requirements on financial companies and other companies, including swap dealers and nonbank financial companies that are determined to be of systemic risk.

The Collins Amendment

The centerpiece of the Act's new regulatory capital requirements is Section 171, the Collins Amendment, which is intended to ensure that "financial institutions hold sufficient capital to absorb losses during future periods of financial distress."[1] Section 171 directs federal banking agencies to establish minimum leverage and risk-based capital requirements on a consolidated basis for insured depository institutions, their holding companies and nonbank financial companies that have been determined to be systemically significant by the Financial Stability Oversight Council (FSOC).

The Act requires that, at a minimum, regulators apply to bank holding companies and other systemically significant nonbank financial companies the same capital and risk standards that such regulators apply to banks insured by the Federal Deposit Insurance Corporation (FDIC). An important consequence of this requirement is that hybrid capital instruments, such as trust preferred securities, will no longer be included in the definition of tier 1 capital. Tier 1 capital includes common stock, retained earnings, certain types of preferred stock and trust preferred securities. Since trust preferred securities are not currently counted as tier 1 capital for insured banks, Section 171's effect is that such securities will no longer be included as tier 1 capital for bank holding companies.

Excluding trust preferred securities from tier 1 capital could significantly decrease regulatory capital levels of bank holding companies that have traditionally relied on trust preferred securities to meet capital requirements. Section 171 may force bank holding companies to raise other forms of tier 1 capital, for example, by issuing perpetual non-cumulative preferred stock. Since common stock must typically constitute at least 50 percent of tier 1 capital, many bank holding companies and systemically significant nonbank companies may also be forced to consider dilutive follow-on offerings of common stock.

Exemptions and Phase-In Periods

In order to ease the compliance burden associated with the new capital requirements, Section 171 provides a number of exceptions and phase-in periods. For bank holding companies and systemically important nonbank financial companies, any "regulatory capital deductions" for debt or equity issued before May 19, 2010 will be phased in incrementally from January 1, 2013 to January 1, 2016. The term "regulatory capital deductions" refers to the exclusion of hybrid capital from Tier 1 capital.

Section 171(b)(5) of the Act fully exempts from the regulatory capital deductions: (1) securities issued to the Treasury pursuant to the TARP program prior to October 4, 2010; (2) any Federal Home Loan Bank; and (3) holding companies subject to the Federal Reserve's policy statement on small bank holding companies (generally, holding companies with less than $500 million in assets). Importantly, the securities of any small bank holding company not otherwise exempted would become subject to heightened capital standards if its assets grew to beyond $500 million.

Section 171(b)(4)(C) grandfathers securities issued before May 19, 2010 by: (1) holding companies with less than $15 billion in assets as of December 31, 2009; and (2) by entities that were mutual holding companies as of May 19, 2010. Pursuant to this grandfather provision, these entities will be able to continue to treat these securities as tier 1 capital subject to existing Federal Reserve limitations through the life of the securities.

Section 171(b)(4)(B) provides a phase-in for securities issued before May 19, 2010 by issuers that are not eligible for the grandfather provisions discussed above. For these entities, securities issued prior to May 19, 2010 will become subject to the Dodd Frank Act's heightened capital requirements over a three-year phase in beginning on January 1, 2013.  Conversely, any securities issued on or after May 19, 2010 will be immediately subject to the Act's heightened capital standards unless otherwise exempted or grandfathered.

Trust-preferred and hybrid securities issued on or after May 19, 2010 will be counted as Tier 2, not Tier 1 capital, regardless of the size of the issuer.

Section 171 excludes small companies (under $500 million in asset bank holding companies) from any provisions of the section. The modification also grandfathers trust preferred stock issued before May 19, 2010, for all bank and thrift holding companies with less than $15 billion in consolidated assets. Holding companies with $15 billion or more are eligible for a five-year phase-in compliance with the provision, and beginning on January 1, 2013, are required to phase out trust preferred securities over a three-year period.

It should be noted that for bank holding companies with outstanding hybrid securities benefiting from a phase-in, the bill's passage may be considered a "capital treatment event" under the terms of securities' indentures and trustee agreements, which may, depending on the language, give the bank holding company that issued the Trust Preferred securities the right to call them, at par, subject to regulatory approval. Issuers should carefully review the provisions in all of their outstanding hybrid securities now.

In addition, the Basel Committee has issued a proposal aimed at implementing Basel III worldwide by the end of 2012, which coincides with the beginning of the phase-in period. In its current form, the Basel III rules would also exclude the forms of hybrid capital typically issued in the U.S. from tier 1 capital, although some Basel III grandfathering and/or phase-in provisions are expected to parallel the Act's respective phase-in and exemptive provisions.

[1] Letter by Shelia Bair to Sen. Collins, Cong. Rec. S. 3460 (May 10, 2010).