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In September, after years of evaluation and consideration, global banking regulators agreed upon new rules representing the biggest change in global banking regulation in decades, a new international regulatory framework referred to as Basel III. The Basel Committee on Banking Supervision, which sets minimum banking standards for the international banking community, has been working to hammer out new international banking regulations designed to make the international financial system more resilient and prevent a repeat of the international credit crisis. The Basel Committee consists of regulatory and central bank representatives from 27 countries. Its work is overseen by the Group of Governors and Heads of Supervision, chaired by Jean-Claude Trichet, president of European Central Bank and including other leading governors such as Federal Reserve chairman Ben Bernanke. These reform recommendations were approved by the Group of Leading Countries (G20) at its November summit in Seoul, South Korea.
New capital requirements
As approved, Basel III guidelines set tougher bank capital and liquidity standards and require banks to increase significantly the amount of capital they hold in reserve. Under the current Basel II global accord, banks are required to hold top-quality capital totaling 2 percent of their risk-bearing assets. The U.S. has been slow to implement Basel II reforms with the largest U.S. banks scheduled to complete the process by the first quarter of 2011, four years after many European countries put the rules into effect.
Under Basel III, banks will be required to hold top-quality capital – known as "core Tier 1" capital and consisting of equity or retained earnings – worth at least 4.5 percent of assets, calculated according to the riskiness of the assets on their books. Banks can include deferred tax assets, mortgage-servicing rights and investments in financial institutions to an amount no more than 15 percent of the common equity component. On top of that, banks will also have to build a new, separate "capital conservation buffer" of common equity of 2.5 percent of assets, bringing the total capital requirement to 7 percent. When credit markets are booming, as determined by national regulators, banks will also be required to build a separate "countercyclical buffer" of between zero and 2.5 percent.
Banks will be allowed to draw on the capital conservation buffer in times of financial stress. However, if a bank approaches the minimum requirements or fails to stay above the buffer, it could face restrictions curbing payouts such as bonuses, dividends and share buybacks.
In order to comply with these new requirements, the largest banks may need to raise hundreds of billions in capital. To ease this burden and give them time to do so, regulators created transition periods for phasing in the new rules. National implementation by Basel Committee member countries will begin January 1, 2013. Before that date, they will need to translate the rules into national laws and regulations. The Tier 1 capital rule will take full effect in January 2015 with the capital conservation buffer requirement scheduled to be phased in between January 2016 and January 2019. In response to the new regulations, some banks believe that meeting the new requirements may mean reduced levels of available money to make loans possibly resulting in slower economic growth. The Basel Committee hopes that the transition periods will enable the banks to meet the new standards without slowing the economy.
In 2009, blaming the global credit crisis partly on risky trading by banks, the leaders of the G20 called on regulators to work on tougher bank capital rules and to help ensure that banks are in a better position to withstand periods of economic and financial stress. Regulators hope the Basel III reforms will encourage banks to pursue less risky business strategies and ensure they have enough reserves to weather financial downturns without needing taxpayer bailouts. Now that the reforms have been approved by the G20, banks must look to the next steps – effective implementation of globally accepted policies and procedures for capital adequacy.
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Current environment significantly increases expectations for financial statement and other disclosures
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Recently, the American Institute of CPAs (AICPA) held its National Conference on Banks & Savings Institutions. Among the presentations was one by representatives of the Division of Corporate Finance of the U.S. Securities and Exchange Commission (SEC) on issues the staff of their group frequently encounters when reviewing bank filings. They discussed areas where they are likely to issue comments if appropriate supporting disclosures are not provided to explain specific issues, as well as suggestions for enhancing disclosure on those issues. As investors demand more information about the risks financial institutions carry, financial institutions could benefit from reviewing these suggestions relevant to their own operations so they can anticipate how to spot problems or missing documentation within their own financial statements.
Clearly describing your institution’s activities and transactions can go a long way toward enhancing investor confidence. Here is a list of areas typically eliciting SEC staff requests for additional disclosure, as well as general suggestions for additional disclosure that you can use to determine specific areas of disclosure that might help improve your institution’s reporting.
Asset quality issues – Items typically drawing staff requests for additional disclosure include commercial real estate (CRE) non-performing loans and charge-offs, appraisals, troubled debt restructurings (TDRs) and modifications, and non-impaired loan allowances.
- For charge-offs, consider disclosing triggering events or circumstances that impacted timing.
- Describe how you defined “confirmed loss” for charge-off purposes.
- Consider enhancing the disclosure surrounding recent trending in nonperforming loans and how that has impacted your asset quality and operating results.
- Describe the steps you take to monitor and evaluate collateral values of your nonperforming loans.
- For CRE workouts or restructurings, consider disclosing the amounts of loans that have been restructured using a specific strategy, the benefits of that strategy and the general terms of the new loans.
- For extensions of construction or commercial loans, consider disclosing the types of extensions being made, how they differ from original loan terms and how you evaluate the financial wherewithal of the guarantor, its reputation and level of success.
- For appraisals, consider disclosing how and when updated third party appraisals are obtained, whether you made any adjustments to the appraisals and why, the type of appraisal, and how partially charged-off loans are classified and accounted for subsequent to receiving an updated appraisal.
- Also define the associated timing, the procedures performed to ensure accurate measurement of impairment of loans, and how you determine the amount to charge-off.
- If you did not use an external appraisal or the appraisal process has not been updated, describe your procedure for estimating the value of the collateral for specific loans.
- For TDRs, consider disclosing key features of a loan modification program including whether the programs are government sponsored or your own, the significant terms modified and whether those modifications are short-term or long-term.
- Quantify TDRs by loan type (residential, home equity, commercial, credit cards, etc.).
- Disclose your policy regarding how many payments the borrower needs to make on restructured loans before returning a loan to accrual status.
- Discuss the bank’s types of concessions made (reductions in interest rate, payment extensions, forgiveness of principal, etc.) and the bank’s success with different types of concessions.
- With respect to your accrual/non accrual accounting policy, consider disclosing the factors you consider when restructuring a loan to determine whether the loan should accrue interest; how you determine that you are reasonably assured of repayment; and whether you have charged off any portion of the loan and how you concluded that repayment of interest and principal due is reasonably assured.
- For loan modifications that are not considered TDRs, consider disclosing factors you review to identify loans for modification, the key features of your modification programs, your success rates, and the amounts of loans modified in each period presented.
- Provide analysis that supports your conclusion that specific modifications should not be classified as TDRs, information on how they are classified, the impact of loan modifications on your past due statistics, and the success rates of short-term modifications.
Securities impairment issues – SEC staff notes commonly missed disclosures such as those not provided but now required by SFAS 115 and FSP 115-1 in quarterly and annual reports. Better disclosure is also suggested for Trust Preferred Securities (TPS), mortgage backed securities, equity securities, and investments in Federal Home Loan Bank (FHLB) stock.
- If a measureable amount of TPS/pooled TPS or impairment of a significant amount of TPS could likely have a material effect on the bank’s operations or capital, consider disclosing additional information for TPS with at least one rating below investment grade.
- Also for TPS, disclose actual defaults and deferrals as a percentage of original collateral, expected deferrals and defaults as a percentage of remaining performing collateral and, for security tranche you hold, additional defaults and deferrals.
- For mortgage backed securities, disclose the nature and type of assets underlying any asset-backed securities.
- For equity securities, SEC staff members are alerted to large unrealized losses for a period of time and to policies that may not appear to comply with GAAP and SAB 111.
- Regarding investments in FHLB stock, consider providing a detailed impairment policy for the investment, including positive and negative evidence considered in concluding that the investment is not impaired.
- Disclosure suggestions for goodwill impairment include providing information for each reporting unit and the percentage by which fair value exceeded carrying value, the amount of goodwill allocated to the reporting unit, a description of key methods and assumptions, the degree of uncertainty associated with key methods and assumptions, and a description of potential events or changes in circumstances that could negatively affect the key assumptions.
SFAS 166/167 – SEC staff is also likely to request enhanced disclosure where a financial institution does not provide sufficient disclosure to explain circumstances relating to changes in structures or transfers of non-performing assets to other entities.
FDIC assisted transactions – If your bank has entered into a loss sharing agreement with the FDIC in connection with an acquisition of a failed financial institution, staff will note the assets covered by the loss sharing agreements and how they are recorded and valued on the balance sheet.
Liquidity and risk management – Staff will request enhanced disclosure to explain circumstances surrounding any known trends, demands, commitments, events or uncertainties that will impact liquidity, as well as the type of risks faced by an entity. Provide a clear picture of your ability to generate cash and meet existing or future cash requirements. Evaluate cash flows and discuss the types of financing that are available to the company and the impact on the company’s cash position and liquidity.
Risk management – Make disclosure regarding credit risk and how it is managed, and how market risk is managed and monitored.
It is evident that the current condition of the credit and investment portfolios of financial institutions, and their efforts to reduce the associated risks, has heightened the expectations for relevant financial statement and other disclosures. The SEC clearly expects greater transparency about specific situations, management’s policies and procedures, and the results of strategic or tactical initiatives intended to reduce the level of risk. Bank executives and managers should be attentive to these expectations and make every effort possible to provide meaningful and relevant disclosures about the areas of highest risk. Involving personnel with responsibility for credit and other risks in the financial reporting process will ensure that the disclosures called for above reflect the most accurate and relevant matters related to the bank’s risk management activities.
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An overview of "The Wall Street Reform and Consumer Protection Act" - Dodd Frank
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On July 21, 2010, President Obama signed into law the "Wall Street Reform and Consumer Protection Act," the main architects of which were Senate Banking Committee Chairman Christopher J. Dodd and House Financial Services Chair Barney Frank. Their intent was a sweeping overhaul of the nation’s financial system in response to widespread calls for change since the fall of 2008 and the global credit crisis which followed. While the bill lays the groundwork for that overhaul, it now falls to regulators to put the financial reform law into effect, a task likely to span the next several years.
Contentious disputes, aggressive lobbying and – ultimately – compromises resulted in a bill that will have potentially broad impact on financial and non-financial institutions. Those provisions of most interest to Banking Advisor readers are summarized here.
New consumer "watchdog" agency
The law created a new independent "watchdog" agency housed within the Federal Reserve that is charged with protecting American consumers in financial transactions and to ensure that consumers of financial products like mortgages and credit cards are provided with clear and accurate information about those products, and not subjected to hidden fees, abusive loan terms or deceptive practices. The Consumer Financial Protection Bureau (CFPB) will be led by an independent director appointed by the President of the United States and confirmed by the Senate. The first goal of the new director and agency will be to create a simplified disclosure form for mortgage loans. It also has the authority to write rules for consumer protections governing all bank and non-bank entities offering consumer financial services or products. This agency will have the authority to examine and enforce regulations for banks and credit unions with assets of over $10 billion and all mortgage-related businesses and large non-bank financial companies.
The actions taken by this agency will apply to banks and financial companies below the $10 billion threshold as well. The oversight and implementation of the CFPB’s standards and requirements, once written and approved, will rest with the company’s primary federal regulator, generally the FDIC or OCC (The Dodd-Frank Act eliminated the Office of Thrift Supervision (OTS) by merging it into the OCC). Bankers generally believe the ultimate requirements arising from heightened federal regulatory oversight of consumer banking products will measurably increase the costs associated with this aspect of their businesses.
The Financial Stability Oversight Council
This newly created entity, a 9-member council led by the Treasury Secretary, will have crystal ball responsibility. It’s role will be to identify, monitor and address emerging systemic risks to the financial system, especially those posed by complex financial firms that grow large and interconnected enough to pose a threat to the financial stability of the United States should they fail to meet their obligations to creditors and customers. Enhancing transparency, data collected and analyzed to identify and monitor those risks will be made public in periodic reports and Congressional testimony. With a two-thirds vote by its members, the council will have the authority to regulate failing non-bank financial companies and to require a large, complex company to divest some of its holdings if it poses a grave threat to the financial stability of the United States. By giving the council the ability to make recommendations to the Federal Reserve for stricter rules regarding capital, leverage, liquidity, risk management and other requirements of larger companies, the goal of the law is to avoid having taxpayers foot the bill for bailouts of failing companies. New requirements and procedures will be in place regarding the orderly shutdown or liquidation of failing companies as well as funding by industry – not taxpayers -- of the cost of those liquidations.
Streamlined bank supervision
The new law also creates clear lines of responsibility among bank regulators. The Federal Deposit Insurance Corporation (FDIC) will regulate state banks and thrifts of all sizes and bank holding companies of state banks with assets below $50 billion. The Office of the Comptroller of the Currency (OCC) will regulate national banks and federal thrifts of all sizes and holding companies of national banks and federal thrifts with assets below $50 billion. The Office of Thrift Savings is eliminated and there will be no new charters for federal thrifts, though existing thrifts will be grandfathered in. The Federal Reserve will regulate bank and thrift holding companies with assets over $50 billion. The law also preserves the dual banking system, leaving in place the state banking system governing most community banks.
Executive compensation and corporate governance
The new law imposed several new requirements on public companies, including publicly-held banks, relating to executive compensation and corporate governance. An impetus of the provisions is to rein in excessive executive pay and help shift management’s focus from short-term profits to long-term growth and stability.
Public companies must hold several types of shareholder advisory votes on executive compensation, starting in 2011. The SEC proposed rules for implementing these requirements on October 18, 2010 with the intent to adopt final rules sometime between January and March 2011. It is important to note that in its proposed rules the SEC did not exclude smaller reporting companies from these requirements.
These shareholder advisory vote requirements include:
- Say-on-Pay Vote: a non-binding shareholder vote on executive compensation to be held at the first annual meeting on or after January 21, 2011. This vote must be held no less frequently than once every three years and must be held whether or not final SEC rules are in effect.
- Frequency Vote: Also, at the first annual meeting on or after January 21, 2011, public companies must hold a separate non-binding vote in which shareholders will express their opinion on whether the Say-on-Pay vote should be held annually, biennially, or triennially. The frequency vote must be held at least once every six years.
- Requirements Not Subject to Adoption of Final SEC Rules: The requirements to hold the Say-on-Pay vote and frequency vote at the first annual meeting on or after January 21, 2011 are effective regardless of whether the final SEC rules have been adopted.
- Parachutes Disclosure and Say-on-Parachutes Vote: The proxy materials to approve any merger, sale of assets, or similar transaction must include enhanced disclosure of the golden parachutes compensation to executives related to the transaction. The proxy materials must also include a separate shareholder advisory vote on the parachute compensation, unless the enhanced disclosure was part of a prior Say-on-Pay vote and there are no new arrangements. The parachutes disclosure and Say-on-Parachutes vote requirements are not effective until the final SEC rules go into effect.
Companies can prepare for implementation of these requirements by taking steps to enhance the clarity and transparency of compensation disclosure, reviewing compensation practices that may be considered problematic , and engaging with large shareholders on potential red flags in the company’s compensation practices. It will also be important to establish the link between executive pay and company financial performance.
Changes to the Federal Reserve
The Federal Reserve will oversee large holding companies with assets over $50 billion and other systematically significant financial firms. The Board of Governors of the Federal Reserve will now have a formal responsibility to identify, measure, monitor, and mitigate risks to U.S. financial stability. To eliminate conflicts of interest, no company, subsidiary or affiliate of a company that is supervised by the Federal Reserve will be allowed to vote for directors of Federal Reserve banks and their past or present officers, directors and employees cannot serve as directors. In addition, the bill provides that the President of the United States, with the advice and consent of the Senate, appoints the president of the Federal Reserve of New York.
There are numerous more provisions in the bill affecting other areas of financial commerce, including the sale of mortgage-backed securities (companies that sell them must retain at least 5 percent of the credit risk), credit rating agencies, hedge funds, insurance, and municipal securities.
The bill is estimated to cost $20 billion over 5 years. To help offset that cost, $11 billion of the fund repaid by banks who participated in the federal bank bailout will be redirected to support the provisions in the bill. As legislative committees struggle to fine tune the bill’s provisions, expect more information on its impact on financial institutions from the Banking Advisor.
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