Daily Rules, Proposed Rules, and Notices of the Federal Government
On February 7, 2011, the FDIC Board adopted a final rule that amended its assessment regulations, by, among other things, establishing a new methodology for determining assessment rates for large and highly complex institutions (the February 2011 rule).
One of the financial ratios used in the scorecards is the ratio of higher-risk assets to Tier 1 capital and reserves.
While institutions already reported C&D loan data in their quarterly reports of condition and income (the Call Reports and the Thrift Financial Reports or TFRs), they did not report the data for the other loans, thus requiring new line items in these reports. Therefore, on March 16, 2011, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Office of Thrift Supervision, and the FDIC (collectively, the agencies) published a Paperwork Reduction Act of 1995 (PRA) notice under normal PRA clearance procedures requesting comment on proposed revisions to the reports that would provide the data needed by the FDIC to implement the February 2011 rule beginning with the June 30, 2011, report date (March PRA notice).
Commenters on the March PRA notice raised concerns about their ability to report subprime and leveraged loan data consistent with the definitions used in the February 2011 rule. They also stated that they would be unable to report the required data by the June 30, 2011 report date. These data concerns had not been raised during the rulemaking process leading up to the February 2011 rule.
As a consequence of this unexpected difficulty, the FDIC applied to the Office of Management and Budget (OMB) for an emergency clearance request to allow large and highly complex institutions to identify and report subprime and leveraged loans and securitizations originated or purchased prior to October 1, 2011, using either their existing internal methodologies or the definitions in existing supervisory guidance. The agencies also submitted corresponding reporting revisions under normal PRA clearance procedures and requested public comment on July 27, 2011 (July PRA notice).
In response to the PRA notices, commenters recommended extending the transition guidance for reporting subprime and leveraged loans until more workable and accurate definitions were developed.
On September 28, 2011, the FDIC informed large and highly complex institutions via email (followed by
The FDIC considered all comments related to the higher-risk asset definitions that were submitted in response to the March and July 2011 PRA notices as part of its review. The FDIC also engaged in extensive discussions with bankers and industry trade groups to better understand their concerns and to solicit potential solutions to these concerns. As a result, the FDIC issued a notice of proposed rulemaking on March 20, 2012 (NPR) to resolve the problems raised in comments on the March and July PRA notices.
The FDIC sought comments on every aspect of the proposed rule. The FDIC received a total of 14 comment letters.
Comments are discussed in the relevant sections that follow.
The FDIC has adopted this final rule to amend the assessment system for large and highly complex institutions by: (1) Revising the definitions of certain higher-risk assets, specifically leveraged loans, which are renamed “higher-risk C&I loans and securities,”
The final rule will be effective on April 1, 2013, predicated on changes to the Call Report instructions having been made. The effective date is discussed in Section E below.
The FDIC uses the amount of an institution's higher-risk assets to calculate the institution's higher-risk concentration measure, concentration score and total score. As noted in the February 2011 rule, the higher-risk concentration measure captures the risk associated with concentrated lending in higher-risk areas. This type of lending contributed to the failure of a number of large banks during the recent financial crisis and economic downturn.
The definition of a “higher-risk C&I loan and security” in the final rule incorporates suggestions from comment letters, including a joint comment letter (the joint letter) from several industry trade groups and discussions with a trade group; the definition differs from the definition proposed in the NPR.
The final rule introduces a new term, a “higher-risk C&I borrower,” which includes a borrower that owes the reporting bank (
• The C&I loan must have an original amount (including funded amounts and the amount of unfunded commitments, whether irrevocable or unconditionally cancellable) of at least $5 million;
• The loan must meet the purpose and materiality tests described below; and
• When the loan is made, the borrower must meet the leverage test, also described below.
To ensure that the definition is equitably applied, all C&I loans that a borrower owes to the reporting bank that meet the purpose test when made and that are made within six months of each other must be aggregated to determine whether they have an original amount of at least $5 million; however, only loans in the original amount of $1 million or more need to be aggregated.
A “higher-risk C&I borrower” also includes a borrower that obtains a refinance
• The refinanced loan must be in an amount (including funded amounts and the amount of unfunded commitments, whether irrevocable or unconditionally cancellable) of at least $5 million;
• The C&I loan being refinanced must have met the purpose and materiality tests when it was originally made;
• The original loan must have been made no more than five years before the refinanced loan (the look-back period); and
• When the loan is refinanced, the borrower must meet the leverage test.
Again, to ensure that the definition is equitably applied, when a C&I loan is refinanced through more than one loan and the loans are made within six months of each other, they must be aggregated to determine whether they have an amount of at least $5 million. Thus, for example, an $8 million C&I refinancing loan that is split into two $4 million loans, where both are made within six months of each other, will still have an amount of $8 million.
A borrower ceases to be a “higher-risk C&I borrower” if: (1) The borrower no longer has any C&I loans owed to the reporting bank that, when originally made, met the purpose and materiality tests; (2) any such loans outstanding owed by the borrower to the reporting bank have all been refinanced more than five years after originally being made; or (3) the reporting bank makes a new C&I loan or refinances an existing C&I loan and the borrower no longer meets the leverage test. A borrower cannot cease to be a higher-risk borrower except as provided above.
Under the final rule, “higher-risk C&I loans or securities” include all C&I loans owed to the reporting bank by a higher-risk C&I borrower, except loans subject to an exclusion described below, and all securities issued by the higher-risk C&I borrower that are owned by the reporting bank, except securities classified as trading book, without regard to when the loans were made or the securities purchased.
A loan or refinance meets the purpose test if it is to finance a buyout, acquisition or capital distribution. Under the final rule, an “acquisition” is the purchase by the borrower of any equity interest in another company or the purchase of all or a substantial portion of the assets of another company; a “buyout” is the purchase or repurchase by the borrower of the borrower's outstanding equity (a buyout includes, but is not limited to, an equity buyout or funding of an Employee Stock Ownership Plan (ESOP)); and a “capital distribution” is a dividend payment or other transaction designed to enhance shareholder value, such as repurchase of stock.
The purpose test will help identify risk and reflect the method used internally by most banks to identify higher-risk loans. The test identifies those borrowers with certain higher-risk characteristics, such as a heavy reliance on either enterprise value or improvement in the borrower's profitability.
A loan or refinance meets the materiality test if the amount of the original loan (including funded amounts and the amount of unfunded commitments, whether irrevocable or unconditionally cancellable) equals or exceeds 20 percent of the total funded debt of the borrower. Total funded debt of the borrower is to be determined as of the date of the original loan and does not include the loan to which the materiality test is being applied.
At the time of refinance, whether the original loan met the purpose or materiality tests may not be easily determined by a new lender. In such a case, the new lender must use its best efforts and reasonable due diligence to determine whether the original loan met these tests.
A borrower meets the leverage test if the ratio of the borrower's total debt to trailing twelve-month EBITDA (commonly known as the operating leverage ratio) is greater than 4, or the ratio of the borrower's senior debt to trailing twelve-month EBITDA (also commonly known as the operating leverage ratio) is greater than 3.
Appendix C provides detailed definitions of many of the terms used in the foregoing definitions.
In the joint letter, commenters took issue with several parts of the NPR's proposed definitions related to higher-risk C&I loans.
• Any commercial loan (funded or unfunded, including irrevocable and revocable commitments) owed by a borrower to the evaluating depository institution with an original amount greater than $5 million if the conditions specified in (a) or (b) below are met as of origination, or, if the loan has been refinanced, as of refinance, and the loan does not meet the asset-based lending (ABL) exclusion or the floor plan line of credit exclusion (discussed in Appendix C).
(a)(i) The purpose of any of the borrower's debt (whether owed to the evaluating insured depository institution or another lender) that was incurred within the previous seven years was to finance a buyout, acquisition or capital distribution and such debt was material; and
(ii) The ratio of the borrower's total debt to trailing twelve-month EBITDA (
(b) Any of the borrower's debt (whether owed to the evaluating institution or another lender) is designated as a highly leveraged transaction (HLT) by a syndication agent.
• All securities held by the evaluating institution that are issued by a commercial borrower, if the conditions specified in (a) or (b) above are met, except securities classified as trading book; and
• All securitizations held by the evaluating institution that are more than 50 percent collateralized by commercial loans or securities that would meet the higher-risk C&I loans and securities definition if directly held by the evaluating institution, except securities classified as trading book.
Under the proposed definition, multiple loans to one borrower were to be aggregated to determine whether the outstanding amount exceeded $5 million to the extent that the institution's loan data systems could do so without undue cost. If the cost was excessive, the institution could treat multiple loans to one borrower as separate loans.
The final rule adopts these suggestions with some modifications primarily intended either to simplify the rule or to ensure that the intent of the definitions cannot be easily circumvented.
In the joint letter and a subsequent email, commenters suggested that debt incurred to fund ordinary business actions such as dividends to make tax payments should be excluded from the definition of a capital distribution in the purpose test. The final rule does not adopt this suggestion because the materiality test should be sufficient to exclude most loans made in the ordinary course of business.
Several industry trade groups and one bank commented that a material increase in debt should be defined as a 50 percent increase in funded debt within one year rather than the proposed 20 percent increase, arguing that 20 percent would include loans made to firms for routine acquisitions in the normal course of business. According to the commenters, such loans might include financing for a modest stock redemption or basic dividend program. Commenters also suggested that the materiality test should apply only to debt that meets the purpose test, rather than all debt. The final rule adopts the suggestion to consider only purpose loans in the materiality test.
Because the materiality test will measure only the increase in total funded debt that results from loans that meet the purpose test, rather than the total increase in funded debt from any source, the final rule continues to define a material increase as at least 20 percent. Increasing the threshold above 20 percent could exclude borrowers that were highly leveraged before obtaining a loan that meets the purpose test, even if the loan was large. Furthermore, the final rule already adopts a narrower definition of higher-risk C&I loans than existing and proposed regulatory guidelines on leveraged lending, which do not contain any materiality test.
The FDIC received no comments on the definition of the leverage test proposed in the NPR.
As proposed in the NPR, the definition of a higher-risk C&I loan and security in the final rule excludes the maximum amount that is recoverable from the U.S. government under guarantee or insurance provisions, as well as loans (including syndicated or participated loans) that are fully secured by cash collateral.
In the joint letter, commenters recommended excluding loans that are collateralized by securities issued by the U.S. government, its agencies, or government-sponsored enterprises (GSEs). The final rule, however, does not exclude loans so collateralized because the collateral is subject to interest rate risk and collateral arrangements are subject to operational risk. Commenters also recommended excluding loans that are fully secured by brokerage account collateral (securities-based loans). The final rule does not exclude these loans because the value of the collateral is subject to several sources of risk, including operational, credit and market risk.
A bank suggested that the definition of higher-risk C&I loans exclude loans acquired at a discount or marked to fair value. Another commenter suggested that the definition exclude modified loans. The final rule does not adopt these suggestions. The higher-risk concentration ratio is a forward looking financial measure aimed at capturing the risk of concentrations in higher-risk assets, irrespective of how the assets are valued on the balance sheet or whether they are modified. These loans have the characteristics of higher-risk loans, despite being recorded at a discount or at fair value at the date of acquisition or having been modified from the original terms. The future performance of these assets remains uncertain; the institution still faces the risk of additional losses on these assets.
In the joint letter, commenters recommended that unplanned overdrafts not be included as higher-risk C&I loans, arguing that they create exposures that are incidental and cured within a few days, if not overnight. The final rule, however, defines C&I loans consistent with the Call Report definition of such loans, which includes unplanned overdrafts. An overdraft alone is unlikely to cause a borrower to be considered higher risk, however; it is only likely to be included as higher-risk to the extent that other loans cause a C&I borrower to be considered higher risk.
The definition of higher-risk C&I loans and securities excludes certain well-collateralized asset-based loans and floor plan loans.
The final rule details the conditions that institutions must meet to be eligible for the asset-based and floor plan lending exclusions. The differences
The final rule permits a bank to exclude an asset-based loan from higher-risk C&I loans owed by a higher-risk C&I borrower, provided that the advance rate on the accounts receivables that serve as collateral for the loan does not exceed 85 percent. This is a change from the NPR, which proposed that advance rates on accounts receivable should
In response to comments, the final rule also provides that:
• The borrowing base may include other assets, but a loan must be fully secured by the portion of the borrowing base that is composed of accounts receivable and inventory.
• Appraisals will not be required for accounts receivable collateral. In addition, when there is a readily available and determinable market price for inventory from a recognized exchange or third-party industry source, inventory may be valued using these sources in lieu of an appraisal.
• An institution need not have the unconditional ability to take control of a borrower's deposit accounts to be eligible for the asset-based lending exclusion; rather, it is sufficient if the lending institution has the legally enforceable ability to take dominion over the borrower's deposit accounts without further consent by the borrower (or any other party). In all cases, the lending bank must have a perfected first priority security interest in the deposit account, a security agreement must be in place and, if the account is held at an institution other than the lending institution, an account control agreement must also be in place.
• The lending bank must have the ability to withhold funding of a draw or loan advance if the outstanding balance on the loan is not within the collateral formula prescribed by the loan agreement.
• A bank's lending policies or procedures must address the maintenance of an inventory loan agreement with the borrower, consistent with the requirements for an accounts receivable loan agreement.
• Banks are required to obtain financial statements from dealer floor plan borrowers, but the statements need not be audited. Original Equipment Manufacturers (OEM) financial statements, otherwise known as dealer statements, will be sufficient.
“Higher-risk consumer loans” are defined as all consumer loans where, as of origination, or, if the loan has been refinanced, as of refinance, the probability of default (PD) within two years (the two-year PD) is greater than 20 percent, excluding those consumer loans that meet the definition of a nontraditional mortgage loan.
As noted by commenters, the FDIC may need to adjust the higher-risk PD threshold after reviewing data for the first reporting period, since the 20 percent threshold in the definition was determined based on preliminary score-to-default rate mappings received from a few credit score providers.
The NPR proposed that the FDIC could change the PD threshold without further notice-and-comment rulemaking. Several trade groups commented that the higher-risk PD threshold, after a potential adjustment following the first reporting period, should remain invariant and not be changed without notice-and-comment rulemaking.
The final rule is generally consistent with these comments.
A threshold of 20 percent was found to be generally consistent with score-based definitions of subprime commonly used by the industry, capturing the riskiest 10 to 20 percent of consumer loans on a national basis. If, once the final rule is in effect, the overall proportion of consumer loans reported as higher-risk among large institutions differs materially from this preliminary estimate of 10 to 20 percent of consumer loans, the FDIC may decide to adjust the 20 percent threshold. The final rule, like the proposed rule, gives the FDIC the flexibility to make this change without further notice-and-
One bank commented that the higher-risk PD threshold should vary by product type, and that volatility in default rates is more relevant than the average level of default rates. As an example, the bank noted that, although credit card default rates were higher than default rates on some other products during the recent crisis, the default rates on credit cards rose less than the default rates on other products. In particular, the default rates on mortgages rose significantly and unexpectedly, causing losses that threatened institutions and the financial system. The bank also commented that other risk factors, such as historic default rates, yields, and resilience to stress, should be taken into account.
While the factors that the commenter mentioned are relevant, taking them into account in the definition of a higher-risk consumer loan would introduce excessive complexity with uncertain improvements in risk differentiation. Under the final rule, as proposed in the NPR, institutions must estimate the two-year PD for a consumer loan based on how loans with similar risk characteristics performed during the recent crisis. The FDIC chose to use the recent stress period for PD estimation, as opposed to a longer history, to capture the consumer behavior that generated significant unexpected losses. The PDs estimated using the specified time periods are not intended to reflect long-run mean default rates or capture product-by-product differences in more favorable periods.
Several trade groups and two institutions commented that the time periods used for PD estimation should be updated bi-annually. These commenters suggested that the average default rates could be calculated on a rolling basis, using the two most recent consecutive 24-month periods, or on a cumulative basis using all consecutive 24-month periods from July 2007 forward. They noted that it is standard industry practice to recalibrate credit models at least once a year, and that model parameters more than two years old are generally considered unreliable. Furthermore, the commenters stated that specifying a regular interval for updating the time periods would make the process more predictable and give institutions an opportunity to adjust their credit policies and pricing in advance of any changes, thus promoting a more stable flow of credit to consumers.
Identifying higher-risk consumer loans based on PD estimates from a time of economic stress is consistent with the FDIC's objective of assessing large institutions during favorable periods based on how they are likely to perform during periods of stress, as explained in the February 2011 rule. If the time period were to be updated on a rolling or cumulative basis, as suggested, the resulting PD estimates would eventually not reflect the performance of loans during the recent crisis. While the updated default rates might be closer to realized two-year default rates during favorable periods, they would generally not capture the relative differences in default behavior among product types that can be expected to occur under stress conditions (and that actually did occur during the recent financial crisis). In addition, unless changes were made to the higher-risk PD threshold of 20 percent, any regular updating of the time period could introduce an undesirable level of pro-cyclicality into the higher-risk concentration measure, whereby the volume of higher-risk loans would tend to rise as credit conditions deteriorated, and fall as conditions improved. This type of volatility could occur even if the distribution of credit scores in a loan portfolio remained static over time. The final rule avoids this volatility by using a fixed historical period for measuring default rates.
Default rates calculated using the recent crisis period may not reflect future changes in macroeconomic factors, industry standards, or consumer behavior that affect the riskiness of different product types. To ensure that the PD methodology continues to accurately identify higher-risk consumer loans, the FDIC may need to update the time period used for PD estimation at some point. Under the final rule, unlike the proposed rule, a change in the time period would require further notice-and-comment rulemaking.
One credit reporting bureau, however, informed the FDIC that historical data on account balances are often either unavailable or difficult to obtain. The credit reporting bureau also suggested that the proposed approach could miss active revolving loans where the balance is completely paid off each month. As an alternative, the credit reporting bureau suggested that an active account could be defined as any loan reported by the lender in the 12 months prior to the observation date, or any loan that has a positive balance as of the observation date.
The FDIC concluded, based on discussions with the three major credit reporting bureaus, that the date of last payment is information that is generally reported and maintained historically. In addition, defining an active loan using the date of last payment should better capture active revolving accounts that pay off monthly compared to both the proposed definition and a definition
One provider of consumer credit scores recommended an alternative to the proposed method of assigning PDs to individual score values. This commenter suggested that the FDIC permit banks to use a least-squares regression or other accepted statistical methodology to estimate the score-to-default rate relationship. The commenter noted that the relationship between the logarithm of the odds of not defaulting and the FICO score is very close to linear. The commenter argued that PDs estimated using a regression would be less dependent on the way institutions structure score bins and provide more reliable estimates of future default rates for a given score.
Depending on the nature of the data, least-squares regression and alternative methods of estimating the score-to-default rate relationship may, in fact, have certain advantages over the proposed approach. Given the minimum sample size and score band requirements, however, estimates generated using the proposed approach should be similar to those generated using alternative statistical methods. While the industry generally understands and uses linear interpolation, many banks that try to develop their own PD estimates according to the requirements may lack the expertise to apply more sophisticated fitting methods to their data. To ensure consistency among estimation methods, the final rule retains the linear interpolation approach.
One trade group commented that the FDIC should publish its criteria for evaluating methodologies that deviate from the PD estimation requirements. The trade group stated that providing the criteria would help smaller institutions evaluate their options before devoting time and resources to developing an alternative methodology. Because the final rule allows institutions to request the use of PD estimates that differ from the specifications only in the two specific respects noted previously (using fewer observations or score bands than the specified minimums), institutions should not be expending resources developing an entirely different methodology. While providing more specific guidance on acceptable alternatives to the score band and sample size requirements may make the decision process easier for institutions, the range of potentially acceptable alternatives is broad enough to preclude the final rule from providing predetermined criteria.
In the joint letter, commenters suggested that a simplified method of reporting should be permitted for banks with minimal exposure to higher-risk consumer loans. The commenters stated that the potential benefit to the FDIC would be small relative to the cost these banks would incur to comply with the new definition. The commenters suggested that if a bank's subprime loans—defined based on the 2001 interagency guidance—were less than one percent of Tier 1 capital and reserves, they should be allowed to report the amount as higher-risk if it is less costly for them to do so. One trade group suggested that if a portfolio has a default rate consistently below 10 percent and the bank maintains prudent underwriting criteria and appropriate monitoring for loans placed in that portfolio, the bank should not be required to estimate and report the PDs of loans in the portfolio. This same trade group stated that loans made before the effective date of the rule should be exempt from PD reporting, or the FDIC should provide a transitional period of at least three years.
Under the final rule, as proposed in the NPR, banks must calculate the PDs of
The final rule definition, like the definition proposed in the NPR, requires institutions to estimate the two-year PD of a loan based, in part, on the credit risk of the borrower as reflected in a credit score.
Several trade groups commented that the proposed rule did not consider how large banks are to treat consumer credits with no credit histories or scores. These groups noted that this issue is relevant for all types of consumer loans, but especially for student and credit card loans. One trade group argued that an institution should not be automatically required to classify unscorable loans as higher-risk, because doing so would cause some products, such as student loans, to become more expensive or less available. In the joint letter, commenters suggested that, to account for unscorable loans, large banks with sufficient data on the performance of such loans should be allowed to develop internal PD estimates using the same time period and sample size requirements in the rule. For large banks that do not have sufficient data to create such a mapping, the commenters stated that unscorable loans could initially be treated as higher-risk and subsequently re-evaluated according to the rule specifications once a credit score becomes available for the borrower. The commenters also noted that, although initially classifying unscorable loans as higher-risk is excessively conservative, it would be considered generally acceptable to large banks so long as a subsequent re-evaluation of these loans is permitted. For unscorable student loans, however, the commenters recommended that a PD distribution based on the bank's long-term default experience be permitted as opposed to initially classifying the loans as higher-risk.
Unscorable loans were not addressed in the proposed rule. In evaluating treatment options for purposes of the final rule, the FDIC sought information from a few credit score providers on the performance of unscorable loans by product type as well as data from large banks on the volume of unscorable loans outstanding. Data on the historical performance of unscorable loans were generally unavailable. Further, where data were available, the performance of unscorable loans relative to their scored counterparts was found to vary significantly by product type, and product definitions were not consistent with the Call Report definitions expected to b