The AOCI Opt-Out: Revisiting How the U.S. Capital Rules Arrived Here
But first, a brief digression on a liquidity stress test SVB was required to conduct
On Friday Dan Davies in a post at FT Alphaville called the SVB situation “a very American mess.” The argument centers on the fact that although the post-financial crisis Basel III rules included new standardized liquidity rules called the liquidity coverage ratio and the net stable funding ratio, “the majority of US banks are not required to follow the NSFR or LCR standards at all.”
As Davies notes, this is partly a consequence of regulatory changes adopted in 2019 following the 2018 enactment of the EGRRCPA.1 This is a subject worthy of further discussion, but in today’s post I want to focus on two other elements of the post-global financial crisis regime as applied, or not, in the United States.
Liquidity Stress Testing and Liquidity Buffer
SVB was not subject to LCR or NSFR requirements because it was below the relevant thresholds set by U.S. regulators for application of those requirements.
SVB did, however, recently become subject to liquidity stress testing and liquidity buffer requirements under Regulation YY. These requirements apply to all bank holding companies with total assets, based on a four-quarter average, over $100 billion. SVB crossed that average threshold in 2021, and therefore was required to start conducting Reg YY liquidity stress tests in 2022.2
Specifically, on a quarterly basis3 SVB was required to conduct a liquidity stress test that took into consideration a number of factors:4
General. A bank holding company subject to this subpart must conduct stress tests to assess the potential impact of the liquidity stress scenarios set forth [below] on its cash flows, liquidity position, profitability, and solvency, taking into account its current liquidity condition, risks, exposures, strategies, and activities.
The bank holding company must take into consideration its balance sheet exposures, off-balance sheet exposures, size, risk profile, complexity, business lines, organizational structure, and other characteristics of the bank holding company that affect its liquidity risk profile in conducting its stress test.
In conducting a liquidity stress test using the scenarios [involving adverse market conditions], the bank holding company must address the potential direct adverse impact of associated market disruptions on the bank holding company and incorporate the potential actions of other market participants experiencing liquidity stresses under the market disruptions that would adversely affect the bank holding company. […]
The test was required to include three different stress scenarios applied over four different planning horizons.
Stress scenarios. Each liquidity stress test conducted under […] this section must include, at a minimum:
A scenario reflecting adverse market conditions;
A scenario reflecting an idiosyncratic stress event for the bank holding company; and
A scenario reflecting combined market and idiosyncratic stresses.
The bank holding company must incorporate additional liquidity stress scenarios into its liquidity stress test, as appropriate, based on its financial condition, size, complexity, risk profile, scope of operations, or activities. The Board may require the bank holding company to vary the underlying assumptions and stress scenarios.
Planning horizon. Each stress test conducted under […] this section must include an overnight planning horizon, a 30-day planning horizon, a 90-day planning horizon, a one-year planning horizon, and any other planning horizons that are relevant to the bank holding company's liquidity risk profile. For purposes of this section, a “planning horizon” is the period over which the relevant stressed projections extend.
The results of these stress tests were then used, among other things, to calculate a required liquidity buffer based on the 30-day planning horizon.
Liquidity buffer requirement. A bank holding company subject to this subpart must maintain a liquidity buffer that is sufficient to meet the projected net stressed cash-flow need over the 30-day planning horizon of a liquidity stress test conducted in accordance with [each scenario set out above].
Net stressed cash-flow need. The net stressed cash-flow need for a bank holding company is the difference between the amount of its cash-flow need and the amount of its cash flow sources over the 30-day planning horizon.
Asset requirements. The liquidity buffer must consist of highly liquid assets that are unencumbered, as defined in [the regulation].
As I hope is clear, I am not asserting that these requirements eliminate the need for LCR or NSFR requirements.
I do think it is interesting context, though, and as policymakers sift through the aftermath of these events I hope we learn more about what SVB's liquidity stress tests looked like in the quarters leading up to last week’s events, whether they indicated any major signs of risk5 and, if so, how management and regulators responded.
AOCI Opt-Out
The Davies piece mentioned in the introduction to this post spurred a discussion on Twitter about other aspects of the U.S. capital rules that do not apply to all firms.
For example, some commentators were surprised to learn that U.S. banking organizations the size of SVB had been permitted to make a one-time election to permanently opt out of recognizing the effects of Accumulated Other Comprehensive Income (AOCI) in regulatory capital.
As with the LCR/NSFR tailoring discussed above, this is absolutely a worthwhile area of discussion. But in a few conversations over the past 72 hours I have seen some people conflate 2018/2019 changes to the AOCI opt out with changes that happened well before then, so I thought it would be helpful to revisit the history.
The retracing of developments below is not meant to be an indictment of anyone involved, and I hope the tone of this post does not come across as me sneering at people from a decade ago with the benefit of hindsight. I certainly cannot claim to have been jumping up and down warning about the potential consequences of the AOCI opt-out in 2013.
Anyways, to the history.
2012 U.S. Implementation Proposal
In 2012 the U.S. banking regulators released their proposals to implement the Basel III standards in the United States. Consistent with the Basel standard, the proposed rules would have required banking organizations to include most AOCI components in CET 1 capital.
As proposed, unrealized gains and losses on all AFS securities would flow through to common equity tier 1 capital. This would include those unrealized gains and losses related to debt securities whose valuations primarily change as a result of fluctuations in a benchmark interest rate, as opposed to changes in credit risk (for example, U.S. Treasuries and U.S. government agency debt obligations).
The agencies believe this proposed treatment would better reflect an institution’s actual risk. In particular, while unrealized gains and losses on AFS securities might be temporary in nature and might reverse over a longer time horizon, (especially when they are primarily attributable to changes in a benchmark interest rate), unrealized losses could materially affect a banking organization’s capital position at a particular point in time and associated risks should be reflected in its capital ratios. In addition, the proposed treatment would be consistent with the common market practice of evaluating a firm’s capital strength by measuring its tangible common equity.
The 2013 Final Rule
The 2012 proposal kicked off a frenzy of comments, meetings and other feedback on the proposed rule. After digesting all this input, the banking regulators adopted final rules in 2013.
The supplementary information accompanying the final rule acknowledged that the regulatory capital treatment of AOCI had been a focus of commenters.
The agencies and the FDIC received a significant number of comments on the proposal to require banking organizations to recognize AOCI in common equity tier 1 capital. Generally, the commenters asserted that the proposal would introduce significant volatility in banking organizations’ capital ratios due in large part to fluctuations in benchmark interest rates, and would result in many banking organizations moving AFS securities into a held-to-maturity (HTM) portfolio or holding additional regulatory capital solely to mitigate the volatility resulting from temporary unrealized gains and losses in the AFS securities portfolio.
The commenters also asserted that the proposed rules would likely impair lending and negatively affect banking organizations’ ability to manage liquidity and interest rate risk and to maintain compliance with legal lending limits.
Further, the supplementary information later stated that the above-referenced opposition came from all corners:
Banking organizations of all sizes, banking and other industry groups, public officials (including members of the U.S. Congress), and other individuals strongly opposed the proposal to include most AOCI components in common equity tier 1 capital.
For instance, then-Senator Claire McCaskill wrote a letter on behalf of Missouri community banks taking issue with, among other things, “the problematic treatment of securities held in investment portfolios prescribed by the rules.”
It was not only Republicans and conservative Democrats who worried about this. For example, Senator Jeff Merkley wrote in to voice concern about what the rule could mean for Oregon community banks. Among other things, Senator Merkley said he had heard complaints from local banks about “the requirement that unrealized gains and losses from the available-for-sale portfolio flow through to capital.”
Here are a few more quotes from the adopting release in which the agencies describe other comments they received about AOCI. Some of these claims have held up better than others.
For unrealized gains and losses on AFS debt securities that typically result from changes in benchmark interest rates rather than changes in credit risk, most commenters expressed concerns that the value of such securities on any particular day might not be a good indicator of the value of those securities for a banking organization, given that the banking organization could hold them until they mature and realize the amount due in full. Most commenters argued that the inclusion of unrealized gains and losses on AFS debt securities in regulatory capital could result in volatile capital levels and adversely affect other measures tied to regulatory capital, such as legal lending limits, especially if and when interest rates rise from their current historically-low levels.
Several commenters used sample AFS securities portfolio data to illustrate how an upward shift in interest rates could have a substantial impact on a banking organization’s capital levels (depending on the composition of its AFS portfolio and its defined benefit postretirement obligations). According to these commenters, the potential negative impact on capital levels that could follow a substantial increase in interest rates would place significant strains on banking organizations.
Many community banking organization commenters observed that hedging or raising additional capital may be especially difficult for banking organizations with limited access to capital markets, while shifting more debt securities into the HTM portfolio would impair active management of interest rate risk positions and negatively impact a banking organization’s liquidity position. These commenters also expressed concern that this could be especially problematic given the increased attention to liquidity by banking regulators and industry analysts.
In light of these and other comments received, the agencies decided that only advanced approaches banking organizations should be required to follow the Basel III approach to AOCI. Other banking organizations would have the one-time right to opt-out.
At the time, an advanced approaches banking organization was defined as a firm with either (i) $250 billion or more in total assets or (ii) $10 billion in on-balance sheet foreign exposures. This meant that, although some of the most vocal criticism of the AOCI treatment in the proposal came from community bankers or was offered on their behalf, the AOCI opt-out wound up being available to banks larger than your typical community bank.
For U.S. firms, the upshot of all this was that only the U.S. G-SIBs and a couple of large regionals were initially subject to a requirement to include the effects of AOCI on regulatory capital. A few more later grew into it.
2013 Open Board Meeting
When it was ready to adopt the final rules, the Federal Reserve Board in July 2013 held an open meeting to discuss them. At the meeting, Governor Jeremy Stein remarked that he understood the general logic behind narrowing to a much smaller group of firms the requirement to include AOCI in regulatory capital. But Governor Stein had a question about interest rate risk.
The question I have is, however, if we leave this AOCI filter in place, we're left in a situation where there's really no regulatory capital device in place that attempts to capture interest rate risk. And as we’ve seen now the last few weeks are sort of a good reminder of the fact that interest rates can move around sometimes pretty sharply. So the question I have is: What other mechanisms aside from capital regulation, presumably either on the supervisory or on the stress testing side, do we have or can we use to reassure ourselves that banks are not getting themselves overly exposed to interest rate risk?
A senior staff member in the Division of Supervision and Regulation offered to take the question. The staff member first explained that the banking agencies had recently put out various advisories about interest rate risk and how banks should be thinking about operating in a low-interest rate environment while at the same time recognizing that rates were likely to rise in the future. The staff member then continued:
So, from the overall standpoint what we are advising firms and have instructed our supervisory staff to do is to continue to be vigilant in their pursuit of interest rate risk management, but not come up with these quantitative adjustments as much. We are incorporating in our queue--we have incorporated in our Q&As, excuse me, some basic assumptions around the way of stress testing or scenario analysis. The typical plus or minus 300 basis point shock in rates, what would that do to your portfolio? So I believe we have the basis for which we can move forward on this. And I think our firms are integrating that into their risk management practices. It just remains as a task for us as supervisors to be vigilant as rates increase or change in this environment, to follow up with firms as they implement appropriate changes to their strategies so we don't invariably fall behind.
At the conclusion of the meeting, the rules were supported by all members of the Board of Governors.6
2019 Changes
Finally we get to 2019. As part of the post-EGRRCPA tailoring changes, the threshold at which firms can no longer exercise an AOCI opt-out was revised upwards, such that now only firms with either (i) $700 billion or more in total assets or (ii) $75 billion of cross-jurisdictional activity are prohibited from opting out of recognizing the effects of AOCI on regulatory capital.
This was a big deal for a handful of regionals who either had not been allowed to opt out under the 2013 version of the rules or had grown in size such that their previous opt out was no longer valid. But it did not make a difference to 99% of U.S. banking organizations, which had already been given, and exercised, the right to opt out.
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None of the above is meant to argue that the U.S. deviation from the Basel approach in terms of AOCI and regulatory capital was the right way to go. The point here is only that this aspect of the U.S. regulatory approach is not something that can be laid at the door of the EGRRCPA or the regulatory tailoring changes adopted thereafter. Instead, thanks to decisions made a decade ago, there was never a final version of the U.S. capital rules that would have required a bank of SVB's size to recognize AOCI in regulatory capital.7
Thanks for reading! Thoughts, challenges, criticisms are always welcome at bankregblog@gmail.com
I use the word “following” here only in terms of chronology and not necessarily as a synonym for “because of.” Not every regulatory change made as part of the 2019 tailoring package was strictly required by the EGRRCPA.
The rules say that compliance is required “no later than the first day of the fifth quarter following the date on which [the company’s] average total consolidated assets equal or exceed $100 billion.”
This is a quarterly requirement for firms in Category IV like SVB, but is a monthly requirement for firms in Categories I, II or III.
Internal section numbering has been omitted and some of the spacing has been adjusted.
A side debate, I suppose, is how much risk it is reasonable to hope for these liquidity stress tests to catch. $42 billion in attempted withdrawals in a single day?
The rules were of course supported by the other federal banking regulators as well. For example, see this 2013 statement from then- (and now again) FDIC Chair Gruenberg:
During the comment period on these proposals, we received a large number of comments, particularly from community banks, expressing concerns with some of the provisions of the NPRs. The interim final rule makes significant changes to aspects of the NPRs to address a number of these community bank comments. […] It allows for an opt-out from the regulatory capital recognition of accumulated other comprehensive income, or AOCI, except for large banking organizations that are subject to the advanced approaches requirements. […] Comments received on all these matters were extremely helpful to the agencies in reaching decisions on the proposals.
As of the end of the most recent quarter, SVB had $212 billion in total assets, down slightly from their all-time high of around $220 billion at the end of March 2022. SVB was actually closer than you might guess to the $75 billion cross-jurisdictional activity threshold, but they were short of that one too.
Update as of 8:10 am PST Sunday March 12: The claim in the text that SVB would not have been subject to the advanced approaches rules based on size alone is correct. But upon reflection, one point this post elided is that it is possible under the old rules that SVB would eventually have crossed the $10 billion on-balance sheet foreign exposure threshold, and thus become subject to the advanced approaches rules that way. SVB’s foreign exposures had been ticking up in the years prior to the tailoring rules — their 10-K states they had $6 billion in such exposures at year-end 2017, and $7.5 billion at year-end 2018.