Testifying Before Congress For NAIC, Florida Insurance Commissioner Kevin McCarty Gives Perspective on Federal Capital Rules

 

Testifying as President of the National Association of Insurance Commissioners (“NAIC”) Chairman at a Congressional subcommittee hearing today, November 29, 2012, Florida Insurance Commissioner Kevin McCarty raised concerns regarding the proposed application of “one size fits all” capital rules on thrift and bank holding companies predominately engaged in insurance activities. 

Commissioner McCarty spoke on behalf of U.S. insurance regulators in the joint meeting of the U.S. House Financial Services’ Subcommittees on Financial Institutions and Consumer Credit and Insurance, Housing and Community Opportunity. 

Click here to view the full text of Commissioner McCarty’s testimony. 

The hearing, entitled “Examining the Impact of the Proposed Rules to Implement Basel III Capital Standards” represented an opportunity for financial regulators to address concerns with related proposed Basel III Rules.  The joint subcommittee heard testimony from a number of financial regulators, in addition to Commissioner McCarty.  A second panel included industry representatives who would be impacted by the proposed rules. 

Click here to access the written testimony of all speakers who appeared today.

“The prospect of bank-centric regulatory rules being imposed on insurance groups is problematic,” stated Commissioner McCarty in his testimony.  “It is critical that the regulatory walls around legal entity insurers that have successfully protected policyholders for decades not be jeopardized.”

The NAIC has submitted comments to the Federal Reserve, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency on proposed capital requirements to be applied to thrift and bank holding companies. 

Click HERE to access the related NAIC comment letter.

Commissioner McCarty’s testimony today reinforced that dependence on capital standards at the expense of other regulatory tools will not sufficiently prevent companies from taking excessive risks.

“We fear the same overreliance on capital could become a reality in our sector, with no diversity of regulation to mitigate the wrong incentives or prevent systemic risk taking.  The existence of global capital standards in the banking sector did not prevent the last crisis and did little to prevent large institutions from becoming larger while chasing each other off their own fiscal cliff,” Commissioner McCarty said.

State-regulated insurance companies have expressed concern that Basel III’s standards could prove costly to insurance companies by subjecting them to rules intended for banks.  Insurance companies fear they may find themselves subject to the Basel III standards if they are affiliated with a depository institution or they have been designated by the Financial Stability Oversight Council for supervision by the Federal Reserve.

If they are brought under Basel III’s standards, insurance companies (which are already regulated at the state level and subject to capital requirements, risk-based capital requirements and accounting standards set by state regulators) may find themselves subject to duplicative standards tailored largely to banks.

Insurance companies also are concerned that the international standards for them that are being developed pursuant to the so-called “Solvency II” process add yet another level of regulatory complexity, and that the Basel III standards may conflict with these international standards as well as state regulators’ risk-based capital standards and requirements.

U.S. Federal Reserve Chairman Ben Bernanke has said that the Federal Reserve recognizes the differences between banks and insurance companies and that the Federal Reserve would consider those differences in its rulemaking and supervision.  He also has said that the Federal Reserve would not try to impose bank-like capital standards on insurance companies, and instead would allow them to continue to be regulated by state authorities and remain subject to state regulatory and capital requirements. 

The degree to which the Federal Reserve will accommodate insurance companies in setting capital requirements, however, remains to be seen

 

Proposed Basel III Rules

• The first proposed Rule revises risk-based and leverage capital requirements to be consistent with those in Basel III.  It tightens the definition of regulatory capital, sets higher minimum capital requirements and requires banks to maintain capital “buffers” to increase their resiliency during periods of financial stress.  Further, the proposed Rule sets transition periods to give banking organizations ample time to adjust to the new requirements.  This Rule would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies.

• The second proposed Rule would apply to all banking organizations other than small bank holding companies with $500 million or less in total assets.  It would change the risk-weighting of assets by expanding the risk-weighting categories from four categories (0, 20, 50 and 100 percent) to a much larger and more risk-sensitive number of categories.

• The third proposed Rule revises the “advanced approach” method that allows banks to develop their own models to quantify required capital for operational risk, subject to approval from regulators, to make it consistent with Basel III and the Dodd-Frank Act.  These revisions are intended to increase the risk-sensitivity of large, internationally active banks to counterparty risk and interconnectedness among financial institutions.  The proposed Rule would apply only to banking organizations with consolidated total assets of at least $250 billion or consolidated total on-balance sheet foreign exposures of at least $10 billion.

 

A History of Bank Capital Requirements and Basel III

Bank capital requirements have been generated by Congress, federal banking agencies and international regulatory bodies.  By the 1980s, U.S. banking regulators had set an explicit ratio for measuring capital adequacy. That ratio (the leverage ratio) is calculated by dividing a bank’s capital by its assets. 

As a measure of capital adequacy, however, the leverage ratio had a major blind spot:  it failed to account for credit risk. Because the leverage ratio treated all of a bank’s assets as equally risky, banks had an incentive to take on high-yield assets with more credit risk.  In the 1980s, for example, some banks responded to tighter leverage limits by replacing low-yielding, short-term Treasury securities with higher-yielding, higher-risk commercial real estate loans.  When the commercial real estate bubble burst, several large banks found themselves on the brink of insolvency. As a result, federal banking regulators began developing risk-based capital standards that required banks to hold more capital against riskier assets.

When U.S. banks voiced concern that the unilateral adoption of these risk-based capital standards by U.S. regulators would place them at a competitive disadvantage globally, federal banking regulators approached their foreign counterparts to negotiate an international agreement on those standards.  In 1988, working through the Basel Committee on Bank Supervision based in Switzerland (the “Basel Committee”), banking regulators from the leading industrialized countries reached agreement on the “International Convergence of Capital Measurement and Capital Standards”–commonly known as Basel I.

Basel I established a basic framework for risk-based capital standards, and U.S. regulators then adopted risk-based standards conforming to that framework.  Although Basel I, by its terms, applied only to large, internationally active banks, the federal banking agencies chose to apply the standards to all insured depository institutions.

Over time, critics of Basel I noted that it failed to adequately capture the risks faced by banks.  These critics claimed that the risk-weighting categories were too broad.  For example, all commercial loans-whether to blue-chip companies or to risky start-up ventures-carried the same risk weighting, even though the former are obviously less risky than the latter.

Critics also pointed out that the securitization of loans allowed banks to easily evade capital standards, because less capital was required to be held against highly-rated mortgage-backed securities than against individual mortgages or commercial loans held in a bank’s portfolio.  Banks responded by purchasing large amounts of securitized mortgages, including many subprime mortgages.

In response to these criticisms, the Basel Committee developed Basel II in 2004, and it was implemented in the European Union that year.  U.S. banking regulators issued regulations to implement Basel II in April 2008, but the financial crisis commanded the attention of regulators and Basel II was never fully implemented in the U.S.

Nonetheless, critics pointed out that Basel II had flaws of its own.  Basel II relied heavily on external credit ratings and the banks’ own internal models for quantifying risk, and the financial crisis demonstrated that neither was a completely reliable measure of risk.  In order to remedy the shortcomings in Basel II that were revealed by the financial crisis, the world’s financial regulators tried again with Basel III.

In September 2010, the Basel Committee reached an agreement on the framework and standards for new capital requirements, and the agreement was formally adopted at the G-20 summit in November 2010.  On June 7, 2012, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation jointly proposed the above three Rules to revise the agencies’ risk-based capital requirements to make them consistent with Basel III. 

The banking agencies designed the proposed Rules to comply with Section 171 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as the “Collins Amendment,” which subjects all insured depository institutions and their holding companies to the same minimum risk-based capital and leverage requirements.  The proposals are also consistent with Section 939A of the Dodd-Frank Act, which requires the banking agencies to remove all references to external credit ratings from their regulations.  Instead, all references to external credit ratings will be replaced with alternative standards of creditworthiness.

On November 9, 2012, federal banking regulators issued a joint statement acknowledging that they do not expect any of the new capital requirements to take effect on January 1, 2013, as previously proposed.  The agencies’ June proposals suggested the January effective date, but many industry participants have expressed concern that that date does not give them sufficient time to understand the rule or to make necessary systems changes.

 

 

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