Author: Brian Bertsch

U.S. bank regulatory proposals to apply unrealized gains and losses (UGL) on available-for-sale (AFS) securities to common equity tier 1 capital could reduce bank capital levels during periods of material market illiquidity. For example, if such rules had been in place during the 2008 financial crisis, Fitch Ratings estimates that nine out of 57 banks we reviewed with assets of more than $25 billion would have experienced a reduction in their common equity tier 1 capital ratio of 100 bps or more.

On June 12, 2012, U.S. regulators including the Office of the Comptroller of the Currency, FDIC, and the Board of Governors of the Federal Reserve System, issued a notice for proposed rulemaking that would deduct unrealized losses and add unrealized gains to common equity tier 1 capital, but would not include unrealized gains and losses on AFS cash flow hedges. Currently, unrealized gains and losses are reported in other comprehensive income (OCI) and are not included in regulatory capital calculations.

The inclusion of unrealized gains/losses in regulatory capital is a procyclical capital policy that could exacerbate capital needs during market disruptions. Large unrealized losses are likely to occur during periods of market illiquidity rather than during period of rising rates. Therefore, the proposed rule is most punitive during times when banks have the least access to capital. Fitch views credit products, such as non-agency mortgage-backed securities and asset-backed securities, as introducing the most potential volatility to bank capital levels, given their potential to exhibit material and prolonged illiquidity during periods of market stress.

The proposed changes to capital calculations could affect how banks manage their balance sheets. For example, some banks have already transferred securities from AFS to held-to-maturity (HTM) classifications to avoid OCI losses, which reduce available liquidity since HTM securities cannot be sold prior to maturity. Further, the exclusion of unrealized gains and losses on hedges of AFS securities creates asymmetry between the hedge and the hedged item. As such, banks might not hedge interest rate risk from their securities portfolio since the hedge gains would not be able to mitigate unrealized losses from AFS securities that flow through to regulatory capital.

Between 2000 and 2007 -- a relatively more benign credit environment than 2008 -- only one bank in our sample would have experienced a reduction in their common equity tier 1 capital of 100 bps or more. Between 2004 and 2007, the Fed funds rate increased more than 400 bps, although unrealized losses during that period would have decreased common equity tier 1 capital ratios of the 57 sampled banks by an average of only 6 bps, reflecting banks' active management of interest rate risk in their investment portfolios.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

 

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