Today, March 17, 2020, the Office of the Comptroller of the Currency (the “OCC”), the Board of Governors of the Federal Reserve System (the “FRB”), and the Federal Deposit Insurance Corporation (the “FDIC”) released an interim final rule that revises the definition of “eligible retained income” in the regulatory capital rules that apply to U.S. banking organizations. The rule is intended to incentivize banking organizations to more freely use their capital buffers, thereby promoting increased lending activity in light of the global economic turmoil created by COVID-19. The rule will be effective immediately upon publication in the Federal Register.
Under the capital rules, the amount that a banking organization with capital ratios that do not exceed relevant capital buffer thresholds (e.g., the 2.5 percent capital conservation buffer) may pay out as capital distributions or discretionary bonus payments is capped at an amount equal to its “eligible retained income” multiplied by a certain percentage. The buffer amounts represent excess regulatory capital, above the minimum risk-based capital and leverage ratios, maintained as a buffer to enhance the resilience of the banking organization and the banking system generally during stress periods. The applicable percentage varies based on the amount of the banking organization’s capital buffers on a graduated, sliding-scale basis. For example, a banking organization that maintains a capital conservation buffer of between 1.875 and 2.5 percent may not make capital distributions in amounts in excess of 60 percent of its eligible retained income, and a banking organization that maintains a capital conservation buffer of between 0.625 and 1.25 percent may not make capital distributions in amounts in excess of 20 percent of its eligible retained income. Banking organizations with sufficient capital buffers do not face any limitations on payout amounts.
Previously, “eligible retained income” was defined as a banking organization’s net income for the four calendar quarters preceding the current calendar quarter, net of any distributions and associated tax effects not already reflected in income. Thus, under that definition, a banking organization that previously distributed all or nearly all of its net income during periods of economic stability would have zero or near zero eligible retained income. When such a banking organization experiences economic shocks (such as those caused by COVID-19) that cause even a modest reduction in its capital buffers, the banking organization could suddenly face severe limitations on its ability to make payouts. This “cliff effect” could create a strong incentive for the banking organization to limit its lending and other financial intermediation activities, further compounding stressful macroeconomic conditions, and making the capital buffer effectively unusable during economic downturns.
To correct this issue, the interim final rule adopts a definition of “eligible retained income” that is the greater of (i) the banking organization’s net income for the four preceding calendar quarters, net of any distributions and associated tax effects not already reflect in net income, and (ii) the average of the banking organization’s net income over the preceding four quarters. The new definition is consistent with the revised definition of “eligible retained income” in the FRB’s final rule on stress capital buffers that was issued March 4, 2020. The federal banking agencies indicated that the revision should make payout limitations for banking organizations that use their capital buffers more gradual, as was intended when the buffer requirements were adopted, and thus incentivize banking organizations to use their capital buffers in stress periods to serve as a source of credit to the economy.
Together with the interim final rule, the agencies issued an interagency statement encouraging banking organizations to use their capital and liquidity buffers as they respond to the challenges presented by the effects of COVID-19.