• Trevor Foo
• CISA / CISM / CRISC
• tfoo@mbafcpa.com
• 1-800-239-1474

Since last summer, it seems that every time you turn on the news there is a story about a tornado, hurricane, flood, earthquake or wildfire in some part of the United States.

Several of those natural disasters, such as this year's record number of tornadoes, have occurred at times and in places that leave people saying, "This isn't supposed to happen here, especially right now."

For executives of banks and of other financial institutions, the rash of disasters is a reminder of why they should have a disaster recovery plan (DRP) in place for the information technology (IT) infrastructure and systems that their organizations rely upon. In fact, having a DRP in place that has been structured using a business impact analysis (BIA) and risk assessment can help to significantly improve outcomes should a disaster occur.

This article will provide details on how banks can prepare a disaster recovery plan, in conjunction with a business impact analysis. The article includes a list of "Key Steps to Disaster Recovery Planning."

Here are two vivid recent examples of why testing and upgrading the DRP should be a year-round project.

• This March and April, following a record warm winter, tornado season arrived early in Texas, several Midwestern states and several Southern states.
  
  In a preliminary estimate, the National Oceanic and Atmospheric Administration (NOAA) reported that there were 223 tornadoes in the United States this March. That was a record for March, a month where the average number of tornadoes is 80.
  
  Then, a series of devastating tornadoes struck the Dallas area in early April.
• Last August, a 5.8 Richter Scale earthquake rocked New York and other Atlantic Coast states just several days prior to the destruction caused by Hurricane Emily.

Of course, there are some disasters that you expect each year, while hoping that they will not happen.

Summer will arrive soon, bringing with it the heaviest months for hurricanes, tornados and flooding for many parts of the country. Thus, May is a month when banks should be conducting thorough reviews of their disaster preparedness and recovery plans.

Springtime should be "test time" for banks in Atlantic Coast and Gulf of Mexico states, where the hurricane season will officially begin on June 1 and extend through November 30.

Banks and other financial institutions are among businesses whose overall success is heavily dependent on the availability of computer systems and data. Especially in hurricane-prone Florida, it is almost unthinkable that a bank would operate without having a DRP and without continually updating and testing it for effectiveness.

Having such a plan in place is also essential for banks in New York and other Atlantic Coast states, and for banks in Gulf Coast states.

Some natural disasters, most notably hurricanes and flooding from overflowing rivers, have several hours or even several days of warning. There usually are several hours of warning for wildfires. Tornadoes hit with just minutes of warning and earthquakes occur with no warning at all.

The earthquakes that hit in several U.S. states and in Japan, Haiti and Chile in recent years are reminders of how natural disasters can have an economic impact across borders, along with the human tragedy in areas where they occur.

Many banks in Florida and in New York have clients and correspondent banks in other states and countries that have histories of earthquakes. Clients in those locations are looking for reassurances from their banks that their financial assets will be secure and easily accessible following an earthquake or other disaster.

Therefore, the availability of customer-facing systems, such as Internet Banking, becomes even more critical in such situations. This is an example of how the initial business impact of a disaster can change due to ongoing events.

Banks, unlike some other businesses, are required to have detailed written plans designed to minimize damage from natural disasters and to implement recovery plans for employees, infrastructure and IT systems. Regulators review those plans during their regular examinations of banks. Internal auditors and external auditors often review those plans each year.

However, the true test of a plan's effectiveness comes when a disaster strikes. Therefore, it is essential for banks to have recovery plans that meet their own specific needs, and not just regulators' requirements.

Here are some important details on the set-up and operation of a disaster recovery plan

The Planning Process

To create an effective DRP, a bank should consider allowing the BIA to drive the disaster planning process.

Since the goal of the BIA is to identify critical business processes and related resources that are needed to support them, it only makes sense that the results of this analysis should guide the DRP. Business resources examined by the BIA may include applications, servers, workstations, communications, networks and personnel.

The DRP addresses these items and puts procedures in place to get business resources up and running following a disaster based on the predefined priorities of the BIA. Ultimately, the BIA saves valuable time in predetermining the order of priority for systems and resources that need to be replicated or recovered.

To have a comprehensive BIA, it is important that all areas in the institution are given the opportunity to participate.

This is best accomplished by developing a standard questionnaire for information gathering. Follow-up interviews may also be necessary.

Items that should be considered for the BIA questionnaire and for the follow-up interviews include:

• Function Description: A brief description of the function being performed.
• Dependencies: A brief description of the dependencies of the function. What has to happen or needs to be available before the function can be performed?
• Financial Impacts: What would the financial impact be to the business if the function were not performed? Describe the financial impact.
• Recovery Resources: What kinds of resources are needed to support the function? How many are needed, and how soon are they needed after a disruption (phones, desks, PC, etc.)?
• Technology Resources: What software and/or applications are needed to support the function?
• Systems: Does the function require a specific workstation, server, application or database?
• Network Access: Does the function require access to the LAN, Internet or WAN?
• Acceptable Downtime: How long can the systems that make the function possible be unavailable?

The questionnaire and/or interview process should also estimate the maximum allowable downtime for critical business processes, recovery point objectives and backlogged transactions, as well as the costs associated with downtime. Management should establish recovery priorities for business processes that identify essential personnel, technologies, facilities, communications systems, vital records and data.

Since disaster recovery is an expensive but necessary undertaking, it is important to ensure that the plan is comprehensive and that it will work as intended when needed. Therefore, the plan as a whole must be tested and the recoverability of critical systems has to be assessed. One key task in every test is to document any lessons learned that will improve the plan's effectiveness.

In the end, a disaster recovery plan that is based on a business impact analysis will yield greater benefits to the institution. Key benefits can include better prioritization of recovery efforts, better identification of critical functions and the ability to meet and exceed stakeholder expectations.

Key Steps to Disaster Recovery Planning

The following list will assist in disaster planning:

1. Define a company policy. Is it management's desire to recover all systems or only those classified as critical?
2. Perform a business impact analysis (BIA). This process will determine those critical systems and processes with their desired timeframe for recovery. It should involve a broad cross section of the organization.
3. Perform a risk assessment to determine the types of threats your organization is exposed to. The assessment should include both the likelihood and the impact of the threat.
4. Define and document procedures for all those tasks that are associated with the systems and processes identified as critical in the BIA.
5. Establish a procedure for data (hard and soft copy) recovery.
   1. Back-up procedure
   2. Off-site storage
   3. Systematic testing of back-ups
   4. Archiving of off-site data for easy retrieval
6. Request and review disaster plans from key vendors and partners. Participating in their tests whenever possible is a great opportunity to improve your readiness.
7. Create a plan based on the BIA to recover hardware, software and communications. Pay attention to integration with key vendors. It is important that all plans should be approved by the board of directors.
8. Establish alternate site(s) and the procedures for their respective use. The type of site (Hot, Warm, Cold, Mirrored, or Mobile) will depend on the established policy.
9. Test the plan at least once annually, and document the process and the findings.
10. Train a large number of employees (including non-IT employees).
11. Update the plan based on experiences from testing and training.

Your bank cannot control when a natural disaster will occur in the geographic area where it is headquartered or where it has other offices.

But with an effective disaster recovery plan, you can reduce the costs and the amount of time it takes to return to full operations while you are also minimizing any inconveniences to customers.

To contact Trevor Foo, email tfoo@mbafcpa.com or call 1-800-239-1474.

• Frank Gonzalez
• CPA / CFF, Principal
• fgonzalez@mbafcpa.com
• 1-800-239-1474

One of today's biggest challenges in banking is keeping capital-to-asset ratios above minimum requirements for being "well capitalized", and a growing number of banks are finding a solution through sales of branches. In a branch sale, a bank adds the proceeds (premium for selling deposits) to its capital and reduces its asset base—thus improving both parts of a ratio.

Banks that are looking to sell branches are finding interest from large multi-state banks that remain strong amid the real estate downturn, as well as from investment groups that bought failed banks and are seeking to expand their franchises.

Several institutions have asked us to analyze how possible sales of branches could impact their balance sheets and capital ratios. We are providing similar advice to several institutions that are interested in buying branches, particularly in Florida.

This activity is part of a growing trend in Florida, New York and other states where various banks have capital ratios that are narrowly above well capitalized or even below that level. Some of those banks are subject to written orders from regulators to improve one or more of their capital ratios.

A listing of minimum capital ratios is provided later in this article.

The solution, of course, is to add capital or to reduce assets.

In today's tight financial markets, very few banks are able to raise capital through sales of stock or from follow-up investments by current owners. That leaves the reduction of assets, also known as shrinking the balance sheet, as the only option.

One standard way to reduce assets is to sell loans. That alternative is not always attractive in today's market, where many real estate loans can be sold only at discounts.

Naturally, a bank can keep its total assets from growing by not making large numbers of loans. But that strategy runs counter to the view that the economy is slowly recovering and that there are more opportunities to make loans and grow profits. Thus, a sale of a portion of a branch network is the most viable step for some banks that need to add capital.

A standard benchmark in branch sales is that the buyer will pay the seller a premium in the range of 5 percent of the deposits in the branches that it acquires. In most sales, all retail deposits and most deposits of small and mid-sized businesses are part of the transaction. So are most consumer loans, including mortgages, and many loans to small and mid-sized businesses.

The impact on capital ratios varies, based on the total assets and deposits a bank takes off its books. But consider an example of a bank that has $1 billion in total assets and $50 million in Tier 1 capital—giving it the minimum 5.0 percent to be well capitalized under the Tier 1 leverage ratio.

Assume this bank sells $100 million in deposits for a $5 million premium. If the amount of asset also declines by $100 million, the result would leave $55 million in capital and $900 million in assets for a 6.1 percent ratio. The sale would take away some pressure about capital, internally and from regulators.

One reason there are expectations of more branch sales is that the pace of bank closings has slowed this year. In its Quarterly Banking Profile for December 31, 2011, the Federal Deposit Insurance Corporation reported that the number of bank failures declined from 157 in 2010 to 92 in 2011. The FDIC said the number of failures in 2011 was lower than what it projected.

As of April 20, there were 17 bank failures in 2012. Since the start of 2010 there have been 43 bank failures in Florida, three in New York State, three in New Jersey and none in Connecticut

With fewer opportunities to buy failed banks, expansion-minded banks are considering acquisitions of banks or of branches. Many banks with capital problems are not seeking mergers but are willing to sell branches.

In a purchase involving an FDIC receivership, a bank can usually acquire the deposit base and assume selected branches while the FDIC keeps most of the loans.

In most cases, banks that acquire deposits and branches from banks that are in receivership will pay the FDIC no premium or less of a premium than they would pay to a bank that has had problems but has avoided a government takeover.

As the economy has improved, numerous banks that were in danger of failing are still seeking to improve their capital ratios and are considering branch sales. The FDIC has reported that the number of banks on its "Problem List" declined from 884 on December 31, 2010 to 813 on December 31, 2011. It does not identify those banks, which have CAMELS ratings. of 4 or 5--the two lowest under that system.

The C in the CAMELs acronym is for capital. Banks that are not well capitalized under one or more ratios usually receive a 4 or 5 on capital, one of six measurements in CAMELS.

Decisions on whether to sell branches and on which ones to sell depend on factors that include a bank's capital situation, other aspects of its financial condition, and the impact that a reduction in branches would have on lending and other operations. In selling branches, a bank improves its capital ratios and also lowers its costs by having fewer locations (generally with leases) and fewer employees.

But the smaller franchise reduces a bank's ability to lend and cross-sell products and services. A bank had reasons to open the branches that is has now disposed. As a smaller company, it might need to revamp its strategic plan.

A prospective buyer must examine the following question: "Are there things about the locations and customer mix of these branches that helped cause the seller's problems?"

A buyer that feels it is gaining the "right locations" has an immediate chance to increase its lending, deposit gathering and other business. But it must consider the cost (premium) in buying deposits. The leasing of sites for de novo branches might be more cost efficient in the short term, but does not bring in a base of customers.

Here are the minimum requirements for FDIC-insured banks to be adequately capitalized and well capitalized under three important ratios:

• Total capital to risk-weighted assets—adequately capitalized, 8.0 percent; well capitalized, 10.0 percent,
• Tier 1 capital to risk-weighted assets—adequately capitalized, 4.0 percent; well capitalized, 6.0 percent,
• Tier 1 capital to total assets (leverage ratio)—adequately capitalized, 4.0 percent; well capitalized, 5,0 percent.

Beginning in 2016, banks will be required to phase in a new capital conservation buffer comprised of additional Tier 1 capital. The buffer will be Tier 1 capital equal to 0.625 percent of risk-weighted assets as of January 1, 2016 and will gradually increase to 2.5 percent as of January 1, 2019.

The purpose of the conservation buffer is to ensure that banks have set aside capital that they can use to absorb losses during periods of financial and economic stress.

The conservation buffer is required under the Dodd-Frank Act of 2010 and the Basel III Accords. This year, the Federal Reserve and other U.S. banking regulators are scheduled to issue rules on the implementation.

It should be noted that money obtained in a sale of branches can be included in Tier 1 capital.

The new buffer will be another reason for some banks to consider selling branches. That fact could lead to more opportunities for banks that can meet the buffer requirements and are looking to add branches in selective states and metropolitan markets.

To contact Frank Gonzalez, email fgonzalez@mbafcpa.com or call 1-800-239-1474.

• Deborah Ladron de Guevara
• CPA
• dladrondeguevara@mbafcpa.com
• 1-800-239-1474

"Do we have to treat this loan as a TDR?"

Again this year, that is one of the questions we are hearing most often when we meet with bankers to review their portfolios of real estate loans.

We begin our answers by reminding them that a Troubled Debt Restructuring (TDR) is a loan modification where the original credit terms have been changed and the borrower is facing financial difficulty due to its own economic circumstances rather than due to general market conditions. ATDR is essentially a restructuring in which a concession has been granted.

The Office of the Comptroller of the Currency (OCC) has been fielding similar questions about TDRs. On April 5, 2012, the OCC provided some answers when it issued a Bulletin on TDRs to the national banks and the federal savings associations that it regulates. The OCC also issued the bulletin to its examiners.

The OCC's policies and practices in examining banks are generally similar to those of state banking regulators, the Federal Deposit Insurance Corporation and the Federal Reserve. As a result, the OCC Bulletin can help all banks determine when a loan modification should be treated as a TDR—and thus be subject to accounting rules on impairment that could require a write-down of a loan.

The OCC issued the Bulletin during a year when many banks continue to have large numbers of residential real estate loans, commercial real estate loans and commercial loans on which they have modified the terms and for which they need to determine a possible TDR status.

This article will provide a summary of the recent OCC Bulletin, and will also review an Accounting Standards Update (ASU) that the Financial Accounting Standards Board (FASB) issued in 2011 with revised guidance on determining when restructured loans should be accounted for as TDRs. In addition, the article will review the FASB's requirements for determining when there should be recognition of an impairment on a TDR.

OCC Bulletin on TDRs

The OCC indicated that it issued its Bulletin "to address many inquiries received from bankers and examiners on the accounting and reporting requirements for troubled debt restructurings."

The OCC added: "Determining whether a loan renewal, extension, workout, or other modification constitutes a TDR is particularly challenging during times of economic stress. This is especially true for loans classified as substandard for which the criteria for placement in nonaccrual status had not been met at or before the time of modification."

The bulletin focuses on factors to consider when evaluating loans for TDR designation and considerations for the appropriateness of accrual status and impairment analyses. According to the OCC, the bulletin is "a refresher of the relevant concepts for evaluating whether a loan modification represents a TDR."

Key points, taken directly from the bulletin, include:

1. All substandard loans on accrual status that are renewed, extended, or otherwise modified are not automatically considered to be TDRs.
   
   When renewing or modifying loans, including substandard accruing loans, a bank must perform a documented analysis that illustrates whether the borrower is suffering financial difficulties and if it granted a concession that the bank would not otherwise consider as a result of the borrower's financial difficulties.
   
   Documentation for renewals, extensions or modifications that are determined not to be TDRs should be robust given the presumption that a substandard borrower is experiencing financial difficulties.
2. Generally, until a loan that is a TDR is paid in full or otherwise settled, sold, or charged off, the loan must be reported as a TDR.
   
   There are, however, exceptions, particularly with some loans that are in accrual status and on which payments are current or less than 30 days past due under modified repayment terms. While loans meeting these conditions need not continue to be disclosed as TDRs in the call report in years after restructuring, the loans will continue to be deemed impaired loans and must be evaluated under ASC Subtopic 310–10, Receivables.
3. Banks should clearly document their policies and procedures for identifying and reviewing potential TDRs.
   
   For example, the procedures should address the process for flagging a modified or renewed loan for review, considering the factors to assess TDR status, and should designate responsibility for the TDR decision. Banks should also clearly document and support the facts and circumstances analyzed for each modification or renewal and the conclusion reached.

FASB ASU on TDRs

The FASB on April 5, 2011 issued Accounting Standards Update (ASU) No. 2011-02, Receivables (Topic 310): A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring.

For privately held companies, the ASU's amendments to previous accounting standards are effective for annual periods ending on or after December 15, 2012, including interim periods within that annual period.

For public companies, the guidance became effective for interim and/or annual periods beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption with the impairment measurement being done prospectively for receivables that are newly considered impaired.

The ASU reiterated previous accounting standards by stating that in evaluating whether a modification constitutes a TDR, a creditor must separately conclude that both of the following exist:

• The restructuring constitutes a concession.
• The debtor is experiencing financial difficulties

The ASU provided clarification on factors that banks should use in determining whether a restructuring should be considered a TDR in these circumstances:

• A creditor has granted a concession to a debtor that does not otherwise have access to funds at a market rate for debt with similar risk characteristics as the restructured debt.
• A restructuring has resulted in a temporary or permanent increase in the contractual interest rate, but the restructured debt is still below the market interest rate for new debt with similar risk characteristics.
• A restructuring has resulted in a delay in payment that is insignificant.

Impairment Measurement

FASB Accounting Standards Codification (ASC) Topic 310 Receivables explains the requirements for determining when there should be recognition of an impairment on a TDR.

A loan is impaired if the creditor will be unable to collect all amounts due according to the contractual terms of the original loan agreement, including principal and interest.

A loan restructured as a TDR is an impaired loan, and since a TDR may include a reduction in principal or interest rate, a TDR is considered an impaired loan for the remaining life of the loan.

Banks are required to monitor the loan in years following the TDR to determine if there are any additional impairments.

In addition, an impairment analysis is required for each TDR to determine if any impairment needs to be recorded and to ensure that all TDRs are adequately disclosed in audited financial statements.

To contact Deborah Ladron de Guevara, e-mail dladrondeguevara@mbafcpa.com or call 1-800-239-1474.

• Frank Gonzalez
• CPA / CFF, Principal
• fgonzalez@mbafcpa.com
• 1-800-239-1474

As banks continue to review and restructure their portfolios of real estate loans, many are finding little if any easing of regulatory scrutiny of appraisals.

In their regularly scheduled examinations, regulators again this year are telling banks to obtain new appraisals on numerous properties and to make changes in processes for obtaining and reviewing appraisals. We are hearing more reports of regulators requiring banks to hire additional in-house personnel to review appraisals and to expand their examination of the methodologies and data that appraisers have used to determine valuations.

As in recent years, regulators are questioning whether some appraisals that are more than a year old can be considered current because overall property values in a geographic market may have changed during that period.

Distressed sales are still a major part of the activity in Florida and many other states, particularly in the residential markets. Thus, regulators remain concerned about the reliability of comparable properties and other data that banks are using in some appraisals.

We again found many of these issues with appraisals in this year's annual audits of banks.

In many instances we are advising banks - and regulators are telling them - that a dated appraisal does not reflect an accurate fair market valuation of a property and that they should obtain a new one. This is happening most often on foreclosed properties and on properties that are the collateral for problem (impaired) loans.

Unfortunately, it could take several more years to resolve these issues with appraisals because many banks have not been able to significantly reduce their numbers of other real estate owned (OREO) properties.

In some cases, several banks during 2012 obtained appraisals on an OREO or on a problem loan's property for the second or even the third consecutive year. Appraised valuations on some of those properties are continuing to decline from the valuations when a loan was made in 2007 or an earlier year.

A lower appraised valuation is among the factors that a bank must consider when taking write downs or charge-offs on a property or on a loan while performing an impairment analysis.

Because of recent years' declines in property values, regulators are sometimes asking banks to have appraisals that are no more than six months old on some commercial real estate properties where the loan has been classified as substandard or as doubtful (impaired loan).

Requests for more frequent appraisals are among reasons why some banks in Florida are finding it necessary to schedule appraisals three months or four months before loan renewal dates.

That advance planning can help a bank obtain appraisals that regulators will not consider outdated. It also can enable a bank to have an appraisal done by one of its preferred appraisal companies, increasing the chances of an appraisal coming in at a valuation and with comparables and other methodologies that are acceptable to the bank and to its regulator.

Banks can find an overview of federal regulators' requirements on appraisals in the Interagency Appraisal and Evaluation Guidelines that the Federal Financial Institutions Examination Council (FFIEC) issued on December 2, 2010. The guidelines are an update of previous supervisory guidance.

In the introduction, the Federal Deposit Insurance Corporation and other regulators that are members of the FFIEC noted that market developments had led to a need for "additional clarification of existing regulatory and supervisory standards to strengthen the real estate collateral valuation and risk management practices."

In a Financial Institutions Letter on December 2, 2010, the FDIC noted the following highlights in the guidelines:

• Recognizing that while borrowers' ability to repay real estate loans according to reasonable terms remains the primary consideration in a lending decision, sound collateral valuation practices represent an integral part of the loan underwriting process.
• The guidelines clarify that collateral valuation methods that use an analytical method or technological tool, such as an automated valuation model, cannot be substituted for an appraisal when the transaction requires an appraisal.
• The requirements for collateral valuation methods for transactions that permit the use of an evaluation are enhanced in the guidelines; clarification is made that valuation methods which do not provide a property's market value, such as a broker price opinion, are not acceptable as a valuation.

The Web page of FFIEC's Appraisal Subcommittee has links to state and federal guidelines on appraisals and to a registry of states' licensed and certified appraisers.

To contact Frank Gonzalez, email fgonzalez@mbafcpa.com or call 1-800-239-1474.

• Trevor Foo
• CISA / CISM / CRISC
• tfoo@mbafcpa.com
• 1-800-239-1474

Trevor Foo, CISA/CISM/CRSIC, has more than a decade of in-house experience providing information technology strategies and solutions to financial institutions. As a senior manager in MBAF's Technology Consulting Group, Trevor is helping area financial institutions meet regulatory requirements and establish formidable security and IT controls to protect their businesses and grow their profits.

At MBAF, Trevor oversees all Computer Assurance engagements for clients and directs the Service Organizations Controls ("SOC") Attestation Group for the Assurance Practice. Over the course of his career, he has assisted a number of CPA firms within Florida in assessing the internal controls of clients such as Bankers Insurance Group, e-Ins (a subsidiary of American Insurance Group), Canaveral Port Authority, the City of Melbourne and the City of Cocoa Beach.

Prior to joining MBAF, Trevor was the vice president of information technology with the Miami subsidiary of an international bank which operates throughout Latin America and the Caribbean, providing technical and strategic direction to integrate IT and all operational processes. He is highly skilled in aligning technological solutions with real business objectives that involve strong internal controls.

Trevor says that his greatest sense of accomplishment comes from being able to use his industry and technical experience to help clients understand and improve their internal control environment.

"I am happy when I can sit with a client to understand their problem and recommend solutions that are both advanced and practical," Trevor says. "My goal is to develop and implement strong controls for clients within every area of IT – compliance, security, operational or strategic."

A graduate of Barry University with a Master of Science degree in Information Technology, Trevor is a member of the Information Systems Audit and Control Association (ISACA) and the Florida ISACA Chapter. He is actively involved in his local community and serves on the Board of His House Children's Home.

To contact Trevor, email tfoo@mbafcpa.com or call 1-800-239-1474.

• Frank Gonzalez
• CPA / CFF, Principal
• fgonzalez@mbafcpa.com
• 1-800-239-1474

As they struggle to recover from a crisis that was brought about by system-wide credit risk, banks are getting reminders from regulators to "be prepared for interest rate risk." The advice comes during a year when interest rates remain at historic lows, and when there are widespread expectations that rates will not start rising significantly for at least the next year. The inexpensive cost of funding is helping many banks increase their net interest margins (NIM) and regain profitability.

But even while the Federal Reserve is committed to its zero rate policy at least until late 2014, regulators and bankers realize that rates on the asset and liability sides of balance sheets will begin to rise if the economy enters a sustained recovery. As a result, as banks continue to restructure following a credit risk cycle, regulators are advising them on how the current environment calls for some specific preparations for a possible future cycle of interest rate risk.

At MBAF, we are finding that federal and state banking regulators, during their regular examinations, are spending increased time reviewing the interest rates and durations of deposits and of loans and other investments. A main concern is that due to low rates on loans and investment securities, some banks are "going long" in lending and in certain cases at fixed rates. That strategy could result in lower NIMs and pressure on earnings if market rates start rising and banks are forced to start raising rates on deposits more quickly than they can raise rates on adjustable loans and before fixed-rate loans mature. The federal banking regulatory agencies provided an overview on those concerns in a recent Financial Institutions Letter on Interest Rate Risk (IRR) management. The Federal Deposit Insurance Corporation and the other member agencies of the Federal Financial Institutions Examination Council (FFIEC) released the letter on January 12, 2012.

The FDIC, the Federal Reserve and the Office of the Comptroller of the Currency recommended that each bank should review its IRR management in the context of complexity, risk profile, business model and scope of operations.

Highlights of the letter include:

• A bank's IRR management processes and measurement systems should be capable of capturing, reporting, and controlling the risks being taken and major new initiatives.
• Management should ensure that it conducts stress tests of IRR exposures using appropriate scenarios, including meaningful interest rate shocks, to identify the inherent risk.
• For example, in a low-rate environment, it should run interest rate shocks of more than 300 and more than 400 basis points. If conditions warrant, institutions should test more severe scenarios.
• Management should use reporting limits, triggers, or thresholds for stress scenarios, including the severe rate shocks discussed above, and others where appropriate, to ensure IRR exposures are within risk tolerance levels.
• Banks are expected to measure the potential effect of changes in market interest rates on earnings and capital. When measuring risk-to-earnings, most institutions should use income simulations.
• Management should perform simulations for one and two year time horizons, conduct model measurements that do not include new business growth, develop reasonable assumptions reflecting the institution's experience, and perform appropriate back-testing.
• Smaller banks that use less complex vendor-supplied IRR models can satisfy some, but not all, validation requirements with independent attestation reports from the vendor

The Financial Institutions Letter included a supplement list of what the regulators said are important questions and answers on interest rate risk management.

The FFIEC members said they issued the letter and list of questions as a follow-up to their issuance of an Interagency Advisory on Interest Rate Risk (IRR) Management on January 6, 2010. In that advisory they noted that increased loan losses and sharp declines in the value of certain securities portfolios had been placing downward pressure on capital and earnings.

They added this warning in 2010: "In this interest rate environment, taking advantage of a steeply upward sloping yield curve by funding longer term assets with shorter term liabilities may pose risks to an institution's capital and earnings should short-term interest rates rise."

In our audits during the past two years, we have found that some of our bank clients in Florida and in New York have adopted that kind of strategy, which they see as the most readily available and perhaps the only way to grow their earnings. During several recent industry conferences that we attended, regulators and analysts made similar observations and explained why they feel it could lead to longer-tern problems.

At MBAF, we can help clients conduct stress tests and corresponding reviews to assure that they are carrying out the appropriate analysis on how various swings in interest rates could impact the costs of their liabilities and the yield on their assets. We have a thorough understanding of our clients' marketplace and we can provide information on how their balance sheets and their asset-liability strategies compare with their peer groups.

The FDIC's Quarterly Banking Profile for December 31, 2011 has data that indicates the extent to which the rates banks pay on deposits and other liabilities have been declining more than the rates they earn on loans and other assets–thus producing larger net interest margins (NIM).

The report showed that for the country's banking industry in 2008, the cost of funding earning assets was 2.17 percent and the yield on earning assets was 5.33 percent. That produced a NIM of 3.16 percent. For 2011 the cost of funding was 0.72 percent and the yield was 4.32 percent, for a NIM of 3.60. The bottom line is that NIM improved by 0.44 percent, during a four-year period when deposit rates declined more than loan rates amid minimal interest rate risk.

The composite data for banks based in Florida were similar. For 2008 the numbers were: cost of funding–2.69 percent; yield–5.77 percent; NIM–3.08 percent. For 2011, the numbers were: cost of funding–0.91 percent; yield–4.69 percent; NIM–3.78 percent. During the period, the NIM for Florida-based banks improved by 0.70 percent for reasons that mirrored the national trend.

It is difficult to predict when and to what extent interest rates will start rising and thus alter the current environment that is proving favorable to banks. But anyone who feels that regulators are "crying wolf" about interest rate risk might want to re-visit a warning they issued on January 13, 2006 about potential problems in commercial real estate lending.

The economy was robust and lending on residential construction, including condominium projects, and on other real estate were growing sources of income for many banks. Fears about over-extension prompted the members of the FFIEC to issue a Financial Institutions Letter on sound risk management practices for concentrations in commercial real estate (CRE) lending, They warned that "concentrations of CRE loans may expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the general commercial real estate market."

Noting that they were reiterating previous guidances, the regulators recommended that banks with high concentrations of CRE loans should have "robust risk-management systems in place and capital levels higher than the regulatory minimums and appropriate to the risk associated with these concentrations."

Unfortunately, problems later ensued even for some banks that heeded those warnings.

Now, regulators are giving banks a similar "heads up" regarding the potential impact of changes in interest rates.

To contact Frank Gonzalez, email fgonzalez@mbafcpa.com or call 1-800-239-1474.

• Jack Brister
• TEP, Principal
• jbrister@mbaf-ere.com
• (212) 931-9158

• Raul Incera
• CPA, Principal
• rincera@mbafcpa.com
• 1-800-239-1474

FATCA is here to stay!

That is our response when foreign financial institutions and U.S. taxpayers ask about the Foreign Account Tax Compliance Act (FATCA) and their obligations to comply.

The Internal Revenue Service (IRS) and the U.S. Treasury Department (Treasury) took an important step on February 8, 2012 when they issued proposed regulations that implement a phase-in of FATCA's reporting and withholding requirements for Foreign Financial Institutions (FFIs).

The primary and most far-reaching requirement imposes a 30 percent income tax withholding on FFIs that do not sign and comply with a reporting agreement with the IRS by June 30, 2013. Any U.S.-source income received by the FFI will be subject to the withholding. FFIs that do not sign such an agreement will be treated as a nonparticipating foreign financial institution (NFFI).

It is anticipated that the IRS and Treasury will issue final regulations in the summer of 2012.

The proposed regulations have several important provisions that make FATCA compliance less onerous and time-consuming than had originally been expected.

For banks and other entities that meet the FATCA definition of an FFI (discussed below), compliance requirements will begin in 2014.

In many instances, FFIs are able to use rules of their home country regulators in identifying accounts that are subject to FATCA reporting, particularly those related to know your customer (KYC) and anti-money laundering (AML). FATCA has become a major concern for non-U.S. based financial institutions, many of which have offices and clients in the United States, as well as for U.S. withholding agents and U.S. individuals with foreign financial holdings.

FATCA is part of the Hiring Incentives to Restore Employment Act (HIRE), passed by Congress and signed by President Obama in March 2010. It is an element in the Obama administration's effort to increase the reporting of, and collection of income taxes on, financial assets held outside the U.S. by U.S. persons.

Foreign Financial Institutions (FFIs)

FATCA defines an FFI as a foreign entity which in its ordinary course of business accepts deposits or holds financial assets for others, or whose primary business activity is the investment in or trading of financial assets or commodities. With limited exceptions, foreign banks, broker dealers, foreign hedge funds, private equity funds, private investment funds, pension funds, insurance companies, foreign trust companies and foreign trusts are included in the FFI definition.

FATCA essentially mandates that foreign financial institutions that receive U.S.-source income either on their own account or on behalf of their clients become the equivalent of a Qualified Intermediary (QI) and look beyond the direct beneficial owner of an account or investment to any indirect, ultimate owners.

The agreement with the IRS will require that the following steps be undertaken by the FFI:

• Implement certain identification and due diligence procedures with respect to its accountholders
• Annually report to the IRS the account information of any U.S. accountholders, including foreign entities, with substantial U.S. ownership
• Impose a 30 percent withholding tax in the cases of non-compliance
• Comply with information requests from the IRS
• Close accounts held by U.S. accountholders who refuse to waive secrecy rights

It is imperative that entities that meet the definition of an FFI accelerate their internal compliance procedures. The following action steps should be taken:

• Develop systems that facilitate electronic information reporting
• Obtain U.S. employer identification numbers for accountholders
• Provide annual compliance reports signed and authorized by the chief compliance officers under penalties of perjury

U.S. Taxpayers

U.S. taxpayers must evaluate whether they have a Form 8938 (Statement of Specified Foreign Financial Assets) filing requirement. This form must be submitted together with the 2011 (and subsequent years') income tax returns. Certain U.S. nonresidents may also have the filing requirement, including those who elect to file a joint U.S. income tax return and certain individuals living in U.S. territories.

Specified foreign financial assets include the following:

• Depository or custodial accounts at foreign financial institutions
• To the extent not held in an account at a financial institution,-stocks or securities issued by foreign persons, any other financial instrument or contract held for investment that is issued by, or has a counterparty that is, not a U.S. person, and an interest in a foreign entity

The filing of Form 8938 is required when the total value of specified foreign assets exceeds the following thresholds:

• Single person or married person living in the U.S. who does not file a joint return-- More than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year
• Married couple living in the U.S. and filing a joint return -- More than $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year
• Single person or married person living abroad who does not file a joint return --More than $200,000 on the last day of the tax year or more than $300,000 at any time during the tax year
• Married couple residing abroad and filing a joint return -- More than $400,000 on the last day of the tax year or more than $600,000 at any time during the year

Penalties may be imposed due to the failure to file a required Form 8938.
It is important to note that the Form 8938 filing requirement does not replace, nor affect, a taxpayer's obligation to file Form TD F 90-22.1 (Report on Foreign Bank and Financial Accounts). Such form must be filed by any U.S. person who has a financial interest in, or signatory or other authority over, any financial account in a foreign country, if the aggregate value of these accounts exceeds $10,000 at any time during the calendar year.

With FATCA deadlines approaching, our International Tax specialists and Financial Institutions specialists at MBAF can provide FFIs and taxpayers that are subject to FATCA with additional information and advise them in their preparations for reporting agreements and other compliance.

To contact Jack Brister, email jbrister@mbaf-ere.com. To contact Raul Incera, email rincera@mbafcpa.com. Or call 1-800-239-1474.

• Frank Gonzalez
• CPA / CFF, Principal
• fgonzalez@mbafcpa.com
• 1-800-239-1474

After a series of delays, the new Consumer Financial Protection Bureau (CFPB) became fully operational in January 2012 and began issuing regulations for banks and other financial companies on mortgage lending and other consumer financial services. The pace of activity to date indicates that the CFPB, a bureau within the Federal Reserve Board, will as expected have a significant role among federal financial regulators.

The Dodd-Frank Act of 2010 created the CFPB and granted it authority that includes working with federal banking agencies on the regulation and supervision of mortgage loans, credit card loans and other loans and services offered to consumers.

The CFPB began operations in July of 2011, one year after passage of Dodd-Frank. However, as specified by the law, the CFPB was not able to issue final rules on consumer financial issues without a permanent director in place and approved by Congress. In line with their goal of amending Dodd-Frank to scale back the authority of the CFPB, numerous Republicans opposed President Obama's choice of Richard Cordray as director. However, on January 4, 2012, the president appointed Cordray to the position as "a recess appointment" while Congress was not in session.

The CFPB has assumed various oversight functions from the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Department of Housing and Urban Development, the Securities and Exchange Commission, the National Credit Union Administration and the Federal Trade Commission. The Bureau will join other federal agencies in issuing regulations and in monitoring for compliance related to a number of laws, including the Home Mortgage Disclosure Act (HMDA), the Truth in Lending Act, the Truth in Savings Act and the Real Estate Settlement Practices Act (RESPA). The list of products and activities in which the CFPB has responsibilities includes mortgage lending, mortgage servicing, foreclosure relief and credit cards.

One early proposed regulation, released on February 13, is the draft of a monthly mortgage statement that the CFPB said is designed to make it easier for homeowners to understand their loans and avoid unnecessary costs and fees. Once the CFPB develops and releases a final monthly statement, mortgage servicers, including banks, will be required to send it as part of their monthly notices to borrowers. The Bureau has not announced a timetable for finalizing that document.

The statement will need to include information about the principal loan amount, the current interest rate, the date on which the interest rate may next reset and a description of any late payment and penalty fees. The statement also will need to include information about housing counselors, and a telephone number and e-mail address that may be used to contact the mortgage servicer.

The CFPB's authority allows the organization to join banking regulatory agencies during their regularly scheduled examinations, where they can review residential lending and other consumer-related areas of banks with more than $10 billion in assets. Those large banks will be among companies that CFPB examiners will review using the Mortgage Origination Examination Procedures manual that it released on January 11. The review procedures follow most of the requirements already in place by federal banking regulators. CFPB examiners will follow them in their reviews of banks and of other financial companies.

In its announcement of the manual, the CFPB said its primary purpose is to establish the first federal supervision of what it calls "non-banks" that are involved in the mortgage origination process. The CFPB said that supervision will be for independent lenders, brokers, servicers, and others unaffiliated with banks and other depository institutions.

The activities of some non-bank originators were major factors that led to the ongoing real estate market problems, and concern about those companies was among the reasons that Congress passed the Dodd-Frank Act. The CFPB examination manual lists a set of standards that non-bank lenders must meet throughout the origination process, including appraisal standards and disclosure requirements on terms of loans.

Several of the CFPB's other early and most publicized proposed regulations deal with operations of payday lenders, credit counselors and debt collection companies.

Links to CFPB regulations and its guidances for banks and other financial companies may be found near the bottom of the home page on its web site.

To contact Frank Gonzalez, email fgonzalez@mbafcpa.com or call 1-800-239-1474.

As banks continue to make large expenditures on technology for anti-money laundering compliance, they would be well-advised to continue employing traditional due diligence and following long-standing and basic Know Your Customer procedures. In the long run, a strong balance of high-tech savvy and common sense diligence can deter and detect criminals who are continually developing new methods to launder and to steal money in wire transfers.

Some of the newest schemes carried out today are built around the fraudulent use of stolen identities and other account information in international wire transfers. Recent reports, for instance, have described efforts by individuals and groups to use stolen information to access funds electronically from banks, and then to transfer the funds to institutions overseas. In these schemes, money is withdrawn before the fraud can be detected.

One tactic that is commonly used by fraudsters is a rush request. In this scenario, a bank employee is asked to rush a transfer, and the result is often a lack of due diligence in the compliance area. In order to meet the expedited timeline, compliance staff may fail to complete a standard call back procedure, where the client is called directly to ensure that he or she has actually requested the transfer.

Other commonly used fraud tactics involve complicit employees. In some cases, an employee, such as an account officer, may participate in and facilitate the fraud, and so maintaining dual controls is critical.

If a bank allows a fraudulent transfer, the funds in question can disappear into cyberspace before any kind of verification is even sent to the client and/or the corresponding receiving bank.

This example of fraud is a reminder to always perform a call back and contact the customer for verification of a transaction that has been requested by a means other than in-person. It also provides a reminder of the overall importance of continually monitoring all anti-money laundering controls to make sure they are effective, up-to-date and in compliance with the U.S. Bank Secrecy Act, the USA Patriot Act and other laws and regulations on money laundering and financial crimes.

Many banks are still devoting considerable time and resources to issues of credit quality as a result of the deterioration of the real estate market. At MBAF, we are reminding our clients that regulators are not reducing their scrutiny, and they do not consider time and money spent on real estate issues as a justification for not maintaining appropriate BSA/AML compliance programs.

A poor rating on compliance could require a bank to obtain additional resources to address regulatory requirements that result from regulatory actions. Such an outcome would impact a bank's bottom line as a result of necessary costs incurred for these resources, as well as costs associated with updating BSA/AML programs. Additionally, if a bank continues to be non-compliant, fees and/or fines may be assessed by regulators.

Banks and other financial institutions also should be preparing for two pending changes in the process for filing Currency Transaction Reports (CTR) and Suspicious Activity Reports (SAR) to their regulators. These changes will be implemented by the U.S. Department of the Treasury's Financial Crimes Enforcement Network (FinCEN).

Current rules require a bank to file a CTR for each transaction in currency of more than $10,000. Under the BSA, banks must file a SAR with their regulator when they detect a known or suspected violation of federal laws or regulations or a suspected action related to money laundering, terrorist financing or other criminal activity. In 2001, the Patriot Act extended those requirements to broker-dealers and other financial companies.

On September 16, 2011 the FinCEN issued a proposed rule that would set June 30, 2012 as the deadline for banks to begin using its new forms for CTRs and SARs. That proposed rule also set June 30, 2012 for ending the paper filing options of those forms.

On December 20, 2011, the FinCEN announced that it intends to extend the deadline for the new forms until March 31, 2013 while keeping June 30, 2012 as the final date for paper filings. The new CTR and SAR forms do not require reporting of additional information, but have changes that are technical in nature.

The FinCEN said it is extending the deadline for use of new reports partly in response to industry concern about having sufficient time to transition, including any necessary changes to internal processes and/or information technology systems. In addition, based upon certain limited hardship exceptions. The FinCEN will consider specific requests for financial institutions to file the most current paper forms for up to one year past the mandatory electronic filing deadline.

With new reporting forms and the need to look out for new types of fraud, the challenges continue to grow and evolve in AML/BSA compliance. One reality that remains constant, however, is the fact that regulators will remain diligent and will require improvements, sometimes with enforcement actions, at banks that are not meeting the challenges.

To contact Deborah Ladron de Guevara, email dladrondeguevara@mbafcpa.com or call 1-800-239-1474.

• Jack Brister
• TEP, Principal
• jbrister@mbaf-ere.com
• 1-800-239-1474

Jack Brister, TEP, is a principal in the Tax and Accounting Department at MBAF CPAs, LLC and is based at the firm's New York office.

Jack is a recognized authority on various private client cross-border, foreign financial institution reporting, and foreign international assignment tax issues. He specializes in tax planning and compliance for international wealth structures including foreign trusts, estates and foundations.

Jack also works with U.S. permanent residents living abroad and foreign nationals residing in the United States, and brings expertise on the subject of foreign investment in the United States. He advises clients on pre-immigration and expatriation, recipient of foreign gifts and inheritance, foreign account compliance, voluntary disclosures and U.S. international assignment services.

"We have the legal and technical knowledge that enables us to digest these complex issues and then provide practical solutions to clients," Jack says. "We give them the confidence that their reports are appropriately planned and presented to the tax authorities."

He adds: "I enjoy working with clients and helping them understand these intricate issues."

Jack has been widely published and is often requested to speak internationally at various venues regarding international private client wealth tax matters, as well as issues related to the Foreign Account Tax Compliance Act (FATCA).

Jack is a designated Trust and Estate Practitioner (TEP) by the Society of Trust and Estate Practitioners. He is a member of the American Institute of Certified Public Accountants' (AICPA) Foreign Trust Task Force. He also is a member of the Society of Trust and Estate Practitioners, where he is New York Branch treasurer and a member of the Technical Comments Committee.

A graduate of Central Washington University, Jack received his Bachelor of Science degree in Accounting. He received his Master of Business Administration degree in Finance and Tax from Wagner College. Jack grew up in the Seattle area and is a fan of the Seattle Mariners and the Seattle Seahawks. His hobbies include attending Broadway shows with his wife and daughters.

To contact Jack, email jbrister@mbaf-ere.com or call 1-800-239-1474.

• Frank Gonzalez
• CPA / CFF, Principal
  
• fgonzalez@mbafcpa.com
• 1-800-239-1474

The challenges of managing capital and of meeting regulators' required capital-to-asset ratios could soon become more difficult and complex for banks as they prepare for the new capital rules of the Federal Reserve and other regulators under the Dodd-Frank Act and the Basel III Accords.

Pending the required issuance of final rules by U.S. regulators, all U.S.-based banks will be required to meet a series of new higher capital ratios beginning on January 1, 2013, with phase-ins through January 1, 2019. It is anticipated that the Federal Reserve, the Federal Deposit Corporation and the Office of the Comptroller of the Currency will issue final rules before the end of 2012.

A major change under the new rules will be an increase in the minimum required ratio of common equity to risk-weighted assets. To meet requirements for being adequately capitalized, a U.S. bank must now have a ratio of at least 3.5 percent. Under Dodd-Frank, the minimum will be 4.0 percent as of January 1, 2014 and 4.5 percent starting January 1, 2015.

Another significant change will be the creation of a new capital conservation buffer, comprised of additional Tier 1 capital, with a phase-in from January 1, 2016 through January 1, 2019. The required buffer will be Tier 1 capital equal to 0.625 percent of risk-weighted assets as of January 1, 2016 and will gradually increase to 2.5 percent as of January 1, 2019.

The purpose of the conservation buffer is to ensure that banks have set aside capital that they can use to absorb losses during periods of financial and economic stress.

Through the combination of minimum equity capital and the conservation buffer, the total capital requirement will be 7.0 percent of risk-weighted assets.

In addition, Dodd-Frank and Basel III establish new rules for determining which assets and other instruments can be included in calculating common equity Tier 1 capital, other Tier 1 capital, and Tier 2 capital.

The charts within this article provide the timetables for banks to meet the new capital requirements, including the buffer.

Banks should not delay their strategic planning for the new capital requirements - especially the buffer. Meeting that requirement could be very difficult for many banks, especially if there is no change from the current tight market for raising capital from existing investors or from new investors.

Increasing capital through earnings also is a challenge for many community banks in Florida, New York and other states that still have earnings that are lower than in pre-recession years and are continuing to make large additions to their loan loss reserves. In this environment, it is difficult to build the retained earnings that are a primary component of common equity.

Banks often attempt to improve their capital ratios by shrinking the asset side of the capital/assets equation on balance sheets. Some banks have already reduced their assets through less lending, due to market conditions, and sales of some problem real estate loans and foreclosed properties (Other Real Estate Owned). Thus, they are limited in the steps they can still take to shed assets.

It is vital for key managers and bank officials to keep in mind that all U.S. banks, including community banks, will need to comply with the new capital rules.

Press coverage this year has focused on several Dodd-Frank rules that will not impact the operations of community banks.

The so-called "Volcker rule" that sets limits on banks' proprietary trading is a major issue for large banks that have securities operations.

Under systemic risk rules, bank holding companies with $50 billion or more in assets must provide regulators with detailed additional information on their capacity to withstand financial crises.

In July 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 The law requires U.S. banking regulators to issue rules that would implement capital requirements that were being prepared by the Basel Committee on Banking Supervision.

On September 12, 2010, the Basel Committee adopted a set of higher global minimum capital standards for implementation by the United States and the 26 other countries whose banking supervisors are members of the committee.

Here are details on the pending new capital rules for U.S. banks:

Common Equity

Under Basel III, common equity consists of:

• Common shares
• Stock surplus
• Retained earnings
• Additional paid-in capital
• Limited minority interests meeting common equity Tier 1 criteria

Under Basel III, deductions and adjustments are generally made to common equity Tier 1. Prior to Basel III, 50 percent of deductions were generally made to Tier 1 capital and 50 percent were made to Tier 2 capital.

Deductions and adjustments include:

• Goodwill and other intangibles (except mortgage servicing rights)
• Deferred tax assets (DTAs) that rely on future profitability of the bank to be realized
• Gains on sale related to securitization transactions
• Threshold deductions, where the following items receive limited (10 percent individually, 15 percent in total) recognition in common equity Tier 1 capital mortgage servicing rights (MSRs); DTAs that arise from timing differences; significant investments in the common shares of unconsolidated financial institutions.

Additional Tier 1 Capital

Additional Tier 1 capital instruments are subject to certain criteria, including:

• Perpetual (that is, no maturity date)
• No incentives to redeem (for example, no step-ups)
• Prior supervisory approval required for redemption
• Full discretion over coupon/dividend payments
• Includes limited amounts of minority interest that meet Tier 1 criteria
• In the United States, additional Tier 1 capital will primarily be composed of non-cumulative perpetual preferred securities.
• With limited exceptions, issues of Trust Preferred Securities (TruPS) are no longer eligible for Tier 1 capital and instead must be treated as Tier 2 capital.
• The minimum Tier 1 risk-based ratio is currently 4.0 percent. It will be increased to 4.5 percent on January 1, 2013, 5.5 percent on January 1, 2014 and 6.0 percent from January 1, 2015 onward.

Tier 2 and Total Capital

Tier 2 instruments are subject to criteria, including:

• Minimum five-year original maturity
• No incentives to redeem (for example, non step-ups)
• Instrument may be callable after five years
• Prior supervisory approval required for redemption
• Limited amounts of loan loss provisions includable
• Up to 1.25 percent of credit risk-weighted assets under the Basel II standardized approach
• Up to 0.6 percent of credit risk-weighted assets under Basel II internal ratings-based approach
• No inclusion of unrealized gains/losses on equity securities (Currently, up to 45 percent of unrealized gains/losses on available-for–sale equity securities may be reflected in Tier 2.)

The minimum total capital to risk-weighted assets ratio will remain 8.0 percent.

Conservation Buffer

Banks will be required to hold a capital conservation buffer in the form of common equity Tier 1.

Banks will be able to draw on it during periods of economic and financial stress. If they do so, they will face mandatory regulatory restrictions on the percentage of earnings that they can pay out in the form of capital distributions or employee discretionary bonuses. Constraints on earnings distributions will increase as a bank's buffer decreases.

The capital conservation buffer, calibrated at 2.5 percent of risk weighted assets, will increase the minimum common equity Tier 1 to 7.0 percent and total Tier 1 to 8.5 percent.

Countercyclical buffer

The countercyclical buffer aims to ensure the banking sector capital requirements take account of the macro-financial environment. National authorities are to make assessments of whether credit growth is excessive and leading to a build-up of risk, and will put in place a countercyclical buffer when circumstances warrant.

Internationally active banks will calculate their buffer based on an average of the requirements applicable to jurisdictions to which they have credit exposures.

In a statement on September 12, 2010, U.S. banking regulatory agencies said that the transition period of the Basel III capital standards is designed to "alleviate the potential for associated short-term pressures on the cost and availability of credit to households and businesses."

They added: "Consistent with this objective, supervisors will be evaluating an institution's capital adequacy on the basis of the then-applicable standards as well as the strength of an institution's plans to meet future standards as they come into effect."

Our Financial Institutions specialists are prepared to advise banks on steps they can take to increase their capital to risk-weighted asset ratios and to meet other requirements of Basel III and pending rules from U.S. regulators.

To contact Frank Gonzalez, e-mail fgonzalez@mbafcpa.com or call 1-800-239-1474.

• Frank Gonzalez
• CPA / CFF, Principal
  
• fgonzalez@mbafcpa.com
• 1-800-239-1474

As part of the Dodd-Frank Act's rules for monitoring systemic risk, foreign bank holding companies (BHCs) that have $50 billion or more in consolidated worldwide assets and one or more offices in the United States are among banking companies that must start preparing so-called "living will" plans. Many non-U.S. banking organizations have foreign branches and agencies in the Miami area or in New York City, and these offices are among the types that make foreign BHCs subject to the living will requirement.

The living will is formally designated by regulators as a resolution plan. In these plans, foreign BHCs with $50 billion or more in assets will be required each year to provide the U.S. Federal Reserve with a report on how they would carry out a rapid and orderly resolution of their company and U.S. offices in the event of material financial distress or a failure. The first plans must be filed in 2012 or 2013, depending on the size of the BHC.

It is important for officials of foreign BHCs to keep in mind that the "living will" requirement is based on the worldwide size of the foreign bank holding company (BHC) and not of its U.S. agency, branch or other office.

In establishing the system for enhanced monitoring of large banks, including the requirement for resolution plans, Congress responded to what regulators found to be one of their biggest problems during the 2008 financial crisis.

The Federal Reserve and other regulators found it difficult to quickly obtain information on the operational and financial relationships among the subsidiaries and other affiliates of some large companies. That was part of the information the U.S. government was seeking as it made decisions on providing funding and in helping to arrange mergers.

During any future crises, U.S. regulators are hoping that they will be able to find that information in large BHCs' living wills.

In addition to branches and agencies, the Dodd-Frank Act defines foreign-owned bank offices in the United States to include: banks in the United States; commercial lending company subsidiaries; and Edge Act corporations acquired after March 5, 1987.

The Federal Reserve has estimated that approximately 100 foreign BHCs have more than $50 billion in worldwide assets and have U.S. branch and agency offices. Many of those offices are in Miami and New York, with some BHCs having offices in both cities.

Officials of some of those U.S. offices that are relatively small, such as the $100 million asset range, have told us that they are concerned about the costs and time that will be required to prepare living will plans. As of late October, many of those officials were uncertain about what responsibilities U.S. offices and headquarter offices would have in obtaining information.

U.S. bank holding companies (BHCs) with $50 billion or more in assets also must provide U.S. banking regulators with plans for orderly resolution. The first filings for U.S. and foreign BHCs will be phased in during 2012 and 2013, based on size, and will be an annual requirement.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which Congress passed and President Obama signed in July 2010, authorized U.S. banking regulators to issue rules on the filing of resolution plans.

The Federal Reserve and the Federal Deposit Insurance Corporation approved their final rules on September 13, 2011. Details of filing requirements begin on page 47 of the document.

Submission of resolution plans will be staggered based on the asset size of a covered company's U.S. operations. The requirements are based on non-bank assets, which represent a large share of the asset bases of many of the world's largest BHCs that have investment banking as well as commercial banking activities.

Deadlines for filing first reports are:

• July 1, 2012 - for foreign based covered companies with $250 billion or more in U.S. non-bank assets and for U.S. BHCs with $250 billion or more in non-bank assets.
• July 1, 2013 - for foreign BHCs with $100 million or more in U.S. non-bank assets and U.S. BHCs with $100 billion or more in total non-bank assets.
• December 31, 2013 - for all other foreign and U.S. BHCs.

All BHCs are required to update their plans annually. A company that experiences a material event after a plan is submitted has 45 days to notify regulators of the event.

Depending on factors that are detailed in the rule, a foreign BHC is determined to have $50 billion or more in worldwide total assets if it meets one of these criteria:

• Average total consolidated assets as reported on the company's four most recent quarterly reports to U.S. regulators
• Total consolidated assets as reported on the company's most recent annual report to U.S. regulators

A foreign BHC will remain subject to the resolution plan requirement until it falls below $45 billion in assets based on both of the criteria.

The rule that the Federal Reserve and the FDIC issued on September 13 requires each foreign and domestic BHC with $50 billion or more in assets to describe its plan of how it could be resolved in a bankruptcy proceeding. The two regulators said their goal is to achieve a rapid and orderly resolution of an organization in such a way as not to cause a systemic risk for the financial system.

The rule also sets specific standards for the resolution plans, including requiring a strategic analysis of the plan's components, a description of the range of specific actions to be taken in the resolution and analyses of the company's organization, material entities, interconnections and interdependencies, and management information systems.

Resolution plans of foreign BHCs must also include the following information with respect to the subsidiaries, branches and agencies, and critical operations and core business lines, as applicable, that are domiciled in the United States or conducted in whole or material part in the United States:

• Identification, description in detail and a mapping of the interconnections and interdependencies among the U.S. subsidiaries, branches and agencies, and critical operations and core business lines of the foreign-based covered company and any foreign-based affiliate
• A detailed explanation of how resolution planning for the subsidiaries, branches and agencies, and critical operations and core business lines of the foreign-based covered company that are domiciled in the United States or conducted in whole or material part in the United States is integrated into the foreign-based covered company's overall resolution or other contingency planning process.

The requirements are complex, and some foreign BHCs and their U.S. offices will probably need outside assistance in gathering information and putting it into proper formats for their first resolution plans. The process could be particularly difficult for the numerous U.S. branch and agency offices that are small, for instance with less than $100 million in assets.

Thus, even though many foreign BHCs will not have to file resolution plans with the Federal Reserve until 2013, it is advisable for officials in home offices and in the United States to learn the requirements of the law, and to obtain the information they need as soon as possible in order to ensure future compliance.

To contact Frank Gonzalez, e-mail fgonzalez@mbafcpa.com or call 1-800-239-1474.