By Brian W. Smith, Managing Director, Smith Regulatory Strategies, and Chad Burhance, Partner, NewOak
In comparison to Basel I and II rules, the recently implemented Basel III regulations (the Regulations) will alter the treatment of bank-owned life insurance (BOLI) separate accounts dramatically.
In short, the Regulations require bank management to examine the portfolios of bank-owned separate accounts closely to determine inherent credit risk in the underlying holdings. The Regulations also make clear that banks must treat an investment in a separate account (such as a BOLI separate account) in the same manner as an equity exposure to an investment fund.
Additionally, banks can no longer rely on rating agencies for risk calculation, as outlined by Section 939A of the Dodd-Frank Act. More significantly, banks must increase their capital holdings based on risk levels to protect against any future financial issues.
While the Regulations allow for three distinct methods for valuing risk-weighted asset (RWA) amounts, it remains the bank’s prerogative to choose which method offered best suits its needs. Using the chosen approach, a bank must assign risk weights to the holdings in order to calculate the impact of a BOLI separate account on its capital ratio.
Three Paths to Compliance
Banks have a choice of three methodologies they can implement to ensure compliance, as prescribed by the Regulations.
They are:
1. Full Look-Through Approach:
Banks may only use this approach when there is sufficient information to calculate the RWA amount for each exposure held by the investment fund. The Regulations ultimately require a bank to set the RWA amount for each fund by aggregating the RWA exposure amounts as if directly held by the bank.
This amount is then multiplied by the bank’s proportional ownership share of each exposure.
2. Simple Modified Look-Through Approach:
Banks can apply the highest risk weight to the adjusted carrying value of the equity exposure in order to generate the RWA amount. The approach applies to any exposure allowed by the fund under its prospectus, partnership agreement or similar contact.
The approach excludes derivatives contracts, which constitute an immaterial percentage of the fund’s total exposure and are used for hedging purposes.
3. Alternative Modified Look-Through Approach:
Banks may assign the carrying value of an equity exposure to a fund on a pro-rata basis to different risk-weight categories under subpart D of the final rule.
Banks calculate the RWA amount for their equity exposure by multiplying the sum of the adjusted carrying value by the applicable risk weight. If the total limits for all allowable investments in a fund exceed 100%, banks must infer that the fund invests the maximum permitted in the exposure with the highest risk weight and continues to make investments based on exposure and the next highest risk weight until the total investment maximum is reached.
For exposures where more than one category applies, banks must use the highest pertinent risk weight. However, this approach excludes derivatives contracts used for hedging purposes and that do not constitute a material percentage of the fund’s total exposures.
How Data Analysis Can Influence Compliance
Significantly, a bank’s choice of methodology hinges on availability of the necessary data and the bank’s ability to perform the required analysis and due diligence on it. Approach selection will be driven by the data the bank receives from its carriers and their chosen investment managers. Some observers have expressed concern over the difficulty of obtaining all the information needed to comply.
However, agencies believe determining the best approach provides a strong incentive to gather all the data to make an informed decision. It is worth noting that sole reliance on banks’ investment managers’ and carriers’ analyses and conclusions likely will not meet the Regulations’ standards, requiring banks to perform a proprietary analysis of the data.
Indeed, it is expected that the majority of banks will be unable to conduct the analysis required to calculate the RWA on their own and will find the increased compliance costs detrimental their operations.
Management Must Recognize the Risks
Knowing the inherent credit risks in a bank’s investment portfolio and having the proper capital allocation to manage those risks is management’s responsibility. Indeed, for some time bank management has been under regulatory pressure to understand their institutions’ BOLI separate account investments.
With the Basel III implementation, if a bank is found deficient in its capital allocations due to a faulty or incomplete understanding of its credit risk positions, its management can be liable for a failure to comply with the Regulations, and potentially, the failure to discharge their fiduciary responsibilities.
Moreover, the failure to properly assess the risks and allocate sufficient capital under the new Regulations may result in a restatement of the bank’s quarterly statement of condition (the “Call Report”) or a revision of its financial statements and related public filings.
Typically, regulators have penalized management for these failures. Official regulatory enforcement actions can include formal agreements or consent cease and desist orders. It is also worth noting that bank management and directors have historically been held personally liable for dereliction in meeting their duties.
A combination of tighter definitions of eligible capital and an increase in RWA will cause an elevation in required capital.
Regulatory penalties against management often include monetary penalties and the barring of the offending manager from the industry. Even in situations where the management is not barred, a formal regulatory finding (or other enforcement actions) can have consequences for the institution and offending managers or directors that live on long after the bank has resolved its deficiencies or the manager has departed.
These might include an inability to qualify for or maintain professional licenses, to obtain liability insurance coverage or to be hired for positions requiring personal bonding. Thus, bank management should treat BOLI investments as seriously as its other investments in its review of credit quality and risk allocation.
Increasing Regulations, Lowering Profitability
Along with the increased stress the Regulations put on bank management, they will have widespread consequences for institutions as well as for the broader financial system.
A combination of tighter definitions of eligible capital and an increase in RWA will cause an elevation in required capital.
Because of the new Regulations, many banks will find it necessary to raise new capital. As a result, profitability and investor returns will come under significant pressure at a time when banks are battling to raise capital and lower costs. Many weaker banks will find it more difficult to meet these demands, spurring a reduction in differentiated business models and pressuring overall industry competition.
Accordingly, it is imperative that banks take concrete action in order to ensure continued viability. Internally, they can benefit by engaging in a review of current RWA methods, models and available data. Banks also must engage in active balance sheet management by considering risk-adverse investment segments and reduced exposure to derivatives and securitized assets.
Some covered institutions may also find it necessary to consider modification to their overall business strategy. Only the most proactive banks will find themselves in a position of strength in light of the Regulations’ more stringent requirements.
To the Rescue: Rising Value of Independent Risk Advisory
It is unavoidable that bank management will be directly impacted by the Basel III Regulations. Given the new concerns over liability, it is essential that bank management demand that requisite steps are taken to properly identify the credit risk in BOLI separate accounts and then to properly allocate risk-based capital to those risks.
Ultimately, it is bank management’s responsibility to question the data provided by its carriers and their investment managers. To support this effort and ensure its success, independent third-party validation of a bank’s internal credit risk findings can be critical in supporting bank management with the information needed to execute their fiduciary duties.
In its use of third-party advisors, bank managements’ directors must comply with the October 30, 2013, expanded guidance for the retention, use and, reliance on third-party advisors (OCC Bulletin 2013-29).
The challenge for banks is to find the right independent financial risk advisory firm for their needs, scope and scale. Criteria banks should have on their checklist in selecting the right provider should include deep experience and specific expertise in the following areas:
- Regulatory mastery to adapt processes to policy requirements
- Credit services, analysis and compliance
- Valuation and risk advisory services
- Senior financial markets practitioners
- Mortgage-backed securities
- Asset-backed securities
- Complex instruments and derivatives
- Deep-dive analytics
- Off-the-shelf and proprietary solutions
- Modeling and surveillance
- Cash flow forecasting
- Outsourcing support services
Not surprisingly, banks likely will find there are few truly independent credit, valuation and risk advisory firms that meet all the criteria required to help banks meet the demands put in place by the Basel III, Dodd-Frank and other regulations existent or yet to come.
The right provider should differentiate its services with an approach that identifies risk drivers of each account through a deep, structured analysis. From people to processes to results, the right provider can deliver a complete portfolio analysis, including the risk-weighted analysis required by the Regulations, and forecast cash flows and capital needs based on a bank’s investments.
Proper use and collaboration between the bank and its third-party advisor will give the former added credibility and support for the credit decisions it makes and the capital it allocates as a result.
With the proper level of external support, banks not only can ensure compliance with the Regulations and safely determine all necessary liquidity needs in light of their BOLI investments made, they might well turn these regulatory obstacles into competitive advantage.
For more information on this or other risk and regulatory issues, contact Brian Smith at brian@smithregulatory.com or Chad Burhance at cburhance@newoak.com.
