In response to the potential economic effects of the coronavirus, the OCC, FRB and FDIC (“the agencies”) published an interim final rule on March 20, 2020, proposing to revise the definition of eligible retained income. On March 26, 2020, the FRB published an interim final rule which revised the definition of eligible retained income for institutions subject to the FRB’s total loss-absorbing (TLAC) rule. The agencies recently published a final rule which made final both of these interim final rules without changes. The goal of this final rule is to help strengthen the ability of banks and TLAC institutions to continue lending and conducting other financial intermediation activities during stress periods by making distribution limitations more gradual, as intended by the agencies.

Under the capital rule, banks must maintain a buffer of regulatory capital above their required minimum risk-based capital and leverage ratio requirements to avoid restrictions on capital distributions. The agencies established the capital buffer requirements to encourage better capital conservation and to enhance the resilience of the banking system during stress periods. Capital buffer requirements, as initially implemented, were intended to gradually limit the ability of banks to distribute capital if their capital ratios fell below certain levels.

Banks under the capital rule were generally subject to a fixed capital conservation buffer requirement, composed solely of common equity tier 1 capital, of greater than 2.5% of risk-weighted assets. On March 4, 2020, the FRB introduced a stress capital buffer requirement, which provides that a covered holding company will receive a new stress capital buffer requirement on an annual basis, which replaced the existing greater than 2.5% capital conservation buffer requirement.

Under the capital rule, if a banking organization’s capital ratios fall within its applicable minimum-plus-buffer requirements, the maximum amount of capital distributions it can make is a function of its eligible retained income. Before the issuance of the March 2020, interim final rule, the capital rule generally defined eligible retained income as four quarters of net income, net of distributions and associated tax effects not already reflected in net income. The interim final rule revised the definition to be:

“(i) The eligible retained income of a national bank, or Federal savings association is the greater of:

(A) The national bank’s or Federal savings association’s net income, calculated in accordance with the instructions to the Call Report, for the four calendar quarters preceding the current calendar quarter, net of any distributions and associated tax effects not already reflected in net income; and

(B) The average of the national bank’s or Federal savings association’s net income, calculated in accordance with the instructions to the Call Report, for the four calendar quarters preceding the current calendar quarter.”

The revised definition of “eligible retained income” under this final rule applies to all of an organization’s buffer requirements, including the fixed greater than 2.5% capital conservation buffer and the countercyclical capital buffer. Once the stress capital buffer requirements apply October 1, 2020, the revised definition would also apply to all parts of a covered holding company’s buffer requirements. Having one definition of “eligible retained income” for all organizations under the capital rule should simplify the regulatory capital framework and ensures fairness across organizations of all sizes.

The requirements in the total loss-absorbing capacity (TLAC) rule build on and complement the capital rule. Back in 2016, the FRB issued the TLAC rule to require the largest and most important bank holding companies (U.S. based) and foreign banking organizations (U.S. operations) to maintain a minimum TLAC amount, consisting of minimum amounts of long-term debt and tier 1 capital. Also, the TLAC rule prescribed buffer requirements above the minimum TLAC amount, which institutions must maintain to avoid restrictions on capital distributions.

As with the capital rule, the TLAC buffer requirements were established to encourage better capital conservation and enhance the resilience of the banking system during stress periods. TLAC buffer requirements were implemented to gradually limit the ability of institutions to make capital distributions under certain circumstances, thereby strengthening the ability of these institutions to continue lending and conducting other financial intermediation activities during stress periods.

Institutions with a TLAC level that falls below the applicable minimum plus-buffer requirements face limitations on capital distributions, in a manner designed to parallel the restrictions on capital distributions under the capital rule. The maximum amount of capital distributions that a TLAC covered company can make is limited as a percentage of its eligible retained income, as defined in the TLAC rule.

Before the issuance of the March 2020, interim final rule, the TLAC rule generally defined eligible retained income as net income for the four calendar quarters preceding the current calendar quarter, based on the globally systematic important U.S. bank holding companies’ FR Y-9C, net of any distributions and associated tax effects not already reflected in net income. This final rule revised the definition to be:

“(i) The eligible retained income of a global systemically important BHC is the greater of:

(A) The global systemically important BHC’s net income, calculated in accordance with the instructions to the FR Y-9C, for the four calendar quarters preceding the current calendar quarter, net of any distributions and associated tax effects not already reflected in net income; and

(B) The average of the global systemically important BHC’s net income, calculated in accordance with the instructions to the FR Y-9C, for the four calendar quarters preceding.”

These revised definitions of eligible retained income should allow institutions to gradually reduce distributions as they enter periods of stress and provide institutions with stronger incentives to continue to lend and carry on other business functions. Although both interim final rules were effective as of the date they were published, the new final rule will be effective January 1, 2021.