The battle over an amendment to establish minimum capital requirements in the regulatory reform bill is the result of a long-standing feud between the Federal Deposit Insurance Corp. (FDIC) and the Federal Reserve Board.
The FDIC, which has argued for years that trust-preferred securities are a form of debt, not equity, successfully convinced Sen. Susan Collins, R-Maine, to add a provision to the Senate reform bill that would ban banks from counting trust-preferreds as Tier 1 capital — a move that would erase billions of capital from the system.
"We don't believe it absorbs losses," said Jason Cave, deputy to the FDIC chairman for supervision issues, of trust-preferred securities. Citing last year's stress tests, he said TRUPS did not provide "meaningful capital support for large banks."
But the Fed argues the amendment goes too far and would undermine its ability to negotiate with international regulators on the proposed Basel III capital accord. The central bank has long defined what counts as core capital for bank holding companies, and ruled in 1996 that trust-preferreds can account for up to 25% of Tier 1 capital.
"The Fed was the one that allowed it years ago and they don't admit to any mistakes," said Paul Miller, an analyst with Friedman, Billings, Ramsey Group Inc. "The FDIC doesn't have the regulatory power to eliminate it. The FDIC by themselves can't shut it down."
The Collins amendment would set minimum capital ratios for holding companies in part by referring to a 1991 law detailing prompt corrective action standards, which do not include trust-preferred securities in the ratio of Tier 1 capital to total assets.
The Fed opposes the amendment, which passed with little debate by voice vote, and has joined bankers in trying to remove or alter it when House and Senate lawmakers meet to hash out differences between their bills.
The Fed has argued that putting capital ratios into law is a mistake, preferring to leave such standards up to agency discretion.
"You can't be in the business of dealing with specific capital instruments, particularly hybrid instruments, in legislation … that's the wrong place to do it," said Oliver Ireland, a former Fed lawyer and now a partner at Morrison & Foerster.
But it seems clear that regulators have been moving to eliminate trust-preferred securities as Tier 1 capital on their own. In interviews with current and former regulators as well as industry officials, few offered any defense of treating trust-preferreds as capital, noting they are a form of debt.
"Regulators have a strong preference for equity as the dominant source of Tier 1 capital," said Kevin Jacques, the Boynton D. Murch Chair in Finance at Baldwin-Wallace College and a former Treasury Department official. "It is the ultimate loss-absorbing element."
Ireland said investors also clearly favored equity. "What we saw in the recent crisis is the market preferred tangible market equity," he said. "The way they seemed to judge institutions was on tangible market equity. The market was less confident with other types of capital instruments."
Industry officials and the Fed are trying to ensure any change that does take place has a transition period.
"Suddenly taking something away that has been considered capital can be quite problematic," said Randall Kroszner, a former Fed governor and economics professor at the University of Chicago. "You really need to give institutions enough time to be able to make adjustments."
The Collins amendment would affect all holding companies immediately if the bill becomes a law as is. But Collins has said her intention was to limit its impact to holding companies with more than $500 million of assets. Collins also has indicated that she would support some type of transition period. The banking industry has argued that existing trust-preferreds should be grandfathered.
The FDIC said it backs phasing in the requirement.
"There is some recognition that holding companies that rely heavily on trust-preferreds may not be able to get out of that immediately," said Paul Nash, deputy to the FDIC chairman for external affairs. "We want to recognize the market realities and give them some time to do it, but there will be no new trust-preferred issued that will count as Tier 1 capital."
Nash said he expects the final bill will include a transition period to give holding companies the chance to divest themselves of trust-preferreds and add new capital.
But the Fed is also concerned because the provision hurts its bargaining position on Basel III. Late last year, the Basel Committee on Banking Supervision proposed eliminating trust-preferreds as Tier 1 capital, but agreed to continue to talk about the issue.
Many said the Fed had hoped to extract some concessions from international regulators for eliminating trust-preferreds, a move that would not be possible if they were already not counted as Tier 1 capital. "They're currently in negotiations for Basel III and the Europeans are trying to eliminate TRUPS as capital," Miller said. "They really feel this undermines their negotiations."
Another industry source, who spoke on condition of anonymity, agreed. "It really undermines the U.S. position," the source said. "The Europeans can say, ‘Wait a minute, one of your own sister agencies doesn't believe it should count, and Congress passed it.' "
Industry representatives said the issue should receive a full airing from Congress and regulators so that its impact is fully understood. They estimate that roughly 644 banks — mostly mid-sized institutions — would be hurt by the provision, and eliminate close to $130 billion in capital. "When you are going to address $130 billion-plus in capital in the banking system it warrants a hearing, it warrants a discussion, it warrants that people understand the ramifications of what they are doing before they do it," said Diane Casey-Landry, senior executive vice president and chief operating officer of the American Bankers Association.
For now at least, it seems likely that some part of the Collins amendment will survive. In a briefing with reporters on Wednesday, Michael Barr, the Treasury assistant secretary of financial institutions, expressed support for the measure. "We 100% share the goal of the Collins amendment," he said. "The basic goal of the Collins amendment is there should be higher capital in the system going forward. Large banks and large bank holding companies, particularly firms that are interconnected should hold significantly more capital than their smaller counterparties."
Still, Barr alluded to unspecified fixes to the provision. "There's some technical issues in the drafting that we hope to work through in the conference process," he said.