We have heard, read and seen (and internally had) some confusion regarding the joint proposed rulemaking regarding the potential simplification of the capital rules as they relate to Mortgage Servicing Assets (MSAs) and certain Deferred Tax Assets (DTAs).

In addition to simply being complicated regulations, the regulators also have two proposed rulemakings outstanding related to these items. In August 2017, the banking regulators jointly sought public comment on proposed rules (the “Transition NPR“) that proposed to extend the treatment of MSAs and certain DTAs based on the 2017 transition period. Then, in September 2017, the banking regulators jointly sought comment on proposed rules (the “Simplification NPR“) that proposed to alter the limitations on treatment of MSAs and certain DTAs (and also addressed High Volatility Commercial Real Estate or HVCRE loans).

The Simplification NPR also addressed the interplay of the Simplification NPR and the Transition NPR. The Simplification NPR provided that the Transition NPR, if finalized, would only remain effective until such time as the Simplification NPR became effective. Accordingly, the Simplification NPR, if adopted, will ultimately control, with no transition periods for MSAs and certain DTAs following January 1, 2018.

Net Operating Loss DTAs

Importantly, neither the Transition NPR nor the Simplification NPR have any affect on the Basel III capital treatment net operating loss (NOL) DTAs. DTAs that arise from NOL and tax credit carryforwards net of any related valuation allowances and net of deferred tax liabilities must be deducted from common equity tier 1 capital. Through the end of 2017, the deduction for NOL DTAs are apportioned between common equity tier 1 capital and tier 1 capital. In 2017, 80% of the NOL DTA is deducted directly from common equity tier 1 capital, while the remaining 20% is separately deducted from additional tier 1 capital. Starting in 2018, 100% of the NOL DTA will be deducted from common equity tier 1 capital.

The end of the transition period will have the effect of lowering the common equity tier 1 capital ratio of all institutions with NOL DTAs, although the tier 1 capital and leverage ratios should remain unchanged. This impact is entirely unaffected by the adoption (or non-adoption) of the Transition NPR and/or Simplification NPR.

Similarly, other aspects of NOL DTAs are unaffected by the proposed rules. Specifically, (i) GAAP still controls the appropriateness of valuation allowances in connection with the DTA, (ii) tax laws still control the length of time over which DTAs can be carried forward, and (iii) Section 382 of the Internal Revenue Code still controls the limitation (and potential loss) of DTAs upon a change in control of the taxpayer.

Temporary Difference DTAs

Unlike Net Operating Loss DTAs, DTAs arising from temporary differences between GAAP and tax accounting, such as those associated with an allowance for loan losses and other real estate write-downs, can be included in common equity tier 1 capital, subject to certain restrictions. To the extent that such DTAs could be realized through NOL carryback if all those temporary differences were deemed to have been reversed, such DTAs are includable in their entirety in common equity tier 1 capital. Essentially, to the extent the temporary difference DTAs could be realized by carrying back against taxes already paid, then such DTAs are fully includable in capital. Carryback rules vary by jurisdiction; while federal law generally permits a bank to carry back NOLs two years, many states do not allow carrybacks.

However, if realization of the temporary differences DTA is contingent on future income, then the regulations subject the DTA to further limitations. Under the existing Basel III regulations, temporary difference DTAs that exceed 10% of the institutions common equity tier 1 capital must be deducted. In addition, the existing regulations provide that further deductions are necessary to the extent that the aggregate amount of otherwise permissible temporary difference DTAs, MSAs and investments in the capital of unconsolidated financial institutions exceeds 15% of the institutions common equity tier 1 capital.

The existing rules also contain two material transition provisions. First, for 2017, only 80% of the excess DTA must be deducted from capital. Starting in 2018, the existing rules call for 100% of the excess DTA to be deducted from common equity tier 1 capital. Second, through the end of 2017, the risk weighting for any DTA that remains included in capital is 100%. Starting in 2018, the existing rules call for any DTAs that remain included in capital and that are contingent on future income to be risk weighted at 250%. (Temporary difference DTAs that be realized through NOL carrybacks will still carry a 100% risk weighting.)

Mortgage Servicing Assets

MSAs are generally subject to the same 10% and 15% limitations and transition rules that are imposed on temporary difference DTAs that are not realizable through carryback. Under the existing Basel III regulations, MSAs that exceed 10% of the institutions common equity tier 1 capital must be deducted. In addition, the existing regulations provide that further deduction is necessary to the extent that the aggregate amount of otherwise permissible temporary difference DTAs, MSAs and investments in the capital of unconsolidated financial institutions exceeds 15% of the institutions common equity tier 1 capital.

The existing rules also contain the same two material transition provisions. First, for 2017, only 80% of the excess MSA must be deducted from capital. Starting in 2018, the existing rules call for 100% of the excess MSA to be deducted from common equity tier 1 capital. Second, through the end of 2017, the risk weighting for any MSA that remains included in capital is 100%. Starting in 2018, the existing rules call for any MSAs that remain included in capital to be risk weighted at 250%.

What 2018 Would Look Like Without the NPRs

Understanding the potential effects of the Transition NPR and Simplification NPR first requires a look at what would be expected if the existing Basel III rules remained in place in 2018.

Based on our review of June 30, 2017 call reports and holding company Y-9’s, less than 100 banks and thrifts were affected by either the DTA or MSA 10% limitation, and most of those affected were affected by one or the other, but not both. Very few institutions have historically been affected by the 15% overall limitation.

First, assuming no other change in capital or level of temporary difference DTA or MSA, institutions that have been reporting a deduction in common equity tier 1 capital based on having temporary difference DTAs or MSAs in excess of 10% of their common equity tier 1 capital should expect to report deductions that are about 25% higher to reflect the transition from an 80% to a 100% deduction. This would mean, barring other changes (which is entirely unrealistic), the affected institutions would all have lower amounts of capital starting in the first quarter of 2018, and thus lower CET1, tier 1, total and leverage capital ratios.

Second, all institutions carrying MSAs or temporary difference DTAs that are not realizable through carrybacks (which we expect is a much larger number than the number of institutions that have more than 10% of their common equity tier 1 capital in either bucket) will experience an increase in their overall risk-weighted assets, as they will need to risk-weight such MSAs and DTAs at 250% rather than 100%. This, in turn, would mean lower CET1, tier 1 and total risk based capital ratios for all institutions with such DTAs or MSAs. Mathematically, the increased risk-weighting should have a larger impact than the increased deductions, although both transition changes have the impact of lowering capital ratios.

Transition NPR

As noted above, the Transition NPR proposes to extend the treatment of MSAs and certain DTAs based on the 2017 transition period. Accordingly, under a Transition NPR framework only 80% of the deduction would be reflected and risk-weighting would remain at 100%.

From a forecasting perspective, this one is the easiest…. call reports and Y-9’s filed for 2018 would continue to report numbers comparable to those reported for 2017. Accordingly, the Transition NPR reflects regulatory relief, but only with regard to what was expected in 2018, not vis-a-vis 2017 capital regulations.

Simplification NPR

Among other changes beyond the scope of this blog post (like High Volatility Acquisition, Development and Construction loans and simplifying investments in unconsolidated financial institutions and minority interests), the principle impact of the Simplification NPR would be to (i) eliminate the 15% overall cap on the inclusion of MSAs, temporary difference DTAs and investments in the capital of unconsolidated financial institutions, and (ii) increase the 10% cap for each of temporary difference DTAs and MSAs to 25%. The Simplification NPR, however, retains the 250% risk weighting for MSAs and temporary difference DTAs not realizable through carryback.

Based on our review of June 30, 2017 call reports and Y-9’s, it would appear that the proposed 25% cap would only limit a handful of institutions from being able to include 100% of their temporary difference DTAs and MSAs in common equity tier 1 capital.

Accordingly, measuring the impact of the Simplification NPR on industry capital levels is complicated. If we’re comparing life in 2018 between the current rules (as they would apply in 2018 without the Transition NPR) and the Simplification NPR, than the Simplification NPR would be expected to raise the capital levels of any institution that is currently experiencing a cut back in their common equity tier 1 capital based on either temporary difference DTAs or MSA’s exceeding 10%. However, if we’re comparing the Simplification NPR with 2017 reports or life under the Transition NPR, the projected results will vary depending on the level of MSAs and/or temporary difference DTAs on each institutions books.

Based on our review of June 30, 2017 call reports and Y-9’s, for those handful of institutions that have significant (i.e. greater than 15% of their common equity tier 1 capital) in temporary difference DTAs or MSAs, the increase in common equity tier 1 capital will more than offset the increased risk-weighting of such assets, and will experience nominally higher capital ratios across the board. However, for those institutions with lower amounts of temporary difference DTAs or MSAs, the increase in common equity tier 1 capital (if any… institutions with less than 10% will experience no positive change) will be entirely offset by the increased risk-weighting of such assets, and will thus report lower risk-based capital ratios.

Conclusions

The Simplification NPR certainly simplifies the application of the capital limitations associated with MSAs and temporary difference DTAs by eliminating the 15% aggregate cap. The Simplification NPR will also provide benefit to those institutions that have more than 10% of their common equity tier 1 capital consisting of MSAs or temporary difference DTAs. However, the scheduled full implementation of the 250% risk weighting for MSAs and temporary difference DTAs will likely have a larger impact on a greater number of institutions.

While temporary difference DTAs are largely beyond the control of institutions, the attractiveness (and size of MSA portfolios) will remain a key decision for management. The Simplification NPR raises the threshold at which institutions will pay a sharp capital penalty for holding MSAs from 10% to 25% of common equity tier 1 capital. However, the 250% risk weighting also effectively increases the capital cost of holding MSAs for all depository institutions. Each depository institution will have to make the decision whether holding 25 cents in total capital for every dollar in MSAs (to achieve a 10% total risk based capital ratio) is in the best interest of its shareholders. We believe that math will continue to favor non-depository institutions and a few depository institutions that can achieve efficiencies through volume, which appears to generally be the industry’s current path.