U.S. Bank Plan Hits Snag in Rules
Treasury Wants Regulators to Allow Government Investment as 'Core Capital'

By Binyamin Appelbaum and David Cho
Washington Post Staff Writers
Saturday, October 18, 2008

The Treasury Department is pressing federal banking regulators to change longstanding rules that are in the way of its plan to invest $250 billion in American banks, raising questions about the independence of the regulatory agencies.

Treasury's plan, announced Tuesday, rests on the ability of banks to use the government's money to buttress their core capital, the financial foundation that supports a bank's operations. Those foundations have been eroded by recent losses, limiting lending to customers and damaging the broader economy.

But under federal banking regulations at the time of the announcement, investments with the conditions attached by Treasury cannot be counted as core capital because that category is reserved for only the most stable kinds of funding.

Now, federal regulators are rushing to clear the road for the rescue plan. The Federal Reserve issued new rules Thursday evening creating a special exception for Treasury's investment. Other agencies are considering following suit.

It is the latest in a string of ad hoc measures to address the financial crisis, highlighting the haste of Treasury's massive and historic interventions and, critics say, a breakdown of the traditional separation between policymakers and banking regulators.

"Banking regulation is very complicated, and when the government is trying to jerryrig a solution, inevitably there are going to be some things that they haven't thought of," said Adam Levitin, a law professor at Georgetown University. "We might worry whether today's solution might be opening up problems tomorrow. On the other hand, it is crucial to remember that we need to live to fight another day."

In what amounted to a partial nationalization of the banking system, Treasury announced that it would invest $125 billion in nine of the nation's largest banks and an additional $125 billion in the rest of the industry. In exchange, the banks would give the government an unusual kind of stock called senior preferred shares. Holders of these shares are excluded from shareholder votes on company business, but they receive annual interest payments and their shares have priority in the event of a bankruptcy.

"The senior preferred shares will qualify as Tier 1 [core] capital," Treasury said in a release announcing the program.

Treasury officials said yesterday that they knew that the rules on core capital needed to be changed to make that true. The officials said they had conversations with the regulators before and after the plan was announced, telling them that the rule changes were necessary for the plan to work.

"As we developed the proposal, we fully consulted with the regulators, and they were directly involved in the design of this program," said Treasury spokeswoman Brookly McLaughlin. She said that the four regulatory agencies that oversee banks had expressed support for the plan, noting that the agency heads stood behind Treasury Secretary Henry M. Paulson Jr. as he announced the program.

But a spokeswoman for the Office of Thrift Supervision, which oversees savings and loans, said yesterday that the agency was reviewing the issue.

The Federal Deposit Insurance Corp., which oversees state-chartered banks, has scheduled a board meeting for Thursday to vote on whether to allow these investments to be counted as core capital.

The Office of the Comptroller of the Currency said it was committed to ensuring that banks can count Treasury's investments as core capital. "Any preferred shares issued to Treasury under this program will count," said spokesman Robert Garsson.

The first nine participating banks all are regulated by the Federal Reserve. Treasury officials said the department could make the first round of investments early next week in the companies, including Bank of America, Goldman Sachs and Citigroup.

If other regulators do not change their rules, however, it could jeopardize the government's broader plan for investing in potentially thousands of smaller banks. The uncertainty surrounding the plan, and the slow pace of the changes, is a frustration to banks eager for clarity and money.

Scott Talbott, senior vice president for government affairs at the Financial Services Roundtable, said the accounting issues "are continuing to slow the recovery effort."

Each banking regulator sets its own rules for the institutions it oversees, including rules dictating how much core capital an institution must hold -- measured as a percentage of its loans and other commitments -- and what kinds of money can be counted. In general, core capital includes money banks do not need to repay, such as funds raised by selling shares of common stock.

Traditionally, banking regulations excluded the kind of preferred shares that banks would sell to Treasury.

The Fed's longstanding rules, for example, excluded from core capital shares that pay a stepped interest rate, meaning that the yield on the shares increases after a fixed period of time. The shares issued to Treasury would pay 5 percent for five years and 9 percent thereafter.

Banking regulators historically have been concerned that the increase in interest payments made such shares a volatile source of capital because it increased the chances that a bank would decide to repay the shareholders' investments. That is the explicit purpose of the stepped interest rate in the Treasury plan.

Such an investment can also interfere with a bank's ability to raise money from other sources because the bank has an obligation to make dividend payments first to the preferred shareholders, potentially limiting payments to common shareholders.

In changing the rules, the Fed noted that its traditional concerns were mitigated by the fact that the terms of the Treasury investment allow the Fed to prevent a bank from selling its shares, and on the other hand that the terms of the investment encourage banks to raise private capital to replace the shares.

The Fed also noted that the plan was designed "to help achieve a fundamental public policy objective in the United States."

Treasury also is in discussions with the Securities and Exchange Commission to change another accounting rule that may make the investment plan less attractive to banks.

The plan requires banks that accept government money to hand over warrants, which would give Treasury the contractual right to shares of their common stock. The measure was intended to give taxpayers some upside if the banks recover and their shares rise.

But under current SEC rules, as share prices rise, banks would have to treat the gains as a projected expense, reflecting the cost to the company if the government decides to exercise its warrants.

Treasury is seeking to change that rule, sources familiar with the matter said.

"We're aware of the issue and are working with the SEC to address it," McLaughlin said.

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