In recent years, approximately two-thirds of all top-level  bank holding companies that are subject to capital requirements  (generally those with more than $500 million in total assets) have  included hybrid instruments in their Tier 1 capital (see fig. These hybrid instruments had a total value of $157 billion, representing  13 percent of all bank holding company Tier 1 capital. Excluding Tier 1 Hybrid Capital Likely Will Have Limited Negative Effects

With the exclusion of hybrid instruments from Tier 1, few banking  institutions will fall below minimum amounts of regulatory capital, and  greater reliance on common equity should improve the overall safety and  soundness of banking institutions. Some market participants identified likely  safety and soundness benefits for banking institutions that increase their  share of common equity or other stronger capital sources. Long-term effects of the hybrid capital exclusion on loan rates will likely  also be small, although the exact impact is unknown. The lack of tax-deductible Tier 1 hybrid capital instruments could result in  a cost disadvantage for U.S. institutions relative to their foreign peers,  although the overall competitive effects are unclear. Smaller Banking Institutions Face Limited Capital- Raising Options but Report Little Unmet Capital Need

Smaller banking institutions generally had limited options for raising capital,  and one important form of capital—trust preferred securities—is now  largely unavailable to these banks. According to market  participants, investors were no longer interested in purchasing trust  preferred securities, partly because of their performance during the  financial crisis and concerns about new regulatory restrictions such as  those under the Dodd-Frank Act. Smaller Institutions’ Ability to Raise Capital Varies by Financial Condition and Other Factors

Smaller institutions consider their financial condition and performance (for  example, profitability, debt and capital levels, and asset quality) as the  most important factor in their ability to successfully access capital. Market participants also identified several factors that inhibited smaller  institutions’ access to public capital markets. Specifically, we estimate that 65 percent of smaller  institutions have not raised capital since January 1, 2008, and 88 percent  of those did not need or want to raise more regulatory capital. Only 3  percent of smaller institutions that had not raised capital since January 1,  2008, attempted to raise capital but were unable to do so. The smaller institutions that had raised capital since January 1, 2008,  were generally satisfied with the capital they had raised. Institutions whose financial condition was relatively strong generally had a  more favorable view of the capital-raising environment. Agency Comments

We provided a draft of this report to FDIC, the Federal Reserve, and OCC  for their review and comment. FDIC and the Federal Reserve provided  technical comments that were incorporated, as appropriate. Appendix I: Objectives, Scope, and Methodology

The objectives of our report were to examine (1) the use of hybrid capital  instruments as Tier 1 capital and the benefits and risks of including them  in this category, (2) the potential effects on banking institutions and the  economy of prohibiting the use of hybrid instruments to meet Tier 1  capital requirements, and (3) options that exist for smaller banking  institutions to access regulatory capital. These instruments— defined by the Federal Reserve as restricted core capital elements—will  be excluded from Tier 1 capital by the Dodd-Frank Wall Street Reform  and Consumer Protection Act (Dodd-Frank Act) and include trust  preferred securities, which are widely recognized as the most common  hybrid capital instrument. Because federal banking regulators did not  allow these instruments as Tier 1 capital for depository institutions— banks and thrifts—our review focused on the use of hybrid instruments by  holding companies. Effects of Excluding Tier 1 Hybrid Instruments on Capital Adequacy and International Competitiveness

To assess the effects of excluding Tier 1 hybrid capital on the capital  adequacy of financial institutions, we analyzed regulatory capital data to  determine the extent to which bank holding companies may fall below  minimum regulatory capital levels without Tier 1 hybrid instruments. Assuming that  the loan is priced so that the rate charged at least covers the weighted  cost of capital and that institutions hold common equity and hybrid capital  as equity, we can write the following:  L*(1-t) >= (E*(EK*rce + EH*rtps(1-t))+((D*r)+C+A-O)*(1-t)
L = effective interest rate on the loan  t = marginal tax rate for the bank  E = proportion of equity backing the loan  rtps = required rate of return (yield) on the marginal hybrid securities (trust  preferred securities)  rce = required rate of return (yield) on the marginal common equity  EK = proportion of equity held as common equity  EH = proportion of equity held as hybrid securities (trust preferred  securities)
D = Proportion of debt and deposits funding the loan  r = Effective marginal interest rate on D  C = the credit spread (equal to probability weighted expected loss on the  loan portfolio)
A = administrative and other expenses related to the loan  O = other offsetting benefits to the bank of making the loan  This formula is used to capture the lower cost of hybrid securities,  including the associated tax benefits (EH*rtps(1-t)). In practice these  instruments are largely trust preferred securities.
Why GAO Did This Study

Hybrid capital instruments are securities that have characteristics of both equity and debt. The Federal Reserve allowed bank holding companies to include limited amounts of hybrid instruments known as trust preferred securities in the highest level of required capital (Tier 1), although other federal banking regulators never approved these or other hybrid instruments for this purpose. Responding to concerns that these instruments did not perform well during the 2007-2009 financial crisis, in 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) required regulators to establish rules that will exclude the instruments from Tier 1 capital and required GAO to study the possible effects of this provision. This report addresses (1) the use, benefits, and risks of hybrid instruments as Tier 1 capital; (2) the potential effects of the exclusion on banking institutions and the economy; and (3) options for smaller banking institutions to access regulatory capital. For this work, GAO analyzed data from financial regulatory filings and other sources, interviewed regulators and market participants, conducted economic analysis, and surveyed smaller banking institutions.
GAO makes no recommendations in this report. GAO provided a draft to the banking regulators for their review and comment. FDIC and the Federal Reserve provided technical comments that were incorporated, as appropriate.

What GAO Found

Tier 1 hybrid capital instruments, particularly trust preferred securities, have been heavily used by bank holding companies because of their financial advantages, but they are not as effective in absorbing losses as traditional forms of Tier 1 capital, such as common equity. As of December 31, 2010, almost two-thirds of all top-level bank holding companies that were subject to capital requirements included hybrid instruments in their Tier 1 capital, for a total value of $157 billion. Hybrid instruments such as trust preferred securities have offered institutions the benefit of lower-cost capital, largely because of their debt-related featuresincluding tax-deductible dividends. These instruments also are accessible to a broader range of potential investors. However, trust preferred securities do not absorb losses like other Tier 1 instruments because of their obligation to repay principal and dividends. Trust preferred securities may provide limited financial flexibility in times of stress, but they may also hinder efforts to recapitalize troubled banking institutions.
Eliminating Tier 1 hybrid capital likely will have modest negative effects on the existing capital measures of individual banking institutions and lending and could improve institutions financial stability. Few institutions will fall below minimum regulatory capital levels without Tier 1 hybrid instruments, and banking institutions overall safety and soundness should improve with higher reliance on common equity. GAOs analysis of the relationship between bank regulatory capital and lending activity suggests that any negative effects on the cost and availability of credit should be small, but the exact impact is unknown. Market participants said that losing access to tax-advantaged Tier 1 instruments could place U.S. institutions at a competitive disadvantage, as some foreign banks may still have access to such instruments. The international competitive effects are unclear, however, given the scope of ongoing worldwide regulatory reforms.
Smaller banking institutions, which often had larger proportions of hybrid instruments as Tier 1 capital, have limited options for raising regulatory capital but indicated little unmet need for it. These smaller institutions now have access primarily to common equity raised from private sources. GAOs survey results showed that smaller institutions consider their financial condition and performance as the most important factor affecting their ability to raise capital. Market participants identified challenges that could impact smaller institutions ability to raise capital, including limitations related to the size of capital raised, liquidity, and return potential for investors. However, GAO estimated that most smaller institutions (65 percent) had not raised regulatory capital since January 1, 2008, and of these, a large majority (88 percent) indicated that they had no need or interest in raising more. Further, most smaller institutions that had raised capital since 2008 were satisfied with the amount and terms involved. Only a small percentage of institutions (3 percent) that had attempted to raise capital since January 1, 2008, were unable to do so. Institutions with a stronger financial condition generally had a more favorable view of the capital raising environment.