Regulatory Capital Treatment of a Subordinated Loan and Goodwill
Cedar Peak Securities is a dealer member with $120 million of common equity tier 1 capital before adjustments. It holds $18 million of goodwill from a 2021 acquisition and $6 million of intangible assets with a 10-year remaining life. It issued a $25 million subordinated loan in 2019 with an original maturity of 12 years and 4 years remaining. The loan has a step-up in interest rate of 200 basis points at year 7 tied to a credit spread benchmark, and Cedar Peak may redeem it at year 7 with regulatory approval. Net income for the year was $9 million, and the firm paid $3 million of common dividends. The CFO wants to count the full $25 million as tier 2 capital and asks whether the goodwill and intangibles can be excluded from the deduction because they are "non-operating." The firm's risk-weighted assets are $610 million.
1. Calculate Cedar Peak's common equity tier 1, tier 1, and total capital and the corresponding ratios. State each adjustment and its rationale.
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Start with common equity of $120 million. Common equity tier 1 (CET1) deductions: goodwill of $18 million and other intangibles of $6 million must be deducted from CET1 under Basel III/regulatory capital rules because they are not available to absorb losses on a going-concern basis. Retained earnings are already included in the $120 million starting figure; confirm that the $9 million net income and $3 million dividends are reflected, giving net retained earnings growth of $6 million. Assuming the $120 million is already post-income and post-dividend, no further adjustment.
CET1 = $120m − $18m − $6m = $96 million.
Tier 1 = CET1 plus additional tier 1 instruments. Assuming none qualify, tier 1 = $96 million.
Tier 2: the subordinated loan is $25 million. However, instruments with an incentive to redeem, such as a step-up at year 7 combined with a call, are disqualified from tier 2 unless the step-up is to a fixed rate and the call is subject to regulatory approval and the instrument meets all other criteria. A 200 bps step-up tied to a benchmark creates an incentive to redeem and generally disqualifies the instrument from tier 2 from the outset, or at minimum requires amortization in the final five years. With 4 years remaining, the instrument must be amortized at 20% per year regardless. If disqualified, tier 2 = $0. If treated as amortizing, eligible amount = $25m × (4/5) = $20 million, but the step-up feature likely disqualifies it. Conservatively, tier 2 = $0.
Total capital = $96 million.
Ratios: CET1 = 96/610 = 15.7%; tier 1 = 15.7%; total capital = 15.7%. All well above minimums of 4.5% CET1, 6% tier 1, and 8% total, plus buffers. The goodwill and intangibles cannot be excluded from deduction merely because they are non-operating; the deduction is mandatory.
2. The CFO proposes reclassifying the intangibles as "other assets" to avoid the deduction. Assess whether this is permissible and describe the internal control and ethics implications.
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Reclassifying intangibles as other assets to avoid a regulatory deduction is not permissible. The deduction follows the substance of the asset, not its balance sheet caption. Regulatory capital rules require deduction of goodwill and other intangible assets, net of associated deferred tax liabilities, regardless of presentation. Moving the $6 million to another line without a change in the underlying nature of the asset would be a misclassification and would overstate CET1 by $6 million, raising the CET1 ratio from 15.7% to about 16.7%.
The control implications are significant. Reclassification to achieve a regulatory outcome is a management override risk. The firm should have a capital policy that defines eligible capital instruments and deductions, with review by the CFO and internal audit and approval by the board or capital committee. Changes to capital classification should require documented rationale and independent review.
Ethically, the proposal is a misstatement of regulatory filings, which may be a violation of securities law and dealer member rules requiring accurate books and records. The CFO should be advised that the deduction is mandatory, that the firm's ratios are already strong, and that no reclassification is needed. If the CFO persists, the matter should be escalated to the audit committee and possibly to the regulator. The firm should document the advice and the decision to ensure a clear record.