Trust Preferred Securities (TruPS)

Trust Preferred Securities (TruPS)

January 10, 2014
Trust Preferred Securities (TruPS)
Overview
subsidiary. In this example, the common stock issued by
the depository subsidiary would receive tier 1 status from
Regulatory implementation of the Dodd-Frank Wall Street
the FDIC and the TruPS issued by the holding company
Reform and Consumer Protection Act (DFA, P.L. 111-203)
would receive tier 1 status (up to a limit) by the Federal
has brought trust preferred securities (TruPS) to
Reserve, even though the FDIC would not have given the
congressional attention. The Volcker Rule (section 619 of
TruPS as favorable capital treatment if they had been issued
the DFA), as issued in December 2013, may force banks to
divest certain TruPS that they already participate in. Banks
by the depository itself. From the FDIC’s perspective, the
have asked Congress to address the treatment of TruPS
banking organization would become more leveraged
under the Dodd-Frank Act, and have challenged agency
(because the FDIC is emphasizing the debt-like
rulemaking in court. This note describes TruPS and
characteristics of the TruPS hybrid security), yet the capital
discusses related policy issues, including bank leverage and
standing at the holding company and depository levels
the relationship between banks and risky investment firms.
would not fully reflect the higher risk of the institution.
What is a TruPS?
Figure 1. TruPS used as Capital by Bank Size (2010)
A trust preferred security is a hybrid investment instrument
(combining features of equity and debt) issued by a trust.
To create a TruPS, a firm establishes a trust, puts debt in it,
then has the trust issue preferred securities. The preferred
securities issued by the new trust are the TruPS, not the
debt deposited in the trust, although TruPS themselves can
be held in a trust which then issues new securities. TruPS
typically pay a quarterly dividend, are redeemable by the
issuer, and have long terms to maturity. Although taxed as
debt, TruPS also constitute part of the capital of bank
holding companies (BHCs), including for small banks.

Source: Created by CRS using data from FDIC Supervisory Insights,
Although any firm can create a trust that issues TruPS,
winter 2010 available at
BHCs are particularly attracted to the investment
http://www.fdic.gov/regulations/examinations/supervisory/insights/siwi
instrument because of tax and regulatory capital treatment.
n10/SI_Wtr10.pdf
Two policy issues associated with bank-related TruPS are
(1) BHC issuance and use of TruPS to increase bank
There is evidence that TruPS were a common method of
leverage and (2) bank ownership of TruPS that might form
funding banks. A 2010 study of TruPS by the FDIC found
an impermissible relationship with risky investment firms.
that banks of all sizes included TruPS in their capital, and
TruPS, Bank Leverage, and the Collins
that TruPS constituted 13% of the tier 1 capital of BHCs for
Amendment
the smallest class of banks. (See Figure 1).
The Collins Amendment sets the more strict depository
The Collins Amendment (section 171(b)(2) of the DFA)
subsidiary regulatory treatment of hybrid securities at the
attempts to address bank leverage. This issue relates to a
time of passage of Dodd-Frank as the floor for capital
banking organization issuing TruPS to fund itself, as
treatment by the holding company regulator. Thus, the
opposed to holding TruPS issued by other organizations.
Dodd-Frank Act reduces the potential for a BHC to use
One measure of leverage is the ratio of a bank’s debt to its
TruPS for a more favorable treatment than would be
capital. Prior to 2010, the regulator of BHCs (the Federal
received if the depository subsidiary were to raise the same
Reserve) gave more favorable capital treatment for TruPS
funds from TruPS itself, although the Collins Amendment
than the regulator of depository bank subsidiaries (the
has some exemptions for smaller banks.
FDIC). Banks could take advantage of this differential
regulatory treatment to increase leverage.
TruPS and the Volcker Rule
The potential for increased debt by the banking
In addition to prohibiting proprietary trading, the Volcker
organization can be illustrated with an example. A BHC
Rule limits the relationships that banks can have with risky
could issue TruPS at the holding company level and use the
investment institutions. Are trusts that issue TruPS covered
proceeds to buy common stock issued by its depository
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Trust Preferred Securities (TruPS)
firms within the meaning of the Volcker Rule? If so, do the
occur going forward.” Figure 2 shows their estimation of
equity-like features of hybrid securities such as TruPS
cumulative defaults by year of origination for CDO-TruPS.
constitute an impermissible relationship between a bank
and the trust that issued the TruPS? For CDO-TruPS
Figure 2. TruPS CDO Cumulative Default as % of
(described below), the December rule answered both of
Balance
these questions in the affirmative. As a result, banks that
own CDO-TruPS have to divest themselves and reclassify
CDO-TruPS as being available for sale. Rapid divestiture
could trigger losses through fire sales, and reclassification
may force immediate recognition of losses under
accounting standards. Banks have responded by
challenging the rule in court and by asking Congress to
address bank ownership of TruPS.
(The Collins Amendment) “...(2) MINIMUM RISK-
BASED CAPITAL REQUIREMENTS.—The
appropriate Federal banking agencies shall establish
minimum risk-based capital requirements on a
consolidated basis for insured depository institutions,

depository institution holding companies, and nonbank
Source: Edited by CRS from
http://www.philadelphiafed.org/research-and-
financial companies supervised by the Board of
data/publications/working-papers/2011/wp11-22.pdf
Governors. The minimum risk-based capital
requirements established under this paragraph shall
Issues Before Congress
not be less than the generally applicable risk-based
capital requirements, which shall serve as a floor for
Banks argue that they will experience significant losses if
any capital requirements that the agency may require,
they are forced to divest themselves of CDO-TruPS by the
nor quantitatively lower than the generally applicable
summer 2014 conformance deadline and reclassify CDO-
risk-based capital requirements that were in effect for
TruPS in their accounting statements. Congress could
insured depository institutions as of the date of
amend section 619 to exempt CDO-TruPS originated or
enactment of this Act. DFA, section 171(b)(2)
acquired before a particular date. Extending the
conformance period could address fire sales, but not
accounting reclassification. On the other hand, commercial
CDO-TruPS
real estate losses might mean that a date-based exemption
might merely delay the recognition of existing losses.
As mentioned above, not only can a trust be formed to issue
TruPS, but a trust can be formed to acquire and hold TruPS
Community banks argue that TruPS in general, and CDO-
themselves, and then issue new securities. One example is
TruPS in particular, are a useful means to raise capital, and
a collateralized debt obligation (CDO) that results from
that the December 2013 Volcker Rule puts them at a
pooling TruPS issued by small and mid-sized banks. Small
competitive disadvantage compared to larger institutions. It
and mid-sized banks argue that these CDO-TruPS allow
could also be argued that fears that banks might misuse
them to access capital markets on more favorable terms
TruPS to increase leverage are addressed by the Collins
than if securities investors had to evaluate each bank
Amendment, although small banks have some exceptions.
individually. Some banks own CDO-TruPS.
Congress could provide an exception based on bank size.
Some who advocate for such an approach argue that small
The holder of a CDO-TruPS is indirectly exposed to the
banks did not cause the recent financial crisis. On the other
market for the class of assets held by the trust. In the case
hand, smaller financial institutions were a significant part of
of bank CDO-TruPS, many small and midsized banks have
the Savings and Loan Crisis.
relatively high concentrations of commercial real estate.
Therefore, holders of these CDO-TruPS are likely to
Congress could wait until regulators and the courts have
experience losses if legacy problems in commercial real
dealt with the issue, although the accounting issue is
estate markets cause regional bank losses.
immediate. Regulators announced they would reconsider
the treatment of TruPS under the Volcker Rule. The courts
Researchers at the Federal Reserve Bank of Philadelphia
have not as yet ruled on the challenge to the December
did a study of bank CDO-TruPS in 2011. They found that
rulemaking.
the legacy problems in commercial real estate have already
caused unrealized losses in bank CDO-TruPS. “Using data
Edward V. Murphy, tmurphy@crs.loc.gov, 7-6201
and valuation software from the leading provider of such
information, we estimate that large numbers of the
IF00007
subordinated bonds and some senior bonds will be either
fully or partially written down, even if no further defaults
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