Federal bank regulators have come out with a new final rule that will affect how large bank holding companies treat insurance subsidiaries in bank risk-based capital calculations.

The Office of the Comptroller of the Currency, the Federal Reserve System, the Federal Deposit Insurance Corp. and the Office of Thrift Supervision published the final rule today in the Federal Register.

The final rule, which will take effect April 1, 2008, is a revised version of a draft published in the Federal Register in September 2006.

The bank regulatory agencies came up with the draft in response to the Basel II “New Accord,” a document released in June 2006 by the Basel Committee on Banking Supervision, Basel, Switzerland. The document creates a framework for setting risk-based capital requirements for credit risk, market risk and operational risk.

The final rule will apply mainly to “core banks.”

The rule defines core banks as those “with consolidated total assets (excluding assets held by an insurance underwriting subsidiary of a bank holding company) of $250 billion or more or with consolidated total on-balance-sheet foreign exposure of $10 billion or more.”

The rule requires some banks and permits others to use an “internal ratings-based” approach to calculate regulatory credit risk capital requirements and “advanced measurement approaches” to calculate regulatory operational risk capital requirements.

Banks that adopt an IRB approach use their internal systems to come up with parameters for calculating credit risk capital needs.

An “advanced measurement approach” relies on a bank’s internal estimates of its operational risks to determine how much risk capital the bank needs to operate.

Affected bank holding companies will have to have enough tier 1 capital, or core capital, to amount to 4% of total risk-weighted assets.

The bank holding companies will have to have “total capital” equal to at least 8% of total risk-weighted assets, officials write.

Total capital includes tier 1 capital and “tier 2,” or supplemental, capital.

The basic definitions of the tier 1 and tier 2 elements will be the same as they are in banks’ current RBC calculations, officials say.

When a bank holding company with an insurance company subsidiary regulated by a U.S. state or a comparable entity is making RBC calculations, “the assets and liabilities of the subsidiary would be consolidated for purposes of determining the [bank holding company]‘s risk-weighted assets,” officials write.

Originally, officials proposed adjusting for insurance underwriting risk by deducting the insurance subsidiary’s minimum regulatory capital requirement from the bank’s tier 1 capital total.

For U.S. insurance underwriting subsidiaries, the deduction would usually be about 200% of the authorized control level established by an insurance subsidiary’s state insurance regulator, officials write.

The philosophy of the Basel II New Accord would be to report information about the insurance subsidiary separately from the information about the banking operations, officials write.

The September 2006 proposal reflected the concerns of the Federal Reserve board that “a full deconsolidation and deduction approach does not capture the credit risk in insurance underwriting subsidiaries at the consolidated [bank holding company] level,” officials write.

Several commenters suggested letting bank holding companies deduct just 50% from tier 1 capital and deducting the rest from tier 2 capital.

Some commenters recommended separating “deconsolidating” the bank and insurance capital requirements. Those commenters said forcing insurers to deduct minimum regulatory capital from either the bank’s tier 1 capital or tier 2 capital would result in a double count of capital requirements for insurance regulation and banking regulation.

The Federal Reserve board still favors consolidating insurance subsidiary risk with other bank holding company risk, officials note.

The Fed believes that a consolidated bank holding company RBC measure “should incorporate all credit, market, and operational risks to which the [bank holding company] is exposed, regardless of the legal entity subsidiary where a risk exposure resides,” officials write.

The Fed also believes that consolidating bank holding company and insurance subsidiary reporting eliminates incentives to book exposures at the subsidiary with the loosest capital requirements

In the view of the Fed, “the consolidated measure of minimum capital requirements should reflect the consolidated organization,” officials write.

Because of those views, the Fed “is retaining the proposed requirement that assets and liabilities of insurance underwriting subsidiaries are consolidated for determining risk-weighted assets,” officials write.

But bank holding companies can subtract half of the insurance subsidiary capital deduction from tier 1 capital and half from tier 2 capital, rather than having to subtract all of the insurance subsidiary capital from the tier 2 capital, officials write.

In another section of the final rule, bank regulators talk about inclusion and exclusion of insurance subsidiary assets in calculations of whether a bank holding company is a “core” company that must normally abide by the new capital regulations or whether is a company that can choose to opt in to adopting the regulations.

The authors of the final rule decided to keep a provision from the draft that excludes assets held in an insurance underwriting subsidiary. The “advanced approaches” to measuring risk were not designed to address insurance underwriting exposures, officials write.

In a section concerning use of guarantees in improving a bank’s risk profile, officials write that a well-regulated insurance company affiliate that does not own the bank can serve as a guarantor, but other insurers cannot serve as guarantors.

“The agencies expect that the prudential regulation of the affiliate would help prevent the affiliate from exposing itself excessively to the credit exposures of the bank,” officials write.

A copy of the final rule is available