Note 7 - Capital and Regulatory Matters

Regulatory Capital Requirements. Banks and bank holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.

Quantitative measures established by regulations to ensure capital adequacy require the maintenance of minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to adjusted quarterly average assets (as defined).

Cullen/Frost’s and Frost Bank’s Tier 1 capital consists of shareholders’ equity excluding unrealized gains and losses on securities available for sale, the accumulated gain or loss on effective cash flow hedging derivatives, the net actuarial gain/loss on the Corporation’s defined benefit post-retirement benefit plans, goodwill and other intangible assets. Tier 1 capital for Cullen/Frost also includes $144.7 million of 5.375% non-cumulative perpetual preferred stock and $120 million of trust preferred securities issued by its unconsolidated subsidiary trust. Cullen/Frost’s and Frost Bank’s total capital is comprised of Tier 1 capital for each entity plus a permissible portion of the allowance for loan losses. The Corporation’s aggregate $100 million of floating rate subordinated notes are not included in Tier 1 capital but the permissible portion (which decreases 20% per year during the final five years of the term of the notes) totaling $60 million at March 31, 2013 and $80 million at December 31, 2012, is included in total capital of Cullen/Frost.

The Tier 1 and total capital ratios are calculated by dividing the respective capital amounts by risk-weighted assets. Risk-weighted assets are calculated based on regulatory requirements and include total assets, excluding goodwill and other intangible assets, allocated by risk weight category, and certain off-balance-sheet items (primarily loan commitments). The leverage ratio is calculated by dividing Tier 1 capital by adjusted quarterly average total assets, which exclude goodwill and other intangible assets.

As more fully discussed in the 2012 Form 10-K, the Corporation’s primary federal regulator, the Federal Reserve, published two notices of proposed rulemaking in June 2012 (the “2012 Capital Proposals”) that would substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including Cullen/Frost and Frost Bank, compared to current U.S. risk-based capital rules. As proposed, one of the 2012 Capital Proposals was to come into effect on January 1, 2013 (subject to a phase-in period) and the other would come into effect on January 1, 2015 (with an option for early adoption); however, final rules have not yet been adopted and the proposed new capital framework is therefore not yet applicable to Cullen/Frost and Frost Bank.

Actual and required capital ratios for Cullen/Frost and Frost Bank were as follows:


	Actual					Minimum Required for Capital Adequacy Purposes					Required to be Considered Well Capitalized
	Capital Amount		Ratio			Capital Amount		Ratio			Capital Amount		Ratio
March 31, 2013
Total Capital to Risk-Weighted Assets
Cullen/Frost	$	1,967,401		15.44	%	$	1,019,653		8.00	%	$	1,274,566		10.00	%
Frost Bank		1,740,052		13.66			1,019,045		8.00			1,273,806		10.00
Tier 1 Capital to Risk-Weighted Assets
Cullen/Frost		1,813,812		14.23			509,826		4.00			764,739		6.00
Frost Bank		1,646,463		12.93			509,522		4.00			764,283		6.00
Leverage Ratio
Cullen/Frost		1,813,812		8.42			861,796		4.00			1,077,245		5.00
Frost Bank		1,646,463		7.65			861,162		4.00			1,076,453		5.00
December 31, 2012
Total Capital to Risk-Weighted Assets
Cullen/Frost	$	1,947,974		15.11	%	$	1,031,526		8.00	%	$	1,289,408		10.00	%
Frost Bank		1,730,444		13.43			1,030,878		8.00			1,288,597		10.00
Tier 1 Capital to Risk-Weighted Assets
Cullen/Frost		1,763,521		13.68			515,763		4.00			773,645		6.00
Frost Bank		1,625,991		12.62			515,439		4.00			773,158		6.00
Leverage Ratio
Cullen/Frost		1,763,521		8.28			851,483		4.00			1,064,354		5.00
Frost Bank		1,625,991		7.64			850,954		4.00			1,063,693		5.00

Management believes that, as of March 31, 2013, Cullen/Frost and its bank subsidiary, Frost Bank, were “well capitalized” based on the ratios presented above.

Cullen/Frost and Frost Bank are subject to the regulatory capital requirements administered by the Federal Reserve, and, for Frost Bank, the Federal Deposit Insurance Corporation (“FDIC”). Regulatory authorities can initiate certain mandatory actions if Cullen/Frost or Frost Bank fail to meet the minimum capital requirements, which could have a direct material effect on the Corporation’s financial statements. Management believes, as of March 31, 2013, that Cullen/Frost and Frost Bank meet all capital adequacy requirements to which they are subject.

Trust Preferred Securities. In accordance with the applicable accounting standard related to variable interest entities, the accounts of the Corporation’s wholly owned subsidiary trust, Cullen/Frost Capital Trust II, have not been included in the Corporation’s consolidated financial statements. However, the $120.0 million in trust preferred securities issued by this subsidiary trust have been included in the Tier 1 capital of Cullen/Frost for regulatory capital purposes pursuant to guidance from the Federal Reserve. As more fully discussed in the 2012 Form 10-K, the 2012 Capital Proposals would require the phase-out of certain hybrid securities, such as trust preferred securities, as Tier 1 capital of bank holding companies in equal installments between 2013 and 2016. However, because the final rules have not yet been adopted, the proposed new capital framework is not yet applicable and no portion of the Corporation’s trust preferred securities has been excluded from Tier 1 capital as presented in the above table as of March 31, 2013. Had a portion of the trust preferred securities been excluded in accordance with the proposed phase-out schedule as of March 31, 2013, Cullen/Frost’s Tier 1 capital to risk-weighted assets would have been 14.00% and the leverage ratio would have been 8.28%.

Preferred Stock. On February 15, 2013, the Corporation issued and sold 6,000,000 shares, or $150 million in aggregate liquidation preference, of it’s 5.375% Non-Cumulative Perpetual Preferred Stock, Series A, par value $0.01 and liquidation preference $25 per share (“Series A Preferred Stock”). Dividends on the Series A Preferred stock, if declared, accrue and are payable quarterly, in arrears, at a rate of 5.375%. The Series A Preferred Stock qualifies as Tier 1 capital for the purposes of the regulatory capital calculations. The net proceeds from the issuance and sale of the Series A Preferred Stock, after deducting underwriting discount and commissions, and the payment of expenses, were approximately $144.5 million. The net proceeds from the offering were used to fund the accelerated share repurchase further discussed below.

Accelerated Share Repurchase. Concurrent with the issuance and sale of the Series A Preferred Stock, on February 15, 2013, the Corporation entered into an accelerated share repurchase agreement (the “ASR agreement”) with Goldman, Sachs & Co. (“Goldman Sachs”). Under the ASR agreement, the Corporation paid $144 million to Goldman Sachs and received from Goldman Sachs approximately 1.9 million shares of the Corporation’s common stock, representing approximately 80% of the estimated total number of shares to be repurchased. Goldman Sachs borrowed such shares delivered to the Corporation from stock lenders, and during the term of the ASR agreement, will purchase shares in the open market to return to those stock lenders. Final settlement of the ASR agreement is expected to occur in the third quarter of 2013, and may occur earlier at the option of Goldman Sachs. Upon final settlement, the Corporation expects to receive the balance of the shares repurchased under the ASR agreement. The specific number of shares that the Corporation ultimately will repurchase will be based on the volume-weighted-average price per share of the Corporation’s common stock during the repurchase period, subject to other adjustments pursuant to the terms and conditions of the ASR agreement. At settlement, under certain circumstances, Goldman Sachs may be required to deliver additional shares of the Corporation’s common stock to the Corporation, or, under certain circumstances, the Corporation may be required to deliver shares of the Corporation’s common stock or the Corporation may elect to make a cash payment to Goldman Sachs. The terms of the ASR agreement are subject to adjustment if the Corporation were to enter into or announce certain types of transactions. Furthermore, during the term of the ASR agreement, and subject to certain limited exceptions, the Corporation may only make repurchases of Cullen/Frost common stock with the consent of Goldman Sachs.

The ASR agreement is part of a stock repurchase program that was authorized by the Corporation’s board of directors in December 2012 to buy up to $150 million of the Corporation’s common stock. The Corporation accounted for the repurchase as two separate transactions: (i) as shares of common stock acquired in a treasury stock transaction recorded on the acquisition date; and (ii) as a forward contract indexed to the Corporation’s common stock that is classified as equity and reported as a component of additional paid in capital.

Dividend Restrictions. In the ordinary course of business, Cullen/Frost is dependent upon dividends from Frost Bank to provide funds for the payment of dividends to shareholders and to provide for other cash requirements. Banking regulations may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of Frost Bank to fall below specified minimum levels. Approval is also required if dividends declared exceed the net profits for that year combined with the retained net profits for the preceding two years. Under the foregoing dividend restrictions and while maintaining its “well capitalized” status, at March 31, 2013, Frost Bank could pay aggregate dividends of up to $216.5 million to Cullen/Frost without prior regulatory approval.

Under the terms of the Series A Preferred Stock, the ability of the Corporation to declare or pay dividends on, or purchase, redeem or otherwise acquire, shares of its common stock or any securities of the Corporation that rank junior to the Series A Preferred Stock is subject to certain restrictions in the event that the Corporation does not declare and pay dividends on the Series A Preferred Stock for the most recent dividend period.