And Finally… Basel III: Impact on Community Banks

By Rick Cyr September 2, 2013

In early July 2013, the Federal Deposit Insurance Corporation (FDIC) issued its interim final “Basel III” rule. The final rule, which incorporates revisions to capital regulations, is significantly different from the initial proposal as it relates to the impact on community banks. The more significant changes from the initial proposal are as follows:

• The final rule provides community banks (under $250 billion) with a one-time opt-out election to remove the impact of certain unrealized capital gains and losses from the calculation of capital. This essentially will allow institutions to continue treating accumulated other comprehensive income (AOCI) items consistent with the current risk-based capital rules. This will alleviate much of the pressure on smaller community banks to manage the regulatory capital volatility that may be associated with AOCI items. Additionally, community banks with significant unrealized actuarial losses on defined benefit pension plans can breathe a sigh of relief. The AOCI opt-out election must be made on the institution’s first Call Report filed after January 1, 2015. If the opt-out election is not made, there is no opportunity to change methodology in future periods.
• The final rule’s treatment of 1-4 family residential mortgage and commercial real estate exposures remains virtually unchanged from the current risk-based capital rules. The initial proposal contained numerous changes that would have significantly increased the risk weightings of these exposures.
• The final rule does not require community banks (under $15 billion for this rule) to phase out trust preferred securities and cumulative perpetual preferred stock from tier 1 capital. This will be welcome news to many banks.

Although the above changes from the initial proposal were well received by community banks and certainly provide some relief from the original proposed rules, the new capital rules include:

• provisions for increases to minimum capital requirements and changes to prompt corrective action thresholds,
• revisions to the definition of capital,
• introduction of the concept of a capital conservation “buffer” and
• provision for changes in risk weighted assets for items deducted from capital.

Below is a brief summary of each of the changes:

New Minimum Capital Requirements and Changes to Prompt Correction Action (PCA) thresholds – The new rules implement higher minimum capital requirements and establish a new common equity tier 1 capital. The new minimum capital requirements are as follows:

• Common equity tier 1 capital to total risk weighted assets of 4.5%
• Tier 1 capital to total risk-weighted assets of 6.0%
• Total capital to total risk-weighted assets of 8.0%
• Leverage ratio of tier 1 capital to adjusted average total assets of 4.0%

Common equity tier 1 capital will generally be composed only of common stock, related surplus, AOCI (unless opted out as discussed above) and retained earnings; less deductions for deferred tax assets, mortgage servicing assets, and significant investments in unconsolidated financial institutions.

Basel III also modifies the PCA thresholds. Please refer to the final rules for details. The FDIC has published a summary for community banks on their website.

Definition of Capital – Basel III implements changes to the definition of capital. The more significant changes are added constraints to the inclusion of certain assets, including investments in unconsolidated subsidiaries, mortgage servicing assets, and certain deferred tax assets. These assets are each subject to an individual limit of 10% of common equity tier 1 capital and an aggregate limit of 15% of common equity tier 1 capital. Amounts in excess of the 10% and 15% thresholds are deducted from common equity tier 1 capital. Additionally, amounts that are not in excess of the thresholds are assigned a risk-weighting of 250%, as compared to the current risk-weighting of 100%. These deductions will phase in over time, from 2015 to 2019.

Capital Conservation Buffer – In addition to minimum capital requirements above, all banks will need to have a capital conservation buffer to avoid being subject to limitations on the ability to make large capital distributions, discretionary bonus payments to executives and similar payments. This requirement begins in 2016 and will be fully phased in by 2019. The purpose of the capital conservation buffer is to ensure banks preserve capital when needed.  Banks with a capital conservation buffer in excess of 2.5% of total risk-weighted assets will not be subject to the limitations. Banks that have less than a 2.5% buffer are subject to increasing limitations on such payments as the buffer approaches 0%. Reference should be made to the final rules for payout restrictions.

Risk-Weightings – Basel III increases risk weights for past due loans, certain commercial real estate loans, and certain equity loans, among other changes to risk weights and credit conversion factors. The more significant changes are:  (1) 150% risk-weight for high volatility commercial real estate (as defined in the rule) as compared to a 100% risk-weight under the current rules; (2) 150% risk-weight for the portion of 90 day past due loans that are not guaranteed or secured as compared to 100% under the current rules; and (3) changes to the risk-weights of mortgage servicing assets and deferred tax assets, as discussed previously.

The new minimum capital requirements become effective for community banks beginning in 2015. The capital conservation buffer and deductions from common equity tier 1 capital phase in over time as indicated above. In addition to becoming familiar with the new rules and their impact on capital, community banks should also be on the lookout for more rules expected by the end of 2013 that are designed to complement the risk-based capital framework.

If you would like to discuss these matters further, please call Rick Cyr or your usual BNN professional at 1.800.244.7444.