Dodging the Basel Bullet

Planning under the new capital rules should start now for 2015

By Howard Schneider

The great majority of community banks won’t be significantly affected by the final Basel III minimum capital rules adopted by U.S. regulators this summer, thanks mostly to effective industry advocacy by ICBA and its members. Community bankers submitted most of the more than 2,600 comment letters the Federal Reserve Board received on the rules, which were originally intended to apply only to the largest internationally active megabanks.

“Regulators heard loud and clear what community bankers were saying,” recalls Patrick Murphy, an attorney at the law firm Godfrey & Kahn SC in Milwaukee.

As a result, most community banks will find that they’re already in compliance with the new capital rules, particularly the Tier 1 capital minimum set at 6 percent for all adequately capitalized banks and 8 percent for all well-capitalized banks. And for those community banks that might need to acquire more capital to comply rules, they’ll have until January 2015 to prepare.

Nevertheless, industry advisors say all community banks should thoroughly review the rules and assess now how they might be affected over the short and long term. When necessary, most community banks bolster their capital through their retained earnings, and improving economic conditions should help community banks build up even greater reserves of retained earnings.

“The federal banking agencies have higher expectations for strategic and capital planning by all banks,” says David Baris, a partner in the law firm BuckleySandler LLP in Washington, D.C. In the future, he says, regulators will expect “even smaller community banks to have stress testing in place, which aims to anticipate capital needs based on worst-case scenarios.”

Time to plan

Under the final Basel III rules, common equity ratios required on risk-weighted assets will rise to 4.5 percent in 2015, and Tier 1 capital minimums are set at 6 percent. An additional “capital conservation buffer” will be phased in over the following four years.

Community banks will be allowed to continue using the current risk weightings on residential mortgages, instead of being put into a more-complicated and stricter compliance regime.

Existing trust preferred securities also will continue being counted as capital for banks with under $15 billion in assets, rather than being phased out as was originally proposed under Basel III.

“For most community bankers, it’s a non-event,” says Jay Brew, co-chairman of Seifried & Brew LLC, a consulting firm in Bethlehem, Pa., that offers strategic and capital planning for community banks.

For standard growth, extra capital shouldn’t be needed by many community banks for Basel III requirements, says Mark Evans, executive vice president and director of investment strategies at ICBA Securities, ICBA’s institutional fixed-income broker-dealer for community banks in Memphis. However, community banks anticipating a need for additional capital during the next two years—whether to fund growth through a merger or acquisition or perhaps support a governance decision to buy back a block of shareholder stock—should begin planning for the possibility now, he and other consultants agree.

Community bank officers and directors should begin putting together balance sheet projections for the coming five to seven years, Evans recommends. Projecting future capital needs under Basel III shouldn’t be difficult for most institutions, he says. Existing reports and spreadsheets can be easily adapted to the Basel III standards.

Asking bank examiners about their expectations regarding the new capital rules probably won’t be helpful now. Examiners haven’t received training regarding the rules, Evans points out, and Basel III requirements “ultimately come down to math,” so accounting for examiner interpretations won’t be a factor.

One step the vast majority of community banks will take is the one-time opt-out allowed for accumulated other comprehensive income under Basel III. Community banks with less than $250 billion in assets can select to permanently remove accumulated other comprehensive income from their regulatory capital calculations.

If banks don’t opt out, unrealized losses on securities treated as available-for-sale for accounting purposes would be marked against their regulatory capital. It will be important for community banks to remember to make this opt-out selection on their first call report in 2015.

Having to account for the fluctuating and potentially volatile value of securities would add a great deal of ongoing complexity to managing capital that most community banks don’t want to deal with, Murphy explains. “I’d be shocked if anyone didn’t opt out,” he says.

Equity is king

The new capital standards emphasize the importance of common equity in a bank’s capital structure. Community banks typically are better capitalized than money center or international lenders. But the new requirements to hold higher levels of higher-quality capital as Basel III intends will pose a significant a challenge for the largest institutions, Baris says.

However, the public equity markets are mostly inaccessible as a viable capital resource for community banks. And alternative capital sources of preferred stock or subordinated debt that community banks rely on won’t boost their Tier 1 capital in the future, Murphy says. Most community banks will continue to have adequate capital even after the new 2.5 percent Basel III capital conservation buffer phases in between 2016 and 2019, Murphy adds. Common equity must be used to satisfy this new requirement, an extra minimum capital precaution against economic downturns. Failure to establish the buffer would curtail a bank’s ability to pay dividends and grant executive bonuses.

Consultants advise community banks to be aware of the initial Basel III requirements and deadlines, and then continue to make sure their capital is adequate as the buffer is phased in. And boards will need to align their bank’s business strategy with the implementation of the Basel III requirements.

One potentially significant change is that “high-volatility” commercial real estate loans will move to a 150 percent risk weighting under Basel III. “I don’t see a major impact in how community banks lend or invest” as a result of the new guidelines, Baris says.

Yet he has concerns for community banks that will need to raise capital in the future. Narrowing margins and higher compliance costs for community banks could make all banks less attractive to potential investors.

Typically new equity capital will be raised locally, rather than using an investment banker to reach public equity markets, Baris says. He suggests approaching board members and existing shareholders before reaching further into the community.

Most community banks should have a compelling story for potential stock investors on their need for capital, Baris adds. Institutions that have their stock trading below book value would dilute the investment of existing shareholders by issuing more shares, he notes, unless current shareholders also “invest in the offering at least up to their pro rata share.”

As a result of the recession, many community banks haven’t raised capital in years and some boards may not be familiar with decisions to maintain adequate equity to cover balance sheet risks.

For these reasons, capital planning should continue to be a focus for community banks, Baris says. Calculating capital needs under Basel III might take some initial adjustment for community banks, Evans says, but the process shouldn’t be any more difficult for them to handle than in the past.

Howard Schneider is a financial writer in Ojai, Calif.