Room for improvement

The Basel III simplification plan, which includes standards for mortgage-servicing rights, is so far a missed opportunity for community banks.

By Ron Haynie and James Kendrick

After years of ICBA advocacy, the federal banking agencies are developing plans to simplify the regulatory capital requirements for community banks, leaving the door open for a long-sought exemption. Unfortunately for the industry, the regulators’ initial proposal is a mixed bag with much room for improvement.

Following a Treasury Department report earlier this year proposing that federal banking regulators refocus the Basel III capital rules on the largest financial firms, the agencies in August announced plans to simplify the rules for community banks. They followed with proposals to simplify standards for mortgage-servicing rights and other high-quality assets and to reclassify other loans that regulators consider risky.

Regulators initially proposed a pause in the phase-in of new regulatory capital deductions and risk weights for mortgage-servicing assets (MSAs), certain deferred tax assets, investments in the capital instruments of unconsolidated financial institutions, and minority interests. The proposal would stop the implementation by banks with less than $250 billion in assets of the fully phased-in requirements for these items, which is scheduled for Jan. 1, 2018.

The agencies followed this proposed pause with a proposal to eliminate the individual 10 percent and aggregate 15 percent common equity tier 1 capital deduction threshold on these assets. They would be replaced with a new 25 percent deduction threshold on the individual categories with no aggregate threshold. The risk weights for non-deducted amounts of MSAs and deferred tax assets would remain 250 percent.

While not a panacea, this is a welcome move for community banks hit hard by the punitive Basel III capital treatment of high-quality community bank assets, such as retained mortgage-servicing rights. By severely lowering the threshold deduction and almost tripling the risk weight assigned to MSAs when they are not deducted, Basel III punishes community banks that would like to service mortgage loans.

These mortgage-servicing provisions have instituted a counterintuitive and counterproductive disincentive for community banks to service the loans they make. In many cases, community banks have invested in these financial assets for many years, and they have performed well for the banks without any problems. Restricting the ability of community banks to hold MSAs results in their being retained by less-regulated entities that may not provide the same level of local care and diligence needed when maintaining a relationship with a borrower or other stakeholder. When loans are serviced by locally based community banks, consumers simply get better service and have better outcomes if a problem arises. Equally important, mortgage-servicing rights retained by community banks act as a natural hedge against rising interest rates and bring stability to earnings and asset valuations when interest rates rise rapidly. Unfortunately, many community banks have stopped carrying MSAs on their balance sheets since the Basel rules took effect, limiting the impact of the regulators’ recent revisions.

Unfortunately for the industry, the regulators’ initial proposal is a mixed bag with much room for improvement.

While the proposed treatment of MSAs and other items is a welcome change, new loan definitions could have a negative capital impact for many banks. The agencies are proposing to prospectively replace the high-volatility commercial real estate (HVCRE) classification with a new classification for high-volatility acquisition, development, and construction loans (HVADC). This would carry a 130 percent risk weight, down from 150 percent. However, the new HVADC category would include a much larger category of loans. One-to-four-family construction projects would continue to be exempted, while the existing minimum investor contributions threshold would be eliminated. This punitive treatment could curtail growth in many local communities.

More work to do
Overall, the proposal is a missed opportunity to reduce the compliance burden on community banks. FDIC Vice Chairman Thomas Hoenig himself spoke out against the plan, calling it “neither simpler nor less burdensome” and well short of providing any meaningful benefits to the industry and its customers. To truly simplify the regulatory capital regime, ICBA continues advocating what it has called for all along—a total community bank exemption.

The Basel III rules were originally designed for the largest and riskiest institutions and should not apply to community banks, which maintain strong capital positions and high-quality balance sheets. Regulators should employ separate regulatory regimes that rein in Wall Street excesses while accommodating community banks’ straightforward models.

The best way to accomplish this objective, ICBA has long argued, is to exempt community banks from Basel III and allow them to revert to the Basel I capital framework.

ICBA achieved some significant victories in the Basel III final rule, including the exclusion of accumulated other comprehensive income from common-equity tier 1 capital, allowing community banks to continue using the Basel I risk weights for their mortgage exposures and grandfathering the inclusion of trust-preferred securities as tier 1 capital. But we have never given up on a complete community bank exemption.

In meetings with policymakers and in a high-profile grassroots campaign (see sidebar), ICBA and participating community bankers have pushed hard for the community bank exemption. If regulators are unwilling to take such a step, ICBA maintains a comprehensive list of amendments that would allow the capital standards to better meet the community banking model. For instance, the ICBA plan would amend Basel III to reflect the loss-absorbing capacity of the allowance for loan and lease losses and exempt community banks from the harsh provisions of the capital conservation buffer.

Advocacy alert

Much is up in the air as regulators reconsider the Basel III rules, but ICBA will remain engaged every step of the way. In meetings with and messages to the agencies, we continue our push for a full exemption, but we need the persistent engagement of community bankers to make the difference.

Stay tuned for updates and grassroots alerts from ICBA, and make your voice heard on this promising opportunity for significant regulatory relief.

Ron Haynie ( is ICBA senior vice president of mortgage finance policy. James Kendrick ( is ICBA first vice president of accounting and capital policy.