Now that the modified Basel capital framework—Basel III—has taken effect for banks of all sizes, those institutions are facing a variety of challenges in implementing the new rules. This article summarizes the new capital requirements and provides some discussion of common implementation challenges.
New capital requirements
Basel III set tougher minimum capital requirements for all banks. Here’s a quick summary (expressed as a percentage of risk-weighted assets, or RWA):
• Minimum Tier 1 capital: 6%
• Minimum total capital: 8%
• Minimum common equity Tier 1 capital: 4.5%
• Common equity Tier 1 capital conservation buffer: 2.5% (phased in from 2016 to 2019)
By 2019, banks should strive to maintain total capital, including the conservation buffer, of at least 10.5% of RWA, as well as common equity Tier 1 capital, including the buffer, of at least 7%.
The buffer is designed to ensure that banks build up a capital cushion that can be drawn down during periods of stress without violating minimum capital requirements. During periods in which the buffer drops below 2.5%, banks are expected to rebuild it by reducing discretionary distributions, such as dividends, stock repurchases, and executive bonuses.
Be aware that meeting minimum capital requirements doesn’t necessarily mean that your bank is adequately capitalized. Adequate capital for your bank depends on its particular risk profile, activities, asset quality, and other factors.
New risk-weighting rules
Implementing new rules on the risk weighting of certain assets is one of Basel III’s biggest compliance challenges. One area that has proven to be particularly difficult is the treatment of securitizations, such as mortgage-backed securities, asset-backed securities, and collateralized debt obligations that are not government-backed.
In addition to setting a minimum risk weight, Basel III eliminated the use of a ratings-based approach for risk-weighting securitization exposures. Regulators held that a big contributor to the financial crisis was banks’ over-reliance on rating agencies’ evaluations of securitizations. Instead, banks should have been conducting their own internal credit analyses.
Under the new rules, community banks have three alternative methods for calculating risk weights for non-government backed securitizations.
1. They may use the simplified supervisory formula approach (SSFA), which is a simplified version of the supervisory formula approach used by the largest banks.
2. They may continue to use a version of the gross-up approach available before Basel III.
The SSFA and gross-up approaches assign relatively higher risk weights—and, therefore, higher capital requirements—to a securitization’s more risky junior tranches, and assign lower risk weights and capital requirements to its more senior tranches.
The difference between these two approaches is that the SSFA approach requires current performance metrics of the underlying security, whereas the gross-up approach does not. Due to the inclusion of this current performance data in the calculation, the SSFA approach will provide a risk weight that is more in line with the current risk of the investment. However, the approach also requires the bank to gather and analyze more detailed data about the securitization and its underlying assets.
3. The final alternative is to apply a 1,250% risk weight to all of your bank’s securitization exposures.
While this method has the advantage of simplicity, it may require your bank to hold an excessive amount of capital in relation to its actual risk exposure.
The Basel III rules made a number of changes to what is, and isn’t, included in Tier 1 capital.
Two significant items are trust-preferred securities (TruPS) and instruments issued under the Troubled Asset Relief Program (TARP) held by bank holding companies.
Originally, regulators considered excluding these items from holding company Tier 1 capital, but the final regulations backed away from that approach and “grandfathered” certain instruments.
Currently, holding company Tier 1 capital includes:
• TARP instruments that qualified as Tier 1 capital when issued, and
• TruPS issued before May 19, 2010, for bank holding companies with less than $15 billion in total consolidated assets. These instruments are limited to 25% of Tier 1 capital with any remainder being includable in Tier 2 capital.
Both cumulative preferred stock and TruPS issued after May 19, 2010, are subject to a maximum of 25% of Tier 1 capital. Bank holding companies with TruPS and TARP instruments in their Tier 1 capital should have a plan for maintaining adequate capital after those assets expire.
Another important consideration is the treatment of deferred taxes. Under Basel III, certain types of deferred tax assets must be subtracted from Tier 1 capital. However, a bank may offset any associated deferred tax liabilities against these amounts, subject to certain restrictions. The rules require banks to track their deferred tax items more closely than in the past and first allocate deferred tax liabilities to their related assets (e.g., the deferred tax liability for mortgage servicing assets) and secondly in a proportionate manner between all carry forwards and other timing differences.
About the author
Ryan M. Abdoo, CPA, CGMA, is senior manager at Plante & Moran, PLLC. Abdoo has more than 11 years of financial institutions experience and is a leader of the firm’s financial institutions professional standards team. He specializes in providing accounting, auditing, and financial analysis and outsourced risk management services to a client base that ranges from de novo status up to $3 billion in assets.
He is also responsible for providing and managing various audit and risk management services, including internal audit, Sarbanes-Oxley Act of 2002 implementation, and financial statement audit services.
He can be reached at Ryan.Abdoo@plantemoran.com