I spent many of my years as a regulator with FDIC and the New Jersey Department of Banking and Insurance. During that time, I was on the Basel Committee on Bank Supervision and was part of the Basel II deliberations. I regularly argued for a Basel leverage ratio. So one may think that I would be wholeheartedly embracing a rule that was designed as “. . . a comprehensive set of reform measures to strengthen the regulation, supervision, and risk management of the banking sector,” as the Basel III rules have been described.
As a matter of fact, I still have the T-shirt that was given to me by my students in a BankSim class at Stonier in the 1980s, and it spells out FDIC in a new way: Forever Demanding Increased Capital.
I do understand the need for the development and implementation of Basel III as it relates to large, complex, internationally active financial institutions. But when I look at the regulatory requirements and burden as well as the resultant economic effects that the Basel III rules will have on community banks, I find myself at least partly in the camp of FDIC Vice-Chairman Thomas Hoenig, who has advocated scrapping Basel III and starting anew. (For purposes of this article, I define community banks as those with total assets under $10 billion.)
Let’s take a look at what Basel III was envisioned to accomplish, and then discuss how community banks must adjust their practices to meet this new challenge.
What Basel III was designed to do
The Bank for International Settlements’ website (www.bis.org) states that Basel III was formulated to improve the banking sector’s ability to absorb the shocks arising from financial as well as economic stress, whatever the source; improve risk management and governance; and strengthen the banks’ transparency and disclosures.
I doubt anyone would argue that these are not commendable objectives, or that a more complex, regimented set of rules was needed for super-large, internationally active banks. However, given the balance sheet and business operations of the vast majority of community banks, such complexity is not needed to accomplish those objectives.
New capital minimums
The final rule applies to all banking organizations currently subject to minimum capital requirements, including top-tier BHCs domiciled in the United States that are not subject to the Federal Reserve’s small bank holding company policy statement (generally less than $500 million; but note that this exclusion does not apply to savings and loan holding companies). Also covered are top-tier SLHCs domiciled in the United States that do not engage substantially in insurance underwriting or commercial activities.
Banking organizations will be required to maintain the following minimum capital requirements:
• 4.5% Common equity Tier 1 capital/standardized risk-weighted assets (new).
• 6.0% Tier 1 capital/standardized risk-weighted assets.
• 8.0% total capital/standardized risk-weighted assets.
• 4.0% (Leverage ratio) Tier 1 capital/average total consolidated assets, minus the amounts deducted from Tier 1 capital.
• An additional 2.5% common equity capital conservation buffer.
The rule also includes a detailed schedule (see Exhibit 1, above) of transition arrangements, which call for most of the new minimum capital requirements to be phased in gradually over periods of up to six years. Instruments no longer qualifying as Tier 1 or Tier 2 capital under Basel III also began to be phased out beginning in 2013, but this will be over a ten-year period.
The banking organizations are generally expected to operate well above these minimum regulatory ratios—with capital commensurate with the level and nature of their risk profiles. The net effect of these changes is that by requiring the banks to hold more capital against their assets, it places limitations on the size of their balance sheets and also limits their abilities to invest with borrowed funding (i.e., it decreases their abilities to leverage).
Community banks have lots of capital
A study of call report data shows that capital ratios at the vast majority of community banks—both at the height of the last banking crisis and as of the third quarter of 2013—exceed the Basel III minimums. Thus, the new proposed complex rules and requirements of Basel III represent overkill as it applies to community banks. The case can certainly be made that the current capital rules, coupled with regular, full-scope examinations, can serve the regulatory agencies’ safety and soundness concerns and the community banking sector’s health very well.
Basel III’s burdens and costs
The final rule is much better for community banks than the original proposal. For example:
• It allows a one-time election to not include most elements of Accumulated Other Comprehensive Income in regulatory capital. (My firm recommends that all community banks make this election.)
• It does not adopt the originally proposed treatment of residential mortgages, and instead keeps the historical risk weights: 50% for one to four family mortgages that are prudently underwritten and performing to original terms, and 100% for all others, including junior liens (unless the bank also holds the first lien and there are no intervening liens).
• It permanently grandfathers nonqualifying capital instruments in the Tier 1 capital of holding companies that have consolidated assets under $15 billion.
Nevertheless, even with the aforementioned final rule adjustments and without factoring in the new liquidity requirements that have not been addressed in this article, Basel III will still place heavy compliance and cost burdens on the nation’s community banks.
A significant amount of new information and recordkeeping will be required to comply with the rule. I have been constantly advising our clients that in today’s regulatory world, “If it ain’t in writing, it didn’t happen.” In addition, computer systems for most banks will likely require some upgrading and/or enhancements. Models for stress testing and scenario analysis will have to be developed or acquired, and in the case of many community banks, outside expertise will need to be enlisted to assist the banks in complying with the rule’s requirements. As a result, expenses will be increasing at the same time growth in earning assets will face new limitations due to the new capital requirements.
Preparing for Basel III
While the aforementioned discussion argues for the non-applicability of the Basel III capital rules for community banks, the die is cast on this issue, and community banks will not be exempted from the rules. What should community banks be doing to ensure they avoid regulatory issues as the new rules come into play?
Most important, they need to recognize that regulatory capital will come to be viewed through three lenses: risk profile, capital adequacy plus buffers, and prompt corrective action standards.
In assessing the level of capital that is required above the capital minimums, regulatory review of capital plan adequacy will be focused in the following areas:
• There will be an evaluation of risk identification, risk measurement, and risk management.
• There will be an assessment of stressed loss and revenue estimation.
• There will be a review of governance and controls around these practices.
As such, banks must ensure that they have an effective enterprise risk management (ERM) program. Under Basel III, ERM will play a key role in assessing overall capital adequacy. This is because risk-based capital rules are minimum standards, generally based on broad credit-risk considerations.
Secondly, risk-based capital rules do not explicitly account for the quality of individual asset portfolios or the range of other types of risks, such as interest rate, liquidity, market, or operational.
Also, a banking organization is generally expected to have internal processes for assessing capital adequacy that reflect a full understanding of its risks, and to ensure that it holds capital corresponding to those risks to maintain overall capital adequacy.
And finally, examiners will assess capital adequacy by determining whether a banking organization plans appropriately to maintain an adequate level of capital given its activities and risk profile, as well as risks and other factors, such as level and severity of problem assets; exposure to operational and interest rate risk; significant asset concentrations; new activities; new products; and more.
By having a robust internal capital planning process, community banks can demonstrate that they have the ability and processes to:
• Assess whether or not the capital level is sufficient to withstand potential economic stress.
• Ensure that the assessment will continue to hold in the future.
• Ensure that sufficient capital will exist in a broad range of future macroeconomic and financial market environments by addressing the capital aspects of dividend payments, share repurchases, and share issuance and conversion.
In summary, all the banks will need an effective capital adequacy process. To be fully effective, the process should be built using the following seven principles:
1. Sound risk management fundamentals.
2. Effective loss-estimation methodologies.
3. Solid resource-estimation methodologies.
4. Sufficient capital adequacy impact assessment.
5. Comprehensive capital policy and capital planning.
6. Robust internal controls.
7. Effective governance.
About the author
Nick Ketcha is executive managing director at FinPro, Inc., a bank consulting firm based in New Jersey. He is a former top federal and state regulator.