Over the past year, my colleagues and I have spent an untold number of hours researching, writing and speaking about the Basel III capital rules. We felt it important to help bankers focus on the proposed rules in order to help them prepare and to help facilitate an appropriate response to the proposed rules. Because the rules were in proposed form, however, many bankers, bank directors and industry participants did not focus on these capital rules, instead waiting until they were finalized. Well, we’re here.
Earlier this month, the regulatory agencies finalized their revisions to the capital and risk-weighting rules, commonly known as the Basel III rules. Even though the rules will not be effective for most banks until Jan. 1, 2015, the finalizing of these rules presents the call to action to begin the dialogue about how the new rules will impact your bank. Of course, given the fact that the final release for the rules was almost 1,000 pages long, many bankers contemplating a board presentation are left to ask, “Where should I start?” Below are a few suggested areas of focus to begin to enhance your directors’ understanding of the new rules.
- The New Rules Limit Leverage. If there is only one sentence for directors to remember regarding the new rules, it is this one. By increasing capital requirements and ensuring that common equity represents a substantial portion of an institution’s capital structure, the new rules limit the leverage that banks may take on. A central premise of the new rules is that by decreasing leverage in the banking industry, a more stable economy will result. This stability was emphasized even at the risk of limiting economic growth. To the extent that your directors viewed the deleveraging of the industry as a cyclical matter, these rules allow bankers to dispel that notion. By the time the required capital conservation buffer is factored in, the required Tier 1 risk-based capital ratio will have increased from the current minimum of 4.0 percent to 8.5 percent under the new rules.
- Maintaining the full capital conservation buffer will be important. In addition to a new Tier 1 common equity requirement, the new rules impose what’s called a capital conservation buffer equal to 2.5 percent of risk-weighted assets (subject to a phase-in period), making total capital minimums go as high as 10.5 percent for community banks. The failure to maintain the full buffer amount will result in restrictions on discretionary reductions in capital such as bonuses for executives, dividends and stock repurchases. Given investor demands for cash flow and the need to provide competitive compensation in order to attract and retain the best talent available, these restrictions could be very meaningful (particularly if an institution is forced to choose between compensating its executives and paying a dividend to shareholders). As a result, one might expect sophisticated investors and bank managers to focus on the maintenance of this buffer.
- The new rules should impact the pricing of certain products. The risk-weighting components of the new rules will change the amount of capital that must be dedicated to certain products. For example, an acquisition, development, and construction loan that is deemed to be a high volatility commercial real estate loan will have a 50 percent higher risk weight and will therefore occupy 50 percent more capital. Therefore, it stands to reason that these products should be priced 50 percent higher in order to achieve the same return for the institution’s shareholders.
- Return on equity is simple math. The ultimate bottom line of the new rules is that with less leverage, it is more difficult to produce optimal returns on equity. Bank management should study the aggregate impact of the new rules on the institution’s capital levels to determine if existing capital levels will be adequate. If not, directors will need to understand that return on equity is likely to suffer unless net income increases. As a result, directors’ expectations of returns may need to be managed and strategies may need to be implemented to become more efficient or to increase revenue.
The regulatory agencies are careful to reassure us that the vast majority of institutions would be in compliance with the new rules if the rules were in effect today. Even though the analysis used to arrive at that conclusion is a bit crude, this point should be emphasized to directors: Now is not the time for panic. It is, however, time for bankers and boards to roll up their sleeves and understand the impact of the rules on their institutions. The sooner bank management can begin a dialogue with directors about the new rules, the more likely it is that the board can develop an informed and effective strategy.