Five Questions that Directors Should Ask about Basel III

Small banks across the country were shocked to find out that they would have to comply with the international Basel III framework under a proposal released by U.S. regulators this summer. The proposed rules issued by the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency would apply to all banks, thrifts and thrift holding companies, as well as bank holding companies with at least $500 million in assets. Gregg Rozansky, an attorney with Shearman & Sterling in New York, answers some questions about capital and Basel III here, with an eye toward community banks.

Q1: What terms do I need to know about capital?

The U.S. proposal generally follows the approach adopted by the international Basel Committee on Banking Supervision. Basel III tightens the minimum qualification requirements for regulatory capital. Permissible capital is divided into the following three categories, from highest quality capital to lowest, in very broad terms.

Tier 1 capital is divided into two categories:

• common equity tier 1 capital: generally, ordinary common shares and retained earnings, which are net earnings not paid out as dividends
• additional tier 1 capital: generally, non-cumulative perpetual preferred stock, which is preferred stock with no maturity date

Tier 2 capital is principally subordinated debt and certain preferred instruments with a minimum original maturity of at least five years, and a limited amount of loan loss reserves.

Basel III, like its predecessors, Basel I and II, also requires banks to risk weight their assets-basically calculate the capital needed based on the riskiness of the assets and certain off?balance sheet items. Liquidity rules for banks are part of the international accord but the Basel III liquidity requirements have not yet been proposed for implementation in the U.S.

Q2: What key changes would be made to the regulatory capital base?

Tier 2 capital would no longer be divided into lower and upper tier 2-instead, a single set of criteria would apply. Trust preferred securities (Trups), which are a form of debt-like preferred instruments, would be phased out of tier 1 capital but would generally qualify for tier 2 capital.

As the new rules phase in, banks could see a decline and/or greater volatility in capital levels to the extent they hold assets to be adjusted (e.g., purchased credit card relationships, certain deferred tax assets and mortgage servicing rights that exceed certain threshold levels). Also, the current market value of held-for-sale securities will impact capital, which isn’t the case under current rules.

Q3: What is the timeline when changes must be made?

Once completely phased in by 2015, the minimum risk-based capital requirements would be set at 4.5 percent for common equity tier 1 capital, 6 percent for tier 1 capital, and 8 percent for total capital. However, in order to avoid restrictions on the payment of dividends or executive bonuses, U.S. banks would need to meet a “buffer” of even higher risk-based capital ratios by 2019. With the buffer, the requirements are:

• common equity tier 1: 7.0 percent
• tier 1 capital: 8.5 percent (4 percent today)
• total capital: 10.5 percent (8 percent today)

Q4: How will risk weightings for certain types of assets change for community banks?

Under the “standardized approach” that applies to community banks, new risk weights would be assigned to several asset classes effective January 2015. Examples of asset classes that will have higher risk weights include:

• many loans that are 90 days past due or on non-accrual status
• non-traditional residential real estate loans, like interest-only, balloon or negative amortization mortgages
• residential real estate loans with loan-to-value ratios of greater than 80 percent
• certain “high volatility” commercial real estate loans

Higher capital will also, generally, be needed for certain off-balance sheet items including:

• loan commitments of not more than a year that are not unconditionally cancelable by the bank
• residential real estate loans the bank sells to investors with representations to repurchase if the borrower defaults within a set period of time

Q5: What questions should I ask bank management about the capital proposals and their impact on my bank?

While key details will remain uncertain until final rules have been issued, questions that merit serious thought include:

• How would our regulatory capital base be impacted by the new qualification criteria for capital, including the phase-out of Trups as tier 1 capital?
• What are the areas of uncertainty or ambiguity in terms of how the proposed rules would apply to us?
• What would be the impact of new risk weightings for our assets and off-balance sheet items, including residential and commercial real estate lending?
• What would be our pro-forma (unaudited) capital ratios, taking into account the proposed multi-year implementation timeline, and would we continue to be “well capitalized” under the new standards?