Basel III is bearing down upon us. The U.S. bank regulators issued their final proposals to adopt Basel III capital standards on August 30, 2012. Numerous members of Congress, the industry and even senior officials at the Federal Deposit Insurance Corp. (FDIC) and the Comptroller of the Currency have expressed concerns about these proposals.On the other hand, the Basel Committee has expressed concerns about timely, consistent implementation of Basel III around the world. The U.S. bank regulators announced on November 9 that they would further consider the Basel III proposals, and that these would not become effective on January 1, 2013, as originally contemplated.
The new rules will affect all depository institutions, depending upon how the Federal Reserve separately implements rules under the Dodd-Frank Act for intermediate holding companies established by commercial entities controlling thrifts. Although the Federal Reserve will not apply the Basel III capital rules to bank holding companies with less than $500 million in assets, the Collins Amendment, Section 171 of the Dodd-Frank Act, requires holding companies to maintain the same types and levels of capital as FDIC-insured depository institutions. Therefore, the proposed new rules will affect all depository institutions.
Among other things, the proposals:
- contain specific, detailed required terms for each type of eligible capital instrument; (For example, to be eligible as “common stock,” such shares must, among other things, be the most subordinated claim in an insolvency and cannot be redeemed without prior regulatory approval, or contain any incentive for the issuer to redeem such shares.)
- add a new common equity Tier 1 risk-based capital ratio;
- add a capital conservation buffer of 2.5 percent, where noncompliance reduces the permissible amounts of dividends, stock buybacks and discretionary management bonuses;
- increase capital minimums;
- phase out trust preferred securities as Tier 1 capital for all holding companies, except those with less than $500 million in assets;
- change risk weightings, especially the treatment of residential mortgage originations, sales and servicing, construction and development loans, deferred tax assets and nonperforming assets; (For example, higher risk weights will be assigned to non-traditional residential loans outside specified criteria such as interest-only mortgages or mortgages with balloon payments. Higher risk weights will also apply to certain “high volatility” commercial real estate loans.)
- increase capital for off-balance sheet items such as warranties for real estate loans sold by banks to investors, and loan commitments of not more than a year; and
- require capital be adjusted based on the current market value of held-for-sale securities.
The New Minimums
The new capital minimum ratios will be phased in over several years until they reach the following in 2019, with the 2.5 percent conservation buffer:
- common equity Tier 1 capital – 7.00 percent (new)
- Tier 1 capital – 8.50 percent (4-5 percent today)
- Total capital – 10.50 percent (8 percent today)
The capital conservation buffer amounts will not be considered in determining whether depository institutions are “well capitalized” under the prompt corrective action (PCA) standards of Section 38 of the Federal Deposit Insurance Act. The PCA standards will change to reflect the proposed new capital measures, however, and will include the common equity Tier 1 capital ratio.
Banks will have to hold more equity. Common stock and perpetual, noncumulative preferred stock will be most valuable. Voting common stock must remain the majority of equity. Access to capital markets will become more essential.
Estimates of the amount of additional capital required under the proposals vary widely. The American Bankers Association anticipates that up to $60 billion of new capital will be needed. The actual amount will depend upon banks’ internally generated capital from profits, and their rates and types of asset growth. Federal Reserve actions to maintain low interest rates for an extended period will challenge interest margins and the industry’s ability to generate capital through earnings.
The proposals are complex and implementation will heavily tax smaller institutions with limited staff, which are also confronted with a deluge of Dodd-Frank Act and Consumer Financial Protection Bureau rules. Traditional banking, such as residential mortgage origination and servicing, will be especially affected by all these factors.
Banks will have to consider more carefully the returns on asset classes adjusted for the new capital levels and costs. Some lines of business may become unsustainable given the level of capital they require, and some segments of the economy may see diminished credit availability. Exactly how this will play out is hard to say.
Returns on capital, which will be less levered than currently, will be important in attracting and maintaining appropriate capital. Public companies, with greater size and access to capital, should have effective shelf registrations, and consider how to best take advantage of the new offering rules under the JOBS Act.
Basel III makes capital planning more important for banks of all sizes. All institutions should plan capital actions in light of Federal Reserve Letter SR 09-4. The Comptroller of the Currency’s Guidance for Examining Capital Planning and Adequacy, OCC 2012-16 (June 16, 2012) is also useful. Stress testing may become more prevalent as regulators seek better risk analyses, even where not mandated by the Dodd-Frank Act or Basel III. (See Community Bank Stress Testing, OCC Bulletin 2012-33, October 18, 2012.) It is unclear whether recent discussions of “reforming” the Basel III proposals will have any meaningful impact, especially given the pressures for consistent global implementation of Basel III. We suggest preparing for the proposals in their current form. The proposals, together with increased regulation, low top-line growth rates, and interest margins and profits squeezed by monetary policy, may be drivers of industry consolidation into banks that can best allocate capital to obtain growth with attractive risk-adjusted returns.