Crapo Bill Only a Drop in Bucket for Deregulation

regulation-8-29-18.pngThe bipartisan “regulatory relief” bill that was adopted by Congress and signed by President Donald Trump earlier this year is a positive development for the banking industry, and it continues a string of good news for banking (and, by extension, the economy at large) since the passage of the Dodd-Frank Act. Banking is highly regulated, and it should be, because most banks’ balance sheets are funded with federally insured deposits to the tune of 90 percent.

The Economic Growth, Regulatory Relief and Consumer Protection Act is not all that the industry had hoped for in a regulatory relief bill, but it is not a complete giveaway to the big banks as some suggested. For the really big banks in this country, the bill does not change much at all.

One of the best things about the legislation is the House and Senate came together to pass a bill that makes sense. On the other hand, the bill seems to further engrain buckets of banks based on asset sizes that have no meaningful support. So, we should get used to the notion that a bank with assets over $10 billion is somehow a “large” bank and that banks with over $250 billion in assets are “systemically important.”

At a high level, the substantive provisions of the new law are relatively brief, when compared to the expanse of Dodd-Frank. Arguably, the mortgage-related provisions of Dodd-Frank did more harm than good because plenty of smaller lenders got out of the housing finance business rather than risk the penalties of noncompliance.

The recent legislation provides that banks with assets of $10 billion or less can avoid some of the more cumbersome qualified mortgage rules under Dodd-Frank, provided that the loans are originated by the bank and kept in the bank’s loan portfolio. Banks that made fewer than 500 mortgage loans in each of the last two years will be exempt from Dodd-Frank’s expanded reporting under the Home Mortgage Disclosure Act as long as the bank has a satisfactory or better Community Reinvestment Act rating.

The new legislation also directs the federal banking agencies to adopt a “Community Bank Leverage Ratio” that will exempt most banks with assets of less than $10 billion from the risk-based capital rules of Basel III. This safe harbor capital requirement is to be not less than 8 percent and not more than 10 percent, and it is going to require an interagency rule-making process, which can take many months to accomplish. So don’t throw away your Basel III models just yet. Most of these so-called small banks will also be exempt from the Volcker Rule, but that too is going to require promulgating rules. It is just going to take time for to reach consensus on what the regulations should say.

A couple of provisions of the new law beneficial to smaller banking organizations should be implemented fairly quickly and without much controversy. The threshold for a “small” bank holding company for purposes of the Fed’s policy statement on the capital and leverage requirements for such entities has been raised from $1 billion to $3 billion. This means bank holding companies with less than $3 billion of total assets will not be subject to capital requirements on a consolidated basis, and allows those holding companies to borrow money at the holding company level and inject it into their subsidiary banks as equity capital. In addition, the exam cycle for well-managed and well-capitalized banks with assets of $3 billion or less has been extended to 18 months. These two provisions could amount to meaningful relief for the banking organizations that can avail themselves of the flexibility afforded by the new law.

For those of us who appreciate the important role that a properly functioning banking system plays in the U.S., our elected officials deserve credit for making changes to Dodd-Frank. But we should not lose sight of the fact that the new law is merely a drop in the bucket of work to be done around bank regulation in the U.S.

Is Your Bank Ready for Basel III Compliance?

10-13-14-fiserv.pngBoard members have an important role to play in implementing the latest directives from the Basel Committee on Banking Supervision.

The first implementation deadlines are looming for the standards in the Third Basel Accord, commonly known as Basel III. It’s time for bank directors to make sure they’re up to speed.

Basel III comes into play at a time of worldwide economic uncertainty. Promulgated by the Basel Committee on Banking Supervision, the international forum for supervisory matters based in Basel, Switzerland, this comprehensive set of regulations seeks to instill greater stability and confidence in the banking system by dealing with deficiencies exposed by the financial crisis of the late 2000s.

The Basel III framework includes six key requirements for banks:

  • Hold more and better-quality liquidity
  • Maintain more and better-quality capital
  • Achieve enterprise risk management maturity
  • Ensure robust, comprehensive stress testing
  • Enhance capital adequacy assessments
  • Integrate comprehensive and actionable capital and strategic planning

A new risk-weighted capital framework to determine regulatory capital adequacy based on Basel III becomes effective for community banking organizations (non-complex, with assets between $500 million and $10 billion) on January 1, 2015.

Community Bank Readiness
Many managers and officers of community banks and small regional banks have told me they believe Basel III is really not an issue for them because they’re extremely well-capitalized. However, if these bankers haven’t run the Basel III calculator provided on each banking regulator’s website, their confidence may not be warranted. The risk ratings under Basel III are radically different from anything we’ve seen in the past. And you can’t determine true capital adequacy simply and solely on the basis of the new regulatory capital ratios. Those ratios are merely the ante into the game, the minimum requirement.

In today’s banking environment, the only true measure of capital adequacy is economic capital measured in a customized way for each financial institution, stress-tested to consider all risk elements across the full probability spectrum. A fresh assessment and approach are needed before you can say you’re well-capitalized in a Basel III world.

A Board Responsibility
Basel III should be a top-of-mind concern with every member of the board. Directors have a critical fiduciary role in ensuring Basel III compliance, and in capital and strategic planning in general. The board should be front and center in these areas:

  • Defining risk appetite. First and foremost, boards of directors must define the level of risk that is acceptable for their organizations. Within acceptance of that risk, they must determine what commensurate returns they expect the financial institution to earn.
  • Scenario planning. Through stress testing and scenario planning, boards of directors should look at all potential outcomes and their impact on capital, from low- to high-probability events. Directors should help frame some of these scenarios and stress tests, and thoroughly understand the results. The board must also have a firm grasp on how integrated strategic and capital plans are driving decision making—including risk assumption, resource allocation and the tactical actions of the organization.
  • Right-sizing capital. The board of directors must be instrumental in making sure that the bank’s capitalization properly aligns with the risks assumed by its banking business model. I am an advocate for the “Goldilocks School of Banking.” Like the porridge sampled by the little blonde-haired girl, capital needs to be “just right”—neither too much nor too little, and customized for the financial institution.

RAROC: The One True Metric
Risk-adjusted return on capital (RAROC) is the most all-encompassing performance indicator your organization can employ in assessing your capital position. It is the only metric that considers both full risk and potential return in a strategic business equation.

RAROC is suitable for assessing your total organization, individual business units, products, customers and customer segments. It enables you to determine your economic capital and capital adequacy, while helping optimize how you allocate capital and resources. Risk-adjusted analysis helps your organization intelligently price customer transactions, evaluate profitability, incentivize employees and right-size capital to your risk profile.

The benefits of RAROC are substantial and far-reaching. I encourage your board to insist on using this important tool.

Getting Started
Basel III awareness and compliance begin with the board asking two things of management:

  • Education. Whether it’s provided by the executive team or an outside consultant, the board should insist on a one- to two-hour overview of Basel III—not just focusing on what the regulations require, but also the implications for your banking business model and a strategy to respond.
  • Basel III status report. The board must ask if the executive team has run the pro forma calculations for Basel III capital compliance, and where the capital levels stand today in light of Basel III requirements.

This simple, two-step questioning process is absolutely essential. If it isn’t already underway at your financial institution, it should begin at your next board meeting.

For more information on capitalization and regulatory compliance, see Orlando Hanselman’s white paper, Capital Conundrum: A Call for Clarity and Action.

Assess, Don’t Assume: The Board’s Role in Basel III

With the change in capital requirements quickly approaching, many community banks believe they are well capitalized under the new Basel III standards. Yet most banks have not used the Basel III calculator provided by the regulators to truly assess their capital levels. In this video, Orlando Hanselman of Fiserv shares his thoughts on why the majority of community banks are not ready for this unprecedented shift to the basic banking business model, and outlines what boards should do to ensure their bank is not caught off guard.

For more information, check out Orlando Hanselman’s article on this topic

U.S. Basel III: Guide for Community Banks

Davis-Polk-White-Paper.pngExecutive Summary

U.S. Basel III is the most complete overhaul of U.S. bank capital standards in nearly a quarter of a century. It comprehensively revises the regulatory capital framework for the entire U.S. banking sector and will have significant implications for community banks from a business, operations, M&A and regulatory compliance perspective. This article provides an overview of the key aspects of U.S. Basel III for community banks.

Introduction to U.S. Basel III

U.S. Basel III is a highly complex, 1,000-page regulation published by the U.S. banking agencies, the Federal Reserve, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corp. (FDIC), to implement the international Basel III capital standards in the United States. Developed originally in 2010, Basel III is an internationally agreed-upon set of reform measures to increase the quality and quantity of regulatory capital at banks. In addition to implementing Basel III, U.S. Basel III also gives effect to key provisions in the Dodd-Frank Act, including the Collins Amendment and the prohibition on references to credit rating agency ratings in federal regulations. The U.S. Basel III final rule makes a number of important changes to the U.S. Basel III proposal that was issued by the U.S. banking agencies in June 2012.

U.S. Basel III Will Affect All Community Banks

U.S. Basel III will apply to all national banks, state member and non-member banks, state and federal savings associations and covered savings and loan holding companies (SLHCs) regardless of size. The regulation will also apply to all bank holding companies (BHCs) other than certain small BHCs with less than $500 million in total assets. However, the bank and thrift subsidiaries of these small BHCs will still be subject to U.S. Basel III.

U.S. Basel III: Key Takeaways for Community Banks

  • The compliance date for community banks is January 1, 2015. The new capital conservation buffer and deductions will be phased in over several years.
  • U.S. Basel III introduces a new tier of capital—Common Equity Tier 1—and a new minimum Common Equity Tier 1 risk-based capital ratio of 4.5 percent.
  • On top of the tougher new minimum capital ratios, community banks must maintain a common equity capital conservation buffer of greater than 2.5 percent of risk-weighted assets (RWAs) to avoid restrictions on dividends, redemptions and executive bonus payments.
  • Compared with existing capital rules, U.S. Basel III will require community banks to deduct much more mortgage servicing assets (MSAs) and deferred tax assets (DTAs) from their common equity capital, shrinking their capital base.
  • Community banks can opt out of a rule requiring banks to include accumulated other comprehensive income (AOCI) in their common equity capital. Opting out could help reduce volatility in a community bank’s regulatory capital levels.
  • U.S. Basel III retains the existing capital treatment of residential mortgages and certain other types of exposures.
  • BHCs with less than $15 billion in total consolidated assets as of year-end 2009 can continue to treat existing trust preferred securities (TruPS) as Tier 1 capital, subject to certain conditions. M&A activity may affect the grandfathering of TruPS in Tier 1 capital.

How Will U.S. Basel III Increase Capital Requirements for Community Banks?

U.S. Basel III contains two types of capital ratio requirements: the risk-based capital ratio and the leverage ratio.

A bank’s risk-based capital ratio is the ratio of its regulatory capital to its risk-weighted assets (RWAs). The risk-based capital ratio is not a new concept, but U.S. Basel III introduces a new tier of capital: Common Equity Tier 1. Thus, under U.S. Basel III, regulatory capital is divided into three different tiers: Common Equity Tier 1 (e.g., common stock, related surplus and retained earnings), Additional Tier 1 (e.g., certain preferred stock) and Tier 2 capital (e.g., certain subordinated debt and other capital instruments). U.S. Basel III subjects banks to three different risk-based capital ratio requirements: Common Equity Tier 1 risk-based capital ratio; Tier 1 risk-based capital ratio (Tier 1 capital is sum of Common Equity Tier 1 and Additional Tier 1 capital); and total risk-based capital ratio (total capital is the sum of Tier 1 and Tier 2 capital).

RWAs constitute the denominator of the risk-based capital ratio. In summary, a community bank must calculate RWAs by multiplying the amount of an asset or exposure by the standardized risk weight (percentage) associated with that type of asset or exposure. The standardized risk weights prescribed in U.S. Basel III reflect regulatory judgment regarding the degree of risk of a type of asset or exposure. RWAs must be calculated for both on- and off-balance sheet assets and exposures. All else being equal, a higher risk weight results in a higher RWA amount which, in turn, gives rise to a lower risk-based capital ratio.

A bank’s leverage ratio is the ratio of its Tier 1 capital to its average total consolidated on-balance sheet assets (minus amounts deducted from Tier 1 capital). Calculation of the leverage ratio does not involve assigning risk weights to assets. Thus, the leverage ratio is commonly referred to as a non-risk-based capital ratio. U.S. banks have been subject to the leverage ratio requirement for many years.

Higher Capital Ratios under U.S. Basel III

U.S. Basel III increases the minimum risk-based capital ratios for all U.S. banking organizations, including community banks. It also requires all U.S. banking organizations, including community banks, to maintain a capital conservation buffer above the minimum requirements to avoid restrictions on capital distributions and executive bonus payments. These aspects of U.S. Basel III are illustrated below.

Capital Conservation Buffer

U.S. Basel III introduces a capital conservation buffer of Common Equity Tier 1 capital above the minimum risk-based capital requirements. The buffer must be maintained to avoid:

  • Limitations on capital distributions (e.g., repurchases of capital instruments or dividend or interest payments on capital instruments); and
  • Limitations on discretionary bonus payments to executive officers such as the CEO, president, CFO, CIO, CLO and heads of major business lines.

As a community bank dips further below its capital conservation buffer, it will be subject to increasingly stringent limitations on capital distributions and bonus payments. The capital conservation buffer will be phased in over three years, beginning on January 1, 2016.

New Well-Capitalized Standard under U.S. Basel III

U.S. Basel III revises the capital thresholds of the prompt corrective action categories for insured depository institutions (IDIs), including the well-capitalized standard, to reflect the new minimum capital ratios in Basel III. The revised prompt corrective action thresholds will become effective on January 1, 2015.

Prompt Corrective
Action Threshold
Risk-Based Capital Ratios Leverage
Total capital (unchanged) Tier 1
Common Equity Tier 1 capital
Well-capitalized ≥ 10% ≥ 8% ≥ 6.5% ≥ 5%
Adequately capitalized ≥ 8% ≥ 6% ≥ 4.5% ≥ 4%
Undercapitalized < 8% < 6% < 4.5% < 4%
Significantly undercapitalized < 6% < 4% < 3% < 3%
Critically undercapitalized Tangible equity (defined as Tier 1 capital plus non-Tier 1 perpetual preferred stock) to total assets ≤ 2%

New Eligibility Criteria for Capital Instruments

In addition to increasing minimum risk-based capital ratios and introducing the capital conservation buffer, U.S. Basel III also defines new eligibility criteria for capital instruments within each tier of regulatory capital. As a result of the new eligibility criteria, certain types of capital instruments that qualified as Tier 1 capital under existing capital rules will no longer qualify, subject to grandfathering or phase-out arrangements for certain existing instruments.  

The following chart illustrates the impact of the new eligibility criteria for BHCs with less than $15 billion in total consolidated assets as of December 31, 2009.  

Impact of M&A on Non-Qualifying Capital Instruments Grandfathered in Tier 1 Capital

As noted above, BHCs with less than $15 billion in total consolidated assets as of year-end 2009 can continue to treat existing non-qualifying capital instruments such as TruPS and cumulative perpetual preferred stock as Tier 1 capital, subject to certain conditions, including an aggregate limit for non-qualifying capital instruments of 25 percent of Tier 1 capital. U.S. Basel III contains specific rules addressing the impact of M&A activity on the ability of a BHC to continue to benefit from the permanent grandfathering of existing non-qualifying capital instruments in Tier 1 capital.  These rules can create disincentives for community banks to expand through M&A transactions instead of organic growth.

Regulatory Adjustments to and Deductions from Capital

On top of increasing minimum risk-based capital ratios, introducing the capital conservation buffer and defining new eligibility criteria for capital instruments, U.S. Basel III will also require banks to make several new deductions from and adjustments to regulatory capital. Most of these will apply to Common Equity Tier 1 capital and have the effect of focusing bank regulatory capital on tangible common equity. The new deductions for mortgage servicing assets (MSAs) and deferred tax assets (DTAs) are much more stringent than under existing capital rules and will reduce community banks’ equity capital base.

U.S. Basel III’s deductions from Common Equity Tier 1 capital include, among other items:

  • Goodwill and other intangibles, other than MSAs, net of associated deferred tax liabilities (DTLs);
  • DTAs that arise from operating loss and tax credit carryforwards, net of associated DTLs; and
  • Defined benefit pension fund net assets, net of associated DTLs. IDIs are not required to make this deduction. However, non-IDIs such as BHCs and covered SLHCs generally must make this deduction.

U.S. Basel III provides for limited recognition of the following items, which are subject to a 10 percent individual threshold and a 15 percent aggregate threshold of Common Equity Tier 1 (after applying certain regulatory adjustments and deductions):

  • DTAs arising from temporary differences that could not be realized through net operating loss carrybacks, net of any related valuation allowances and net of DTLs;
  • MSAs net of associated DTLs; and
  • Significant investments in unconsolidated financial institutions in the form of common stock, net of associated DTLs.

AOCI Opt-out for Community Banks

AOCI includes unrealized gains and losses on available-for-sale (AFS) securities. Under existing capital rules, unrealized gains and losses on AFS debt securities are not included in regulatory capital, i.e., these unrealized gains and losses are filtered out of regulatory capital. This feature of the existing capital rules is referred to as the AOCI filter. One of the perceived benefits of the AOCI filter is that it reduces volatility in a bank’s capital levels, especially during periods of interest rate movements. In the June 2012 U.S. Basel III proposal, the U.S. banking agencies proposed to remove the AOCI filter. This was one of the most contentious aspects of the proposal.

In a significant change from the June 2012 proposal, the U.S. Basel III final rule permits community banks and many other U.S. banking organizations to make a one-time, permanent election to retain the AOCI filter. This feature of the final rule is referred to as the AOCI opt-out election because the banking organization would be electing to opt-out of the removal of the AOCI filter. An opt-out election must be made in the regulatory report filed for the first reporting period after the banking organization becomes subject to U.S. Basel III. If a top-tier banking organization makes an election, any consolidated banking organization subsidiary must make the same election as its parent. We expect that many community banks will opt out of the removal of the AOCI filter.

New Risk Weights under U.S. Basel III

In addition to making significant changes to the numerator of the risk-based capital ratio (regulatory capital), U.S. Basel III makes important changes to the calculation of RWAs, the denominator of the risk-based capital ratio. Among other things, U.S. Basel III:

  • Retains existing risk weights for residential mortgages, i.e., assigns a 50 percent risk weight to prudently underwritten first-lien exposures that are performing according to their original terms and a 100 percent risk weight to other residential mortgage exposures;
  • Assigns a 100 percent risk weight to most commercial real estate loans; and a 150 percent risk-weight for high volatility commercial real estate loans;
  • Assigns a 150 percent risk weight to past due exposures (except sovereign exposures and residential mortgages);
  • Retains the existing 100 percent risk weight for corporate and retail loans;
  • Increases the risk weight for exposures to qualifying securities firms from 20 percent to 100 percent;
  • Introduces new methods for calculating RWAs for over-the-counter and centrally cleared derivatives;
  • Introduces new methods for calculating RWAs for securitizations;
  • Establishes new methods for calculating RWAs for equity exposures;
  • Introduces new rules for recognizing collateral and guarantees as credit risk mitigants; and
  • Removes references to credit rating agency ratings in methods for calculating RWAs.

Effective Date and Transitional Arrangements

Community banking organizations will become subject to U.S. Basel III beginning on January 1, 2015. Certain aspects of U.S. Basel III will take effect immediately on that date, including new minimum risk-based capital ratios, revisions to the capital thresholds in the prompt corrective action framework and the new risk weights regime. Other aspects of U.S. Basel III will be phased in over several years, including new deductions from and adjustments to regulatory capital and the new capital conservation buffer.

If you are interested in learning more about U.S. Basel III and its impact on your bank, we invite you to visit Davis Polk’s Basel III resources website,, where you can access webcasts, visual memos, interactive web tools and other materials on U.S. Basel III and other related topics.

Is Basel III Good for Banking?

There are a lot of complaints about the complexity of the new Basel III rules, which increase minimum capital ratios, establish a new set of risk weights for certain assets and increase liquidity requirements. All banks and thrifts, plus thrift holding companies, are subject to the new rules. Bank holding companies also are included, unless they have assets of fewer than $500 million. But will the new rules be good for banking, when all is said and done? Bank Director asked a panel of experts to weigh in on the new rules, which were finalized earlier this year.

Is Basel III good for banking?

Peter-Weinstock.jpgMore and more, I find myself to be in [Federal Deposit Insurance Corp. Vice Chairman] Tom Hoenig’s camp. Regulations have become monstrously complex. The Basel III regulations are more than 900 pages. If the question is whether higher minimum capital ratios and liquidity requirements make sense, I would say sure, but 900 pages? Beyond the complexity, there is considerable administrative burden even for community banks. I laugh when I read what amount of time regulators say is needed to comply with new regulations. They must all be masters of Evelyn Wood’s Reading Dynamics. I needed over two weekends just to read the first 280 pages of regulation.

— Peter Weinstock, Hunton & Williams LLP

Jonathan-Hightower.jpgBasel III is good for banking in that it directs the industry back into the more conservative role of a traditional financial intermediary rather than the high growth, boom or bust mentality that was so pervasive in the industry in the early to mid-2000s. The Basel III rules, in a general sense, promote more modest risk-taking by banks. The rules also moderate growth through limiting leverage for those institutions that have more aggressive asset mixes. By doing this, the rules will help curb competition that is strictly based upon which institution is willing to take the most risk. Hopefully, these rules will lead the industry back into an environment in which the most successful institutions are the smartest, not just the most aggressive.

— Jonathan Hightower, Bryan Cave LLP

Lamson_Don.pngYes and no. People generally accept that banks should have had more capital prior to the recent financial crisis, but Basel III has clear weaknesses. The problem lies in recognizing that overly complex rules and prohibitively high capital levels can be incompatible with increasing economic activity or at least contribute to driving borrowers to the shadow banking environment. The key is to understand the interrelationship of new requirements in addition to Basel III, both national and international, both imposed by Dodd-Frank and independently by bank regulators, to recognize that the cumulative effect of those rules may be more onerous than at first supposed.

— Donald Lamson, Shearman & Sterling LLP

Luigi-DeGhenghi.jpgIt’s a mixed bag. Since all U.S. banks will be required to hold more capital, especially common equity, than under the existing rules, they will be more likely to absorb significant losses and thus may be less likely to fail. However, in order to raise or maintain additional common equity, banks still have to deliver attractive returns to their shareholders. The cost of additional capital, plus the compliance burden arising from more complex rules, makes it too early to tell whether banks will succeed without cutting back on the availability of credit. The Basel III rules also create disincentives for smaller U.S. banks to expand through M&A transactions instead of organic growth. That could act as a brake on consolidation and affect the competitive landscape between banks of different sizes.

— Luigi L. De Ghenghi, Davis Polk & Wardwell LLP

Zaunbrecher_Susan.jpgThe application and implementation of Basel III to community banks is unnecessary. Community banks were not the cause of the troubles leading up to the Great Recession. Then, as now, most healthy community banks have more capital than will be required in 2015. When deemed necessary for safety and soundness, troubled institutions often have increased capital ratios imposed on them by their regulators. This has not changed, nor should it. Basel III may have the undesired effect of driving more consolidation of healthy community banks because they will not be able to profitably keep up with increased regulatory compliance costs, new CFPB rules, information technology advances, along with maintaining higher capital standards. This will be our loss.

— Susan B. Zaunbrecher, Dinsmore & Shohl LLP

Robert-Monroe.jpgWe believe Basel III will be good for banking, so long as the rules are clearly set out. Basel III will require banks to maintain higher capital levels, even though there are changes to what can be included in Tier 1 capital.

— Bob Monroe, Stinson Morrison Hecker LLP

Stanford_Cliff.pngBasel III implementation risks pushing banks to pursue similar business strategies to manage their regulatory capital burdens (which contributed to the 2008-2009 systemic crisis as well). Regulators have pushed banks to adopt model risk management practices to ensure that each institution does not slavishly follow underwriting, valuation, or risk management models without routine and independent validation. However, these same model risk management principles have not been built into the Basel III standards themselves, which are static and risk similar effects.

— Cliff Stanford, Alston & Bird LLP

Final Basel III Rules Revealed: Community Banks Aren’t Completely off the Hook

7-19-13_Naomi.pngThe Basel III final rules recently released make clear one thing: Small, community banks are getting a break. It may not actually feel that way. In fact, community bank CEOs across the country tell me they are very frustrated with new regulation, with Basel III, with the Dodd-Frank Act and with examiners scrutinizing their banks and coming up with problems that never seemed to be a problem before. The overarching theme is that more regulation is coming down the pike, Basel III’s final rules are just one part, and they will be burden to digest and implement.

“It’s a massive rule where they consolidated three notices of proposed rulemakings,” says Dennis Hild, a former Federal Reserve bank examiner and Crowe Horwath LLP director. Even though Hild is based in Washington, D.C. and it is his job to understand this stuff, even he admitted he had a lot of reading to do. So it will be a bundle for a small bank CEO to figure out, too. “There is still much to learn. We need to dig through it. We need to find out what’s important.”

The news in late June and early July that the Federal Reserve Board, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corp. (FDIC) would jointly mitigate some of the proposals most onerous to community banks was a welcome, if small, relief in a heavily regulated industry.

Under the final Basel III rule:

  • Banks under $15 billion in assets can continue to count trust-preferred securities—known as TRuPS—as Tier 1 capital.
  • Banks can continue to risk-weight residential mortgages as they had under the original Basel I regime. The final rule abandons a proposal to institute a complicated formula of risk weights for residential mortgages.
  • All but the largest banks (above $250 billion in assets) can keep available-for-sale securities on the balance sheet without having to adjust regulatory capital levels based on the current market value of those securities. Banks have a one-time opportunity to opt-out on their first regulatory call report after Jan. 1, 2015 from what’s called the accumulated other comprehensive income (AOCI) filter. If they miss doing so, they can’t opt-out later.

FDIC Chairman Martin J. Gruenberg specifically said in a press release that changes to the final rule had been made because of community bank objections. The Federal Reserve even published a guide just for community banks to explain the new rules. The Independent Community Bankers of America (ICBA) acknowledged the gesture on behalf of community banks but said in a statement that it still supported an outright exemption from Basel III capital standards for community banks.

It doesn’t appear that community banks will be getting that. The goal of the new rules is to improve the quality and quantity of capital maintained by banks, should another financial crisis take place.

Most community banks will have to comply with the higher regulatory capital standards under the Basel III final rules. Small bank holding companies with less than $500 million in assets are exempt, but their depository institutions must comply. Thrifts and thrift holding companies also must comply with the new rules. The FDIC estimated that 95 percent of insured depository institutions already meet the capital standards required under the final rules. Still, bank management teams, and the bank boards that oversee them, will have to figure out if their banks need to raise capital, and if so, how.

Many other aspects of Basel III will impact community banks as well. Bank officers have been calling consultants and law firms to figure out the impact of the new rules.

One of the biggest questions has been how an acquisition might subject a bank to new rules under Basel III, say if an acquisition bumps the bank above $15 billion in assets. How will the TRuPS on the merged companies’ books be treated?

The biggest banks might feel deterred from M&A if it propels them into the ranks of “advanced approach” institutions, which are those with more than $250 billion in assets or more than $10 billion in on-balance sheet foreign exposure, such as foreign government debt. Such a category subjects those banks to special Basel III rules and higher standards. Also, under yet another proposed rule from all three federal banking regulators, bank holding companies with more than $700 billion in combined total assets or $10 trillion in assets under custody must maintain double the current minimum leverage ratio of 3 percent to be considered “well capitalized.” Regulators estimate only eight institutions in the country would be subject to this leverage requirement.

One aspect of Basel III that might impact community banks is exposure to certain “high volatility” commercial real estate loans, usually acquisition and development loans, which will require higher risk weights. There also will be limitations on certain kinds of deferred tax assets, says Hild.

His advice? Don’t freak out right now. Banks will have time to figure this out.

Although banks with more than $250 billion in assets will have to comply with new capital rules during a phase-in period that starts January 1, 2014, smaller institutions have until January 1, 2015 to begin phasing in the new standards. That will certainly be enough time to figure out if Basel III is a non-event for your organization.

Stress Testing: Top Down or Bottoms Up?

Stress_Test_1-9-13.jpgRecent rule making for expansion of stress testing requirements to new constituencies and Basel III implementation have stirred uncertainty and angst among banks. Stress testing regulation includes significant detail on reporting templates, model management and capital planning guidance. Standards of practice are beginning to form.  However, regulatory guidance provided on methodological and modeling approaches to date has created confusion and caused a divergence of practice and a variety of modeling approaches among financial institutions. The appropriateness of each approach is widely debated. 

One point often lost in the discussion is that multiple approaches are suggested by the regulators’ Interagency Guidance on Stress Testing (SR 12-7) published in May, 2012, to properly manage and control model risk:

“An effective stress testing framework employs multiple conceptually sound stress testing activities and approaches.”

This guidance applies across the capital planning process, including credit loss estimation, liabilities, new business volumes, and pro-forma balance sheet and income statements. In this article, we limit our discussion to two conceptual approaches for modeling stressed credit losses: top-down and bottoms-up. 

In top-down modeling, exposures are treated as pools with homogeneous characteristics. Scenarios (i.e., macroeconomic or idiosyncratic, event-driven) are correlated to historical portfolio experience. The outputs from this approach are intuitive and easily understood outside of the credit risk function and can be readily calibrated and back-tested against on-going actual and projected performance. This is increasingly important as stress testing and capital planning requirements are forcing stress-testing analytics to be coordinated among treasury, finance and risk groups.

Top-down approaches can also be easier to develop since pool modeling is not exposed to idiosyncrasies or noise of modeling single-firm financial statements.  Additionally, historical data is readily available at most institutions since the same type of data is needed for modeling allowances for loan losses. A bank’s own loss experience can, therefore, be incorporated into the analysis, satisfying an element of the “use-test” criteria to validate models, which is so critical for management and regulators. 

Top-down modeling is well adopted for retail portfolios where homogeneous groupings are more easily identifiable. This approach can ignore important risk contributors and nuances for more heterogeneous portfolios (e.g., commercial real estate, commercial and industrial loans, project finance, municipal exposures). For these portfolios, top-down models serve better as a secondary or “challenger” modeling approach, rather than a firm’s primary modeling methodology. 

Bottoms-up modeling refers to counterparty or borrower-level analyses. Typically, the risk drivers for a specific segment or industry are correlated to macroeconomic variables.  Granular, borrower-level analysis reaches beyond regulatory mandated stress testing and can serve as a foundation for risk-based pricing, improved budgeting and planning, economic capital modeling and limit- and risk-appetite setting. It can also highlight the most desirable banking relationships while isolating the riskiest relationships and concentrations.   

Methodologically, there are several approaches to bottoms-up modeling. Many banks use actuarial modeling to determine credit risk transition, delinquency, default, as well as loss frequency and magnitude, but often miss critical factors such as the timing of delinquency, default and losses, which requires cash-flow based approaches. Many organizations do not possess the required data necessary to calibrate credit-adjusted, cash-flow models.

Few institutions have systemically collected borrower-level financial statements, or default and loss data over several business cycles. However, many treasury and asset-liability committee (ALCO) members prefer to think of balance sheet risk in a cash-flow (i.e., option-adjusted) fashion.  As a result, many organizations are required to supplement internal modeling with external data, modeling, and model calibration techniques from third parties. 

Bottoms-up modeling for stress testing will soon be applied to Basel III, potentially making it the preferred methodology in the long term.  For bank officers embarking on developing a stress-testing program who are less familiar with data and risk quantification requirements, development and firm-wide adoption may require additional time and cross-organizational buy-in.  Rapid implementation timelines driven by regulation, flexibility and intuitiveness of the approach, may make top-down modeling more attractive in the short-run; however, while expediency to meet requirements is critical, it is equally important to ensure the firm’s modeling architecture is designed to be leveraged and re-used once the firm is ready to graduate to a more comprehensive and holistic approach. 

While no single modeling approach has been blessed by regulators or emerged as a best practice, one thing appears clear: Use of multiple, conceptually sound approaches is prudent given the imprecision of existing state-of-the-art modeling techniques. Regulators also recommend multiple approaches.

U.S. Basel III Proposals: Infographic

U.S. bank regulators have proposed to apply the Basel III capital rules to virtually all U.S. banking organizations. If adopted, the U.S. Basel III proposals would represent the most comprehensive revision to U.S. bank capital standards in over two decades. We have created some visuals that highlight certain key aspects of the U.S. Basel III proposals. An overview of the U.S. Basel III proposals and Davis Polk’s summaries of related Dodd-Frank bank regulatory rulemakings is available here.

View Davis Polk’s full-size visuals in pdf format including a timeline of U.S. Basel III implementation as proposed in June 2012.

Banks Dodge Superstorm Basel— for Now

storm.jpgThe entire U.S. banking industry breathed a collective sigh of relief recently when the three federal bank regulatory agencies postponed indefinitely the effective date of the Basel III capital and liquidity rules, which had been set for Jan. 1, 2013. The proposed rules, which would have applied more or less equally to all institutions—from the country’s largest bank, JPMorgan Chase & Co., to very small community banks in out-of-the-way rural locations—set off a firestorm of protest throughout industry.

Following their release in June, the proposed rules reportedly generated more than 2,000 comment letters from bankers as both the American Bankers Association and Independent Community Bankers of America orchestrated letter writing campaigns. Members of the U.S. Congress, including 53 senators from both parties, also expressed their concern during the comment period. And one prominent federal regulator—former Kansas City Federal Reserve Bank President Tom Hoenig, now a board member of the Federal Deposit Insurance Corp.—even urged that the entire proposal be scrapped and replaced with a simpler plan.

Community banks in particular were not objecting to higher capital levels per se since many of them—a great percentage of which are privately owned—have traditionally carried higher levels of capital on their balance sheets than large publicly owned banks, which tend to be more highly leveraged. But they did object strongly to certain Basel III provisions, such as a fairly stringent risk-weighting system that would have required them to put higher levels of capital against certain kinds of assets, including mortgage loans, commercial loans and even U.S. government securities. Basel III also would eliminate a highly popular form of Tier I capital at many small banks—trust preferred securities—from consideration, forcing them to raise new capital at a time when many investors, both public and private, are wary of banks generally. 

Some community bankers stated flatly that the new rules would force them to sell out if they couldn’t raise fresh capital. Others worried that the risk-capital weighting for mortgage loans would effectively shut them out of that business, negatively impacting their profitability and possibly the home buying market itself.

When announcing the postponement, federal regulators did not indicate how the Basel III rules might be modified or when they would take effect. The least likely outcome is that the feds will actually lower the overall capital requirements for banks, including very small ones, because there seemed to be widespread consensus in Washington coming out of the 2008 financial crisis that the banking industry needed to have a stronger balance sheet. A more likely outcome might be that the regulators create a simpler and less onerous risk weighting system for small banks, and then give them ample time to come into compliance with whatever approach they adopt.

One thing is for sure: Bankers often fuss and fume—with more than a little justification—that the regulators in Washington never listen to their complaints about the regulatory burden, but this time the feds heard them loud and clear.

Basel III: How the New Standards Will Affect Your Bank

rules-help.jpgBasel 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 Basics

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.