Congress Makes Capital Requirements Easier for Small Banks

3-9-15-BryanCave.pngFor many years, bankers have asked the question, “What size is the right size at which to sell a small community bank?” Some offer concrete asset size thresholds, while others offer more qualitative standards. We have always believed the best answer is “whatever size allows an acquirer’s profits and capital costs to deliver a better return than yours can.” While that answer is typically greeted with a scratch of the head, a recent change in law impacts the answer to that question for smaller companies. Given a proposed regulatory change by the Federal Reserve, a growing number of small bank holding companies will soon have lower cost of capital funding options that are not available to larger organizations.

President Obama recently signed into law an act meant to enhance “the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, and increase individual savings.” The new law directs the Board of Governors of the Federal Reserve System to amend its Small Bank Holding Company Policy Statement by increasing the policy’s consolidated assets threshold from $500 million to $1 billion and to include savings and loan holding companies of the same size. By design, more community banks will qualify for the advantages of being deemed a small bank holding company.

The Federal Reserve created the “small bank holding company” designation in 1980 when it published its Policy Statement for Assessing Financial Factors in the Formation of Small One-Bank Holding Companies Pursuant to the Bank Holding Company Act. The policy statement acknowledged the difficulty of transferring ownership in a small bank, and also acknowledged that the Federal Reserve historically had allowed certain institutions to form “small one-bank holding companies” with debt levels higher than otherwise would be permitted for larger or multibank holding companies. The first version of the policy statement had a number of criteria for what constituted a small bank holding company, most importantly that the holding company’s subsidiary bank have “total assets of approximately $150 million or less.” The asset threshold has been revised on several occasions, most recently in 2006 to the current level of $500 million in consolidated assets.

In light of this new law, the Federal Reserve has proposed these changes to its policy statement and recently announced parallel changes in reporting requirements for these small bank holding companies. The primary benefit of being deemed a “small bank holding company” is the exemption from the requirement to maintain consolidated regulatory capital ratios; instead, regulatory capital ratios only apply at the subsidiary bank level. This rule allows small bank holding companies to use non-equity funding, such as holding company loans, to finance growth.

This change should affect strategic and capital planning for all bank holding companies with consolidated assets of between $500 million and $1 billion and for all savings and loan holding companies with assets of less than $1 billion. These companies, which previously were required to comply with the capital requirements applicable to much larger institutions, can now use traditional debt at the holding company level to generate higher returns on equity. With trust preferred securities now a thing of the past, larger institutions cannot use debt or hybrid equity to meet their requirements for Tier 1 capital. Instead, larger institutions are left with traditional equity sources such as common stock and non-cumulative preferred stock, which typically carry a higher cost of capital.

Small bank holding companies can also consider the use of leverage to fund share repurchases and otherwise provide liquidity to shareholders to satisfy shareholder needs and remain independent. One of the biggest drivers of sales of our clients is a lack of liquidity to offer shareholders who may want to make a different investment choice. Through an increased ability to add leverage, affected companies can consider passing this increased liquidity to shareholders through share repurchases or increased dividends.

Of course, each board should consider its practical ability to deploy the additional funding generated from taking on leverage, as interest costs can drain profitability if the proceeds from the debt are not deployed in a profitable manner. However, the ability to generate the same income at the bank level with a lower capital base at the holding company level should prove favorable even without additional growth.

While new threshold has not received much press, we believe it could and should have an impact on merger discussions involving smaller institutions. Those companies that will soon be considered “small bank holding companies” should revisit their financial projections to consider whether introducing debt funding at the holding company can increase returns on equity without taking on unwarranted financial risk. Boards may find that this change makes the option of staying independent more viable in the future. Potential acquirers of small banks should also be aware of this change in order to demonstrate that a potential transaction provides a better risk-adjusted return to shareholders than remaining independent. On both sides of the transaction, this relatively quiet change should generate a new way of analyzing the question, “Is bigger really better?”

Buyers & Bleeders: Why Banks Need to Consolidate Now

According to the report “Buyers and Bleeders,” Invictus Consulting Group predicts that half of the banks across the country will need to participate in M&A in order to survive over the long haul. In this short video, Adam Mustafa, managing director, provides an overview of the study which analyzes the current M&A landscape and how capital plays a major role in this evolving environment.

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.

Banking Panel: Top Challenges in 2013

Everybody in banking knows this by now. Banks have been hit with an onslaught of new regulations right when low interest rates are continuing to erode profitability. But what will happen in 2013? Experts who will speak at Bank Director’s upcoming April Bank Chairman/CEO Peer Exchange say what they think boards will be dealing with next year.

 “What is the top strategic challenge facing bank CEOs, chairmen and their boards in 2013?”

Brown_Scott.jpgThe greatest challenge to CEOs, chairmen and their boards will be how to generate acceptable returns to shareholders in the face of ever-growing compliance concerns and a continued sluggish economy with high unemployment and historically low interest rates.  Without an administration change, 2013 promises to continue increasing and more stringent banking supervision and additional regulation, including consumer compliance initiatives and aggressive enforcement from the Consumer Financial Protection Bureau and new capital requirements from Basel III.  This will not only impact decisions on day-to-day operations and planning but also shape thinking on mergers and acquisitions  activity and the raising of capital.  Specifically, if new capital rules are adopted, boards will need to explore the availability of capital, and whether capital can be raised at satisfactory pricing levels.

— Scott Brown, Kilpatrick Townsend & Stockton LLP

Boehmer_David.jpgTalent. There is a shifting environment of constant change that is the new normal for how all businesses operate. Pressure is intensifying—from regulators to creative innovators who are bucking the traditional banking models trying to influence change.  Bottom line, CEOs need to have the right talent in place to lead effectively—not only to confront the current challenges, but to create an organization with a connected culture to be the bank of the future.

— David Boehmer, Heidrick & Struggles

Plotkin_Ben.jpgThe top challenge is that banks cannot earn their cost of capital in today’s environment.  The combination of higher capital requirements, margin pressure due to extraordinarily low rates, slow economic growth and cost pressures associated with regulation translates into inadequate returns for shareholders.  A CEO’s job is to outperform peers in this environment while making investors realize that these challenges will not last forever.  In the event that a bank can’t operate more effectively than its peers, it is the CEO’s responsibility to his/her board to face that reality and proactively explore exit opportunities.

— Ben A. Plotkin,Stifel, Nicolaus & Company and Stifel Financial Corporation

Bronstein_Gary.jpgNotwithstanding the difficult business climate and the continuing economic challenges facing the banking industry today, the regulatory burden is the top strategic challenge facing bank management and boards today. While the reelection of Obama results in some certainty that the barrage of new regulations will continue, there continues to be considerable uncertainty. For example, what will the creation of the CFPB mean for community banks not directly regulated by the CFPB? What will happen with Basell III? Regulatory costs are also a significant factor when considering the optimal asset size to best leverage today’s cost of doing business.  

— Gary Bronstein, Kilpatrick Townsend & Stockton LLP

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.

How Will Basel III Impact Banks?

With Basel III looming, financial institutions are yet again bracing themselves for the changes to come from new regulation. In simple terms, Basel III will require banks of all sizes to maintain higher capital ratios and greater liquidity as a safety measurement, but what will this really mean for a bank? Several bank attorneys think lending will suffer, as many banks will have to focus on increasing capital and taking on less risky loans.

How will the new Basel III capital requirements impact the banking industry in the U.S.?

Luigi-DeGhenghi.jpgBasel III will generally require all U.S. banks, large or small, to hold more capital than under existing rules, especially in the form of common equity. The effect will be to incentivize banks to reduce their risk-weighted assets by reducing their exposures or their level of risk in order to maintain a sufficient return on equity to attract investors. The impact on bank mergers and acquisition activity is unclear. Increased capital requirements will drive banks as sellers, but will temper banks as buyers. But there will likely be a contraction in the supply of credit from banks, which may drive lending into less regulated parts of the financial sector. This seems at odds with the prevailing political push for more lending from banks and more financial regulation.

—Luigi L. De Ghenghi, Partner, Davis Polk

Gregory-Lyons.jpgIf adopted as proposed, the Basel III requirements will have a significant impact on U.S. banks of all sizes.  Community banks were surprised that they were subject to Basel III at all, and the higher substantive and procedural burdens on both residential and commercial lending can reasonably be expected to force many of them to exit the industry.  For the larger banks, much of what is in the U.S. proposals is consistent with what they have been tracking from the Basel Committee since late 2010.  Nonetheless, the higher capital charges likely will continue to force the shrinking of business lines in the short term, and severely inhibit large bank mergers over the longer term.  

—Greg Lyons, Debevoise & Plimpton

Mark-Nuccio.jpgThe impact will be positive in the long term.  Basel III’s higher capital requirements will be phased in over a number of years.  While many are eager for banks to become more generous lenders, Basel III’s capital demands encourage banks to husband their resources.  The new capital regime will be a drag on economic recovery, but it ought to produce greater long-term financial stability. 

—Mark Nuccio, Ropes & Gray

Jonathan-Hightower.jpgThe real impact will be the change on Main Street.  The proposed risk-weighting rules will require banks to tie up more capital with certain asset classes, which will cause banks to increase their pricing of those assets in order to achieve the same return on equity. Therefore, we can expect higher pricing for junior lien mortgage loans, highly leveraged first mortgage loans, and highly leveraged acquisition and development real estate loans.

This change in pricing will affect the demand for these loans, which will in turn limit the number of developers and homebuyers in the market. That contraction will impact both the supply and demand sides of the economic equation. At the end of the day, these changes will lead to a slower recovery of the facets of the economy related to housing and development.

—Jonathan Hightower, Bryan Cave

rob_fleetwood.jpgThe implementation of the Basel III regime will highlight the need for banks to be creative in their capital planning. We have already been assisting numerous community banks in capital raising initiatives to provide support for the development and implementation of lending and other income-producing programs, as well as strategic acquisitions or expansions. We are encouraging our clients, to the extent they have not done so already, to implement comprehensive capital plans that focus on careful management of existing capital resources and proactive research of available sources of future capital.

We have also been discussing with clients the ability to implement new lending programs, other non-interest income sources and deposit products in anticipation of the new requirements. If done correctly, these initiatives may provide additional resources for banks to grow, despite the new requirements. However, as with all new programs, they need to be carefully studied and managed to ensure compliance with all regulatory requirements, not just the new capital rules.

—Rob Fleetwood, Barack Ferrazzano

Peter-Weinstock.jpgBasel III and the changes to risk-based capital regulations provide substantial penalties, in the form of increased capital allocations, for risk taking.  Former chairman of the Federal Deposit Insurance Corp. Bill Isaac, in his book, “Senseless Panic: How Washington Failed America” demonstrated the pro-cyclical nature of mark-to-market accounting.  Yet, the Basel accord now mandates it for the securities portfolio.  The risk-based capital ratios dramatically increase the risk-weighting of several asset classes, including mortgages that are not “plain vanilla” and problem loans.  Because such penalties have a potentially severe impact on capital, prudent bankers will reduce their risk of a capital shortfall either by rejecting loans at the margin or maintaining higher capital cushions.  Either way, the credit crunch for all but the clearly creditworthy is likely to be exacerbated.

—Peter Weinstock, Hunton & Williams