Final Basel III Capital Rule—Less Impact on Community Banks

In early July, the Federal Reserve Board of Governors, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. approved the final Basel III risk-based capital rule. This rule aims to improve the quality and quantity of capital for all banking organizations.[1] The agencies, in response to comments on their June 2012 proposed capital rule, sought to minimize the potential burden on community organizations where consistent with applicable law and the establishment of a robust and comprehensive capital framework. For community banking organizations, the rule in final form provides some relief from the initial proposal in three important areas: residential mortgage exposure, accumulated other comprehensive income (AOCI) and grandfathered capital instruments. Community banking organizations first become subject to the final Basel III rule on Jan. 1, 2015. Thereafter begins a phase-in period through Jan. 1, 2019.[2]

While Basel III increases minimum capital requirements, the vast majority of Eighth District bank holding companies (BHCs)—as well as BHCs across the country—already comply with the new minimums. The final rule also looks to minimize the potential burden on community banks—in response to comments received by the agencies on the June 2012 proposed rule—while remaining consistent with applicable law and the establishment of a robust and comprehensive capital framework.

Key Changes from the Proposed Capital Rule that Affect Community Banks

Comments from community banks resulted in three major changes from the proposed rule. These changes include:

Residential Mortgage Exposure: The proposed rule called for higher risk weights applied to certain residential mortgage exposures. None of the proposed changes are found in the final rule. Thus, remaining unchanged is the 50 percent risk weight for prudently underwritten first-lien mortgage loans that are not past due, reported as nonaccrual or restructured, and a 100 percent risk weight for all other residential mortgages. Similarly, the new rule does not change the current exclusions from the definition of credit-enhancing representations and warranties.

Accumulated Other Comprehensive Income (AOCI) Filter: The initial proposal would have included most AOCI components in regulatory capital. In the new rule, community banking organizations are given a one-time option to filter certain AOCI components, similar to current treatment. The AOCI opt-out election must be made on the institution’s first regulatory report filed after Jan. 1, 2015.

Grandfathered Capital Instruments and Tier 1 Capital: The initial proposal would have required trust preferred securities and cumulative perpetual preferred stock to be phased out of tier 1 capital. The new rule exempts depository institution holding companies with less than $15 billion in total consolidated assets as of Dec. 31, 2009, or organized in mutual form as of May 19, 2010, from this requirement. Grandfathered capital instruments, consistent with current treatment, are limited to 25 percent of adjusted tier 1 capital elements.

Major Changes from the Existing Basel I Capital Rule

The new rule implements higher minimum capital requirements and emphasizes the use of common equity through the introduction of a new capital ratio: common equity tier 1 (CET1).[3] In addition, the new rule establishes stricter eligibility for capital instruments included in CET1, additional tier 1 capital or tier 2 capital. In addition, the rule introduces the requirement of a capital conservation buffer, beginning on Jan. 1, 2016, and ending on Jan. 1, 2019. Banking organizations without other supervisory issues that wish to distribute capital freely must maintain the buffer. Tables 1 and 2 compare current treatments versus final capital rule treatments.

TABLE 1

Minimum Capital Standards

  Current Minimums Final Rule
  Minimum Buffer Total
Common equity tier 1 capital (CET1) ratio N/A 4.5%* 2.5% 7.0%
Tier 1 capital ratio 4% 6.0%* 2.5% 8.5%
Total capital ratio 8% 8.0%* 2.5% 10.5%
Leverage ratio 4% 4.0%* N/A N/A

* Please note when the new capital rule is fully phased in, the minimum capital requirements plus the conservation buffer will exceed the prompt corrective action well-capitalized thresholds below. This 0.5-percentage-point cushion allows institutions to dip into a portion of their capital conservation buffer before reaching a status that is considered less than well capitalized for prompt corrective action purposes.


TABLE 2

Prompt Corrective Action Well-Capitalized Thresholds

  Current Treatment Treatment in Final Rule*
Common equity tier 1 capital (CET1) ratio N/A ≥6.5%
Tier 1 capital ratio ≥6.0% ≥8.0%
Total capital ratio ≥10.0% ≥10.0%
Leverage ratio ≥5.0% ≥5.0%

* Conservation buffer is included in the above standards reflective of the final transition date of Jan. 1, 2019.

The new rule emphasizes common equity as the preferred capital instrument. It also limits the inclusion of intangible assets, including mortgage servicing assets, deferred tax assets and significant investments in unconsolidated capital of financial institutions. Each will be subject to a 10 percent individual limit and 15 percent aggregate limit of CET1.

The new capital rule addresses the Dodd-Frank Act prohibition on reliance on external credit ratings specified in the regulations of the federal banking agencies. Consequently, the new capital rule replaces the previous credit-rating-based risk-weighting approach of certain assets with the simplified supervisory formula approach. As an alternative, banking organizations may use a gross-up approach or otherwise default to the seemly prohibitive 1,250 percent asset risk weight.

Impact on Banking Organizations

We estimate that approximately 96 percent of U.S. BHCs and 90 percent of Eighth District BHCs immediately meet the 4.5 percent CET1 to risk-weighted assets ratio required under the final capital rule. Thus, the immediate effect is small, while in addition, community banking organizations have a lengthy period to meet the final phased-in requirements.

Summary

The new Basel III capital rule introduces a comprehensive new regulatory framework for U.S. banking organizations which is consistent with international standards. For the most part, community banking organizations have been insulated from a capital rule that results from a severe knee-jerk reaction to the financial crisis.

Based on our estimates, for the majority of community banking organizations, the final rule will have little impact on their capital level and structure. However, for a minority, some capital will need to accrue prior to final phase-in of the new rule.

Endnotes

  1. See the Federal Register Notice on Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, and Standardized Approach for Risk-Weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule and Market Risk Capital Rule at www.federalreserve.gov/newsevents/press/bcreg/20130702a.htm. [back to text]
  2. Altogether exempt from the final rule are bank holding companies with less than $500 million in assets, as they remain subject to the Board’s Small Bank Holding Company Policy Statement. [back to text]
  3. CET1 is broadly defined as the sum of common stock, surplus and retained earnings, adjusted by AOCI, other equity capital and qualifying noncontrolling minorities; with goodwill, net deferred assets (DTA), mortgage servicing assets (MSA) and unconsolidated subsidiaries deductions. [back to text]

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