As part of the proposed Basel III capital rules, banks will be required to hold a greater portion of their total capital in the form of common equity. With the creation of a new Common Equity Tier 1 (“CET1”) ratio to be included with other minimum capital ratios and a new Capital Conservation Buffer to be composed exclusively of common equity, the proposed new capital rules signal a regulatory departure from allowing forms of hybrid capital to constitute a significant amount of a bank’s total capital. While the impacts of the new preference for CET1 will be significant, the methodology for calculating the CET1 ratio will also affect the interest rate and liquidity risk management tools available to community banks.

In calculating the new CET1 ratio under the proposed rules, banks would be required to include Accumulated Other Comprehensive Income (“AOCI”) as part of CET1. For most community banks, the primary driver of AOCI is unrealized gains and losses in the bank’s available-for-sale (“AFS”) securities portfolio. Such securities are generally designated as available for sale to provide the bank with a beneficial source of liquidity. While Generally Accepted Accounting Principles require a financial institution to record changes in the fair value of the bank’s AFS securities portfolio in the equity section of its balance sheet, regulatory precedent currently excludes unrealized gains and losses on the AFS portfolio from the calculation of Tier 1 regulatory capital, instead including that amount in the calculation of the institution’s Tier 2 capital.

This regulatory capital treatment is justified, as interest rate swings create increases and decreases in the market value of securities that often do not reflect changes to the portfolio’s value that will be realized by the institution. Instead, the securities will continue to be held, often as a hedge against contrary interest rate risk elsewhere on the balance sheet. Should these unrealized securities gains and losses be counted in regulatory capital calculations, regulatory capital levels would become more sensitive to interest rate fluctuations without providing significant benefit to the safety and soundness of banks. For example, in the current long-term low rate environment, including AOCI as a component of CET1 would likely require banks to maintain increased capital levels in relation to their available-for-sale securities portfolios, knowing that a future increase in interest rates would reduce the bank’s CET1. Even more perversely, in a falling rate environment, such as that experienced in 2007 and 2008 when banks were also experiencing significant loan losses, the unrealized gains associated with an AFS securities portfolio could actually have worked counter-cyclically to increase the regulatory capital levels of banks.

With many community banks using their AFS securities portfolio primarily for liquidity and interest rate risk management rather than for income-producing purposes, the proposed rule could make a risk management tool significantly more expensive to banks from a capital perspective. In managing the increased volatility of their capital ratios, banks would have two alternatives – convert their AFS securities portfolio to a held-to-maturity portfolio, which would reduce the liquidity options available to a bank, or hold much more capital in reserve (rather than deploying it through making loans) in order to offset downward pressure on their CET1 caused by an increase in interest rates. We are hard pressed to see how increased volatility in regulatory capital levels, reduced liquidity resources and fewer options for managing a bank’s interest rate risk that would result from the proposed rule would improve the safety and soundness of community banks.