Given the tremendous volume of comments from industry participants regarding the Basel III capital rules and the mounting political pressure regarding adoption of the rules, many industry observers had speculated that the Federal Reserve, FDIC, and OCC would be challenged to adopt the final rules before January 1, 2013 (the date established for effectiveness of portions of the rule in the release of the proposed rules). On November 9, 2012, the agencies announced that they indeed will not be able to meet that deadline. This announcement runs contrary to the recently renewed directive by the Basel Committee on Banking Supervision for all members of the committee to adopt final rules prior to January 1, 2013. However, we believe it is appropriate for the U.S. regulatory agencies to carefully consider the impact of the rules on the U.S. banking system, particularly in light of our unique community banking system, and support the agencies delay in adopting the rules.
It is our understanding that the regulatory agencies are working through the comment letters submitted to them and are well aware of the concerns of community bankers, including the inclusion of unrealized gains and losses in the available-for-sale securities portfolio in Common Equity Tier 1 capital and the changes in risk-weighting for mortgage loans. We will continue to carefully monitor the progress of the rulemaking process as the agencies consider the impacts of the Basel III rules on the industry.
Bank regulators have been as busy as usual in 2012, but some of the more interesting regulatory and legal changes have come from non-bank regulators and the courts. And, the JOBS Act changes described below actually lifts the regulatory burden on banks a bit, a rare respite in an otherwise challenging regulatory environment.
The JOBS Act eases bank capital activities and M&A. The Jumpstart Our Business Startups Act affects community banks in 4 key ways:
- “Going public” is easier. Banks that have less than $1 billion in gross revenue can qualify as an “emerging growth” company and take advantage of relaxed rules that allow them to “test the waters” and obtain a confidential prior review of an IPO filing by the SEC, provide reduced executive compensation disclosures and file without a SOX 404 attestation by the bank’s auditors.
- The “crowdfunding” rule (expected in early 2013) will provide banks significant flexibility in raising $1 million per year from their community without IPO-type expenses and without adding new investors to their shareholder count.
- Private offerings are easier. Rules affecting private offerings are being relaxed so that a bank will be able to use public solicitation and advertising to attract investors as long as the bank takes reasonable steps to ensure that those investors are accredited.
- Going or staying private is easier because the shareholder count triggering “going public” was raised from 500 to 2,000. And, shareholders from a bank’s “crowdfunding” offerings and from employee compensation plans are now excluded from the shareholder count. These helpful changes to shareholder count rules mean that some banks can bring in new investors or even acquire another bank without triggering the obligation to “go public,” a significant cost and compliance barrier. Also, banks with a shareholder count under 1,200 can “go private” following a 90-day waiting period.
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.
On October 12, 2012, the Georgia Bankers Association (the “GBA”) delivered a public comment letter on the proposed Basel III capital rules and the related proposed risk-weighting rules. A copy of the letter is available for viewing here. In the comment letter, the GBA identifies over a dozen categories of key flaws in the proposed rules and concludes that the proposals should be withdrawn for further study or, at the very least, should be modified to exempt community and regional banks from their requirements.
The GBA takes the position in the comment letter that the regulatory agencies have a duty to apply the principles that they espouse for stress testing and enterprise risk management to their own rulemaking process. The GBA argues that the proposals are likely to introduce complementary risks to financial institutions, especially community banks, the impacts of which are not yet fully understood. As a result, the GBA asserts that the regulatory agencies should take time to study the impact of each rule change on the industry and then “stress” those impacts together and under a wide variety of market circumstances as a part of their role in managing risks to the banking industry.
The comment letter provides a wealth of themes and talking points as financial institutions make their final efforts to deliver their own comment letters, which are due no later than October 22, 2012. We encourage all financial institutions to identify any issues in the proposed rules that may significantly impact them and to submit a comment letter regarding those issues.
The GBA developed a task force to study the impact of the proposed rules on banks in Georgia and to develop thoughts for the comment letter. That task force included a number of bankers and service providers, including Bryan Cave’s Jonathan Hightower.
In recent weeks, we have been closely monitoring a flurry of activity among many banking organizations to respond formally to the proposed Basel III rules. With few exceptions, the response of the banking industry, particularly with respect to the impact of the proposed Basel III rules on community-focused financial institutions, has been roundly negative.
In mid-September, U.S. Senator Mark Warner (D-VA) and U.S. Senator Pat Toomey (R-PA) circulated a letter to the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation that has garnered the signature of 51 of their colleagues in the U.S. Senate. The senators’ letter raises their concerns with the “significant, unintended consequences for community banks” that may stem from the proposed capital rules that would make it tougher for smaller banks to raise capital or result in reduced lending in the communities they serve.
Another prominent critic of the proposed rules has been FDIC Director Thomas Hoenig, a former chief executive of the Federal Reserve Bank of Kansas City, who recently proposed that the entire Basel III proposal be scrapped in favor of a more simple capital calculation based on tangible common equity ratios. While Director Hoenig’s proposal would result in higher minimum capital requirements for all banks, it could potentially avoid many of the pitfalls associated with the proposed rules, particularly with respect to the complex deductions from capital and new asset risk-weights that are part of Basel III.
In recent weeks, three Bryan Cave lawyers have briefed state banking association members on the impact the Notices of Proposed Rule Making regarding Basel III could have on banks of all sizes. On July 12, Jonathan Hightower presented via webinar to the Georgia Bankers Association. On August 16, Jonathan Hightower and B.T. Atkinson participated in a live seminar on Basel III presented by the South Carolina Bankers Association that also included presentations by Garry Rank of Elliott Davis, LLP and Jim Mabry of Keefe, Bruyette & Woods. The SCBA program also included a segment advising institutions on how to prepare a comment letter on the proposals for submission to their primary federal banking agency. On August 20, Michael Shumaker and B.T. Atkinson presented via webinar to the North Carolina Bankers Association. In all three programs, bankers were strongly encouraged to submit comments on the proposals by the October 22 deadline, citing specific examples of how the proposed rules could negatively impact their bank. Areas noted for potential comment included:
- phase-out of trust preferred from Tier 1 capital for institutions having less than $15 billion in assets;
- appropriateness of the capital conservation buffer for banking organizations that are not systemically significant;
- inclusion of unrealized gains and losses on securities in common equity Tier 1 capital;
- whether the exclusion for bank holding companies having total assets of $500 million or less should be increased to $1 billion and include savings and loan holding companies; and
- the impact of the proposed risk-weighting of first and second lien mortgages on product availability and the anticipated burdens of implementation.
Links to related Financial Institution Letters:
As we continue our review of the proposed Basel III capital and risk-weighting rules, we have identified additional features of the proposed rules that may prove meaningful to community banks. One of the more significant changes provided by the Basel III proposal relates to the higher risk weights given to credit exposures (other than exposures to sovereign debt or residential mortgages) that are more than 90 days past due.
Under the current risk-weighting rules, there is no change in risk-weighting when an asset becomes 90 days past due, with all commercial loans, regardless of whether they are past due or paying as agreed, given a risk weight of 100%. However, under the proposed Basel III rules, the “portion of the [past due] exposure that is not guaranteed or that is unsecured” would receive a risk weight of 150%.
If the new Basel III rules had been in place during the last crisis, many banks could have found themselves in much deeper trouble earlier on in the cycle. With falling collateral prices resulting in more loans becoming unsecured, the increased risk weights assessed on high levels of past due loans would have resulted in lower capital ratios more quickly. However, considering the language of the proposed Basel III rules, would the existence of a borrower’s unconditional guarantee have been enough to avoid assessment of the higher risk weights? Although the letter of the proposed Basel III rules seems to create an exception from the new risk weights for fully guaranteed loans that are past due, recent regulatory guidance seems to undercut this reading.
On August 8, 2012, the banking regulators (Federal Reserve, OCC, and FDIC) extended the comment period on the three notices of proposed rulemaking that implement the Basel III capital standards and revised risk-weighting rules. Many organizations representing community banks had requested more time for community banks to analyze the impact of those proposed rules on their operations, and the regulatory agencies have responded to those requests.
The deadline for submitting comments is now October 22, 2012 (comments had been due on September 7, 2012). We recommend that community banks carefully analyze the impact of the proposals on their balance sheets and business plans and submit comments as appropriate. These comments are key in the effort to effect change in the final rules. We have heard from many bankers that they are concerned about the new rules’ impact on a wide variety of facets of their banks, including mortgage lending, real estate lending, and the structure of their securities portfolios.
Please contact any member of the Bryan Cave financial institutions team if you would like to discuss the impact of the rules on your bank or if you need help drafting your comment letter.
As the industry gains a greater understanding of the proposed Basel III capital rules, some management teams are identifying potential problems for their organizations in the rules. One such problem is the broad-based dividend restrictions and the consideration of how those restrictions may impact S Corporations.
Many states recognize in their banking laws and regulations that a different set of standards should apply in determining dividend restrictions for S Corporation banking institutions and their holding companies. Because the taxable income of these entities is passed through to the shareholders of the organization, it is expected that these entities will pay distributions that allow their shareholders to fund their personal tax liabilities attributable to the taxable income of the organization.
The proposed Basel III capital rules have a number of dividend restrictions. Most bankers are familiar with the dividend restrictions imposed under Prompt Corrective Action, but the new capital rules also contain dividend restrictions if the organization is not in full compliance with the requirement to maintain the required capital conservation buffer: a requirement for banking organizations to maintain common equity Tier 1 capital equal of 2.5% of total risk-weighted assets in addition to the minimum risk-based capital requirements.
If a banking organization does not maintain the full capital conservation buffer, it becomes subject to restrictions on the payment of dividends and on payments of discretionary bonuses to executive officers. These restrictions increase as the organization’s capital conservation buffer decreases, and if the organization does not maintain a capital conservation buffer of at least 1.25% of risk-weighted assets, it will be able to pay dividends of no more than 20% of its eligible retained income in dividends, subject to receiving a waiver of these restrictions from its regulators. Eligible retained income is defined as the organization’s net income for the previous four quarters, net of dividends and discretionary bonus payments to executive officers during that period.