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.

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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GBA identifies over a dozen categories of key flaws in the proposed rules and concludes that the proposals should be withdrawn for further study or, at the very least, should be modified to exempt community and regional banks from their requirements.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.

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Many bankers are spending their evenings attempting to work through the very dense and long Joint Notices of Proposed Rulemakings that together propose new capital standards for financial institutions.  Even though the proposed Basel III rules would not become effective until January 1, 2013 and the proposed risk-weighting rules would not become effective until January 1, 2015, bankers need to begin to understand how these rules will affect their capital planning now.  While the regulatory agencies are busily assuring bankers that the vast majority of financial institutions would have been in compliance if the proposed rules had been effective on March 31, 2012, the rules, as proposed, will certainly change how many financial institutions approach their capital planning and asset mixes.

One facet of the rule that may impact many community banks and their borrowers is the proposed risk-weighting of certain commercial real estate (CRE) loans.  While acquisition, development, and construction (ADC) lending has certainly fallen out of favor with regulators and bankers in recent years, many bank boards realize that a part of their long-term success will be a re-entry into this market.  Many lenders are very experienced in underwriting ADC loans and have deep relationships with successful real estate developers.  While bank boards are more cautious with respect to ADC and CRE lending concentrations, continuing to engage in lending activities that have provided good returns over the long-term still makes sense.

The Notice of Proposed Rulemaking entitled “Regulatory Capital Rules—Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements” will apply to all banking organizations other than bank holding companies with less than $500 million in total consolidated assets.  As a part of the new risk-weighting rules, certain higher risk CRE loans will carry a 150% risk-weighting, as opposed to the standard 100% risk-weighting.  Those higher risk loans are proposed to be defined as a credit facility that finances or has financed the acquisition, development, or construction of real property, unless the facility finances:

(1)    one- to four-family residential property; or

(2)    commercial real estate projects in which:

i.    the LTV ratio is less than or equal to the applicable maximum LTV ratio in the agencies’ real estate lending standards (generally 65 to 80%);
ii.    the borrower has contributed capital in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15% of the real estate’s appraised “as completed” value; and
iii.    the borrower contributed the amount of capital required under 2(ii) before the bank advances funds and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project (i.e., when permanent financing is obtained).

The proposed rule defines those ADC loans not meeting the criteria above as High Volatility Commercial Real Estate (HVCRE) loans.

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Congress Passes Tax Package

On Monday, the Senate passed the $858 billion tax package sending the bill back to the House where it passed late Thursday night. The bill now heads to President Obama’s desk for his signature into law. While the package does not include a repeal of the Form 1099 health care requirement or extension of the Buy American Bond program, the bill does the following major items:

• extends through 2012 the current individual income tax brackets, capital gains and dividends rates for all taxpayers;
• increases the AMT exemption amounts for 2010 to $47,450 (individuals) and $72,450 (married filing jointly) and for 2011 to $48,450 (individuals) and $74,450 (married filing jointly);
• extends through 2011 the ability to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction permitted for state and local income taxes;
• exempts from taxation the first $10 million of a couple’s estate and the first $5 million of an individual’s estate, with the remaining portion taxed at the 35 percent rate;
• extends and temporarily increases the bonus depreciation provision for investments in new business equipment;
• reduces the payroll/self-employment tax during 2011 to 4.2 percent on wage-earners and to 10.4 percent on self-employment income up to the threshold;
• reinstates through 2011 the research and development credit;
• extends the 100 percent exclusion of the gain from the sale of qualifying small business stock that is acquired before January 1, 2012 and held for more than five years;
• extends through 2011 the special 15-year cost recovery period for certain leasehold improvements, restaurant buildings and improvements, and retail improvements;
• extends through 2011 the $0.50 per gallon alternative fuel credit and credit for energy-efficient improvements to existing homes.

Fed Proposes New Interchange Fees

On Thursday, the Federal Reserve announced a set of new debit-card fee restrictions more aggressive than most industry experts expected. The new restrictions, most of which will not be made final until April 21, are designed to restrict the fees that debit-card issuers can charge merchants. Banks would face a seven-to-12-cent-per-transaction cap on the interchange fees under either of the two proposals unveiled Thursday. Under the first plan, card-issuing banks could use a formula to determine the maximum amount of the interchange fee that it would collect, based on certain processing costs and would set a “safe harbor” standard at seven cents per transaction. The second alternative would set the cap at 12 cents without any safe harbor. Under the Fed’s proposal, the Fed Board would re-evaluate the cap every two years.

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