New U.S. capital framework may prove burdensome for small banks

By Guest Contributor
June 25, 2012

By Bora Yagiz

NEW YORK, June 25 (Thomson Reuters Accelus) - As part of an effort to bring the United States in line with the international standards of Basel III, the Federal Reserve Board, the Office of the Comptroller of Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC), on June 8, 2012, jointly proposed three rules dubbed together as the integrated regulatory capital framework.

Two of these rules, namely the proposal on Basel III, and the proposal on Standardized Approach (the approach used by small banks) would modify standards for risk-weighted assets calculation, set new minimum capital requirements and refine capital quality through various eligibility restrictions for all banks, savings associations, bank holding companies (BHC) with greater than $500 million of assets, and all savings and loan holding companies (SLHC).

The rules were intended for and long-anticipated by large banks, which had been gearing up for the last two years. But they come as a “wake-up call” for small banks, said Karen Shaw Petrou, Managing Director of Federal Financial Analytics put it. And they may carry onerous implications for them.

“They get the gain, we get the pain” said Rusty Cloutier, CEO of MidSouth Bank, implying that small banks are being unfairly lumped with large banks for capital considerations, and suffer more as a consequence.

For a start, banks will have to make adjustments to their capital ratio calculations by either increasing their capital (i.e., the numerator) or lowering their asset size (i.e., the denominator), or a combination of both.

This sounds straightforward enough, and it has been for most of the large banks, as they have beefed up their capital levels since 2008. Indeed, the 19 bank holding companies that had participated in the Supervisory Capital Assessment Program (SCAP) increased their common equity by more than $300 billion and brought their Tier I common ratio from 5.4 percent in the 4th quarter of 2008 to 9.4 percent by 4th quarter of 2010, even as Basel III was taking shape. The Comprehensive Capital Analysis and Review (CCAR), conducted in March 2012, has further enhanced big banks’ preparation for the new capital regime by evaluating their capital planning processes in place.

Beyond the radar of Basel III’s more stringent capital considerations until recently, small banks will now find themselves scrambling for funds. Deprived of similarly relative easy access to markets available to bigger banks, it is questionable as to how many options they have in their toolkits. Indeed, when asked about these options, Stefan Walter, a Principal at Ernst & Young and a former Basel secretary-general, said they would have to dip into their retained earnings. Earnings may prove to be difficult to rely on as there has been only a modest loan growth (largely due to competitive pricing and decline in loan delinquencies) according to the latest Beige book of the Federal Reserve Bank. Put simply, small banks may be up against the wall. 

Worries of small banks, however, do not stop there. The calculation of risk-weighted assets is likely to cause headache, particularly for those with loan portfolios with heavy concentration in commercial or residential real estate, traditionally areas of specialization for small banks.

While Basel III is not the first accord to introduce higher than 100 percent risk weightings for capital calculation purposes (Basel II had put in place a 150 percent weighting for borrowers with relatively low credit ratings), it does provide more granularity on different types of loans. Importantly, residential mortgages will no longer carry a uniform 50 percent risk-weighting across the board, but will instead be subjected to a range of 35 percent to 200 percent risk-weighting based on their specific loan-to-value ratios and underwriting criteria. Faced with such heavy burden of capital, banks’ earnings may suffer as a result of a potential withdrawal from their core areas of lending.

Further complications will also arise regarding the quality of capital small banks will be allowed to carry in their books, specifically with regards to the Tier I portion. This is most pronounced in the area of Trust preferred securities (Trups), which are debt-like equity instruments that were permissible as Tier I capital but will no longer be considered as such under Basel III.

Here again, unlike their large counterparts which will have recalled almost all of their Trups by the end of 2012 (and were able to replace them with equity from the market), regional and community banks that pooled such instruments into collateralized debt obligations (CDOs) to the tune of $50 billion from 2000 to 2008, will not find it easy to discard them. Indeed, they have been unwilling to redeem them at a deep discount ever since the sudden collapse of the CDO market in the subprime crisis. And they would hate to do just that now.

To be sure, the Dodd-Frank Act Section 171, also known as the Collins Amendment, allows these instruments to be phased out over three years starting in 2013 for bank holding companies with $15 billion or more of assets. But even here confusion arises with regards to banking entities with less than $15 billion: the amendment previously allowed grandfathering of Trups issued before May 19, 2010, therefore guaranteeing their indefinite inclusion in the books, but the new proposals stipulate a phase-out of such non-qualifying capital instruments within 10-years.

Unless changed from their current form, the proposals could, therefore, instigate a drastic reduction in lending of small banks (hence their asset size), potentially furthered by a consolidation in the industry through a flurry of merger and acquisitions.

Regional and community bankers are simmering with anger in reaction to the proposed rules. “It’s no level playing field” said Frank Sorrentino, the CEO of North Jersey Community Bank. He added that the changes “make it more difficult and not easier” for small banks that have limited options in raising capital in extending loans at a time when small businesses need them most.

Not everyone sees the rules as part of the wider framework of Basel III. “I don’t see it as anything out of Basel. I see it as a result of the crisis. Regulators are really looking at risk management and internal controls. This is based on traditional supervision processes rather than anything coming out of Basel”, said Nicholas Ketcha, Director at FinPro, a bank consultancy, and a former Director of Supervision at FDIC.

Be that as it may, with grim growth prospects, restricted market access, and further curtailments on Tier I capital instruments, small banks are bound to buckle up for 2013.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=” ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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In other words, large banks got Basel III drafted to put their small fry competition out of business, and the fads are playing along. Remember though, that what’s great for governments and lucrative for big banks is usually bad for the rest of us.

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