United States

Basel III capital standard What it means for community banks


As community banks struggle to compete in a sluggish economy, along comes Basel III, an international proposal for new capital standards that would increase capital requirements on all insured depository institutions and bank and thrift holding companies with assets over $500 million. Adopted by the Federal Reserve on June 7, 2012, the proposed rules are open for public comment through Oct. 22, 2012. The final rules will be phased in from 2013-2019, according to the roll-out schedule recommended by the Basel Committee on Banking Supervision, with the first phase going into effect on Jan. 1 of next year in the U.S.

Basel III constitutes a fundamental redefinition of bank capital requirements. It adds a new capital component, common equity tier 1 capital, and increases the minimum Tier 1 capital ratio requirement. Banks would be required to set aside capital over and above what has been set aside in the past. If capital levels fall below minimum requirements, a new capital conservation buffer framework would limit payments of retained earnings through capital distributions or discretionary executive pay.

Who is affected?

Beginning in 2013, all insured depository institutions and bank and thrift holding companies with assets of or over $500 million will be subject to increased capital requirements. The proposals would apply to all banking organizations currently subject to the minimum capital requirements, including national banks, state member banks, state nonmember banks, state and federal savings associations, certain top-tier bank holding companies domiciled in the U.S. and top-tier U.S.-based savings and loan holding companies.

Basel III is designed to ensure a consistent standard for quality of capital. Although its definition of capital is largely the same for small and large banks, the method used to measure the risk weighting of assets varies. Banks will have to track 13 categories of deductions and adjustments to capital and changes to risk weighted assets on a quarterly basis. The capital conservation buffer is intended to encourage banks to hold enough capital to reduce the probability of capital levels falling below minimum requirements in times of financial stress.

General proposals

The proposed changes will do the following:

  • Revise the definition of capital to improve the ability of regulatory capital instruments to absorb losses
  • Provide a multi-year transition period for the proposed requirements (expected to be from 2013-2019)
  • Increase common equity capital requirements of 7 percent for common equity Tier 1 capital
  • Phase out Trust Preferred as Tier 1 for all bank holding companies
  • Establish higher capital requirements for high risk lending
  • Remove references to credit ratings

Revised capital ratios

When fully phased-in, Basel III capital ratio requirements will be as follows:

  • Tier 1 Leverage or Average Assets Ratio = 4 percent
  • Common Equity or Risk-Weighted Assets Ratio = 7 percent *
  • Tier 1 Leverage or Risk-Weighted Asset Ratio = 8.5 percent *
  • Total Capital or Risk-Weighted Assets Ratio = 10.5 percent *
  • Supplementary Leverage Ratio (Advanced Approach Investments Only) = 3 percent

*Includes the 2.5 percent capital conservation buffer

Banks will have to demonstrate compliance with the three minimum capital requirements plus the capital conservation buffer. The complexity of Basel III's capital rules, with thirteen deductions and adjustments to common equity and changes to risk weighting of assets, will affect the bank's ability to calculate, track and monitor ratios on a quarterly basis.

The costs of compliance

The timing of these proposed regulatory changes is, to put it mildly, not ideal for the community banking industry. It is occurring at a time when market conditions are lackluster, and full economic recovery has yet to be achieved. Many community banks are still grappling with anemic portfolios, a contracting deposit base and a decreasing revenue stream. Thus, at a time when many banks are still struggling, they are faced with the complex task of implementing new capital requirements. While some community banks are already in compliance with the new standards, others are not. For them, Basel III will force major revisions to capital plans and even require new sources of capital.

Some community banks could face significant compliance costs and administrative burdens. While larger community banks may be able to absorb these costs, small community banks with limited resources and expertise will have to hire additional resources to implement and monitor compliance going forward. The cost of complying with the new rules may put additional pressure on earnings, reduce net income and lead some community banks to seek out life preservers in the form of mergers or acquisitions.

The unintended consequences of Basel III

Implementing the new capital standards could have far-reaching effects on the health and viability of the community bank, with many unintended and possibly unforeseen consequences. Here are a few of those possible consequences:

  • Greater volatility of regulatory capital in a rising interest rate environment
  • Increase in tangible common equity as a percentage of Tier 1 capital raising the effective cost of regulatory capital
  • Reduced ability to leverage capital thereby reducing shareholder rates of return
  • Capital levels more directly tied to relative credit risk exposure
  • The possibility of deteriorating asset quality
  • Limits on dividends and discretionary executive bonus payouts if capital is not adequately conserved
  • Additional pressure on community banks to consolidate

Change is coming

The political momentum in Washington, D.C. is moving in the direction of stronger protections for consumers and the financial industry. This trend, which grew out of the financial crisis, appears unlikely to change course in the foreseeable future. Even if the Federal Reserve delays the start date for rolling out the Basel III rules, a major change to the nation's bank capital framework seems inevitable. Therefore, we recommend that community banks begin assessing the scope of their needs and begin implementing policies and practices that will demonstrate compliance with the proposed rules.

For more information

For more information on Basel III and what it will mean for individual community banks, please contact Sharon Griffin, director, McGladrey LLP, at 213.330.4728.