Disassembling the Basel III and Standardized Approach Capital NPRs
On June 7, 2012, U.S. banking regulators released three notices of proposed rulemaking (NPRs) on the Basel III-based risk-based capital (RBC) standard:
- Basel III Capital Standards – Deals with definitions of capital, capital requirements, and transitions.
- Standardized Approach – Deals with changes in risk weights and conversion factors for on- and off-balance sheet positions for smaller, less complex institutions (generally <$250 billion).
- Advanced Approach – Deals with changes in risk weights and risk asset methods for large banks.
Note that while this proposal doesn’t relate specifically to credit unions, based on what we’ve been hearing, it is likely that proposals for credit union regulations will follow a similar path.
This article will focus on the first two NPRs. The effects of these NPRs will vary significantly from institution to institution, but following are the changes that are likely to have the broadest effects on the industry:
Definitions of capital are changing, with some current forms of capital moving to a lower category and others disappearing entirely. In some cases, death is immediate, and in others, the slow lingering variety. For example, trust-preferred stock is phased out of Tier 1 and, in some cases, Tier 2. The phase out is much quicker for bigger banks (>$15 billion) than smaller banks. The effect is that some measures of capital will have smaller numerators.
- A new capital measure was introduced and a set of new standards along with it. Common equity capital, primarily made up of common stock and retained earnings, is fully phased in by January 1, 2015. If you don’t have much of that “old fashioned” capital, you may struggle with this measure!
- Accumulated other comprehensive income (AOCI) gains and losses are included in (netted against) common equity capital. The biggest AOCI component for most banks is unrecognized gains and losses on AFS securities. This change is phased in over five years.
- Requirements were raised on the Tier 1 RBC ratio, fully phased in by January 1, 2015.
- The three ratios with risk-based assets in the denominator (common equity, Tier 1, and total capital) are going to result in a bigger denominator for most shops because of changes to risk weights on risk-based assets. The regulators expect a minimum 20% increase in total risk assets across the industry. Risk asset changes become effective January 1, 2015. The areas in which you are most likely to see an increase are mortgage loans that are 90 days or more past due, high volatility commercial real estate Loans, and equity positions (fortunately not FHLBank stock).
- A capital conservation buffer is introduced and is phased in from January 1, 2016, through January 1, 2019. Institutions failing to maintain capital above the required buffer will suffer limits on dividends, stock repurchases or retirements, and discretionary management bonuses. This buffer is added to adequately capitalized minimums for the three ratios with risk assets in the denominator and hits its fully phased-in target of an additional 2.5% of risk assets in 2019. Because most shops wish to maintain a well-capitalized status, the adequately capitalized minimum plus the buffer isn’t a significant issue until the buffer breaks through the well-capitalized minimum by 0.5% in 2019.
Did I mention this proposed regulation is very complex with lots of moving parts? It is so complex that the only way I felt I could get my arms around it was by modeling it in Excel. So I built an annual model that runs from January 1, 2013, through January 1, 2019, and considers all the phase-ins. Then, I began to experiment with a case study institution, ABC Bank. This $120-million shop has a fairly typical balance sheet for a mortgage lender. Capital is made up of $6 million in common equity, other Tier 1 TARP funds equal to $3 million, a small amount of Tier 2 subordinated debt ($300,000), and Tier 2 ALLLs equal to 1.25% of risk assets ($700,000). The common equity is net of a $500,000 unrecognized loss—well short of the potential loss in a rising rate environment. Risk assets are 63% of total assets before the risk weight changes effective January 1, 2015, and 74% of total assets thereafter.
The proposed regulations also indicate the capital standards are minimums. Capital goals should be set sufficiently above regulatory minimums so that the risk in your balance sheet is covered and you remain well-capitalized after a stress event. ABC Bank set a capital ratio target range of 2 to 3% above the regulatory minimums for all four ratios.
Figure 1 below shows ABC Bank’s performance on the Tier 1 leverage ratio in the base case scenario, in which growth was assumed to be 7.5% per year. An ROA of 0.8% and a dividend payout percentage of 33% of income drove growth in retained earnings. It also assumes ABC Bank hopes to retire the $3 million in TARP effective January 1, 2017.
Lines on the chart show the regulatory “undercapitalized,” “adequately capitalized,” and “well-capitalized” minimums, as well as ABC Bank’s goal range. The bars on the chart project ABC Bank’s Tier 1 leverage ratio. In the first four-years, the Tier 1 leverage ratio falls comfortably within ABC Bank’s goal range. The TARP payoff in January 1, 2017, drops the ratio well below the goals and slightly above well-capitalized minimums.
Figure 1 – ABC Bank Tier 1 Leverage Ratio / Projections
Figure 2 shows the new requirement: common equity capital to risk assets. Note that the requirement is phased in over three years, hitting 4.5% for adequately capitalized and 6.5% for well-capitalized in January 1, 2015. However, that isn’t the end of the story. From January 1, 2016, through January 1, 2019, the capital conservation buffer is phased in, adding a 2.5% buffer to the 4.5% adequately capitalized minimum, a combined requirement of 7% by January 1, 2019. Fail to meet this buffer requirement, and you’ll see restrictions on your ability to pay dividends and discretionary management bonuses, and your ability to retire stock (like TARP).
Because TARP isn’t included in common equity capital, the decision to pay off TARP doesn’t affect this ratio. On the other hand, the change in risk weights on January 1, 2015, does—dropping common equity capital to risk assets to a bit above well-capitalized minimums and significantly below ABC Bank’s goals.
Figure 2 – ABC Bank Common Equity RBC Ratio / Projections
Figure 3 shows Tier 1 capital to risk-based assets. This requirement increases from the current requirement of 4% for adequately capitalized and 6% for well capitalized to 6% and 8%, respectively, phased in over a series of three years, to the new requirement by January 1, 2015. Note that the capital conservation buffer is added on top of this ratio beginning January 1, 2016, and hits its fully phased in level of 8.5% by January 1, 2019.
ABC Bank’s Tier 1 RBC ratio feels the effect of both the risk weight changes on January 1, 2015, and the TARP retirement on January 1, 2017. The combined effect is that ABC Bank falls below well-capitalized minimums in 2017, and remains below for the remainder of the forecast. Of course, they are also well below their capital goals.
Figure 3 – ABC Bank Tier 1 Capital to Risk-Based Assets / Projections
Figure 4 shows total capital to risk-based assets. While the minimum capital requirement for this ratio doesn’t change under the proposed regulations, some shops will see a reduction in the numerator of the ratio (capital that no longer qualifies), and an increase in the denominator (new risk-based assets effective January 1, 2015). What does change from the current regulation is the phase-in of the capital conservation buffer.
Note that the capital conservation buffer is added to all three capital ratios with risk assets in the denominator. So which of the three ratios do the regulators use in determining whether you have met your buffer requirements? The ratio in which you fare most poorly, of course!
For ABC Bank, the double effect of the risk-assets increase and the TARP retirement is felt in its total capital to risk-based assets ratio—which falls to barely above adequately capitalized minimums in the last three-years of the forecast. Note that with this ratio, the shortfall from the capital conservation buffer minimum is the greatest. Restrictions on dividends, discretionary management bonuses, and retirement of stock become increasingly severe the further you fall below the buffer minimums.
Figure 4 – ABC Bank Total Capital to Risk-Based Assets / Projections
Clearly, ABC Bank cannot afford to retire its TARP stock, unless it is willing to implement a significant shrinkage strategy.
Figure 5 shows the total capital to risk-based assets ratio without retiring the TARP funds. As you can see, the decision to retain TARP capital allows ABC Bank to barely meet well-capitalized and capital-conservation-buffer minimum requirements. However, the bank falls well short of its goals.
Figure 5 – ABC Bank Total Capital to Risk-Based Assets / Projections – Keeping TARP
Of course, the biggest blow to ABC Bank is the potential effect of the netting of AOCI losses against common equity capital. Assume that ABC Bank has a $36 million AFS portfolio (30% of assets), with a duration of three years. Assume rates increase in 2015 by 3%. The AOCI unrecognized loss would be $3.24 million! Figure 6 shows the increased AOCI’s effect on the common equity to risk-based assets ratio.
Figure 6 – ABC Bank Common Equity RBC Ratio / Projections with AOCI Losses
Figure 7 shows the effect on the total RBC ratio. ABC Bank falls below well-capitalized minimums and below their minimum buffers for the common equity and total RBC ratios. Similar damage would be done to the other two ratios as common equity capital is a part of both Tier 1 and Total Capital.
Figure 7 – ABC Bank Total Capital to Risk-Based Assets / Projections with AOCI Losses
Ladies and gentlemen, it is time to fire up Word and start writing comment letters.
Probably the most pressing issue is the proposal that AOCI losses are netted against common equity capital. This particular provision will be the most damaging to institutions with lower-than-desired loan/asset ratios, that reached out to the yield curve to get yield out of their investment portfolios, classifying those investments as AFS so they can be converted to cash to meet loan demand or liquidity needs. The fact that the regulation proposes implementation at the depths of the rate cycle increases the likelihood that rising rates will bury your AFS portfolio, taking your capital ratios with it. You probably match-funded these assets with CDs or non-maturity deposits, but that doesn’t matter–you pay the price on the asset side anyway.
- If you look at the above charts, you will also see that the change in risk weights has the potential to hit hard any ratio with risk assets in the denominator, beginning January 1, 2015. Keep in mind, ABC Bank’s jump in risk assets is less than the 20% regulators are predicting across the industry. Institutions with large mortgage portfolios, significant non-performing loan problems, or significant activities in high volatility commercial real estate Loans will probably be hit the hardest. The new common equity RBC ratio and the increase in the Tier 1 RBC ratio are also fully phased in on January 1, 2015. In your shoes, I’d be asking that the risk weight changes be phased in more gradually, so you don’t find yourself in the January 1, 2015, perfect storm.
- The disappearance of some forms of capital may be very hard on institutions with significant trust-preferred securities positions and other forms of non-traditional capital. Those of you to whom this applies may want to raise your voice on this issue. Also, unless you qualify for small bank holding company status (<$500 million), you need to realize that this regulation applies to both the bank and its holding company. Depending on your structure, your bank could be just fine, while the holding company is in deep trouble!
- This regulation is going to require massive call report changes, asking for data that may not be produced by your core systems. For example, can you segregate consumer mortgages between Type 1 (generally well-underwritten first liens) and Type 2 (not well-underwritten, junior-liens without the first-lien position, mortgages 90 days or more past due), then by LTV ranges for each type? Probably not very easily. Can you put the words “regulatory burden” on paper? Maybe smaller shops should be exempted from the risk weight changes.
The comment period is there for you to voice your concerns.
Thomas A. Farin is President and Chief Executive Officer of FARIN & Associates.
Mr. Farin is a widely known banking industry lecturer and consultant. He has delivered national educational programs for the American Bankers Association and the Credit Union National Association. He serves on the faculty of the Graduate School of Banking at the University of Wisconsin and has served as faculty of the CUNA Management School in Madison WI. Mr. Farin has also been a featured speaker at a number of regional programs sponsored by state and regional trade associations.