Bank Board Letter — January 2014
Sanford Brown, Justin Long, Joshua McNulty

The Basel Committee on Banking Supervision announced the proposed international reforms of the Third Basel Accord in 2010. On July 2, 2013, the Federal Reserve Board approved final rules that implemented the Basel III regulatory capital reforms and requirements of the Dodd-Frank Act, and within a week the FDIC and the Office of the Comptroller of the Currency followed suit. Although they do not seem to be as onerous as those imposed on the largest financial institutions operating in the United States, the new rules do impose significant changes to the regulatory capital framework for community banks.

In general, the regulatory agencies adopted rules that install higher minimum capital requirements, institute a new minimum capital requirement and establish criteria that instruments must meet in order to be considered common equity Tier 1 capital, additional Tier 1 capital or Tier 2 capital. In addition to increasing the minimum regulatory capital ratios, the new rules increase the risk weights for certain assets such as past-due loans, certain commercial real estate loans and some equity exposures.

Beginning Jan. 1, 2015, the minimum Tier 1 capital ratio will increase from 4 percent to 6 percent, the minimum leverage ratio will be 4 percent for all institutions, and there will be a new minimum common equity Tier 1 capital ratio of 4.5 percent. In order to be well capitalized under the new rule, a community bank must have a common equity Tier 1 capital ratio, Tier 1 capital ratio and total capital ratio of greater than or equal to 6.5 percent, 8 percent and 10 percent, respectively. The increases should not be an area of significant concern for a great majority of community banks. According to the Federal Reserve, “nine out of 10 financial institutions with less than $10 billion in assets would meet the common equity Tier 1 minimum plus buffer of 7 percent in the final rule.” The FDIC believes that 95 percent of all insured depository institutions would be in compliance with the minimums and buffers if the new rules were effective immediately.

The new rules do include material changes to the capital criteria. The implementation of stricter eligibility criteria for regulatory capital will prohibit the inclusion of financial instruments such as trust-preferred securities in Tier 1 capital going forward; however, the banking agencies did show some restraint by revising or striking certain overly burdensome and unnecessary provisions of the previous proposals.

For example, one area of particular importance to community banking organizations is the treatment of TRuPs that are already on the books of community banking organizations. The treatment of TRuPs under the previous proposals would have been extremely detrimental to community banking organizations. Community bankers across the country voiced their concerns and opposition to the new treatment. In an effort to ease the burden on community banking organizations, the agencies provided exemptions for smaller organizations.

Under the new scheme, bank holding companies with less than $15 billion in total consolidated assets as of Dec. 31, 2009, may continue to classify TRuPs that were issued prior to May 19, 2010, as Tier 1 capital. The grandfathered TRuPs may only account for up to 25 percent of the bank holding companies’ Tier 1 capital. This is particularly important for community banking organizations that have limited access to additional capital, and should be seen as a victory for community banks.

(EDITOR’S NOTE: This article was written before federal regulators issued the long-awaited Volcker Rule on Dec. 10, 2013, which may require community banks to write down their holdings of collateralized debt obligations backed by trustpreferred securities. Following objections from trade groups, the regulators said they would consider whether it is appropriate and consistent with the provisions of the Dodd-Frank Act not to subject pooled investment vehicles for TRuPS, such as collateralized debt obligations backed by TRuPS, to the prohibitions on ownership of covered funds in section 619 of the Dodd- Frank Act, and promised to address the matter by Jan. 15.)

The proposals relating to residential mortgage exposures were also noticeably absent from the new rules. Accordingly, treatment of one-to-four-family residential mortgage exposures remains the same as under the current general risk-based capital rule. This means that prudently underwritten first-lien mortgage loans that are not past due, reported as non-accrual or restructured will receive a 50 percent risk weight, while all other residential mortgages will default to a 100 percent risk weight. This prevents community banks from having to reclassify much of their mortgage loan portfolios, which could have caused many banks to reduce their regulatory capital levels.

Another concern was the requirement that all banking organizations must include available for sale securities in their common equity Tier 1 capital. The conveyance of those concerns by community banks caused regulators to rethink the proposals. In the new rules, community banks will not have to adjust capital levels due to the fluctuations in the current market value of the available for sale securities on their balance sheets. This should help those banks avoid unsafe and unnecessary volatility in capital adequacy.

Additionally, community banks are given a one-time opportunity to opt out of the filter of accumulated other comprehensive income. The AOCI opt-out election must be made on the institution’s first call report, FR Y-9C, or FR Y-9SP, as applicable, filed after Jan. 1, 2015.

In addition to creating the common equity Tier 1 capital minimum, beginning in 2016, banking organizations will be required to hold a capital conservation buffer. The buffer will be the amount of an institutions’ common equity Tier 1 capital above its minimum risk-based capital requirements. This will prevent many institutions from issuing dividend payments or certain discretionary bonus payments to executive officers.

The institutions holding a buffer greater than 2.5 percent will not be restricted from issuing capital distributions. On the other hand, institutions that do not meet the 2.5 percent minimum will face ever-increasing limits on distributions as the capital conservation buffer approaches zero. Community banks will not be subject to the capital conservation buffer requirements until Jan. 1, 2016; however, once they are fully implemented, the minimum capital requirements plus the capital conservation buffer will exceed the current well capitalized minimum.

Only time will tell whether the new rules will produce more-appropriate capital requirements that in turn lead to a stronger banking system. In the meantime, community banks must do what may be the hardest aspect of complying with the new rules implementing Basel III — take the time to analyze and understand the new rules and commit the resources necessary to ensure they are in compliance with the increased regulations on Jan. 1, 2015.

Sanford Brown, a partner with Bracewell & Giuliani, LLP and can be reached at Justin Long, a partner in Bracewell & Giuliani’s financial institutions section, can be reached at Joshua McNulty is an attorney with Bracewell & Giuliani and can be reached at