Final Basel III capital rule will affect community banks

The final rules for the Basel III international capital accord, which will be phased in between the beginning of this year and 2019, include some relief for community banks. There are also some changes that affect the capital standards and reporting for community banks.

Proposals that would have changed residential mortgage exposures, the accumulated other comprehensive income (AOCI) filter, non-qualifying capital instruments, and tier 1 capital were scrapped, but a number of requirements have changed for community banks.

The major changes

Revised minimum capital requirements and adjustments to prompt corrective action (PCA) thresholds

Community banks must:

  • Meet higher minimum capital requirements
  • Meet a new common equity tier 1 capital requirement
  • Satisfy new criteria that instruments must meet in order to be considered common equity tier 1 capital, additional tier 1 capital, or tier 2 capital

The new minimum capital to risk weighted assets (RWA) requirements are a common equity tier 1 capital ratio of 4.5% and a tier 1 capital ratio of 6.0%, which is an increase from 4.0%, and a total capital ratio that remains at 8.0%. The minimum leverage ratio (tier 1 capital to total assets) is 4.0%.

Additional improvements to quality of regulatory capital

The new rule changes the definition of capital, including:

  • Stricter eligibility criteria for regulatory capital instruments that would disallow the inclusion of instruments such as TruPS in tier 1 capital going forward
  • New constraints on the inclusion of minority interests, mortgage-servicing assets (MSAs), deferred tax assets (DTAs), and certain investments in the capital of unconsolidated financial institutions

The new rule also requires that most regulatory capital deductions be made from common equity tier 1 capital.

Capital conservation buffer

To avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer of common equity tier 1 capital above its minimum risk-based capital requirements. This buffer is calculated relative to RWA. A banking organization with a buffer greater than 2.5% would not be subject to limits on capital distributions or discretionary bonus payments; one with a buffer of less than 2.5% percent would be subject to increasingly stringent limitations as the buffer approaches zero.

The new rule also disallows distributions or discretionary bonus payments during any quarter if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% at the beginning of the quarter.

When the new rule is fully phased in on January 1, 2019, the minimum capital requirements plus the capital conservation buffer will exceed the PCA well-capitalized thresholds.

Credit ratings

Because the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits using references to, and reliance on, external credit ratings in the regulations of federal agencies, the new rule replaces the current ratings-based approach with the simplified supervisory formula approach to determine the appropriate risk weights. As an alternative, banking organizations may use the existing gross-up approach to assign securitization exposures to a risk weight category or assign such exposures a 1,250% risk weight.

MSAs and DTAs

MSAs and DTAs are now subject to stricter limitations than those applicable under the current general risk-based capital rule. Certain DTAs arising from temporary differences, MSAs, and significant investments in the capital of unconsolidated financial institutions in the form of common stock are each subject to an individual limit of 10% of common equity tier 1 capital elements and an aggregate limit of 15% of common equity tier 1 capital elements.

Revised risk weights

The new rule increases the risk weights for past-due loans, certain commercial real estate loans, and some equity exposures, and makes selected other changes in risk weights and credit conversion factors.

For more information on this topic, or to learn how Baker Tilly banking specialists can help, contact our team.