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How Basel III Capital Requirements Hurt Community Banks

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Despite the prevalent cliché, pouring salt on a wound can actually help to heal a cut. If done correctly, the sacrifice is likely worth the result. For community banks, the financial crisis has been very painful and the healing process slow. However, evidence suggests that banks are, in fact, healing.

While many banks have been closed, and many more remain in a critical state, the overall community banking sector is improving. According to data from the Federal Deposit Insurance Corp., the number of unprofitable banking institutions has dropped from 28% of the total in 2009 to 11% in 2012. The number of banks whose earnings increased rose from 35% to 68%. The number of problem loans in the banking system has dropped by 26% since 2010. And most importantly, total capital is up nearly 10% since its low in 2009.

Despite improving performance ratios, Basel III has incorporated capital standards for community banks in order to ensure effective longer-term risk management practices among all financial institutions. The fear is that an increase in capital requirements will hamper community banks' ability to leverage equity and therefore risk diminishing shareholder returns.

For most community banks, regardless of how well-capitalized they are, an increase in capital requirements reduces earnings, minimizes returns and contributes to a stagnant environment where loan production is at a minimum and bank acquisitions are very few.

Today, in order for regulators to view a community bank as adequately capitalized, the bank must show that their Tier I risk-based capital ratio is greater than 4%. This number is affected a great deal by the makeup of the bank's assets. For example, a local bank in a small community has $100 million in assets. As part of the fabric of the small community, the bank has a large loan portfolio that consists of commercial real estate, land and development and some residential loans. Due to the deterioration in the economy, examiners require that the bank place a risk-weighting of 90% on assets. Therefore, the ratio must be figured on 90% of the bank's assets, or $90 million. In order for the bank to maintain regulatory compliance, it will need $3.6 million in Tier 1 capital (4% of $90 million).

The new Basel III requirements will force the bank to increase the Tier 1 Capital Ratio to 6% by January, 2015. This is significant for two reasons. First, the community bank in the above example must now maintain $5.4 million in Tier 1 capital (6% of $90 million). In a bank with $100 million of total assets, that $1.8 million increase in Tier 1 capital is felt in several ways, both by the bank itself and by the community it serves: The increase in Tier 1 capital will force the bank to invest in lower-yielding instruments, thus having a tremendous impact on future earnings. Further, it restricts lending in the community and further hurts local economic conditions.

Currently, a bank that is not well-capitalized cannot lend at a level necessary to improve earnings. In order for the bank to expand, additional capital or an acquisition partner must be found. As a result of Basel III, the value of the bank will be reduced a great deal, as any capital invested is greatly affected by the new capital requirement.

The Organization for Economic Cooperation and Development concluded that the medium term impact of Basel III could be a decline in U.S. GDP in the range of 0.05% to 0.15% per year as a result of banks having to increase their lending spreads by roughly 15 basis points in order to offset the costs associated with the requirements. By 2019, when Basel III is fully implemented, the increase in spreads will be near 50 basis points. However, this report fails to identify the impact of fewer loans and the stagnancy that remains in the lending and banking environment.

Basel III's impact is already being felt. However, the greatest impact will be in early 2015. In the meantime, it is critical that community banks focus on creating efficiencies and reducing exposure within their respective loan portfolios in order to minimize any future negative effects of the new capital requirements.

Banks have no doubt felt the pain associated with pouring salt on the wound. Only time will tell whether it will ultimately lead to the necessary healing.

Shea Dittrich is a director for the financial institutions group at Sageworks, a provider of risk management software.

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Comments (5)
The B3 proposed implementing rules for the standardized approaches are a bad fit for community banks. In fact, I am hard pressed to find any U.S. banks for which they are a good fit. The one-size-fits-all structure of the standardized approaches don't fit any bank. They are far more complicated than they need to be, and punitive for way too many aspects of the U.S. economy, without producing offsetting improvements to safety and soundness. They need to be withdrawn and reworked to take into account the many problems that are being raised, and only reproposed in a form that will truly enhance safety and soundness and strengthen not weaken an already weak economy.
Posted by WayneAbernathy | Wednesday, September 26 2012 at 2:52PM ET
It not only hurts community banks. It hurts all banks.
Posted by neall12 | Wednesday, September 26 2012 at 2:57PM ET
American is fast becoming non competitive in the global market place. Banks are already being crushed by the cost of new regulations. The quickest way to be sure that banking can't lend to help the economy recover is to implement Basel III. Please withdraw and take another look. Given the opportunity banks will help in the process.
Posted by Moneychanger | Wednesday, September 26 2012 at 3:25PM ET
There is no logic including community banks at all. B3 is and was intented to protect the financial systems from SYSTEMIC RISK. There are not one community bank that can even begin to threaten our system. If you look at the other participants in B3 they don't even have a community banking system. What has taken place is our multi regulators attempting to have another sword to poke at our nations smaller banks. The only explanation I can think of is because they CAN and it will give them more comfort, power an authority but forgetting that it would offer not one iota of national or international protection to the financial systems. If the Obama people want to create jobs and improve the economy they will put a stop to this absurdity.
Posted by Rhsmith999 | Wednesday, September 26 2012 at 3:31PM ET
Shea makes several good points and reinforces Thomas Hoenig's recent comments. Basel has a long, irregular history of unintended consequences starting with favorable risk-weighting for residential mortgages and OECD sovereign debt. This promoted heightened resi lending among US banks and heavy sovereign debt concentrations among Euro banks. We're living with the results.
Posted by bolasov | Thursday, September 27 2012 at 9:43AM ET
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