Community bankers won several concessions that were meant to cushion the blow of Basel III, but they have plenty left to worry about.
Higher capital ratios, risk weighting for certain assets and the potential impact on mergers and acquisitions are major concerns. And confusion exists over banks' opt-out from the requirement to deduct unrealized gains and losses from accumulated other comprehensive income, or AOCI. Only holding companies with assets of $500 million or less get a pass on Basel III.
American Banker held a webinar on Sept. 25 that focused on what small banks can do to prepare for Basel III, set to take effect in January 2015.
The panelists — Bob Bean, associate director of the capital markets branch of the Federal Deposit Insurance Corp.; Ron Farnsworth, chief financial officer at Umpqua Holdings (UMPQ) in Portland, Ore.; and Keith Fisher, a lawyer at Ballard Spahr —fielded questions from attendees.
Here is an edited except of their remarks.
What can community banks do to prepare for Basel III?
RON FARNSWORTH: I’d advise everybody to opt out [of the AOCI filter], given the volatility that’s possible out there from an interest-rate-risk standpoint.
You’re going to want to leave yourself some cushion above well capitalized levels [to account] for unknown and future balance sheet changes. We’re adding 150 basis points [of capital] as a cushion. . . . So our base-case capital policy floors are, in essence, well capitalized plus 150 basis points.
For an adverse scenario, we want to be well capitalized and, for a severely adverse scenario, we want to be adequately capitalized. The key is to project out all your capital ratios two years out and compare those projections to your policy floors. . . . You can also layer in the stress test scenarios.
The key is that you want to be proactive with Basel III. Chances are there are only a handful of items that will affect your capital levels. … At the end of the day, the goal should be to have no surprises.
Why did regulators make the AOCI election irreversible?
BOB BEAN: We’re always concerned the ability to arbitrage the risk-based capital framework. If you chose to disregard the filter when you had gains and then decided to apply the filter when you have losses, then you would have a situation where you could essentially game the framework.
Most banks said they liked the filter. They didn’t want it taken away. . . . but we had to put something in there to prevent the gaming of that process.
Banks could change course if they buy a bank that made the opposite election for AOCI, correct?
KEITH FISHER: I guess technically that’s correct. When you do a merger, to a certain degree you are free to choose the charter of the surviving institution. If you decided that you want to be in or out, and the two institutions are one of each, then you could pick the charter that has made the election that you want.
That seems to be the tail wagging the dog. I think there are a lot more serious and important concerns in an M&A transaction. ...But it certainly is an option.
Umpqua’s deal to buy Sterling Financial (STSA) will put it above $15 billion in assets. How does that tie into Basel III?
FARNSWORTH: Front and center, the single biggest impact is the trust preferred phasing from Tier 1 to Tier 2. We knew we were going to get to that point eventually, in terms of the asset size.
We’re already over $10 billion [in assets] in size so we’re already subject to Durbin in Dodd-Frank, stress testing and all the other fun that goes along with that. The next line in the sand was $15 billion and the treatment of the trust preferred.
I have viewed trust preferred as a kind of a bird in the hand — a low-cost form of Tier 2 capital compared to some higher cost for [subordinated] debt or other forms of Tier 2. I know that in 2015 I’ll get 25% of that combined Trups in Tier 1. In 2016 it will all phase out into Tier 2.
We took that into account when we did the modeling.
Bankers are also talking about high-velocity commercial real estate loans. What are those?
BEAN: It is a subset of your [residential lot] acquisition, development and construction lending. It is not really a permanent loan. It is a bridge facility in general, but it is not one that’s used for 1-4 family residential mortgages. … And it is also not going to include certain other important facilities.
It is not going to be used for community development or the purchase of agricultural land. And it won’t include any commercial projects that meet the supervisory loan-to-value ratio that’s been placed in the real estate lending standards. And certain good- to high-quality real estate projects would be excluded from that.
So it is not as expansive as a lot of people might fear.
Mutuals are really worried about the proposed capital levels. What capital-raising options do they have beyond a conversion or initial public offering?
BEAN: A lot of mutuals are going to make this framework [work] . . . because they’ve had good, steady earnings. This is an ongoing issue that I understand this is more pronounced for mutuals because the ratios are higher.
We’ve seen mutuals create an intermediate C Corporation between the mutual holding company and the mutual, dependent upon various state laws. We’ve seen instances where there is a capital issuance out of the intermediate holding company with the proceeds being downstreamed into the mutual institution.
When it comes to mutuals — this is a good opportunity to reiterate that, when there are gaps or issues, reach out to your regulator and discuss those gaps.
Risk weighting for residential mortgages was unchanged in Basel III. But what is the likelihood that regulators will revisit that in the future?
BEAN: During the Basel III rulemaking we looked at everything that was happening in mortgage reform. We’ve got a significant amount of rulemaking coming out from the CFPB. We’ve got issues coming out with respect to QRM and risk retention on mortgages. We’ve got a broader GSE reform process that is under way.
The agencies decided that there was going to be significant reform in the process. … That is going to occur over the next little while. Let’s not add to that mix. We’ll let those reform processes settle out and take a look in the future post-reform to see if there’s something [that should be addressed]. . . . That’s something we’ll do way down in the future.
FISHER: Congress might also get involved because this whole notion of mortgage lending and homeownership as a component of the increasingly ephemeral American dream is a politically charged issue. It is possible that Congress might want to put its two cents in if the agencies decided to make a significant change.