The proposed application of Basel III to U.S. community banks is a travesty.

Such application by regulators and lawmakers can be explained, at best, as an insufficient understanding of America's truly unique community banking system.  At worst, the implementation of Basel III could have the unintended consequence of destroying many local banks in the U.S.

As a result, community banks and their associations are breathing a sigh of relief at the recent delay in implementing Basel III. Bankers, however, should use the time to prepare for when it does take effect as Basel III is inevitable. 

The genesis of Basel III was to provide uniformity, specificity and focus, primarily in situations akin to Europe, where a few large banks dominate each country. It was also a tacit acknowledgment that stress-testing methodologies applied by different national regulatory bodies were too subjective to individual country's priorities.

The core principles of Basel III are sound.  All economies need a safe, sustainable banking sector, and clearly identified areas of bank vulnerability need to be addressed.  These principles are best articulated by the Federal Reserve's Comprehensive Capital Analysis and Review of the 19 "too big to fail" banks. CCAR defined capital adequacy in the new banking environment as the amount of regulatory capital necessary under a severely adverse economic scenario. Given the abject failure of Basel I and II in the recession of 2008, it is difficult to argue against this new concept of capital adequacy.  Any forthcoming regulations are likely to rely on aspects of Basel III.

Unfortunately most of the objections by community banks to Basel III have been focused on the specific rules and formulas that directly impact individual bank situations.  Such arguments, however, are doomed to failure. Practically every single individual rule or formula within Basel III can be defended by regulators within the context of ensuring capital adequacy – and survival – in the face of a "black swan" event. 

Community banks are smaller with less complex portfolios than their larger counterparts. Their markets are local and cannot fit into a national straitjacket.  As such, the attack that community banks need to make must be against Basel III's criteria and formula as a check-box exercise

  • Basel III applies rules generated for homogeneous markets to non-homogeneous entities. Community banks operate in a micro-economy that defines the nature, funding needs and creditworthiness of their customer base. Rules based on macro-homogeneous data  – national statistics – have no relevance to these unique and diverse community banking markets.
  • Basel III ignores community banks' counterbalancing strengths and weaknesses.  Basel III disregards community banks' portfolio composition, loan structures and client creditworthiness which can offset each other. Instead, Basel III focuses on cumulatively penalizing potential weaknesses. This simplicity and disregard of different factors adds to Basel III's inappropriateness.
  • Basel III is biased by the investment banking approach of product standardization. That approach assumes loans of a certain type are relatively homogenous. This helps large banks securitize and sell asset-backed instruments nationwide. Totally ignored is the traditional credit analysis employed by community bankers, built around years of lending experience and market knowledge. This enables these banks to structure financings unique to their local economies.

Community banks need to recognize that all the ratios in the concentration and liquidity criteria in Basel III are designed to shore up areas of vulnerability in a severely adverse stress scenario. To prove and defend their capital adequacy, community banks must fight fire with fire. They must focus on linking the results of stress testing to the core principles that underlie Basel III's stand-alone ratios.
The fact is that a limited geographical footprint greatly facilitates the ease of community banks to prove themselves through stress testing. That they have smaller portfolios, limited loan categories and understand their market substantially increases the power of their stress testing results in dealing with regulatory authorities, minimizing regulatory capital requirements, enhancing their competitive position and maximizing shareholder returns. The big banks will all have the opportunity to use stress tests to counteract some of the rigid rules and ratios inherent to Basel III – community banks should follow suit.

Thus, community banks should be strongly advocating – and regulators and lawmakers should be offering -- the use of stress testing to counteract the direct application of Basel III, and avoid seemingly simple solutions.

To argue for elimination of Basel III without addressing an alternative could easily lead community banks from the frying pan into the fire.  One alternative under discussion comes from Federal Deposit Insurance Corp. director Thomas Hoenig. Asked what he thought the minimum leverage ratio should be for banks in lieu of Basel III, he said 10%.  That would kill many community banks as well.  By implementing a regular stress testing process, community banks can seize the initiative.

Kamal Mustafa is chairman and CEO of Invictus Consulting Group LLC, a bank analytic and consulting firm. He is the former head of global mergers and acquisitions for Citibank. Malcolm Clark is managing director of technology and product development at Invictus. He has more than 25 years of experience in financial markets and technology, primarily with Morgan Stanley and Credit Suisse.