The proposed Basel III regulations have caused mutual banks in the United States to ponder the implications for their long term competiveness.
Basel III would increase the common equity Tier 1 capital requirement to be considered "well capitalized" to 6.5%. It would create fluctuating risk weighting based on volatile market indices, and it would impose a more strict definition of common equity tier 1 capital, or "CET1."
Unlike large publicly traded stock banks, mutual banks have no ability to augment capital other than through retained earnings or sacrificing their mutuality for conversion to stock, a dubious alternative in today's environment. CET 1 is defined as common equity that meets a restrictive laundry list of qualifications such as non-cumulative dividends, no maturity date and discretionary repurchases subject to regulatory approval.
Mutuals generally enjoy much higher capital ratios than stock companies. However, they are not able to raise their capital ratios through an external injection of capital in anticipation of higher capital requirements. Whether caused by growth or investment in riskier, higher-yielding assets, as capital requirements rise, mutuals may seek a larger margin or comfort zone between regulatory well capitalized status and their actual capital.
Luckily, the British building societies (which are similar to U.S. thrifts) are leading the way for mutual banks to fashion a CET 1 capital instrument.
The societies have historically relied on an instrument termed "permanent interest bearing shares" for Tier 1 capital under Basel II. PIBS are a hybrid instrument – not a bond and not capital stock. They are junior to all savings accounts as well as all debt, ranking on liquidation at the lowest level, similar to common stock. As their name implies, they are permanent, with no maturity date, although they carry a stated call date which is optional for the issuer. Typically, in practice the issuer would honor the call date, funding the redemption of the PIBS with a subsequent issue. PIBS also carry interest which can be reduced in the event the issuing bank becomes troubled. Notwithstanding their permanent maturity and the other features which posed relatively high risk to investors in the PIBS, these securities are listed on the London Stock Exchange and traded regularly.
PIBS would of course be a very attractive means to raise capital for U.S. mutual banks but the feature of paying a fixed coupon disqualifies them as CET1 capital under Basel III.
The proposal in Britain which has emerged from the need to find an alternative to the PIBS is for the issuance of "core capital deferred shares." Last May, Nationwide Building Society pioneered the way, obtaining the approval in principle from Britain's Financial Services Authority of the CCDS as a CET 1 instrument.
The terms of the CCDS differ in a number of ways from the PIBS. With CCDS there are no fixed coupons but discretionary payments which are linked to earnings levels. However, a bank could make payments similar to dividends at a rate commensurate with its earnings in good years, offering investors an attractive expectation. Unlike the PIBS, the CCDS has no stated call date.
Nationwide has said it will use the authority to issue these instruments as a backup, as it already enjoys a high capital ratio of 12.5%, similar to what you'll find among mutual in the U.S. The CCDS are not insured by the Financial Services Compensation Scheme, the U.K.'s equivalent of our FDIC.
Most importantly, what is different in Britain than in the U.S. is that investors and brokers have already accepted the high yields on PIBS as attractive investments. This has sustained their marketability even though investors have sustained losses on PIBS issued by a few troubled building societies.
The precedent of an active market for PIBS has caused Nationwide (presumably on the advice of its investment bankers) to believe that there will be similar interest in the CCDS. Already, investment articles are appearing which have cautioned as to their risks but seem to suggest CCDS's issued by Britain's strongest building societies are attractive.
What is needed is a more proactive attitude by U.S. regulators in customizing CET1 capital instruments for mutuals and greater interest by U.S. underwriters who specialize in bank securities. Now that the conversion market has practically dried up compared to precrisis levels, underwriters will presumably be searching for new fee opportunities.
There is no reason why a marketable instrument which protects the interests of the FDIC cannot be designed for mutual banks. It is inconsistent with Congressional intent, and with statutory provisions governing the makeup of capital in mutuals, to treat them as the proverbial square pegs to be pounded into the round holes of a capital construct designed for publicly traded common stock banks.
Douglas Faucette is a partner in the Washington office of Locke Lord Bissell & Liddell LLP. He heads the firm's banking and transactional group and is counsel to the trade group America's Mutual Banks.