‘Capital cushion’ rules give community banks options
While the recent adoption of new capital reserve and leverage guidelines for U.S. banks offered lenders a bit of regulatory clarity this month, North Bay bankers said time will tell how those rules play out amid the bevy of new regulations that followed the recent financial crisis.
Named for the international rulemaking summit for financial regulators in Basel, Switzerland, the so-called Basel III rules are the third iteration of an international regulatory framework designed to limit highly leveraged and otherwise risky practices by the world’s banks. The rules, approved on an interim basis by the Federal Reserve Board and other U.S. regulators this month, define the amount of capital that a bank must maintain as a cushion against losses.
Adopting Basel III was considered a major goal for lawmakers in the wake of the recent financial crises and seen as a way to rein in the risky lending practices that some argue pushed the U.S. financial system to the brink of collapse.
Yet as community banks saw themselves subject to some of the same requirements as what regulators call the largest “systematically significant” institutions, industry comment over the past year inspired a number of tweaks meant to limit the impact on those “small, noncomplex community banking organizations.”
Rules for small banks start in 2015
Bankers in the North Bay acknowledged the benefit of those provisions, which will begin phasing in for smaller institutions in 2015.
“For us, this is pretty good news,” said Greg Jahn, chief financial officer at Exchange Bank, of the impact of those revisions for community banks in general. The Santa Rosa-based lender reported $1.69 billion in assets as of June 30.
Yet Basel III is only the latest development in a regulatory landscape that continues to take shape after the worst of the recession, contributing to an evolutionary period for the regulatory environment that banks face throughout the country, bankers said.
The specifics of the Basel III rules involve provisions like the so-called “risk weight” applied to various bank assets. Riskier loans and investments carry greater “weight” and require more allocations towards minimum capital reserves. The rule also defines tiers of assets, cash or otherwise, that count in varying degrees toward the reserve.
Banks are required to maintain a reserve of the highest-quality equity capital equaling at least 4.5 percent of risk-weighted assets, along with a 2.5 percent “capital-conservation buffer.” Banks would be only able to leverage their capital until it accounts for at most 4 percent of their total assets, with higher requirements proposed for the largest banks.
The interim Basel III rules were first made available for comment in December 2010. The version that regulators adopted this month includes a list of provisions that were changed after an extended comment period.
‘Could be a big deal’
Among the altered provisions included in the adopted rule is the option for community banks to omit the impact of unrealized gains and losses on some available-for-sale investment securities from their supply of regulatory capital.
Mandating their inclusion in the calculation of regulatory capital stood to introduce a potentially large amount of volatility for the many banks that have beefed up their bond portfolios amid tepid loan demand. An expected rise in interest rates would dampen the value of older, lower-yielding bonds, thus reducing the bank’s capital cushion.
For an institution such as Exchange Bank, that rule could have caused capital to swing by $10 million or $20 million, Mr. Jahn said.
“That could be a big deal,” he said.
Exchange Bank had nearly $430 million in investment securities available for sale as of June 30, a volume commonly seen at banks of its size in the current period.
New risk ‘weight’ for home loans
Other changes in the final rule include a simplified calculation for the risk weight of residential mortgages, as well as an ability for bank holding companies with less than $15 billion in assets as of 2009 to continue counting the proceeds of so-called “trust-preferred securities” and similar instruments sold to investors as high-quality capital.
While those rules are of a benefit to many community banks, Mr. Jahn noted that Basel III was still only one element of a changing regulatory landscape. He lauded the effort by regulators to protect consumers, but also noted that the increased burden of precise compliance is being felt even by the most prudent of institutions.
“The fastest growing part of our bank in the past few years has probably been in compliance and risk management,” he said.
Banks of all sizes have long-anticipated the new rules, and about 90 percent of banks with less than $10 billion in assets already meet required ratios for equity capital compared to risk-weighted assets, according to the Federal Reserve.
“The movement for banks to retain capital has been underway for a long time, and for good reason,” said Tom Duryea, president and chief executive of Summit State Bank, which has $440 million in assets. “Capital is there to grow and absorb losses. We want these banks to be here in five years, in 10 years, and beyond.”
With the potential for banks’ return-on-equity ratios to decline as more capital is set aside for regulatory purposes, more attention could shift toward a bank’s return on average assets, Mr. Duyea said. It is a measurement that some have said has come to more closely define the value of a bank in the recent tumultuous economic period, reflecting its ability to generate continuing income based on its portfolio of loans and investments.
“Banks will have to focus much more on being efficient in their income statement,” Mr. Duryea said. That’s instead of further stretching their retained earnings and investor capital.
Investor reaction unclear
Among the questions in the community banking world is how investors will react to Basel III’s potential impact on financial statements, said Allen Christenson, chief financial officer of Santa Rosa’s AltaPacific Bank, which recently reported assets of $221 million.
“There are goods and bads with everything,” he said. “The more we can leverage our capital, traditionally, the more we can improve our earnings. If we have to keep more equity, how does the investment community take that? How will they take it if ROE goes down? That remains to be seen.”
Western Independent Bankers, a community bank trade group that works with state organizations throughout the western United States, has been working throughout the recent period to assist banks with their compliance efforts. The organization does not hold positions on regulations and other issues, but recently appointed president and CEO Ellen Sas said that her years as a bank executive provided a framework for considering the potential impact of those rules.
“While the intention may not be to impact community banks, it is very difficult to do that,” she said. “The reality is, because of the crisis, the regulators have already required a lot more capital.”
“Banks are spending a lot more on compliance,” she added. “As much as everyone has good intentions, there are often unintended consequences.”
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