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Community Banks Should Prepare for New Regulatory Capital Rules
Beginning January 1, 2015, all community banks must implement revised regulatory capital rules that incorporate the Basel III framework. The new rules increase minimum capital requirements and establish a new capital conservation buffer, which could limit the ability of some banks to pay dividends and bonuses. Though most banks are expected to remain well capitalized under the new requirements, community banks should familiarize themselves with the new rules and prepare for them prior to the year-end.
Overview of new capital requirements
The Basel III framework requires banks to hold additional capital in proportion to the level of risk in their portfolios and places additional emphasis on core capital in the form of common stock and retained earnings. This is accomplished under the new rules by dividing Tier 1 capital into two components, Common Equity Tier 1 (CET1) Capital and Additional Tier 1 Capital, and through the establishment of the new Common Equity Tier 1 Risk-Based Capital ratio.
In order to remain well capitalized under the revised prompt corrective action requirements, banks will need to meet the following capital ratios:
|Current Rules||New Rules|
|Total Risk-Based Capital||10%||10%|
|Tier 1 Risk-Based Capital||6%||8%|
|Common Equity Tier 1 Risk-Based Capital||N/A||6.5%|
|Tier 1 Leverage Capital||5%||5%|
In addition, dividends and discretionary bonuses are limited if banks fail to maintain a buffer above the minimum required capital ratios. This buffer is phased in over the next five years as follows.
|Phase-In Required Percentage||N/A||.625%||1.25%||1.875%||2.5%|
|Total Risk-Based Capital Ratio With Buffer||N/A||8.625%||9.25%||9.875%||10.5%|
|Tier 1 Risk-Based Capital Ratio With Buffer||N/A||6.625%||7.25%||7.875%||8.5%|
|Common Equity Tier 1 Risk-Based Capital With Buffer||4.5%||5.125%||5.75%||6.375%||7%|
The FDIC offers a capital estimation tool on its website to assist banks in calculating projected capital ratios under the new rules, and a community bank guide that provides additional information regarding these requirements.
Calculating Common Equity Tier 1 Capital
For most non-complex community banks, Common Equity Tier (CET) 1 Capital will be calculated as follows:
- Common Stock and Related Surplus
- + Retained Earnings
- +/- Accumulated Other Comprehensive Income
- +/- Certain Deductions and Adjustments
Banks should understand several key differences between the current Tier 1 capital calculation and CET1 capital.
Accumulated other comprehensive income
On the March 31, 2015, call report, institutions will need to make a one-time election to opt in or out of including accumulated other comprehensive income in CET1. We anticipate that most community banks will choose to opt-out in order to avoid fluctuations in capital caused by changes in unrealized gains and losses on available-for-sale securities.
Deferred income taxes
Under the new rules, banks taxed as C corporations will need to know more about their deferred taxes than previously required. The prior calculation of disallowed deferred tax assets has been eliminated and replaced with two separate deductions. First, if a bank has any deferred tax assets associated with net operating loss carryforwards and/or tax credit carryforwards, these must be netted against any related valuation allowance and deducted dollar-for-dollar from capital. Banks are no longer allowed to consider their future projections of taxable income in calculating the amount disallowed for capital purposes.
Second, a bank’s deferred tax items associated with timing differences — which include the allowance for loan loss, other real estate owned (OREO) write-downs, deferred compensation, and depreciation — are aggregated and may be subject to the threshold deductions established in the new rules.
If these deferred items exceed 10 percent of capital or if combined with certain other threshold items exceed 15 percent of capital, the excess over the threshold will be deducted from capital. Given the changes to the treatment of deferred taxes under the new rules, banks should consult with their tax preparers before preparing their March 31, 2015, call report to ensure they have an adequate understanding of the types of items making up their deferred tax account balances.
Mortgage servicing rights
Under the new rules, mortgage servicing rights are also a threshold deduction from capital. If total mortgage servicing rights net of any associated deferred tax liabilities exceed 10 percent of capital or combined with certain other threshold items exceed 15 percent of capital, the excess over the threshold will be deducted from capital. We anticipate that the mortgage servicing rights recorded by many institutions will remain below these thresholds, but the new rules may influence banks’ future decisions regarding their servicing portfolios.
Calculating risk weighted assets
The new capital standards place an additional emphasis on risk in a bank’s portfolio. Though the risk weighting for many types of assets will not change under the new rules, certain asset classes perceived to carry additional risk will receive a higher risk weighting.
For example, all non-residential loans past due more than 90 days or on non-accrual status will now be risk weighted at 150 percent. In addition, the regulations define a new subset of loans called High Volatility Commercial Real Estate (HVCRE) loans that will also be risk weighted at 150 percent. Non-residential construction and development loans will be assumed to be HVCRE loans unless they meet certain loan-to-value and borrower capital contribution requirements.
The major risk weighting changes that are expected to impact community banks are outlined below.
|Asset Type||Current Rules||New Rules|
|Loans past due more than 90 days or on nonaccrual (other than residential loans)||100% risk weighted||150% risk weighted|
|High volatility commercial real estate loans (Sub-set of non-residential construction loans)||100% risk weighted||150% risk weighted|
|Mortgage servicing rights (Not deducted from CET1)||100% risk weighted||250% risk weighted|
|Deferred taxes related to timing differences (Not deducted from CET1)||100% risk weighted||100% risk weighted to the extent of carryback potential, 250% risk weighted for remaining|
Community banks should begin preparing for the new regulatory capital rules by:
- Becoming familiar with the requirements, revised call report schedules, and related instructions
- Measuring the impact of the new rules on their capital ratios using the FDIC’s Capital Estimation Tool
- Considering the impact of higher required capital ratios and the capital conservation buffer on their bank
- Discussing their deferred income tax components with their tax preparer or auditor
- Identifying any HVCRE loans in their portfolio so they can be tracked and reported
Though most community banks will not see a significant change in their regulatory capital ratios under the new rules, beginning to prepare for these changes early will minimize stress and confusion when it comes to preparing the March 2015 call report. Early preparation will also help ensure that management and the board of directors are well versed in the changing requirements before their next examination.