FAQs: New Regulatory Capital Requirements for Community Banks
Since it took effect this year, we have received many questions about Basel III and the revised Call Report Schedule RC-R. The new rules revise how regulatory capital must be calculated and how certain assets and off balance sheet liabilities must be risk weighted. With over 130 pages of revised instructions for Schedule RC-R, some confusion remains in the industry, particularly regarding changes to risk weighted assets.
In an effort to clarify some of the common areas of misunderstanding among community banks, below are a series of frequently asked questions and answers based on our review and interpretation of the new requirements.
1. How should multifamily loans be risk weighted under the new rules?
Schedule RC-R, Part II Line 5a, Residential Mortgage Exposures, may include some, but not necessarily all, multifamily loans. The regulatory capital rules’ definition of a residential mortgage exposure includes loans with an original balance of $1 million or less that are primarily secured by a first or subsequent liens on multifamily property. Therefore, multifamily loans with an original balance of $1 million or less can be reported in Line 5a on Part II of the call report.
In addition, larger multifamily loans that meet the definition of a statutory multifamily mortgage may also be reported in Line 5a. In order to qualify, these loans must conform to certain criteria including prudent underwriting standards, established loan-to-value and debt service coverage ratios, timely principal and interest payments for at least one year, and other requirements.
In most cases, first liens on multifamily loans with an original balance of $1 milion or less or that meet the statutory multifamily mortgage criteria can be risk weighted 50%, if they are not past due more than 90 days or on nonaccrual.
Larger multifamily loans that do not meet these criteria must be reported with other commercial exposures in Line 5d on Part II.
2. How are past due or nonaccrual 1-to-4 family residential loans risk weighted and reported?
Similar to the previous capital rules, residential loans past due more than 90 days or on nonaccrual are not eligible for 50 percent risk weighting. These loans must be 100 percent risk weighted; however, they should continue to be reported on Line 5a on Part II of Schedule RC-R. They do not need to be reclassified to Line 5c with the other types of past due and nonaccrual loans and are not subject to the 150 percent risk weighting requirement for other past due loans.
3. How do troubled debt restructurings (TDRS) effect risk weightings?
The call report instructions specify that residential mortgage exposures that are restructured or modified (with the exception of loans restructured solely pursuant to the U.S. Treasury’s Home Affordable Modification Program) are not eligible for 50 percent risk weighting. This requirement is irrespective of the payment status of the loan.
For all other loan types, the call report instructions do not specifically address troubled debt restructurings. The risk weighting of these loans will therefore depend on whether or not the loan is performing in accordance with its modified terms. Loans past due more than 90 days or on nonaccrual should generally be risk weighted at 150 percent. Loans that are not past due more than 90 days based on their modified terms will generally not be subject to increased risk weighting simply for being classified as a TDR.
4. When is a loan no longer considered a High Volatility Commercial Real Estate (HVCRE) loan?
An HVCRE loan is a loan that finances or has financed the acquisition, development, or construction of real property unless certain exceptions are met. Once a loan is determined to be an HVCRE loan, it continues to be classified as such until permanent financing is received. This generally occurs when the loan is paid off or re-written as a permanent amortizing loan.
For loans that are originally written as combination construction and permanent financing loans, the instructions for Schedule RC-C indicate that the loan will continue to be classified as a construction loan (and therefore, by extension, an HVCRE loan) until construction is completed or principal amortization payments begin, whichever comes first.
5. Subsequent to loan origination, if an updated appraisal is received, can the results of this appraisal be used for calculating the loan-to-value requirements for HVCRE loans?
No. An HVCRE loan is determined based on the information available to the bank at the time of loan origination. The loan-to-value calculation should be made based on the “as completed value” in the original appraisal and compared to the maximum supervisory loan-to-value ratios in the real estate lending standards. Even if property values subsequently increase, a loan must continue to be carried as an HVCRE loan until it converts to permanent financing.
6. Is a loan for the purchase of bare land where there is no current plan to develop, construct, or make improvements considered an HVCRE loan?
An acquisition loan to purchase bare land that is not agricultural land may qualify as an HVCRE unless it is a permanently financed loan. If the loan is not an amortizing loan, it should be reviewed to see if it meets the exceptions from classification as an HVCRE.
7. How are mutual funds risk weighted under the new rules?
Under the new rules, risk weighting mutual funds requires a look-through approach where the bank examines the underlying investments held within the mutual funds. To accomplish this, most community banks will review the mutual fund’s prospectus to determine the investment limits assigned for the fund.
The bank’s risk weighted asset amount is based on the proportion of the fund’s investment in each type of underlying security times the applicable risk weighting percentage laid out in the call report instructions.
For example, if a bank owns $100,000 in mutual funds and the prospectus specifies a 50/50 split between U.S. corporate bonds (which have a 100 percent risk weighting) and U.S. agency bonds (which have a 20 percent risk weighting), total risk weighted assets for this investment would be $60,000. The risk weighted assets would be reported in Columns R and S of Line 2b.
8. How is Bank Owned Life Insurance (BOLI) risk weighted under the new rules?
Investments in general account life insurance policies continue to be risk weighted 100 percent on Line 8 of Part II of the revised Schedule RC-R. These are the most common types of BOLI policies held by community banks.
Banks with investments in a hybrid account or separate account life insurance policies are subject to new risk weighting provisions. These types of policies represent an interest in underlying investment securities and require a look-through approach somewhat similar to the methodology described for mutual funds above.
If you have investments in hybrid or separate account BOLI, you should contact your insurance broker for assistance with risk weighting these assets. The risk weighting for these assets must be reported in the new Line 8a on Part II of Schedule RC-R.
9. If the bank sells mortgages to the secondary market, could it be subject to risk weighting requirements after the loans are sold?
Certain contracts to sell loans to the secondary market involve credit-enhancing representations or warranties that may be subject to risk weighting under the regulatory capital standards.
Under certain loan sale agreements including some Federal Home Loan Bank (FHLB) programs, banks are provided with a credit enhancement obligation amount that represents their share in the credit risk if the loans were to default. The credit enhancement obligation is an off-balance sheet securitization exposure and must be risk weighted on Line 10 of Part II of the Schedule RC-R using one of three available approaches (the Simplified Supervisory Formula Approach, the Gross Up Approach, or a default risk weighting of 1250 percent).
Other types of contracts may contain early default clauses or warranties that permit the return of loans if they default within a set number of days from the original sale. The new requirements allow for a safe harbor period of 120 days for these types of provisions. If the early default period in your contract exceeds 120 days, the loans may need to continue to be risk weighted on Schedule RC-R, Part II, Line 17, until the warranty expires.
How we can help
The new regulatory capital rules are complex and the situations described above may not specifically address the unique facts and circumstances facing your institution. We can help you if you have any questions about the rules and Schedule RC-R.