How the Capital Conservation Buffer Affects Community Banks
As bankers across the country continue to have questions about last year's regulatory capital changes under Basel III, the March 31, 2016, call reports marks the start of an additional requirement, the capital conservation buffer.
Though many banks retain capital levels far in excess of the buffer requirements, it is critical that community banks understand and incorporate these requirements as part of their capital and strategic plans.
The buffer, which phases in over the next four years, could limit the payment of dividends and discretionary bonuses to officers if a bank fails to maintain required capital levels (with a possible exception for S corporation banks paying tax distributions in certain circumstances). Though many banks retain capital levels far in excess of the buffer requirements, it is critical that community banks understand and incorporate these requirements as part of their capital and strategic plans.
Overview of the requirement
The buffer is separate from the capital ratios required under the Prompt Corrective Action (PCA) standards. Therefore, it is possible for a bank to be adequately capitalized, or even well capitalized, under the PCA standards and still be limited in its ability to pay dividends or discretionary bonuses.
The buffer was designed to curb what regulators and the general public perceived as abuses during the financial crisis, when many organizations continued to pay significant dividends and bonuses despite their deteriorating financial condition.
Calculating the conservation buffer
The buffer will be calculated by all banks and reported on Line 46.a of Schedule RC-R of their quarterly call report. It is equal to the lowest of the following calculations:
- Common Equity Tier 1 Ratio (RC-R, Line 41) minus 4.5 percent
- Tier 1 Ratio (RC-R, Line 42) minus 6 percent
- Total Capital Ratio (RC-R, Line 43) minus 8 percent
The transition provisions for the buffer allow a phase-in through 2019, as follows:
Maintaining capital levels in excess of the buffer requirements will allow the bank to pay dividends and bonuses.
Eligible retained income
Banks that do not meet the requirements shown above may still be able to pay dividends and/or bonus payments; however, these payments will be limited. The payout ratio is based on a percentage of the bank’s eligible retained income (Schedule RC-R, Line 47), which is the bank’s net income for the four calendar quarters preceding the current quarter net of any capital distributions. The payout ratios allowed are shown below.
Maximum payout as a percentage of eligible retained income
|60%||≥0.469% - 0.625%||≥0.938% - 1.25%||≥1.41% - 1.875%||≥1.875% - 2.5%|
|40%||≥0.313% - 0.469%||≥0.625% - 0.938%||≥0.938% - 1.41%||≥1.25% - 1.875%|
|20%||>0.156% - 0.313%||>0.313% - 0.625%||>0.469% - 0.938%||>0.625% - 1.25%|
Banks that do not meet the phase-in requirements should remember that if eligible retained income for the last four quarters is negative, no distributions or bonuses will be allowed.
Distributions and discretionary bonuses
The distributions and discretionary bonus payments limited by the buffer are much broader than most bankers would anticipate by simply reading the call report instructions.
Distributions, as defined under the interim final rule, include not only dividends paid during the quarter, but also:
- Dividends declared but not yet paid as of quarter end.
- Repurchases of capital instruments, including common stock, except in limited cases when a bank within the same quarter fully replaces the capital instrument with net capital that meets certain eligibility requirements.
- Reductions in Tier 2 capital instruments through a repurchase or redemption.
- Dividend declarations or interest payments on Tier 2 capital instruments, if the institution has full discretion to suspend or defer payment.
The final three items listed are particularly critical for holding companies that must meet consolidated capital ratio and conservation buffer requirements.
Discretionary bonus payments are also defined under these requirements. The limits apply not only to executive officers as defined by Regulation O, but a larger swathe of officers, including the president, executive chairman, CEO, COO, CFO, CLO, CRO, and heads of any major business line. In addition, other individuals that perform these functions — regardless of their title — are also considered to be executive officers for this purpose.
Payments made to these officers are considered to be discretionary (and therefore potentially subject to limitation) if they meet the following conditions:
- Until the payment is rewarded, the bank retains discretion about whether to make the payment and the payment amount.
- The amount paid is determined without prior promise to, or agreement with, the officer.
- The officer has no contractual right to the bonus payment.
Many banks rely on dividends to their holding company to support debt service costs or to pay dividends to shareholders. As organizations review their capital and strategic plans, it will be important to consider the buffer and to plan for contingencies. The risk associated with a poor earning quarter or retroactive adjustment by the regulators may have a significant impact on the bank’s ability to meet debt service requirements, make tax distribution payments, or pursue acquisition/growth opportunities.
In addition, the possibility of restricted bonus payments may impact the compensation structures at some institutions. In other cases, banks may choose to accrue but delay the payment of bonuses in order to ensure compliance with conservation buffer limits
How we can help
Bank management, directors, and major shareholders need to have a proper understanding of how these requirements may impact the future of their institutions. We can help address your questions and concerns and help to develop your capital and strategic plans.