polsinelli pc. in california, polsinelli llp basel iii and community banks larry k. harris...
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Polsinelli PC. In California, Polsinelli LLP
BASEL III AND COMMUNITY BANKS
Larry K. Harris
Polsinelli PC
314-889-7063
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Some Basel III Definitions
Common Equity Tier 1 Capital (CET1) Additional Tier 1 Capital Tier 1 Capital Tier 2 Capital Capital Conservation Buffer HVCRE
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Common Equity Tier 1 Capital
Common Stock and Retained Earnings
plus or minus
Limited Accumulated Other Comprehensive
Income (AOCI) [If you opted out]
plus or minus
Deductions and Adjustments
plus
Qualifying Common Equity Tier 1 Minority
Interest in Subsidiaries
___________________________
CET1
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Common Equity Tier 1 Capital
AOCI: Banks under $250 billion in assets will be allowed to make a one time election to opt-out of fully reflecting AOCI in CET1 Capital
(i.e., keep things like they are)
Election is to be made in Call Report due March 2015
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Common Equity Tier 1 Capital
Deductions:: Goodwill
Certain Deferred Tax Assets Other Intangibles (but not Mortgage
Service Assets) Significant Investments in other
(unconsolidated) financial institutions’ common stock
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Common Equity Tier 1 Capital
Deductions:
Significant Investments in other
(unconsolidated) financial institutions’ common stock
What is that?
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Common Equity Tier 1 Capital
Deductions: What is an investment in other
(unconsolidated) financial institutions’ common stock?
Think:
Midwest Independent Bancshares, Inc.
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Common Equity Tier 1
Deductions:
When is an investment significant?
When your financial institution owns more than 10% of the other financial institution’s common stock
So it is unlikely any community bank will need to deduct from its CET1 because of investments in any other financial institution, and certainly not for MIB stock.
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Common Equity Tier 1 Capital
Qualifying CET1 minority interest in a
subsidiary
What qualifies?
Only Tier 1-type capital in a bank subsidiary
(not non-bank subsidiaries) held by minority shareholders.
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Additional Tier 1 Capital
Non-cumulative Perpetual Preferred Stock including surplus
plus
Troubled Asset Relief Program (TARP)
plus
Small Business Lending Fund (SBLF)
plus
Trust Preferred Securities (TruPS)
plus
Qualifying Tier 1 Minority Interest
_____________________________________________
Additional Tier 1 Capital
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Additional Tier 1 Capital
Non-cumulative Perpetual Preferred Stock, including surplus
Why non-cumulative?
Because the financial institution may skip
dividends, and not pay them later.
But does that make it unattractive to investors?
Pretty much so.
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Additional Tier 1 Capital
TARP SBLF
These are only grandfathered in; the programs are closed.
But if a financial institution has it, it counts as Additional Tier 1 Capital.
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Additional Tier 1 Capital
Trust Preferred Securities
In the original proposal these were to be phased out.
In an about-face, the banking regulators revised thefinal rule: all institutions of less than $15 billion in assets may continue to treat grandfathered TruPS as Additional Tier 1 Capital.
Under Collins amendment to the Dodd-Frank Act no new TruPS are treated as Tier 1 capital.
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Additional Tier 1 Capital
Qualifying Tier 1 Minority Interest
Tier 1-type instruments in non-bank
subsidiaries (pretty much just capitalstock)
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Tier 1 Capital
Common Equity Tier 1 Capitalplus
Additional Tier 1 Capital________________________________
Tier 1 Capital
This is not very different from the prior Federal Reserve rules, which divided holding company Tier 1 Capital into Tier 1 Core Capital and Tier 1 Non-Core Capital.
There are differences, but the similarities outweigh the differences.
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Tier 2 Capital
ALLL (limited)plus
Preferred Stockplus
Subordinated Debtplus
Qualifying Tier 2 Minority Interest____________________________
Tier 2 Capital
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Tier 2 Capital
ALLL
Include ALLL up to 1.25% of risk weighted assets.
This is the same as the current rule.
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Tier 2 Capital
Preferred Stock
Includes cumulative preferred stock
That is, the dividends cumulate if not paid; so no common stock dividends until all cumulated
dividends have been paid.
This is much more attractive to investors.
No limit on the amount of Preferred Stock
included in Tier 2 Capital.
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Tier 2 Capital
Qualifying Tier 2 Minority Interest
Tier 2-type capital held by minority
shareholders in any type of consolidated subsidiary.
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Tier 2 Capital
No Limit!
Before Basel III, Tier 2 Capital was limited to an amount equal to the financial institution’s Tier 1 Capital.
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Capital Conservation Buffer
A new concept
And a very different concept:
The first time capital rules are being used to directly limit the payment of dividends.
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Capital Conservation Buffer
The most important number: 2.5%
This is the percentage by which a financial institution
must exceed all adequately capitalized risk weighted ratios to be unrestricted in the
payout of dividends payout of discretionary bonuses redemption of securities
We will look at this more closely shortly.
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HVCRE
High Volatility CRE
Why do we care what this is?
Because these assets are risk weighted at 150%
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HVCRE
All Real Estate Acquisition and Development Loans, except
1-4 family residential projects Loans secured by properties for
agricultural purposes Community Development Loans
and Acquisition and Development Loans
– That meet certain loan-to-value criteria– Where the borrower is contractually required to
contribute and keep throughout the life of the project capital equal to 15% of the “as completed” appraised value of the assets
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So What Does Basel III Change?
Creates a new risk weighted capital ratio requirement
(CET1/RWA)
Changes one important existing risk weighted capital
ratio requirement (Tier 1/RWA)
Alters risk weightings
Limits the payment of dividends, discretionary bonuses,
and redemptions (the Capital Conservation Buffer)
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Common Tier 1 Capital/Risk Weighted Assets
The minimum CET1/RWA (that is, to be adequately capitalized) is: 4.5%
To be well capitalized, CET1/RWA must be 6.5% or greater
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CET1
Keep in mind, most community banks rely heavily on common stock for Tier 1 Capital. Those banks should have no trouble meeting the CET1/RWA thresholds.
Bank holding companies with consolidated assets of under $500 million do not have capital ratio requirements under the Federal Reserve’s rules. This will not change, so for many community banks, much of Basel III does not affect their holding company.
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Tier 1 Capital/Risk Weighted Assets
Current requirements:
Adequately Capitalized 4.0%Well Capitalized 6.0%
Basel III requirements:
Adequately Capitalized 6.0%Well Capitalized 8.0%
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Tier 1 Capital/Risk Weighted Assets
But keep this change in perspective:
Most community banks mostly have Tier 1 Capital
The biggest exception to this is the part of Tier 2 Capital that is ALLL
Total Capital/Risk Weighted Assets was and remains:
Adequately capitalized 8.0%
Well Capitalized 10.0%
So a bank that mostly has Tier 1 Capital and meets the well capitalized threshold for Total Capital should not have any problem meeting the new Tier 1/RWA ratio.
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Capital Ratios
Current Ratio
Basel III Ratio
Leverage 5% 5%CET1/RWA -- 6.5%Tier 1/RWA 6% 8%Total Capital/RWA 10% 10%
To be Well Capitalized
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CAPITAL CONSERVATION BUFFER
Most radical change in capital regulations
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Capital Conservation Buffer
Most radical change is capital regulation
For the first time, capital rules are being used to regulate/restrict:
Dividends Discretionary Bonuses Redemptions of Stock
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Capital Conservation Bonus
The concept: Limits on the amount of dividends, etc.,
unless the financial institution exceeds
being adequately capitalized by at least
2.5% in all risk weighted ratios.
The “Buffer”: The least amount by which the financial
institution exceeds the 3 risk weighted
ratios.
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CAPITAL CONSERVATION BUFFER
When fully phased in (2019), the following limits apply:
Buffer Maximum Payout*> 2.5% No payout limit
> 1.875% to 2.5% 60% > 1.25% to 1.875% 40% > 0.625% to 1.25% 20% ≤ 0.625% 0%
*Expressed as a percentage of Eligible Retained Income
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Capital Conservation Buffer
What is: Eligible Retained Income?
The financial institution’s net income for the 4 calendar quarters preceding the current
quarterless
Distribution (dividends, discretionary
bonuses, redemptions) during that 4-quarter period
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Illustrative Calculations of Capital Conservation Buffer(2019 and After)
Risk WeightedAsset Ratio
Adequately Capitalized Threshold
(2015 and on)
2019 Capital (Including
Buffer) Needed for Unlimited
Distributions Bank 1 Bank 2 Bank 3 Bank 4 Common Equity 4.5% 7.0% 8.6% 8.2% 5.3% 6.5% Tier 1 Capital 6.0% 8.5% 8.6% 8.3% 8.0% 6.8% Total Capital 8.0% 10.5% 11.4% 10.6% 9.9% 8.2% Buffer Distribution Limit (% of Maximum Amount)
2.6%
Unlimited
2.3%
60%
0.8%
20%
0.2%
No distribution
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ILLUSTRATIVE Calculations of Capital Conservation Buffer(2019 and After)
Risk WeightedAsset Ratio
Adequately Capitalized Threshold
(2015 and on) Bank 1 Buffer Common Equity 4.5% 8.6% 4.1% Tier 1 Capital 6.0% 8.6% 2.6% Total Capital 8.0% 11.4% 3.4%
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Illustrative Calculations of Capital Conservation Buffer(2019 and After)
Risk WeightedAsset Ratio
Adequately Capitalized Threshold
(2015 and on) Bank 2 Buffer Common Equity 4.5% 8.2% 3.7% Tier 1 Capital 6.0% 8.3% 2.3% Total Capital 8.0% 10.6% 2.6%
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ILLUSTRATIVE Calculations of Capital Conservation Buffer(2019 and After)
Risk WeightedAsset Ratio
Adequately Capitalized Threshold
(2015 and on) Bank 3 Buffer Common Equity 4.5% 5.3% 0.8% Tier 1 Capital 6.0% 8.0% 2.0% Total Capital 8.0% 9.9% 1.9%
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ILLUSTRATIVE CALCULATIONS OF CAPITAL CONSERVATION BUFFER(2019 AND AFTER)
Risk WeightedAsset Ratio
Adequately Capitalized Threshold
(2015 and on) Bank 4 Buffer Common Equity 4.5% 6.5% 2.0% Tier 1 Capital 6.0% 6.8% 2.3% Total Capital 8.0% 8.2% 0.2%
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Illustrative Calculations of Capital Conservation Buffer(2019 and After)
Risk WeightedAsset Ratio
Adequately Capitalized Threshold
(2015 and on)
2019 Capital (Including
Buffer) Needed for Unlimited
Distributions Bank 1 Bank 2 Bank 3 Bank 4 Common Equity 4.5% 7.0% 8.6% 8.2% 5.3% 6.5% Tier 1 Capital 6.0% 8.5% 8.6% 8.3% 8.0% 6.8% Total Capital 8.0% 10.5% 11.4% 10.6% 9.9% 8.2% Buffer Distribution Limit (% of Maximum Amount)
2.6%
Unlimited
2.3%
60%
0.8%
20%
0.2%
No distribution
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COMPARISON OF CURRENT AND BASEL III CAPITAL RATIOS
Current Bank Prompt Corrective Action
Capital Requirements Current Holding Company
Capital Requirements
Final BASEL III(Fully Phased-in at 2019)
Capital Requirements
Capital Status:
Adequate
Adeq.+
Buffer Well Adequate
Adeq.+
Buffer Well AdequateAdequate + Buffer Well
Leverage
(Tier 1/Total Assets)
3.0-4.0% -- 5.0% 3.0-5.0% -- -- 4.0% -- 5.0%
Common Equity/RWA -- -- -- -- -- -- 4.5% 7.0% 6.5%
Tier 1 Capital/RWA 4.0% -- 6.0% 4.0% -- 6.0% 6.0% 8.5% 8.0%
Total Capital/RWA 8.0% -- 10.0% 8.0% -- 10.0% 8.0% 10.5% 10.0%
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S CORPORATIONS AND THE CAPITAL CONSERVATION BUFFER
A key facet to S corporations is that income is taxed at the shareholder level and not the corporate level.
Said another way, shareholders are taxed on an S corporation’s income, and not on the distributions received from the S corporation.
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S CORPORATIONS AND THE CAPITAL CONSERVATION BUFFER
Assume the following scenario
An S corporation suffers losses over several years
As a result, its RWA ratios all decline, and approach being only adequately capitalized
After several years, the bank begins to recover
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S CORPORATIONS AND THE CAPITAL CONSERVATION BUFFER
As the bank recovers, it experiences taxable income
Taxable income means the shareholders will need to pay federal income taxes
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S CORPORATIONS AND THE CAPITAL CONSERVATION BUFFER
But the bank will be unable to pay any dividends to its shareholders to cover the taxes
At first, the bank will not have any Eligible Retained Income
Even after the Bank does have Eligible Retained Income, it will be prohibited from dividend payments until its Capital Conservation Buffer is >0.625%
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S CORPORATIONS AND THE CAPITAL CONSERVATION BUFFER
So should most banks cease being S corporations?
Generally, no.
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