polsinelli pc. in california, polsinelli llp basel iii and community banks larry k. harris...

Polsinelli PC. In California, Polsinelli LLP

BASEL III AND COMMUNITY BANKS

Larry K. Harris

Polsinelli PC

314-889-7063

[email protected]

real challenges. real answers. sm

Some Basel III Definitions

Common Equity Tier 1 Capital (CET1) Additional Tier 1 Capital Tier 1 Capital Tier 2 Capital Capital Conservation Buffer HVCRE


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



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



Deductions:: Goodwill

Certain Deferred Tax Assets Other Intangibles (but not Mortgage

Service Assets) Significant Investments in other

(unconsolidated) financial institutions’ common stock



Deductions:

Significant Investments in other

(unconsolidated) financial institutions’ common stock

What is that?



Deductions: What is an investment in other

(unconsolidated) financial institutions’ common stock?

Think:

Midwest Independent Bancshares, Inc.


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.



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.


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

_____________________________________________




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.



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.



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.




Tier 1-type instruments in non-bank

subsidiaries (pretty much just capitalstock)


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.


Tier 2 Capital

ALLL (limited)plus

Preferred Stockplus

Subordinated Debtplus

Qualifying Tier 2 Minority Interest____________________________

Tier 2 Capital


Tier 2 Capital

ALLL

Include ALLL up to 1.25% of risk weighted assets.

This is the same as the current rule.


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.


Tier 2 Capital


Tier 2-type capital held by minority

shareholders in any type of consolidated subsidiary.


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.


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.



The most important number: 2.5%



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.


HVCRE

High Volatility CRE

Why do we care what this is?

Because these assets are risk weighted at 150%


HVCRE

All Real Estate Acquisition and Development Loans, except….


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


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)


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


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.


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%


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.


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


CAPITAL CONSERVATION BUFFER

Most radical change in capital regulations



Most radical change is capital regulation

For the first time, capital rules are being used to regulate/restrict:

Dividends Discretionary Bonuses Redemptions of Stock


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.


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



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


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


ILLUSTRATIVE Calculations of Capital Conservation Buffer(2019 and After)



(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%


ILLUSTRATIVE Calculations of Capital Conservation Buffer(2019 and After)





ILLUSTRATIVE CALCULATIONS OF CAPITAL CONSERVATION BUFFER(2019 AND AFTER)








(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


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%


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.



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



As the bank recovers, it experiences taxable income

Taxable income means the shareholders will need to pay federal income taxes



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%



So should most banks cease being S corporations?

Generally, no.


Polsinelli provides this material for informational purposes only. The material provided herein is general and is not intended to be legal advice. Nothing herein should be relied upon or used without consulting a lawyer to consider your specific circumstances, possible changes to applicable laws, rules and regulations and other legal issues. Receipt of this material does not establish an attorney-client relationship.

Polsinelli is very proud of the results we obtain for our clients, but you should know that past results do not guarantee future results; that every case is different and must be judged on its own merits; and that the choice of a lawyer is an important decision and should not be based solely upon advertisements.

© 2013 Polsinelli PC. In California, Polsinelli LLP. Polsinelli is a registered mark of Polsinelli PC

polsinelli pc. in california, polsinelli llp basel iii and community banks larry k. harris...

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