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PCBB Banc Investment Daily July 17, 2013
Banc Investment Daily
July 17, 2013

The Explosion of Basel III - Part 1 of 2

Just before everyone took off for the 4th of July to grill hot dogs and blow up fireworks, the Fed set off some fireworks of their own by approving its final rule implementing the Basel III capital framework. For bankers, this marks the most significant revision to regulatory capital in more than 2 decades. To get a better understanding, it is important to note that Basel III arose from the post-crisis landscape, replacing Basel I which had become outdated and completely bypassing Basel II which never really got legs. As with most landscape-changing regulation, it's not clear whether Basel III will perfectly fit the needed response to the crisis. However, one thing is crystal clear: the primary objective of Basel III is to ensure banks have larger amounts of higher quality capital.
The rule weighs in at a whopping 972 pages long it will take some time to digest entirely. We have been working on this for some time and our two part article running today and tomorrow on the subject should help community bankers.
Since the introduction of the proposed rules last summer, the banking industry has fired back more than 2,600 comment letters to the regulators. Suggestions to improve the proposed rules have run the gamut, but it appears that in turning out the final rules, the Fed heard the collective community bank voice. Basel III makes key concessions that will help community banks including: keeping the same risk weighting for residential mortgages; eliminating the phase-out of capital instruments such as trust preferred securities; and allowing an opt out of Accumulated Other Comprehensive Income. This is all good news, but there is nuance that needs to be understood.
To begin, under the new rules, regulatory analysis indicates the overwhelming majority of banking organizations already have sufficient capital to comply with the rule if immediately implemented. In fact, an estimated 95% of insured depository institutions would be in compliance with the minimum ratios and buffers established by Basel III. That is good, but many bankers would likely argue having record amounts of capital on the books and weak loan demand isn't the ideal mix for performance, so you have to dig even deeper to get the full picture. Overall, the rule is designed to ensure that banking organizations maintain their capacity to absorb losses in the future - period.
The next key thing to know is that community banks will not need to implement the standardized approach until Jan. 1, 2015, so your bank has some time to get a handle on things. Capital drives all else, so the deadline itself is a "win" for community banks (the original requirement was Jan 1, 2014). However, we know it is not easy to turn a bank on a dime, so the new rules should be quickly reviewed and considered by your bank, with a particular focus on setting up a capital planning committee.
In our last piece of discussion today, we note Basel III sets up a brand new capital ratio, called Common Equity Tier 1 (CET1). CET1 must be 4.5% of Risk Weighted Assets (RWA) and is made up of common stock (plus related surplus) and retained earnings, less the majority of regulatory deductions (including items like goodwill, gain-on-sale associated with a securitization exposure or defined benefit pension fund net assets). This new category is designed to ensure banks hold sufficient high quality regulatory capital to absorb losses on an ongoing basis. We will pick up tomorrow, with more fireworks and discuss the new capital buffer and other important elements.