Yesterday, we began picking apart the new Basel III capital rules, so today we continue where we left off (describing the new capital buffer, different definitions of Tier 1). We will then move on to the new risk weightings, as we close the discussion.
??To begin, the Capital Conservation Buffer is composed of Common Equity Tier 1 (CET1) capital and should be at least 2.5% of risk weighted assets (RWA). This buffer is in addition to the minimum CET1, Tier 1 capital and total capital ratios and was created by regulators in response to the actions of financial institutions during the financial crisis that continued to pay dividends and substantial discretionary bonuses - even as their financial condition deteriorated. Regulators viewed those actions as a significant contributor to the crisis, so a buffer was added. If a bank's buffer is short of the 2.5% level, regulatory limitations kick-in on capital distributions and discretionary bonuses.
As we noted yesterday, the main purpose of Basel III is to drive more and better capital into the banking system. In response to this objective, regulators have increased the Tier 1 capital requirements from 4% to 6%. In addition, fewer items now qualify under Tier 1. This shift has resulted in a new definition of Tier 1 capital: CET1 plus non-cumulative perpetual preferred stock.
On the higher quality capital side of things, community banks dodged a bullet when regulators grandfathered in trust-preferred and other securities, but larger banks are excluded from this carve out, so regulators appear determined they do not want to see this market come back to life. There is no change to the Total Capital Ratio requirement of 8% or the leverage ratio of 4%.
The Basel III rules also make regulatory capital measurements more risk-sensitive, as the final rule increases the risk weighting requirements for certain assets. Regulations currently require 100% risk weighting for all commercial real estate (CRE) loans and for most loans that will remain the same. However, for the newly-created CRE subset of high-volatility CRE (HVCRE), the requirement will increase to 150%. Under the rule, HVCRE loans are made for the acquisition, development or construction of real property, prior to the conversion to permanent financing. While regulators have made some exceptions here (i.e. 1-4 family residential, agricultural, etc.), it is clear they are discouraging banks from certain behaviors and loan asset classes.
Finally, Basel III zeros in on 90 day past due exposures. Past due loans had previously not required any change in risk weighting, but now will require 150% risk weighting. Non-accrual loans will also require 150% risk weighting. In scanning community bank numbers for the 5,887 institutions under $1B, 90 day past due loans are not a huge number anymore and have declined over the past 5Ys from an average of $330k to $232K, but non-accruals are significant. While non-accruals have declined from an average of $3.5mm at the end of Q1 2013, they stand at an average of $2.9mm still, so this piece of the rule would have a significant impact and would chew up regulatory capital when recessions or downturns occur.
These are some key items to know for now about the new rule and we will write more on this subject soon as we continue to dig in. Implementation is still a ways off, so that is good, but it will be here before you know it so it is something to ponder over your summer vacation as you try to construct this new capital puzzle.