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Client Alert: Basel III In Bite-Sized Pieces - Part II

A 5-Part Series For Community Banks

Key Elements of the New Capital Rules

The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency adopted the much anticipated new capital rules implementing Basel III.  The new rules will become effective for community banks on January 1, 2015, with many provisions of the new rules phasing-in over a four-year period. This series will discuss the following:

Steps You Can Take To Prepare For The New Capital Ratios

Part II. Changes To The Minimum Capital Requirements

The central theme of Basel III is the increased importance of capital, particularly common equity. Consequently, the new capital rules increase the amount of capital that a banking organization must maintain. Because calculating capital ratios is a division problem (regulatory capital divided by assets), under the new rules, capital requirements are being affected in three ways:

  1. Increasing the capital ratios that an institution must maintain;
  2. Limiting what qualifies as regulatory capital; and
  3. Increasing the risk-weightings assigned to an institution’s assets.

Part II of our series focuses on the increase in the capital ratios. Part III will discuss the changes to regulatory capital, and Part IV will discuss the changes to the risk-weighting of assets. Because this series is only a summary of these issues, we encourage you to contact us directly with any questions.

Increased Capital Ratios

The new capital rules require institutions to maintain higher Tier 1 capital ratios and to maintain a new capital ratio of Common Equity Tier 1 (“CET1”) measured against total risk-weighted assets. CET1, which will be discussed in greater detail in Part III of this series, generally consists of core, permanent capital instruments, such as common equity.

The new capital requirements will become effective on January 1, 2015, and will not be phased-in. At that time, the new minimum capital ratios that an institution must maintain to be considered adequately capitalized, including CET1, are as follows:

Ratio

Current Rule

New Rule

Total Risk-Based Capital

8.0%

8.0%

Tier 1 Risk-Based Capital

4.0%

6.0%

Common Equity Tier 1

N/A

4.5%

Leverage

3.0%, 4.0%

4.0%

The leverage ratio requirement also is retained in the new capital rules. Consequently, in addition to the minimum capital ratios discussed above, every institution must maintain a leverage ratio (Tier 1 capital divided by average assets) of 4.0%. The exemption currently available to both highly-rated banks and certain bank holding companies, which allowed them to maintain a lower leverage ratio of 3.0%, is eliminated by the new rules.


Point Of Interest

Every institution must now maintain a leverage ratio of 4.0% at all times, regardless of its rating.


The Real Minimum Capital Ratio

Although the new capital rules refer to the ratios listed above as the “minimums,” the regulators will continue to expect that institutions be at least “well-capitalized” and maintain a CET1 buffer of 2.5%. However, the prompt correction action (“PCA”) thresholds also have changed to reflect the increased capital requirements and the implementation of the CET1 capital ratio.

Point Of Interest

The Federal Reserve is still formulating the specific capital requirements for bank holding companies, which will be promulgated in 12 C.F.R. Part 217 as a new Regulation Q.  It is unclear when the Federal Reserve will issue the new rules, but it is anticipated that to be “well-capitalized” a bank holding company will need to maintain a Total Risk-Based Capital ratio of 10.0% and a Tier 1 Risk-Based Capital ratio of 6.0%. These new capital requirements do not apply to small bank holding companies with less than $500 million in assets, subject to certain exceptions.

Below is a chart comparing the PCA thresholds under the new capital rules with those currently in place. The new PCA thresholds are not being phased-in and will become effective on January 1, 2015.

PCA Threshold

Total Risk-Based Capital

Current

New

Tier 1Risk-Based Capital

Current

New

Common Equity
Tier 1

Current

New

 Leverage  

Current

New

Well-Capitalized

> 10.0%

> 10.0%

> 6.0%

> 8.0%

N/A

> 6.5%

> 5.0%

> 5.0%

Adequately Capitalized

> 8.0%

> 8.0%

> 4.0%

> 6.0%

N/A

> 4.5%

> 4.0%,
> 3.0%

> 4.0%

Undercapitalized

< 8.0%

< 8.0%

< 4.0%

< 6.0%

N/A

< 4.5%

< 4.0%,
< 3.0%

< 4.0%

Significantly Undercapitalized

< 6.0%

< 6.0%

< 3.0%

< 4.0%

N/A

< 3.0%

< 3.0%

< 3.0%

Critically Undercapitalized

No Change:  Tangible equity to total assets of less than or equal to 2.0%

The new capital rules also require that an institution maintain a capital conservation buffer of 2.5% of CET1, or the amount of distributions and discretionary bonuses that it can pay will be limited drastically. Although the calculation of this buffer and its effects will be discussed in Part V of this series, the capital conservation buffer effectively increases by 2.5% the CET1 capital thresholds that an institution must maintain to avoid such restrictions.

Consequently, even though an institution will be considered well-capitalized if it maintains capital ratios of 10.0%, 8.0% and 6.5% (plus the 5.0% leverage ratio), bankers need to be aware that they must maintain capital ratios of 10.5%, 8.5% and 7.0% to be clear of restrictions on distributions and discretionary bonuses. The capital conservation buffer, however, does not apply to the leverage ratio.

The table below sets forth the capital ratios that an institution must maintain to be both “well-capitalized” and compliant with the capital conservation buffer. The capital conservation buffer will be phased-in through 2019.

 Capital Ratio

Well-Capitalized

With Capital Conservation Buffer

Total Risk-Based Capital

10.0%

10.5%

Tier 1 Risk-Based Capital

8.0%

8.5%

Common Equity Tier 1 Capital

6.5%

7.0%

Resources

As with any new rulemaking, implementation of the required changes and thorough planning for the impact of new concepts will take time. We urge you to begin the process of understanding how these rules will impact your organization as soon as possible. To aid in this understanding, we have provided links to Part I of our series, Basel III in Bite-Sized Pieces, and the following useful regulatory guidance for community banks:

Please feel free to contact us with any questions concerning the new capital rules or any other issues.

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