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October 16, 2013

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

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 Capital Conservation Buffer
Part V.  The Impact Of The Capital Conservation Buffer

As discussed throughout this series, the new capital rules emphasize the importance of core capital and, consequently, increase the amount of capital that a banking organization must maintain.  Part II of this series addressed the general increase in the minimum capital ratios, as well as the implementation of a new Common Equity Tier 1 (“CET1”) capital ratio.  Part III focused on the changes to the definitions of regulatory capital and how those changes further increased the minimum capital ratios.  Part IV focused on the changes to risk-weighted assets.

Part V – the final part of our series – discusses the new capital conservation buffer imposed by the new capital rules, which requires banking organizations to maintain a buffer composed of CET1 capital in addition to the minimum capital requirements.  An organization’s failure to maintain the capital conservation buffer in addition to its minimum risk-based capital requirements will result in limitations being placed on its ability to make capital distributions, including issuing dividends and paying discretionary bonuses.  

Because this series is solely a summary of these issues, we encourage you to contact us with any questions. 

Point Of Interest

  • Subchapter S-corporations are not exempt from the requirement to maintain the capital conservation buffer, and their ability to issue a tax dividend may be limited if the buffer is not maintained.
  • There is currently legislation pending in Congress that could remove certain of the restrictions on S-corporations’ ability to raise capital.  If those restrictions are lifted, S-corporations may have an easier time raising the capital necessary to satisfy the capital conservation buffer requirements.
The Minimum Required Capital Conservation Buffer

The new capital rules require that banking organizations maintain a capital conservation buffer, comprised of CET1 capital, of 2.5% over each minimum risk-based capital ratio in order to avoid limitations on capital distributions.  The capital conservation buffer, therefore, effectively increases, by 2.5% of CET1 capital, each of the minimum risk-based capital ratios that an organization must maintain to avoid restrictions.  The required capital conservation buffer will be phased-in between 2016 and 2019 as follows:



Consequently, even though the new “minimum” total, Tier1 and CET1 risk-based capital ratios are technically 8.0%, 6.0% and 4.5%, respectively, the actual minimum risk-based capital ratios necessary to avoid restrictions are higher.

In addition, the prompt correction action thresholds under the new capital rules do not affect the capital conservation buffer.  Therefore, an organization can be “well-capitalized” without having a fully-funded capital conservation buffer.  As a result, even if an organization is considered “well-capitalized,” its ability to make capital distributions and discretionary bonus payments may still be restricted if it does not maintain a buffer of at least 2.5% of CET1 capital over each minimum capital ratio (i.e., the capital ratios that an organization must maintain to be considered “adequately capitalized” under the prompt corrective action thresholds).  

The chart below illustrates the capital ratios that an institution must maintain to satisfy the minimum risk-based capital ratios and the capital conservation buffer, and compares that to the ratios an institution must maintain to be both “well-capitalized” and compliant with the capital conservation buffer.

The capital conservation buffer does not impact the leverage ratio, and financial institutions must maintain a leverage ratio of 4.0% to be considered adequately capitalized and 5.0% to be considered well-capitalized.

Effects Of Failure To Maintain Minimum Capital Conservation Buffer

As mentioned above, a banking organization’s ability to make capital distributions or pay discretionary bonus payments will be limited if an organization does not maintain the minimum capital conservation buffer.  The limitations are applied on a sliding scale and become more stringent as an organization’s capital conservation buffer approaches zero.  These increasing limitations on capital distributions and discretionary bonus payments are shown in the table below:

 

Point Of Interest

In addition to the restrictions limiting payments imposed by the capital conservation buffer, financial institutions will still be subject to other factors that may restrict or limit their ability to make payouts (e.g., applicable regulatory restrictions, contractual provisions and state law).

The calculation of the maximum payout amount is made as of the last day of the previous calendar quarter and any resulting restrictions apply during the current calendar quarter. Compliance with the capital conservation buffer is determined prior to any capital distribution or discretionary bonus payment.

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 Parts I-IV of our series, Basel III in Bite-Sized Pieces, and the following useful regulatory guidance for community banks:

Barack Ferrazzano Materials

Regulatory Materials


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

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