The Federal Deposit Insurance Corporation (the "FDIC")
recently issued its final rules implementing the U.S. version of
the international bank capital standards adopted by the Basel III
Accords1 and the bank capital requirements under the
Dodd-Frank Act,2 specifically the Collins
Amendment.3 The Dodd-Frank Act requires federal bank
regulators to enhance the minimum risk-based capital requirements
and other capital adequacy requirements to "... address the
risks that the activities of such institutions pose, not only to
the institution engaging in the activity, but to other public and
private stakeholders in the event of adverse performance,
disruption, or failure of the institution or the activity."
The FDIC's actions will have a significant impact on the U.S.
banking industry and a larger impact on community and small banking
institutions. These banks may be required to raise additional
capital in challenging market conditions and find a more difficult
environment for mergers and acquisitions. On the other hand, the
new capital rules may provide well capitalized community and small
banking institutions with a unique opportunity to consolidate or
roll-up other banks.
The FDIC's action was joined by the other U.S. bank regulators as part of a coordinated international effort that has, as the FDIC noted in its final rule, "one of the key objectives of the capital framework, ... to mitigate interconnectedness and systemic vulnerabilities within the financial system" primarily through liquidity and capital reforms.
A Historical Perspective
To understand the perspective of the Basel III Accords and the corresponding U.S. regulations requiring an increase in the amount and quality of required minimum capital, it is helpful to first understand the special relationship of the FDIC with commercial banks that accept insured deposits and the history and mission of the FDIC. The relationship of the FDIC and its sister federal and state regulators with banks is unique and similar in large part to a parental relationship. In 1819, the U.S. Supreme Court decided the case of M'Culloch v. Maryland. Justice John Marshall's opinion for the Court equated banks with agents of the government. If a bank is an agent of the government, then for almost 200 years it is the government that has been the parent or principal. Banks are private enterprises. However, a bank's right to effectively borrow money (take in deposits) that are insured by (effectively) the federal government (FDIC) and their access to the Federal Bank window to borrow additional funds has certain consequences (a quid pro quo). Banks must operate their franchise subject to complex and unyielding regulatory oversight and control of federal and state regulators. Consistent with this viewpoint, the federal and state banking laws accord the FDIC and other bank regulators a great degree of deference in their ability to prescribe regulations and rules for every aspect of a bank's management, operations, capital structure and business, especially when it comes to "safety and soundness" concerns. This position is expressly stated in the Federal Deposit Insurance Act, which permits the FDIC to establish the required minimum capital for banks. More simply put, if bank regulators want more capital in banks, then banks are required to get the additional capital.
The FDIC was established during the administration of President Franklin D. Roosevelt pursuant to the Banking Act of 1933. One may view the FDIC as the final bastion that was built to prevent the repeat of a horrible financial history. The FDIC was organized during the Great Depression. This was a time with "bank runs" that resulted from a massive liquidity crisis that caused localized bank failures, initially by smaller rural banks. The bank failures quickly spread to more established and (then thought) better capitalized banks that were thought to be "too good to fail." The bank failures in the 1930s and the resulting financial contagion were not stymied until President Roosevelt declared a "national bank holiday" that was orchestrated by President Roosevelt and the Emergency Banking Act of 1933. The environment during the 1930s has some parallels to our more recent "Great Recession."
It is important to remember that the FDIC's fundamental obligation is to maintain a functioning banking system so that consumers have a safe and sound place for their "nest egg" and may conduct the essential retail commerce of our modern society.
Directly put, a bank is the one financial institution that provides depositors with a truly risk-free investment option. You put money in, and you get to take it all out at any time, with a little interest. The FDIC's "official" mission is to, as "an independent agency created by the Congress to maintain stability and public confidence in the nation's financial system by: insuring deposits, examining and supervising financial institutions for safety and soundness and consumer protection, and managing receiverships."
One only needs to look at the photos of the bank runs during the Great Depression and the financial misery that spread from a lack of confidence in the banking system to understand why the FDIC must take appropriate, and, if necessary, tough, action, even if it will likely mean a difficult time for small and community banks and, likely, a further consolidation of the banking industry. The mandate to build a system of well-capitalized commercial banks that do not fail or fall like dominos is the FDIC's absolute priority. There is evidence that our bank regulatory regime has succeeded in this mission. In stark contrast to the pre-FDIC period, there is currently no consumer and financial panic or bank runs associated with the contemporary bank foreclosures. From October 2000 to July 25, 2014, the FDIC has supervised 530 bank failures that had an aggregate of more than $1.87 trillion in deposits and which represented an aggregate of more than $86 billion in estimated losses (measured as of 12/31/13). These failed banks include two community banks located in Manhattan. Even the July 2011 failure of the larger IndyMac Bank (Pasadena, California) did not cause panic as the FDIC took control of this bank, and made sure that the retail depositors had the full benefit of the insurance and that this depository institution was liquidated in a relatively orderly process.
The right to increase capital and require a better quality of regulatory capital is easily rationalized given the relationship of the regulators with banks and the absolute need of the regulators to defend the banking system from systemic risk. The fundamental objectives of the new capital rules are simple: more capital is better and more capital reduces the risk that (i) banks will fail, (ii) the FDIC insurance fund will be used and (iii) retail commerce and the global economy will be disrupted.
Overview of the New Capital Rules
The FDIC has stated that its rules will:
- promote the safety and soundness of the banking industry;
- improve the quality and the quantity of the regulatory capital of banks by, among other provisions, revising the definition of regulatory capital, requiring compliance with a new common equity-only capital ratio, increasing the Tier 1 capital requirements and, for certain institutions, requiring certain supplementary leverage ratios;
- limit capital distributions and certain discretionary bonus payments if a bank does not hold a specified amount of common equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements;
- introduce a higher risk weight for certain past due exposures and acquisition, development, and construction real estate loans;
- provide a more risk-sensitive approach to exposures to non-U.S. sovereigns and non-U.S. public sector entities;
- replace references to credit ratings with new measures of creditworthiness;
- provide more comprehensive recognition of collateral and guarantees; and
- provide a more favorable capital treatment for transactions cleared through qualifying central counterparties.
A full discussion of the capital requirements and measurement of capital ratios, including the risk weighting of assets and deductions and related formulas, would resemble an advanced course in calculus and is not attempted in this article. In general, the FDIC's rules look at the total capital of a banking institution. The capital of a banking institution is divided into (i) Tier 1 capital, which in turn is divided into Common Equity Tier 1 and Additional Tier 1, and (ii)Tier 2 capital.
Tier 1 capital is, generally, the accumulated retained earnings of the bank and the amount of the capital paid to the bank for capital stock and other permitted securities. Common equity capital is the purest form of capital and consists primarily of cash paid in for non-callable or redeemable common stock and additional paid-in-capital and retained earnings, subject to certain FDIC adjustments or deductions. Other permitted securities are defined in the regulations as the Additional Tier 1 capital elements and include fully paid in securities that:
- deeply subordinated;
- treated as capital under generally accepted accounting principles;
- subject to suspension of dividends and other payments without penalty or adverse effect at the FDIC's discretion;
and are not:
- guaranteed by a bank or a bank affiliate, or otherwise credit enhanced;
- subject to any maturity or redemption right or contain an incentive for the bank to redeem the security such as an increasing dividend rate;
- subject to any call right, except to the extent approved by the FDIC, and other specified conditions, including a minimum term of five years;
- subject to redemption or repurchase without the prior approval of the FDIC;
- subject to liquidating dividends or distributions;
- subject to any credit-sensitive feature or other events that require payment; or
- subject to any features, such as anti-dilution provisions, that would limit or discourage additional issuance of capital by the issuer.
Tier 2 capital, in large part, includes the same components as the Additional Tier 1 capital elements described above.
Each of Tier 1 capital and Tier 2 capital are subject to adjustments that are required by the regulations. One of the significant modifications or limits to Tier 1 capital is the limitation on Trust Preferred Securities which are no longer included in Tier 1 capital unless they were issued prior to May 19, 2010 and therefore "grandfathered." The amount of trust preferred securities that may grandfathered and included in Tier 1 is limited to 25% of Tier 1 capital (after specified exclusions and regulatory deductions and adjustments). Trust Preferred Securities are a type of security often used by community banks to increase capital. Generally, the investor received a specified fixed return in the form of a distribution and the bank received capital and a tax deduction for the payment of dividend or distribution to the investors. Accordingly, the security had many of the benefits of a subordinated debt instrument. As this security will often be on a bank's balance sheet, investors and acquirers of community banks need to appreciate the loss or limitations of this regulatory capital.
The new FDIC rules require banking institutions to maintain, among other things, the following minimum capital ratios:
- Tier 1 leverage capital to all assets ratio of 4%;
- common equity Tier 1 capital to risk-weighted assets ratio of 4.5%;
- Tier 1 capital to risk-weighted assets ratio of 6%; and
- total capital to risk-weighted assets ratio of 8%.
The capital ratios are generally calculated by taking the specified amount of the regulatory capital and dividing the value or amount of the assets as adjusted by the risk weight. In this way, the regulators have a method to measure the perceived risk to the bank, both in quality of an asset and the liquidity of an asset.
There are numerous categories of assets and related risk weightings. The risk weighting is based on the regulators' determination of the risk, which is primarily based on the regulatory perceived market, value and/or liquidity risk of the specified asset. This risk weighting process has the advantage of making the capital calculation less complex but resembles a "one size fits all" approach that does not appreciate market changes, transaction structures or other factors that could change the asset's risk profile. For example, one of the provisions of the new capital rules changes the risk weight for unsecured exposures that are past due for 90 days or more and that are not sovereign risk exposures. This particular change, and other changes to, and existing provisions of the risk weighting regime, provide certain trip wires that, if activated, would adversely affect a bank's regulatory capital. There may be numerous facts and circumstances that result in a 90-day past-due exposure to pose less risk to a bank than its exposure to a current asset that is about to realize a material adverse financial result. For example, compare: (i) a borrower that is late due to a day's delay in collecting a receivable, or selling an asset and using the net proceeds to pay the loan to the bank (ii) a borrower that made a payment but has aggregate current liabilities in excess of its aggregate current assets or significant, aged or slow-moving inventory that will not be converted to cash. The first credit will be paid but will have a larger risk weight. The second credit satisfies the formula to have a normal risk weight, but clearly presents more credit risk to the bank than the first credit.
Effect of the FDIC's Capital Rules on Community Banks and Small Banking Institutions
While certain commentators and articles criticize the FDIC risk-weighting regime because it is not dynamic and sensitive to current market conditions and risk, one can understand the regulator's position that a standardized formula will yield greater security, safety and soundness than a dynamic approach that could more accurately measure risk, but could prove inaccurate and in any event would be subject to certain judgments. For example, one needs only to look at the recent inaccuracy and degree of judgment that was used in underappreciating the market risk of syndicated residential home mortgage investments. The current risk-weighting regime also provides more certainty to the bank executive managing the bank's portfolio. A dynamic risk-weighting approach could result in a vicious cycle that causes a rush to liquidate assets when market conditions turn adverse, which in turn would decrease values and increase the risk, which in turn would create incentives to liquidate more of the same class of assets, and so on.
Prudent bank executives are required to assess and manage a bank's portfolio within the structure of the risk weighting and capital regimes. The current risk-weighting regime provides greater certainty for such management because each class of assets or investments is treated in a consistent and clear manner. Bank executives must assess their banks' capital position, determine appropriate investments that maintain additional capital as a buffer in case of asset value deterioration or any of the factors under the risk- weighting regime that cause a reduction in the bank's capital ratio. The consistent and clear risk-weighting regime incentivizes a small bank to make investments that limit its business to less risk-weighted assets. The consequence, and the conundrum, for bank executives is that less risk in their portfolio will likely lead to less profits but a more stable bank. However, lower profits will mean a lower ability to provide dividends and would make the less risky bank less valuable. This could cause the bank to be passed over by investors in favor of investments that are perceived to be more profitable. One analogy to this management process is driving a car on a busy highway. The bank executive is required to keep the car in a lane as other cars (risks) come into the lane, sometimes without signaling their lane shift or as a result of erratic driving (business operations). The amount of risk of an accident is reduced by the driver reducing the speed (risky assets) of the vehicle (bank). The balance to be struck is to go fast enough to move the vehicle down the road and be profitable so other vehicles do not pass the bank (which is a requirement for investors seeking a return), but not go so fast as to make it difficult or impracticable to react to erratic drivers (specific asset risks) and inclement weather (general economic risk) and, consequently, get into an accident (fall below its regulatory capital).
The FDIC noted in its release for the final rule that "[a]s a result of the new requirements, some small FDIC-supervised institutions may have to alter their capital structure (including by raising new capital or increasing retention of earnings) in order to achieve compliance." At first glance, this appears to be a significant understatement. The FDIC's position was initially announced in the proposed rules and received many comments, including that the additional capital requirements and compliance burdens applicable to small and community banks would be a difficult burden that would cause many banks to change their asset allocations or investment policies that would have an adverse effect on the U.S. economy, particularly in rural areas. The FDIC did not change its position and the proposed rules were adopted in substantially the same form in the final rules. The comments advocating a change to the proposed rules noted that the new capital rules would:
- "severely" limit the ability of a community bank or small bank to grow;
- reduce returns to shareholders that would reduce investor demand for the equity of banking organizations;
- significantly increase compliance costs;
- diminish a bank's access to the capital markets because of reduced profit and from dividend restrictions associated with the capital buffers;
- "encourage," if not require, the consolidation of community banks through mergers and acquisitions specifically in rural markets, because such banking organizations would need to spread compliance costs among a larger customer base; and
- confuse market observers of community banks in part because the regulatory capital framework does not allow investors and the market to clearly ascertain regulatory capital from measures of equity derived from a banking organization's balance sheet.
The FDIC's position was similarly not changed by comments that argued that the objectives of the proposal could be achieved through regulatory mechanisms other than the proposed risk-based capital requirements, including enhanced safety and soundness examinations, more stringent underwriting standards, and alternative measures of capital or that the FDIC recognize community banking organizations' limited access to the capital markets and related difficulties raising capital to comply with the new rules.
Some comments to the FDIC argued that the proposed rules also included that the rules would materially and adversely affect the banking industry and the U.S. economy. The simple fact is that if a bank has to hold more capital in less risk-weighted assets (e.g., cash and treasuries), then the bank has less money to deploy to loans to businesses and generate the liquidity for commerce and growth. Comments included that the FDIC capital rules would inevitably lead to:
- restricted job growth and employment;
- reduced lending or increase the cost of lending, including to small businesses and low-income or minority communities;
- limited availability of certain types of financial products; and
- impair the recovery of the U.S. economy because banks would not lend capital but be required to maintain capital to satisfy unnecessary static capital level requirements.
The U.S. bank regulators and the Basel III Accord constituents were not persuaded by these comments and moved forward with the revised capital rules to increase the safety and soundness of the banking industry through increased bank capital levels. It may be that the rules echo a theme to the new vision of bank regulation – that there should be bigger and fewer banks in the industry. Certainly, under the new capital rules, community banks face many challenges.
Community banks will require additional capital to maintain their operations. Even if banks have sufficient capital to satisfy the increased regulatory minimums, additional capital, in particular the newly created Common Equity Capital, will be required to continue the lending to risk weighted assets. The discussion of capital has several parts. The bank must maintain:
- an increased level of regulatory minimum capital;
- a new and further restricted minimum capital ratio that is comprised primarily of the amount paid into capital for common stock in cash and retained earnings;
- a new capital conservation buffer and countercyclical capital buffer amounts;
- additional capital to address, and be an additional buffer for, operating losses resulting from loans, operations or other matters, each of which will reduce retained earnings and therefore reduce all capital amounts and ratios; and
- additional capital to fund improvements and capital expenditures including those to enhance compliance, operational, and financial controls.
The FDIC noted that (i) 74 small FDIC-supervised institutions, or 3% of such supervised banks, with total assets of $500 million or less on the date of the final rule, do not hold sufficient capital to satisfy the requirements of the final rule; and (ii) that these banks must raise an aggregate of $233 million in regulatory capital to meet their increased minimum capital requirements. It should be noted that this data from the FDIC is for banks to meet their minimum capital. As noted earlier, a prudent bank executive would need significantly more capital than the regulatory minimum and would need to manage and allocate the bank's assets/investments to significantly less risky assets (drive their vehicle at such a slower speed). Consequently, these banks, that may be sound and have an excellent portfolio of loans and assets, will be required to exit profitable lines of businesses and face reduced profitability. These banks would find that they are the vehicle that gets passed by as if they were out of gas. It is possible, if not likely, that such vehicles would find it preferable to sell their loan portfolio and deposit base and climb aboard someone else's bigger and more stable vehicle. The FDIC did not attempt to note the difficulty of a community bank that is undercapitalized raising additional equity capital in the current market conditions other than to note that the cost of the capital for equity (as required for the new common equity Tier 1 capital and for total capital requirements) would be somewhat more costly than tier 2 capital, which includes subordinated debt, due to the fact that the subordinated debt would generate interest deductions. Similarly, the FDIC did not note the dilution that existing investors in such community banks would be required to suffer given their difficult capital position. Such investors (and the bank management) should speak earnestly with seasoned investment bankers to better position the bank and illustrate the bank's earnings potential and value on a pro forma basis. Such conversations and capital plan should be developed quickly. Failure to act quickly could result in making it impossible to act at all. The implementation of the new capital rules will cause sound banks that do not raise additional capital to re-allocate their portfolio to less risk weighted assets. The longer the period that a bank maintains its asset base in lower risk (and generally less profitable) assets, the longer the period that the bank will present decreased income performance, which will make the investment case for the bank to be less compelling.
Community and small banks are also challenged by the changes to the risk weightings and operations. In addition to maintaining the capital, a bank will need to address the other part of the algebraic equation – the denominator or their assets (loans and investments). In the FDIC release with respect to the final rules, the FDIC noted that it "... expects that some [banks] may change internal capital allocation policies and practices to accommodate the requirements of the final rule." For example, bank executives may need to make loans and other investments with less risk (a lower risk weight). We may already be seeing the effect of this decision process. The final capital rules codify the FDIC's regulatory capital rules, which have previously resided in various appendices to their respective regulations, into a harmonized integrated regulatory framework. Accordingly, bank executives have had time to develop and implement asset management, investment and allocation strategies to work within the new regime and have already been implementing their revised allocation strategies. This may be one of the reasons that banks have been reducing their commercial real estate and commercial and industrial loans.
Certain of the changes to the capital rules and risk-weighting regime will have a greater impact on community banks.
Increased Capital Requirements
The required minimum capital for banks has increased. One significant change in the regulatory capital requirements is that banks must now have part of their Tier 1 capital as common equity Tier 1 capital, as briefly discussed above. The fact that a minimum of 4.5% of the risk weighted assets of a bank must be the purest form of capital (generally common stock and retained earnings) is expected to significantly impact and limit small and community bank activities. The new common equity Tier 1 capital is the lowest level in the capital stack, making it more expensive to acquire. This requirement will likely:
- require banks to raise additional common stock which, under current market conditions, may result in substantial dilution to the current common stockholders;
- make an acquisition of a bank less attractive, and therefore lower the value of a bank, as the investors or acquirer will be required to use a more expensive type of investment capital that does not permit leverage; and
- increase the due diligence risk in an investment or acquisition because this additional type of capital is another hurdle for banks to conduct operations in full compliance.
A new development instituted by the capital rules is that banks are now required to maintain additional capital as a so-called "buffer." This buffer is effectively an additional minimum capital requirement because a bank will be unable to make any distributions or pay certain bonus compensation if its capital buffer is not maintained.
Risk Weighting of Assets
As noted above, the regulatory regime sets forth a formula, the numerator is the amount of a specified capital and the denominator is, generally, the amount of risk weighted assets. Assets of a bank are assigned a risk weight in the regulations, which is expressed as a percentage. The regulatory capital calculus is that assets with more risk are assigned a greater risk weight, which increases the amount of risk weighted assets, which (because this is the denominator) increases the denominator and results in a lower regulatory capital ratio. Accordingly, banks that are near their minimum capital ratios will be required to either (1) get additional capital, as noted above, or (2) manage their assets by selling higher risk-weighted assets and shifting the proceeds to lower risk weighted assets or making loans and other investments (acquiring assets) that have a lower risk weight.
Some of the risk-weighting provisions that may disproportionately affect small and community banks include the following:
High Volatility Commercial Real Estate (HVCRE) Exposures
Small and community banks traditionally have a portfolio of real estate loans, although this portfolio allocation has been modified over recent years as regulators have reacted (or overacted) to the real estate investment recession by requiring banks to limit their real estate loans and re-allocate to commercial and industrial loans or assets. The net capital rules continue to discourage real estate loans that are perceived as risky, including High Volatility Commercial Real Estate ("HVCRE") by assigning a 150% risk weight to HVCRE loans. HVCRE is a credit that finances the acquisition, development, or construction ("ADC") of real property where:
- the commercial property loan has a loan-to-value ratio that is less than or equal to the applicable maximum specified ratios established by the FDIC (generally, 80% for commercial, multi-family and other non-residential property; 75% for development properties and 85% for residential properties). The determination of the applicable limits requires further regulatory scrutiny. For example, in determining this loan-to-value ratio, the appropriate limit is the limit applicable to the final phase of the project funded by the loan and loan disbursements cannot exceed actual development or construction outlays. There are other regulations with respect to loans secured by a portfolio or more than one property;
- the borrower has not contributed equity equal to at least 15% of the project, based on the appraised "as completed" value; and
- the borrower contributes capital prior to the first advance of the loan by the bank and the capital is subject to a contractual commitment to stay in the project throughout the life of the project, that is until permanent financing takes out the ADC and actually remains in the project.
There are certain exceptions to HVCRE. HVCRE does not include:
- residential mortgages;
- loans that qualify under the Community Reinvestment Act to a business or farm that is a small business under the size eligibility standards of the Small Business Administration's Development Company or Small Business Investment Company programs or have gross annual revenues of $1 million or less; or
- loans secured by agricultural land that is not in any part valued or used for any activity other than farming, and accordingly HVCRE will include loans secured by farm land if the purpose is to develop the land for any commercial, residential or other non-farm purpose.
ADC loans are an important component of community development and generate numerous well-paying jobs in a community. The limitations, noted above, increase the risk weight for a performing loan that is HVCRE to 150%. In addition, the requirement for strict loan to value and for the real estate developer or sponsor to make a 15% equity contribution prior to the first funding of the loan in order for such loan not to be classified as HVCRE will continue to restrict the ability of commercial banks to make profitable loans to develop their communities. The risk-weighting static requirements for HVCRE may require small and community banks to leave a significant amount of ADC to larger banks that may not have the community connections and local knowledge with respect to real estate market conditions and trends and other important local conditions. In addition, the risk- weighting requirements do not accommodate project-specific credit issues. For example, a local developer that land banked a project and needs financing for guaranteed construction costs with a loan-to-value ratio of 60% would still have an HVCRE loan if the developer could not contribute at least 15% of the project costs.
Community banks that have excess regulatory capital may be in an advantageous position to acquire banks with a real estate portfolio that includes HVCREs, as the combined portfolios on a pro forma basis may permit expansion into HVCREs that have significant income potential. Similarly, banks faced with the increased capital requirements that are more challenging given their portfolio with HVCREs will need to syndicate their exposures, raise additional capital or combine their portfolios with other banks.
A bank must assign a 150% risk weight to assets that are unsecured loans (or assign the risk weight to the portion that is under-secured) that are not to a sovereign borrower or a residential mortgage and are past due for 90 days or more. This requirement is a significant change to the risk-weight matrix. The 90-day period may arbitrarily force a bank to liquidate an exposure that has a sound credit profile other than a momentary "hiccup" in payment. For example, the significant increase in a risk weight will require banks to take more prompt action, and perhaps liquidate or sell their exposure, prior to the 90-day mark, even if the delay is due to a good reason, for example a delay in the payment of an asset sale by the borrower or a delay in the payment of escrowed funds or receivables. In addition, any investor or acquirer of a small or community bank needs to continuously monitor and assess these exposures as the closing date approaches. If the target bank falls over this 90-day trip wire at or near the closing date, even if after the closing date, the investor or acquirer will be surprised and find that additional capital will be required to be invested in the bank to implement their business plan.
The FDIC's new rules provide a more risk sensitive approach to non-U.S. sovereign credits, including central banks and credits that may arise from selling or syndicating assets. Under the new rules a risk weight between 0% and 150% is applicable, depending on the country risk classification ("CRC") of the non-U.S. government, as determined by reference to the most recent CRC consensus published by the Organization for Economic Cooperation and Development (or OECD). A credit to a sovereign that has a default in any of its obligations will have a risk weight of 150%. There is a similar risk-weighting regime for exposures to foreign banks and non-U.S. public sector entities ("PSEs"). The practical effect of this risk-weighting regime is that the risk weight for specific CRC is generally greater for foreign banks and PSEs than for sovereigns. As non-U.S. government agencies and foreign banks are increasing their participation in U.S. commerce, there is a greater likelihood that a community bank will have some sovereign credit exposures. The change in the risk weighting may require some small banks to avoid such exposures. This could adversely affect community banks serving immigrant communities or US branches that are established by non-U.S. companies by limiting the exposure that a community bank should prudently have to these institutions.
Repos and Other Derivatives
The new rules significantly modified the risk weighting of collateralized transactions including derivatives and securities financing transactions. Banks must now take into account the fair value of the underlying securities or collateral, which is subject to regulatory discounts or "haircuts." The new rules also significantly changed the risk weighting to cleared derivatives and securities financing transactions to encourage parties to invest in such derivatives through cleared transactions with qualifying central counterparties (e.g., an exchange). These changes reflect a theme in the Dodd-Frank Act to encourage the transparency and lower risk profile of transacting derivatives through exchanges. Community banks will likely make greater use of exchange-traded derivatives.
One of the recurring concerns in the Dodd-Frank Act was to reduce or eliminate the reliance on ratings from credit rating agencies. This concern is reflected in the FDIC's changes to the risk weighting for securitization exposures. Banks previously used credit ratings in part of the calculus of risk weighting securitizations. Banks will continue to use a "gross up" approach so that the risk weight is the aggregate risk of the underlying assets, subject to a specified minimum of 20%. Banks are now required to calculate the risk of the underlying securities based on a matrix of considerations, including the structure, delinquency and loss exposure. Banks are also required to have comprehensive due diligence procedures that appreciate the various risk exposures. Failure to comply with these due diligence obligations to the satisfaction of the primary regulator could lead to a severe result, such as a risk weight of 1,250% for such exposures.
There are numerous other factors in the capital and risk-weighting calculus that challenge bank executives as they attempt to navigate a regulatory environment and provide an attractive return to investors.
The new capital rules implement the core objectives of the FDIC and its sister bank regulators to enhance the safety and soundness of our banking system by making banks maintain more capital and influencing or requiring small and community banks to operate with a lower and more stable risk profile. The regulations continue the static and formulaic approach to determining the risk to a bank and did not take the opportunity to develop a dynamic risk sensitive regime. While an approach that would assess the actual risk profile of bank assets in "real time" would certainly be a great step forward in regulating and monitoring bank capital and operations, such an approach would be subject to substantial discretion by bank executives that would inevitably lead to a difficult and inconsistent regulatory regime. Additionally, given the relative success of the FDIC and its sister regulators in defending the bank system during the Great Recession, in comparison to the unregulated chaos of the early 1930s, it would be difficult to advocate a comprehensive new approach to capital monitoring and risk assessment which would be subject to overly optimistic calculations of underlying risk, as evidenced by the factors that contributed to the need for the Dodd-Frank Act.
The new regulatory capital requirements will likely change the operations, investments and assets of small and community banks and force these banking institutions to avoid HVCRE loans and closely monitor and react to unsecured exposures. The inevitable consequence of these more stringent regulatory capital requirements is that small and community banks will be more stable, generate less profit, have a lower return on capital and find it attractive to merge with larger institutions that have the ability to absorb their assets without materially affecting their capital ratios. The fact that a bank finds its capital ratios deteriorate under the new rules does not necessarily mean that its portfolio is problematic or less profitable. An additional consequence is that certain financings, such as HVCRE and unsecured credits, will be provided by private funds and other financial institutions as small and community banks find it more difficult to maintain these assets. This will lead other financial institutions to, over time, build a portfolio of loans that is perceived by the capital rules to provide greater risk. If such risks are realized and defaults in such loans begin to accumulate, then the contagion scenario will begin again, but this time regulated financial institutions will not be on the front line. While this may be beneficial to the FDIC and bank regulators, the effect may be simply "not at my table" as the risk in banks is shifted to other financial institutions. The next step for the bank regulators will be to assess the exposures of banks to the portfolios of loans made by unregulated financial institutions. It remains to be seen if our next chapter in bank regulatory capital will be written in a proactive or reactive manner.
1 Basel Committee on Banking Supervision (BCBS) and described in Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems (Basel III), as well as subsequent changes to the Basel III framework and recent BCBS consultative papers.
2 Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act).
3 The amendment proposed by Senator Collins (SA 3879), May 6, 2010, page S3371.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.