Regulatory Capital; Basel III and the Standardized Approach

Position

  • ICBA supports strong capital requirements for all banks and their respective holding companies.
  • ICBA supports a full exemption from Basel III for non-systemically important financial institutions (non-SIFIs). If a full exemption is not possible, ICBA proposes the following amendments:
  • The allowance for loan and lease losses (ALLL) should be included in tier 1 capital up to 1.25 percent of risk-weighted assets, with the remaining balance included in tier 2 capital.
  • ICBA supports a recent proposal by the prudential bank regulators to raise the deduction threshold for mortgage servicing rights, certain deferred tax assets, and certain investments in other financial institutions from 10% to 25%. Regulators should also amend the punitive risk weights and provide a higher threshold for community banks.
  • Community banks should be exempt from the capital conservation buffer. In particular, Subchapter S banks should not be restricted from paying dividends to cover shareholders’ tax liability. The buffer also has a disproportionate adverse impact on mutual banks as well as any bank that relies on retained earnings to build capital, particularly in a low interest rate environment.
  • Acquisition, development, and construction (AD&C) loans are critical to economic growth. ICBA appreciates recent attempts by prudential bank regulators to ease the punitive Basel III capital requirements for high volatility commercial real estate (HVCRE) loans, though their proposal raises new concerns for community banks.
  • Capital standards should not disadvantage community banks relative to credit unions.
  • Banking regulators should not impose liquidity coverage ratio restrictions on high-quality investment securities that would impact the liquidity of those securities for community banks.

Background

ICBA supports strong minimum capital levels for all banks, including community banks. However, the originally proposed Basel III capital rules failed to recognize that community banks were not the cause of the financial crisis of 2008-09. Their simplified balance sheets, conservative lending, and common-sense underwriting shielded their regulatory capital from the losses incurred by large, complex, internationally-active and interconnected financial institutions. ICBA achieved major victories in the final Basel III rule including the exclusion of AOCI with its capital volatility from common equity tier 1 capital, allowing community banks to continue using the Basel I risk weights for their mortgage exposures, and grandfathering the inclusion of TruPS in tier 1 capital for certain community banks and TruPS issuances, consistent with Congressional intent. However, as described below, the Basel III final rule continues to burden community banks and must be further amended.

Recognition of ALLL Loss Absorption

Basel III largely fails to recognize the loss absorption abilities of ALLL and does not permit the inclusion of ALLL in tier 1 capital. This failure is based on the agencies’ erroneous view that the allowance represents losses already present within a financial instrument. FASB’s CECL accounting guidance clarifies that the allowance actually represents the first layer of the capital cushion to absorb bank losses, and as such it should be included in tier 1 capital. Moreover, because the CECL accounting guidance requires the allocation of more capital to ALLL, it results in a larger omission from tier 1 regulatory capital calculations. ICBA believes that ALLL should be included in tier 1 capital in an amount up to 1.25 percent of risk weighted assets, and the remaining balance of ALLL should qualify for inclusion in tier 2 capital.

Basel III Punishes Mortgage Servicing

Basel III punishes community banks that would like to service mortgage loans by severely lowering the threshold deduction for holding mortgage servicing assets (MSAs) as well as almost tripling the risk weight assigned to MSAs when they are not deducted. The threshold deductions for mortgage servicing assets should be raised from 10 percent of common equity tier 1 capital to 100 percent of tier 1 capital. Additionally, for mortgage servicing assets that are not deducted, the risk weight should be restored to 100 percent from the overly punitive 250 percent. Regulators have not presented any evidence that community banks’ level of MSAs held in portfolio made any contribution to the financial crisis of 2008 and 2009. In fact, in an environment where banks are being asked to consider interest rate sensitivity in the balance sheet, MSAs are a natural hedge against rising interest rates. A recent proposal by the bank regulators to raise the threshold deduction on mortgage servicing assets is a positive first step. However, regulators must recognize the value of MSAs and restore deductions to their pre-Basel III levels.

Capital Conservation Buffer Harms All Community Banks


Basel III imposes a capital conservation buffer for all measures of minimum regulatory capital. This is harmful to all community banks, in particular for mutual banks and other banks that rely on retained earnings to build capital. Subchapter S shareholders, who rely on dividends to cover their tax liability on their share of the banks’ earnings, will be harmed when a bank is prevented from paying dividends because it has not satisfied the capital conservation buffer. This prospect will exacerbate Subchapter S banks’ difficulty in raising new capital. At a time when regulators are encouraging the formation of new community banks, the capital conservation buffer represents a roadblock.

HVCRE

The banking agencies must take appropriate measures to revise the definition of HVCRE when assessing risk weights for AD&C loans. ICBA supports the regulators’ recent proposal to remove the HVCRE classification prospectively for all AD&C loans. However, ICBA is concerned that the proposal’s classification of AD&C loans as “HVADC” exposures with a punitive risk weight of 130% harms community banks and their communities, particularly in areas where economic growth is ongoing and expected in the future. AD&C loans should not be universally penalized simply because they are viewed as temporary or non-permanent financing arrangements.

Regulators Must Recognize Quality of Housing GSE Securities

ICBA is concerned that any restrictions placed on high quality mortgage assets like Fannie Mae and Freddie Mac mortgage-backed securities, financial instruments widely held by community banks, will reduce the liquidity of these securities and

adversely impact their fair values. Regulators should ensure that GSE securities get high quality liquidity recognition commensurate with their treatment in the capital markets.

Staff Contact: James Kendrick