BASEL III AND
COMMUNITY BANKS
Larry K. Harris
Polsinelli PC
314-889-7063
lharris@polsinelli.com
Polsinelli PC. In California, Polsinelli LLP
Some Basel III Definitions
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Common Equity Tier 1 Capital (CET1)
Additional Tier 1 Capital
Tier 1 Capital
Tier 2 Capital
Capital Conservation Buffer
HVCRE
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Common Equity Tier 1 Capital
Common Stock and Retained Earnings
plus or minus
Limited Accumulated Other Comprehensive
Income (AOCI) [If you opted out]
plus or minus
Deductions and Adjustments
plus
Qualifying Common Equity Tier 1 Minority
Interest in Subsidiaries
___________________________
CET1
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Common Equity Tier 1 Capital
AOCI:
Banks under $250 billion in assets
will be allowed to make a one time
election to opt-out of fully
reflecting AOCI in CET1 Capital
(i.e., keep things like they are)
Election is to be made in Call
Report due March 2015
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Common Equity Tier 1 Capital
Deductions:
:
 Goodwill
 Certain Deferred Tax Assets
 Other Intangibles (but not Mortgage
Service Assets)
 Significant Investments in other
(unconsolidated) financial
institutions’ common stock
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Common Equity Tier 1 Capital
Deductions:

Significant Investments in other
(unconsolidated) financial institutions’
common stock
What is that?
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Common Equity Tier 1 Capital
Deductions:
 What is an investment in other
(unconsolidated) financial institutions’
common stock?
Think:
Midwest Independent Bancshares, Inc.
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Common Equity Tier 1
Deductions:
When is an investment significant?
When your financial institution owns more than 10% of
the other financial institution’s common stock
So it is unlikely any community bank will need to deduct
from its CET1 because of investments in any other
financial institution, and certainly not for MIB stock.
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Common Equity Tier 1 Capital
 Qualifying CET1 minority interest in a
subsidiary
What qualifies?
Only Tier 1-type capital in a bank subsidiary
(not non-bank subsidiaries) held by minority
shareholders.
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Additional Tier 1 Capital
Non-cumulative Perpetual Preferred Stock including surplus
plus
Troubled Asset Relief Program (TARP)
plus
Small Business Lending Fund (SBLF)
plus
Trust Preferred Securities (TruPS)
plus
Qualifying Tier 1 Minority Interest
_____________________________________________
Additional Tier 1 Capital
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Additional Tier 1 Capital
Non-cumulative Perpetual Preferred Stock, including surplus
Why non-cumulative?
Because the financial institution may skip
dividends, and not pay them later.
But does that make it unattractive to investors?
Pretty much so.
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Additional Tier 1 Capital
 TARP
 SBLF
These are only grandfathered in; the
programs are closed.
But if a financial institution has it, it
counts as Additional Tier 1 Capital.
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Additional Tier 1 Capital
 Trust Preferred Securities
In the original proposal these were to be phased out.
In an about-face, the banking regulators revised the
final rule: all institutions of less than $15 billion in
assets may continue to treat grandfathered TruPS
as Additional Tier 1 Capital.
Under Collins amendment to the Dodd-Frank Act
no new TruPS are treated as Tier 1 capital.
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Additional Tier 1 Capital
 Qualifying Tier 1 Minority Interest
Tier 1-type instruments in non-bank
subsidiaries (pretty much just capital
stock)
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Tier 1 Capital
Common Equity Tier 1 Capital
plus
Additional Tier 1 Capital
________________________________
Tier 1 Capital
This is not very different from the prior Federal Reserve
rules, which divided holding company Tier 1 Capital into
Tier 1 Core Capital and Tier 1 Non-Core Capital.
There are differences, but the similarities outweigh the
differences.
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Tier 2 Capital
ALLL (limited)
plus
Preferred Stock
plus
Subordinated Debt
plus
Qualifying Tier 2 Minority Interest
____________________________
Tier 2 Capital
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Tier 2 Capital
 ALLL
Include ALLL up to 1.25% of risk weighted
assets.
This is the same as the current rule.
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Tier 2 Capital
 Preferred Stock
Includes cumulative preferred stock
That is, the dividends cumulate if not paid; so no
common stock dividends until all cumulated dividends
have been paid.
This is much more attractive to investors.
No limit on the amount of Preferred Stock
included in Tier 2 Capital.
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Tier 2 Capital
 Qualifying Tier 2 Minority Interest
Tier 2-type capital held by minority
shareholders in any type of
consolidated subsidiary.
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Tier 2 Capital
 No Limit!
Before Basel III, Tier 2 Capital was
limited to an amount equal to the
financial institution’s Tier 1 Capital.
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Capital Conservation Buffer
 A new concept
 And a very different concept:
The first time capital rules are being
used to directly limit the payment of
dividends.
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Capital Conservation Buffer
 The most important number: 2.5%
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Capital Conservation Buffer
 The most important number: 2.5%
 This is the percentage by which a financial institution
must exceed all adequately capitalized risk weighted
ratios to be unrestricted in the
 payout of dividends
 payout of discretionary bonuses
 redemption of securities
 We will look at this more closely shortly.
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HVCRE
 High Volatility CRE
Why do we care what this is?
Because these assets are risk
weighted at 150%
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HVCRE
 All Real Estate Acquisition and
Development Loans, except….
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HVCRE
 All Real Estate Acquisition and Development Loans, except
 1-4 family residential projects
 Loans secured by properties for
agricultural purposes
 Community Development Loans
and
 Acquisition and Development Loans
– That meet certain loan-to-value criteria
– Where the borrower is contractually required to
contribute and keep throughout the life of the project
capital equal to 15% of the “as completed” appraised
value of the assets
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So What Does Basel III Change?
 Creates a new risk weighted capital ratio requirement
(CET1/RWA)
 Changes one important existing risk weighted capital
ratio requirement (Tier 1/RWA)
 Alters risk weightings
 Limits the payment of dividends, discretionary bonuses,
and redemptions (the Capital Conservation Buffer)
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Common Tier 1 Capital/Risk Weighted
Assets
 The minimum CET1/RWA (that is, to be
adequately capitalized) is: 4.5%
 To be well capitalized, CET1/RWA must
be 6.5% or greater
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CET1
Keep in mind, most community banks rely heavily
on common stock for Tier 1 Capital. Those banks
should have no trouble meeting the CET1/RWA
thresholds.
Bank holding companies with consolidated assets
of under $500 million do not have capital ratio
requirements under the Federal Reserve’s rules.
This will not change, so for many community
banks, much of Basel III does not affect their
holding company.
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Tier 1 Capital/Risk Weighted Assets
Current requirements:
Adequately Capitalized
Well Capitalized
4.0%
6.0%
Basel III requirements:
Adequately Capitalized
Well Capitalized
6.0%
8.0%
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Tier 1 Capital/Risk Weighted Assets
But keep this change in perspective:
 Most community banks mostly have Tier 1 Capital
 The biggest exception to this is the part of Tier 2 Capital that is ALLL
Total Capital/Risk Weighted Assets was and remains:
Adequately capitalized
8.0%
Well Capitalized
10.0%
So a bank that mostly has Tier 1 Capital and meets the well capitalized
threshold for Total Capital should not have any problem meeting the new
Tier 1/RWA ratio.
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Capital Ratios
To be Well Capitalized
Leverage
CET1/RWA
Tier 1/RWA
Total Capital/RWA
Current
Ratio
Basel III
Ratio
5%
-6%
10%
5%
6.5%
8%
10%
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CAPITAL CONSERVATION BUFFER
 Most radical change in capital regulations
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Capital Conservation Buffer
 Most radical change is capital regulation
For the first time, capital rules are being
used to regulate/restrict:
 Dividends
 Discretionary Bonuses
 Redemptions of Stock
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Capital Conservation Bonus
The concept:
Limits on the amount of dividends, etc.,
unless the financial institution exceeds
being adequately capitalized by at least
2.5% in all risk weighted ratios.
The “Buffer”:
The least amount by which the financial
institution exceeds the 3 risk weighted
ratios.
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CAPITAL CONSERVATION BUFFER
When fully phased in (2019), the following limits
apply:
Buffer
Maximum Payout*
> 2.5%
No payout limit
> 1.875% to 2.5%
60%
> 1.25% to 1.875%
40%
> 0.625% to 1.25%
20%
≤ 0.625%
0%
*Expressed as a percentage of Eligible Retained Income
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Capital Conservation Buffer
What is: Eligible Retained Income?
The financial institution’s net income for the 4
calendar quarters preceding the current
quarter
less
Distribution (dividends, discretionary
bonuses, redemptions) during that 4-quarter
period
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Illustrative Calculations of Capital Conservation Buffer
(2019 and After)
Adequately
Capitalized
Threshold
(2015 and on)
2019 Capital
(Including
Buffer)
Needed for
Unlimited
Distributions
Bank 1
Bank 2
Bank 3
Bank 4
Common Equity
4.5%
7.0%
8.6%
8.2%
5.3%
6.5%
Tier 1 Capital
6.0%
8.5%
8.6%
8.3%
8.0%
6.8%
Total Capital
8.0%
10.5%
11.4%
10.6%
9.9%
8.2%
2.6%
2.3%
0.8%
0.2%
Unlimited
60%
20%
No
distribution
Risk Weighted
Asset Ratio
Buffer
Distribution Limit
(% of Maximum
Amount)
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ILLUSTRATIVE Calculations of Capital Conservation Buffer
(2019 and After)
Adequately
Capitalized
Threshold
(2015 and on)
Bank 1
Buffer
Common Equity
4.5%
8.6%
4.1%
Tier 1 Capital
6.0%
8.6%
2.6%
Total Capital
8.0%
11.4%
3.4%
Risk Weighted
Asset Ratio
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Illustrative Calculations of Capital Conservation Buffer
(2019 and After)
Adequately
Capitalized
Threshold
(2015 and on)
Bank 2
Buffer
Common Equity
4.5%
8.2%
3.7%
Tier 1 Capital
6.0%
8.3%
2.3%
Total Capital
8.0%
10.6%
2.6%
Risk Weighted
Asset Ratio
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ILLUSTRATIVE Calculations of Capital Conservation Buffer
(2019 and After)
Adequately
Capitalized
Threshold
(2015 and on)
Bank 3
Buffer
Common Equity
4.5%
5.3%
0.8%
Tier 1 Capital
6.0%
8.0%
2.0%
Total Capital
8.0%
9.9%
1.9%
Risk Weighted
Asset Ratio
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ILLUSTRATIVE CALCULATIONS OF CAPITAL CONSERVATION BUFFER
(2019 AND AFTER)
Adequately
Capitalized
Threshold
(2015 and on)
Bank 4
Buffer
Common Equity
4.5%
6.5%
2.0%
Tier 1 Capital
6.0%
6.8%
2.3%
Total Capital
8.0%
8.2%
0.2%
Risk Weighted
Asset Ratio
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Illustrative Calculations of Capital Conservation Buffer
(2019 and After)
Adequately
Capitalized
Threshold
(2015 and on)
2019 Capital
(Including
Buffer)
Needed for
Unlimited
Distributions
Bank 1
Bank 2
Bank 3
Bank 4
Common Equity
4.5%
7.0%
8.6%
8.2%
5.3%
6.5%
Tier 1 Capital
6.0%
8.5%
8.6%
8.3%
8.0%
6.8%
Total Capital
8.0%
10.5%
11.4%
10.6%
9.9%
8.2%
2.6%
2.3%
0.8%
0.2%
Unlimited
60%
20%
No
distribution
Risk Weighted
Asset Ratio
Buffer
Distribution Limit
(% of Maximum
Amount)
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COMPARISON OF CURRENT AND BASEL III CAPITAL RATIOS
Current Bank Prompt
Corrective Action
Capital Requirements
Current Holding Company
Capital Requirements
Final BASEL III
(Fully Phased-in at 2019)
Capital Requirements
Capital Status:
Adequate
Adeq.
+
Buffer
Leverage
(Tier 1/Total Assets)
3.0-4.0%
--
5.0%
3.0-5.0%
--
--
4.0%
--
5.0%
Common Equity/RWA
--
--
--
--
--
--
4.5%
7.0%
6.5%
Tier 1 Capital/RWA
4.0%
--
6.0%
4.0%
--
6.0%
6.0%
8.5%
8.0%
Total Capital/RWA
8.0%
--
10.0%
8.0%
--
10.0%
8.0%
10.5%
10.0%
Well
Adequate
Adeq.
+
Buffer
Well
Adequate
Adequate
+ Buffer
Well
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S CORPORATIONS AND THE CAPITAL
CONSERVATION BUFFER
A key facet to S corporations is that income
is taxed at the shareholder level and not the
corporate level.
Said another way, shareholders are taxed
on an S corporation’s income, and not on
the distributions received from the S
corporation.
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S CORPORATIONS AND THE CAPITAL
CONSERVATION BUFFER
Assume the following scenario
 An S corporation suffers losses over
several years
 As a result, its RWA ratios all decline, and
approach being only adequately capitalized
 After several years, the bank begins to
recover
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S CORPORATIONS AND THE CAPITAL
CONSERVATION BUFFER
 As the bank recovers, it experiences
taxable income
 Taxable income means the shareholders
will need to pay federal income taxes
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S CORPORATIONS AND THE CAPITAL
CONSERVATION BUFFER
 But the bank will be unable to pay any
dividends to its shareholders to cover the
taxes
 At first, the bank will not have any Eligible
Retained Income
 Even after the Bank does have Eligible
Retained Income, it will be prohibited from
dividend payments until its Capital
Conservation Buffer is >0.625%
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S CORPORATIONS AND THE CAPITAL
CONSERVATION BUFFER
 So should most banks cease being S
corporations?
 Generally, no.
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