It s Finally Here BASEL III First Quarter 2015 Call Report Changes for Community Banks

Transcription

1 It s Finally Here BASEL III First Quarter 2015 Call Report Changes for Community Banks

2 It s Finally Here BASEL III First Quarter 2015 Call Report Changes for Community Banks The ink on the Basel Committee on Banking Supervision s BASEL II accords had barely dried when the financial crisis of erupted. Policymakers and regulators quickly realized that the regulatory capital requirements memorialized in the BASEL II accords would not have had a significant impact in preventing the financial crisis nor have added significantly greater stability to financial institutions to withstand a similar crisis. Policymakers and regulators began to look past BASEL II and onto a more rigorous regulatory capital framework that they hoped would forestall future financial catastrophes like the one experienced in On July, 2, 2013, after a lengthy regulatory comment process, the Federal Reserve Board (FRB) approved a final rule adopting the Basel Committee on Banking Supervision s revised capital framework ( BASEL III ) into the United States banking regulatory structure. The Federal Deposit Insurance Corporation (FDIC) introduced an Interim Final Rule on BASEL III on July 9, 2013, and subsequently adopted the Final Rule on BASEL III on April 8, The most significant impact as a result of BASEL III adoption relates to changes to the calculation of regulatory capital and risk-weighted assets. These changes result in considerably altered Call Report Schedules RC-R Part I (Regulatory Capital Components and Ratios) and Part II (Risk-Weighted Assets) and are effective for all financial institutions beginning with the March 31, 2015 Call Report. Community banks generally are defined for BASEL III purposes as less complex financial institutions not subject to the market risk or advanced approaches risk based capital rule 1. The discussion that follows highlights the major changes that community banks should keep in mind while preparing their March 31, 2015, Call Report. Changes to RC-R Part I Advanced approaches financial institutions began using the updated Schedule RC-R, Part I.B. on March 31, 2014, and are already subject to the changes made to the Regulatory Capital Components and Ratios section of the Call Report as a result of BASEL III. However, all financial institutions will need to comply with the updated Schedule RC-R, Part I.B 2 as of March 31, Common Equity Tier 1 Capital (CET1) CET1 capital is a new measure of regulatory capital meant to reflect a financial institution s core equity capital. CET1 capital consists of common stock, surplus, retained earnings, accumulated other comprehensive income (see discussion below of the opt-out election), includable minority interest, and various adjustments and deductions. The minimum required CET1 ratio is equal to 4.5 percent of riskweighted assets. Accumulated Other Comprehensive Income (AOCI) Opt-Out Election Non-advanced approaches institutions have the opportunity to make a one-time, non-revocable election to opt out of including AOCI in the calculation of CET1 capital. This election MUST be made in connection with the March 31, 2015, Call Report filing. If an institution elects to opt out, then the institution may continue to treat AOCI in a manner consistent with risk-based capital rules prior to the adoption of BASEL III. Banks wishing to elect the AOCI opt-out should enter 1 on line 3a, of Schedule RC-R, Part I in the March 31, 2015, Call Report. The one caveat to the permanence of the AOCI opt-out election is in the case of a merger or acquisition. If two financial institutions merge that have made the same opt-out election, then the surviving institution must continue to use that election. If two institutions merge that have made differing 1. 1 A national bank or Federal savings association that has, or is a subsidiary of a bank holding company or savings and loan holding company, with total consolidated assets of $250 billion or more, total consolidated on-balance sheet foreign exposure of $10 billion or more, or that has elected to use the advanced approaches regulatory capital framework 2. 2 On March 31, 2015, Schedule RC-R, Part I.A, will be removed and Part I.B will be designated Part I

3 opt-out elections, then the surviving institution is required to make a new election when filing the first combined Call Report after the merger. Adjustments and Deductions Goodwill and intangible assets, other than mortgage servicing assets, are deducted from CET1 capital, net of any associated deferred tax liabilities (DTLs). Deferred tax assets that arise from net operating loss and tax credit carryforwards (net of related valuation allowances and DTLs) must also be deducted from CET1 capital, subject to certain transition provisions (40 percent of the adjustment is applied in 2015 and increasing by 20 percent each year until completely phasing in at 100 percent in 2018). If an institution makes the AOCI opt-out election, then adjustments for items in AOCI are made on lines 9a through 9e. There are other miscellaneous deductions and adjustments for changes in fair value of liabilities that are due to changes in an institution s own credit risk, as well as non-significant investments in common stock of nonconsolidated financial institutions, but these adjustments and deductions are expected to be less significant for community banks. Threshold Deductions After making the above mentioned adjustments and deductions, CET1 capital is subtotaled on line 12 of Schedule RC-R, Part I and additional threshold deductions and adjustments are made based on the identified asset as a percentage of subtotaled CET1 capital. The most significant of these threshold deductions are for mortgage servicing assets and deferred tax assets (DTAs). Mortgage servicing assets that exceed 10 percent of Schedule RC-R, Item 12 are deducted from CET1 capital subject to transition provisions (40 percent in 2015 increasing 20 percent annually until reaching 100 percent in 2018). Deferred Tax Asset Threshold Deduction Prior to BASEL III, deferred tax assets that could be included in regulatory capital were limited to taxes paid that were recoverable under a carryback provision plus the lesser of the tax on the next 12 months of taxable income or 10 percent of Tier One capital. Temporary differences were assumed to reverse at the Call Report date and the calculation was done as one overall limit that includes all tax jurisdictions. Beginning with the March 31, 2015, Call Report, the ability to use the tax liability on 12 months of future earnings to support deferred tax assets is no longer available. Additionally, the determination of recoverable taxes is done on a jurisdictional basis. There will no longer be the ability to net federal recoverable taxes against state deferred tax assets. As a result, institutions will need to understand state-by-state carryback provisions to determine whether or not a state deferred tax asset is realizable. In general, banks with a net deferred tax asset made up of tax attributes, such as net operating loss or tax credit carryforwards, may experience a significantly greater limitation under the new rules. DTAs resulting from tax credit carryforward and net operating losses are deducted in Line 8 prior to calculating the threshold deduction for DTAs on line 15 of Schedule RC-R, Part I. Capital Adequacy Changes There are also a number of changes to the ratios for overall capital adequacy purposes. As noted in the table below, the CET1 ratio is a new ratio (discussed above) and the required Tier 1 risk-based capital ratio for capital adequacy purposes also increased. The Tier 1 leverage and total risk-based capital ratios for capital adequacy purposes remains unchanged, except for the addition of the capital conservation buffer discussed in the next section. Revised Regulatory Capital Minimum Ratios (%) excludes Capital Conservation Buffer Current Rule Tier 1 Leverage Capital 4% / 3% 4% Common Equity Tier 1 Risk-based Capital N/A 4.5% Tier 1 Risk-based Capital 4% 6% Total Risk-based Capital 8% 8% Final Rule

4 Capital Conservation Buffer The capital conservation buffer is an additional level of capital required over and above normal levels. The theory behind the buffer is that banks should build up additional capital outside periods of stress which can be drawn down during more stressful times when losses are incurred. The buffer is equal to 2.5 percent of total risk weighted assets above the regulatory minimums for CET1, Tier 1 capital and total capital and begins phasing in during The buffer phase-in period is as follows: Phase-In Period for Capital Conservation Buffer Additional Buffer 0.625% 1.25% 1.875% 2.5% Total CET1 Ratio including Buffer 5.125% 5.75% 6.375% 7.0% Total Tier 1 Ratio including Buffer 6.625% 7.25% 7.875% 8.5% Total Capital including Buffer 8.625% 9.25% 9.875% 10.5% Other Items An institution that previously included trust preferred securities and cumulative perpetual preferred stock in its Tier 1 capital and had less than $15 billion in total consolidated assets as of December 31, 2009, would still be allowed to include capital instruments issued prior to May 29, 2010 in Tier 1 capital. The inclusion of these capital instruments is subject to current limits of 25 percent of Tier 1 capital elements, after nonqualifying elements and capital deductions/adjustments. Items includible in Tier 2 capital generally are unchanged for community banks with regard to subordinated debt and the allowance for loan losses. Changes to RC-R Part II Part II of schedule RC-R has seen a significant change by the introduction of numerous new columns to incorporate new risk weighting categories. Columns R and S have been added to address certain exposures where the risk weight may differ depending on a variety of factors (primarily underlying collateral, if applicable). Most community banks will continue to use the old categories in addition to the new 150 percent column. However, some asset and off-balance sheet exposures may require use of some of the other new columns as addressed below. Residential Mortgages There is new required disclosure of residential mortgage exposures, which includes one to four family residential properties and multi-family residential properties with an original and outstanding amount of $1 million or less. This disclosure should also include additional multi-family mortgages greater than $1 million that meet certain defined underwriting and performance criteria. Generally, the risk weighting rules for residential mortgage exposures have remained unchanged. High Volatility Commercial Real Estate High Volatility Commercial Real Estate (HVCRE) are generally acquisition, development and construction (AC&D) loans, and now must be separately disclosed on Part II of schedule RC-R. Loans to finance one to four family residential projects and certain other projects that meet underwriting and performance criteria can be excluded. The new risk weight for exposures in this category is 150 percent. Equity Exposures Equity investments in unconsolidated entities may now attract significantly higher risk weights to the extent that they are allowed to be included in the determination of capital. Publicly traded equity exposures will now receive a 300 percent weighting, while non-publicly traded exposures will receive a 400 percent weighting. Certain exposures to investment firms may require a 600 percent weighting.

5 Bank Owned Life Insurance Generally, bank-owned life insurance receives a 100 percent risk weight, similar to previous capital rules. However, in certain instances, separate account bank-owned life insurance products may qualify for a lookthrough approach and allow a risk weighting of less than 100 percent, depending on the collateral that is underlying the policy. Securitizations/Structured Products Securitization exposures (other than to Government Sponsored Entities) now must be separately evaluated for risk weighting. An institution can elect to calculate the risk weight using the simplified supervisory formula approach (SSFA) or use a default 1,250 percent weighting. In summary, the changes to the call report instructions will require additional data gathering and analysis on the part of community banks to prepare Schedule RC-R. The biggest changes for community banks likely will come in the area of the adjustments and deductions for the deferred tax asset, as well as risk weighting of HVCRE. Since the various components of the deferred tax inventory must be allocated across multiple line items and risk weightings when preparing Schedule RC-R, more frequent and detailed tracking of the deferred tax inventory is necessary. With regard to HVCRE exposures, community banks will need to understand and track the underwriting and performance criteria of commercial real estate AC&D portfolios to accurately capture those lending exposures that would qualify as HVCRE. Finally, the FDIC, FRB and Federal Financial Institutions Examination Council (FFIEC) have a number of resources available to help with implementation and provide further detail on the Call Report changes. FDIC Resources: FFIEC Resources: FRB Resources: ABOUT THE AUTHOR Wesley Allen, CPA Wesley Allen is a Director in the DHG Financial Services practice in Charlotte. He has more than 12 years of public accounting experience, working with financial institutions in the areas of process and control evaluation, external financial reporting to regulatory agencies and investors, and compliance with laws and regulations. Contact Wesley: wesley.allen@dhgllp.com dhgllp.com Will Neeriemer, CPA Will Neeriemer is a Partner based in Charlotte in the DHG Financial Services practice. Will began his career with DHG and has more than 15 years of experience performing external audit engagements, including audits of internal controls over financial reporting, merger and acquisition accounting and valuation techniques. Contact Will: will.neeriemer@dhgllp.com dhgllp.com About DHG: With more than 1,800 people in 12 states, Dixon Hughes Goodman ranks among the nation s top 20 public accounting firms. Offering comprehensive assurance, tax and advisory services, the firm focuses on major industry lines and serves clients in all 50 states as well as internationally. Visit for additional information.