Comment Letter Primer: Basel III Proposals

Comment Letter Primer: Basel III Proposals The Virginia Bankers Association urges member banks to review and submit comments on the proposed Basel III regulatory capital rules by the October 22, 2012 deadline. We also encourage banks to send copies of their comment letters to their U.S. senators and congressman. The VBA provides the following material to help Virginia banks with the commenting process. As part of its commitment to Virginia banks, the VBA will submit a comment letter on behalf of all Virginia banks. A copy of that letter is attached to this primer. The big picture. Required Capital Ratios (Increased) = Capital (Narrowed) Risk-Weighted Assets (Increased) The proposals increase the required capital ratios, while at the same time making it more difficult to meet those ratios by limiting qualified capital and increasing the risk weights for many assets. The rules are complicated and lengthy, require extensive data collection and detailed calculations, and will make compliance difficult, time consuming and costly. The proposals generally apply to banks of all sizes and bank holding companies with assets of $500 million or more. A separate advanced approaches risk-based capital proposal applies to large banks only. While the regulators goal is to protect the banking system and the American economy, these regulations, coupled with a flood of other regulations, will devastate the banking industry, severely limit the availability of credit, and significantly harm our economy. To avoid this harm, the regulations should be withdrawn and rewritten to address these concerns for all banks and, in particular, to exempt community banks from most of the proposals. Ratio with Capital New capital to risk-weighted assets (RWA) ratios. Ratio Conservation Buffer Common equity tier 1to RWA ratio (CET1) (new ratio): 4.5% 7% Tier 1 capital to RWA ratio (increased from 4%): 6.0% 8.5% Total capital to RWA ratio (no change) 8.0% 10.5% Leverage ratio (tier 1capital to average assets): 4% (no change, modified definition) Adds a new 2.5% capital conservation buffer. If you don't maintain it, there are restrictions on dividends, distributions and discretionary bonuses to executive officers. Incorporates the new capital ratios into the prompt corrective action (PCA) framework used to constrain the activities of banks that fail to meet the new capital ratios. Capital restrictions. CET1 limited to common stock and retained earnings, subject to several limitations and exclusions. All unrealized gains and losses on available for sale securities (AFS) must flow through CET1. Any mortgage servicing assets (net of deferred tax liabilities) that exceed 10% of CET1 are excluded from CET1. Mortgage servicing assets, aggregated with deferred tax assets and investments in common stock of an unconsolidated financial entity, together may not exceed 15% of CET1. The amount of mortgage servicing assets below the 10% threshold will receive a 250% risk weight. Contrary to the Dodd-Frank Act, the proposal requires the phase-out of trust preferred securities (TruPS) from tier 1 capital over a 10-year period. 1

Deferred Tax Assets (DTAs) that result from carryovers of net operating losses and tax credits must be deducted from capital. Complexity will require banks to carefully monitor DTAs and other assets to insure that capital levels are appropriate. Risk weighting. Generally increases capital requirements by risk weighting assets. Residential mortgages generally: The proposals assign risk weights to residential mortgages based on (1) whether the mortgage is a traditional category 1 mortgage or a riskier category 2 mortgage, and (2) the loan-to-value (LTV) ratio of the mortgage. The risk weights for category 1 mortgages range from 35% to 100% and for category 2 mortgages from 100% to 200% depending on the LTV ratio. Junior liens: The proposals classify all junior liens, such as home equity loans and lines of credit, as category 2 exposures with risk weights ranging from 100%-200%. Generally, a bank that holds two or more mortgages on the same property is required to treat all the mortgages on the property as category 2 exposures, even the first lien mortgage. Delinquent mortgages and loan modifications: Under existing rules, the risk weight of a loan does not change when the loan becomes delinquent. Instead, the additional risk is addressed through the allowance for loan and lease losses. The proposals change this approach by assigning nonresidential loans over 90 days past due a risk weight of 150%. Banks must re-assess a mortgage s category and risk weights after a modification, unless the modification is made under HAMP. PMI: The proposed rules do not recognize private mortgage insurance (PMI). Mortgages are subject to high risk weights even if PMI reduces the risk of loss on such loans. Credit enhancements: Banks must hold capital for assets with credit enhancing representations and warranties, including for pipeline mortgages in the process of being sold. These apply to any mortgage sold with a representation or warranty that contains an early default clause or premium refund clause that covers assets guaranteed by the U.S. government or GSEs. High Volatility Commercial Real Estate (HVCRE) will be assigned a 150% risk weight. Under existing rules, these loans are risk weighted at 100%. HVCRE loans are defined as acquisition, development and construction (ADC) commercial real estate loans except: (1) one- to- four family residential ADC loans; or (2) Commercial real estate ADC loans that meet certain LTV, down payment and liability requirements. Banks will be required to collect and report very granular information in order to calculate the risk weights of assets, including new information about underwriting features and LTV ratios of credit exposures, as well as sufficient information to satisfy due diligence requirements. Existing loans are not grandfathered, and new information will need to be collected on banks existing portfolios. Effective dates. Generally, many of the new capital ratios and exclusions of certain types of capital will phase in over a two-year period beginning in January 2013, but will not be fully implemented until January 2015. The new risk-weighted assets provisions will become effective in January 2015. Several provisions, including the capital conservation buffer, will phase in over a longer period, with all of the provisions being effective by 2019. Read the full proposals: (1) capital ratios proposal and (2) risk-weighted assets proposal. 2

Calculators: The regulators have prepared calculators to help evaluate the impact of the Basel III proposals on the capital structures of banks and BHCs. Click here to access the regulators' calculators. 1 The ABA has developed a private label securitization calculator to assist banks in analyzing the impact of the proposed securitization treatment on their applicable portfolios. Click here to access the ABA securitization calculator. Suggested Comments. In your comment letter, consider addressing some of the following issues and ideas. Pick a few that are the most important to your bank and your customers. You do not have to address them all. You can use the attached VBA comment letter as a guide, but it is best to express the ideas in your own words. Most importantly, use real world examples and data that are specific to your bank s operations to highlight the impact these regulations will have on the communities and customers you serve. Oppose the disqualification of many common types of bank capital. The proposals exclude TruPS from tier one capital, severely limit mortgage servicing assets in CET1 and reduce CET1 for unrealized losses on AFS securities. Each of these capital classes have long been used by banks as stable, reliable sources of regulatory capital. Removing any one of them from qualified capital will make it more difficult for banks to be adequately capitalized. The combined effect of these and other qualified capital limitations will severely reduce bank capital at a time when it is extremely difficult for banks to raise capital. Without adequate capital, banks will need to reduce lending, merge with other banks or close. All of which will harm consumers, businesses and local communities. Discuss how the phase out of TruPS from tier 1 capital will negatively impact your bank. o Do you have TruPS included in your regulatory capital? If so, were you planning to retain them longer than the period allowed in the proposal? o If so, how easily will you be able to replace that capital? Or will you more likely have to reduce assets or take other action as a result of the proposed phase-out of TruPS? o If you have to consider reducing assets, what impact would that have on your customers and your community? What kind of assets would likely be affected? o If you have issued TruPS, what would investors likely do with your TruPS under this proposal? Would they continue to hold them, or would they likely sell them? Would that matter to your bank? Would it harm investors? o If you are an investor in TruPS of other banks, would this proposal induce you to continue to hold those investments or make you more likely to sell them? o Describe how TruPS allow your bank to raise capital in a safe and predictable way. Discuss how the proposed capital rules related to mortgage servicing assets will adversely affect your bank and your services to customers. o Would the size of your mortgage servicing business be affected at all by the thresholds in the proposal? If so, to what extent? o If it would be affected, what would be the choices that you would be faced with? Would that include discontinuing services you now provide to customers? o What would those choices mean for your customers and communities? 1 VBA cautions overreliance on the calculator s results. The calculator offers banks only a point in time and high level overview of the of capital requirements under the proposed rules to assist institution s in their analysis. Actual impact of the proposed rules is heavily dependent on technical new definitions, individual loan underwriting data and changing market conditions. VBA notes that the calculator is a point in time assessment that does not take into account the increased volatility that results from the proposals allowing unrealized gains and losses to flow through capital. Therefore, there may be institutions that meet the minimum requirements today, but could fail to meet certain capital requirements in a raising interest rate environment. The calculator also includes several gaps, including the securitization treatment. The ABA has developed a private label securitization calculator to assist banks in analyzing the impact of the proposed securitization treatment on their applicable portfolios. 3

o o o What would those choices mean for your bank s overall earnings? Would there be any employment impact on your bank? Explain the importance of mortgage servicing agreements to your bank. Identify regulations and internal practices that you use to maximize the safety of your investment. Describe how mortgage servicing agreements help you to foster better relationships with consumers in your community. Discuss how unrealized gains and losses on AFS securities flowing through regulatory capital will adversely impact your bank. Unrealized gains and losses occur in AFS portfolios primarily as a result of movements in interest rates as opposed to changes resulting from credit risk. Interest rates, particularly on debt securities, can fluctuate frequently, and the proposed rules will introduce significant volatility into capital calculations. o To what extent would your current AFS investment portfolio be affected by the proposal today? How would it be impacted in a rising interest rate environment? o What steps might your bank take to address the impact? o Would your bank need to hold more capital as a cushion against volatility? If so, approximately how much? Would that capital divert resources from customer services and growth? o Would your bank need to limit investments in longer duration assets? What impact if any would that have on the funding of housing markets and national and local governments? o Would your bank need to consider selling all or part of its AFS portfolio? What impact would that have on the markets for those securities? o If your bank is considering changes in your AFS portfolio, what impact, if any, would the proposed rule have on your asset liability function and your liquidity or contingency funding plans? Discuss how the exclusion from capital of certain DTAs will negatively affect your ability to service your bank s customers and communities needs. o Do you have DTAs resulting from net operating losses and tax credits? If so, what impact will the proposed deduction of these assets from capital have on your bank s capital ratios? o What steps if any would you consider taking to address these deductions? Would those steps affect your ability to provide products and services to your customers? o Would the deduction from capital of DTAs resulting from tax credits affect your bank s participation in any tax credit programs? Oppose the heavily burdensome and highly complex risk weightings. These regulations were meant to address the activities that led in part to the recent global recession. Banks focused on traditional banking activities were not the major contributors to the downturn, but will be hit hard by these unnecessarily complicated regulations. Additional capital or types of capital may be appropriate in some cases. But the requirements for traditional commercial banks and community banks should be simple, straightforward and easy to comprehend and evaluate. Healthy banks, especially community banks, operate with tight budgets and low margins and do not have extensive resources to devote to evaluating compliance with unnecessarily complicated regulations. Discuss how the proposed risk weights on residential mortgages will adversely affect your bank and your services to customers. o How would this proposal affect your bank s capital and earnings given your residential mortgage business? o What steps would you take to address the impact? How would it affect your ability to offer mortgages? o Would it affect the types of mortgages you offer (e.g., make fewer non-traditional mortgages)? Would it affect the pricing of the mortgages that you offer? 4

o Would customers currently reached by the mortgage markets find it harder to obtain mortgages meeting their needs and situations? Discuss how the requirement to hold capital for credit enhancing representations and warranties will negatively impact your bank and your services to customers. o Does your bank sell mortgages into the secondary market? If so, how would the proposal impact your activities? How significantly would your current practices impact capital and earnings? o What steps would you take to address the impact of the proposal? Would you decrease or reduce certain business lines that otherwise make good business sense? Would those changes affect the amount of mortgages you make? o Would you drop enhancements and warranties on mortgages you sell? How would investors react to that? o What impact would changes that you may make in response to the proposal have on the availability and cost of mortgages to customers? Discuss how the heightened risk weights for HVCRE will adversely impact your bank and the products and services you offer your customers. o What impact would the proposal have on your bank s existing portfolio? o What would be the choices that you would be faced with given the impact? To what extent would those choices affect your ability to provide business loans? o Would there be any employment impact on your bank? Discuss how the potential for increased risk weights on delinquent loans and modified loans will impact your ability to work with your customers. o What impact would the proposal have on your bank s existing portfolio? o Would the proposed rules affect how your bank approaches delinquent customers? o If so, would you be less likely to pursue loan workout strategies and instead proceed directly to foreclosure or loan sale? Discuss the negative impact the scope and granularity of the proposed rules will have on your institution. o Will your bank need to change its internal reporting systems, provide additional employee training or hire additional personnel? o How will your bank go about collecting the new data requirements? Will the data need to be collected manually? Will your bank need to install new systems or modify existing systems? Is your bank considering hiring a third party to assist you with meeting the new requirements? o Will your bank consider changing the services and products it offers to its customers in order to comply with this greater complexity? If so, will those changes benefit or harm your customers? o How much time is needed to meet the data, system and personnel requirements? Oppose the new capital conservation buffer. The additional 2.5% capital conservation buffer layered on top of already increased capital requirements will lead to unreasonably high levels of capital, which will substantially reduce lending and adversely affect the profitability and viability of many banks business operations. Limiting the ability of banks to pay dividends and distributions to investors will hurt their ability to attract investors and raise necessary capital. Limits on executive compensation will hurt the ability of banks and the entire banking industry to attract talented business leaders who will be lured away to other businesses and industries by higher market-driven compensation packages. 5

Explain the dangers of requiring too much capital. The recent financial crisis highlighted a need for more capital in many financial institutions. Appropriate capital is necessary, but superfluous capital increases risk in banks, is unprofitable, shrinks competition, reduces lending and hurts consumers and communities. Excessive capital increases risk in banks. As capital is increased, return on equity (ROE) to the investor decreases. For a bank to attract outside investors it must provide the return the investor expects. To increase ROE, many banks may feel pressure to take on more risk by making riskier loans they otherwise would not make. Excessive capital shrinks competition, hurts customers. Lower ROEs will mean fewer banks can raise capital to meet ratios that are too high. Those banks may feel pressure to shrink their lending or to merge with or sell to competing banks reducing the number of competitors. Less competition among lenders will ultimately harm consumers. Excessive capital reduces credit availability. Requiring more capital to offset increased riskweighted assets, coupled with the difficulty banks will have raising capital with lower ROEs, will lead many banks to one alternative reducing the amount of mortgage assets on their balance sheets by reducing lending. For example, for each additional dollar of required capital that a bank cannot raise, it will likely need to reduce its lending capacity by $10. Accordingly, for a community bank with $100 million of assets that experiences a 2.5% increase in required capital ($2.5 million), the local community it serves will suffer a $25 million decrease in available lending. Pushes consumers to less regulated lenders. Higher capital requirements and risk-weighted assets will push certain loans out of banks with the demand for these loans met only by the shadow banking industry, the less heavily regulated nonbanks. This is contrary to the intent of the Dodd-Frank Act and repeats one of the causes of the recent financial crisis. Oppose the application of the Basel III capital requirements to community banks. We should not allow a one-size-fits-all capital requirement structure to govern our banking system. The international committee that drafted the Basel III standards designed them to apply to, and address issues unique to, large internationally active banks. Imposing these requirements on small community banks will have a crippling effect on the community banking industry in this country and the consumers, businesses and local economies it serves. Discuss your bank s current safety and soundness precautions. Discuss your bank s current compliance burden. If the new Basel III capital requirements become law, will your bank cease or cut back on consumer lending? On community investments? On public debt investments? Describe the types of businesses and borrowers your bank serves. What impact will the Basel III regulations have on them if your bank stops making loans? Suggest a tiered approach to Basel III, where regulators address the unique needs and circumstances of community banks and large international banks separately. Demand more time to review, comment on, and implement the Basel III Proposal and other recently proposed regulations. In the last two months alone, more than 4,000 pages of proposed rulemaking notices have been issued by the regulators (Basel III proposals, high-cost mortgage proposal, mortgage 6

disclosure proposal, mortgage servicing proposals, appraisal proposals and others). Describe how difficult it is for your bank to keep up with all of the recently proposed regulations and why your bank needs more time to review and understand the combined impact of all of the proposed rules in order to provide the regulators with meaningful comments. Emphasize why your bank needs as much time as possible (at least 18-24 months) to implement all the new regulations by describing the process your bank must go through to comply with the new rules, including reviewing the rule, consulting appropriate lawyers, accountants and consultants, writing new procedures, preparing revised documents and retraining staff. How and Where to Submit Comment Letters. Comments on the Basel III proposals may be submitted by e-mail to: The Federal Reserve at regs.comments@federalreserve.gov. Include the following docket numbers in the subject line of the e-mail: Docket No. R 1430, RIN No. 7100 AD87; and Docket No. R 1442, RIN No. 7100-AD87. The OCC at regs.comments@occ.treas.gov. Include the following docket numbers in the subject line of the e-mail: Docket ID OCC 2012 0008; RIN 1557 AD46; and Docket ID OCC 2012 0009; RIN 1557 AD46. The FDIC at comments@fdic.gov. Include the following docket numbers in the subject line of the e- mail: RIN 3064 AD95; and RIN 3064 AD96. Suggested Format for Comment Letters. Comment letters are most effective when they are brief and follow an easily understood format. Heading - In the top left corner of the letter, insert the date, address, the proposal, and a salutation. See the attached VBA comment letter as an example. Introduction - A brief description of your bank: your size, location, lines of business. Include a brief description of the community you serve and how you serve it. Body - Identify what parts of the regulation interest you. Express whether you support or oppose the provisions you mentioned. Most importantly, explain how the provision will affect your bank. Concrete examples or data projections help regulators realize the practical effects of a proposal. Will this cause your bank to increase/decrease lending? How will the regulation affect consumer costs? If this proposal will cause changes to your bank structure or the lines of business that you offer, you should describe these changes. Will the proposal change your bank s competitiveness? Finally, how will this proposal affect the community you service? Conclusion - Summarize your argument and, if you wish, provide a more effective alternative. Guidelines for Writing Comments. As you look at the specific comment suggestions above, think about how the issues impact your bank and your community in the following ways: Consumer Impact: How will this proposal affect credit availability? How will competition between banks change? Will this proposal help consumers or hurt them? How will this proposal affect loan terms? Will this proposal push consumers towards unregulated nonbanks? Bank Impact: How will this change the way you service your community? Will it affect your credit offerings? How does this proposal change your compliance efforts? Will your bank need to change other investments in order to accommodate this regulation? Will this regulation result in a financial loss to your bank? 7

More Information. For more information on the proposed regulation or on preparing a comment letter, please contact Mel Tull, VBA General Counsel, at mtull@vabankers.org or (804) 819-4710, or Matt Bruning, VBA Director of Government Relations, at mbruning@vabankers.org or (804) 819-4704. 8