Polsinelli PC. In California, Polsinelli LLP BASEL III AND COMMUNITY BANKS Larry K. Harris Polsinelli PC

real challenges. real answers. sm Some Basel III Definitions  Common Equity Tier 1 Capital (CET1)  Additional Tier 1 Capital  Tier 1 Capital  Tier 2 Capital  Capital Conservation Buffer  HVCRE

real challenges. real answers. sm 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

real challenges. real answers. sm 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

real challenges. real answers. sm 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

real challenges. real answers. sm Common Equity Tier 1 Capital Deductions:  Significant Investments in other (unconsolidated) financial institutions’ common stock What is that?

real challenges. real answers. sm Common Equity Tier 1 Capital Deductions:  What is an investment in other (unconsolidated) financial institutions’ common stock? Think: Midwest Independent Bancshares, Inc.

real challenges. real answers. sm 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.

real challenges. real answers. sm 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.

real challenges. real answers. sm 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

real challenges. real answers. sm 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.

real challenges. real answers. sm 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.

real challenges. real answers. sm 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.

real challenges. real answers. sm Additional Tier 1 Capital  Qualifying Tier 1 Minority Interest Tier 1-type instruments in non-bank subsidiaries (pretty much just capital stock)

real challenges. real answers. sm 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.

real challenges. real answers. sm Tier 2 Capital ALLL (limited) plus Preferred Stock plus Subordinated Debt plus Qualifying Tier 2 Minority Interest ____________________________ Tier 2 Capital

real challenges. real answers. sm Tier 2 Capital  ALLL Include ALLL up to 1.25% of risk weighted assets. This is the same as the current rule.

real challenges. real answers. sm 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.

real challenges. real answers. sm Tier 2 Capital  Qualifying Tier 2 Minority Interest Tier 2-type capital held by minority shareholders in any type of consolidated subsidiary.

real challenges. real answers. sm 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.

real challenges. real answers. sm 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.

real challenges. real answers. sm Capital Conservation Buffer  The most important number: 2.5%

real challenges. real answers. sm 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.

real challenges. real answers. sm HVCRE  High Volatility CRE Why do we care what this is? Because these assets are risk weighted at 150%

real challenges. real answers. sm HVCRE  All Real Estate Acquisition and Development Loans, except….

real challenges. real answers. sm 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

real challenges. real answers. sm 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)

real challenges. real answers. sm 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

real challenges. real answers. sm 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.

real challenges. real answers. sm Tier 1 Capital/Risk Weighted Assets Current requirements: Adequately Capitalized4.0% Well Capitalized6.0% Basel III requirements: Adequately Capitalized6.0% Well Capitalized8.0%

real challenges. real answers. sm 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 Capitalized10.0% 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.

real challenges. real answers. sm Capital Ratios Current Ratio Basel III Ratio Leverage5% CET1/RWA--6.5% Tier 1/RWA6%8% Total Capital/RWA10% To be Well Capitalized

real challenges. real answers. sm CAPITAL CONSERVATION BUFFER  Most radical change in capital regulations

real challenges. real answers. sm 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

real challenges. real answers. sm 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.

real challenges. real answers. sm CAPITAL CONSERVATION BUFFER When fully phased in (2019), the following limits apply: BufferMaximum 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

real challenges. real answers. sm 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

real challenges. real answers. sm Illustrative Calculations of Capital Conservation Buffer (2019 and After) Risk Weighted Asset Ratio 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% Buffer Distribution Limit (% of Maximum Amount) 2.6% Unlimited 2.3% 60% 0.8% 20% 0.2% No distribution

real challenges. real answers. sm ILLUSTRATIVE Calculations of Capital Conservation Buffer (2019 and After) Risk Weighted Asset Ratio 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%

real challenges. real answers. sm Illustrative Calculations of Capital Conservation Buffer (2019 and After) Risk Weighted Asset Ratio 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%

real challenges. real answers. sm ILLUSTRATIVE Calculations of Capital Conservation Buffer (2019 and After) Risk Weighted Asset Ratio 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%

real challenges. real answers. sm ILLUSTRATIVE CALCULATIONS OF CAPITAL CONSERVATION BUFFER (2019 AND AFTER) Risk Weighted Asset Ratio 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%

real challenges. real answers. sm Illustrative Calculations of Capital Conservation Buffer (2019 and After) Risk Weighted Asset Ratio 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% Buffer Distribution Limit (% of Maximum Amount) 2.6% Unlimited 2.3% 60% 0.8% 20% 0.2% No distribution

real challenges. real answers. sm 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. + BufferWell Adequate Adeq. + BufferWell Adequate Adequate + BufferWell Leverage (Tier 1/Total Assets) %--5.0% %-- 4.0%--5.0% Common Equity/RWA %7.0%6.5% Tier 1 Capital/RWA 4.0%--6.0% 4.0%--6.0% 8.5%8.0% Total Capital/RWA 8.0%--10.0%8.0%--10.0%8.0%10.5%10.0%

real challenges. real answers. sm 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.

real challenges. real answers. sm 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

real challenges. real answers. sm 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

real challenges. real answers. sm 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%

real challenges. real answers. sm S CORPORATIONS AND THE CAPITAL CONSERVATION BUFFER  So should most banks cease being S corporations?  Generally, no.

real challenges. real answers. sm Polsinelli provides this material for informational purposes only. The material provided herein is general and is not intended to be legal advice. Nothing herein should be relied upon or used without consulting a lawyer to consider your specific circumstances, possible changes to applicable laws, rules and regulations and other legal issues. Receipt of this material does not establish an attorney-client relationship. Polsinelli is very proud of the results we obtain for our clients, but you should know that past results do not guarantee future results; that every case is different and must be judged on its own merits; and that the choice of a lawyer is an important decision and should not be based solely upon advertisements. © 2013 Polsinelli PC. In California, Polsinelli LLP. Polsinelli is a registered mark of Polsinelli PC