The $500 Million Question. Proactive Planning for Consolidated Capital Requirements. By: Lowell W. Harrison and Derek W. McGee

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1 The $500 Million Question Proactive Planning for Consolidated Capital Requirements By: Lowell W. Harrison and Derek W. McGee Recently, we have received a number of questions from our clients regarding the impact of consolidated capital requirements applicable to growing bank holding companies that expect to exceed $500 million in total consolidated assets. This question is particularly important in light of the new Basel III capital rules, which become effective on January 1, 2015, subject to various phase-in periods. The purpose of this article is to provide an overview of the consolidated capital requirements applicable to bank holding companies with $500 million or more in consolidated assets, including an overview of the new Basel III capital rules. I. Background and Overview A bank holding company ( BHC ) with consolidated assets of less than $500 million is considered a small bank holding company under the rules and regulations of the Board of Governors of the Federal Reserve System ( Federal Reserve ). This designation means that the BHC is only required to maintain certain minimum capital ratios at the bank level, i.e., the BHC has the ability to use much more leverage at the holding company level. As a small bank holding company, any debt or other leverage at the holding company level can be contributed to the subsidiary bank as tier 1 capital. However, under the Federal Reserve s Small Bank Holding Company Policy Statement set forth in 12 C.F.R. Part 225, Appendix C, a small bank holding company is required to ensure that it has adequate cash flow to service its debt obligations and must maintain a debt to equity ratio of 1:1 or less in order to pay dividends without prior regulatory approval. Conversely, when a BHC exceeds $500 million in total consolidated assets, the company must report its regulatory capital ratios on a consolidated basis. As a result, existing holding company leverage will be treated as debt in the consolidated entity, which can adversely affect consolidated capital ratios, depending on the amount of leverage at the holding company level. The $500 million total consolidated assets test is conducted as of June 30 of each calendar year. If the BHC exceeds $500 million in total assets as of the June 30th testing date, the institution will be required to (i) meet the Federal Reserve s consolidated capital requirements as of March 31 of the following year and (ii) file consolidated financial statements with the Federal Reserve on Form FR Y-9C, beginning with the first quarter of the following year. For example, if a BHC exceeded $500 million in consolidated assets as of June 30, 2014, then the institution becomes subject to the consolidated capital requirements as of March 31, 2015 and will be required to file its first FR Y-9C beginning with the first quarter 2015 filing (which would be due in May of 2015). The existing regulatory capital framework will be replaced by the new Basel III capital rules in Accordingly, to the extent that a BHC exceeds $500 million prior to 2015, it would be subject to the existing consolidated capital requirements set forth in 12 C.F.R. Part 225,

2 Appendix A. If, however, the BHC exceeds $500 million in total assets during 2015, the Basel III capital rules would apply to the company. The paragraphs below provide an overview of the existing consolidated capital rules and the new Basel III capital rules. II. Existing Consolidated Capital Requirements Like the capital rules that currently apply at the bank level, the Federal Reserve s capital rules utilize a two-tier capital framework to evaluate the capital adequacy of BHCs with $500 million or more in total consolidated assets. Under the current capital rules, tier 1 capital generally consists of common stockholders equity, retained earnings, a limited amount of qualifying perpetual preferred stock, qualifying trust preferred securities and noncontrolling interests in the equity accounts of consolidated subsidiaries, less goodwill and certain intangibles. Tier 2 capital generally consists of certain hybrid capital instruments and perpetual debt, mandatory convertible debt securities and certain qualifying subordinated debt instruments, qualifying preferred stock, a portion of the loan loss allowance, and unrealized gains on certain equity securities. Like the existing capital ratios calculated at the bank level, BHCs with more than $500 million in total consolidated assets must calculate two consolidated capital ratios on the basis of risk-weighted assets: (1) the ratio of tier 1 capital to total risk-weighted assets must equal at least 4.0%, and (2) the ratio of total capital (tier 1 and tier 2 capital) to total risk-weighted assets must equal at least 8.0%. In addition to the risk-based capital rules and regulations, the Federal Reserve uses a leverage ratio as an additional tool to evaluate the capital adequacy of BHCs. The leverage ratio is a company s tier 1 capital divided by its average total consolidated assets. Under the current rules, certain highly rated BHCs may maintain a minimum leverage ratio of 3.0%, but most BHCs are required to maintain a leverage ratio of at least 4.0%. The federal banking agencies risk-based and leverage capital ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria. However, the federal bank regulatory agencies typically require banking organizations to maintain capital levels well in excess of the statutory minimum capital requirements, particularly when the institution engages in any non-traditional or risky activities. Federal Reserve guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. III. Basel III Capital Rules On July 2, 2013, the federal banking agencies adopted a final rule revising the regulatory capital framework applicable to all top tier BHCs with consolidated assets of $500 million or more and all banks, regardless of size. The Basel III framework replaces the existing regulatory capital rules beginning January 1, 2015, although the capital conservation buffer, which is 2

3 discussed in greater detail below, will be phased in over a three-year period, beginning January 1, Basel III requires banking organizations to maintain the following minimum regulatory capital ratios on a consolidated basis: A new ratio of common equity tier 1 capital to total risk-weighted assets of not less than 4.5%; A tier 1 risk-based capital ratio of 6.0% (an increase from 4.0%); A total risk-based capital ratio of 8.0% (unchanged from the current rules); and A leverage ratio of 4.0%. Basel III separates the existing tier 1 capital measure into two components: (1) common equity tier 1 capital and (2) additional tier 1 capital. Common equity tier 1 capital generally consists of common equity, surplus, retaining earnings and certain qualifying minority interests. The common equity tier 1 capital calculation also includes numerous deductions, including, for example, goodwill and intangible assets (other than mortgage servicing rights net of associated deferred tax liabilities) and certain deferred tax assets arising from tax net operating losses and tax credit carryforwards, net of associate deferred tax liabilities. In addition, the common equity tier 1 capital calculation includes certain other threshold deductions, which allow limited recognition in common equity tier 1 capital, subject to a 10% individual threshold and 15% aggregate threshold based on the institution s measure of common equity tier 1 capital. The threshold deductions include (1) certain deferred tax assets arising from temporary differences that could not be realized through net operating loss carrybacks; (2) mortgage servicing assets, net of associated deferred tax liabilities, and (3) significant investments in unconsolidated financial institutions in the form of common stock, net of associated deferred tax liabilities. In addition, under the Basel III framework, unrealized gains and losses on available-for-sale debt securities would be included in the common equity tier 1 capital calculation. However, in response to significant industry outcry, the final Basel III capital framework allows community banking organizations the ability to make a one-time, permanent election to continue treatment of other accumulated comprehensive income ( AOCI ) under the existing capital rules, which exclude unrealized gains and losses on available for sale debt securities from the tier 1 capital calculation. The AOCI opt-out election must be made on the institution s first regulatory report filed after January 1, We expect that most community banking organizations will take advantage of the opt-out election in order to mitigate the effect that fluctuating interest rates could have on regulatory capital ratios. The tier 1 capital ratio would include common equity tier 1 capital and any other instruments qualifying as additional tier 1 capital. Additional tier 1 capital instruments include qualifying non-cumulative perpetual preferred stock, certain minority interests not qualifying as common equity tier 1 capital, and current tier 1 capital instruments issued under the U.S. Department of Treasury s Troubled Assets Relief Program ( TARP ) and the Small Business Lending Fund ( SBLF ). The total capital ratio would include common equity tier 1 capital, additional tier 1 capital and any other instruments qualifying as tier 2 capital, including (1) 3

4 certain preferred stock instruments that do not qualify as additional tier 1 capital, (2) qualifying subordinated debt instruments, (3) minority interests not included in tier 1 capital, (4) allowance for loan and lease losses, up to 1.25% of total risk-weighted assets, and (5) tier 2 capital instruments issued under TARP and SBLF by Subchapter S corporations. In addition, Basel III implements a requirement for all banking organizations to maintain a capital conservation buffer above the minimum risk-based capital requirements in order to avoid certain limitations on capital distributions, stock repurchases and discretionary bonus payments to executive officers. The capital conversation buffer must be composed of common equity tier 1 capital, and it applies to each of the three risk-based capital ratios but not the leverage ratio. When fully phased in during 2019, the effect of the capital conservation buffer will be to increase the minimum common equity tier 1 capital ratio to 7.0%, the minimum tier 1 risk-based capital ratio to 8.5% and the minimum total risk-based capital ratio to 10.5%, for banking organizations seeking to avoid the limitations on capital distributions, stock repurchases and discretionary bonus payments to executive officers. The following table shows the phase-in schedule for the capital conservation buffer and the minimum regulatory capital ratios under Basel III in order to comply with the capital conservation buffer requirements. Minimum Capital Ratios and Phase-In Schedule for Capital Conservation Buffer under Basel III Capital Conservation Buffer (in the form of Common Equity Tier 1 Capital) Minimum Common Equity Tier 1 Capital Ratio Plus Capital Conservation Buffer Minimum Tier 1 Capital Ratio Plus Capital Conservation Buffer N/A 0.625% 1.25% 1.875% 2.5% 4.5% 5.125% 5.75% 6.375% 7.0% 6.0% 6.625% 7.25% 7.875% 8.5% Minimum Total Capital Ratio Plus Capital Conservation Buffer 8.0% 8.625% 9.25% 9.875% 10.5% Maintaining the capital conservation buffer is particularly important for BHCs structured as Subchapter S corporations. There are no carve-outs in the Basel III rules that would allow a Subchapter S corporation to continue making distributions to its shareholders to cover passthrough income tax liabilities. As such, if a Subchapter S corporation fails to maintain the requisite capital conservation buffer in the form of common equity, then the institution will have a limited, if any, ability to pay dividends to its shareholders. The Basel III rules also revise the capital classifications of insured depository institutions for purposes of the FDIC s Prompt Corrective Action rules. Under Basel III, to be categorized as well capitalized, an insured depository institution must have a minimum common equity tier 1 capital ratio of at least 6.5%, a tier 1 risk-based capital ratio of at least 8.0%, a total risk-based capital ratio of at least 10.0%, and a leverage capital ratio of at least 5.0%. Note that the well capitalized capital ratios are 50 basis points less than the minimum capital ratios, plus the capital conservation buffer, when fully phased in. As a result, it is conceivable that an organization would be considered well capitalized for Prompt Corrective Action purposes, but 4

5 would be subject to limitations on dividends, stock repurchases and discretionary bonus payments by application of the capital conservation buffer. In addition, Basel III establishes more conservative standards for including an instrument in regulatory capital and imposes certain deductions from and adjustments to the measure of tier 1 capital and tier 2 capital. For example, under Basel III, trust preferred securities and cumulative perpetual preferred stock no longer qualify as tier 1 capital and must be phased out, except for such capital instruments issued prior to May 19, 2010 that are included in the tier 1 capital of BHCs with less than $15 billion in total consolidated assets as of December 31, However, such grandfathered capital instruments must comprise no more than 25.0% of tier 1 capital (subject to certain deductions and adjustments). Although this change will not affect most community banks with existing trust preferred securities or cumulative perpetual preferred stock, it is important to note that these capital instruments will not qualify as common equity tier 1 capital under Basel II, which could adversely affect the institution s ability to meet the new common equity tier 1 capital ratio and the capital conservation buffer. Basel III also alters the method under which banking organizations must calculate riskweighted assets in an effort to make the calculation of risk-weighted assets more risk-sensitive, to better account for risk mitigation techniques, and to create substitutes for credit ratings under the provisions of the Dodd-Frank Act. The standardized approach includes additional exposure categories as compared with current standards. Although a number of asset classes will be riskweighted differently, Basel III does not change standardized risk-weightings for certain assets, including residential mortgages. The primary changes to risk-weights under Basel III that will impact community banking organizations include the following: the introduction of a new category of commercial real estate loans called High Volatility Commercial Real Estate, or HVCRE, which loans are risk-weighted at 150%; An increase in risk-weighting of past due assets from 100% to 150% in most cases; An increase in risk-weights applicable to certain equity exposures, to the extent that the carrying value of the equity exposure exceeds 10% of total capital; Introduction of a 20% risk-weight for contractual commitments with an original maturity of one year or less and not unconditionally cancelable by the bank; Change in methodology and alternatives for risk-weightings of securitization exposures; and Adjustments to risk-weights applicable to eligible guarantees and collateralized transactions (for which the risk-weight of the guarantee or collateral may be substituted for the risk-weight of the exposure), including the expansion of eligible guarantors and collateral to include certain investment grade debt securities. 5

6 IV. Application to a Growing BHC If a BHC has less than $500 million in total consolidated assets, the small bank holding company designation allows the BHC to issue debt and other forms of leverage at the holding company level that can be contributed to its subsidiary bank as tier 1 capital. In preparation for exceeding $500 million in total consolidated assets, however, the BHC should analyze its regulatory capital ratios on a consolidated basis. As part of this analysis, BHCs should review the impact of existing leverage at the holding company level on the consolidated capital ratios. Funds treated as capital in the bank s regulatory capital ratios would be treated as debt in the consolidated capital calculation to the extent that the BHC has created bank level capital through leverage. In addition, BHCs exceeding $500 million in consolidated assets should consider the need for any additional common equity or other capital instruments qualifying as additional tier 1 capital at the holding company level in light of Basel III s enhanced capital requirements. Basel III clearly increases regulatory emphasis on common equity and tier 1 capital instruments as the primary components of consolidated capital. To augment common equity tier 1 capital, we have recently counseled numerous institutions with various types of common equity capital raises, including offerings to existing shareholders and new investors, private equity offerings, and offerings conducted to newly-established or existing employee stock ownership plans. We expect this trend to continue as Basel III approaches. In addition, as a result of favorable market response to income producing equities in the continued low interest rate environment, we have recently counseled numerous BHCs conducting preferred stock offerings structured to qualify as additional tier 1 capital under the Basel III framework. By issuing preferred stock qualifying as additional tier 1 capital, an institution could increase its tier 1 capital ratio in response to heightened tier 1 capital requirements under Basel III; however, the preferred stock would not count as common equity tier 1 capital. In order to qualify as additional tier 1 capital under Basel III, the preferred stock must be noncumulative and perpetual, and it can include other features like conversion to common stock and optional redemption or repurchase by the company. We have recently seen a notable increase in investor appetite for tier 1 qualifying preferred stock offerings, particularly in light of Basel III s emphasis on increasing tier 1 capital. These instruments can provide attractive dividends for investors and they are less dilutive to common shareholders than common stock offerings, which reduces the BHCs cost of capital. In addition, because preferred stock is typically non-voting, a preferred stock offering typically does not present the control issues and other regulatory filings that can be triggered by a common stock offering. In order to supplement common equity tier 1 capital, an institution could conduct a common stock offering along with a tier 1 qualifying preferred stock offering, or offer the two securities to investors in a single unit in an effort to control the proportion of preferred equity to common equity raised by the institution. In summary, BHCs that are approaching $500 million in consolidated assets need to proactively address consolidated capital ratios, particularly in light of Basel III s heightened capital requirements and emphasis on common equity and tier 1 capital instruments. Capital 6

7 adequacy remains a hot button issue with bank regulatory agencies, and we expect this trend will continue, if not increase, as Basel III replaces the existing regulatory capital framework. About the Authors Lowell W. Harrison and Derek W. McGee are attorneys with Fenimore, Kay, Harrison & Ford, LLP, a boutique law firm that specializes in providing legal services to financial institutions on a full range of corporate, securities and regulatory matters. Since its formation in June 2010, FKHF has served as legal advisor on more than 30 whole-bank and branch acquisition transactions involving community banking organizations, including several Section 363 bankruptcy-assisted transactions. In addition, FKHF has served as legal counsel in connection with more than 45 private and public capital offerings totaling more than $1 billion, including two initial public offerings by community banking organizations in The attorneys at FKHF are alumni of financial institutions practice groups within large international law firms, bringing a wealth of sophisticated experience in representing financial institutions. 7