Basel III Standardized ApproachNew Capital Requirements for Mid-Tier Banks

tarting January 1, 2015, US banks will be subject to new regulationsunder the Basel III capital accord designed to mitigate systemic risk to the global economy posed by financial institutions. Basel IIIrepresents a significant change to existing US financial regulations.

The new regulatory framework will apply to all US banks with more thanUS$500 million in assets and the exact manner in which the new rules are applied will vary significantly depending on a multitude of factors.

On Tuesday, September 16, GARP hosted “Basel III Standardized Approach—New Capital

Requirements for Mid-Tier Banks,” a SAS-sponsored webcast led by Henry Fields, Partner

at Morrison & Foerster, and Tom Kimner, Head of the Americas Risk Practice at SAS. The

discussion focused on what mid-tier financial institutions can do to prepare themselves for

the coming regulatory changes.

Many banks are still unprepared for either the costs involved or the complexity inherent

in adhering to such a wide-ranging set of rules. “While Basel III may seem straight forward

on the surface, there’s an enormous amount of complexity underneath when you start look-

ing at the rules, the conditions of different asset classes, and the complexity around the

application of the rules,” Kimner said during his opening remarks.

“This is a rational scheme, but it’s highly complicated,” Fields said. “It basically reflects

what the standardized approach under Basel II was. US banks did not adopt the standard-

ized approach for Basel II as a general rule. So it’s going to require a significant amount of

internal work to determine how to comply.”

The major changes going into effect under Basel III include new capital rules and capital

floors (as outlined in Section 171 of the Dodd-Frank Act); higher capital ratios; changes in

the components of capital ratios; the introduction of an entirely new capital ratio (known as

Common Equity Tier 1); a capital conservation buffer; new thresholds for prompt corrective

action; and substantial changes to credit risk weightings.

New Capital Ratios

Perhaps the most significant regulatory change being promulgated as part of Basel III is

the introduction of new rules for capital ratios. Banks covered by Basel III are required to

maintain a minimum Tier I capital ratio of 6%, compared to a previous minimum of 4%. The

minimum total capital ratio will remain at 8%. The minimum ratio of Tier I capital to average

consolidated assets, which had been 3% for CAMELS 1-rated banks will now climb to 4%.

Although these additional requirements may not be applicable to mid-tier banks, Fields

said it is still in their interests to pay attention to the ramifications. “Consider the high lever-

age ratios these banks will have and what businesses may not be as attractive to them, and

where there might be opportunities for smaller banks.”

Basel III introduces an entirely new concept, known as Common Equity Tier I. This capital

category includes common stock, retained earnings, and accumulated other comprehensive

income (AOCI). Mid-tier banks will also have a one-time opportunity to elect to not include

most AOCI components in Tier I capital. “Banks should be sitting down and looking hard at

how they’re going to treat this election,” Fields said. Other significant changes to capital

ratios include the exclusion of cumulative preferred stock, which will no longer qualify as

Tier I capital of any kind. Prompt corrective action ratios are also higher than before.

S

analytics. Risk weighting for overdue

loans will also increase, which will

need to be taken into account in

capital planning.

However, several new categories

of credit risk mitigants can lower a

bank’s risk weight. But in order to take

advantage of such mitigating factors,

banks will again need to have the

proper analytics in place to demon-

strate that the credit risk mitigation is

being used properly.

The Tech Objective

The level of complexity reflected in

the Basel III framework is likely to be

the biggest issue for mid-tier banks,

according to Fields. Developing appro-

priate compliance procedures for the

new rules will be both technically chal-

lenging and expensive to implement.

“While Basel III may

seem straight forward on

the surface, there’s an

enormous amount of

complexity underneath

when you start looking at

the rules, the conditions of

different asset classes, and

the complexity around

the application of the rules”

—Tom Kimner

Banks will need to implement

appropriate technology, tracking

systems and procedures to comply

with the new rules. “For many smaller

banks, Basel III is really a large leap,”

Kimner said. “Many institutions are

new to the process.”

Even if a mid-tier bank’s capital

level is technically adequate, it will

have to build much more systematic

compliance programs to meet Basel III

requirements for sourcing and audit-

ing data.

Certain areas of the Basel III

framework, such as deductions to the

Common Equity Tier I category, will

represent a particular challenge to

mid-tier banks. “There are a lot of

elements that are deducted. All the

categories have to be looked at and

treated,” Fields said. “You need to

have the software and the capability

of looking at your financial state-

ments and making the appropriate

deductions.”

Among the key issues required to

comply with Basel III is the ability to

structure and validate data appropri-

ately. Regulators will require banks

to go into detailed explanations of

where their data comes from, how

reliable it is, and how it was gener-

ated, manipulated and transformed

throughout the reporting process.

“There’s an entire body of work that

goes around sourcing the appropriate

information,” Kimner explained.

Capital calculation updates, risk

reporting and auditability will also be

key aspects of Basel III. “It’s increas-

ingly important to make sure these

rules are applied correctly and that

the data used is managed appropri-

ately,” Kimner said. In particular,

Even institutions that meet the

higher standard for well-capitalized

ratios will not necessarily receive

automatic permission for acquisition

activity from regulators, Fields warned.

Banks will still be required to stress

test their portfolios to determine what

levels of capital are appropriate for

the kind of risk in its portfolio. “Meet-

ing the minimum rules is not neces-

sarily going to cut it,” Fields added.

The Conservation Buffer

Banks will also need to maintain an

additional capital conservation buffer

of 2.5% over the minimum capital

ratios. Compliance with this ratio will

impact the ability of mid-tier financial

institutions to pay bonuses and make

capital distributions without restric-

tions. Banks that fail to maintain the

2.5% buffer will not be able to make

discretionary bonuses, with a sliding

scale being applied to those banks

that fall somewhere in between.

“In capital planning, you’re going to

need to take this into account,” Fields

said. “Not being able to meet the mini-

mum buffer is going to be a significant

impediment on your ability to make

distributions and probably will have

an adverse effect on your stock price.”

Risk weighting is another area

affected by Basel III. Of particular

concern to mid-tier and community

banks will be the creation of 11 new

asset categories, each with different

rules for risk weighting. Some changes

to risk weighting will make certain

loans more expensive to hold. The

categorization scheme includes a new

category for unsettled transactions.

Rules for securitization exposure,

meanwhile, have become more com-

plex and will require a different set of continued on back page

Risk Reporting• Dashboards• Management Reports• Regulatory Reports

Risk Aggregation• On demand aggregation• Ad hoc analytics• Cross risk aggregation

Data Management• Data quality metrics• Linking report data

to source• Business and IT

collaboration

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regulators will be looking to ensure

that calculations banks do for their

reporting is easily repeatable.

In terms of risk reporting, it is

important to make sure not only that

compliance requirements are being

met but also that the reporting offers

a comprehensive look at risk exposure

and weights. Identifying and sourcing

data will be a major challenge for

many mid-tier banks, Kimner said.

“Information mapping is an area that

takes a considerable amount of time

when trying to undertake something

like a Basel III compliance program.”

Due to the sheer number of rules

and their underlying complexity,

information will be difficult to track

with general tools such as an Excel

spreadsheet. “A lot of institutions are

looking for technology solutions that

let them track what rules and weights

are applied to what asset classes,”

Kimner explained.

Complicating matters further,

some rules can be expected to evolve

over time. Compliance targets such as

capital ratios may see changes in the

future, providing mid-tier banks with

a moving target. The evolving nature

of these regulations will create a

dynamic effect that will impact how

the data is not only sourced, but also

how it is applied to different asset

classes, according to Kimner.

“One thing that helps is having a

robust data governance program,”

he said. “As regulations change, you

want to be able understand what is

happening to the data in the overall

system.”

Deploying and maintaining an

integrated data platform will be criti-

cal to complying with the new rules

in Basel III. This type of platform not

only allows a bank to source informa-

tion into a larger repository for com-

pliance purposes but also helps

facilitate business decisions.

“Having an integrated platform to

capture all the information and model

it in a structured way may be a neces-

sary building block for organizations

to meet the demands of Basel III com-

pliance,” Kimner said.

Basel III was designed in an interna-

tional context to help assess and mini-

mize potential systemic risk. In the US,

mid-tier and community banks face

some unique challenges in complying

with this complex regulatory frame-

work, which was initially designed for

much larger financial institutions.

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Having an integrated platform to capture all the information and model it in a structured way maybe a necessary building block for organizations to meet the demands of Basel III compliance...

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