basel iii capital rules finally final iii capital rules finally final what does it mean? about the...

August 29, 2013

Andrew K. Gibbs, CFA, CPA/ABV Mercer Capital

Ralph F. “Chip” MacDonald, III Jones Day

Jeff K. Davis, CFA Mercer Capital

Basel III Capital Rules Finally FinalWhat Does It Mean?

About the Speakers Andrew K. Gibbs, CFA, CPA/ABV

[email protected]

Andrew K. Gibbs leads Mercer Capital’s Depository Institutions practice. He provides valuation and corporate advisory services to banks, thrifts, and credit unions for purposes including ESOPs, mergers and acquisitions, profit sharing plans, estate and gift tax planning, compliance matters, and corporate planning. In addition, Andy directs projects related to the valuation of intangible assets under Accounting Standards Codification (“ASC”) 805 and impairment testing under ASC 350.

Andy has extensive experience working with depository institutions in merger and acquisition advisory engagements. He assists buyers in evaluating the attractiveness of acquisition candidates, determining a price for the target institution, structuring the transaction, and evaluating different forms of financing. For sell-side clients, Andy analyzes the potential value that the institution may receive upon a sale, assists in locating potential buyers, and participates in negotiating a final transaction price and merger agreement.

Andy is a frequent speaker on issues related to community bank valuation and is the co-author of three books: The ESOP Handbook for Banks, Acquiring a Failed Bank, and The Bank Director’s Business Valuation Handbook.

Ralph F. “Chip” MacDonald, III

[email protected]

Chip’s practice emphasizes securities, mergers and acquisitions, corporate governance, financial institutions (including REITs, investment managers, and broker-dealers), and financial products. His professional affiliations include the American Bar Association (Business Law Section), Alabama State Bar (chairman, Banking Business and Corporation Law Section, 1986-1987), and Atlanta and Georgia Bar Associations. Chip is featured in The Best Lawyers in America, Chambers USA “Leading Lawyers,” Best Lawyers in Atlanta, Georgia Super Lawyers (2007), and in Who’s Who Legal (2007). He is a frequent speaker and author on matters related to financial and investment services and products.

Jeff K. Davis, CFA

[email protected]

Jeff K. Davis is the Managing Director of Mercer Capital’s Financial Institutions Group. Prior to rejoining Mercer Capital, Davis spent 13 years as a sell-side analyst providing coverage of publicly traded banks and specialty finance companies to institutional investors evaluating common equity and fixed income investment opportunities. Jeff was most recently Managing Director of Guggenheim Securities, LLC, and was previously head of the Financial Institutions Group at FTN Equity Capital Markets. While at Mercer Capital in the 1990s, Jeff led the firm’s financial institutions practice, providing valuation and transaction advisory services.

Jeff is a speaker at industry gatherings, including SNL Financial/University of Virginia’s annual analyst training seminar, the ABA, various state banking meetings as well as security industry gatherings. Additionally, he regularly makes presentations to boards of directors and executive management teams.

He is a periodic guest on CNBC, Bloomberg TV and Bloomberg Radio and is quoted in the American Banker, the Wall Street Journal, Reuters, Forbes and other media outlets. Presently, he is an editorial contributor to SNL Financial.

Basel III Capital Rules Finally Final!

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© 2013 Mercer Capital // Jones Day!

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Outline for Today’s Presentation

PART ONE

Basel III Regulations PART TWO

Implications PART THREE

Regulatory Materials & Citations


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FINALIZED BASEL III REGULATIONS

SECTION ONE

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What Does Basel III Do?

§  Revises the definition and categories of capital for banks, thrifts,

bank holding companies and thrift holding companies, and other

nonbank financial companies supervised by the Federal Reserve

§  Dodd-Frank Act, Section 171 (the “Collins Amendment”) requires

holding companies to maintain the same types and levels of leverage

capital and risk based capital as banks.

§  A new Common Equity Tier 1 Risk-Based Capital Ratio (“CET1”)

§  A capital conservation buffer of 2.50% where noncompliance

reduces or eliminates capital distributions and management

bonuses


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§  A countercyclical buffer also is required for the largest banks

§  Changes various capital additions, deductions and adjustments

§  Changes certain on and off-balance sheet risk weightings

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§  Federal Reserve – July 2, 2013 (subject to finalization in

the Federal Register)

§  OCC – July 9, 2013 – identical to the Federal Reserve’s

July 2, 2013 rule

§  FDIC – July 9, 2013 – Interim Final Rule seeking

comments, especially as to SIFIs


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§  Effective Dates and Phase-Ins

§  January 1, 2015 for standardized approaches banks

§  January 1, 2015 for new PCA rules

§  Various minimum capital ratios phased in

§  AOCI opt-out date – first Call Report or Y-9 after January 1,

2015 for standardized approaches banks

§  January 1, 2016 to January 1, 2019 for capital conservation

buffer

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Potential Effects of Basel III

§  Capital Minimums are increased.

§  Types of capital are more limited:

§  No new trust preferred with phase out of existing trust preferred for banks over $15 billion of

assets. Smaller banks’ Trust Preferreds are grandfathered.

§  Common stock and perpetual noncumulative preferred stock are most valuable under the

regulations

§  Voting common stock should be a majority of CET1

§  The terms of capital instruments, especially subordinated debt, are changed

§  All buyback and redemptions of capital will be subject to prior regulatory scrutiny and

approval

§  The Prompt Corrective Action (“PCA”) Rules of FDI Act, Section 38 are

revised to reflect the new capital measures, and will affect deteriorating

banks more quickly.


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Potential Effects of Basel III

§  Risk weightings of assets and off-balance sheet exposures are revised in

various cases.

§  The amounts and risk weights of certain assets will require better capital

planning, and may cause capital to be reallocated internally to seek better

returns on investment.

§  The changes in treatment of deferred tax assets and the increased risk

weights on NPAs will cause problem banks to be resolved or recapitalized

faster.

§  The value of DTAs will be diminished.

§  Banks will need continuing and better access to the capital markets.

§  Returns and shareholder value will depend on improved capital planning.

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Other Facts that Affect Regulatory Capital

§  Banking organizations with high levels of risk are also expected to operate even

further above minimum standards. In addition, the supervisory assessment

takes into account the quality and trends in a banking organization’s capital

composition, including the share of common and non-common equity capital

elements.

§  A banking organization must maintain capital commensurate with the level and

nature of all risks to which it is exposed and that a banking organization have a

process for assessing its overall capital adequacy in relation to its risk profile,

as well as a comprehensive strategy for maintaining an appropriate level of

capital.

§  The supervisory evaluation of a banking organization’s capital adequacy, may

include such factors as whether the banking organization is newly chartered,

entering new activities, or introducing new products.


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Other Facts that Affect Regulatory Capital

§  Whether a banking organization is receiving special supervisory attention, has or is

expected to have losses resulting in capital inadequacy, has significant exposure

due to risks from concentrations in credit or nontraditional activities, or has

significant exposure to interest rate risk, operational risk, or could be adversely

affected by the activities or condition of a banking organization’s holding company.

§  A banking organization should have an appropriately rigorous process for assessing

its overall capital adequacy in relation to its risk profile and a comprehensive

strategy for maintaining an appropriate level of capital, consistent with the

longstanding approach employed by the agencies in their supervision of banking

organizations. Supervisors would evaluate the comprehensiveness and

effectiveness of a banking organization’s capital planning in light of its activities and

capital levels. An evaluation of the level of sophistication of an individual banking

organization’s capital adequacy process would be commensurate with the banking

organization’s size, sophistication, and risk profile, similar to the current supervisory

practice.

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_________

CPE Code


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Capital

§  CET1

§  Generally common equity, retained earnings, accumulated other

comprehensive income (“AOCI”) (subject to one time opt out election)

and “common equity minority interest”

§  Reduced by:

§  Goodwill and intangibles (excluding mortgage servicing rights (“MSAs”))

net of associated deferred tax liabilities (“DTLs”);

§  Deferred tax assets (“DTAs”) arising from tax NoLs and tax credit

carryforwards net of allowances and DTLs;

§  Gains on sale from any securitization exposure; and

§  Defined benefit pension fund net asset (i.e. excess plan assets) net of

associated DTLs, unless the bank has unrestricted/unfettered access to the

fund’s assets.

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Capital

§  Adjusted for, where an AOCI opt out is made

§  Unrealized gains and losses on AFS securities, AFS preferred stock classed as

“equity” under GAAP, accumulated net gain or net loss on cash flow hedges at

FMV on the balance sheet, among others; and

§  Unrealized gains and losses due to changes in the fair values of liabilities

resulting from changes to the bank’s credit risk

§  Reduced further by these “threshold deductions” of the following that are

individually greater than 10% of CET1 or collectively greater than 15% of

CET1 (after above deductions):

§  MSAs

§  DTAs

§  Significant common stock investments in unconsolidated financial institutions


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Capital

§  Additional Tier 1 Capital

§  Noncumulative perpetual preferred stock

§  Tier 1 minority interest not in CET1, subject to limits

§  Current Tier 1 capital instruments issued under TARP and SBLF

§  Tier 2 Capital

§  Preferred stock and most current subordinated debt;

§  Total capital minority interest not included in Tier 1 capital, subject to limits;

§  ALLL, up to 1.25% of total risk-weighted assets (“RWA”);

§  Tier 2 capital instruments issued under TARP and SBLF; provided

§  These instruments meet the requirements of Rule ___.22.

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Capital Ratios

1 20% per year phase in starting 2015.

2 6.625%, 7.25%, 7.875% for 2016, 2017 and 2018, respectively.

3 8.625%, 9.25% and 9.875% in 2016, 2017 and 2018, respectively.

Jan. 1, 2015

Fully Phased in Jan. 1, 2019

Minimum CET1 / RWA 4.50% 4.50%

CET1 Conservation Buffer － 2.50%

Total CET1 4.50% 7.00%

Deductions and threshold deductions1 40.00% 100.00%

Minimum Tier 1 Capital 6.00% 6.00%

Minimum Tier 1 Capital plus capital conservation buffer2 －

8.50%

Minimum Total Capital 8.00% 8.00%

Minimum Total Capital plus conservation buffer3 8.00%

10.50%


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Capital Ratios

Minimum Ratios

Current Basel III

CET1 / RWA － 4.5%

Leverage Ratio 4.0% 4.0%

Tier 1 capital/RWA 4.0% 6.0%

Total capital/RWA 8.0% 8.0%

Capital conservation buffer － 2.50%

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Prompt Corrective Action Categories Effective January 1, 2015

Minimums

Current Basel III

Well-Capitalized

CET1 － 6.5%

Tier 1 risk-based capital 6.0% 8.0%

Total risk-based capital 10.0% 10.0%

Tier 1 leverage ratio 5.0% 5.0%

Undercapitalized

CET1 － < 6.0%

Tier 1 risk-based capital < 4.0% < 6.0%

Total risk-based capital < 8.0% < 8.0%

Tier 1 leverage ratio < 5.0% < 4.0%

Critically undercapitalized Tangible equity to total assets ≤ 2.0%

Tangible equity to total assets ≤ 2.0%


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Capital Conservation Buffer

§  The capital conservation buffer amount does not affect PCA levels.

§  Capital conservation buffer deficiencies may restrict or limit

dividends, share buy-backs and distributions on Tier 1 capital

instruments (“capital actions”) and discretionary bonuses based on

the amount of “eligible retained earnings.”

§  “Eligible retained earnings” means the most recent 4 quarters of net

income less capital distributions (net of certain tax effects, if the tax

effects are not already included in net income.

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§  Calculation of the capital conservation buffer:

§  Subtract the Basel III minimum ratios for each of CET1 (4.5%),

Tier 1 Risk-Based Capital (6.0%) and Total Risk-Based Capital

Ratio (8.0%) from the bank’s actual capital under each of these

measures.

§  The actual buffer used to determine capital actions and

discretionary bonuses is the lowest buffer percentage for all 3

capital ratios.

§  If any of these capital ratios is less than the minimum required,

the capital conservation buffer is zero.


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§  Fully phased in buffer limits on capital actions and discretionary bonus are

subject to regulatory discretion in light of bank risk, CCAR, enforcement

actions, etc.

§  The phase in occurs January 1, 2016 to January 1, 2019.

Buffer %

Buffer % Limit

More than 2.50% None

> 1.875% ≤ 2.50% 60.0%

> 1.250% ≤ 1.875% 40.0

> 0.625% ≤ 1.250% 20.0

≤ 0.625 - 0 -

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Selected Standardized Approach Risk Weights

§  One-to-Four Family, First Lien Residential Mortgages

§  Significant changes from 2012 Proposal

§  Considerably simplified from 2012 Proposal

§  50% risk weight when made in accordance with prudent underwriting

standards on owner-occupied or rented properties

§  100% on all others

§  The banking agencies may develop and propose changes in the

treatment of residential mortgages taking into account market,

regulatory and product developments, and implementation issues


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§  High Volatility CRE

§  Includes ADC loans, except where the LTV is less than regulatory maximums

and the borrower has contributed before the loan is made and maintains at all

times equity of 15% of the project’s “as completed” value

§  Other exceptions include 1-4 family residences, certain community development

investments, and the purchase and development of agricultural land

§  150% risk weight

§  Past due assets – 150% risk weight

§  Does not apply to HVCRE and 1-to-4 family residential mortgages

§  Structured securities, including private label mortgage securities, trust

preferred CDOs and ABS – up to 1,250%

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§  Substitutions for risk weights

§  Generally, risk weight applicable to collateralized portion of the exposure cannot

be less than 20%

§  Collateral (U.S. government securities or cash) – may decrease risk weight from

20% to 0%

§  Guarantees may reduce risk weights to that of an applicable guarantor

§  MSAs – 250% risk weight to extent not deducted from capital subject to the

10% / 15% of CET1 maximums

§  DTAs – 250% risk weight to the extent not deducted from capital subject to

the 10% / 15% of CET1 maximums

§  Equity exposures other than FRB, FHLB and CDFIs – 250% to 600% risk

weight


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_________

CPE Code

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IMPLICATIONS

SECTION TWO


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Implications

Positive §  Years of uncertainty resolved

§  More capital = resilient system

§  Preferred and sub-debt remain viable

capital supplements

§  Trust preferred grandfathered for

BHCs with < $15B of assets

§  Ability to opt-out of AFS mark

embedded in AOCI for non-advanced

approaches banks

§  Residential mortgages not subjected

to enhanced risk-weighting

Negative §  Lower ROE (and ROTE)

§  Less distribution capacity

§  Smaller industry asset base = less

credit to the economy

§  Pro-cyclical nature = incentive to

exceed conservation buffers

§  Some businesses ceded to specialty

finance

§  Higher capital requirements another

incentive-but not a mandate-for banks

to merge

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Capital Planning

§  Regulators and Basel III require more and better planning, or these

drivers of shareholder value may become less consistent and less

valuable to investors

§  Regulatory capital rules do not encompass all risks, including

operational risks and the “amplification of risks through correlations,

concentrations and the business cycle”

§  Capital planning is a responsibility of the board of directors and

part of directors’ duties

§  Failure to properly plan for capital may be an unsafe and unsound

practice


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Capital Planning

§  Banking organizations contemplating expansion need capital well above

regulatory minimums for “well capitalized” organizations

§  More risks, including concentrations and correlated assets and funding,

require more capital

§  Planning varies with size, complexity, and risk profile

§  Capital planning and capital levels are affected by:

§  Corporate governance

§  Risk management

§  Internal controls

§  The complexity and risks of product lines

§  Earnings

§  Access to capital

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Capital Planning

§  Organizations with TARP, SBLF, and non-grandfathered

trust preferreds need to be especially proactive in

planning to replace these

§  Stress testing is not mandated under Basel III or Dodd-

Frank for banks with less than $15 billion of assets, but

assume an expectation to implement

§  We view annual stress testing as a good exercise even if

the future at best only rhymes with the past


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Capital Planning

§  Capital planning dovetails with value planning:

§  Optimize parent capital structure – margin of safety

vs. (some) leveraging to enhance ROE

§  Capital for organic and M&A growth

§  Appropriate distribution policy – greater importance

to shareholder return when growth is modest

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Capital Planning

§  Parent company capital structure remains the focus given intent to

reduce parent double leverage

§  Bank-level capital levels comfortably above Basel III mandates due

to: (a) improved profitability; (b) weak loan growth; and (c) parent

leverage used to create equity in the bank

§  Risk-weighting pressure on capital lessened today via reduction in

ADC, CDOs, etc. … banks will have to extract extra yield as

demand for higher risk-weighted assets improves

§  If Fed maintains ZIRP, we think banks will find a receptive market

for coupon capital and senior debt


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Capital Planning

Bank-Level Capital Profile

Tier 1 Common / RWA Deciles

Tier 1 Common / RWA

Leverage Ratio

Total Risk-‐Based Ratio

Texas Ratio

NPAs / Loans + OREO

YTDROA

Number of Banks

1st 37.11 17.27 37.97 3.0 1.74 0.74 697

2nd 24.11 12.45 25.20 9.1 2.15 0.78 697

3rd 20.14 11.24 21.24 11.1 2.33 0.77 699

4th 17.76 10.80 18.93 13.2 2.52 0.82 696

5th 16.12 10.22 17.26 13.6 2.43 0.81 693

6th 14.89 9.85 16.09 15.7 2.53 0.86 699

7th 13.80 9.59 15.02 18.1 2.71 0.85 696

8th 12.84 9.25 14.01 17.9 2.49 0.84 702

9th 11.73 8.97 12.95 16.7 2.24 0.89 696

10th 10.02 7.89 11.38 29.5 3.47 0.64 699

Bank Median of Decile (%)

Source: SNL Financial

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Capital Planning Parent-Level Tier 1 Common Equity

Chart reflects current calculation of Tier 1 common equity and risk-weighted assets (i.e., does not give effect to Basel III) Data set includes bank holding companies with assets less than $5 billion filing form FR Y-9C at June 30, 2013 Source: SNL Financial, Mercer Capital research


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Capital Planning Parent-Level Capital Structure


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Capital Planning Parent-Level Capital Structure



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Capital Planning

Tier 1 Common / RWA Deciles

Tier 1 Common / RWA

Leverage Ratio

Total Risk Based Ratio

Double Leverage Ratio

TruPs / Tier 1 Capital

TruPs / Total RBC

YTD ROA

# of BHCs Filing Y-‐9C

1st 22.75 13.21 24.94 98 0.00 0.00 0.87 102

2nd 16.97 11.23 18.75 99 0.00 0.00 0.95 101

3rd 14.72 10.06 16.56 100 0.00 0.00 0.88 103

4th 13.41 10.04 15.39 100 2.87 2.71 0.87 98

5th 12.59 9.94 15.04 102 5.56 5.13 0.95 105

6th 11.79 9.44 14.30 104 6.29 5.72 0.89 102

7th 10.74 9.32 13.94 109 8.47 7.66 0.87 103

8th 9.58 9.34 13.81 114 15.47 13.75 0.78 105

9th 8.38 8.73 13.63 120 16.96 14.39 0.75 107

10th 4.76 5.49 11.10 143 25.77 22.23 0.25 109

Bank Holding Company Median of Decile (%)

Parent-Level Capital Profile


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_________

CPE Code


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Valuation & Shareholder Return

§  Basic valuation framework:

§  Net Income / Assets x Assets / Equity = Net Income / Equity …

or ROA x Leverage = ROE

§  Net income / Equity x Price / Earnings = Price / Book … or

ROE x P/E = P/B

§  P/E in relation to normalized (core) earnings is

influenced by multiple factors … investors focus on

growth, franchise quality, M&A potential

§  … lower P/B (P/TB) multiples all else equal

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Source: FDIC

Bank-Level Return on Assets


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Valuation & Shareholder Return Bank-Level Leverage Ratio

Source: FDIC

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Valuation & Shareholder Return Bank-Level Return on Equity

Source: FDIC


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Source: FDIC and Federal Reserve’s H.15

§  ROE is low relative to 92-06 “great moderation”, but

§  Long-term average is for ROE to exceed 10-year US Treasury by

500-700bps

§  Current spread of 480-640bps for banks with assets > $100 million

is within historical norm

§  Investors and bankers have to reset their expectations with Basel III

and impact of Fed’s ongoing ZIRP

LTM 10-Yr Current Current84-89 90-99 00-07 08-12 00-12 84-12 ROE UST Spread v. 84-12

Assets > $10B 1.7% 7.4% 9.1% 3.3% 7.6% 7.1% 9.2% 2.8% 6.4% -0.6%

Assets $1-10B -1.7% 7.6% 8.3% -1.5% 6.8% 5.6% 9.0% 2.8% 6.2% 0.6%

Assets $100M-$1B -4.6% 5.7% 6.6% 0.4% 5.8% 5.0% 7.6% 2.8% 4.8% -0.2%

Assets < $100M -2.5% 3.8% 3.3% 0.5% 2.9% 2.4% 5.9% 2.8% 3.1% 0.6%All Insured Institutions -3.0% 7.1% 8.4% 2.2% 7.2% 6.6% 9.0% 2.8% 6.2% -0.3%

Bank-Level ROE Less 10-Year UST ("Spread")

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§  Valuations have rebounded from the 3Q11 sell-off (debt ceiling & European bank

issues)

§  P/Es approximate long-term average; P/TB does not because ROTE is lower in spite

of greatly reduced credit costs and outsized mortgage gains for many banks


Median Price/Earnings YE09 YE10 YE11 YE12 26-‐Aug YE09 YE10 YE11 YE12 26-‐Aug$100 Million -‐ $1 Billion 14.7x 13.6x 11.8x 11.5x 12.8x 13.6x 108% 100% 87% 84% 94%

$1 Billion -‐ $10 Billion 15.0x 15.1x 12.9x 12.9x 14.8x 14.3x 105% 106% 90% 90% 104%

> $10 Billion 19.1x 17.6x 13.4x 12.9x 15.5x 15.3x 125% 115% 88% 85% 101%

Average Acquisition P/E nm nm nm 33.5x 22.5x

Median Price/TBV YE09 YE10 YE11 YE12 26-‐Aug YE09 YE10 YE11 YE12 26-‐Aug$100 Million -‐ $1 Billion 75% 77% 68% 77% 92% 117% 65% 66% 59% 66% 79%

$1 Billion -‐ $10 Billion 108% 122% 105% 119% 144% 165% 66% 74% 64% 72% 87%

> $10 Billion 153% 155% 132% 134% 170% 219% 70% 71% 60% 61% 78%

Median Acquisition P/TBV 114% 116% 106% 114% 118%

20-‐ Year Average

20-‐ Year Average

Public Market P/E Relative to 20-‐Year Average

Public Market P/TBV Relative to 20-‐Year Average

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M&A

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No Basel III Wave Yet


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M&A Modest P/TBV Reflective of ROTE

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Capital Raising

§  Markets generally are open to community and regional banks –

though pricing can be punitive if investors do not see growth or a

possible sale

§  Although trust preferred issuers obtained a break with Basel III,

many smaller banks still have parent capital structure issues due to

the pending re-pricing of TARP and SBLF preferred shares in 2014

and 2015 to 9% from 5%

§  Pools of institutional capital are available to purchase newly issued

preferred and sub debt

§  Institutional investors will be much more demanding than the typical

privately-held bank is accustomed to


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Capital Raising

§  Noncumulative perpetual preferred stock offerings rising in

frequency

Source: SNL Financial, Mercer Capital research

Aggregate Issuance ($000s) Median YieldPreferred

Stock Senior DebtSubordinated

DebtPreferred

Stock Senior DebtSubordinated

Debt

2013 YTD* $1,829,243 $982,954 $321,960 6.22% 5.75% 7.25%

2012 $1,509,725 $3,261,592 $628,825 6.58% 5.00% 6.90%

2011 $415,200 $2,238,096 $307,950 8.00% 5.00% 6.90%

2010 $35,062 $2,222,063 $533,241 9.00% 5.38% 8.00%

2009 $75,421 $1,357,236 $578,577 7.00% 9.00% 9.00%

* through August 27, 2013

1. Preferred stock offerings exclude convertible offerings, TARP/SBLF transactions (offerings and auctions), and offerings by banks with assets greater than $50 billion

2. Senior debt offerings exclude TLGP transactions and offerings by banks with assets greater than $50 billion

3. Subordinated debt offerings exclude convertible offerings and offerings by banks with assets greater than $50 billion

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Capital Raising

2013 yield

ranges vs.

median ROE for

four BHC groups ($500M to > $10B)

Source: Wall Street Journal, SNL Financial and FFIEC

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10Y UST BBB Corp High Yield Preferred 2013 BHC ROE


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Sub Debt & Shelf Registration Statements

§  Basel III will require updates to existing shelf

registration statements and changes to

instruments registered

§  If you do not have a shelf registration statement,

you need one!

§  The required terms of subordinated debt are

especially changed

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S Corporations

§  S Corps disadvantaged

§  Capital conservation buffer may limit distributions to fund pass-through

tax liability

§  More potential volatility to capital ratios, buffers, and eligible retained

earnings in periods of losses

§  Final rules did not permit an exception for distributions to cover taxable

income

§  Note in the following example that the S corporation would be

unable to make distributions in period 3 because it has negative

eligible retained earnings, while the C corporation could pay

dividends


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S Corporations C Corporation S Corporation

Bank Perspective Period 1 Period 2 Period 3 Period 1 Period 2 Period 3

Common Equity Tier 1 Capital $7,100 $6,232 $7,100 $5,700

+ GAAP Pre-Tax Income / (Net Loss) (1,400) 260 (1,400) 260

+ GAAP Income Tax Effect @38% 532 (99) 0 0

- Dividends 0 (13) 0 0Common Equity Tier 1 Capital $7,100 $6,232 $6,380 $7,100 $5,700 $5,960Eligib le Retained Earnings $900 $32 $180 $900 ($500) ($240)

Risk-Weighted Assets 100,000 100,000 100,000 100,000 100,000 100,000

CET1 / RWA 7.10% 6.23% 6.38% 7.10% 5.70% 5.96%Capital Conservation Buffer 2.60% 1.73% 1.88% 2.60% 1.20% 1.46%

Buffer Limit on Bonuses/Dividends 0% 40% 60% 0% 20% 40%

Shareholder Perspective

Dividends $0 $13 na na

Pass-Through Taxable Income na na 260 260

Taxable Income $0 $13 $260 $260

x Applicable Tax Rate 20.0% 20.0% 40.0% 40.0%= Shareholder Tax Obligation $0 $3 $104 $104

Dividends $0 $13 $0 $0

- Shareholder Tax Obligation 0 (3) (104) (104)= After-Tax Shareholder Cash Flow $0 $10 ($104) ($104)

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Counter-Cyclicality

§  Capital ratios become more sensitive to deterioration in

the institution’s performance than under the existing

rules

§  Deduction of DTAs relating to net operating losses from Tier 1

common

§  Increased risk weightings applied to past-due loans

§  Assuming no DTA impact on CET1, an increase in past-due

loans from 1% to 10% of the portfolio causes an impact of 0 to

29 basis points on the Tier 1 common capital ratio, depending

on the pre-existing risk weighting category of the loans


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Counter-Cyclicality

Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 4

Tier 1 Capital Ratios -- Sensitivity to Rising Past-Due Loans Normal Past-

Dues

10% Past-Dues; Proportionate

Increase

10% Past-Dues; 100% of

Deterioration in 1-4 Family


Deterioration in Non 1-4 Family


Deterioration in HVCRE

Common Equity Tier 1 Capital $20,000 $20,000 $20,000 $20,000 $20,000

Risk-Weighted Assets $278,500 $286,455 $278,500 $290,200 $278,500

Tier 1 Common / RWA 7.18% 6.98% 7.18% 6.89% 7.18%

Risk-Weight

1-4 Loans 50.0% $58,000 $52,727 $34,600 $58,000 $58,000

Non 1-4 Loans 100.0% 175,000 159,091 175,000 151,600 175,000

HVCRE Loans 150.0% 24,400 22,182 24,400 24,400 1,000

Non-Current Residential Mortgages 50.0% 0 5,273 23,400 0 0

Other Non-Current Loans 150.0% 2,600 20,727 2,600 26,000 26,000

Securities 20.0% 70,000 70,000 70,000 70,000 70,000

Other Assets 100.0% 20,000 20,000 20,000 20,000 20,000

Total Assets $350,000 $350,000 $350,000 $350,000 $350,000

Risk-Weighted Assets $278,500 $286,455 $278,500 $290,200 $278,500

Non-Current / Total Loans 1.00% 10.00% 10.00% 10.00% 10.00%

56

Business Line Management

§  Basel III, with its new CET1 capital measure and new risk weights, will

require better allocations of capital to business lines and products to

achieve targeted returns

§  To evaluate capital allocations, one beginning point is to calculate the

return on capital deployed by product, business line, etc. Analysis is a

function of the following general inputs for a loan:

§  Rate on the loan

§  Funding costs for the portion of the loan not funded with equity

§  Any fees or other charges associated with the loan

§  Servicing costs, overhead, and the like

§  Potential credit losses

§  Taxes

§  The required capital allocated against the loan


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Business Line Management

§  Loan pricing becomes more critical under Basel III – this example assumes

a yield of 4.50% to produce an IRR of 12% on allocated capital assuming

the loan is 100% risk weighted

§  If the risk-weight rises to 150%, then IRR falls to 8.2%

§  Yield (price) would have to rise 100bps to 5.50% to offset the higher capital

allocation to restore the 12% IRR

Time PeriodAssumption 0 1 2 3 4 5

Interest Income 4.50% $225 $225 $225 $225 $225

- Interest Expense 1.00% (45) (45) (45) (45) (45)

- Servicing Costs 1.50% (75) (75) (75) (75) (75)= Pre-Tax Income $105 $105 $105 $105 $105

- Taxes 40.00% (42) (42) (42) (42) (42)= Net Income $63 $63 $63 $63 $63

Cash Flows ($525) $63 $63 $63 $63 $588Return on Allocated Capital 12.03%

58

Dividends

§  Regulators and Basel III require more and better planning, or these

creators of shareholder value may become less consistent and less

valuable to investors

§  Due to the capital conservation buffer, dividends as well as

discretionary bonuses may be more unpredictable after Basel III

§  As a potential future indicator of the greater difficulty in assessing a

bank’s ability to pay dividends, see the CCAR (for example SunTrust,

Fifth Third, and Citigroup) banks as an example

§  Some small banks have adopted a policy of a “regular” dividend and

annual “special” dividend dependent upon profitability (e.g., FFBC)


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Liquidity

§  Liquidity is part of capital planning

§  Basel III has a liquidity component, but it has not yet

been proposed by U.S. bank regulators

§  FASB Exposure Draft on Liquidity and Interest Rate Risk

Disclosures

§  Anticipating a higher, more normal interest rate

environment

60

REGULATORY MATERIALS & CITATIONS

SECTION THREE


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Capital Planning

§  Federal Reserve

§  SR 09-4 Applying Supervisory Guidance and Regulations on the

Payment of Dividends, Stock Redemptions and Stock Repurchases at

Bank Holding Companies (Rev’d. Mar. 27, 2009) plus FAQs,

Temporary Addendum and Attachments A and B

§  Comprehensive Capital Analysis and Review 2012: Methodology for

Stress Scenario Projections (Mar. 12, 2012) (“CCAR”)

§  CCAR FAQs (Mar. 21, 2012)

§  CCAR Q&A (Nov. 22, 2011)

§  Federal Reserve, “Capital Planning at Large Bank Holding Companies:

Supervisory Expectations and Range of Current Practice” (Aug. 2013)

62

Capital Planning

§  Tarullo, “Developing Tools for Dynamic Capital Supervision” (Apr. 10, 2012)

§  Tarullo, “The Evolution of Capital Regulation” (Nov. 9, 2011)

§  “Supervisory Guidance on Stress Testing for Banking Organizations With More Than

$10 Billion in Total Consolidated Assets” (May 17, 2012)

§  “Proposed Supervisory Guidance on Implementing Dodd-Frank Act Company-Run

Stress Tests for Banking Organizations with Total Consolidated Assets of more than

$10 Billion but Less than $50 Billion” (July 30, 2013)

§  “Interagency Proposed Supervisory Guidance on Implementing Dodd-Frank Act

Company-Run Stress Tests for Banking Organizations with Total Consolidated

Assets of More than $10 Billion but Less than $50 billion,” 78 F.R. 47217 (Aug. 5,

2013)


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Capital Planning

§  OCC

§  Guidance for Examining Capital Planning and Adequacy, OCC

2012-16 (June 7, 2012)

§  MacDonald, TARP and SBLF Repayments by Bank Holding Companies

(Dec. 2011) http://www.jonesday.com/tarp_and_sblf/

64

_________

CPE Code


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65

Questions?

Jeff K. Davis, CFA

615.345.0350

[email protected]

Andrew K. Gibbs, CFA, CPA/ABV

901.685.2120

[email protected]

Ralph (Chip) F. MacDonald, III

404.581.8622

[email protected]

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