Many community bankers have looked surprised at the “internationalization” of our banking rules. Standards coming out of the Basel Committee, particularly the Basel III Capital Rules, do not seem to fit community banks. The Basel Committee focuses primarily on the European banking system, which is dominated by very large banks. The rules have seemed to be a bad match for the U.S. economy, in which small community banks play such a large role. The initial proposal for the Basel III Capital Rules, which apply to community banks January 1, 2015, took that to an extreme.
Fortunately, comments from community bankers resulted in three important changes to the new rule:
(1) The risk weight for first-lien mortgage loans that are not past due, restructured or on nonaccrual, was kept to 50 percent, with a 100 percent risk weight for other residential mortgages;
(2) Community banks have a one-time option to filter certain accumulated other comprehensive income components, similar to current treatment, but the election must be made on the institution’s first regulatory report filed after Jan. 1, 2015; and
(3) Banks with less than $15 billion in assets (all true “community” banks) do not have to phase out from tier 1 capital trust preferred securities and cumulative perpetual preferred stock, to the extent these accounts are no more than 25 percent of tier 1 capital. (See, http://www.stlouisfed.org/publications/cb/articles/?id=2415
.) Similarly, the new rule does not change the current exclusions from the definition of credit-enhancing representations and warranties. Even so, many community bankers did not like the new rules.
The Federal Reserve seems to be coming to this party a bit late. After adopting Basel III in July 2013, the Fed now seems to be backing off of its support. In a speech on May 8, Daniel Tarullo, a Fed Governor, proposed the Fed needs to look at a different regulatory model for the U.S., using Dodd-Frank to expand regulation to nonbanks and to certain activities by all financial actors.
While this is not necessarily bad news for community banks, Mr. Tarullo’s next suggestion is. He proposes the 80 largest banks be regulated, by law, by the Fed under the more liberal (but also more complicated) Basel III capital rules, primarily focused on stress tests. Only the larger, systemically important banks would be risk-managed almost continually to ensure they do not fail. Regional banks would have less complicated rules for capital. Smaller banks would be regulated according to the more simple, already established, Basel I capital rules. This is because failure of smaller banks would not pose a threat to national financial stability. Less regulation for community banks? That sounds great! So, what is the problem?
Paul Kupiec pointed out in his May 22, 2014 Wall Street Journal
article, “The Fed’s Blueprint for Financial Control,” that this will ultimately damage the less regulated community banks. Uninsured depositors, particularly municipalities and businesses, will migrate uninsured deposits to the larger banks that are virtually guaranteed not to fail. Community banks will lose a large source of deposits over time to the largest banks. This would happen particularly in times of trouble, when community banks typically rely most heavily on these deposits as a source of liquidity. This may accelerate the consolidation of the banking system into a few large institutions, similar to what we see in most European countries.
In short, “be careful what you wish for.” We need to keep a close eye on this regulatory development. More regulation costs more money. And, disproportionately more for community banks who do not have the economies of scale larger banks have. But less regulation combined with a different “status” may be even more damaging to community bank futures.