The Senate-approved version of the Restoring American Financial Stability Act of 2010 raises many issues for community banks.  Provisions added to it by the amendment of Senator Susan Collins (R-Maine), however, are drawing special attention.  The full text of the amendment can be found as Section 171 of the Senate-approved legislation.  The Senate unanimously consented to Senator Collins’ amendment by voice vote on May 13, 2010.

The amendment requires the various federal banking regulators to establish minimum leverage and risk-based consolidated capital requirements for all banks, all bank holding companies, and those non-bank financial firms subject to regulation by the Federal Reserve, regardless of size, that are no less than the capital requirements currently in effect for banks.  While unstated in the legislation, this amendment has two primary effects on community banks.  First, it eliminates the current regulatory exemption from consolidated capital requirements available to bank holding companies having less than $500 million in assets. Second, it would exclude trust preferred securities and bank holding company TARP CPP Preferred Stock from the consolidated Tier 1 treatment of bank holding companies.

The elimination of the small bank holding company exemption puts additional pressure on community bank holding companies to raise capital through the sale of common stock, as such holding companies will no longer merely need to assure that cash is down-streamed into the bank as Tier 1 capital.  However, for purposes of complying with regulator-mandated higher capital requirements at the bank level (whether by memorandum of understanding, IMCR, formal agreement or consent order), the treatment of the capital at the holding company level will continue to be of less importance than the treatment at the bank level.

Under the current regulations, subject to certain limitations, both trust preferred securities and TARP CPP cumulative preferred stock are treated as Tier 1 capital for bank holding companies.  However, neither are treated as Tier 1 capital if issued by a depository institution directly.  (The TARP CPP securities issued directly to banks without holding companies were originally issued in the form of non-cumulative preferred stock to preserve the Tier 1 treatment for such institutions.)  Current estimates are that there is approximately $129 billion in Tier 1 capital that would be eliminated by the disqualification of trust preferred securities as Tier 1 capital, which could force a corresponding $1.3 trillion deleveraging of bank balance sheets, and would cause an average decline of over 200 basis points in the capital ratios of publicly owned bank holding companies. (As background, the FDIC has always objected to the Federal Reserve’s determination, starting in 1996, that trust preferred securities should be included as Tier 1 capital.)

Although the impact appears to be great on community banks, commentary by FDIC Chairman Sheila Bair and Senator Collins have both focused on a desire to increase capital requirements for the largest bank holding companies and non-bank financial firms.  Chairman Bair has stated that if “bank holding companies are to become sources of financial stability for insured banks, then they cannot operate under consolidated capital requirements that are numerically lower and qualitatively less stringent than those applying to insured banks.” In its final provision, the Collins amendment calls for regulators to increase capital requirements where institutions engage in activities deemed to pose systemic risk.  Sen. Collins explained on the Senate floor that this element of her proposal was meant to permit regulators “to adjust capital standards for risk factors as financial institutions grow in size and engage in risky practices.”  The amendment specifically identifies as such practices an institution’s trading in “significant” volumes of derivatives, securities products, financial guarantees, and repurchase agreements; certain asset concentrations; and “concentrations in market share for any activity that would substantially disrupt financial markets if the institution is forced to unexpectedly cease the activity.”

The Senate version of the financial reform bill now enters a stage of reconciliation with the House version, passed last fall, which does not contain any provisions comparable to the Collins amendment.  The Senate has nominated as its representatives on the Conference Committee seven Democrats, including Chris Dodd of Connecticut, and five Republicans, including Richard Shelby of Alabama and Saxby Chambliss of Georgia.  House Speaker Nancy Pelosi (D-Calif.) is expected to name that chamber’s representatives after the Memorial Day recess.  Rep. Barney Frank (D-Mass.) will spearhead the House constituency and has a stated goal of delivering a reconciled bill to the President by July 4.

As this process begins, there are preliminary indications that the concerns about the Collins amendment raised by the banking community are being shared and/or taken up by regulators themselves.  FDIC staff have indicated that they are pushing for a two-year moratorium followed by a three-year phase-in period for the trust preferred securities exclusion from  Tier 1 capital.  Sen. Collins has herself suggested since the bill’s passage that she would support a transition period and that there are “technical issues” with the amendment that will need to be addressed.

Our own contacts in Washington suggest some sympathy on Capitol Hill for the idea that although increased capital standards might be inevitable, phasing them in slowly is only fair.  As always, the broader political context for this discussion will play a large role in its resolution.  We will continue to follow this and all aspects of the financial reform legislation and share updates here as they develop.