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Basel III Treatment of DTAs and MSAs

We have heard, read and seen (and internally had) some confusion regarding the joint proposed rulemaking regarding the potential simplification of the capital rules as they relate to Mortgage Servicing Assets (MSAs) and certain Deferred Tax Assets (DTAs).

In addition to simply being complicated regulations, the regulators also have two proposed rulemakings outstanding related to these items. In August 2017, the banking regulators jointly sought public comment on proposed rules (the “Transition NPR“) that proposed to extend the treatment of MSAs and certain DTAs based on the 2017 transition period. Then, in September 2017, the banking regulators jointly sought comment on proposed rules (the “Simplification NPR“) that proposed to alter the limitations on treatment of MSAs and certain DTAs (and also addressed High Volatility Commercial Real Estate or HVCRE loans).

The Simplification NPR also addressed the interplay of the Simplification NPR and the Transition NPR. The Simplification NPR provided that the Transition NPR, if finalized, would only remain effective until such time as the Simplification NPR became effective. Accordingly, the Simplification NPR, if adopted, will ultimately control, with no transition periods for MSAs and certain DTAs following January 1, 2018.

Net Operating Loss DTAs

Importantly, neither the Transition NPR nor the Simplification NPR have any affect on the Basel III capital treatment net operating loss (NOL) DTAs. DTAs that arise from NOL and tax credit carryforwards net of any related valuation allowances and net of deferred tax liabilities must be deducted from common equity tier 1 capital. Through the end of 2017, the deduction for NOL DTAs are apportioned between common equity tier 1 capital and tier 1 capital. In 2017, 80% of the NOL DTA is deducted directly from common equity tier 1 capital, while the remaining 20% is separately deducted from additional tier 1 capital. Starting in 2018, 100% of the NOL DTA will be deducted from common equity tier 1 capital.

The end of the transition period will have the effect of lowering the common equity tier 1 capital ratio of all institutions with NOL DTAs, although the tier 1 capital and leverage ratios should remain unchanged. This impact is entirely unaffected by the adoption (or non-adoption) of the Transition NPR and/or Simplification NPR.

Similarly, other aspects of NOL DTAs are unaffected by the proposed rules. Specifically, (i) GAAP still controls the appropriateness of valuation allowances in connection with the DTA, (ii) tax laws still control the length of time over which DTAs can be carried forward, and (iii) Section 382 of the Internal Revenue Code still controls the limitation (and potential loss) of DTAs upon a change in control of the taxpayer.

Temporary Difference DTAs

Unlike Net Operating Loss DTAs, DTAs arising from temporary differences between GAAP and tax accounting, such as those associated with an allowance for loan losses and other real estate write-downs, can be included in common equity tier 1 capital, subject to certain restrictions. To the extent that such DTAs could be realized through NOL carryback if all those temporary differences were deemed to have been reversed, such DTAs are includable in their entirety in common equity tier 1 capital. Essentially, to the extent the temporary difference DTAs could be realized by carrying back against taxes already paid, then such DTAs are fully includable in capital. Carryback rules vary by jurisdiction; while federal law generally permits a bank to carry back NOLs two years, many states do not allow carrybacks.

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HVCRE Update – New Interagency FAQ

As previously mentioned, the federal banking regulators have been working on a FAQ on the topic. The interagency FAQ was published on April 6, 2015. While there were no surprises in what was published there were a number of takeaways from the FAQ that lenders need to keep in mind and I have added those to my previous list of FAQ. Under Basel III, as a general rule, a lender applies a 100% risk weighting to all corporate exposures, including bonds and loans. There are various exceptions to that rule, one of which involves what is referred to as “High Volatility Commercial Real Estate” (“HVCRE”) loans. Simply put, acquisition, development and construction loans are viewed as a more risky subset of commercial real estate loans and are assigned a risk weighting of 150%.

HVCRE is defined to include credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances:

  1. One- to four-family residential properties;
  2. Real property that would qualify as a community development investment;
  3. agricultural land; or
  4. Commercial real estate projects in which:
    • The loan-to-value ratio is less than or equal to the applicable regulator’s maximum amount (i.e., 80% for many commercial bank transactions);
    • The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised ‘‘as completed’’ value; and
    • The borrower contributed the amount of capital before the lender advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.
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High Volatility CRE Rules and Contributed Capital

The new risk weighting rules applicable to commercial real estate are now fully in effect for all banks. The rule flows out of the new capital rulemaking carried out by the federal banking agencies as a result of Basel III. As a general rule, the agencies agreed to apply a 100% risk weighting to all corporate exposures, including bonds and loans. There were various exceptions to that rule, one of which involves what is referred to as “High Volatility Commercial Real Estate” (“HVCRE”) loans. Simply put, acquisition, development and construction loans are viewed as a more risky subset of commercial real estate loans and are assigned a risk weighting of 150%.

HVCRE is defined to include credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances:

  1. One- to four-family residential properties;
  2. Real property that would qualify as a community development investment;
  3. agricultural land; or
  4. Commercial real estate projects in which:
    • The loan-to-value ratio is less than or equal to the applicable regulator’s maximum amount (i.e., 80% for many commercial bank transactions);
    • The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised ‘‘as completed’’ value; and
    • The borrower contributed the amount of capital before the lender advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.

Developers and lenders have been looking at the guidance and applying it to real world situations.  Here are some of the issues:

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AOCI Opt-out Election Process

AOCI Opt-out Election Process

February 18, 2015

Authored by: Robert Klingler

In connection with the effectiveness of BASEL III, most banks are required to decide whether to elect to opt-out of the inclusion of Accumulated Other Comprehensive Income (“AOCI”) in their Common Equity Tier 1 Capital.  All non-advanced approaches institutions (i.e.  banks less than $250 billion in total assets with less than $10 billion in on-balance sheet foreign exposure) will need to indicate whether they are making the AOCI opt-out in their March 31, 2015 Call Reports.  This is a one-time election and generally irrevocable, except in the limited cases of subsequent mergers between institutions with different elections.

As a reminder, AOCI includes such items as unrealized gains and losses on certain securities.

For institutions that opt out, most AOCI items will not be included in the calculation of Common Equity Tier 1 Capital (and thus Tier 1 Capital generally). In other words, most AOCI items will be treated, for regulatory capital purposes, in the same manner in which they were prior to BASEL III.  (Unrealized gains and losses on available-for-sale debt securities will continue to be excluded from regulatory capital; unrealized losses on available-for-sale equity securities will continue to be recognized in regulatory capital; and up to 45% of unrealized gains on available-for-sale equity securities will continue to be recognized in Tier 2 capital.)

For institutions that do not opt out, most AOCI items will be included in the calculation of Common Equity Tier 1 Capital (and thus Tier 1 Capital generally).  (Unrealized gains and losses on available-for-sale debt and equity securities will be recognized in Common Equity Tier 1 Capital.)

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BASEL III: The Final Rules are Here and It’s Time to Get Ready

Over the past year, my colleagues and I have spent an untold number of hours researching, writing and speaking about the Basel III capital rules. We felt it important to help bankers focus on the proposed rules in order to help them prepare and to help facilitate an appropriate response to the proposed rules. Because the rules were in proposed form, however, many bankers, bank directors and industry participants did not focus on these capital rules, instead waiting until they were finalized. Well, we’re here.

Earlier this month, the regulatory agencies finalized their revisions to the capital and risk-weighting rules, commonly known as the Basel III rules. Even though the rules will not be effective for most banks until Jan. 1, 2015, the finalizing of these rules presents the call to action to begin the dialogue about how the new rules will impact your bank. Of course, given the fact that the final release for the rules was almost 1,000 pages long, many bankers contemplating a board presentation are left to ask, “Where should I start?” Below are a few suggested areas of focus to begin to enhance your directors’ understanding of the new rules. 

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Wow! The Fed responds to comments from Community Banks on Basel III

While the final Basel III capital rules have not been published at the time of this post, it was clear from this morning’s comments at the meeting of the Board of Governors of the Federal Reserve System that community banks have been heard. Highlights from the meeting include the following positions of the Federal Reserve on the Basel III rules.

  •  AOCI – Non-internationally active financial institutions (i.e., all community banks) will be allowed a one-time option to opt out of the inclusion of accumulated other comprehensive income in Tier 1 regulatory capital. This opt-out option will ease the potential burden on community banks from incorporating fluctuations in the value of their available for sale securities portfolio in their regulatory capital calculations. We view this as a big win for community banks.
  • Mortgage Loan Risk-Weighting – Many community banks expressed a great deal of concern with the proposed risk weighting of residential mortgage loans, which was based on loan-to-value ratios and certain other features, including whether or not the loan had a balloon feature. In response to those comments, the final Basel III rule will contain no changes to the current risk weighting of residential mortgage loans. While this is a nice win for banks and borrowers, the separate qualified mortgage rules will likely impact mortgage lending in the future.
  • Trust Preferred Securities – The final Basel III rules will grandfather the eligibility of trust preferred securities to qualify as Tier 1 capital for bank holding companies with less than $15 billion in total consolidated assets. This change will obviate the need for many community banks to raise capital through the issuance of common equity to replace the Tier 1 capital previously provided by the issuance of trust preferred securities.

While the written rule will undoubtedly contain a great deal of additional clarifications, the early comments from the meeting of the Board of Governors of the Federal Reserve System indicate that the rally of community banks against certain aspects of the Basel III rules was very successful. We will publish more analysis as we digest the final rules.

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Regulators Announce Delay in Adoption of Final Basel III Capital Rules

Given the tremendous volume of comments from industry participants regarding the Basel III capital rules and the mounting political pressure regarding adoption of the rules, many industry observers had speculated that the Federal Reserve, FDIC, and OCC would be challenged to adopt the final rules before January 1, 2013 (the date established for effectiveness of portions of the rule in the release of the proposed rules). On November 9, 2012, the agencies announced that they indeed will not be able to meet that deadline.   This announcement runs contrary to the recently renewed directive by the Basel Committee on Banking Supervision for all members of the committee to adopt final rules prior to January 1, 2013. However, we believe it is appropriate for the U.S. regulatory agencies to carefully consider the impact of the rules on the U.S. banking system, particularly in light of our unique community banking system, and support the agencies delay in adopting the rules.

It is our understanding that the regulatory agencies are working through the comment letters submitted to them and are well aware of the concerns of community bankers, including the inclusion of unrealized gains and losses in the available-for-sale securities portfolio in Common Equity Tier 1 capital and the changes in risk-weighting for mortgage loans. We will continue to carefully monitor the progress of the rulemaking process as the agencies consider the impacts of the Basel III rules on the industry.

 

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Fall 2012 Update on Regulatory and Legal Changes Affecting Community Banks

Bank regulators have been as busy as usual in 2012, but some of the more interesting regulatory and legal changes have come from non-bank regulators and the courts. And, the JOBS Act changes described below actually lifts the regulatory burden on banks a bit, a rare respite in an otherwise challenging regulatory environment.

The JOBS Act eases bank capital activities and M&A.  The Jumpstart Our Business Startups Act affects community banks in 4 key ways:

  • “Going public” is easier. Banks that have less than $1 billion in gross revenue can qualify as an “emerging growth” company and take advantage of relaxed rules that allow them to “test the waters” and obtain a confidential prior review of an IPO filing by the SEC, provide reduced executive compensation disclosures and file without a SOX 404 attestation by the bank’s auditors.
  • The “crowdfunding” rule (expected in early 2013) will provide banks significant flexibility in raising $1 million per year from their community without IPO-type expenses and without adding new investors to their shareholder count.
  • Private offerings are easier. Rules affecting private offerings are being relaxed so that a bank will be able to use public solicitation and advertising to attract investors as long as the bank takes reasonable steps to ensure that those investors are accredited.
  • Going or staying private is easier because the shareholder count triggering “going public” was raised from 500 to 2,000. And, shareholders from a bank’s “crowdfunding” offerings and from employee compensation plans are now excluded from the shareholder count. These helpful changes to shareholder count rules mean that some banks can bring in new investors or even acquire another bank without triggering the obligation to “go public,” a significant cost and compliance barrier. Also, banks with a shareholder count under 1,200 can “go private” following a 90-day waiting period.
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Basel III Proposals Will Bring Changes to the Accounting of Bank Securities Portfolios

As part of the proposed Basel III capital rules, banks will be required to hold a greater portion of their total capital in the form of common equity. With the creation of a new Common Equity Tier 1 (“CET1”) ratio to be included with other minimum capital ratios and a new Capital Conservation Buffer to be composed exclusively of common equity, the proposed new capital rules signal a regulatory departure from allowing forms of hybrid capital to constitute a significant amount of a bank’s total capital. While the impacts of the new preference for CET1 will be significant, the methodology for calculating the CET1 ratio will also affect the interest rate and liquidity risk management tools available to community banks.

In calculating the new CET1 ratio under the proposed rules, banks would be required to include Accumulated Other Comprehensive Income (“AOCI”) as part of CET1. For most community banks, the primary driver of AOCI is unrealized gains and losses in the bank’s available-for-sale (“AFS”) securities portfolio. Such securities are generally designated as available for sale to provide the bank with a beneficial source of liquidity. While Generally Accepted Accounting Principles require a financial institution to record changes in the fair value of the bank’s AFS securities portfolio in the equity section of its balance sheet, regulatory precedent currently excludes unrealized gains and losses on the AFS portfolio from the calculation of Tier 1 regulatory capital, instead including that amount in the calculation of the institution’s Tier 2 capital.

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The Georgia Bankers Association Delivers a Detailed Critique of the Basel III Proposals

On October 12, 2012, the Georgia Bankers Association (the “GBA”) delivered a public comment letter on the proposed Basel III capital rules and the related proposed risk-weighting rules. A copy of the letter is available for viewing here.  In the comment letter, the GBA identifies over a dozen categories of key flaws in the proposed rules and concludes that the proposals should be withdrawn for further study or, at the very least, should be modified to exempt community and regional banks from their requirements.

The GBA takes the position in the comment letter that the regulatory agencies have a duty to apply the principles that they espouse for stress testing and enterprise risk management to their own rulemaking process. The GBA argues that the proposals are likely to introduce complementary risks to financial institutions, especially community banks, the impacts of which are not yet fully understood. As a result, the GBA asserts that the regulatory agencies should take time to study the impact of each rule change on the industry and then “stress” those impacts together and under a wide variety of market circumstances as a part of their role in managing risks to the banking industry.

The comment letter provides a wealth of themes and talking points as financial institutions make their final efforts to deliver their own comment letters, which are due no later than October 22, 2012. We encourage all financial institutions to identify any issues in the proposed rules that may significantly impact them and to submit a comment letter regarding those issues.

The GBA developed a task force to study the impact of the proposed rules on banks in Georgia and to develop thoughts for the comment letter. That task force included a number of bankers and service providers, including Bryan Cave’s Jonathan Hightower.

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