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Senate-passed Regulatory Reform Offers Real Benefits to Depository Institutions under $10 Billion in Assets

On March 14, 2018, the Senate passed, 67-31, the Economic Growth, Regulatory Relief and Consumer Protection Act, or S. 2155.  While it may lack a catchy name, its substance is of potentially great importance to community banks.

The following summary focuses on the impact of the bill for depository institutions with less than $10 billion in consolidated assets.  The bill would also have some significant impacts on larger institutions, which could, in turn, affect smaller banks… either as a result of competition or, perhaps more likely, through a re-ignition of larger bank merger and acquisition activity.  However, we thought it was useful to focus on the over 5,000 banks in the United States that have less than $10 billion in assets.

Community Bank Leverage Ratio

Section 201 of the bill requires the federal banking regulators to promulgate new regulations which would provide a “community bank leverage ratio” for depository institutions with consolidated assets of less than $10 billion.

The bill calls for the regulators to adopt a threshold for the community bank leverage ratio of between 8% and 10%.  Institutions under $10 billion in assets that meet such community bank leverage ratio will automatically be deemed to be well-capitalized.  However, the bill does provide that the regulators will retain the flexibility to determine that a depository institution (or class of depository institutions) may not qualify for the “community bank leverage ratio” test based on the institution’s risk profile.

The bill provides that the community bank leverage ratio will be calculated based on the ratio of the institution’s tangible equity capital divided by the average total consolidated assets.  For institutions meeting this community bank leverage ratio, risk-weighting analysis and compliance would become irrelevant from a capital compliance perspective.

Volcker Rule Relief

Section 203 of the bill provides an exemption from the Volcker Rule for institutions that are less than $10 billion and whose total trading assets and liabilities are not more than 5% of total consolidated assets.  The exemption provides complete relief from the Volcker Rule by exempting such depository institutions from the definition of “banking entity” for purposes of the Volcker Rule.

Accordingly, depository institutions with less than $10 billion in assets (unless they have significant trading assets and liabilities) will not be subject to either the proprietary trading or covered fund prohibitions of the Volcker Rule.

While few such institutions historically undertook proprietary trading, the relief from the compliance burdens is still a welcome one.  It will also re-open the ability depository institutions (and their holding companies) to invest in private equity funds, including fintech funds.  While such investments would still need to be confirmed to be permissible investments under the chartering authority of the institution (or done at a holding company level), these types of investments can be financially and strategically attractive.

Expansion of Small Bank Holding Company Policy Statement

Section 207 of the bill calls upon the federal banking regulators to, within 180 days of passage, raise the asset threshold under the Small Bank Holding Company Policy Statement from $1 billion to $3 billion.

Institutions qualifying for treatment under the Policy Statement are not subject to consolidated capital requirements at the holding company level; instead, regulatory capital ratios only apply at the subsidiary bank level. This rule allows small bank holding companies to use non-equity funding, such as holding company loans or subordinated debt, to finance growth.

Small bank holding companies can also consider the use of leverage to fund share repurchases and otherwise provide liquidity to shareholders to satisfy shareholder needs and remain independent. One of the biggest drivers of sales of our clients is a lack of liquidity to offer shareholders who may want to make a different investment choice. Through an increased ability to add leverage, affected companies can consider passing this increased liquidity to shareholders through share repurchases or increased dividends.

Of course, each board should consider its practical ability to deploy the additional funding generated from taking on leverage, as interest costs can drain profitability if the proceeds from the debt are not deployed in a profitable manner. However, the ability to generate the same income at the bank level with a lower capital base at the holding company level should prove favorable even without additional growth.  This expansion of the small bank holding company policy statement would significantly increase the ability of community banks to obtain significant efficiencies of scale while still providing enhanced returns to its equity holders.

Institutions engaged in significant nonbanking activities, that conduct significant off-balance sheet activities, or have a material amount of debt or equity securities outstanding that are registered with the SEC would remain ineligible for treatment under the Policy Statement, and the regulators would be able to exclude any institution for supervisory purposes.

HVCRE Modifications

Section 214 of the bill would specify that federal banking regulators may not impose higher capital standards on High Volatility Commercial Real Estate (HVCRE) exposures unless they are for acquisition, development or construction (ADC), and it clarifies what constitutes ADC status. The HVCRE ADC treatment would not apply to one-to-four-family residences, agricultural land, community development investments or existing income-producing real estate secured by a mortgage, or to any loans made prior to Jan. 1, 2015.

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Regulators Propose Simplification of Capital Rules

the-bank-accountOn the latest episode of The Bank Account, “Adding HVADC to our Banking Alphabet Soup,” Jonathan and I are joined by colleague Jerry Blanchard to discuss the new capital rules proposed by the federal banking regulators on September 27, 2017.  The newly proposed regulators propose to overhaul the HVCRE regime with a “new and improved” HVADC regime, while also increasing the amount of Mortgage Servicing Assets (MSAs) and Deferred Tax Assets (DTAs) that can be included in Tier 1 Capital.

As discussed yesterday, the new HVADC rule would likely expand the scope of loans that require elevated risk-weighting, but reduce the risk-weighting from 150% to 130%.  In addition, the new rules would eliminate the need (or risk-weighting benefit) to require borrower contributed capital (and to retain any internally generated profits from the project for the life of the loan).

The proposed rule for MSAs and DTAs would require 250% risk-weighting for such assets (as contemplated in the original BASEL III rules as of January 1, 2018 and proposed to be delayed in August), but would also allow financial institutions to include MSAs and DTAs as capital, each up to 25% of Tier 1 Capital (with no separate aggregate cap amongst them).

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HVCRE Gets a Reboot

HVCRE Gets a Reboot

September 27, 2017

Authored by: Jerry Blanchard

As we mentioned just a couple of weeks ago, the federal banking regulators have taken aim at the risk weighting rules for High Volatility Commercial Real Estate (“HVCRE”) loans that went into effect back in 2015. In a proposal published on September 27, 2017, the regulators seek to simplify the approach in several ways. First, the existing HVCRE definition in the standardized approach would be replaced with a simpler definition, called HVADC, which would apply to credit facilities that primarily finance or refinance ADC activities. Second, an HVADC exposure would receive a 130 percent risk weight.as opposed to the 150% risk weight for HVCRE exposure under the existing rule. The tradeoff though is that HVADC would apply to a much broader set of loans. For example, as compared to the HVCRE exposure definition, the proposed HVADC exposure definition would not include an exemption for loans that finance projects with substantial borrower contributed capital and consequently removes the restriction on the release of internally generated capital.

The definition of “primarily finance” means credit facilities where more than 50 percent of loan proceeds will be used for ADC activities. So for example, multipurpose facilities where more than 50 percent of loan proceeds finance non-ADC activities, such as the purchase of equipment, would not be considered HVADC.

As with the HVCRE rule, there are certain exemptions. HVADC would exempt permanent loans, community development loans, loans for the purchase or development of agricultural land and loans for one to four family residential.  Thus, lot development loans and loans to finance the ADC of townhomes or row homes would not be considered HVADC but raw land loans and loans to finance the ADC of apartments and condominiums generally would be considered HVADC.

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HVCRE Lending: An Area of Regulatory Examination Focus

the-bank-account

Jonathan and I are joined by our colleague, Jerry Blanchard, to discuss High Volatility Commercial Real Estate (HVCRE) Loans on the latest episode of The Bank Account.

HVCRE Loans are one of the areas of focus on regulatory exams, and we’re seeing increased attention to not only ensuring that a bank’s reported HVCRE loans are correct, but also that the bank has sufficient internal controls in place to monitor and track HVCRE lending.

Formal regulatory guidance on HVCRE lending is still rare, as the various regulatory agencies struggle to find consensus in an area that is fraught with technicalities and details.  Our colleague, Jerry Blanchard, has assisted numerous banks in evaluating overall HVCRE programs as well the application of the HVCRE requirements to countless loans.  In addition, he’s written extensively on the topic, including:

You can always follow us on Twitter.  Jonathan is @HightowerBanks, I’m @RobertKlingler, and Jerry is @Blanchard_Jerry.  Our producer, Sam Katz, is @SamathaJill1, and is not responsible for my inability to read simple copy at the end of this episode.

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The HVCRE Easter Egg for Community Banks

We have written several times about the rules concerning the appropriate risk weighting for High Volatility Commercial Real Estate (“HVCRE”) loans. The interagency FAQ published on April 6, 2015 provided some guidance but many banks continue to have questions about fact situations that are not addressed under the regulation.  Despite indications that an interagency task force was looking at a further set of FAQ nothing has yet come out. Despite that, there are actually grounds for optimism that the rules will yet be simplified.

Section 2222 of the Economic Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA)  requires that, not less than once every 10 years, the Federal Financial Institutions Examination Council (FFIEC) and the Board of Governors of the Federal Reserve System (Board), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) must conduct a review of their regulations to identify outdated or otherwise unnecessary regulatory requirements imposed on insured depository institutions. In conducting this review, the statute requires the FFIEC or the agencies to categorize their regulations by type and, at regular intervals, provide notice and solicit public comment on categories of regulations, requesting commenters to identify areas of regulations that are outdated, unnecessary, or unduly burdensome.

In late spring of this year the FFIEC reported to Congress that one of its goals was to simplify the capital rules for community banks. The very first area of attention listed under that heading was to replace the complex treatment of HVCRE exposures with a more straightforward treatment for most acquisition, development, or construction (“ADC”) loans. While the agencies are not ready to lift the curtain on what the revised rule might look like they did cite certain comments they had received from community banks including (i) that the definition of HVCRE is neither clear nor consistent with established safe and sound lending practices; (ii) the 150 percent risk weight applied to HVCRE lending is simply too high; (iii) the criteria for determining whether an ADC loan may qualify for an exemption from the HVCRE risk weight are confusing and do not track relevant or appropriate risk drivers; and (iv) in particular, commenters expressed concern over the requirements that exempted ADC projects include a 15 percent borrower equity contribution, and that any equity in an exempted project, whether contributed initially or internally generated, remain within the project (i.e., internally generated income may not be paid out in the form of dividends or otherwise) for the life of the project.

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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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New Proposed Capital Rules May Mean the Death of Highly Leveraged ADC Transactions

Many bankers are spending their evenings attempting to work through the very dense and long Joint Notices of Proposed Rulemakings that together propose new capital standards for financial institutions.  Even though the proposed Basel III rules would not become effective until January 1, 2013 and the proposed risk-weighting rules would not become effective until January 1, 2015, bankers need to begin to understand how these rules will affect their capital planning now.  While the regulatory agencies are busily assuring bankers that the vast majority of financial institutions would have been in compliance if the proposed rules had been effective on March 31, 2012, the rules, as proposed, will certainly change how many financial institutions approach their capital planning and asset mixes.

One facet of the rule that may impact many community banks and their borrowers is the proposed risk-weighting of certain commercial real estate (CRE) loans.  While acquisition, development, and construction (ADC) lending has certainly fallen out of favor with regulators and bankers in recent years, many bank boards realize that a part of their long-term success will be a re-entry into this market.  Many lenders are very experienced in underwriting ADC loans and have deep relationships with successful real estate developers.  While bank boards are more cautious with respect to ADC and CRE lending concentrations, continuing to engage in lending activities that have provided good returns over the long-term still makes sense.

The Notice of Proposed Rulemaking entitled “Regulatory Capital Rules—Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements” will apply to all banking organizations other than bank holding companies with less than $500 million in total consolidated assets.  As a part of the new risk-weighting rules, certain higher risk CRE loans will carry a 150% risk-weighting, as opposed to the standard 100% risk-weighting.  Those higher risk loans are proposed to be defined as a credit facility that finances or has financed the acquisition, development, or construction of real property, unless the facility finances:

(1)    one- to four-family residential property; or

(2)    commercial real estate projects in which:

i.    the LTV ratio is less than or equal to the applicable maximum LTV ratio in the agencies’ real estate lending standards (generally 65 to 80%);
ii.    the borrower has contributed capital in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15% of the real estate’s appraised “as completed” value; and
iii.    the borrower contributed the amount of capital required under 2(ii) before the bank advances funds 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 (i.e., when permanent financing is obtained).

The proposed rule defines those ADC loans not meeting the criteria above as High Volatility Commercial Real Estate (HVCRE) loans.

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