A Basel III discussion regarding capital

There has been a collective groan from the leagues of bankers as they consider what they might need to do to comply with Basel III capital guidelines.

Basel III is a set of voluntary banking guidelines for capital adequacy, market risk and stress testing.  The Basel III accords do not regulate banks, but bank regulators have taken a liking to the Basel guidelines and have used them to form new regulations.

In the United States regulators approved an inter-agency proposal in October of 2014 outlining the US version of Basel III compliance.  The guidelines are comprehensive and the goal of this post isn’t to summarize what the regulators have decided.  Instead I want to focus on one specific aspect of Basel III compliance and look at how many banks will be forced to raise capital in the near future.

Under the new Basel III capital guidelines banks are required to have higher levels of capital to protect against losses.  Under the new guidelines banks are required to have 4.5% of equity capital and 6% of Tier 1 capital.  Regulators can require higher capital levels beyond those based on economic factors or risk weighted factors.  An additional rule is that common shares and retained earnings must be at least half of a bank’s capital.  This will be a high hurdle for some banks to overcome if they’ve had significant losses in the past due to the Financial Crisis.

A lot of the outcry over the new regulations has been that community banks will be unfairly punished.  The argument is that these small banks that serve local communities will be forced to raise significant amounts of capital and that regulations will imperil their business.

I decided to dig into the data.  At the end of Q4 2014 there were 42 banks in the US where their equity capital plus retained earnings were less than 50% of their Tier 1 capital.  These 42 banks will be required to merge or be forced to raise capital to be in compliance with the new Basel III guidelines.  As expected all of these potentially deficient banks are small community banks.  The largest potentially deficient bank has $1.03b in assets and the smallest $31m in assets.

If the criteria is loosened to include banks whose equity and retained earnings are less than Tier 1 the number of banks increases to 86.  In the increased set only two have assets over $1b, and four have assets over $500m, the rest are sub-$500m in assets institutions.

Many of these institutions will decide that it’s easier to merge rather than raise capital or exist under the new regulatory regime.  For investors there are 18 listed stocks in the first group and 42 listed banks in the second group.

Based on the data the criticism that Basel III will unfairly hurt small banks appears true at first glance.  The banks potentially most deficient are small community banks.  What the data misses is that all banks will be potentially impacted.  This is because the Basel III guidelines are more conservative in the types of assets banks can hold for regulatory purposes as well as requiring certain types of assets to meet liquidity guidelines.

What we do know from the data I pulled is that the banks most deficient are smaller community banks.  What happens to these banks is yet to be seen, but this will probably fuel the merger and acquisition story for the next few years.

Leave a Reply