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November 13, 2014Client Alert

Impact of Basel III’s Capital Conservation Buffer and Possible Sub-S Implications

The regulations published by the U.S. banking agencies to implement the international Basel III capital standards runs close to 1,000 pages. The complexities and nuances in the regulations are enough to make any normal person’s head spin. While this may not be surprising given the fact that Basel III is the most complete overhaul of U.S. bank capital standards in nearly a quarter of a century, it does not make implementation any easier. Many aspects of Basel III including the increased minimum capital requirements and revisions to the regulatory capital calculation have been analyzed in detail. However, one aspect of Basel III that is often overlooked, but which still can have significant impact, is the capital conservation buffer.

The unmistakable theme of the Basel III regulations is the importance of core capital. The new capital rules increase the amount of capital that a banking organization must maintain. To further encourage adequate capital maintenance, Basel III establishes a capital conservation buffer - designed to ensure that banks have access to supplementary capital during periods of stress. Thus, in addition to the minimum risk-based capital requirements, all banks must hold Common Equity Tier 1 (CET1) capital (the highest-quality and most loss-absorbing form of capital) in an amount greater than 2.5% of total risk-weighted assets if they are to avoid limitations on capital distributions. The capital conversation buffer, therefore, effectively increases by 2.5% each of the minimum risk-based capital ratios that a bank must maintain. Thus, even though the new “minimum” total, Tier 1, and CET1 risk-based capital ratios are technically 8.0%, 6.0% and 4.5%, respectively, the actual minimum risk-based capital ratios necessary to avoid restrictions are higher.

The capital conservation buffer must be maintained to avoid limitations on both (i) capital distributions (e.g., repurchases of capital instruments or dividend or interest payments on capital instruments), and (ii) discretionary (i.e., non-contractual) bonus payments to executive officers such as CEO, president, CFO, CIO, CLO and heads of major business lines. The limitations are applied on a sliding scale. Thus, as a bank dips further below its capital conservation buffer, it will be subject to increasingly stringent limitations on capital distributions and bonus payments. The capital conservation buffer will begin to be phased-in on January 1, 2016 and will be fully phased-in as of January 1, 2019.  When fully phased-in, the limitations on capital distributions and bonus payments will be as follows:

 

 Capital Conservation Buffer
(as a percentage of risk-weighted assets)

 Maximum Payout
(as a percentage of eligible retained income

Greater than 2.5 percent

No payout limitation applies

Less than or equal to 2.5 percent and greater than 1.875 percent

60 percent

Less than or equal to 1.875 and greater than 1.25 percent

40 percent

Less than or equal to 1.25 and greater than 0.625 percent

20 percent

Less than or equal to 0.625 percent

0 percent

 

The maximum dollar amount that a bank can pay in the form of capital distributions or discretionary bonus payments during a calendar quarter is equal to the applicable maximum payout ratio in the chart above (as calculated as of the last day of the previous calendar quarter) multiplied by the bank’s eligible retained income. For purposes of this calculation, eligible retained income means a bank’s net income (as reported in the bank’s quarterly regulatory reports) for the four calendar quarters preceding the current calendar quarter, net of any capital distributions and associated tax effects not already reflected in net income.

The prompt corrective action thresholds under the new capital rules do not affect the capital conservation buffer. Therefore, a bank can be “well-capitalized” without having a fully-funded capital conservation buffer. As a result, even if an organization is considered “well-capitalized,” its ability to make capital distributions and discretionary bonus payments may still be restricted if it does not maintain a buffer of at least 2.5% of CET1 capital over each minimum capital ratio.

The limitation on capital distributions imposed on banks failing to maintain the capital conservation buffer can cause illogical results for S-corporation banks. S-corporations are treated, for tax purposes as disregarded entities and do not pay federal income taxes. Instead, their shareholders are responsible for paying the tax on the S-corporation’s income, regardless of whether that income is distributed to them. Thus, under Basel III, a bank could have net income but not be able to pay a dividend (which could result in shareholders not receiving cash to pay their individual tax liability on the bank’s income.

To address this unfair result, the Basel III regulations contain a provision allowing any bank to request approval from its primary federal regulator to make a dividend payment that would not otherwise be permitted by the capital conservation buffer. Recognizing the concern that the capital conservation buffer could increase the frequency with which S-corporation shareholders face a tax liability without having received dividends, and the concern that investors’ fear of this scenario could make it more difficult for S-corporation banks to attract capital, the FDIC recently announced the factors it will consider when determining whether to permit S-corporation bank dividends that would otherwise be impermissible under the capital conservation buffer. These factors are:

  • Whether the S-corporation bank is requesting a dividend of no more than 40 percent of net income.
  • Whether the S-corporation bank believes the dividend payment is necessary to shareholders to pay income taxes associated with their pass-through share of the bank’s earnings.
  • Whether the requesting S-corporation bank has a CAMELS bank examination rating of 1 or 2 and is not subject to a written supervisory director.
  • Whether the S-corporation bank satisfies the pre-existing prompt corrective action requirements (at least “adequately capitalized”) and would remain so after paying the requested dividend).

If the FDIC determines that the S-corporation bank satisfies each of these factors, the requested dividend generally would be approved, so long as there are no significant safety-and-soundness concerns. There is no current guidance as to whether a failure to meet one of these requirements will prevent issuance of a dividend waiver; however, it seems likely that a significant failure on one, or a failure on two or more, may result in denial. 

To avoid adverse restrictions on bank dividends or payment of discretionary executive bonuses, banks should start planning now to comply with the capital conservation buffer. Although banks may be focused on other capital rules that will become effective earlier than 2016, failure to focus now on strategies to fully comply with the capital conservation buffer as it becomes effective may result in banks finding themselves subject to these adverse restrictions. A good first action step would be to run pro forma calculations of your bank’s capital ratios under Basel III now, in advance of implementation and taking into account the multi-year implementation timeline of the new rules. Such calculations will give you an understanding of how the capital conservation buffer may affect your bank.

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