Basel III Redefines Capital: For Community Banks, the Third Time around for the Global Rules May Be Less "The Charm" Than Cause for Alarm

[ILLUSTRATION OMITTED] The sleepy town of Basel, Switzerland, seems an unlikely source for radical changes to the global banking environment. Best known as a pharmaceutical headquarters, it is also home to the Bank for International Settlements, sponsor of the Committee on Banking Supervision. The committee sets international standards for the conduct and risk management of a wide range of bank activities, including standards for appropriate levels of capital to be held against risks of those activities. The committee's most recent previous pronouncement on regulatory capital--dubbed II--was applied in the U.S. only to large, internationally active banks. Thus the Committee has not been on the radar of most community banks since adoption of I in 1988. That changed in September when the committee announced a fundamental redefinition of capital as well as heightened standards intended to apply to all banks. For many, the changes will force revisions to capital plans and, for some, require new sources of equity capital. Bumpy road from I to III Current capital rules applied to U.S. banks and bank holding companies are based on the I accord, which started the risk-sensitive approach to capital requirements. Exposures on and off the balance sheet were classified into broad categories of credit risk. Over time, I was criticized for being insufficiently granular in its assignment of assets to risk categories. Exposures with very different risk profiles would be slotted into the same risk bucket. The committee sought to improve the risk sensitivity of I and embarked on a multi-year upgrade. II was adopted in 2004 as a more risk-sensitive measure that employed banks' own estimates of risk in determining minimum capital requirements. When the Committee adopted II, U.S. federal banking agencies decided to adopt only the advanced approaches that apply to certain internationally active banking organizations. Others could opt-in voluntarily. After adoption of II, some committee members expressed concerns about the perceived expansiveness of the definition of capital. Concerns centered around the ability of certain instruments included in Tier 1 capital to absorb loss on a going-concern basis. To discuss these concerns, a working group was formed to review the definition of capital. The lengthy deliberations of this group influenced significantly the consultative paper released in December 2009--Strengthening the resilience of the banking sector. That paper proposed a substantial narrowing of the types of instruments that could be included in Tier 1; a stronger reliance on common shareholders' equity; and a very aggressive increase in capital requirements--all with a goal of implementation by yearend 2012. In response to comments filed by banks, trade groups--including ABA--and others, some onerous provisions were revised. The resulting agreement, released in September, is known as Basel It was expected to be formally endorsed at the November meeting of the G-20. III in brief Space constraints allow only an overview of III. The framework increases capital requirements and limits the types of instruments that can be included in Tier 1. While it represents a moderation of the most onerous provisions of the consultative paper, the impact should not be underestimated. III requires a minimum common equity capital ratio of 4.5% of risk-weighted assets by Jan. 1, 2015, plus adoption of a capital conservation buffer equal to common equity in the amount of an additional 2.5% of risk-weighted assets by Jan. 1, 2019. III also limits the types of instruments that can be included in Tier 1 capital to common shareholders' equity plus a limited sin bucket that is capped at 15% of common equity in the aggregate and 10% of common equity for any one component. …