Basel III Presents Opportunities for Smaller Banks

By Steven Jones-D’Agostino


In July 2013, the Federal Reserve Board approved a final rule to implement the Basel III regulatory capital reforms in the U.S. That rule stemmed from the Basel Committee on Banking Supervision and certain changes required by the federal Dodd-Frank Wall Street Reform and Consumer Protection Act.

Under the final rule, large, national banks had to begin phasing in their Basel III requirements in January 2014. Smaller institutions, including all savings and loans, will have to begin phasing in their requirements in January 2015. Both types of banks will have until 2017 to implement their respective requirements. Only the 39 U.S. banks with more than $50 billion in assets were directly impacted by the final rule.

The final U.S. Basel III rule was intended to require American banks to fortify their capital positions to ensure continued lending to creditworthy households and businesses, despite unforeseen losses and during severe economic downturns. The final rule minimized the burden on smaller, less-complex financial institutions. It also established an integrated regulatory capital framework that addressed shortcomings in capital requirements – particularly for larger, internationally active, “too important to fail” banking organizations – that became apparent during the recent financial crisis.

The final rule also increased minimum requirements for both the quantity and quality of capital held by U.S. banking organizations. Consistent with the international Basel framework, the final rule included a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5 percent and a common equity tier 1 capital conservation buffer of 2.5 percent of risk-weighted assets that applies to all supervised financial institutions.

In addition, the final rule raised the minimum ratio of tier 1 capital to risk-weighted assets from 4 percent to 6 percent and included a minimum leverage ratio of 4 percent for all U.S. banking organizations. And for the largest, most internationally active banking organizations, the final rule included a new minimum supplementary leverage ratio that took into account off-balance sheet exposures.

On the quality-of-capital side, the final rule emphasized common equity tier 1 capital, the most loss-absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments. The final rule also improved the methodology for calculating risk-weighted assets to enhance risk sensitivity.


Opening up a competitive edge for smaller banks

In a September 2014 American Banker article, “How Basel III Will Shake Up Banks’ Deposit Strategies” by Randy Rosen, director of commercial earnings allowance and deposit research, and Zoya Lieberman, director of commercial research at Informa Research Services, financial institutions are getting a better handle on Basel III as they work their way though compliance efforts. Those that want to get ahead of the game are reinventing products and methods to bypass the regulation to maintain profitability while continuing to meet liquidity coverage ratio (LCR) requirements, they said.

Considering the limitations now faced by large commercial institutions, Rosen and Lieberman stated their belief that Basel III has opened up the opportunity for a competitive edge for all banks with assets of less than $50 billion.

Banks not subject to LCR requirements could now begin devising campaigns to pursue clients that larger institutions find it no longer advantageous to maintain, such as correspondent banking clients, Rosen and Lieberman continued. Smaller institutions may also be capable of offering product types less-profitable for larger institutions under Basel III. They may be able to offer higher interest rates and lower fees to certain types of clients because they are not discouraged from doing so by LCR requirements.

“In the coming months,” Rosen and Lieberman concluded, “it may well pay to be small.”


Double-edged sword

However, the U.S. final rule for Basel III may also be a double-edged sword for some smaller banks. Larger regional and community banks may have the infrastructure in place to support the larger clients that the big banks choose to no longer service under Basel III. But smaller banks may lack that infrastructure to do likewise.

Smaller banks could experience a negative impact if they must fund upgrades on their internal systems to accommodate the needs of larger clients, Lieberman said.

For smaller banks without many commercial clients, though, Lieberman sees a silver lining. “Chances are, they have not invested many funds in infrastructure in the first place, so they don’t have the maintenance,” she said. If they were to determine to seek larger clients with more sophisticated needs, they won’t have to upgrade existing systems, but instead, can purchase top-line software to compete directly with large institutions.

Under Basel III, smaller banks will also gain an advantage with product opportunities, Rosen said, because Basel III requires much tighter controls on larger banks than on smaller banks on when deposited funds get withdrawn. As a result, he said, larger banks may be reluctant to offer no-penalty CDs, which allow depositors to withdraw those funds at any time, to their customers, who may then decide to do business with smaller banks that have looser controls imposed on them.

A “great opportunity” for community banks and larger credit unions, according Lieberman, is one that does not directly flow from Basel III. It involves attracting clients that are small businesses but also have more complex and more sophisticated needs than the mom-and-pop type of enterprise.

“I know they are looking for these types of clients and would like to gain a revenue share from these types of clients,” Lieberman said. “In terms of what they should do, I think the prudent thing would be to decide what types of clients they would want to attract, look at the infrastructure expenses that are required for that, and also make sure that their front-line teams are trained properly in explaining and selling the product that would appeal to that audience.”

What Lieberman and Rosen see “way too often,” she said, “is smaller institutions coming out with “wonderful products, but nobody knows how to sell them. And therefore, they’re not attracting the clients that they would like to have.”

If anything, Lieberman observed, smaller banks need to focus more on the opportunities stemming from Basel III. “Even though [Basel III] doesn’t have a direct regulatory impact on these institutions, it can have a significant impact on their market share and potential revenue increase. These institutions are not paying nearly as much attention to this regulation as they should. [They should do so] because it is to their advantage.”


Eyes wide open

All of this begs the question: Are banking regulators now regulating with eyes wide open instead of wide shut, as was too often the case leading up to the crash of 2008 and the need for Basel III? Lieberman and Rosen think the regulators are now holding the banks responsible for their actions.

“After Sarbanes-Oxley and other [legal and regulatory reforms], I think there is no way around [banks now being responsible for their actions]. Unlike before, when you could say, ‘I didn’t know,’” Lieberman said. “Now, it’s implied that you do know.”

Regarding the regulators, Lieberman said, “I think we’re getting to the point where we’re starting to get slightly over-regulated. But in terms of eyes wide open, I think right now it’s much more of an aggressive approach than it was before.”

Rosen agreed with Lieberman. When sectors such as banking and automotive bottom out, as they did over the past several years, he pointed out, “you’re going to come up with people who kind of go over and beyond, to protect us, so it doesn’t happen again. One could maybe say that they’re being over-regulating, like Zoya said. … But again, they’re trying to make sure [the consumers] don’t lose their money like they did years ago, when they did have banks that failed and customers lost lots of money from that situation.”


Room for interpretation

That said, are enough of the right sorts of regulations on the books? And are the regulators enforcing them in the right ways? Or are there some gaps that still need to be filled?

“I’m sure there are [gaps], even based on the regulations that came out in the last five years,” Lieberman said. “A lot of them are very complex, and I don’t think that they’re being necessarily used or implemented in the way that they were intended. I think there is a lot of room for interpretation. I think your question is very general, but I’m sure there is room for improvement. But at the same time, I’m not confident that the regulations that we have in place are right on point with what needs to happen.”

Still, both the regulations and the enforcement of them are significantly better, Lieberman agrees, in terms of improving greatly the chances of mitigating another crash such as the one in ’08. “I think that’s a fair statement,” she said. “I think things are more stable in terms of regulation, to avoid the [bank] failures that we had in the last six to 10 years.”


Steven Jones-D’Agostino is a strategic partner of Susan Wagner PR + Best Rate of Climb. Follow on Twitter @SWPR+BROC.


This article first appeared in the December issue of Banking New England.