Basel Rules Would Hit Regional Banks Hardest

Several large and regional banks have disclosed in recent days what their capital ratios would look like if Basel III were in effect now and early results show that First Horizon National (FHN), Huntington Bancshares (HBAN), SunTrust Banks (STI) and TCF Financial (TCB) would take the biggest capital hits if they do not take steps to change their asset mix.

Among larger banks, the four carry the highest concentrations of home equity loans and risky residential mortgages, which means they would have to set aside more capital than competitors that are less exposed to home loans. Perhaps not surprisingly, the four banks' share prices all tumbled last week following earnings announcements in which they disclosed their estimated ratios.

The disclosures provided the first glimpse of the potential impact of Basel III requirements since the Federal Reserve released proposed Basel guidelines last month. According to a research note from Keefe, Bruyette & Woods, SunTrust, First Horizon, Huntington and TCF would see the biggest dips in Tier 1 common equity, while Bank of America (BAC), Citigroup (NYSE: C) and Bank of New York Mellon (BK), all would see their pro forma capital ratios increase.

"Banks with higher concentrations in home equity loans, nonconforming first mortgages, and elevated non-performing assets may be most at risk for reduction in capital ratios," says Frederick Cannon, director of research and chief equity strategist Keefe, Bruyette & Woods.

To be sure, not all large banks provided Basel III guidance in their second-quarter earnings. Banks were under no obligation to offer up estimates and PNC Financial Services Group (PNC), M&T Bancorp (MTB) and Fifth Third Bancorp (FITB) were among the banks that skipped the exercise entirely.

Some observers also speculated that banks' motivation for disclosing the potential impact was not to provide guidance to investors but to influence regulators to make changes to the risk-weightings before the rules kick in. The proposed Basel III rule-making takes effect Jan. 1, 2013, but most changes have phase-in schedules that don't require full compliance until 2015 to 2019. The comment period on the proposal ends in September.

Keith Fisher, an attorney at Ballard Spahr, says it makes sense for banks to publicize the results early to alert regulators that the proposed guidelines might need some fine-tuning.

"The fact that the capital ratios don't look great now at least suggests this merits a closer examination," Fisher says. "If banks were to do this now, it would look ugly."

Banks were caught off guard by changes made in June when the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency released proposals that dictate how much risk-based capital banks must hold against certain assets, including residential mortgages.

Under the proposed Basel III capital framework, residential mortgages guaranteed by the government or its agencies would maintain a zero risk-weight for those unconditionally guaranteed and 20% risk-weight for those conditionally guaranteed. All other mortgages would be divided into two categories depending on loan-to-value ratios. A category 1 mortgage has a risk weighting of 35% to 100%, while category 2 loans including home equity lines of credit, first liens with balloon features, delinquent loans and more exotic adjustable-rate mortgages, would receive risk-weightings of 100% to 200%.

The guidelines would not just apply to the biggest banks.

"Any large bank with lots of second liens, balloon mortgages and interest-only loans is going to take a hit," says James Kendrick, a vice president of accounting and capital policy at the Independent Community Bankers of America.

While the Basel III rules will force banks to increase the amount of money they hold against liabilities and prevent them from being over-leveraged, they also could cut into profit margins, forcing changes in loan products and pricing.

"If those risk-weightings stay the way they are, it makes it very difficult for banks to figure out a way to make profitable residential lending going forward, and that can't be good for winding down the government-sponsored enterprises," says William "BJ" Losch 3rd, First Horizon's chief financial officer. "We'll have to structure products differently and price them differently."

Still, Losch says he was surprised by the market reaction — First Horizon's shares fell more than 5% after it reported earnings Friday — given that the proposed Basel III rules don't kick in until 2015 at the earliest. First Horizon's Tier 1 common equity ratio of 10.6% would decline to an estimated 8.2% today, but that the number is purely "theoretical," Losch says.

"What we were trying to do was say if everything passed as proposed, here's what our impact would look like in July 2012, which is a very theoretical number because it's not reality or law for years," he says. "We're very much of the mind of being as transparent as we can. Someone is going to calculate it one way or another so we might as well calculate it ourselves."

First Horizon sold its mortgage origination platform in 2008 and expects a large number of home equity loans that have a higher risk-weighting to runoff by the time the rules go into effect, he says.

Daryl Bible, the chief financial officer at BB&T (BBT), agrees that the higher capital requirements for mortgages will have an impact on the company and the overall economy.

"Unless the classifications between a Category 1 and Category 2 (change), a lot of mortgages are going to the higher category," Bible said on a conference call last week. "They're going to double in capital and maybe quadruple depending on how (a loan) is underwritten and how it's calculated."

Don Kimble, Huntington's chief financial officer, said on a conference call with analysts that he was surprised by the proposed rules for U.S. adoption of the Basel III regulatory capital framework. Huntington estimated a 150 basis point reduction to Tier 1 common risk-based capital.

"We'll have to take a look at our focus on certain products and our pricing associated with those products, if there truly is a change in the capital charge associated with those," Kimble said.

The Basel III plan dictates the quality and quantity of capital institutions must hold, essentially raising banks' minimum capital requirements to as high as 7%. The plan requires a common equity Tier 1 capital ratio of 4.5%, and further revises risk weightings and subject institutions with substantial off-balance sheet activities to an extra 3% leverage ratio.

Kendrick at ICBA says the proposed changes come at a particularly tough time.

"We have a struggling housing market that is trying to recover and we're placing burdens on lending," he says. "Really all banks can do is hold more capital against those mortgages or stop doing those altogether and only originate 30-year fixed rate loans because without that, under the new calculations, they could become undercapitalized. It will be a hit to capital regardless."