Banks with government assistance such as the Troubled Asset Relief Program face the greatest risk under Basel III proposals, bank advisors say.
Three panelists from Mercer Capital and Jones Day said during a webinar Thursday that the banks at greatest risk to Basel III are those holding funds from the Tarp or the Small Business Lending Fund. The panelists said they are concerned how regulators would treat SBLF and Tarp funds as capital under Basel III.
Banks with Tarp obligations are the ones that have likely endured "reduced retained earnings and common equity," Andrew Gibbs, the head of Mercer's depository institutions practice, said during the seminar. He said those banks are the most likely face pressure to sell or raise capital.
Panelists advised banks to file shelf registrations for stock offerings or update old registrations based on Basel III proposed requirements so they are prepared to raise capital at any given time.
"The markets tend to open and close unpredictably for increasingly short periods of time," Chip MacDonald, a lawyer at Jones Day in Atlanta, said. "Existing shelves are probably in need of updates because they get stale after three years and a lot of [banks] haven't touched them" since the downturn.
Panelists covered many key proposals including the higher capital risk-weighting on certain real estate loans, treatment of deferred-tax assets and mortgage-servicing rights.
MacDonald said he expects mortgage-servicing rights to be "more expensive to carry and less profitable" and that valuations on deferred-tax assets are likely to fall. MacDonald also said that he expects regulators to have a "strict and faster application" process for prompt corrective actions in light of Basel III's higher risk-weighting requirements.
Fear of regulatory reprimand coupled with a lower earnings outlook, will encourage banks to reconsider compensation policies and be more meticulous in paying dividends, panelists said. Under the Basel III proposals, banks would be restricted from benefits such as dividend payouts once they fall under the 2.5% "buffer" capital requirement — even before the bank hits the well-capitalized minimum, or worse, a prompt corrective action.
"Some [banks] have lowered quarterly dividends and then offered a year-end special dividend based on profitability," Gibbs said. "That might be more consistent with capital planning under Basel III."
Panelists also advised bankers to find new business lines or redirect capital to existing business lines not directly impacted by Basel III's higher risk-weighting, such as certain commercial real estate loans.
"There are ways to establish what return on equity is allocated to different divisions or product lines to make sure you get the appropriate risk-adjusted return," Gibbs said. One way "would be to jettison into business or look at restructuring a business that generates an equivalent return on capital to other areas of the bank that are more profitable."
Investors and banks should also expect "normalized earnings" but at a lower rate than before the financial crisis, said Jeff Davis, who recently joined Mercer as managing director of its Financial Institutions Group.
"The ultimate arbiter will be how's the economy doing; The better the economy, the faster the growth and the better returns and valuations we'll see in the sector," Davis said. "But the overlay of Basel III in addition to regulatory and legislative moves . . . will serve to depress profitability."
