On March 7, the Federal Reserve Board (FRB) released summary results of stress tests conducted for the 18 largest banks. This is the third round of stress tests conducted by the FRB, but the first conducted under new Dodd-Frank Act stress test requirements. According to the FRB, under the severe, nine-quarter hypothetical scenario, projected losses at the 18 bank holding companies would total $462 billion, and the aggregate tier 1 common capital ratio would fall from an actual 11.1 percent in the third quarter of 2012 to 7.7 percent in the fourth quarter of 2014. The FRB assures that despite the large hypothetical declines, the aggregate post-stress capital ratio exceeds the actual aggregate tier 1 common ratio of approximately 5.6 percent prior to the government stress tests conducted in the midst of the financial crisis.

On February 28, the European Parliament announced that negotiators from the Parliament and the European Council agreed to alter bank capital rules and limit executive pay. The capital requirements, developed to implement aspects of Basel III, would raise to eight percent the minimum thresholds of high quality capital that banks must retain. The announcement does not specify what types of capital would satisfy the requirement, but does indicate that good quality capital would be mostly Tier 1 capital. With regard to executive pay, the base salary-to-bonus ratio would be 1:1, but the ratio could increase to a maximum of 1:2 with the approval of at least 65 percent of shareholders owning half the shares represented, or of 75 percent of votes if there is no quorum. Further, if a bonus is increased above 1:1, then a quarter of the whole bonus would be deferred for at least five years. Finally, the legislation would require banks to disclose to the European Commission certain information that subsequently would be made public, including profits, taxes paid, and subsidies received country by country. The European Parliament is expected to vote on the legislation in mid-April, and each member state also must approve the legislation. Once approved, member states must implement the rules through their national laws by January 2014.

On February 19, House Financial Services Committee members Shelley Moore Capito (R-WV) and Carolyn Maloney (D-NY) sent a letter to the Federal Reserve Board, the OCC, and the FDIC regarding the lawmakers’ concerns about the implementation of Basel III. Citing potential compliance costs and the potential derivative impact on consumers, Representatives Capito and Maloney ask that the agencies carefully tailor the Basel III capital requirements to ensure they are appropriate for community banks. The House and Senate have in recent months placed significant focus on the Basel III rulemakings, with both houses recently holding hearings on the issue and lawmakers previously sending letters to the regulators.

On November 29, two Subcommittees of the House Financial Services Committee held a joint hearing regarding the federal banking agency proposals to implement the Basel III international regulatory capital accords. As with a Senate hearing on the same topic last week, committee members focused bipartisan attention on the proposals’ potential impact on community banks and insurance companies that are holders of depository institutions. The committee also explored the interplay between the Basel III proposals and the pending rules to set forth the “qualified mortgage” standard and the “qualified residential mortgage” standard. The regulators promised lawmakers that they would carefully consider the concerns of community bankers. The regulators did not provide a timeline for their final rulemaking.

On November 15, the Federal Reserve Board, the OCC, and the FDIC released the macroeconomic and financial market scenarios to be used in annual stress tests conducted by covered institutions pursuant to rules the regulators finalized last month. The economic scenarios are the same for each regulator and their covered institutions and include baseline, adverse, and severely adverse scenarios with variables that reflect, among other things, economic activity, unemployment, exchange rates, prices, incomes, and interest rates. The baseline scenario represents expectations of private-sector forecasters, while the adverse and severely adverse scenarios present hypothetical conditions designed to assess the strength and resilience of financial institutions, as well as their ability to continue to meet the credit needs of households and businesses in stressful economic and financial environments. The Federal Reserve Board also published a proposed policy statement and the OCC issued interim guidance to describe how those agencies will develop and distribute stress test scenarios in future years. Comments are due on the Federal Reserve Board policy statement by February 15, 2013, and on the OCC interim guidance within 60 days after publication in the Federal Register. Finally, last week, the Federal Reserve Board issued instructions and guidelines for covered institutions, including timelines for submissions. In a shift from prior years, the Federal Reserve Board will provide covered firms an opportunity to adjust planned capital distributions based on the stress test results before the Federal Reserve Board makes a final decision on their capital adequacy.

On November 14, the Senate Banking Committee held a hearing regarding rules proposed by federal banking regulators to implement the Basel III international regulatory capital accords. The hearing featured testimony from representatives of the Federal Reserve Board, the FDIC, and the OCC, the federal regulators responsible for the proposed rules. Committee Chairman Tim Johnson (D-SD) and Ranking Member Richard Shelby (R-AL) asked regulators to explain the Basel III process generally, and the potential impact of implementation on community banks specifically. The committee also explored (i) the impact of proposed risk weights, particularly with regard to small banks’ willingness to offer mortgages, (ii) the treatment of accumulated other comprehensive income, (iii) the treatment of insurance businesses, (iv) sovereign debt ratings, and (v) the rulemaking process. The witnesses did not provide a timeline for the final rule or discuss any specific changes to the proposed rules to accommodate small banks’ concerns, but did promise a long implementation timeframe. The witnesses generally acknowledged those concerns and assured that they are considering them as regulators prepare the final rules.

On November 9, in a speech to the Community Bankers Symposium, Federal Reserve Board Governor Elizabeth Duke reviewed in detail the role community banks play in the mortgage market and the post-Dodd-Frank Act mortgage lending challenges facing community banks. Ms. Duke explained that new rules to implement the Basel III capital accords, as well as those to put in place by Dodd-Frank Act requirements regarding escrow accounts for higher-priced mortgages, loan officer compensation, and appraisal requirements will burden community banks significantly. Ms. Duke highlighted the pending qualified mortgage and qualified residential mortgage rules, noting that they could have a “profound effect on the mortgage terms offered and the underwriting conditions.” not only for community banks, but for all banks. Specifically, she said that these rules could “constrain community bankers from using their experience with the cash flows from a small business customer or their knowledge of local real estate markets to customize a loan for an ‘irregular’ situation, such loans may not be made.”. Given the “cost of regulation that is prescriptive with respect to underwriting, loan structure, and operating procedures” and the “lack of evidence that balance sheet lending by community banks created significant problems,” relating to the financial crisis, Ms. Duke concluded that policymakers should establish a separate, simpler regulatory structure applicable to community bank mortgage lending.

On November 9, the Federal Reserve Board, the OCC, and the FDIC announced that proposed rules to implement the Basel III regulatory capital accords will not take effect on January 1, 2013. The agencies cite the large volume of comments received in response to the proposed rules as the reason for the delay. Recently, members of three states’ congressional delegations joined others in submitting letters to the federal banking regulators in response to the proposed Basel III regulations. The letters all raise concerns about the potential disproportionate impact of the proposed rules on smaller, community and regional institutions, and challenge the attempt by regulators to apply international accords to all U.S. institutions regardless of size. Members of the Texas delegation focused on provisions that would require all unrealized gains and losses on available-for-sale securities to flow through to common Tier-1 equity, which the lawmakers believe will require community banks to divert capital resources from customer services and bank growth. Indiana Members added concerns about the effect of proposed excessive risk weighting and restrictions on dividends and discretionary bonuses, while Members from South Carolina echoed general concerns about the impact of the proposals on community banks. These legislators join other federal and state policymakers who have submitted similar comments in recent weeks. Scrutiny of the proposals will continue next week with a Senate Banking Committee hearing planned for November 14, 2012 to review the pending rules with representatives from the Federal Reserve Board, the OCC, and the FDIC.

On October 18, the OCC issued Bulletin OCC 2012-33, which provides guidance to community banks with assets of $10 billion or less on how to implement stress testing to assess risk in their loan portfolios. Stress tests are exercises designed to gauge the potentially adverse impact that a hypothetical scenario might have on earnings, loan loss reserves, and capital levels. The OCC reiterated that stress testing procedures for smaller community banks do not need to be as sophisticated as those used by larger national banks, but noted that all banks are expected to assess their capital adequacy in relation to overall risks and to have a plan for maintaining appropriate capital levels. The bulletin also included explanations of specific types of stress testing, a sample method for performing stress tests on a basic portfolio, and a table of common real estate characteristics that should be considered when evaluating the impact of a stress event on specific property types. Additionally, the OCC announced the availability of a new tool for performing stress tests on income-producing commercial real estate loan portfolios. The OCC plans to host a teleconference for bankers on December 3, 2012 to discuss this new guidance.

Last week, federal and state policymakers sent letters to federal regulators urging a change in course with regard to proposed regulations to implement the Basel III capital accords. On October 17, U.S. Senators Sherrod Brown (D-OH) and David Vitter (R-LA) expressed concern that the proposed approach would not be sufficient to prevent another financial crisis and urged the federal prudential regulators to simplify and enhance capital rules that will apply to U.S. banks. Specifically, the Senators asserted that Basel III’s continued focus on risk-based capital ratios is too complex and opaque; instead the proposal should focus on “pure, loss-absorbing capital.” On the same day, the Conference of State Bank Supervisors (CSBS) encouraged the federal agencies to consider the impact of their proposal on the national and local economies. The CSBS argued that Basel III is intended only to apply to large, internationally active banks, and suggested that capital requirements for other U.S. banks should be set through a separate rulemaking. In a second letter, the CSBS commented on a related rulemaking regarding a standardized approach to risk-weighted assets. In that letter, the state supervisors expounded on their recent objection to the proposal as “reactionary” and “overly complex.” Earlier in the week, on October 15, Senate Banking Committee Ranking Member Richard Shelby (R-AL) objected to the rulemaking process and challenged the regulators to better explain (i) why the Basel III standards are appropriate for U.S. banks and how the regulators came to their determinations, and (ii) the impact on the U.S. baking system and the economy, including a detailed cost-benefit analysis. Also this week, other federal lawmakers, including Republican members of the House Committee on Financial Services, and the congressional delegations from Arkansas, Colorado, and Mississippi, submitted letters commenting on the proposals.

On October 3, the Conference of State Bank Supervisors (CSBS) announced its opposition to the “highly reactionary” approach federal regulators have proposed to implement the Basel III capital accord. Although they support higher levels and improved quality of capital, the state regulators argue that the transaction-level approach proposed by federal regulators is too complex and leaves the financial system susceptible to more volatility. Instead, the state regulators favor an approach based on risk management and the supervisory process. Further, the state regulators charge that the federal proposal, including the proposed specific risk-weighted asset requirements, lack empirical support. The CSBS argues that the proposed standardized risk-weighted assets present a specific challenge to mortgage lending, and in other areas would replace supervisory judgment and institution-specific analysis. The state regulators believe that implementing Basel III as currently proposed will only increase industry costs, limit credit availability, and force industry consolidation.