The potential impacts of the Dodd-Frank Wall Street Reform and Consumer Protection Act and of the guidelines described in Basel III have been felt from large banks to community banks around the country. Both of these regulatory frameworks recognized the need for banks to increase capital levels in order to account for the inherent risk within their portfolios.
While implementation delays have occurred with both Dodd-Frank and Basel III, it is extremely likely that banks will in the future be required to report appropriately how their institutions’ risk correlates with their given capital. While most of the regulatory concern from bankers has focused on the required common equity Tier 1 capital ratio, which under both rule sets is expected to rise significantly, it is critical that banks begin to plan now for changes to capital requirements. A good place to begin is with the methodology for risk-weighting.
Regulators realized, with both Basel III and Dodd-Frank, that capital frameworks must include an understanding of the risks associated within each financial institution. But, in order for capital requirements to reflect risk appropriately, the institutions must have a sound way of measuring that risk, namely risk-weighting.
The current methodology to determine risk-weighted assets is somewhat simple. Presently, banks place their assets into four risk-weighting categories: 0%, 20%, 50% and 100%. A commercial loan, for example, is weighted at 100%. This weighting does not account for collateral, cash flow or character of the borrower. Moreover, it does not account for the complexities that have surfaced over the past several years with cross-collateralization and multiple guarantors. Consequently, setting a regulatory capital requirement based on the existing risk-weighting calculation does not truly measure the different risk within each financial institution.
The FDIC, Federal Reserve and OCC are making efforts to create a new, standardized risk-weight approach to assets that is much more indicative of the potential risk that may exist within a financial institution This approach applies more stringent weighting based on certain concentrations and requires that each bank implement new processes to determine the risk. If banks were utilizing this method today or had to implement it immediately, it could be detrimental to their current capital situation.
For the 1-4 Family Loans category, for example, the proposed risk weight is dependent upon the loan to value (LTV) as well as the risk category of the loan. According to the FDIC, “The proposed definition of category 1 residential mortgage exposures would generally include traditional, first-lien, prudently underwritten mortgage loans. The proposed definition of category 2 residential mortgage exposures would generally include junior liens and non-traditional mortgage products.” Therefore, category 1 benefits from a lower risk weight than category 2.
The proposed changes would also assign a new risk weight to exposures that are 90 days or more past due. Generally, with current risk weighting rules, past-due exposures did not change risk weights when the loan becomes past due. This does not hold for 1-4 Family Loans under the current system, which did increase to 100% risk when the loan reached 90 days past due.
The agencies are moving towards a new standardized risk-weighting approach that measures capital by risk. This method allows banks to implement strategic plans – what concentrations in which to focus lending, for example – that take into account their business objective and appetite for risk. However, in determining these new risk-weightings, they are forced to also account for potential risks that were not previously accounted for.
A large percentage of community banks that failed had high concentrations in commercial real estate (CRE) loans. Many of these banks are still struggling with troubled debt restructurings and interest rate sensitivity as part of their workout efforts. If banks were to go ahead and begin implementing the new standardized approach, the negative impact would be tremendous; many community banks have CRE loan concentrations of over 300%. The proposed risk-weighting reform would alter these community banks’ common equity Tier 1 capital ratio by a significant amount.
While there may be some revisions to Basel III and Dodd-Frank, it is evident that the regulatory agencies will take measures in the near future to understand more completely the risk associated within a financial institution’s assets, particularly the loan portfolio. To help prepare, financial institutions should be asking themselves the following questions:
- How sensitive is our loan portfolio to the proposed changes in the standardized risk-weighting approach?
- How do the potential changes affect our current capital position?
- Does our strategic plan address capital needs concurrent with our appetite for risk?
- Have we stressed our capital situation in light of potential changes?
As financial institutions move toward a more centralized process and approach to handling different types of risk, they need to understand thoroughly their appetite for risk and, concurrently, be certain that board members understand the risk. Capital and risk will go hand in hand and senior management, boards and regulators all will be held accountable to ensure that appropriate capital levels are in place based on the bank’s risk and that the different constituencies work together to develop a strategic plan for each institution that incorporates a change in the approach to risk-weighting.
Mr. Dittrich is a director for the Financial Institutions Group at Raleigh, N.C.-based Sageworks Inc., a financial information company that provides risk management solutions to financial institutions. He can be reached at firstname.lastname@example.org.