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Recent Rules Add to Challenges in Managing Capital

Thursday, April 01, 2010 - Frank Gonzalez,CPA / CFF

Frank Gonzalez

The long-standing principle that "capital is king" has gained added significance and will undoubtedly remain a major challenge for the banking industry until the United States emerges from its real estate and financial crises.

Almost all banks are facing difficult operational and strategic decisions this year on managing and preserving capital. Some are under bank regulators' pressure to keep their capital-to-asset ratios higher than the standard minimum for "Well Capitalized" in order to keep that classification.

Unfortunately, banks in both circumstances are facing a continuation of recent years' tight markets for raising capital – unless they have parent companies that can make additional equity investments. Thus, it is vital for banks' management to understand the Financial Accounting Standards Board's accounting standards and bank regulators' rules and guidances related to capital. That includes: certain loans and other assets that this year must be reported on balance sheets, rather than included in off-balance sheet entities; impaired loans and investments; management of loan loss reserves; and limits on use of tax deferred assets as capital.

This article will review the accounting and banking regulatory requirements on capital, and provide details on revisions that have been made since 2009.

A Federal Deposit Insurance Corporation summary of "Capital Groups and Supervisory Groups" lists the requirements for being Adequately Capitalized and Well Capitalized. One of the most important requirements is a Total Capital to Risk-Based Assets ratio of at least 10.0 percent to be Well Capitalized.

Actions by regulators during the past year indicate the importance for pro-active development of strategic plans for exceeding that ratio. This is especially important for banks whose problems with earnings and non-current loans have led to declines in capital ratios over several quarters.

There are reports that federal and state regulators, in private summaries at the end of their regular examinations, are requiring some banks to maintain risk-based capital ratios above 10.0 percent to be Well Capitalized. Publicly, many of the Cease & Desist orders that the FDIC and other regulators issued during the first quarter of 2010 are requiring subject banks to maintain a ratio of 12.0 percent or higher to keep their status as "well-capitalized." Some of those orders also require subject banks to have Tier 1 Capital to Risk-Based Capital ratios and Tier 1 Leverage Ratios higher than those stated in FDIC rules to remain Well Capitalized.

Banks that are given those capital requirements are usually already above the capital levels they are told to maintain. But their capital ratios have been declining, amid quarterly losses. Thus, the orders provide an urgency to reduce total assets and, if possible, to add capital. Some C&D orders also are placing restrictions on banks' lending and requiring them to add to their loan loss reserves.

These public enforcement actions are usually issued after a bank has not made satisfactory progress in carrying out a regulators' non-public order on capital and related issues.

The regulators' enhanced focus on capital ratios stems from their goal of preventing banks from falling to Under Capitalized, and possibly becoming a candidate for takeover by regulators. Even during a period such as 2009-2010, regulators and bankers regard capital as a cushion that can help absorb operating losses until a bank's operations and the business cycle improve.

Many banks in Florida and other states are experiencing quarterly declines in capital ratios as their balance sheets reflect the impact of weaker earnings and ongoing additions to loan loss reserves. This has increased the urgency for banks to demonstrate that they have capital preservation, loan loss and portfolio management strategies that will not result in regulators imposing private or publicly announced restrictions. For many banks, that includes a strategy of limited growth in loans and other assets in order to maintain their capital ratios. Even for publicly traded banks, the market for raising capital through issuance of stock, warrants and other offerings has become extremely limited.

The FDIC's database on the 286 Florida-based banks for the quarter ended December 31, 2009 indicates how banks have become reliant on holding companies and other parent companies in adding capital. Florida, like the nation's banking industry, showed an improvement in composite capital ratios in 2009 – partly because of a decline in total assets. The risk-based capital ratio for Florida-based banks improved from 11.85 percent at the end of 2008 to 13.40 percent at the end of 2009. Capital investments by parents more than made up for 2009's composite net loss.

Banks based in Florida increased their total equity capital from $14.7 billion at the end of 2008 to $14.9 billion at the end of 2009. But that increase is largely due to a raising of $2.3 billion in equity capital in 2009 from "other transactions with parent holding company." In 2008, Florida-based banks added $1.2 billion in equity from parents.

Accounting and Bank Regulatory Rules

Whether or not a bank has access to new capital from its parent, it is vital to understand the FASB's capital-related accounting statements and bank regulators' rules.

In their annual reviews and audits, internal auditors and external auditors are making sure that banks' valuations and allocation of reserves are consistent with those requirements.

One important change in 2010 is that the Financial Accounting Statements known as FAS 166 and FAS 167 are requiring some banks to make balance sheet changes that could result in the need to add regulatory capital to retain risk-based capital ratios that are Well Capitalized.

On June 12, 2009, the FASB issued:

The combined impact was the elimination under Generally Accepted Accounting Principles of Qualified Special Purpose Entities, which many banks had used to form securitizations. The accounting rule changes are requiring some banks to consolidate previously off-balance sheet securitizations and structured finance transactions (i.e. loans). That will increase some banks' assets and liabilities, which in turn may require higher regulatory capital.

FAS 166 and167 were effective for reporting periods that begin after November 15, 2009.

On December 15, 2009 the FDIC and other federal banking regulators approved a final interagency rule that allows banks the option to phase-in during 2010 the risk-based capital requirements under the two Financial Accounting Standards Board statements regarding the consolidation of various assets to their balance sheets.

The FDIC rule allows banks to delay the impact of FAS 166 and 167 on risk-weighted assets through the end of 2010's second quarter and exclude 50 percent of newly designated risk-weighted assets during the third and fourth quarters of 2010. The rule only applies to risk-based capital requirements and not to the leverage ratio.

For purposes including calculations of capital, banks must follow accounting rules for determining loan loss reserves. Details on those rules can be found in an article in the May 2009 issue of The Balance Sheet.

Banks must also understand the FDIC's limits on the amount of loan loss reserves that can be accounted for as deferred tax assets. A rule the FDIC issued in 1995 puts restrictions on that use of deferred tax assets. The limit is the lesser of the amount that the bank is expected to realize within one year of the most recent calendar quarter-end date, based on the institution's projection of taxable income for that year, or ten percent of Tier 1 Capital. Deferred tax assets in excess of this limit will be deducted from a bank's Tier 1 Capital and from its assets when calculating the risk-based and leverage capital ratios. However, deferred tax assets that can be realized through carrybacks to taxes paid on income earned in the past generally will not be subject to limits on regulatory capital.

An understanding of accounting and regulatory rules on capital is essential for banks in managing capital, assuring that they will not be told by auditors to make adjustments in calculations in capital or ordered by auditors to maintain high capital ratios.

The purpose of this newsletter is to provide general information on tax, audit and other issues related to the financial services industry. The information contained herein may not apply to all institutions or organizations and their specific circumstances. Financial services organizations are encouraged to consult directly with an accounting expert before making tax and accounting decisions.