Basel III Update, Accounting Update, and Best Practices Kathleen Fields, CPA

1. Basel III Update, Accounting Update, and Best Practices Kathleen Fields, CPA

2. Agenda • Basel III Update • Impact • What’s next? • Accounting Update – Current Issues • Comprehensive income reporting • Goodwill impairment testing • Accounting Update – Upcoming or Proposed Issues • Liquidity and interest rate risk disclosures • Lease accounting • Financial instruments • Allowance for loan losses • Best Practices

3. What were they thinking??????

4. Key Provisions • Applies to all banks • Changes the definition of regulatory capital and capital calculations • Adds a new Common Equity Tier 1 Risk-Based Capital Ratio • Implements new capital conservation buffers • New Prompt Corrective Action capital categories • Establishes Basel III leverage ratio • Revises risk weighting and classifications

5. Potential Impact • Increased required capital • Limits on dividends • Limits on discretionary bonuses • Additional consolidation in the industry • Volatility of capital ratios due to changes in market values of securities • Increase in time required to manage capital

6. Primary Elements of NPRs • Capital definitions and minimum capital • Capital conservation and countercyclical capital buffers • Adjustments to Prompt Corrective Action thresholds • Introduction of Basel III leverage ratio • Changes in risk-weighted assets

7. Common Equity Tier 1 Capital (CET1) *Originally, the AOCI exclusion from capital is proposed to be phased out starting at 100% exclusion in 2013 and reducing exclusion by 20% each year until 2018. By 2018, the AOCI would be fully included in equity.

8. Threshold Deductions • There are also threshold deductions to CET1 to each of the following that, individually, are above 10% of the Bank’s CET1 capital elements: • Mortgage servicing assets net of associated deferred tax liabilities • Deferred tax assets related to temporary timing differences • Significant investments in another financial institution’s common stock • In addition, the threshold items above cannot exceed 15% of the CET1 in the aggregate.

9. Additional Tier 1 Capital • Tier 1 capital is the sum of: • CET1; and • Additional Tier 1 capital additions and deductions.

10. Tier 2 Capital • The proposed rule would define Tier 2 capital as the sum of Tier 2 elements and related surplus, less regulatory adjustments, and deductions. • Tier 2 capital elements would include: • Allowance for loan and lease losses • Subordinated debt and preferred stock • Total capital minority interest • Instruments that would qualify as Tier 2 capital under the agencies’ general risk-based capital rules Total capital would consist of three capital components 1. CET1 2. Additional tier 1 3. Tier 2 capital

11. Tier 2 Capital (continued) • Would eliminate the existing limits on the following: • Subordinated debt • Limited-life preferred stock • Amount of Tier 2 included in Total Capital

12. Minimum Capital Requirements

13. Adjustments to Prompt Corrective Action (PCA) Thresholds

14. Buffers • The NPR introduces two new terms and concepts impacting the way capital in banks will be managed and are referred to as capital “buffers.” • Capital Conservation Buffer (CCB) – designed to conserve capital by limiting distributions/payments if a bank does not hold a certain amount of capital in addition to the minimum risk-based capital ratios • Countercyclical Capital Buffer applies only to advanced approaches banking organizations (generally those exceeding $50 billion in consolidated assets)

15. Capital Conservation Buffer • The CCB is composed of Common Equity Tier 1 capital but is separate from minimum capital guidelines and Prompt Corrective Action (PCA). As proposed, a banking organization’s capital conservation buffer would be the lower of the following measures: • The Bank’s Common Equity Tier 1 Capital ratio minus its minimum Common Equity Tier 1 ratio of 4.5%; or • The Bank’s Tier 1 Capital ratio minus its minimum Tier 1 Capital ratio of 6%; or • The Bank’s Total Capital ratio minus its minimum Total Capital ratio of 8%

16. Capital Conservation Buffer (continued) • A bank with a CCB greater than 2.5% of RWA is not subject to any limitations from the NPR, but the respective agencies would still be able to restrict dividends and discretionary bonuses for other reasons, commensurate with the bank’s risk profile. • A bank with a CCB less than 2.5% of RWA would have limited capital distributions and bonus payments until it is able to increase capital through earnings or raising additional capital. • The CCB requirement begins January 1, 2016, at 0.625% and increases each anniversary date by 0.625%, reaching a total amount in 2019 of 2.5%.

17. Basel III Leverage Ratio • Banking organizations in the United States have calculated and been required to maintain capital using a leverage ratio. • Basel III has introduced a leverage ratio defined as Tier 1 Capital to a combination of on- and off-balance sheet assets, referred to as a Total Leverage Exposure Ratio (only applies to advanced approaches banking organizations – exceeding $50 billion in consolidated assets – and is expected to be set at 3%). • All banks in the United States would continue to have a minimum leverage ratio (Tier 1 capital to average assets) of 4%.

18. Trust Preferred • Both Dodd-Frank and Basel III exclude cumulative preferred securities such as trust preferred from Tier 1 capital. • Basel III generally gives a much longer time period (10 years) to phase out these types of securities (3 years by Dodd-Frank). • Under Dodd-Frank, the smallest banks are not subject to the statutory requirements to phase out trust preferred securities from Tier 1 capital; however, Basel III does not currently provide a similar exemption. • Many of these instruments could qualify for inclusion as Tier 2 capital under the proposed eligibility criteria for Tier 2 capital instruments.

19. Seriously……? Risk-Weighted what???

20. Changes in Risk-Weighted Assets (RWA) • Revised risk-weighting methodology for some on-balance sheet assets: • 1-4 family residential real estate loans • “High Volatility” commercial real estate • Past due assets • Structured securities • Equity holdings • Revised risk-weighting methodology – off-balance sheet items • Allows for substitution of a wider range of financial collateral and eligible guarantors for calculating risk-weighted assets

21. Changes in Risk-Weighted Assets (continued) • The FDIC and OCC estimate in the NPR addressing RWA that RWA will increase between 10% - 20% based on assumptions from analyzing current call report data. • The proposed risk-weighting for 1-4 family loans will require detailed information to be gathered from the loan records in order to obtain the lowest possible weighting.

22. Risk Weighting for 1-4 Family Loans • Currently 1-4 family loans are weighted at 50% if they are first lien, prudently underwritten, owner occupied or rented, and less than 90 days past due – otherwise the risk-weighting is 100%. • The proposed risk-weighting for 1-4 family loans will require classification between Category 1 and Category 2.

23. Risk Weighting for 1-4 Family Loans (continued) • Category 1 loans include the following characteristics: • Term not to exceed 30 years • Repayment terms fully amortize the loan, with no balloon payment • Meets current underwriting standards • Is not more than 90 days past due or non-accrual • Is not a junior lien

24. Risk Weighting for 1-4 Family Loans (continued) • 1-4 family loans that are not Category 1, will be classified as Category 2. • The risk-weighting is based on the lower of the acquisition cost or fair value at the time of the loan origination. • This will require banks to obtain and systematically store information about the original loan-to-value so that the calculation can be calculated each quarter.

25. How will I do this?

26. Risk Weighting for 1-4 Family Loans(continued)

27. Risk Weighting for 1-4 Family Loans (continued) • It is not uncommon for community banks to have 1-4 family loans that amortize over 30 years, but have a balloon payment at 5 years. These types of 1-4 family loans would automatically be classified as Category 2. • In addition, it may be time intensive to determine and track the loan-to-value, so a bank may decide to classify their 1-4 family loans with a risk weighting of 200%. • This would be an extreme assumption, but depending on the institution, it may have a minimal impact on the RWA and resulting capital ratios. The cost/benefit of weighting all 1-4 family loans at 200% would have to be carefully analyzed.

28. Other Key Risk Weighting Changes • High Volatility CRE loans would increase from 100% to 150%. • As proposed, loans and other exposures past due over 90 days or non-accrual would be risk-weighted at 150%. • Changes in risk-weightings for investment securities can be potentially challenging, though the risk-weightings for U.S. agencies and government sponsored agencies are expected to remain the same. • Other securities will require a complex analysis to determine the correct risk-weighting. • Three approaches for structured securities

29. Structured Securities • Examples would be: Private Label MBS, Trust Preferred Collateralized Debt Obligations, asset-backed securities. • Risk-weighted based on one of three approaches: • Weighted average of underlying collateral (Gross Up) • Formula based on subordination position and delinquencies • 1,250% • Other requirements/options: • Must apply selected approach consistently • 1,250% option may be used regardless of approach selected • Requirements for comprehensive understanding and due diligence

30. One Size Fits All Approach

31. Considerations • Most community banks currently maintain capital that exceeds the new minimum capital and related “buffers” required by the NPRs. • With proposed rules, the FRB estimates U.S. banks overall will require an additional $60 billion in capital. • FDIC and OCC also believe most capital currently included in Tier 1 and Tier 2, in most cases, will continue to be Tier 1 and Tier 2. • The NPRs will add an additional burden to banks.

32. Considerations (continued) • Risk-weighting complexities for 1-4 family loans will be a disincentive for community banks to continue this type of lending. • Inclusion of unrealized gains/losses on AFS securities as a component of Tier 1 Common Equity will introduce significant volatility into capital calculations.

33. The Future???? • Petitions, letters, etc. from a united banking industry helped! • Your trade associations are diligently working for you. • Working to see the following in the revised regulations: • Exemption for $50 billion and under in assets • Less complex and “punishing” categories for 1-4 family loans • Continue to exclude AOCI from regulatory capital ratios • Preserve the inclusion of Trust Preferred

34. Accounting Update

35. Accounting Update • Current issues • Comprehensive income reporting • Goodwill impairment testing • Upcoming and proposed issues • Liquidity and interest rate risk disclosures • Lease accounting • Financial instruments • Allowance for loan and lease losses

36. Comprehensive Income Reporting • FASB ASU 2011-05 issued in 2011; effective for year-end 2012 financial reports of non-public companies • Old U.S. GAAP permitted three methods, including reporting in the statement of changes in equity • New GAAP (consistent with IFRS) only permits two choices: • A single statement in the existing income statement • A two-statement approach – presents the components of net income in first statement, followed by a separate statement showing components of OCI and total comprehensive income • Does not affect how EPS calculated or what items reported in net income or in OCI

37. Goodwill Impairment Testing • FASB ASU 2011-08 issued September 15, 2011 and could be applied immediately • Prior GAAP required an annual impairment test, comparing the fair value (“FV”) of the reporting unit with its carrying amount (“CA”), including goodwill. If FV < CA, then an impairment loss is measured. • New GAAP allows an assessment of qualitative factors first to determine if it is necessary to perform the impairment testing. • If qualitative factors conclude it is more likely than not (>50%) that FV exceeds CA, then no impairment testing is necessary.

38. Proposed FASB: Liquidity and Interest Rate Risk Disclosures • Exposure draft issued June 27, 2012; comment period through September 25, 2012; no decisions made yet • Requires new liquidity risk disclosures in the footnotes • Carrying amounts of financial assets and liabilities in a table, segregated by expected maturities, including off-balance sheet financial commitments and obligations • A table of liquid funds, including any unencumbered cash, highly liquid assets, and any available borrowings (unpledged securities, lines of credit, etc.) • Cost of time deposit liabilities during the previous four fiscal quarters

39. Proposed FASB: Liquidity and Interest Rate Risk Disclosures (Continued) • Requires new interest rate risk disclosures in the footnotes • Re-pricing table of financial assets and liabilities • Interest shock/sensitivity table based on hypothetical shifts in interest rates (several scenarios would be required) • Narrative disclosure about interest rate risk exposure and strategies to manage the risk

40. Proposed FASB: Lease Accounting • Proposal draft originally issued in 2010; expect revised proposal Q2 of 2013 with a 120 day comment period • Would substantially do away with off-balance sheet operating leases and require all leases be accounted for as capital-type leases by both lessee and lessor • For lessee – use right of use model and recognize: • An asset representing the right to use an underlying asset • A liability for the obligation to make lease payments • Amortization expense on asset (shorter of lease term or useful life) • Interest expense on the liability to make lease payments

41. Proposed FASB: Financial Assets and Liabilities • Exposure draft originally issued in 2010, which proposed a much greater use of fair value • Revised proposal out February 14, 2013 with comments due by May 15, 2013 • Feedback was that fair value was not thought to be the most appropriate measurement for such instruments as loans, deposits, and financial liabilities the entity does not have the ability to trade. • Under new proposal, measurement of financial assets is based on the asset’s cash flow characteristics and the entity’s business model of managing the asset (rather than legal form).

42. Proposed FASB: Financial Assets and Liabilities (continued) • Financial assets would be classified into one of three categories: • Amortized cost – those with solely payments of principal and interest that are held for collection of contractual cash flows • Fair value through other comprehensive income – those with solely payments of principal and interest that are both held for the collection of contractual cash flows and for sale • Fair value through net income – those that do not qualify for measurement at either of the above • Equity investments would be measured at fair value with changes in fair value recognized in net income (do not have payments of principal and interest). • Financial liabilities would be measured at amortized cost, unless the entity’s business strategy is to transact at fair value.

43. Proposed FASB: Allowance for Loan Losses (ALLL) • FASB’s love affair with the allowance for loan and lease losses appears to be never ending…… • Several models have been considered • Common model developed by the FASB and IASB is the three-bucket impairment model – significant concerns that it would not be understandable, operable, or auditable • Current proposed FASB model is a “current expected credit loss” (CECL) model – comment period ends April 30, 2013 • Changes model from incurred loss to expected loss • Level of credit losses could significantly increase

44. Proposed FASB: Allowance for Loan Losses (continued) • CECL model uses a single “expected credit loss” measurement objective for the ALLL. • Under CECL model, the allowance would reflect management’s current estimate of the contractual cash flows that the bank does not expect to collect based on its assessment of risk as of the reporting date. • CECL considers more forward-looking information than permitted under current GAAP.

45. Proposed FASB: Allowance for Loan Losses (continued) • Current GAAP – Bank would only consider past events and current conditions when measuring the incurred loss • Proposed CECL model – estimate based on relevant information about past events, current conditions, and reasonable and supportable forecasts that affect the collectability of the financial assets’ remaining contractual cash flows • Bank would estimate at each reporting period • Neither a “best case” or “worse case” scenario • Estimates would never be limited to losses expected over a specific time period

46. Proposed FASB: Allowance for Loan Losses (continued) • Balance sheet would reflect the current estimate of expected credit losses at the reporting date. • The credit deterioration (or improvement) that has taken place during the period is reflected in the income statement and would include changes in the estimate of expected credit losses resulting from: • Changes in the credit risk of assets held by the bank • Changes in conditions since the previous reporting date • Changes in reasonable and supportable forecasts about the future

47. Best Practices

48. Be Proactive

49. Stay Up to Date on Current Events

50. Active Compliance Committee