A proposal by regulators to revamp the way banks must measure risk on certain assets is alarming many community bankers, who argue it will raise capital requirements, increase compliance costs and curb lending.

For the most part, small banks had expected the majority of the Basel III plan, which dictates the quality and quantity of capital institutions must hold, to apply to them, including a requirement that they hold 7% in common Tier 1 capital.

But they were caught off guard by changes that dictate how much risk-based capital banks must hold against certain assets, such as U.S. government securities, corporate exposures and residential mortgages.

Many said that that — if finalized in its current form — the plan would represent a sea change in capital requirements for smaller banks.

"Rather than just adding on Basel III as an additional addendum to Basel II framework, they in fact used it as an occasion to rewrite basically the entire capital rule framework," said Greg Lyons, a partner at Debevoise & Plimpton LLP.

While larger banks have been required to press ahead with updated versions of the Basel rules, known as the "advanced" approach, the roughly 7,000 smaller institutions have been allowed to stay with the earliest edition of the Basel accord, which was initially adopted in the late 1980s.

But the latest proposals, issued by the banking regulators at varying times within the past week, effectively rework the so-called "standardized" approach, updating the capital standards for the smallest banks.

Regulators moved in this direction for two reasons. One was to ensure that the way banks measure risk weights was more updated and risk-sensitive. The other was to comply with a statute under Dodd-Frank, which bars regulators from issuing rules that reference external credit ratings.

It's a significant deviation from the global rules agreed to by the Basel Committee on Banking Supervision, but deemed necessary given the mandate in Dodd-Frank.

Regulators were forced to come up with a new way of calculating risk weights both for debt securities in the trading book, and for loans in the banking book that didn't rely on external credit ratios.

For example, under the new proposals, banks would be asked to use the country risk classifications published routinely by the Organization for Economic Cooperation and Development to determine the risk weights for sovereign debt.

"The U.S. not only did what we expected, which was across the industry really spice up the numerator in the capital equation — which is the heart of Basel III — but also to do the same to the denominator in the risk-weighted assets," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc. "Together they make this is a very, very, very stringent rule."

But community bankers didn't expect the risk-weighting changes to apply to them.

"We were surprised that the Fed basically took a one-size-fits-all approach to the Basel capital risk-weighting rules," said Camden Fine, president of the Independent Community Bankers of America, who called the rules "extremely complex."

Wayne Abernathy, the head of financial institutions policy and regulatory affairs at the American Bankers Association, agreed.

"It seems to be very complex and complicated and probably more complex and complicated then it needs to be just at every level, but certainly the level of community bankers," he said.

Industry representatives only learned a few months ago that regulators were likely to move in this direction, sparking efforts to get them to change their minds.

Fine said this aspect of the plan "makes absolutely no sense" and will require smaller institutions to go through a tough exercise of showing how they meet the new standards, usually at a great cost to the bank. The proposals as a whole, combined with other pending regulations, may also severely restrict credit.

Some observers said institutions were still coming to grips with the plan.

"My guess it's still been quite a shock to the small- and mid-sized banks who just suddenly realized the new capital regime is a tangible common equity-based one," said Petrou.

Although bankers have been warned for months, even years, that Basel III would apply to all banks, Abernathy said it is just sinking in with the release of the proposals.

"What they're seeing now is there are some real details that may affect the way they count their capital, the way they apply capital to the various assets, and the types of hoops and hurdles they are going to have to go through just to prove that they are okay where they are — and I think that's what's new to the bankers," said Abernathy.

A campaign is already underway to educate bankers on what the proposed rules will mean for individual institutions.

"I know that the community bankers have pushed back against that and you're probably going to see a ramped up education of what that would do to the industry from the ICBA and Camden Fine," said Patrick Sims, a senior analyst at Hamilton Place Strategies.

Fine and others are clear, however, that they aren't objecting in principle to higher capital requirements — it's the risk-weightings of assets that trouble them.

Other experts also see cause for concern, especially the risk weighting for residential mortgages.

"It will have an impact on the systems for making loans because the mortgage calculations are a bit more complicated," said Lyons.

Under the plan, bankers can expect a significant change in how they measure risk.

Currently, they utilize four categories of risk weightings 0%, 20%, 50% and 100%. Under the new proposals, which would take effect in January 2015, it would expand the number of categories that could apply depending on the kind of asset.

U.S. government securities, for example, would receive a risk weighting of 0%, while residential mortgage exposure, which is currently assigned a 50% risk weight for high-quality mortgages could be assigned a risk weight of up to 200% based on the mortgages' loan-to-value ratio and other criteria.

The proposal would also automatically assign a 150% risk weighting to certain commercial real estate exposures.

Additionally, regulators have prescribed significant changes to the treatment of banks' off-balance sheet exposures.

Banks would be required to calculate risk weights on their securitization positions either by using an approach, known as the simplified supervisory formula approach, which is applied to those who banks who must adhere to the market-risk capital rule.

Moreover, the rule would establish a new risk-based capital requirement floor based on a provision in Dodd-Frank commonly referred to as the Collins Amendment.

Banks have a three-month window to convince regulators they made a mistake, but many observers are skeptical there will be enough time to make necessary changes to the plan, which is supposed to be in place by the end of the year.

"I doubt — particularly in 90 days — that the community banks and regional banks will try to create a whole new capital regime as an alternative," said Lyons. "More likely they'll just say, we just don't think this should apply to us."

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