Last year, as noted by this blog, the FDIC, OCC, and Federal Reserve imposed harsher capital requirements on certain “high volatility commercial real estate,” or HVCRE, exposures, in accordance with the Basel III international banking standards. These new requirements were opposed not only by the real estate industry but also by banking associations, particularly the Independent Community Bankers of America (ICBA). The ICBA argues that the Basel III rules were intended to apply only to large, internationally active banks, and that the rules place too great a regulatory burden on smaller institutions. A recent report by the Federal Reserve Bank of Philadelphia notes that CRE regulations disproportionately affect smaller banks, as “CRE represents approximately 50 percent of small bank loan portfolios, compared with just over 25 percent of large bank portfolios.” The report goes on to state that loans that might be classified as HVCRE under the new rules represent approximately 5% of total loans for the median commercial bank with total assets below $10 billion, “a modest, but certainly not insignificant, portion of small banks’ CRE portfolios.”
Furthermore, the report points out that the information required to be collected under these regulations imposes higher costs upon banks, whether a CRE loan ends up being high-volatility or not. And if the regulatory burden becomes so great that a community bank has to hire a lawyer to ensure compliance, the community bank may be at a competitive disadvantage compared with a large bank that already has a legal department. Economists at the Minneapolis Fed estimate that 40 basis points is the minimum return on assets that investors require of a small bank, and that hiring an additional full-time employee would cause 18% of banks with less than $50 million in assets and 2.5% of banks with assets of $500 million to $1 billion to fall below this minimum return.
In response to the banks’ concerns, Federal Reserve Board Governor Daniel Tarullo has repeatedly expressed a commitment to tiered regulations for banks, proportional to their systemic importance, a view applauded by the ICBA. Specifically, Tarullo mentioned as “promising” an idea proposed by FDIC Vice Chairman Thomas Hoenig: relaxing requirements on community banks engaged only in “traditional” banking activities, i.e., not holding trading assets or liabilities and minimizing derivative positions. These traditional community banks could opt into a simpler set of risk-weighted capital requirements (essentially opting out of Basel III) in return for maintaining a higher capitalization ratio, which most community banks already have.
As of this date, the Federal Reserve has taken no concrete action to relax HVCRE rules for community banks. Nevertheless, community banks may find potential in the Fed’s recognition of the harmful effects of these rules on community banks and openness to reform.