Publications & Resources
January/February 2011
Regulatory Reform
New Capital Rules and Raising New Capital
By Robert L. Freedman, P.C. and Nancy M. Stiles, P.C.
By January, 2012, new capital rules for banks are due. These will be shaped by two forces: the Dodd-Frank Act (DFA) and the “Basel III” reforms announced by the Basel Committee on Banking Supervision, an international committee that formulates broad supervisory standards for banks to be implemented by member countries through their own regulatory systems.
While it is premature to predict exactly what the new rules will require for community banks, clearly there will be more emphasis on tangible common equity as an element of capital and higher capital levels. Both the DFA and Basel III aim to restrict hybrid capital instruments as an element of Tier 1 capital. The DFA calls for minimum leverage and risk-based capital standards no less stringent than now apply under the prompt corrective action rules and countercyclical capital standards that would increase during economic expansions and decrease during economic contractions. Logically, the countercyclical elements of capital must be in addition to the minimums. Basel III calls for these minimum risk-weighted ratios to be phased in over time: common equity of 4.5% of risk-weighted assets, Tier 1 (including common equity) of 6.0%, and total capital of 8%, plus 2.5% more of common equity to serve as a buffer, with banks that draw on the buffer facing restrictions on capital distributions through dividends, stock repurchases and discretionary bonuses. The US banking regulators are free to set minimums higher than Basel III and to decide when their new capital rules become effective.
What should a community bank that foresees a need for more capital do? First, evaluate the ways to raise it. Shrinking the bank and retaining earnings probably won’t add significant capital and reducing assets is likely to reduce earnings as well. Focusing on tangible common equity means selling shares of common stock. Leaving aside conversions to stock for mutual entities, raising capital from sources outside the bank happens in two forms: public offerings and private offerings. A community bank with assets under $200 million is likely to find a public offering challenging, due to cost and other factors, but a larger bank can consider a public offering.
Well in advance of a possible public offering, the bank should work to clean up its balance sheet to make it as attractive as possible to investors. This means fixing problems in the portfolio, for example, recognizing losses so that the bank avoids unfavorable market or regulatory reactions from writedowns after an offering. You should begin to establish relationships with lawyers and investment bankers experienced in taking community banks public. They can give detailed advice on what to expect and how to prepare, as well as likely amounts that can be raised. The bank will want to know about the ongoing responsibilities of a public company, such as reporting and disclosure requirements, and the rules of the exchange on which its stock will be listed. The bank must review what experience its management team has with operating a public company. If the chief financial officer in particular does not have this experience, the bank will need to build the right expertise in-house before an offering. The bank should also consider whether its independent public accountants have the appropriate experience with public companies.
There are times when the market is favorable for raising capital and times when it is unfavorable. No one can predict when these times will occur. In unfavorable times, planned offerings may be deferred, so the bank should anticipate that its timeline for an offering could have to be modified. As the features of the forthcoming capital rules become known, many community banks will be motivated to conduct public offerings. That may mean a glut of offerings in the marketplace will occur, reducing the prospects for community banks seeking capital then and later. A wiser choice may be to act sooner, and start the process now.
Private offerings, on the other hand, are an option for both smaller and larger community banks. In general, private offerings are more suitable for raising smaller amounts of capital. A private offering can be attractive, if it would produce enough capital, because costs are lower, and the bank will not incur ongoing additional responsibilities and costs. Experienced investment banks and lawyers can be helpful with private offerings as well.
Whether you think a public or a private offering is a good choice for your bank, if you expect to need more capital, your bank is very likely to benefit from acting now to prepare a plan for raising capital.
Robert L. Freedman, P.C. and Nancy M. Stiles, P.C. are partners with Silver, Freedman & Taff, L.L.P. Freedman can be reached at bobf@sftlaw.com or 202-295-4502, and Stiles can be reached at nancy@sftlaw.com or 202-295-4504.
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