Tier II Sub Debt for Community Banks

November 20, 2013 11:47 by Clayton Reeves in   //  Tags:   //   Comments (0)

We have all heard the saying “Capital is King.” After the passage of Basel III, we might revise it for banks to read “Tier 1 Common Capital is King.” The new Basel III rules made many revisions to the risk-based capital framework including, but certainly not limited to: new Prompt Corrective Action thresholds, adding a Common Equity Tier 1 Capital Ratio, no new trust preferred, introducing a capital conservation buffer and changing how risk weighted assets are calculated. The following table compares today’s capital thresholds to Basel III:


The Common Equity Tier 1 Capital Ratio ensures common equity will be the dominant form of bank capital as does the change in the Tier 1 Risk Based Capital Ratio which was the only existing capital ratio whose minimum threshold was increased. But upon closer review, we find there is still a place in a bank’s capital structure for other forms of regulatory capital.

The graph above provides a breakdown of the Total Risk Based Capital Ratio and the capital types needed to meet the fully phased-in ratios with the capital conservation buffer under Basel III. Banks will certainly want to operate above those fully phased-in levels stipulated by the regulators but the same capital component mix would apply. This graph demonstrates that common equity is required to be the dominant form of capital, but it does not have to be the only form of capital; there is a place for other types of Tier 1 capital, noncumulative perpetual preferred or convertible preferred, and/or Tier 2 subordinated debt.

Comparing the cost of the different types of capital shows us a blend of capital securities is ideal from a return perspective. The chart below compares the estimated after-tax cost of different forms of capital:


While access to capital is driven by a bank’s financial health and access to the public markets, unfortunately not all forms of capital are available to all banks. The good news is that Tier 2 Subordinated Debt is becoming a viable capital alternative for healthy public and private banks looking for growth capital or to refinance higher coupon debt. Subordinated debt typically matures in seven to ten years, is generally callable at par after five years and contains minimal covenants. At a pre-tax cost of 7.5% to 9.5% (5.0% to 6.2% after-tax) subordinated debt is an attractive alternative for banks looking for regulatory capital to supplement common equity.

For more information contact Shelley Reed, Managing Director, CC Capital Advisors at (816) 968-1511.

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