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To opt-out or not to opt-out, that is the question – A reminder on March 31, 2015 Call Report, Schedule RC-R, item 3.a

Posted by OnCourse Staff April 10, 2015 5:41pm

Photo Credit: http://www.business2community.com

 By Chris Van Der Stad, Director of Credit Risk Management

Over the last year there has been much discussion regarding the changes in regulatory capital measurement and reporting rules for Community Banks. The implementation of the Basel III related changes will come for community banks with the March 31, 2015 Call Reports (and FR Y-9C for their related bank holding companies). These changes were already implemented for the large banks (i.e., “advanced approaches” institutions) a year ago in 2014.

The most important item in the March Call Report is probably the one time “opt out” item on Schedule RC-R, line 3.a. This is meant to be a “one-time” election, which means that once made, your bank must keep it forever. To opt out, you must enter “1” for item 3.a.   A “0” indicates that you don’t want to opt out. Taking the “opt out” election allows your bank to eliminate the impact of certain items on regulatory capital. These are detailed in lines 9.a through 9.e. The most important such adjustment for most community banks is on line 9.a, which is to eliminate the market value adjustment for AFS securities from the regulatory capital calculation. You should look at and consider the additional items detailed in 9.b through 9.e and how they might impact your institution. Most community banks, however, will probably not be impacted in a major way by these additional items, now or in the future.

Many, if not most, Community Banks will probably choose “1” and elect to “opt out”. Their main reason for this is simple: the “yes” or “1”  election to “opt out” on item 3.a will keep the current treatment of the market value adjustment for Available for Sale securities in the determination of your bank’s regulatory capital. That is, a bank’s level of regulatory capital will not be affected by the market value adjustment on your AFS securities portfolio. Such market value adjustments are often a reflection of interest rate changes, and many expect rates to become more volatile in the future than they have been recently.

If you do not opt out, the market value adjustment will become part of your regulatory capital, and volatility in market values will create volatility in your regulatory capital level, hence your capital ratios. This volatility, combined with the coming phase in of higher regulatory expectations for capital ratios, is generally thought to be a source of unnecessary risk.

On the other side, there may be some benefits for “opting in” (i.e., putting a “0” in item 3.a). This will depend on whether there are any items detailed on lines 9.a through 9.e you want to include in regulatory capital, and whether you have (or expect to have) a large AFS portfolio. This depends on your particular situation and expectations for the future. However, as noted above, the AFS portfolio is commonly the largest impact from the “opt out” decision.

We have seen articles in the business press which describe some banks’ decisions to actually re-classify AFS securities to HTM. Such reclassifications have generally been done only by large banks which do not have the choice to “opt out”.  Rather, the only choice for them is to reclassify from AFS to HTM and thereby lose flexibility in managing their portfolios, or to accept the higher regulatory capital volatility and risk.  Their acceptance of a loss of portfolio management flexibility demonstrates their perception of the additional risks to regulatory capital ratios inherent in including the AFS market value adjustment.

Fortunately, community banks do not have to sacrifice flexibility in investment portfolio management to avoid regulatory capital volatility. They can keep the flexibility and eliminate regulatory capital volatility of the AFS portfolio market values by answering “1” on Schedule RC-R, item 3.a, thereby “opting out”.

Given the importance of your Bank’s election, we recommend a careful analysis by your senior management, the ALCO and Board of Directors. Many banks are adopting Board resolutions to affirm their choice on this matter. There are model resolutions to be found on the internet. At a minimum, the decision regarding this election and the reasons should be formally documented by your Bank. This should be done soon, as you probably do not want to put it off until the last minute and risk a clerical mistake (which could become a permanent election). This item should also be checked and rechecked before you submit your March 31, 2015 Call Report at the end of April 2015.

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