They cannot avoid most branch real estate leases because it would
be impossible to own the real estate they use in their business since
branches are generally located in city store fronts or mall locations.
Leasing also provides the flexibility and avoids the risk related to
owning real estate. Banks also lease equipment, primarily ATMs,
computers and office equipment.
Operating leases are executory contracts under commercial law,
which are off balance sheet under current GAAP. U.S. commercial
bankruptcy liquidation law for equipment leases requires the asset to
be delivered to the lessor and extinguishes the future lease liability, so
there is absolutely no bank capital risk.
For real estate branch leases in a bank bankruptcy, often the
branches are purchased by another bank (arranged by regulators)
which assumes the leases. In the worst case, where no assumption
takes place, and if a lease is rejected in bankruptcy, the landlord’s
damage claim for termination of the lease will be treated as a pre-filing
unsecured claim. The damage claim for future rent under the lease will
be capped at an amount equal to the greater of one year’s rent or 15%
of the remaining lease term (up to a maximum of three years of rent)
calculated from the earlier of the date the bankruptcy petition was filed
or the date when the landlord recovered possession of, or the tenant
surrendered, the premises.
This ability to cap a landlord’s claim in bankruptcy is often a major
benefit to a debtor tenant, especially when it involves a long-term lease
with rent obligations higher than current market rates. As a result, the
bank capital risk for a real estate lease is minimal and should be reflected
in a low-risk weighting of 10% to 20% of the ROU asset amount to keep
it simple. Another option would be to conduct a lease-by-lease risk
weighting with equipment leases weighted 0% and the real estate risk
weighting adjusted for the individual lease’s term and the probability
that the branch will not be acquired by another bank.
The new lease accounting rules will put a new operating asset and
liability on books equal to the present value of future lease payments,
but the new rules do not change the risk profile of operating leases.
That new asset will attract regulatory capital of 10.5% unless U.S.
regulators change their minds. The regulatory capital is designed to
U.S. and IFRS 16 for the rest of the world).
The Basel Committee, responsible for setting international capital rules, decided the ROU operating lease
assets require capital. The Controller of the Currency
and Federal Reserve, responsible for setting U.S. bank
capital rules, tentatively decided to go along with Basel’s
decision. Although the OCC and Fed have the power
to differ on behalf of U.S. banks, they do not seem to
be so inclined. This means banks will have to apply
10.5% capital to those new assets. Currently, operating
leases are executory contracts not recognized on the
balance sheet, with no capital required for both U.S.-and foreign-based banks. I predict banks will cut back
on lending to address the new capital need.
How Do the New Lease Rules Affect Bank Capital?
Banks are heavy users of operating leases, primarily
for their real estate branches and office space leases.
Lease Accounting Rules Add to Bank Capital Woes:
Topic 842 May Cause Credit Crunch in 2019
BY BILL BOSCO
In his final Monitor article before retirement, Bill Bosco examines how banks will be affected by the Basel
Committee’s decision on international capital rules. He predicts a negative effect on worldwide economic activity
in 2019 as banks address their need to increase capital which, in turn, will likely diminish lending activities.
The Basel Committee, responsible for setting international capital
rules, decided the ROU operating lease assets require capital. The
Controller of the Currency and Federal Reserve, responsible for setting
U.S. bank capital rules, tentatively decided to go along with Basel’s
decision. Although the OCC and Fed have the power to differ on behalf
of U.S. banks, they do not seem to be so inclined. This means the
banks will have to apply 10.5% capital to those new assets.
CRUNCHING numbers THE ±