The implementation of the Basel 3 banking regulations, in which a European-devised strategy is levied among American financial institutions, appears to have disproportionately impacted smaller banks for the worse.

Basel 3, which redefined capital requirements to make banks more able to withstand financial hardships, requires mortgage servicing rights to be counted toward Tier 1 capital at a much lower rate.

(Full Basel 3 coverage from HousingWire available here.)

According to Deutsche Bank (DB) analyst Christopher Helwig, writing in today’s Outlook report, a bank’s servicing could contribute up to 50% of a bank’s total capital in the past. Basel 3 now caps that at 10% of the institution’s Tier 1 common equity.

“If a bank’s MSAs breach that 10% threshold, not only is the value of the MSA no longer accretive to a bank’s capital position, the value of the asset in excess of the 10% threshold would be deducted from the bank’s capital, “ Helwig writes.

The result?

“Despite the fact that changes to servicing capitalization have been telegraphed to the market as early as 2010, a disproportionate amount of small banks appear to have been negatively impacted by the newly implemented rules,” he said.

“Given a potentially fairly limited menu of options at their disposal, we would expect small banks to sell servicing, especially in the face of higher rates,” he concludes. “Some larger banks look better positioned to add and consolidate servicing although smaller institutions may be more inclined to sell MSAs to non-banks in an effort to retain customer relationships.”

With the exception of Wells Fargo (WFC), all of the other big banks could take the excess MSRs from the smaller ones in not-too-distant-future, Helwig writes.

This exit will almost certainly be complication with the announcement that the Office of the Comptroller of the Currency will restrict MSR proceedings at some of the nation's biggest banks.

But why sell MSRs when rising rates mean higher profits?

Helwig explains the smaller players just don't have the critical mass to handle large MSR portfolios. He believes holding more whole loans or securitizing excess servicing, a strategy among big banks, will be unfeasable to smaller ones.

"Smaller banks also may not have the appetite to hold more loans as it could increase the duration gap between assets and liabilities," Helwig said. "Additionally, it seems unfeasible to raise capital as the cost of equity would likely be greater than the yield they could achieve on the servicing asset."