U.S. regulators’ Basel III rules package signals intent to maintain momentum in big-bank reforms

By Guest Contributor
July 17, 2013

By Bora Yagiz

NEW YORK, July 17 (Thomson Reuters Accelus) - In a move considered to be the most complete overhaul of U.S. bank capital standards since Basel I in 1988, three U.S. banking regulators (the Federal Reserve Board, Office of Comptroller of the Currency, and Federal Deposit Insurance Corporation) have finalized the three Basel III-related notices of proposed rulemaking (NPRs) from 2012 on capital rules.

Collectively, the rules raise capital ratios, expand the base of assets for risk-based capital calculations, make changes to the methodology for calculation of credit risk weightings for banking and trading book assets and put emphasis on a stricter definition of capital, especially with regards to common equity Tier 1 (CET1) capital, the highest quality of equity. Higher quality of equity is perceived to provide a better safety net for the financial system in economic downturns, but this safety comes with a higher cost of business for the banks. Simply put, money kept as capital is not invested. 

More importantly, the rules reveal regulators’ intent that this represents only the first in a series of coming steps to enhance prudential standards at large (more than $250 billion of assets) and tightly interconnected banking institutions whose failure could put the financial system at risk.

The rules also contain concessions for small banks that argued the rules were too burdensome and would put them at a competitive disadvantage by mandating a heavier capital foundation for large banks.

Under the new rules, financial institutions are now required to hold a common equity Tier 1 capital ratio of 4.5 percent, a Tier 1 (CET1 plus non-cumulative perpetual preferred stock and grandfathered securities) capital ratio of 6 percent, and a total capital ratio of 8 percent of risk-weighted assets. They will have to comply with a leverage ratio of 4 percent. A capital conservation buffer of 2.5 percent of total risk-weighted assets is also part of the rules.

Consistent with the proposed rules, mortgage servicing rights will also be subject to strict capital treatment, with a cap of 10 percent of CET1. This lucrative business may shift to non-bank financial companies and to smaller banks.

The biggest banks operating under the Advanced Approach — with consolidated total assets of $250 billion or more, or consolidated on-balance sheet foreign exposure of $10 billion or more — will also have to contend with a supplemental leverage ratio of 3 percent.

According to the rules, common equity Tier will only be composed of common stock and related surplus, and retained earnings, with deferred tax assets and mortgage servicing assets, and significant investments in the capital instruments of unconsolidated financial institutions being deducted.

Except in three significant areas, where regulators took steps to accommodate the concerns of smaller banks with less than $250 billion in assets, the final rules did not differ materially from the proposed rules from a year ago. There were no changes in the rules for larger banks, and this came as no surprise. Most of them, however, already meet the higher capital standards.

Small-bank concessions

Small banks had vigorously argued that they had no role in the financial crisis, and that they were being subjected to too many regulations written mainly for the larger financial institutions. They may not have gotten a two-tier regulatory structure, championed by Massachusetts Democratic Sen. Elizabeth Warren, but they won the regulators’ backing for a number of important concessions.

First, small banks will benefit from a reversal in residential and commercial real estate risk weightings, both of which have traditionally been their core business areas. Many of the small banks that had long been important sources of funding for borrowers buying homes were being hurt by the new mortgage rules. They will now be able to continue to keep the current risk weights of 20 percent, 50 percent or 100 percent for the former, and 100 percent (or 150 percent for those that qualify as high volatility) for the latter. Previously, eight weighting categories ranging from 35 percent to 200 percent were proposed, depending on the loan-to-value ratio, lien status, and other underwriting criteria.

Second, regulators allowed permanent grandfathering of trust preferred securities (TRUPS) issued before May 19, 2010 for banks with less than $15 billion of assets. These are the legacy of pre-crisis years, when small banks had bundled them into collateralized debt obligations. While TRUPS are long-term debt-instruments making periodic interest payments, they are also essentially considered equity for regulatory capital purposes if issued by bank holding companies, and subject of course to some restrictions.

Third, critically, small banks were granted a one-time opt-out opportunity from the requirement of deducting from their capital the unrealized gains and losses considered as accumulated other comprehensive income (AOCI). The inclusion of the AOCI could have introduced significant volatility in capital ratios.

“I think those are important accommodations, and it is entirely appropriate that they apply to the community banks and thrifts that had nothing to do with bringing on the crisis,” says Comptroller Thomas Curry.

Small banks were also given an additional year of transition to comply with the rules compared to other banks, with the deadline set on January 1, 2015.

Frank Sorrentino, the CEO of North Jersey Community Bank, expressed mixed feelings about the changes. “Sure we welcome them, but I just don’t see the rationale behind instituting more rules with reporting and disclosure requirements for the community banks that already comply with the new capital levels.”

According to Federal Reserve system data from March 2013, 95 percent of banks with less than $10 billion of assets currently meet the minimum common equity Tier 1 ratio of 4.5 percent, and 90 percent of them meet the 7 percent threshold of minimum common equity Tier 1 ratio plus the conservation buffer.

More to come

Federal Reserve Governor Daniel Tarullo has indicated that, in addition to the recently proposed rule on leverage ratio as part of the Dodd Frank act’s Collins Amendment (Section 171), regulators are working on three more rules to complement the risk-based capital framework in place. Banks will be on the lookout for a rule restricting the issuance of long-term debt in order to facilitate an orderly resolution, a rule on capital surcharge, and another one on addressing the risks in short-term wholesale funding.

All of these rules are expected to be finalized before the end of the year.

The supplementary leverage ratio of 6 percent proposed by the OCC, Federal Reserve and the FDIC on July 9 affects eight U.S. banks considered to be global systemically important banks (G-SIB), and effectively doubles the previous threshold of 3 percent.

These banking organizations are Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley, State Street, and Wells Fargo. The leverage ratio is the Tier 1 capital divided by total leverage exposure, taking into account both on and off-balance sheet assets.

The Director of the FDIC, Thomas Hoenig, has stated previously that the 3 percent leverage ratio is too low.

This comes on the heels of Basel’s release of a consultative document on the topic, where the committee proposed modifications to the denominator of the leverage ratio. The Basel Committee will also conduct later this year a Quantitative Impact Study on the leverage ratio’s impact and its relationship with the risk-based framework.

The finalization of Basel III-related capital rules seems to promote the community banking model, where common stock and retained earnings are to be the fiat of equity. The U.S. Basel III package duly puts emphasis on capital and leverage, and the U.S. regulators are intent on walking the extra mile. It is now critical to use the momentum and complement these rules in the remainder of the year with rulemakings on short-term borrowing and the issuance of long-term debt.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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