The Basel III Tier 1 common equity ratio uses risk-weighted assets in the denominator, meaning that banks' capital requirements are based in part on the amount of risk they are taking. For example, cash has a zero risk-weighting, so it is not added to risk-weighted assets and it doesn't increase a bank's capital requirement. Direct obligations of the U.S. government have a 20% risk-weighting. Mortgage-backed securities with AAA or AA ratings have a 20% rating. A-rated MBS have a 50% risk-weighting, while BBB paper has a 100% risk-weighting, and BB paper has a 200% risk-weighting under Basel III, because of the higher likelihood of default.
Based on determinations by the Basel Committee, the additional capital surcharges for Citigroup (C) and JPMorgan Chase (JPM) are 2.5%, so each of these banks has a fully phased-in minimum Basel III Tier 1 common equity ratio requirement of 9.5%.
Senators Brown and Vitter said that under their proposal, "regulators would walk away from Basel III, and institute new capital rules that don't rely on risk weights and are simple, easy to understand, and easy to comply with." They also said in their press release that the biggest banks "will be faced with a clear choice: either become smaller or raise enough equity to ensure they can weather the next crisis without a bailout."When the senators say their rules "don't rely on risk weights," they mean that banks will be required to set aside the same amount of capital for cash as they would for junk bonds. Mayra Rodriguez Valladares -- managing principal of MRV Associates, a financial regulatory consultancy -- says that the simplified capital rules excluding risk-weighting would provide "perverse incentives for traders to go into riskier assets, because they wouldn't be punished from a capital requirement perspective." Rodriguez Valladares says this phenomenon was already observed under the Basel I capital rules, which is why Basel II included risk-based capital requirements. Kevin Petrasic -- a partner in the Global Banking and Payments Systems practice of Paul Hastings in Washington -- says "the notion of not having any sort of risk-weighting raises some concerns," adding that the straight 15% capital-to-assets requirement for the largest banks would have "economic consequences that need to be weighed carefully."
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