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Bank Stress Tests May Get More Stressful

NEW YORK ( TheStreet) -- The nation's biggest banks may be facing a much more difficult set of stress tests in 2014, according to KBW.

Several senior federal regulators have recently called for higher capital requirements for large U.S. banks. Senators Sherrod Brown (D., Ohio) and David Vitter (R., La.) in April introduced a bill calling for regulators to "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."

Under the Basel III agreement, the focus is on the Tier 1 common equity ratio, which uses risk-weighted assets in the denominator, in order to incorporate the perceived risk of various asset classes. 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 securities has a 100% risk-weighting and BB securities has a 200% risk-weighting under Basel III, because of the higher likelihood of default.

The Brown-Vitter bill would require regulators to focus on the "leverage ratio," which is a bank's Tier 1 capital divided by its average total assets. The leverage ratio is, of course, much easier to calculate than the Tier 1 common equity ratio, which can require some interpretation by the banks and regulators. Brown-Vitter would require a 15% leverage ratio, while Basel III requires a ratio of 3.0%. Current U.S. rules require banks to maintain leverage ratios of at least 5.0% to be considered well-capitalized.

When introducing their bill, Senators Brown and Vitter said if the bill passes, the largest U.S. 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."

Even though leverage ratios don't use risk-weighting, KBW analyst Frederick Cannon has written in several recent reports that the market -- as represented by beta (volatility) measures and credit default swap spreads -- places greater emphasis on leverage ratios than it does on Basel III ratios. The Basel III Tier 1 common ratio "is very complex, has to be computed internally by the company, and cannot be calculated externally by analysts," Cannon wrote in a note to clients on May 5, adding that "the second problem with Basel III is that the measurements do not appear to be accepted by the market as appropriate measures of risk. This is a major issue as it is exactly the same problem that pre-crisis regulatory ratios had."

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