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Big Bank Bashers See First Unintended Consequences

Risk-based means a bank's assets are weighted, as defined by regulators. Cash or U.S. Treasury bonds, for example, have zero risk-weightings. A one-to-four-family residential mortgage loan that was properly underwritten, with the borrower keeping current on payments, is assigned a 50% risk-weighting. Any other one-to-four family mortgage loan has a 100% risk weighting.

JPMorgan Chase estimated that its Basel III Tier 1 common equity ratio was 9.3%, quite close to the company's fully implemented requirement of 9.5%. JPMorgan's fully phased-in minimum Basel III Tier 1 common equity ratio includes the 7.0% basic requirement, plus an additional 2.5% "buffer" required as a global systemically important financial institution (GFISI). That's the maximum GFISI buffer, with most of the other large banks having smaller buffer requirements.

In order to comply with Basel III, the big banks have had to build capital, while also managing the denominator of the Tier 1 common equity ratio by trimming assets with higher risk-weightings.

That's all well and good, but the new leverage ratio requirements mean the banks can also comply by simply reducing the size of their balance sheets. Many politicians -- including Sens. Sherrod Brown (D., Ohio) and David Vitter (R., La.) who in April proposed forcing the large banks to boost their leverage capital ratios to 15% -- and regulators think this is a good thing. Why not shrink the biggest banks?

The bank regulators took a far more sane approach in proposing the eight bank holding companies listed above be required to maintain supplementary Basel III Tier 1 leverage ratios for their bank subsidiaries of at least 6%. The supplementary Basel III Tier 1 leverage ratio brings many off-balance-sheet items onto the banks' balance sheets, which is also a good thing.

But the upshot of the proposal is that the largest banks will be forced to make their entire balance sheets as efficient as possible, since all assets will have the same capital requirement. This proposal will make the banks more likely to pursue higher returns -- meaning higher risk -- for their assets.

Under the proposal, banks not included in the eight listed above would only be required to maintain minimum U.S. Tier 1 leverage ratios of 4.0%. That means the "smaller large banks" will continue to have the same leverage ratio requirements they had before the proposal, without the addition of off-balance-sheet items the biggest banks will face through the supplementary Basel III Tier 1 leverage ratio requirement.

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