The Deal: Fed Holds Line on Basel III Rules

NEW YORK ( TheDeal) -- The Federal Reserve Board on Tuesday, July 2, approved a final rule implementing international regulatory capital reforms recommended by the Basel Committee on Banking Supervision as well as some changes required by the Dodd-Frank financial reform act.

The unanimously approved rules are meant to ensure that banks maintain capital positions sufficient to let them continue lending after unforeseen losses and through severe economic downturns. The rules contain substantial changes from a version proposed last summer, which were made to minimize the burden on smaller, less complex financial institutions.

The most burdensome rules will primarily affect JPMorgan Chase ( JPM), Citgroup ( C), Bank of America ( BAC), Wells Fargo ( WFC), Goldman Sachs ( GS), Morgan Stanley ( MS), Bank of New York Mellon ( BNY), and State Street ( STT). Many of the tougher rules also might apply to U.S. Bancorp ( USB), Capital One Financial ( COF), and PNC Bank ( PNC). General Electric's ( GE) GE Capital Corp. is also likely to be subjected to the rules when they are set for oversight of systemically important nonbank financial firms.

The Fed also made clear that the largest, most complex banks will in a few months also face additional capital rules, a higher leverage ratio, a long-term debt requirement and a surcharge for wholesale funding.

The rules make some important deviations from the Basel III guidelines, as do individual capital regimes that have been implemented on several European guidelines. The Basel Committee is expected to review the various national rules to gauge how closely they adhere to Basel III.

According to Federal Reserve members and agency staff, the final rules minimize the burden on smaller, less complex financial institutions, while establishing an integrated regulatory capital framework for institutions large and small. The rules are meant to address shortcomings in capital requirements, particularly for large international banking organizations that contributed to the 2008 financial crisis.

"This framework requires banking organizations to hold more and higher-quality capital, which acts as a financial cushion to absorb losses, while reducing the incentive for firms to take excessive risks," Fed Chairman Ben Bernanke said as he opened a meeting veiling the rules. "With these revisions to our capital rules, banking organizations will be better able to withstand periods of financial stress, thus contributing to the overall health of the U.S. economy."

Fed Governor Daniel Tarullo, who oversaw the rule writing process, said improved risk-based capital requirements, coupled with better day-to-day supervision of banking institutions, will make the financial system safer.

"While strong capital requirements alone cannot ensure the safety and soundness of our financial system, they are central to good financial regulation, precisely because they are available to absorb all kinds of losses, no matter how unanticipated," Tarullo said. "Along with the stress testing and capital review measures we have already implemented, and the additional rules for large institutions that are on the way, these new rules will be an essential component of a set of mutually reinforcing capital requirements."

FBR Capital Markets analyst Edward Mills said the biggest surprise was that the Fed had backed off requiring higher risk weightings for residential mortgages. "They want to continue supporting the housing recovery and to get banks to continue putting mortgages in their portfolios," he said.

More broadly, Mills noted the creation of a banking system with multi-tiered rules, but said the Federal Reserve had probably struck the right balance with regulation.

Under the rules, minimum requirements will increase for both the quantity and quality of capital held by banking organizations.

In line with the Basel guidelines, all supervised financial institutions must have a common equity Tier 1 capital no less than 4.5% of risk-weighted assets and must have a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. Overall Tier 1 capital is being raised from 4% to 6% and includes a minimum leverage ratio of 4% for all banking organizations. In addition, the largest, most internationally active banking organizations face a new minimum supplementary leverage ratio that takes into account off-balance sheet exposures.

Regarding quality of capital, the rule implements strict eligibility criteria for regulatory capital instruments, particularly what qualifies as common equity Tier 1 capital, the most loss-absorbing form of capital. The Fed said it also improves the methodology for calculating risk-weighted assets to make the calculations more sensitive to risk in an institution's portfolio. Risk-weighting assigns different levels of risk to different classes of assets, with an institution being required to hold higher capital cushions for riskier assets.

Fed staffers said they made a great effort to address concerns raised by community banks about the initial proposal. For instance, small banks received more lenient risk weightings for residential mortgages and regulatory capital treatment of certain unrealized gains and losses and trust preferred securities.

The Fed said nine out of 10 financial institutions with less than $10 billion in assets would meet the common equity Tier 1 minimum plus buffer of 7%, based on data from March 2013.

Community banks also will have a more generous transition period to meet the new requirements. The phase-in period for smaller, less complex banking organizations will not begin until January 2015, while the phase-in period for larger institutions begins in January 2014.

"The issues that most concerned the small and midsized banks were, for the most part, resolved in their favor," said Brian Christiansen, a partner in the financial institutions regulation and enforcement group at Skadden, Arps, Slate, Meagher & Flom LLP.

Barclays analyst Jason Goldberg said the final rule was either neutral or more beneficial than expected for smaller banks and those with high-risk mortgage portfolios.

But Independent Community Bankers of America senior vice president and regulatory counsel Chris Cole said he was disappointed community banks had not received a general exemption from Basel III. "Community banks will have to raise capital and may be crimped in lending," he said, arguing that Basel III was conceived for the largest and most complex international financial institutions rather than community banks. Nevertheless, "the final rule is a lot better than proposed."

Insurance companies also got a break. In another change from the proposal, savings and loan holding companies with significant commercial or insurance underwriting activities will not be subject to the new requirements. The Fed plans on creating a different regulatory capital framework for them.

Ernie Patrikis, partner in White & Case LLP's bank and insurance regulatory practice, said institutions will not wait until their deadlines to begin raising capital and borrowers could feel the pinch. "Banking organizations have been preparing for these rules -- raising capital, selling assets, or issuing smaller dividends," he said. "It is possible that there will be some impact on lending. Various subsidiaries or divisions will fight within the organization for larger capital allocations. Tightening of capital requirements will feed into those calculations."

The outcome was a true a disappointment for large banks, whose top lobbying priority was to remove a provision that would make their regulatory capital vulnerable to unrealized gains and losses in securities they hold available for sale. The rules added to Tier 1 common equity accumulated other comprehensive income, or AOCI, which contains the unrealized gains and losses of available-for-sale securities, along with pension costs and cash flow hedges that are not included in the profit-and-loss statement. Prior to Basel III, unrealized gains and losses on available-for-sale debt securities were filtered out of Tier I common equity.

"For the biggest banks, there is little to cheer," said Jaret Seiberg, an analyst at Guggenheim Securities LLC.

"I don't think there were any shocks in this," added Skadden's Christiansen. "The real story is not today's formal action, but rather the definitiveness with which the Fed governors laid out the coming steps for the big banks."

Tarullo laid out those steps in his opening statement. They include establishing a leverage ratio threshold above the Basel III required minimum. "Despite its innovativeness in taking account of off-balance-sheet assets, the Basel III leverage ratio seems to have been set too low to be an effective counterpart to the combination of risk-weighted capital measures that have been agreed internationally," he said.

Second, he said the Fed would propose combined equity and long-term debt levels these firms should maintain in order to facilitate orderly resolution if the institutions fail and must be wound down. Third, after the Basel Committee has established its framework for capital surcharges on banking organizations that play a significant role in the global financial system, the Fed will adapt the framework for the United States. He predicted a proposal could come late this year.

Finally, he said the Fed staff is working on a recommendation to require that firms hold additional capital if they rely on short-term wholesale funding. That move is seen as aimed at shifting the big institutions toward reliance on traditional deposits as a source of funds rather than wholesale financing, which dried up after the 2007 housing market collapse and turned the housing meltdown into a global financial crisis.

The Federal Reserve coordinated the final rule with the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency. The FDIC has said it will vote on the framework and interim final rule on July 9. The OCC said it will consider a final rule by July 9 as well.

--Written by Bill McConnell And Jane Searle in New York

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