The Deal: U.S. Banks Face Tougher Capital Mandate Than Global Rivals

NEW YORK ( The Deal) -- Building upon last week's action by the Federal Reserve Board, the Federal Deposit Insurance Corp. on Tuesday proposed that the country's eight globally significant banks hold capital equal to 6% of assets, in some cases more than doubling what the Fed required on July 2 when it implemented international guidelines on bank capital.

The action will have the practical effect of restraining big banks' reliance on debt to finance their activities and prodding them to seek additional equity capital. If finalized, the requirements would take effect Jan. 1, 2018.

The move was expected -- Fed officials last week acknowledged that its action would soon be supplemented by the FDIC, and banking regulators have acknowledged in public comments for months that the biggest U.S. institutions likely would be under tougher constraints than Basel requires.

The affected institutions are JPMorgan Chase ( JPM), Citigroup ( C), Bank of America Merrill Lynch, Wells Fargo Bank ( WFC), Goldman Sachs ( GS), Morgan Stanley ( MS), Bank of New York Mellon ( BK) and State Street ( STT).

The banking industry quickly reacted with a harsh assessment of the FDIC's action.

"While we support financial institutions holding more capital, this new proposal, combined with existing capital and leverage requirements, will make it harder for banks to lend and keep the economic recovery going," said Tim Pawlenty, president of the Financial Services Roundtable, the trade group for the 100 largest financial companies. "To increase the safety and soundness of the industry, the vast majority of banks have already made important strides to increase capital levels. This new heightened requirement would only impact U.S. institutions, resulting in American banks being put at a global competitive disadvantage."

Frank Keating, president of the American Bankers Association, said federal regulators' stress tests show that the largest U.S. banks are already well capitalized and the latest move will serve only to increase the cost of capital. "Just when there appears to be some agreement on international capital standards, U.S. regulators are proposing to undermine the whole exercise under a mistaken belief that doubling capital requirements will have no impact on credit availability or the ability to hedge risk."

Although the ABA criticized the latest international capital standards -- drafted by the Basel Committee on Banking Supervision and known as Basel III -- Keating said the Basel accords at least had the merit of creating a similar framework for global banking institutions.

"If Basel III had a fundamental purpose -- and we certainly criticized its details -- it was to create a basic global standard that would end international competition over capital levels," he said. "This proposal goes beyond Basel III to impose a more difficult standard on our nation's internationally active banks, one that would make them less competitive with their European counterparts by making U.S. loans -- including loan commitments and derivatives that hedge risk -- more expensive to offer. Raising capital is not without cost -- it means higher funding costs for loans and that fewer loans will be made."

Added William Sweet, head of the Financial Institutions Regulation and Enforcement Group at Skadden, Arps, Slate, Meagher & Flom: "The FDIC adopted an entirely domestic leverage requirement above and beyond Basel III. It appears the leverage capital ratio at the eight U.S. globally systemically important banks will increase somewhere between 100% to 66%, compared to what the Basel Committee put in place."

FBR Capital Markets analyst Edward Mills said the new capital requirements would shift the balance of power from banks to regulators around capital decisions by setting an objective standard. "Many regulators felt that at the heart of the capital crisis, banks were reluctant to cut their dividends which may be seen as a sign of weakness but returned capital they could have used to better weather the crisis," he said.

Mills suggested major banks were likely to meet the requirements by the time they took their phased-in effect. But he pointed to the FDIC board meeting transcript, which estimated that covered bank holding companies would have needed to increase their Tier 1 capital by about $63 billion to achieve a 5% supplementary leverage ratio if that requirement had been in effect as of third quarter of 2012. The agencies also estimated that the lead insured banks of these organizations would have needed to increase their Tier 1 capital by about $89 billion, to achieve a 6% supplementary leverage ratio.

Rafferty Capital Markets bank analyst Richard Bove said the new requirements were the result of a longstanding rift between the FDIC and the Federal Reserve. He noted that the Fed preferred to follow global Basel standards while the FDIC believed these allowed banks to "cheat" as they did not require capital holdings against cash or Treasuries. "The FDIC wanted a different capital ratio which encompassed all assets and neither party wanted to change their position, so now we have two sets of capital requirements," Bove said.

Keefe, Bruyette & Woods analysts have said that among global SIFIs, or systemically important financial institutions, only Wells Fargo and Bank of America would have met a 5% Basel III Tier 1 leverage ratio as of the first quarter. Wells Fargo is the only bank to meet a leverage ratio of 6% or more, and would not hit a shortfall unless this was raised to 8%, according to KBW.

Other analysts said the new requirements were unlikely to meaningfully change the way banks conducted their businesses. Many banks have disposed of certain business lines, such as mortgages and structured products, given more punitive regulatory requirements and lower credit growth since the financial crisis.

The Independent Community Bankers of America voiced strong support for supplementary capital standards for the largest financial institutions. Community bank representatives had previously denounced the need for them to adhere to more stringent capital rules, given the larger role of Wall Street banks in the financial crisis and their systemic risk.

"The proposed rule introduced today supports ICBA's longtime call for policymakers to take a tiered approach to regulation that distinguishes low-risk and highly capitalized community banks on Main Street from the large and risky financial firms of Wall Street," said Camden Fine, the association's president and CEO.

FDIC Vice Chairman Thomas Hoenig supported the proposal but opposed his colleagues' decision to follow the Fed in implementing Basel III right now, which calls for institutions to set their own capital levels based on internal assessments of risks in their assets and calls for a minimum level of only 3%. Hoenig said they should have waited another couple of months in order to establish a single proposal on capital and leverage all at once.

Banks covered by the proposal would need to satisfy the 6% supplementary leverage ratio threshold to be considered well capitalized by federal regulators. Bank holding companies' 5% threshold would be made up of Basel's 3% minimum ratio plus a 2% buffer.

Although the move was foreshadowed in statements by various bank regulators, it was unclear whether banks and bank holding companies would have different leverage ratio standards, Skadden Arps' Sweet said. Setting different levels -- 5% for holding companies and 6% for their bank subsidiaries -- will have the practical effect of limiting big banks' ability to pay dividends to shareholders and bonuses to employees. It also will factor greatly in banks' capital planning and their ability to preparing for stress tests conducted by regulators to gauge their ability to withstand a financial downturn.

According to the FDIC, "maintenance of a strong base of capital at the largest, most systemically important institutions is particularly important because capital shortfalls at these institutions can contribute to systemic distress and can have material adverse economic effects." The agency said its research shows a 3% minimum supplementary leverage ratio would not have appreciably mitigated the growth in leverage among these organizations in the years preceding the recent crisis.

That is why regulators should have waited until the leverage ratio proposal is ready to be implemented before going ahead with Basel III, said Hoenig.

"I support more and better capital; however, the Basel III standard without a binding leverage constraint remains inadequate to the task of assuring the American public, who paid a high price for the financial crisis, that our capital standards are adequate to contribute to financial stability," he said in a statement. "A capital standard, to be useful, must be understandable and enforceable and must be sufficient to absorb unexpected loss. Unfortunately, the Basel III interim final rule, as proposed, fails to fully meet these criteria."

By relying on risk-weighted capital measures, Hoenig said Basel III's approach will correlate poorly with actual future losses. Basel III "continues to rely on risk-based measures, ignoring the usefulness of the leverage ratio to constrain excess risk taking for the largest, most complex institutions," he said.

Hoenig said U.S. regulators were needlessly rushing to implement Basel III, noting that all of the largest, most complex U.S. firms currently meet the 3% threshold.

"Nothing is accomplished by acting now and failing to wait an extra 60 or 90 days to receive comment and then implement a complete rule with a stronger leverage ratio," he said. "By separating the implementation of Basel III from the supplemental leverage ratio proposal, we gain little and risk a stronger leverage ratio being delayed, or worse, not being adopted."

Guggenheim Securities analyst Jaret Seiberg said that while banks might have some opportunity to moderate the proposal before it is finalized, the greater probability is that Democratic lawmakers on Capitol Hill and maybe even some bank regulators will try to make it even tougher.

"We do not see this plan appeasing industry critics on Capitol Hill," he wrote in a research note. "Hoenig did not fully endorse the combination of Basel III and the extra leverage proposal. There were similar questions by other FDIC board members. So there is a feeling coming from the agency that regulators might not have gone far enough with the leverage proposals."

He said lawmakers such as Sen. Sherrod Brown, D-Ohio, might "pick up on this dissent" and continue pushing legislation to break up the biggest banks.

Written by Bill McConnell and Jane Searle

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