The Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) voted for the final rule on the implementation of Basel III brought in by the Federal Reserve Board (the Fed). A significant aspect of the new rule includes the higher leverage ratio for the global systemically important financial institutions (G-SIFI), the minimum 4.5% CET1 ratio-Tier 1 common/risk weighted assets, also known as the capital conservation buffer, the inclusion of off-balance sheet items in the definition of asset and retention of the current risk weightages on mortgages. In the article below, I have tried to consolidate an analysis on what these ratios imply and the effect expected on the banking industry and the U.S. economy.
Basel III norms were laid down in 2010, and the 26 committee member nations asked to enact domestic regulations to carry out the reforms. The domestic regulations were to be phased in through 2019. The meeting of the Financial Policy Committee of Bank of England (BOE) in March raised concerns on the adequacy of minimum capital requirements laid down in Basel III. U.S. Republican Senator David Vitter and Democrat Sherrod Brown also proposed a bill that comes down strictly on larger banks. The bill has not been enforced yet, and the likelihood of that happening is low.
What led to the stricter rules?
There is general acceptance that larger banks generally already meet the Basel capital requirements. For instance, if one looks at the leverage ratio, analysts assess leverage ratios at 4.6% for Morgan Stanley, 5.1% for Citigroup, 5.3% for JPMorgan Chase, 5.7% for Goldman and Bank of America Corp, and 7.5% for Wells Fargo. As pointed out by Fitch, "We believe the banks we rate are well positioned and capitalized to cope with the implementation of the Basel III rules."
Hence, the push for more stringent provisions. According to the final rule, G-SIFI shall maintain a 6% leverage ratio, whereas the other banks may adhere to the Basel III minimum of 3%. Eight institutions in the category are JPMorgan Chase & Co. (NYSE:JPM), Wells Fargo & Co. (NYSE:WFC), Goldman Sachs Group, Inc. (NYSE:GS), Bank of America Corp. (NYSE:BAC), Citigroup, Inc. (NYSE:C), Morgan Stanley (NYSE:MS), State Street Corp. (NYSE:STT), and Bank of New York Mellon Corp. (NYSE:BK). Regulatory authorities have been concerned because of the complex way in which banks measure risk. Basel norms allow them to continue doing so.
More to follow…
Further measures on the cards are capital surcharges and additional capital for banks which resort to short-term wholesale funding, according to the Federal Reserve Governor Daniel Tarullo. All these measures are being implemented with a view to avoid costly bail-outs of top financial institutions in the unfortunate scenario of a 2009 type financial crisis.
One difficulty that Fitch predicts banks would face is that of unrealized gains and losses, currently reported as part of other comprehensive income (OCI), being included in assets and not adjusted for riskiness. The risk weights assigned currently by banks are calculated through complex formulae difficult to measure from public filings. Banks would need to keep a tab on the variations in the figure and maintain higher levels of equity capital to meet the new ratio requirements, also to the exclusion of hybrid capital, such as convertible securities.
Smaller banks exempted
The regulations provide some relief for smaller banks. The Fed allowed them to opt out on the condition that they treat cost of capital as the market value of their trading assets variations. Mortgages are assets for banks, and authorities have been attempted to work out acceptable standards to measure them. The complex proposals of Basel III scared the smaller lenders, who were lobbying for exclusion from compliance. The Fed granted them the requested respite to the advantage of Wells Fargo & Co., the home loan giant. The Fed allowed the current practice to continue, which means the risks assigned to troublesome mortgages remain at 100%, and similarly for residential mortgages at 50%, and for certain underwritten mortgages at 25%. The proposed eight groups of risks did not become regulation, and neither did the 200% weights.
Impact on the Industry
The management of top banks seems to share the Fed's and Fitch's view that the banks are geared up for the regulatory changes. But that does not reflect the perspective of all those involved.
"The real test for Basel III is whether the rule makes it easier or more difficult for banks to serve their customers. If it makes it harder, that's not what our still-recovering economy needs," American Bankers Association (ABA) on the final rule.
In case of breach of the capital requirements, dividends and other capital distributions, such as share buybacks, will be impacted. Banks could be forced to issue further equity, thus raising funding charges for them. Management bonuses could also take a hit.
"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," Chairman Ben Bernanke said. "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."
In conclusion, we may say that taking into account the relief to smaller banks on complex calculations of risk weights on mortgages, the impact of the larger banks' failure could have on the economy, the readiness of the concerned banks to bring up their capital structures to meet the requirements, and the time frame within which the various provisions are to be phased in, the measures are neither harsh nor do they lend the U.S. banks to being at a competitive disadvantage.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.