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Monday's Wall Street Journal (Dec 19) reports that the Fed is expected to adopt a new rule imposed by the Basel III capital standards that would require systemically important banks to hold capital of 9.5% of risk-weighted assets. There is no release on this subject posted on the Fed’s website this morning. A listing of systemically important banks has not yet been made official, either.

The large banks that most likely will be affected by this rule have been fighting it for several months. It will, they say, lead to less lending and higher costs.

But let us look at the facts. The Fed, the Comptroller of the Currency, and the FDIC already have a rule that requires all U.S. banks to maintain at least a 10% ratio of capital to risk-weighted assets in order to be deemed “well capitalized,” which is the benchmark that all U.S. banks seek to maintain because falling out of the “well capitalized” category brings increased regulatory scrutiny. And well-run major U.S. banks such as JP Morgan Chase often have maintained capital to risk-weighted assets ratios of 12% or even 14%. (There are some differences between the Basel and U.S. computations, but I do not believe they are significant for this purpose.)

Thus, this event should have little impact on American banks or their valuations. The banks have been fighting against these rules because they believe they must fight all capital rules that impose higher requirements on systemically important banks. The real test is not whether the Fed will follow Basel but whether the Fed will impose significantly higher requirements, which some Fed Governors have advocated in recent months. From today’s report, it appears that the banks may have won that battle.

What is at stake here is the degree to which the Fed will use higher capital requirements for very large banks in order to prevent those that might be deemed too big to fail from failing. This is a laudable goal. The criticism of this approach, led by Peter Wallison of the American Enterprise Institute, has been that being deemed systemically important will give designated banks a funding advantage because they will be perceived as too big to fail; thus their funding costs will decline. Thus, the reasoning goes, the policy will not only declare that these banks are too big to fail, thus reinforcing rather than ending TBTF, but also help those banks to grow even bigger.

There is reason in the criticism of the policy. But there is no perfect solution to TBTF. And higher capital requirements are one way at least to protect the public from having to bail out the large banks.

Source: Higher Capital Requirements Under Basel III For Systemically Important Banks