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From Banking and Finance Law Daily, July 2, 2013

Fed approves Basel III rules

By John M. Pachkowski, J.D.

At its July 2, 2013, open meeting, the Federal Reserve Board unanimously approved a final rule implementing the Basel III capital framework for U.S. banks. The Fed will issue the final rule jointly with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. The FDIC is expected to approve the final rule at its July 9, 2013, meeting, and the OCC is expected to review and consider the matter as a final rule by July 9, 2013.

In his opening statement, Fed Chairman Ben S. Bernanke noted, “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. He added, “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.”

Quantity. Under the final rule, minimum requirements will increase for both the quantity and quality of capital held by banking organizations. There will be a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5 percent and a common equity tier 1 capital conservation buffer of 2.5 percent of risk-weighted assets. These standards apply to all supervised financial institutions, regardless of size and complexity.

The final rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from 4 percent to 6 percent and includes a minimum leverage ratio of 4 percent for all banking organizations. In addition, for the largest, most internationally active banking organizations, the final rule includes a new minimum supplementary leverage ratio that takes into account off-balance sheet exposures.

Quality. To ensure quality of capital, the final rule emphasizes common equity tier 1 capital, the most loss-absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments. The final rule also improves the methodology for calculating risk-weighted assets to enhance risk sensitivity. Risk weighting is used by banks and regulators to assign different levels of risk to different classes of assets—riskier assets require higher capital cushions and less risky assets require smaller capital cushions.

“Milestone.” During the meeting, Fed Governor Daniel Tarullo called the final rule a “milestone” and noted that it has a number of consequences. The final rule: (1) consolidates the progress that has been made by banks and regulators over the last four years in improving the quality and quantity of capital held by banking organizations; (2) remedies shortcomings in existing risk-weighted assets calculations that became apparent during the financial crisis, and also enhances the effectiveness of the Collins Amendment (12 U.S.C. §5371), by making it applicable to capital buffer, as well as minimum, requirements.

Community banks. In her opening statement, Fed Governor Elizabeth A. Duke stated that the final rule maintained the objective of strengthening capital requirements but “without the more onerous regulatory burden” on smaller institutions. She pointed to three changes that were put into the final rule based on the 2,600 comments received by the Fed. First, the final rule retains the current risk weights for residential mortgage loans. Second, smaller banks will be able to make a one-time election to opt-out of the requirement to include most elements of accumulated other comprehensive income—unrealized gains and losses—in regulatory capital; however, they will not be permitted to switch back and forth to take advantage of unrealized gains and ignore unrealized losses. Third, in recognition of community banks’ limited access to the capital markets, the final rule grandfathers certain existing trust preferred securities as permitted by the Dodd-Frank Act.

Duke concluded her statement by noting that there will be “a continuing effort to improve communication with community banks about regulatory changes” and that the Fed Staff prepared a one-page guide that describes the key changes and “will allow community bankers to quickly zero in on the changes that affect them.”

Transition period. To accommodate smaller banks, the final rule provides a “significant” transition period with smaller banks having to meet the requirements beginning in January 2015. On the other hand, the phase-in period for larger institutions begins in January 2014.

SLHCs. Savings and loan holding companies with significant commercial or insurance underwriting activities will not be subject to the final rule due to their unique business models and accounting requirements. The Fed expects to take additional time to evaluate the appropriate regulatory capital framework for these entities.

The future. Although Governor Tarullo noted that “the rule we adopt today will mark the end of major modifications we plan to capital rules,” he added, “With respect to larger banking organizations, we have a number of capital-related initiatives remaining.” Full stress testing requirements and capital plan reviews will be extended to a dozen or so banking organizations with greater than $50 billion in assets that have not been fully covered in the exercises that the Fed has undertaken since 2009. Also, there are four rulemakings, in various stages of development, which will enhance capital requirements for the eight U.S. banking organizations already identified as of global systemic importance.

He noted that the Fed is “very close” to completing a notice of proposed rulemaking that will establish a leverage ratio threshold for these firms above the Basel III required minimum. A second notice of proposed rulemaking would address the combined amount of equity and long-term debt that these eight firms should maintain in order to facilitate orderly resolution in appropriate circumstances. A third notice of proposed rulemaking would be issued once the Basel Committee has completed final methodological refinements to its framework for capital surcharges on banking organizations of global systemic importance. The final regulatory action, currently being worked on by the Fed’s staff, would seek comment on possible approaches to requiring additional measures that would directly address risks related to short-term wholesale funding, including a requirement that large firms substantially dependent on such funding hold additional capital.

Industry reaction. A number of groups issued reactions to the final rule. The American Bankers Association noted, “Today’s rule is the latest—but not the final—step in an ongoing process to find the optimal capital regime for the U.S. economy. During Basel III’s implementation period, the door is open for regulators to make the necessary adjustments to ensure the rule works for banks of all sizes and doesn’t impede economic growth.” The ABA also stated its support for legislation that would require a comprehensive economic analysis of the rule’s impact—particularly for community, mid-size and regional banks—before it goes into effect.

Richard Hunt, president and chief executive officer of the Consumer Bankers Association, stated, “CBA is pleased the Fed addressed our concerns regarding the complex residential mortgage risk-weighing calculations in their original proposal. In today’s economic environment, staying with current capital requirements for mortgages will help ensure consumers have access to affordable home loans and home equity products. CBA will continue to monitor regulatory developments to ensure further rulemaking proposals will not impede our member banks’ ability to serve their communities.”

John W. Ryan, president and chief executive officer of the Conference of State Bank Supervisors, added, “While the framework approved today significantly reduces the complexity and the number of issues banks need to address, the rule still represents a significant change and burden for the industry. The extended implementation period will be needed by the industry as they continue to recover from the financial crisis and adjust to the new rules.”

The Independent Community Bankers Association stated, “ICBA appreciates that regulators scaled back some of the most harmful provisions of the Basel III rules that we opposed. Allowing banks with less than $250 billion in assets to opt out of including accumulated other comprehensive income (AOCI) as part of regulatory capital, allowing banks to continue using the Basel I risk weights for residential mortgages, and allowing bank holding companies with assets under $15 billion to continue treating the proceeds of trust-preferred securities as Tier 1 capital consistent with the Collins Amendment of the Dodd-Frank Act will help preserve the community bank lending model.” The ICBA, however, was “disappointed that regulators did not grant an outright exemption from the Basel III capital standards to all financial institutions with consolidated assets of $50 billion or less, as advocated by ICBA. The new capital conservation buffer and the new threshold limits on mortgage-servicing rights are examples of the obstacles that community banks will face with the new requirements.”

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