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Banking

Introduction | Spotlight: Banker Outreach | Spotlight: Basel III | State of the District | National Banking Trends


Spotlight: Basel III

The New Face of Bank Capital
For more than a year, speculation has built over whether the United States would adopt the new international framework known as Basel III. When the last capital framework, Basel II, was developed, the United States adopted only a portion of it and required only the largest banks to use the framework. Finally, the speculation ended on June 7, 2012, when the Federal Reserve published three notices of proposed rulemaking (NPR) to revise the risk-based capital rules for banks to make them more consistent with the new Basel III requirements as well as certain requirements of the Dodd-Frank Act.

To the surprise of many, the new rules will apply to all state and national commercial banks, bank holding companies with assets above $500 million, and all savings and loan holding companies regardless of size. Each NPR deals with a different element of Basel III, broken down among capital requirements, the standardized approach, and the advanced approach.

Once fully implemented, the proposed rules would replace the existing capital requirements and would generally require banks to hold more capital than under the current capital guidelines (see the chart). The proposed new rules would be phased in from January 1, 2013, to January 1, 2018, and would not be fully implemented until January 1, 2022.

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Capital requirements
The first of the three new NPRs addresses the capital ratio's numerator and focuses on implementing the revisions to the capital requirements under Basel III. The capital proposal includes a more restrictive definition of regulatory capital, higher minimum regulatory capital requirements, and additional capital buffers, designed to enhance banks' ability to absorb losses during periods of economic stress.

The proposal introduces a new capital ratio, common equity tier 1 (CET1). The reason for the new ratio is to increase the quantity and quality of capital required. The new ratio would require a minimum of 4.5 percent CET1. The level of tier 1 capital would be raised from 4 percent to 6 percent. The total risk-based capital and tier 1 leverage ratios would remain the same (8 percent and 4 percent, respectively); however, the proposal would remove the lower leverage ratio exception for institutions with a composite rating of 1, which allowed a minimum ratio of 3 percent rather than 4 percent for all other banks.

In addition to the current leverage ratio, starting in 2015 the proposal includes a new supplemental leverage ratio that incorporates certain off-balance-sheet assets. The new supplemental leverage ratio would apply only to banks required to use the advanced approach (about which, more below). Initially, the new supplemental leverage ratio would be evaluated through a parallel run that extends through 2018, at which time a final decision about its use would be determined. Regarding the introduction of new buffers, CET1 would have a capital conservation buffer of 2.5 percent. Failure to maintain the 2.5 percent buffer would result in limits being placed on a bank's capital distributions, including dividend payments, discretionary bonus payments, and share buybacks (see the table). The level of restrictions would increase inversely with the level of declines in capital conservation buffers. The countercyclical buffer would act as an extension of the capital conservation buffer and would apply only to the institutions required to use the advanced approach. It would initially be set at 0 percent, and the banking agencies would adjust it based on market conditions.

As a result of the changes being made to the required capital levels, the proposal includes revisions to the banking agencies' prompt corrective action (PCA) rules to incorporate the proposed revisions to the minimum regulatory capital ratios.

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Standardized approach
Currently, the majority of banks use a standardized approach to calculate risk-weighted assets (the capital ratio's denominator), using basically four risk weights. The second NPR would make changes to that approach. The proposal aims to enhance the risk sensitivity of the standardized approach by revising the current methodology to calculate risk-weighted assets to incorporate elements contained in the Basel II framework published in 2009.

Compared with current methodology, this proposed standardized approach would include a greater number of risk-weight categories for purposes of calculating total risk-weighted assets. In addition, it provides for greater recognition of financial collateral and permits a wider range of eligible guarantors. This proposed approach should provide a more favorable capital treatment for derivatives. As part of the standardized approach proposal, calculation of risk-weighted assets would use alternative standards to determine creditworthiness—as opposed to credit ratings—for sovereign, public sector, bank, and securitization exposures as required under the Dodd-Frank Act.

The alternative standards include a country risk classification established by the Organisation for Economic Co-Operation and Development (OECD); seniority of securitizations; and leverage, cash flow, and stock volatility over a 12-month period for public debt. These alternative standards would be used to assign risk weights to several categories of exposures. The standardized approach NPR would require banking organizations to implement the revisions contained in that NPR on January 1, 2015; however, the proposal would also allow banking organizations to adopt early the standardized approach revisions.

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Advanced approach
The advanced approach, the subject of the third NPR, was originally developed as the denominator in the capital ratio for banks subject to Basel II. In the United States, only a limited number of banks—typically institutions with consolidated total assets of at least $250 billion or consolidated total on-balance sheet foreign exposures of at least $10 billion—were required to adopt the advanced approach to risk-weighted assets. Under the third proposal, those banks would still be required to use the advanced approach.

In addition, the Board proposes to apply the advanced approach to savings and loan holding companies. Although many requirements for the advanced approach would remain the same, the new proposal would amend the requirements to incorporate changes contained in the Basel II 2009 enhancements and the new Basel III. The more significant revisions include treatment of counterparty credit risk, computing risk-weighted assets for securitization exposures, and risk weights for exposures to central counterparties. Under the revised advanced approach, banks would be required to conduct more rigorous credit analyses of their securitizations and increase their disclosure requirements.

As in the standardized approach proposal, the agencies also are proposing to remove references to credit ratings from certain defined terms under the advanced approaches rules and replace them with alternative standards of creditworthiness as required by Dodd-Frank. Also in accordance with Dodd-Frank, the amended advanced approach would no longer allow a ratings-based approach or internal assessment approach to determine securitization ratings. Instead, a simplified supervisory formula approach would be used as a methodology to calculate risk-weighted assets for securitization exposures.

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Implications
The proposed capital requirements contained in the NPRs could have a significant impact on Sixth District institutions, given their traditional reliance on real estate loans. However, most provisions that will have the greatest impact on a large number of banks will be phased in over a few years, with the risk-weighted asset changes effective January 1, 2015. Some other significant provisions are subject to phase-in periods that generally begin in either 2014 or 2016 and end in 2019.

At a community bank level, banks would have a reduced ability to leverage capital, thereby reducing shareholder rates of return. Most of the changes relate to the capital treatment of residential and commercial real estate as well as loan performance. Regarding residential real estate, the proposed rules would vary the amount of capital that banks must hold against residential mortgage loans based on loan-to-value ratios and compliance with regulatory underwriting criteria (see the table).

Contained within the proposal is a new rule that could cause all residential mortgages to be risk-weighted at a minimum of 100 percent, which may cause the cost of mortgages to homeowners to increase. Certain commercial real estate exposures, defined as high-volatility commercial real estate exposure (HVCRE), which currently receive a 100 percent risk weighting under the current capital rules would be assigned a higher 150 percent risk weighting. This assignment could cause banks to increase the fees and interest rates on the loans. A commercial real estate loan that is not an HVCRE exposure would be treated as a corporate exposure. Also, for the first time, a loan's performance would have a greater impact on capital. Loans that are nonperforming or more than 90 days past due will now be risk-weighted at 150 percent.

In addition, changes in these far-reaching proposals affect the capital treatment of accumulated other comprehensive income (AOCI), mortgage-backed securities, and mortgage servicing rights (MSR) assets held by banks. One of the most significant changes made in the proposal is the removal of the existing filter for unrealized gains and losses accumulated from available for-sale securities recorded AOCI from regulatory capital measurements. The change could inject much volatility into the capital calculation each quarter. As the market fluctuates, so could capital levels at banks. It could be difficult for banks to keep capital right at the minimal level, because a change in the market could bring it below the minimum standard.

The proposed rules would also impose significant restrictions on the inclusion of MSR in capital. MSRs that exceed 10 percent would have to be deducted from tangible common equity. Community banks have already started commenting on this proposed change. At a time when larger institutions have been criticized for the way they handle mortgage servicing, the new capital limitations could be a factor for community banks in determining whether to engage in mortgage servicing. One possible outcome is that community banks could cease servicing the mortgages they originate, meaning that mortgage holders would make payments to and deal with a third party. Such an arrangement could place further distance between community banks and their customers.

Finally, under the stricter interpretation of capital imposed by the proposals, the full amount of deferred tax assets arising from operating losses and credit carry-forwards will have to be deducted from CET1 beginning in 2013 and will gradually be deducted—at an additional 20 percent per year—from all risk-based capital by 2018. During the recent financial crisis, deferred tax assets (DTAs) became a larger part of troubled banks' capital base. However, the crisis showed that DTAs are useful only when the institution foresees making a profit once all carry-backs have been exhausted. Since profitability at some institutions was in question, the DTAs had to be written down, further weakening banks. The proposal removes any reliance on DTAs once the elimination is fully phased in by 2018.

This article was written by Robert Canova, a senior policy analyst in the Atlanta Fed's supervision and regulation division.

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