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AmericasSeptember 24 2012

‘American finish’ to Basel takes the shine off smaller banks

US regulators have extended the consultation over their proposed rules to implement the international Basel III capital requirements, as implementation fears mount up for smaller banks.
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What is happening?

The US Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC) published a notice of proposed rule-making for consultation in June 2012, setting out how Basel III capital requirements will be applied to American banks. The deadline for responses was originally in early September, but this has been extended to 22 October 2012. The proposed date for bringing the new rules into effect is January 2015.

What are the main provisions?

There are three main proposals. One proposal defines capital, effectively setting the numerator for calculating the capital adequacy ratio. The two other proposals apply to the denominator of the ratio. An 'Advanced Approach' for calculating risk-weighted assets would apply to the largest financial institutions, in line with Basel. A 'Standardised Approach' proposal would apply to all banks with consolidated assets of more than $500m.

Basel III with American spelling?

Not quite. The US authorities have grasped the nettle in a bid to weed out reliance on credit ratings agencies for regulatory purposes, so the risk-weighting of assets under the standardised approach excludes the use of these agencies altogether. The authorities have set a scale of capital deductions against various types of asset, while sovereign and foreign bank exposures would be deducted using the export credit country risk ratings of the multilateral Organisation for Economic Co-operation and Development. The weighting rules for mortgages will assign higher risk to certain structures, such as balloon payment or adjustable rate mortgages.

“If this is intended to capture existing balance sheet risks rather than influence underwriting behaviour, then it makes sense to grandfather existing mortgages that are well seasoned and therefore lower risk,” says Hugh Carney, senior counsel at the American Bankers Association.

In addition, the provisions go beyond Basel III in defining Tier 1 capital. Mortgage servicing rights must for the first time be deducted from Tier 1 capital, if they exceed 10% of a bank’s total Tier 1.

“Mortgage servicing rights are not a significant factor in European bank balance sheets, so there may have been little discussion of them on the Basel committee. But that would also mitigate in favour of greater national discretion to meet the specific needs of the US market structure,” says Anna Pinedo, a banking and securities law partner at Morrison & Foerster.

RageometerOCT

The definition of additional (non-core) Tier 1 is also tougher than under Basel. To qualify, capital instruments must be booked as equity for accounting purposes. But Ms Pinedo says this threatens to eliminate many hybrid instruments that are booked as bonds for tax purposes, creating uncertainty about the future of the hybrid market in the US.

What do the banks say?

The central concern among banks is the decision to apply the risk-weighting process so far down the scale that it will capture many small community banks that have not had to comply with Basel II. Mr Carney says that without mortgage grandfathering provisions and a long transition period, many of the smallest banks may struggle to cope.

“Many community banks will face challenges gathering data and assembling the technology to calculate risk weights on books of mortgages that go back up to 30 years. And if their capital requirements rise, they have little access to capital markets, so they will have to raise money from retained earnings, which is not easy in a super-low interest rate environment,” he says.

That means cutting loan books to maintain their capital ratio. Mr Carney says he has met managers of community banks that operate the only branch in a town of 2000 people, so their customers may be forced to travel out of town to maintain their access to bank credit. He believes there is already some evidence of smaller banks beginning to dampen new lending or stepping away from mortgage servicing business.

How will regulators respond?

Mr Carney says the regulators, especially the FDIC, have launched an unprecedented outreach campaign among smaller banks. In addition, they are providing banks with a risk-based capital calculator tool designed to simplify compliance. He is hopeful that this engagement, together with the decision to extend the consultation period, are signs of flexibility from the regulators.

Barbara Matthews, an independent regulatory consultant who was previously US Treasury attaché to the EU, says the standard practice among regulators is not to implement significant new rules that may have an economic impact less than six weeks before a presidential election. That means the final package may well wait until after the next administration takes office. But she cautions against expecting too much flexibility on the minimum size threshold.

“The Federal Reserve spent a decade arguing that it was not appropriate to apply Basel to smaller banks. Having only just reversed that stance, the Fed is very unlikely to change course again any time soon,” she says.

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