The Federal Reserve has approved rules that revise the regulatory capital framework for U.S. banks in accordance with the Basel III international accord and to satisfy related mandates of the Dodd-Frank Act.
The rules, approved by the Fed at a meeting of its governors on Tuesday morning, are tied to a global effort, developed by the Basel Committee on Banking Supervision, to increase the quantity and quality of bank capital. The intent is to enable institutions to weather losses without the systematic problems that belied the financial crisis.
Minimum requirements will increase for both the quantity and quality of capital held by banking organizations. The rules includes 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 that will apply to all supervised financial institutions. The 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.
For the largest, most internationally active banking organizations, there is a new minimum supplementary leverage ratio that takes into account off-balance sheet exposures. Common equity tier 1 capital is emphasized as “the most loss-absorbing form of capital,” and the final rule improves the methodology for calculating risk-weighted assets to enhance risk sensitivity. Banks and regulators use risk weighting to assign different levels of risk to various classes of assets, with riskier assets requiring higher capital cushions.
The new requirements affect nearly the entire U.S. banking sector, including community and regional banks, the largest Wall Street institutions, U.S. bank subsidiaries, holding companies of foreign banks, international banking groups, and, to the extent they are deemed as systematically important (a designation made by the Financial Stability Oversight Council), certain non-bank institutions.
A key concern the Fed sought to address in its final rules was how Basel III would affect community and regional banks. Prior to Tuesday's vote, Federal Reserve Governor Elizabeth Duke said more than 2,600 comments were received on the proposal, with the majority coming from community banking organizations. The new rules include changes from the original proposal intended to reflect those concerns. For example, the final rule is significantly different from the proposal in terms of risk weighting for residential mortgages and the regulatory capital treatment of certain unrealized gains and losses and trust preferred securities for community banking organizations.
In total, for community banks, the changes from current regulations target a few areas that are higher risk, but are otherwise minimal, a statement issued by the Federal Reserve. Nine out of 10 financial institutions with less than $10 billion in assets would meet the common equity tier 1 minimum and buffer of 7 percent in the final rule, according to data from March 2013.
In light of concerns about the burden of calculating the proposed risk weights for banking organizations' existing residential mortgage portfolios, the final rule retains the current risk weights for residential mortgage loans.
Community banks will also have “a significant transition period” to meet the new requirements. The phase-in period for smaller, less complex banking organizations will not begin until January 2015. The phase-in period for larger institutions begins in January 2014.
Changes, as they affect community banks, are detailed in a one-page document issued by the Fed.
The final rule, for all banks, prohibits discretionary bonus payments if the organization does not hold the specified amount of common equity tier 1 capital in addition to what is necessary to meet its minimum risk-based capital requirements.
In another change from the proposal, savings and loan holding companies with significant commercial or insurance underwriting activities will not be subject to the final rule at this time. The Federal Reserve will evaluate the appropriate regulatory capital framework for these entities in the near future.
Beyond Basel III's capital requirements, the Fed's final rules also implement some provisions in the Dodd-Frank Act, including a ban on references to credit ratings in federal regulations.
Twenty-seven nations have agreed to implement rules crafted over the course of more than two years as part of the Basel III effort spearheaded by the Bank for International Settlements in Basel, Switzerland.
“Adoption of these rules means that we will have met international expectations for U.S. implementation of the Basel III capital framework,” said Governor Daniel Tarullo. “This gives us a firm position from which to press our expectations that other countries implement Basel III fully and faithfully, thereby promoting global financial stability."
A full breakdown of the changes implemented by the Fed's final rule can be found here.