Changes are in the air for banks, according to some new rules adopted by the U.S. Federal Reserve yesterday. Now, under the Dodd-Frank comprehensive banking reform laws, banks will need to hold more capital in order to buffer against loans made and risky assets purchased.
This is, of course, the inverse of what happened during the great American bailout a few years back. Banks found they simply did not have enough capital to absorb the losses made due to their risky behavior, and the U.S. government ended up having to haul them out to safety. “Too big to fail,” and all that.
The new rules, surprisingly, cover mortgages and related bonds in much the same way as was done before the crash. An early Fed proposal linked risk to the size of a borrower’s down payment and called for banks to hold even more capital. However, complaints arose, claiming that this would hurt mortgage lending (and thus retard the ongoing recovery in the domestic housing sector).
So, despite things being mostly the same for mortgage lending now as before, banks will still need to hold more capital as a buffer. Collectively, this means banks need to raise another $4.5 billion in capital by early 2015, which is when the new rules take effect (per CNN).
Thus far, it is unclear which banks specifically will need to raise this extra capital. But if you consider that some 95 percent of all the banks in the U.S. with more than $10 billion in assets already command enough capital on board to meet the new requirements, the picture becomes a bit clearer. Even Citigroup (NYSE: C), the smallest of the “big four” banks, has $1.3 trillion in assets.
One notable (and welcome) change mandated by the new rules focuses on derivatives. If you recall, derivatives were among the financial instruments most criticized for their key function in the big meltdown back in 2008.
The new rules include a supplementary capital requirement that would be a test of sorts to evaluate how much capital banks can put up against all their assets, derivatives included. This includes credit default swaps and other bond contracts. U.S. banks conventionally exclude these from their capital calculations.
Under the new rules, banks would need to possess enough capital to buffer against a drop in their collective assets up to 3 percent. This brings U.S. banking rules in line with the Basel III requirements proposed internationally some years back.
Overall, the new rules not only follow the Basel regulations more closely; Bloomberg reports they also double the minimum ratio for capital and assets and deem derivatives and mortgage-based securities as much riskier than before.
Bloomberg quotes Ben Bernanke on the new rules:
“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,” Fed Chairman Ben S. Bernanke said in prepared remarks. “Banking organizations will be better able to withstand periods of financial stress, thus contributing to the overall health of the U.S. economy.”
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Certain parts of the new rules—like the non-risk-based leverage threshold—will concern only the biggest U.S. institutions. This is because smaller community banks don’t really have the capital heft necessary to pose a serious threat in the event of a systemic meltdown.
Previously, U.S. regulators attempted to include these smaller banks under the new Basel rules but faced stiff criticism on precisely the point just mentioned. Accordingly, the new revised version permits all but the biggest banks to opt out of the responsibility to take capital charges in response to market fluctuations for their assets.
Moreover, mortgage risk calculation will now be much more simplified. These are critical points, since these smaller banks comprise as much as 90 percent or slightly more of all U.S. lenders.
Banks holding below $15 billion in assets will continue to hold hybrid securities that the new regulations do not consider capital, while most banks holding below $10 billion in assets already comply with the new rules. Those that do not will need about $2 billion extra.
All this aside, the Fed is also apparently considering further capital restrictions for banks relying “too heavily” on short-term public debt, reports CNBC.
All of this is good news for the banking sector in general, as it represents some much-needed overhaul of the banking sector.
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