The broad supervisory standards and guidelines issued by the Basel Committee on Banking Supervision (‘the Committee’) have greatly influenced the manner in which Banks are organized in various jurisdictions. The Committee claims that the main culprit behind the current financial crisis is excessive leverage assumed by banks both on and off the balance sheet. The latest in the series of proposed changes propounded by the Committee is Basel III, which seeks to restructure banks like shock absorbers rather than transmitters of financial risk.
The Federal Reserve Bank (‘Federal Reserve’) has responded to Basel III by asking bank holding companies (‘BHCs’) to submit comprehensive capital plans over the next 24 months. It is noteworthy that BHCs are required to notify the Federal Reserve of any change in their capital structure under Section 224.5(b) of Regulation Y issued under section 5(b) of the Bank Holding Company Act of 1956. Basel III, which has been designed conservatively, creates a framework whereby banking companies are to maintain higher common equity ratios, institute tougher stress tests for liquidity, and enhance market discipline and disclosure, among other things. Furthermore, trading positions will be subject to more stringent review, as the Federal Reserve believes that such changes are in the spirit of financial reform initiated by the Dodd-Frank Act.
In February 2009, the Federal Reserve along with other federal agencies initiated a Capital Assessment Program. It is a forward-looking program “to evaluate [BHCs] with assets exceeding $100 billion under two economic scenarios: a baseline and a more adverse scenario.” May 2009 report discovered that 9 of the 10 eligible BHCs needed to raise capital or improve the quality of their capital to withstand a worse-than-expected economic scenario. This augmentation was completed by November 9, 2009 through reduced dividend payments, issuance of common shares to employee stock ownership plans, and larger-than-anticipated pre-provision net revenue. By March 2011, the Federal Reserve had completed another Comprehensive Capital Analysis and Review (‘CCAR’) of the 19 largest BHCs. As a result of the CCAR, some firms are expected to increase or restart dividend payments, buy back shares, or repay government capital. Interestingly, the current round of CCAR is being undertaken with adjustments made to incorporate potential sharp market price movements in European sovereign debt and financial sectors.
However this conservative attitude towards capital does not please BHCs. In a slow market, when a company’s stock is underperforming, share repurchases or buy-backs provide an inorganic route to increasing earnings per share and returns on investment for shareholders.
The implementation of Basel III norms shall highlight the reforms in the banking sector for the coming decade. Federal Reserve Board Governor Daniel K. Tarullo in his testimony to the Committee on Financial Services made a very pertinent observation that merely enhancing the quantity and quality of capital requirements would not suffice. The Basel Committee should target effective cross-jurisdiction monitoring of banks and create a regime for systemically important financial institutions.