The financial crisis generated concern that banks were taking excessive risks and they did not have adequate capital to run their operations. It was not clear if the existing Basel framework demonstrated weakness to contain the crisis or if it was the framework that led to the liquidity crisis and ultimately to the financial crisis. The U.S. government, through the Federal Reserve used funds under TARP to inject liquidity in the financial system. Even today the printing of money (quantitative easing) is going unabated to prop up the economy. Given this background, the regulation of banks has become increasingly important. Under the new Basel III requirements, U.S. regulators are requiring stronger leverage ratios for major U.S. banks. This would restrict banks to limit their borrowing and force them to fund their operations through equity.
Leverage allows banks to issue more loans and act as parties for other types of financial transactions such as insurance, reinsurance, swaps, and the like. Pure banking is a lending business, however, other derivative related transactions are not. The new rules would require a percentage of total assets as opposed to earlier risk-weighted assets, which are subject to various interpretations. The eight largest U.S. banks including JP Morgan Chase, Citigroup, Bank of America, Wells Fargo, Goldman Sachs, Morgan Stanley, Bank of New York Mellon, and State Street will have to hold capital equal to 6 percent of their total assets. Other bank holding companies will have to meet a 5 percent ratio. The ratios are higher than the 3 percent minimum required by the global Basel agreement. However, smaller U.S. banks would be held to the 3 percent ratio. The new regulations will make banks re-evaluate whether derivative transactions are worth the risk.
Securitization is another area of banking that is currently undergoing changes. Banks’ off-balance sheet transactions were not regulated before Basel III. Under the Dodd-Frank Act, use of a ratings-based approach for assigning risk-based capital requirements to securitization exposures is replaced with a simplified supervisory formula approach (the “SSFA”) which requires new due diligence and calculating risk-based capital requirements as guided by the economic substance of a transaction rather than its legal form. The affected instruments include loans, mortgage-backed securities, asset-backed securities, credit-enhancing representations and warranties provided tranching is required. The obligation will not be treated as securitization exposure if no tranching is required for the underlying credit risk. A 20% floor has been established as the minimum for risk weight for any securitization regardless of the underlying credit risk.
Another important aspect of the changes to the Basel framework is Pillar 3 disclosure requirements. Banks should have a formal disclosure policy approved by the board of directors. The disclosure should be timely and should accurately reflect bank’s financial condition. Pursuant to the disclosure requirements, three broad areas are covered: capital, risk exposure, and capital adequacy.
On March 15, 2013, the Basel III Capital Impact Study Act was referred to the House Committee on Financial Services to study the cumulative effect of certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act to determine regulatory ratios and risk-weighted asset requirements before a final ruling is issued by the federal banking agencies. According to an estimate, the eight major U.S. banks will have to raise about $68 billion in order to meet all the new requirements.
There are other areas which require some regulation to deal with the “too big to fail” risk. There is an on-going debate on the liquidity standard and significant financial institutions surcharge. The liquidity standard would require banks to hold enough capital for at least one month in a period of stress without government support. The financial surcharge will be another buffer for systematically important banks; it is expected that it will range between 1 to 2.5 percent. There are also other guidelines pending for banks’ derivative related transactions.
Overall, banks need to be more transparent and they have to identify and manage their risks properly. A stable and transparent financial system will offer a strong backbone to the economy for sustained growth. The new rules along with the recent proposed regulatory changes are a welcome step towards a stable financial system and a better economy.