Despite Controversy, Implementation of U.S. Basel III Capital Regime Moves Forward

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In June 2012, the Board of Governors of the Federal Reserve System (the “Board”), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) issued proposed regulations that would establish a newer, more comprehensive capital framework for U.S. banking organizations by implementing the Basel III capital regime, as modified by U.S. legal requirements mandated by Congress in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Certain aspects of these rules met with strenuous objections from the banking industry. This was especially true with regard to application of Basel III standards to community banks. Furthermore, as recently as April of this year, legislation introduced with some fanfare by Senators Sherrod Brown (D-Ohio) and David Vitter (R-La.) calls into question the adequacy of Basel III as a response to the recent banking crisis, particularly as regards preventing undue concentration of large financial institutions that are “too big to fail.”

Notwithstanding the vociferousness of the critics, on July 2, 2013, the Federal Reserve promulgated final Basel III capital rules substantially unchanged from those proposed a year ago. The most stringent capital requirements for “advanced approaches banking organizations”—those with $250 billion or more in total consolidated assets or $10 billion or more in foreign exposures—were kept in the final rules. The only changes of note were those affecting community banks and other small banking organizations. The Board’s action was followed closely by adoption of Basel III rules by the OCC and the FDIC (as an interim final rule). The FDIC has also issued a notice of proposed rulemaking to strengthen the leverage capital ratio.

The U.S. version of Basel III will apply to:

  • All national banks, state member banks, and state nonmember banks
  • All federal and state savings associations
  • Bank holding companies other than those with less than $500 million in consolidated assets, provided they do not:

    - Engage in significant nonbank activities
    - Conduct significant off-balance sheet activities
    - Have a significant amount of SEC-registered debt or equity

  • Savings and loan holding companies (SLHCs), other than:

    - Grandfathered unitary SLHCs with more than half of their assets or revenues in commercial activities
    - SLHCs that are insurance underwriting companies or that have more than 25 percent of their assets in insurance underwriting subsidiaries

  • Any of the above that are subsidiaries of foreign banks

The Board’s Basel III release was approximately 1,000 pages long. In this alert and others to follow, we will cover the key aspects of the final rules, as well as the treatment of community banking organizations.

Even as U.S. regulators uncork their strong capital brew, events at the Bank for International Settlements have also been developing rapidly. At the same time that the Federal Reserve final rules were released, the Basel Committee on Bank Supervision (BCBS) updated its assessment methodology for global systemically important banks (G-SIBs) and issued disclosure requirements. To help banks and participating jurisdictions prepare for the implementation of the G-SIB framework, the BCBS intends to finalize and publish by November 2013 certain elements of the regime. This publication will occur one year in advance of timeline set out in 2011 to enable banks to calculate their scores and higher loss absorbency requirements using year-end 2012 data before the requirements come into effect based on year-end 2013 data.

On July 5, 2013, the BCBS published a set of proposals that would revise the prudential treatment of banks’ equity investments in funds. The proposal’s underlying principle is that banks should apply a look-through approach to identify the underlying assets whenever investing in schemes with underlying exposures such as investment funds. As a full look-through approach may not always be feasible, the BCBS proposes a staged approach based on different degrees of granularity of the look-through. The proposal’s risk weighting framework is designed to enable application of a consistent risk-sensitive capital framework providing incentives for improved risk management practices. Further, the proposal is designed to help address risks associated with banks’ interactions with shadow banking entities.

Finally, on July 19, 2013, the BCBS issued a consultative document on liquidity coverage ratio (LCR) disclosure standards. First introduced in January 2013, the LCR is intended to ensure that a bank has an adequate stock of unencumbered high-quality liquid assets that can be converted into cash easily and immediately in private markets to meet its liquidity needs for a 30 calendar day liquidity stress scenario. (The Federal Reserve has notably stolen the march on the BCBS in this regard for U.S. banking organizations and has already begun implementation of rigorous stress testing based on a variety of market conditions). The BCBS believes that it is important that banks adopt a common disclosure framework to help market participants consistently assess the liquidity risk position of banks. To promote consistency and ease of use of LCR-related disclosures, internationally active banks across Basel member jurisdictions will be required to publish their LCR according to a common template. Comments on this consultative document are due by October 14, 2013.

Nor is U.S Basel III regulation likely to remain static for long. When the Board unveiled its final rules, Governor Daniel K. Tarullo issued a statement in which he previewed a considerably more rigorous set of capital requirements for the eight U.S. G-SIBs (Bank of America, Bank of New York/Mellon, Citigroup, Goldman Sachs, J.P. Morgan/Chase, Morgan Stanley, State Street, and Wells Fargo). When added to the Basel III final rules and the Board’s stress testing requirements, these capital requirements could well have a major impact on the cost and availability of credit. We shall discuss these additional requirements if and when they are promulgated.