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Basel III and Capital Adequacy: Are We Paying Enough Attention to Consequence Risks?
October 29, 2013

“Historically, banking crises are often followed by long periods of diminished lending and economic growth.” Page 24 of FIL-33-2013

As part of our ongoing R&D process to review and adjust our analytics systems as U.S. banking regulations evolve, we regularly read the Financial Information Letters (FIL’s) published by the FDIC. On July 9, 2013, the FDIC released three Financial Institution Letters on Capital Adequacy and Liquidity requirements for Basel III compliance requesting comments.

FIL-31-2013, “Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action; Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements”

FIL-32-2013, “Regulatory Capital Rules: Advanced Approaches Risk-Based Capital Rule and Market Risk Capital Rule”

FIL-33-2013, “Regulatory Capital Rules: Regulatory Capital, Enhanced Supplementary Leverage Ratio Standards for Certain Bank Holding Companies and their Subsidiary Insured Depository Institutions”

The message of these documents is the capital adequacy reserve ratio requirements are going up. The highlights are,

The U.S. regulators have decided that the way to implement Basel III is through the good old measure of Tier One Capital Leverage Ratio. It’s not a bad choice given the fact that the other ratios proposed by Basel III that use Risk Weighted Assets (RWA) as the denominator have come under criticism because every country computes RWA differently; and in some cases, questionably. T1 Leverage uses total balance sheet assets in the denominator, very simple, very easy.

As a special treat for the now “formerly too big to fail” banks, US regulators are looking at adding a supplemental ratio test based on combining on-balance sheet assets with off-balance sheet derivatives as a means to create more systemic protection against “domino” risk events from these post Glass-Steagall commercial/investment bank hybrids that start on the derivatives market maker desk and propagate into the main body of the institution.

The increases in T1 Leverage ratio under consideration are about what I expected based on past parametric analysis done to calibrate how to align this US measure were it to be driven by international concerns. The core number is Basel III’s 1.5 percent jump in Tangible Common Equity (TCE) ratio from the U.S. norm of 3 percent up to a 4.5 percent minimum. There is without a doubt a greater need to protect the sovereign preferred equity investment in banks overseas that drives the Basel III TCE ratio number.

The U.S. regulators are following suit despite the fact that the U.S. banking system is a privately financed system. Even Fannie Mae is on the verge of paying off its debt obligations. If one scales up T1 Leverage ratios in proportion to the Basel III increase in TCE to create the supplemental buffer for sovereign protection you get to the numbers U.S. regulators are proposing. I did this very parametric analysis earlier this year testing for how many banks would be negatively impacted by proportional increases in T1 Capital ratio after coming to the same conclusion that I could not rely on RWA based numbers in overseas bank Annual Reports to Shareholders or SEC Form 20-F or 40-F filings for running counterparty quality analytics on non-US banks for the international toolkit in the TBS Bank Monitor system. The nation specific RWA’s for Basel III compliance did not translate into cross border comparability in the spirit of the 2003 Basel II transparency framework. When the implied ratios are applied to US domestic banks, it doesn’t bode that well.

Table: Potential U.S. Bank Stress from Increases in Capital Adequacy Requirements
Tier 1 Capital Ratio Requirement Total number of banks that fail. Number of $1B to $10B that fail Number of over $10B banks that fail. Notes
5%11161Baseline “Well Capitalized”
1.2X = 5.8%18373
1.34X = 6.66%2681112
1.5X = 7.5%2924419Equates to TCE rise from 3% to 4.5% minima proposed by international parties to Basel III.
1.67X = 8.33%115212034
1.8X = 9.167%202420150
2X = 10%350633167
Source: FDIC/TBS Bank Monitor, data as of 2Q2013.

The table says a number of banks are going to need to engage in adjustment pain as we enter in to Basel III alignment. This imposed regulatory stress will come on top of asset side stresses from valuation write downs that are already besetting banks with stale book valuations on certain loan classes in their portfolios. We noted these in our October 22, 2013 article, “Reset Switch: Is the Can Coming to the End of the Road?” The confluence of all these factors is a tuffy. Referring back to that quote from page 24 of FIL-33-2013, there might not be a lot of lending going on to help whoever becomes President in 2016.

Remember that banks have three options when beset by capital adequacy stress. They can call on their sources of strength to write checks and bolster capital. They can shrink the bank, an option that means for all intents cutting back on lending because they don’t have the discretionary liabilities on their balance sheets to support previous levels of lending. Or they can grow the bank either organically – a slow and arduous option – or by acquisition – a path fraught with integration risks. None of these options make for happy bankers. The American Banking Association (ABA) also sees these consequence risks and has been calling for what they call a “stop and study” process before proceeding further. It might not be a bad recommendation to heed.

FDIC FIL’s are requests for technical comment responding to which a long missive ensues. But questions one and two deserve a little airing in the open I think. They ask, “How would proposed strengthening of the supplementary leverage ratio for covered BHCs and their subsidiary IDIs contribute to financial stability and thus economic growth?” and “Would the proposed strengthening of the leverage ratio mitigate public- policy concerns about the regulatory treatment of banking organizations that may pose risks to the broader economy?”

They may do neither. Perhaps we should be asking an even more fundamental question. Does this mathematical alignment of the US to Basel III’s buffering to set safety and soundness policies to protect sovereign capital overseas help or hurt the U.S. economic recovery? It is essential to the US’ national interests put them at even greater risk? That’s really the question to ask isn’t it? We must not forget that the impetus for the Dodd-Frank Act is that we don’t want a repeat of the 2008 debacle. Can we really afford to pull that much money out of the Main Street economic recovery money pool for the remainder of the decade? That may just be creating yet another avoidable debacle.


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