The Federal Reserve approved new rules last week to implementglobal Basel III capital-adequacy standards and applied thoserequirements to virtually all U.S. financial institutions. The movemay make providing services to middle-market corporate clientsprohibitively expensive for banks.

Other U.S. banking regulators are expected to follow the Fed'slead and approve similar rules soon. Ultimately, brokers and othernonbank entities are expected to be subject to similarstandards.

The Fed rules, which will be fully in effect by 2019, requirefinancial institutions to hold common equity equal to 4.5% of theirrisk-weighted assets and an additional 2.5% buffer, for a totalequity cushion of 7%. That compares with a current standard thatcan be as low as 2%. The largest institutions will be tagged with acapital surcharge between 1% and 2.5%.

The Fed's new capital requirements are no surprise for largerregional and national banks. But the Fed's rule also applies tosmaller banks, which were expected to be exempt from the newcapital rules.

Basel III capital requirements will affect most bankingproducts, and especially those regulators deem riskier, includingsecuritizations, letters of credit and over-the-counter financialproducts such as swaps. And while corporate end users of swaps havebeen lobbying regulators and legislators to ensure their exemptionfrom margin rules that regulators have suggested they may imposethrough their banking counterparties, the capital requirements mayoffset those efforts.

Tom Deas, treasurer and vice president at FMC Corp. and chairmanof the National Association of Corporate Treasurers (NACT), notesthat even if end users successfully avoid margin requirements,higher capital requirements for banks will push that cost throughto customers.

“It will make buying financial protection through thesederivatives too expensive, so some companies may end up retainingthe risk,” Deas says.

That will be especially true for lower-rated companies, sincetheir banks will have to hold more capital against their riskier,and hence higher risk-weighted, assets.

Smaller banks did get a break in April whenregulators raised the proposed threshold to be considered a swapdealer under the Dodd-Frank Act to $8 billion notional value ofswaps generated annually, from $100 million. Now, banks under thethreshold will escape many burdensome regulations, but they'llreceive no breaks on capital requirements.

“If you're weaker credit that's used to getting swaps from aregional bank, the bank may conclude that even though it won't betagged as a swap dealer and face those regulations, the new capitalrequirements make the swap business no longer attractive,” Deassays. “So that could have a dramatic impact for the middle-marketcorporate world in terms of hedging.”

Jiro Okochi, CEO and co-founder of Reval, says the new capitalstandards could further concentrate risk in the largest banks,contrary to regulators' intent. The Fed's applying the standards toall banks—and likely also nonbank financial companies–echoesrecommendations set out in a report published earlier last week bythe International Organization of Securities Organizations (IOSCO),Okochi notes. It recommends applying “capital or other financialresources requirements” to all derivative market intermediaries,whether banks or nonbanks.

“The philosophy is aiming for as much [regulatory] convergenceas possible, so there are no major gaps that could createregulatory arbitrage opportunities,” he says.

Luke Zubrod, a director at Chatham Financial, said his firmagrees with IOSCO's recommendation that capital standards reflectthe risks intermediaries undertake. However, he contends BaselIII's capital standards far outweigh the risk they are intended tomitigate.

“Of the $2.1 trillion in losses financial institutions worldwidesuffered during the credit crisis, only 3.6% stemmed fromderivatives, and more than half of that was from AIG'smortgage-related credit default swaps,” Zubrod says, adding thatmost losses came from loans.

For another recent look at the new capital requirements,see BaselIII: Next Steps.

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