The Federal Reserve approved new rules last week to implement global Basel III capital-adequacy standards and applied those requirements to virtually all U.S. financial institutions. The move may make providing services to middle-market corporate clients prohibitively expensive for banks.
Other U.S. banking regulators are expected to follow the Fed’s lead and approve similar rules soon. Ultimately, brokers and other nonbank entities are expected to be subject to similar standards.
The Fed rules, which will be fully in effect by 2019, require financial institutions to hold common equity equal to 4.5% of their risk-weighted assets and an additional 2.5% buffer, for a total equity cushion of 7%. That compares with a current standard that can be as low as 2%. The largest institutions will be tagged with a capital surcharge between 1% and 2.5%.
The Fed’s new capital requirements are no surprise for larger regional and national banks. But the Fed’s rule also applies to smaller banks, which were expected to be exempt from the new capital rules.
Basel III capital requirements will affect most banking products, and especially those regulators deem riskier, including securitizations, letters of credit and over-the-counter financial products such as swaps. And while corporate end users of swaps have been lobbying regulators and legislators to ensure their exemption from margin rules that regulators have suggested they may impose through their banking counterparties, the capital requirements may offset those efforts.
Tom Deas, treasurer and vice president at FMC Corp. and chairman of the National Association of Corporate Treasurers (NACT), notes that even if end users successfully avoid margin requirements, higher capital requirements for banks will push that cost through to customers.
“It will make buying financial protection through these derivatives too expensive, so some companies may end up retaining the risk,” Deas says.
That will be especially true for lower-rated companies, since their banks will have to hold more capital against their riskier, and hence higher risk-weighted, assets.
Smaller banks did get a break in April when regulators raised the proposed threshold to be considered a swap dealer under the Dodd-Frank Act to $8 billion notional value of swaps generated annually, from $100 million. Now, banks under the threshold will escape many burdensome regulations, but they’ll receive no breaks on capital requirements.
“If you’re weaker credit that’s used to getting swaps from a regional bank, the bank may conclude that even though it won’t be tagged as a swap dealer and face those regulations, the new capital requirements make the swap business no longer attractive,” Deas says. “So that could have a dramatic impact for the middle-market corporate world in terms of hedging.”
Jiro Okochi, CEO and co-founder of Reval, says the new capital standards could further concentrate risk in the largest banks, contrary to regulators’ intent. The Fed’s applying the standards to all banks—and likely also nonbank financial companies--echoes recommendations set out in a report published earlier last week by the International Organization of Securities Organizations (IOSCO), Okochi notes. It recommends applying “capital or other financial resources requirements” to all derivative market intermediaries, whether banks or nonbanks.
“The philosophy is aiming for as much [regulatory] convergence as possible, so there are no major gaps that could create regulatory arbitrage opportunities,” he says.
Luke Zubrod, a director at Chatham Financial, said his firm agrees with IOSCO’s recommendation that capital standards reflect the risks intermediaries undertake. However, he contends Basel III’s capital standards far outweigh the risk they are intended to mitigate.
“Of the $2.1 trillion in losses financial institutions worldwide suffered during the credit crisis, only 3.6% stemmed from derivatives, and more than half of that was from AIG’s mortgage-related credit default swaps,” Zubrod says, adding that most losses came from loans.
For another recent look at the new capital requirements, see Basel III: Next Steps.