In trying to implement a provision of the Dodd-Frank Act, regulators have proposed a rule that would, if adopted, put large U.S. banks at a competitive disadvantage with foreign institutions. By requiring an approach to capital that is not risk-based, the rule would also make it unaffordable in the long run for large U.S. banks to hold low-risk credit assets in their banking book. The rate of return on their capital investment would simply be too low.
The Dodd-Frank Act contains two provisions dealing with regulatory capital minimums — Sections 165 and 171. They are intended to reduce the chances of another capital crisis.
Section 171 calls for capital requirements for the large banks that are no less than for the general banking population. Section 165 is more specific, calling for large bank holding companies and systemically important nonbanks to have higher capital requirements than smaller banks.
In crafting a notice of proposed rulemaking that deals only with Section 171, the regulators were naturally focusing on what to do about what we call Basel III banks — the ones that will become subject to the complex, risk-based capital rules established on a global basis.
A simple way to do that would have been to have the large institutions calculate capital ratios (capital divided by risk-weighted assets) each of two ways, under Basel I (as it evolves in the U.S.) and under Basel III (as forthcoming in the U.S.). The bank would then have to make sure that the Basel I ratios continue to meet the Basel I minimum capital requirements as they evolve over time, while the separate Basel III calculations meet the new, dramatically higher Basel III capital ratio requirements.
Instead, the NPR requires the large banks to calculate their capital to RWA ratios using the two differing methodologies (Basel I and Basel III) for calculating RWA. Then the large bank would have to substitute the harsher of the Basel I and Basel III outcomes for RWA to meet the much higher Basel III capital ratio minimums.
An important underlying detail not mentioned within the NPR is that the U.S. agencies are instituting dramatic new increases to the trading account capital requirements for all U.S. banks. These changes will make trading account capital charges roughly equal between the U.S. and the rest of the Basel countries.
But while the trading account will be treated roughly the same for large and small banks, and between the U.S. and foreign banks, the banking book would not. Past studies conducted by the agencies show that RWA in the banking book under Basel I for the large banks are generally somewhat higher than RWA under Basel III, because large banks hold more low-risk or fully collateralized credits in their banking book than they do high-risk assets. This point is key.
The NPR, therefore, has two potentially harmful and unintended effects for large U.S. banks. First, large U.S banks would face strong disincentives to continue to hold largely sound, low-risk positions in their banking books.
Yields on credit assets are determined by the marketplace not by regulation — and the large U.S. banks simply could not afford over the long run to hold low-risk credit assets if the rate of return on capital is set too low by an inappropriately high capital requirement. For example, a fully collateralized commercial loan under Basel I still receives a 100% risk weight, while under Basel III its risk weight might be substantially less than 100%. The Risk Management Association has long advocated that a risk-based approach to capital is necessary because it promotes sound risk management.
Second, large U.S. banks would have to hold more capital than large foreign banks under Basel III, as a result of the U.S. banks holding capital for the banking book that is not risk-based. Is there a social benefit of such a policy that can offset its obvious competitive inequity?
Consider two banks, one U.S. and one foreign, both with the same asset size, exactly the same trading account positions, and the same Tier 1 capital.
But domestic Bank A holds substantially safer assets in its banking book than does the foreign Bank B. The U.S. bank would be penalized by having to hold higher capital than the foreign bank, even though the U.S. bank is more sound.
We respectfully ask that the agencies reconsider the NPR in order to minimize the unintended consequences described above. Our view is that the agencies should require U.S. banks with advanced approaches to use Basel I calculations to meet the general capital ratio minimums as these minimums move higher, while the separate Basel III calculations would be used to meet the still-higher requirements of the advanced approaches' capital minimums.
Before the crisis, capital ratios were simply too low, the quality of capital was insufficient and the industry and its regulators did not fully appreciate the risks — particularly systemic risks posed by large financial institutions. We all want to make it less likely that we find ourselves in that situation again.
