The Federal Reserve Board on Thursday proposed a substantial overhaul of risk-based capital rules for recourse agreements and similar tools used to sell securitized assets.
Under the plan, banks holding the riskiest portion of a securitization would face higher capital requirements than those holding less risky pieces. Currently 8% capital must be held against all securitized assets, regardless of risk.
By demanding the same capital backing for recourse agreements and direct credit substitutes such as lines of credit, the proposal would abolish a loophole banks have been using to reduce capital requirements.
The comptroller of the currency has agreed to put the plan out for comment; the Federal Deposit Insurance Corp. and the Office of Thrift Supervision will consider the proposal next month.
The proposal is expected to affect at least 300 banks, although regulators noted that more and more institutions are entering the $200 billion-a-year market for asset-backed securities. (The proposal does not apply to securitizations of mortgages or student loans, which are subject to separate capital rules.)
"For banks, this would make it more attractive to invest in asset securitizations," said Thomas R. Boemio, the Fed's supervisory financial analyst.
But lawyers and industry officials were less sure about the impact of the 80-page proposal.
"This could be a tremendous hit to the banking industry," warned Gilbert T. Schwartz, a partner at the Washington law firm of Schwartz & Ballen. "It would be a dramatic increase in the amount of capital banks must keep."
"This is going to raise the cost of banks' providing direct credit substitutes and therefore will raise the costs of some securitization deals," said Paul A. Smith, senior federal counsel at the American Bankers Association. "We are worried because insurance companies and foreign banks won't be subject to these higher capital requirements."
But an official at a money-center bank said the effect on capital charges will depend on the bank's portfolio. Banks with high-risk portfolios will hold more capital than those with conservative positions. "The Fed has been very interested in taking these capital requirements and making them sensible," he said. "This could be an improvement."
Richard M. Whiting, general counsel at the Bankers Roundtable, said the proposal makes sense. "This is very consistent with the supervision-by-risk approach to regulation," he said. "They will be looking at the risk weighting of these assets to determine capital requirements."
Also on Thursday, the Fed eliminated nearly two dozen firewalls that made it difficult for bank-affiliated section 20 units to compete with securities firms. The change, adopted without debate, permits banks to extend credit to customers of their underwriting units, counts invests in section 20 units toward holding company capital requirements, and authorizes banks to issue letters of credit to underwriting customers.
"We strongly support the Fed's further reduction of firewalls, which brings U.S. market practices in line with the global financial environment," said Lawrence R. Uhlick, executive director of the Institute of International Bankers.
Regulators have been trying to rewrite recourse rules since 1990, issuing an advanced notice of proposed rulemaking in May 1994. Several Fed governors criticized the length of the review, which Mr. Boemio said may not be wrapped up until June 1998.
"This matter is a shining example of just how cumbersome an interagency rulemaking can be," Fed Governor Edward W. Kelley Jr. said. "I would urge our staffs and other agencies' staffs to expedite this."
The proposal, out for comment until late October, would use credit ratings to force banks with risky assets to hold more capital.
Any portion of a securitization rated AAA would be subject to a 1.6% capital requirement, much less than the 8% required today. Banks holding pieces rated BBB to AA would have to hold 8% capital against the assets owned or 4% of the total assets in the pool.
Below-investment-grade portions would require 8% capital against the entire pool of assets. This would mean for a $10 million securitization, a bank would have to keep $800,000 in capital reserves. Currently, banks may use a loophole in the law so they only must hold $80,000 in capital.
The interagency proposal also suggested basing capital requirements on the historical loss experienced by similar securitizations or establishing guidelines to determine the credit risk posed by different types of securitizations.