WASHINGTON — As the Federal Reserve Board gets set to vote on a final package of Basel III capital rules at a meeting Tuesday, it remains unclear just how far regulators will go to placate community bankers outraged by the proposal offered last year.

Also unknown is if policymakers will tackle raising a proposed leverage ratio even higher — or wait until later to address that issue.

What's certain is that the vote on a package of rules is just the start of the final stage of implementation of the agreement global regulators struck in 2010 in an effort to prevent another financial crisis.

Even once Basel III is finalized here, international regulators must still revise a global leverage ratio, currently set at 3%, while U.S. regulators must put out proposed rules on liquidity requirements and a capital surcharge for the eight U.S. systemically important banks.

"You have to think about the whole Basel framework as a living organism these days," said Susan Krause Bell, a managing director of Promontory Financial Group and a former official at the Office of the Comptroller of the Currency, who also cited additional areas that global regulators are now beginning to look at, such as securitization and the trading book. "It's practically like software updates, you have to expect tweaks here and there, and revisions here and there. The fundamental Basel III framework proposed in December 2009, and finalized in 2010, was supposed to begin implementation at the beginning of this year. What still needs to be completed in Basel is the leverage ratio and the second liquidity pieces."

Even with a number of outstanding items that will be left off the table on Tuesday, observers said the final rule will still be critically important in its scope for institutions large and small.

"It will represent the most significant overhaul of U.S. bank capital standards since the U.S. adoption of Basel I almost a quarter of a century ago," said Andrew Fei, an associate at Davis Polk & Wardwell LLP and a Basel expert.

It isn't just the higher capital standards, but the narrower eligibility criteria for capital instruments, he said. The rule will also fundamentally change how banks will make capital deductions for such items as unrealized gains and losses and what they can count as regulatory capital.

Broadly, observers anticipate that the final rule will closely match the proposal released last June by all three banking agencies, with some possible technical changes as well as adjustments made in how the rules are applied to community banks. Each agency is required to sign off on the package, but the Fed is taking the first step. The Federal Deposit Insurance Corp. and the OCC have yet to announce plans for actions on the rules.

U.S. regulators released three proposals as part of the package of rules. The first would establish minimum capital and liquidity requirements for all banks. A second plan, known as the standardized approach, would fundamentally change risk weightings on assets. It is considered the most controversial piece of the package because of its impact on banks' capital ratios. The third proposal, known as the advanced approach, would add requirements for the largest banks, such as a leverage ratio and countercyclical buffer.

Community bankers strongly objected to the second plan because it changed the risk weightings for residential mortgages, a bread-and-butter product for community banks. Small banks have lobbied for a wholesale exemption from Basel III, which regulators are unlikely to grant.

Instead, some observers suspect regulators might punt on finalizing how banks should calculate their capital for residential mortgages, deferring on the issue until later. Such a move would diminish any potential immediate backlash from community bankers and their allies on Capitol Hill.

"If you think about it there wasn't that much controversial in the proposal when you ripped the community bank piece out of it," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc. "There were major technical questions like the AOCI [accumulated other comprehensive income], but there wasn't huge amount of anything else."

Regulators could argue that other recent regulations, such as the Consumer Financial Protection Bureau's "qualified mortgage" rule, require them to study the issue further.

"My guess is they're going to duck both the community banks in hopes that the storm blows over and the next round of mortgage discussions and buy some time on the grounds that they didn't know anything about 'qualified mortgage' rule when they issued the proposed rule," said Petrou.

However, other observers expect that community banks will see the relief they've been seeking when it comes to mortgage risk-weights and a provision that would require banks to account for unrealized gains and losses of available-for-sale-securities when calculating capital requirements, because it eliminates a filter for AOCI.

"I don't think they'll exempt community banks totally," said Camden Fine, president of the Independent Community Bankers of America. "I'm anticipating that community banks will still be subject to Basel III guidelines, but I believe the regulators will significantly modify those guidelines favorably for community banks."

Lawmakers have been highly critical of the impact the package of rules could have on community banks, and have pressed regulators to make significant changes, if not exempt them entirely from Basel III. Rep. Shelley Moore Capito, R-W.Va., and Rep. Gregory Meeks, D-N.Y., reintroduced a bill shortly after the Fed announced plans to vote on a final rule calling on regulators to undertake an impact study on community banks before proceeding.

"Congress is already signaling if the community banks don't like this rule 'We're on you,' " said Petrou.

Fine said that all three regulatory agencies have been "very open" to community bank concerns and have "listened closely," often consulting smaller-sized institutions, since the proposal was released. But while he expects "regulators will respond to our concerns," he said he knows "that at some point Congress will respond to our concerns."

What's less clear is whether the largest institutions can expect to see the similar modifications applied to them, especially when it comes to the AOCI filter.

"There have been meetings where that issue has been raised by community, regional, and even mid-size banks, and the regulators have told them the equivalent of 'You'll be happy with where we ended up,'" said an industry source, who requested anonymity. "The downside is that some of the largest banks have not heard that. It's unclear to me why the larger banks could be hearing something different than smaller banks."

Another closely watched issue will be whether U.S. regulators have agreed to lift the leverage ratio. For legal and policy reasons, regulators are highly unlike to propose a higher leverage in the final rule, but could suggest either in writing or during the meeting that they plan to proceed with a separate proposal to increase it.

"People are looking with great interest at what is going to be said about the supplemental leverage ratio," said Krause Bell. "Whether it's going to be proposed along with the final rule, or whether they're going to signal something to come, or maybe say nothing and wait to address it in the future."

The FDIC has been pushing U.S. regulators to raise the proposed 3% ratio because they cite weaknesses in the risk-weighting regime's ability to accurately capture risk. Top officials from the Fed and OCC have said publicly they think increasing the leverage ratio is worthy of a second look.

However, there is some uncertainty in the picture given that the international process has yet to be completed. The Basel Committee announced proposed changes to the leverage ratio last week, which will be open for comment until September.

"Even if the U.S. agencies were inclined to implement some version of the revised Basel III leverage ratio in the United States, it's hard to imagine they would put that in a final rule because the Basel process is still a consultative process," said Fei. "I think just as a practical matter it would take some time for the U.S. agencies to translate the revised Basel document and Basel framework into the U.S. regulatory context."

But observers said that, due to outside pressure from Congress, including Sens. David Vitter and Sherrod Brown, who are pressing to raise capital requirements much higher, U.S. regulators will have to revisit the leverage ratio eventually.

"There's so much pressure," said Krause Bell. "There's the Brown-Vitter bill with a leverage ratio of 15% and even though no one thought that was going to go anywhere, it clearly has affected the conversation. The agencies will be worried that Congress may step in if they don't."

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