WASHINGTON Community bankers emerged victorious Tuesday after regulators made a number of key changes to a final package of Basel III capital rules in an effort to address smaller institutions' concerns.
But the biggest banks, in contrast, fared far worse, as regulators warned they are preparing to raise the leverage ratio for globally systemically important institutions and take other steps to rein in such behemoths.
Federal Reserve Board officials hailed the final rules as a "delicate balance" that reflected the concerns of community bankers, noting at a board meeting that there were roughly 2,600 comment letters filed on a plan first unveiled last year. In the end, Fed governors said the final package offered an "appropriate sensitivity" in its treatment of smaller-sized financial institutions, forgoing placing too much burden on firms while still strengthening overall capital standards.
"After hearing these concerns, numerous changes have been made to the proposal to reduce its complexity and to minimize the potential burden that would be placed on smaller and community banking organizations," said Fed Gov. Elizabeth Duke.
The Fed board approved the final rules at its meeting on Tuesday, while the Office of the Comptroller of the Currency said it would do so by the end of this week. The Federal Deposit Insurance Corp., which must also approve the rules, said it would meet July 9 to consider the final package along with a separate plan to raise the leverage ratio on the largest institutions.
Comptroller Thomas Curry said regulators were careful not to overburden small banks in the final rules.
"I think those are important accommodations, and it is entirely appropriate that they apply to the community banks and thrifts that had nothing to do with bringing on the crisis," said Curry in a press release.
Regulators agreed to a number of significant changes that were specifically tailored for community banks. For example, smaller institutions could continue to keep the current risk weights for residential mortgage loans in two categories until other mortgage-related rules were finished. Regulators also agreed to allow banks with less than $15 billion of assets to grandfather trust-preferred securities as part of their Tier 1 capital.
Additionally, small banks were given a one-time opportunity to opt-out of deducting unrealized gains and losses from their capital. They were warned, however, they would not be permitted to reverse any decision in order to avoid an opportunity for regulatory arbitrage. Those banks were also provided a much longer transition period of one year, which would begin on Jan. 1, 2015.
Observers said regulators had given small banks significant ground.
"It was something they needed to do, but regulators shouldn't have done it in the first place," said Ernest Patrikis, a partner at White & Case and a former general counsel of the New York Fed, regarding applying the rules broadly to community banks. "Generating all that concern was not necessary."
Regulators have been under immense pressure by community banks and their allies in Congress to ensure that such institutions would not face overly complex rules. As a result, regulators clearly sought to be as responsive as possible, even providing community bankers with a one-page cheat sheet to describe changes made in the final rule.
But despite winning some serious concessions from regulators, trade groups that advocate on behalf of community bankers, including the Independent Community Bankers of America and the American Bankers Association, said the results of the final rules were "mixed."
Camden Fine, president of the ICBA, said his group had been "vigorously advocating" for a total exemption from Basel III, but they "didn't achieve that." Additionally, he said the definition of equity capital was narrowed by regulators to exclude mortgage servicing assets and tax-deferred assets, which could adversely affect community banks.
"They did a lot of things to address many concerns, but certainly not all of them," echoed Wayne Abernathy, executive vice president for financial institutions policy for the ABA. He said the trade group would be examining the minor details, which still could have an impact on smaller-sized institutions, noting that "any 972-page rule is still a complex rule" that community banks will have to wrestle with.
Otherwise, regulators largely adhered to the initial draft proposal released last June, leaving most of the capital requirements, including two closely watched leverage ratios, unchanged.
"When you look at the big global banks there are very little changes to what was originally proposed and quite consistent with Basel III," said Stefan Walter, former secretary general of the Basel Committee and current leader of Ernst & Young's global regulatory network.
Thousands of financial institutions will now have to hold a common equity Tier 1 capital ratio of 4.5%, plus a capital conservation buffer of 2.5%. Despite community bankers' objections to this piece of the rule, regulators agreed it would improve the safety of the financial system by limiting capital distributions or bonuses during times of stress. All banks will also have to meet a 4% leverage ratio, while the largest financial institutions will also see an additional 3% supplemental ratio, which will capture certain off-balance sheet exposures like derivatives.
Even if the rules themselves didn't change for the largest banks, Fed officials warned they must expect much tougher standards going forward that will be rolled out in four additional rules, including a higher leverage ratio.
"This is really the beginning, or the framework for which the work will be done, for strengthening our largest, internationally active banks," said Fed Chairman Ben Bernanke at the meeting.
Under the rule, the largest banks must begin implementation on Jan. 1, 2014 and they will not receive a one-time exemption on the AOCI filter. They will also be required to hold a countercyclical buffer in order to be in line with the global Basel III framework.
"There aren't a lot of surprises, but because of the efforts for the relief for community banks, it stands out," said Abernathy.
Fed Gov. Daniel Tarullo said such future measures would "round out a capital regime of complementary requirements that focus on different vulnerabilities and together compensate for the inevitable shortcomings in any single capital measure."
He said the banking agencies were "very close" to completing a proposed rule that would lift the leverage ratio for the eight U.S. institutions that are currently considered to be globally systemically important banks by the Basel Committee on Banking Supervision, including JPMorgan Chase & Co. and Bank of America Corp.
"Despite its innovativeness in taking account of off-balance-sheet activities, the Basel III leverage ratio seems to have been set too low to be an effective counterpart to the combination of risk-weighted capital measures that have been agreed internationally," said Tarullo.
It was widely anticipated that regulators would address the issue given the months of negotiations among the FDIC, OCC and the Fed on increasing the leverage ratio. It's unclear how high regulators may propose lifting that leverage ratio, but it's been speculated to be anywhere between 5% and 6%. The FDIC is expected to tackle the issue at its board meeting next week.
Regulators are also planning to release a proposal in a few months that would change how much equity and long-term debt that firms should hold to facilitate an orderly resolution.
Additionally, the Fed also plans to release a proposal later this year to implement the capital surcharge for those eight firms. And lastly, staff at the Fed are working on a recommendation to see how regulators can require more capital to address risks related to short-term wholesale funding.
Observers said such additional measures were meant as ways for regulators to directly address the probability of failure of a systemically important financial institution.
"If they were to fail, they could have a bigger impact on the financial system and economy. Therefore, given the greater potential impact of a systemic institution on the financial system, you want to reduce the probably of an institution failing," said Walter.
Under the final rule, regulators also stuck to the strict regulatory capital deductions from common equity Tier 1 capital. Once the rules take effect, banks will no longer be able to use deferred tax assets, mortgage servicing assets, and "significant" investments in the capital instruments of unconsolidated financial institutions in order to remain consistent with the global framework. Regulators provided a lengthy transition period to give banks an opportunity to comply with the capital distributions.