Fed endorses Basel III capital requirements for Wall Street

"The crisis was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street. The overwhelming evidence is that those institutions deceived their clients and deceived the public, and they were aided and abetted by deferential regulators and credit ratings agencies who had conflicts of interest" Levin Coburn Report in  Wall street and the Financial Crisis: Anatomy of a Financial Collapse.

It is in the backdrop of the global economic recession, Basel III, a group of global bank regulators have recommended that all banks maintain a ratio of common equity to risk weighted assets of atleast 7%, as compared to 4% of Basel II. In addition to this, systemically important banks (Systemically too important to fail or SIFI) like Citibank, Morgan Stanley and Goldman Sachs are expected to maintain an additional 2-3% of capital to risk weighted assets, termed as a surcharge. Systemically important means these players have more than $50 billion in assets.

The affected parties are howling, calling it anti-American even. They argue that while the American economy seems to be limping back to some sort of normalcy, these strict norms on Tier I capital could make lending difficult and consequently economic development.

Jamie Dimon, head of CEO JP Morgan argues that these capital requirements are skewed against American financial institutions, since they target asset-based mortgages. He feels that these over regulations will hurt lending and job creation. He fears this will have banks using up their almost liquid transaction tools like T-bills.

Mark Carney, chair of the Basel based Financial Stability Board, the man against who much of the howling is directed calls these arguments erroneous. The implementation schedule for these norms starts only in 2013, not right away and ends in 2019.  "It is difficult to believe that prolonging this implementation phase even further would have a material impact of real economic outcomes," he said. "If some institutions feel pressure today, it is because they have done too little for too long, rather than because they are being asked to do too much, too soon.”

Basel III insists on higher common equity, with an increase in Tier I capital (equity capital and disclosed reserves). All perpetual capital instruments qualify to be under Tier I. The so called surcharge buffer of 2.5% can be brought down to 0. This will however affect earnings distributions also, that will affect dividends and discretionary compensation payments. This buffer will be implemented once the minimum regulatory capital requirements of 6-8% are met, in about 2016. The idea being SIFIs should be able to absorb loss better, without disrupting the financial framework.

US investment banks, the biggies of Wall Street’s will be looking at major structural changes if these capital requirements come into place. The Fed on its part wants to stay clear of bailouts like AIG and crashes like Lehman. They do not want to be caught unawares again. In the event of possible closure the government can do so by seizing and liquidating them. Consumer will benefit vastly by the greater overseeing of SIFIs by government regulatory agencies.

Conversely, there is real concern that if traditional banks and financial institutions are required to maintain stringent capital requirements, funds may move to shadow banking. These include hedge funds, investment banks and consumer finance companies, which fund long term assets using short term credit sources. Shadow banking uses asset back securities to borrow short-term credit. They then use this credit to fund other lending activities. This is the reason investment banks in the US are protesting. They fear the strict norms will just see credit move back to shadow banking. They are calling for regulations on asset classes. For example there are capital requirements on say haircuts.

This may lead to some roll back of the ratio in capital requirements sometime later. Globally though the US has lower capital requirements than most of Asia which averages at 12-15% already.

Ultimately the Fed is going to be using these capital requirement ratios to faster identify and address systemic risk.