The Federal Reserve Board on Thursday unanimously approved the release of a set of proposals that would raise banks' minimum capital requirement to 7%.
U.S. regulators have been working steadily to draft rules that would effectively adopt international capital standards set by the Basel Committee on Banking Supervision that are designed to prevent a repeat of the financial crisis.
The central bank's board met Thursday afternoon to consider and vote on three proposals, which would establish minimum capital requirements, a leverage ratio, and a countercyclical buffer. It also voted to approve a final rule that would reduce banks' reliance on credit ratings in capital requirements.
While the proposals were largely as expected, their significance cannot be understated.
Fed Chairman Ben Bernanke hailed the three proposals as an "attractive package," which laid out measures for banks to provide more and better capital consistent with the international accord and within an integrated framework.
"This may well be the standard which other countries around the world are measured going forward," said Bernanke at the board meeting. "And I hope other countries, other jurisdictions will meet this standard."
Newly installed Fed Gov. Jeremy Stein drew attention to the significance of lifting capital requirements.
"It's worth stepping back and sort of recognizing the accomplishment here," said Stein. "There's always more to do on financial reform. There's a lot of important stuff to be done, but on the simplest metric we have which is common equity capital we're moving from a world where 2% was the norm to a world where 7% is the norm. That alone is one of the most important steps that we can take to safeguard the financial system."
Still, not all governors — even those who were supportive of the measures — believed the new set of rules would sweep away all risk.
"From a regulatory and supervisory perspective, we cannot declare with these proposed rules mission accomplished," said Fed Gov. Sarah Bloom Raskin. "While the imposition of these capital rules and buffers are important and necessary steps toward strengthening the regulatory framework that large, complex banks operate within they are not sufficient."
Raskin noted that the proposed capital rules were designed to focus on risk created by particular types of assets. Operational risk or reputational risk, for example, wouldn't necessarily be accounted for.
"In short, the proposed capital rules provide a guide, a roadmap so to speak about certain parts of the balance sheet where risk may be lurking. But this is an imperfect guide because as we all know risk can develop and lurk in spaces no one outside the bank or sometimes even inside the bank can see or expect," she said.
Even with further work ahead, the move by regulators to proceed with the rules swept away any fears that the U.S. would not adopt the Basel accord. The international agreement signed off by the 27-member countries is a non-binding agreement and becomes effective Jan. 1, 2013.
The proposals, which amassed hundreds of pages, largely kept with the Basel accord, according to Federal Reserve officials. However, regulators opted to delay including liquidity requirements and an additional surcharge that globally active international banks like JPMorgan Chase & Co., Citigroup Inc. and Bank of America Corp. will have to face.
Fed Gov. Daniel Tarullo, who is in charge of bank supervision, noted it was still the first step in a much longer process.
"While approval of today's proposals will mark major progress on the way to overhauling capital requirements, it does not signal the end of that effort," said Tarullo. "Clearly, of course, we will need to finalize the three proposed rules. Next, once refinements of the Basel framework on capital surcharges have been completed, we will need a regulation to apply surcharges to U.S. institutions with the largest systemic footprints."
Tarullo has been working with U.S. institutions to meet the capital requirements since the non-binding rules were agreed upon by the Basel Committee.
Under the plan, institutions will have to hold a minimum of 4.5% common equity Tier 1 capital; a tier 1 capital ratio of 6% and tier 1 leverage ratio of 4%.
Roughly 90% of bank holding companies, which have between $10 billion and $500 billion in assets, already hold a 4.5% common equity Tier 1 capital ratio. Moreover, 70% of bank holding companies would meet the 7% capital ratio required under Basel III. The shortfall of capital that banks would raise most likely through retained earnings would be about $3.6 billion. For the largest banks above $10 billion of assets, the shortfall would be $6 billion.
Additionally, under the proposal, banks with extensive off-balance sheet activities would also have an additional leverage ratio of 3% to maintain. Those institutions would be expected to calculate and report their supplementary leverage ratios starting on Jan. 1, 2015, and meet the requirement starting in 2018.
Regulators said the revised capital ratios would be incorporated into the agencies' "prompt corrective action" process, the framework typically used to subject troubled institutions to enhanced supervision when their capital levels fall below a certain level.
These capital rules will become effective Jan. 1, 2013 as required under the Basel agreement, but firms would not be required to be in full compliance until 2019. Regulators are proposing a transition for certain requirements.
"The proposed transition arrangements aim to provide banking organizations sufficient time to adjust to the new capital framework while limiting any negative economic impact," the central bank said.
The proposals also specify a minimum capital conservation buffer of 2.5% for those banks which do not want to be restricted from issuing dividends or bonus payments to executives. If a bank fell below that additional buffer, it would potentially face limitations on capital distributions.
The draft rules also would revise definitions of capital to include only instruments that can absorb losses. For example, instruments like trust-preferred securities would be excluded from Tier 1. (Dodd-Frank has a similar provision.)
Additionally, items like goodwill, deferred tax assets and mortgage servicing assets would be deducted from common equity.