While the Basel II process dragged on for years, international and domestic regulators appear intent on delivering a new set of capital and liquidity standards on time by yearend.

Although some were skeptical when the Group of 20 industrialized nations pledged to agree to higher standards by their upcoming meeting in November, the Basel Committee on Banking Supervision has already made significant progress toward that goal. It released revisions last month to its December 2009 proposal, and is set to unveil later in August its economic impact assessment on new capital rules. The panel is expected to put forth finalized calibration and phase-in agreements by its next meeting in September.

"They are moving ahead quite expeditiously," said Mary Frances Monroe, vice president of the Office of Regulatory Policy at the American Bankers Association (ABA). "It looks like they are going to keep to their word of having fully fleshed out rules by the end of the year."

The assessment is a critical next step in the process, and is expected to focus on the macroeconomic implications of raising capital standards and other requirements. Regulators said they expect it to prove that higher capital makes the system safer, rebutting concerns it can impede lending.

"We want to have banks hold a cushion of capital over the minimum, so that in a severe scenario, they can take the hits, they can take the losses and continue to have enough capital to meet their regulatory minimums and keep lending," said George French, the deputy director for policy in the Federal Deposit Insurance Corp.'s (FDIC) division of supervision and consumer protection. "We expect the conclusion of the economic analyses will be, on balance, it's a clear positive to increase the capital requirements."

Still, observers said that even though Basel III is coming together quickly, uncertainty in the market about its final conditions is helping reduce available credit. "One of the key indicators people will want to see is when they finally calibrate the capital both for Tier 1 and common equity capital. They still haven't issued those numbers yet," said Richard Spillenkothen, a former director of supervision at the Federal Reserve Board and now the director of governance, regulatory and risk strategies at Deloitte & Touche. "That will make a big difference."
Observers said two critical unknowns are details on calibrations and the transition period that will be set by the committee.

Phase-in of the new capital standards is expected to begin within the next few years, but details have yet to be released on when capital deductions can be phased-in or even the exact timing of how long banks have to make deductions.

Observers said that financial institutions are taking a wait-and-see approach. "The best thing regulators in the U.S. could do right now is try to provide some transparency to financial markets about what they intend to do with Basel III," said Kevin Jacques, the Boynton D. Murch, chair in Finance at Baldwin-Wallace College and a former Office of the Comptroller of the Currency (OCC) and Treasury Department official. "Financial institutions want to know what is going to happen and when it is going to happen."

Industry representatives and others were pleased, however, by the changes the Basel Committee made last month to its capital proposal, which dialed back many of the toughest requirements of the December 2009 plan.

"The December proposals were very stringent," French said. "The July proposal is not quiet as severe, but still is very strong on the quality of capital and is a great improvement from where we are now."

Industry groups like the ABA called the changes "pragmatic."

"There are still unanswered questions, but certainly it is a pragmatic acknowledgement that we need longer transition periods and there needs to be some reconsideration of the elements of Tier 1 capital from the original proposal," Monroe said.

Among the major changes made by the latest plan was to broaden the definition of common equity by including such items as minority interest. The proposal also now allows mortgage servicing rights, investments in other financial firms and deferred tax assets to be accounted for on a limited basis toward common equity. Individually, each item can account for 10%, but combined cannot exceed 15% of Tier 1 capital.

Inclusion of some mortgage servicing rights as Tier 1 capital was viewed as a big win for the U.S. Originally, the December proposal excluded such rights because they are viewed as an intangible asset which, like goodwill, could vanish should a bank fail.

The U.S. successfully argued that institutions have been able to sell mortgage servicing rights when banks get into trouble.

Still, some said the proposal did not go far enough, arguing a combined 15% cap is too low. "There is a bucket for minority interest, deferred tax assets and mortgage servicing rights," Monroe said. "A bigger bucket would be better, but at least we have a bucket."

Among the biggest changes in the plan was an international agreement that a global ratio should be enacted. The committee proposed a minimum leverage ratio of 3% for a trial period from 2013 until 2017 to assess how well it works. A final cap could be effective as early as 2018. Such a level is less stringent than U.S. rules.

Karen Shaw Petrou, a partner at Federal Financial Analytics, warned that such a prolonged transition period could inevitably make the proposal "irrelevant."

"When a final rule has a 2018 deadline, quarter-by-quarter planners put it aside for another day," Shaw Petrou said. "Even longer-term planners … discount it because so delayed a deadline seeds hope that a rule will be reversed."

Regulators also added more regulatory buffers, including a fixed capital conservation buffer that would place restrictions on dividends and stock buybacks in order to conserve capital, as well as a countercyclical buffer that would vary depending on where an institution is in the business cycle.

"The idea behind the countercyclical buffer is that banks would have to hold a little bit more capital during the boom times — that would help to put some constraint on how fast credit can grow, and reduce the danger of a bubble," French said. "This has conceptual appeal but is a tricky concept to implement. We think what is needed, first and foremost, is a simple fixed buffer of capital over and above the regulatory minimums, so that banks can absorb losses and keep lending during a period of stress."

Also unclear is what kind of assessment governments will put on systemically important companies and whether regulators can successfully create a contingent capital instrument that converts from debt to equity in certain circumstances.

"The nature of the charge and when it will be imposed is up in the air at Basel," Shaw Petrou said. "Another unresolved issue is contingent capital, a charge under ongoing review that's a lot harder to impose in practice than support in principle."

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