One of the largest banks in the nation, Citigroup (C) cautioned that the Basel III rules for capital reserves at financial companies may lead to a reshape of bank investments, said head of risk architecture James Garnett of Citi in his testimony.

The proposed rules would require gains and losses on securities held as “available for sale” by a bank to move through its regulatory capital levels, said Garnett. The current rules impose a “filter” to prevent value fluctuations in the securities from passing through to regulatory capital. Basel III would remove the filter.

As a result, banks would favor short duration securities because it’s less likely to be vulnerable to swings in interest rates. Long-date Treasurys and mortgage-backed securities could fall by the wayside, Garnett said, adding a lack of MBS purchases would impact the housing recovery. 

"The elimination of the filter will create inaccurate reports of actual capital strength; it will mean that capital will look like it is increasing as interest rates fall and decreasing as interest rates rise – but neither result will reflect reality," Garnett said. 

Removing the filter would also will put U.S. banks at a disadvantage to foreign banks because they follow international accounting standards, which allows filers to defer gains and losses by "accounting for certain debt securities as loans."

While Citi states that it understands the reasons for the proposed change — due to credit losses — the bank urges that a better solution is to keep the filter in effect for government agencies issue or guarantee obligations.

"This approach would create consistency between the regulatory capital treatment of securities and the regulatory capital treatment of the deposit liabilities they are largely hedging, and it would reduce the negative consequences caused by volatility in regulatory capital levels," Garnett said.

The joint hearing on Thursday to discuss the impact of the proposed rules on the implementation to Basel III at the House Committee on Financial Services included two panels. The first panel was comprised of the same agency officials with similar testimonies who met at the Senate Bank Committee meeting on Nov. 14. The second panel featured various persons including professors, banks and chief economists.