The Federal Reserve laid out plans for future banking institution reforms Tuesday, approving the final regulatory capital rules for the Basel Committee on Banking Supervision.
While there have been hiccups along the way — specifically, delays in regulatory implementation — the new rule will help ensure banks maintain strong capital positions.
Furthermore, the final regulations will enable institutions to continue lending to households and businesses even after unexpected losses or during a severe economic meltdown. A major criticism to Basel is that in times of tightening credit conditions, lenders will hang on to their cash to maintain capital adequacy, potentially reducing economic liquidity.
“This framework requires banking organizations to hold more and higher quality capital, which acts as a financial cushion to absorb losses, while reducing the incentive for firms to take excessive risks,” Federal Reserve Chairman Ben Bernanke said.
He added, “With these revisions to our capital rules, banking organizations will be better able to withstand periods of financial stress, thus contributing to the overall health of the U.S. economy.”
The final rule will minimize the burden on smaller, less complex financial institutions as well as established an integrated capital framework that addresses shortcomings in capital requirements —particularly for larger, active banking institutions that became apparent during the recent financial crisis, the central bank explained.
Under the new regulations, minimum requirements will increase for both quality and quantity of capital held by banks.
For instance, the rule includes a new minimum ratio of Common Equity Tier 1 capital to risk-weighted assets of 4.5% and a capital conservation buffer of 2.5% that will apply to all supervised financial institutions.
The rule also raises the minimum ratio of Tier 1 to risk-weighted assets for 4% to 6% and includes a minimum leverage ratio of 4% for all banks.
For the largest, internationally active institutions, the final rule includes a new minimum supplementary leverage rate that takes into account off-balance sheet exposures.
On the quality of capital side, the final rule emphases Common Equity Tier 1 capital and implements strict eligibility criteria for regulatory capital instruments.
The final rule also improves the methodology for calculating risk-weighted assets to enhance risk sensitivity, with riskier assets requiring higher capital cushions and less riskier assets requiring small capital cushions.
“Adoption of the capital rules today is a milestone in our post-crisis efforts to make the financial system safer,” Federal Reserve Governor Daniel Tarullo said.
He added, “Along with the stress testing and capital review measures we have already implemented, and the additional rules for large institutions that are on the way, these new rules are an essential component of a set of mutually reinforcing capital requirements.”
The lengthy implementation of Basel III paid off for community banks as regulators reviewed comments received on the proposals to address concerns about monitoring burdens on the companies.
For instance, the final rule is different from the proposal in terms of risk weighting for residential mortgages and the regulatory capital treatment of certain unrealized gains and losses as well as trust preferred securities for community banks.
In total, the changes for community banks from current regulations target a few areas that are higher risk, but otherwise considered minimal, the central bank noted.
As with all financial institutions subject the final rule, community banks will have a transition period to meet the new requirements.
The phase-in period for community banks will not begin until January 2015 while the phase-in period for larger banks will begin in January 2014.
Looking ahead, the market will wait to see what the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency decided as they consider the final rule and make a decision on July 9.