Higher capital requirements needed on ABS, Federal Reserve governor says
The 2008 financial crisis showed that capital requirements were set too low for particular assets, and that regulators were overly dependent on them while ignoring other important issues like size and leverage, a Federal Reserve governor said Friday. The capital requirement for asset-backed securities in the trading books of banks was based on returns over a 10-day holding period, said Federal Reserve Gov. Daniel Tarullo. It used a one-year observation period characterized by low price volatility, and “neglected the credit risks inherent in these traded instruments." “It was also apparent that at least some of the instruments that qualified as Tier 1 capital for regulatory purposes were not reliable buffers against losses, at least not on a going-concern basis,” he said in a speech at George Washington University. Market actors looked almost exclusively to the amount of tangible common equity held by financial institutions in evaluating the creditworthiness and overall stability of those institutions, Tarullo said, noting that they essentially ignored Tier 1 and total risk-based capital ratios in regulatory requirements. “In the fall of 2008, there was widespread doubt in markets that the common equity of some of our largest institutions was sufficient to withstand the losses that those firms appeared to be facing," he said. "This doubt made investors and counterparties increasingly reluctant to deal with these firms, contributing to the severe liquidity strains that characterized financial markets at the time.” The nation’s post-crisis regulatory system won’t be as dependent on capital requirements, he said. “There will be increased emphasis on market discipline, liquidity regulation, activities restrictions and more effective supervision.” Basel 3, he noted, creates a new minimum common equity capital requirement and is a strong step forward for global market stability. The new equity capital requirement prevents firms or national regulators from including in the calculation of common equity certain assets that could dilute its loss-absorbing character. “The minimum common equity ratio will be set at 4.5% of risk-weighted assets, with an additional requirement for a 2.5% conservation buffer,” Tarullo said. “The concept behind the two-level requirement is that a banking organization should be able to withstand losses associated with systemic stress and still be a viable financial intermediary.” Tarullo also noted that banks that have demonstrated solid earnings and strong capital levels for several quarters will be interested in resuming dividend payments. The Fed will soon issue supervisory guidelines applicable to such requests from the largest holding companies for the first quarter of 2011, he said. Write to Kerry Curry.