Bi-Partisan Senate Letter to Fed Urges Simpler Capital Requirements Around Basel III

Amidst growing calls from the nation’s community banks, Senators Sherrod Brown (D-OH) and David Vitter (R-LA), members of the Banking Committee, urged federal banking regulators to simplify and strengthen new bank capital standards.  With the U.S. beginning to implement the Basel III Accord on international capital standards, Senators Brown and Vitter urged the Federal Reserve Board to abandon the overly complex approach of the Basel II Accord and focus on higher and more loss-absorbing capital buffers.

There is a growing bipartisan consensus on the Senate Banking Committee on the appropriateness of requiring banks to fund themselves with equity sufficient to withstand significant economic shocks.  With financial regulators considering a host of new domestic and international capital requirements fueled by the Dodd-Frank Act and the financial crisis, the Senators urged the Fed to simplify and enhance the capital rules that will apply to U.S. banks.  Simpler, more robust capital rules will benefit smaller banks by lessening their regulatory burden, they noted, and properly aligning incentives for megabanks by lessening government support for the financial sector and reassuring financial markets that the U.S. financial system is healthy.

The Basel Committee has proposed requirements of a 4.5 percent Tier 1 Common Equity risk-based capital ratio, with an additional proposed surcharge between 1.0 percent and 2.5 percent for systemically important banks. The proposal also contains a 3 percent Tier 1 capital leverage ratio. While the proposal is an improvement over the existing Basel II framework, conceded the Senators, they remain concerned that the proposal will still not be sufficient to prevent another financial crisis.  These standards are considerably lower than the Basel Committee’s conservative estimate of the optimal capital ratio of 13-14 percent. Global banks hold assets with average risk-weighting of 40 percent, meaning that the 10 percent risk-weighted Basel III ratio would amount to leverage 25 times their equity. Were a megabank’s assets to decline by 4 percent under that scenario, it would become insolvent. The Senators agreed with a recent assessment by FDIC Board Member Thomas Hoenig that Basel III’s continued focus on risk-based capital ratios is overly complex and opaque.

They asked the Fed to focus on pure, loss-absorbing capital.  In their view, this will strengthen mega banks’ balance sheets, protect taxpayers, reassure investors, and reduce the regulatory burden on the community banks that are already better capitalized than Wall Street banks.

The largest U.S. financial institutions have become remarkably complex and opaque, said the Senators, raising the specter of regulatory arbitrage. Moreover, this complexity inhibits corporate executives or regulators from properly executing their oversight responsibilities, and making the calculation of the proper capital standards next to impossible. 

The answer is not more and more complex capital regulations, said the Senators, rather it is simpler, more robust capital rules, which will benefit smaller banks and properly align incentives for megabanks.  In their view, simplifying capital and leverage calculations will benefit small banks that lack large legal and compliance divisions, but are nonetheless facing a deluge of new rules pursuant to Dodd-Frank and Basel III.

Finally, clear capital standards will reassure financial markets.  Accounting gimmicks may help financial institutions appear to have higher regulatory capital levels and avoid raising more equity, noted the Senators, but when risk weights are gamed, the markets lose faith in banks’ balance sheets. 

In an earlier letter to the Federal Reserve Board, Senators James Inhofe (R-OK) and Tom Coburn (R-OK) expressed concern that Basel III and Dodd-Frank Act regulations being crafted for large global financial institutions are being imposed on financial institutions of all sizes, including community banks. Changes in the definition of capital and an increase in the risk weights of many asset classes will squeeze financial institutions as their broader regulatory burdens are increasing. The Senators ask if the Fed ultimately intends to exempt smaller financial institutions from these regulations.

More specifically, the Senators also ask the Fed to explain how it measured the impact on smaller financial institutions as it developed the Basel III proposals. The Fed should also explain how the added costs of the impending regulatory changes will be justified by commensurate improvements in the safety and soundness of financial institutions. Importantly, continued the Senators, the Fed should explain why the Basel III and Dodd-Frank regulations are being imposed on smaller financial institutions when the regulations are designed to protect the financial markets from systemic risk.