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For U.S. Banks, It's Finally Time For The Full Basel Rules

Publication date: 18-Jun-2012 11:53:52 EDT

After a long delay, the Federal Reserve Board announced final Basel 2.5 and draft Basel III capital rules for financial institutions on June 7. The U.S. has lagged Europe and Asia in finalizing these rules because of the added complexity of coordinating with legislation under the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA). Standard & Poor's believes that large, complex banks mostly anticipated the new trading risk regulation and proposed capital rules, given capital planning requirements under DFA. However, some of the specific details, including the broader scope of application, might have surprised smaller and regional banks, but we view them favorably.

We don't expect the Fed's final Basel 2.5 rules to have a broad impact on U.S. bank ratings because the risk-adjusted capital (RAC) framework we use to assess banks' capital and earnings applies much higher charges to banks' trading positions than the Basel 2.5 accord required. However, although transparency will improve, more complete disclosures based on Basel 2.5 measures may lead us to revise our capital and earnings assessments for banks, which could result in downgrades in some isolated cases. Similarly, given our use of the RAC framework, we don't expect to take any rating actions as the U.S. inches closer to the implementation of Basel III capital rules. Because the rules are subject to national discretion, which limits global comparability, in our view, we apply our RAC framework to better capture risks in a globally consistent manner (see "Bank Capital Methodology And Assumptions," published Dec. 6, 2010). Still, meeting or exceeding minimum regulatory capital requirements is essential for a financial institution to operate as a going concern in the normal course of business.

(Watch the related CreditMatters TV segment titled, "What The New Basel Capital Rules Will Mean For U.S. Banks," dated July 30, 2012.)

Our understanding is that most bank management teams still need to digest the rules' many details before being able to offer a clear picture of what the ultimate impact might be. At the Fed's open meeting and in one of its notices of proposed rulemaking (NPR), Fed officials indicated that the vast majority of banks would meet the fully phased-in minimum capital standards as of March 31, 2012. Furthermore, they estimated that the current shortfall in meeting new minimum Tier 1 capital requirements is $50 billion for the largest 19 banks that participated in the most recent Comprehensive Capital Analysis and Review (CCAR).

We believe that the Fed's estimates may not include additional capital surcharges for systemically important financial institutions (SIFIs) because these were not part of the proposals. We estimate a much higher capital shortfall when using our RAC ratio (total adjusted capital to risk-weighted assets) as a proxy for the Basel III capital calculation, ranging from $415 billion to $640 billion for all banks when we assume growth in loans (that is, risk-weighted assets) and capital surcharges for SIFIs--where most of the capital needs are concentrated. (See "Higher Capital Needs Through 2019 Could Stunt U.S. Bank Loan Growth," published Feb. 7, 2012.) We don't think U.S. banks could necessarily meet the incremental capital need with retained earnings, and we believe a portion would need to come from the equity market.

Details Of The Rules

The proposed rules aim to increase the level and quality of capital and enhance the risk-sensitivity in the calculation of risk-weighted assets for capital adequacy purposes. Basel 2.5 rules essentially impose higher capital requirements for the trading book and securitizations. These rules take effect on Jan. 1, 2013. The four main elements of Basel 2.5 are:

  • A stressed value-at-risk (SVaR) model, which adds to the VaR-based capital requirements in Basel II. The SVaR should better capture the potential consequences of more volatile market conditions than those encountered in the historical prices on which the banks' VaR models are based.
  • The incremental risk charge (IRC), which aims to capture default and credit migration risk.
  • New standardized charges for securitization and resecuritization positions.
  • The comprehensive risk measure (CRM) for correlation trading positions, which assesses default and migration risk of the underlying exposures.

The Fed's draft Basel III rules came through three separate NPRs--the Basel III NPR, the Standardized Approach NPR, and the Advanced Approaches and Market Risk NPR--that propose greater harmonization of current U.S. banking regulations with Basel III standards while being consistent with the legal framework the DFA established. The Basel III NPR focuses on quality and quantity of capital, with some modification to the components of capital and to risk-based capital and leverage requirements (see table). The Standardized Approach NPR enhances the risk-sensitivity in the calculation of risk-weighted assets. The Advanced Approaches and Market Risk NPR revises the advanced approaches risk-based capital rule for the large, complex banks.

For the most part, these rules will apply to all U.S. banks with more than $500 million in assets, although some will apply more onerously to larger and more complex banks. However, these proposals do not yet incorporate either the SIFI surcharges or the liquidity risk management rules Basel III proposed. Comments on the draft rules are due to the Fed by Sept. 7, 2012. The Fed intends to implement the new minimum regulatory capital ratios and changes in their calculation by Jan. 1, 2015. The Fed will phase in the capital conservation buffer between 2016 and 2018 and fully implement it by Jan. 1, 2019.

Minimum Capital Requirements (%)
Current Proposed (2019)
Common equity Tier 1 - 4.5
Tier 1 capital 4.0 6.0
Tier 2 capital 4.0 2.0
Total capital 8.0 8.0
Capital conservation buffer - 2.5
Countercyclical buffer* 0-2.5
G-SIB Surcharge (not in NPR) - 1-2.5
Leverage ratio 3 (CAMEL 1)§ and 4 4
Supplemental leverage ratio* - 3
*Banks under Advanced Approaches. §A scoring system regulators use that is based on capital, asset quality, management, earnings, and liquidity.

New Basel 2.5 Rules Won't Have A Big Rating Impact For U.S. Banks

The final rules on Basel 2.5 require U.S. banks to hold greater capital against the market risks they run in their trading operations. The rules apply to organizations with aggregated trading assets and liabilities of at least $1 billion, or 10% of total assets, as well as to savings associations under certain conditions. We don't anticipate that the Fed's finalized rules will affect our ratings on U.S. banks, though more complete disclosures based on Basel 2.5 measures may lead us to revise our capital and earnings scores--which are part of our stand-alone credit assessments--for banks, which could result in downgrades in some cases.

As the SVaR and the IRC metrics become publicly available, we expect the improved disclosure to help market participants' analysis of trading-book market risks. (See "Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III," published on June 9, 2011.) Overall, the average capital requirements for market risk in the trading book for a sample of international banks have tripled with the implementation of Basel 2.5. We anticipate that the impact on capital requirements will be similar for the large, complex U.S. banks, but more limited for regional banks, most of which fall under the standardized approach for market risk capital requirements. Both Basel 2.5 and our RAC ratios should converge over time.

Although we view the finalization of market risk rules for banks as a positive development, we believe the rules are complex and that implementation gaps and inconsistencies could continue for banks that have significant trading activity (see "Basel 2.5 Increases The Squeeze On Investment Banking Returns," published on May 14, 2012). One major difference in market risk rules in the U.S. is the requirement that banks use alternatives to external credit ratings (section 939A) when determining the standardized specific risk capital requirements for debt and securitization positions. This includes exposures to sovereigns, banks, public-sector entities, financial and nonfinancial companies, and securitization transactions. The published rule details the definition of covered positions, requirements for their identification, requirements for internal models, and "determination conditions" to calculate VaR and SVaR capital requirements, among others.

We believe that Basel 2.5 (and the Fed's new rule) reduces capital arbitrage opportunities between banking and trading books. In particular, it aligns capital charges for securitization positions in the trading book with charges for securitization positions in the banking book. This includes banks with an approved VaR model and excludes correlation trading positions for which a comprehensive risk measure can be developed with supervisory approval.

With respect to sovereigns, the new Fed rule requires that banks apply specific risk weights to their sovereign exposures according to the Organization for Economic Co-operation and Development's Country Risk Classifications (CRC), which range from 0 to 7. These classifications are usually used for export transactions to calculate the premium interest rate to charge to cover the risk of nonrepayment of export credits. CRCs are updated periodically, though we have yet to evaluate their capacity to capture shifts in risk amid rapidly deteriorating conditions, such as those in Europe.

The Fed has assigned risk weights that range from 0% for U.S. government exposure to 150% for a country with a CRC of 7. The risk weight will be 150% for debt from a sovereign that defaulted in the prior five years, or 100% if the sovereign has no CRC but has not defaulted. Standard & Poor's assigns risk weights in its RAC model based on sovereign ratings. Our risk weights can vary from 3% for 'AAA' rated countries to 173% for 'B-' rated countries, so capital ratios from our RAC model can be more conservative than regulatory ratios, particularly as sovereign ratings decline. To illustrate, exposures to both Spain (BBB+/Negative/A-2) and Portugal (BB/Negative/B) receive a 0% risk weight under the Fed's proposed approach, whereas under our approach, exposures to those countries would have a risk weight of 23% and 79%, respectively. Risk weights for corporate exposures follow an investment-grade concept based on the bank's assessment of a firm's repayment capacity. For securitizations, external credit ratings will be replaced by the supervised formula approach (SFA) or a simplified supervised formula approach (SSFA), already being used under Basel II rules, which reflect capital requirements of the underlying assets.

We're in the process of updating the charges we apply to market risk exposure for banks that are domiciled in jurisdictions subject to the Basel 2.5 regulatory framework and that have regulatory-approved internal market risk models (see "Advance Notice Of Proposed Criteria Change: Updating Market Risk Charges For Banks In Our Risk-Adjusted Capital Framework," published on May 14, 2012). The charges are a component of our calculation of a bank's RAC ratio. We are making these revisions to better capture market risk in our RAC methodology, following the improved disclosure on banks' trading book exposures in Pillar 3 reports under the new Basel 2.5 framework. We expect to publish the revised charges for market risk exposure in the coming weeks.

The Basel III Draft Rules Showed Some Additional Insights

We expected the Basel Committee to establish new regulatory capital minimums, yet the draft rules had a few unexpected elements. The scope of the NPRs is greater than we had anticipated. The Basel III NPR and the Standardized Approach NPR apply to all insured banks and bank holding companies with more than $500 million in assets. The Advanced Approaches and Market Risk NPR only applies to organizations with more than $250 billion in assets or consolidated on-balance-sheet foreign exposures of at least $10 billion.

Under both U.S. GAAP and International Financial Reporting Standards (IFRS) rules, all securities classified as AFS are valued on the balance sheet using mark-to-market accounting, although unrealized gains and losses do not affect net income until the bank sells the securities or determines they are impaired. Instead, unrealized gains and losses are included within accumulated other comprehensive income (AOCI), a component of equity. Currently, regulatory capital excludes certain unrealized gains and losses within AFS portfolios, such as those related to holdings of debt. Under Basel III and the proposed Fed rules, all unrealized gains and losses related to the AFS portfolio would flow through to common equity Tier 1 capital, thereby making capital more volatile and encouraging banks to hold higher capital buffers to avoid swings that may breach the minimum levels. Under our RAC framework, we neutralize the impact of all mark-to-market fluctuations that are recorded in equity related to securities within the AFS portfolio (see "Financial Institutions Group Provides More Transparency Into Adjustments Made To Bank Data," published on April 26, 2007). What surprised us is that the Fed is asking for comments regarding the potential carve-out of unrealized gains and losses on debt securities whose changes in fair value may be primarily due to changes in benchmark interest rates, as opposed to changes in credit risk, such as U.S. government and agency debt securities. By potentially carving out some securities from this calculation, the Fed may introduce one more way in which the U.S. Basel III standards will be inconsistent with those of other countries.

In addition, the proposed capital rules don't include anything about SIFI charges or additional countercyclical buffers for the larger banks. Also, the draft rules include increased deductions for mortgage servicing rights (MSRs) and deferred tax assets (10% of CET1 individually or 15% collectively), as well as increased risk weights for some asset classes, including foreign exposures, commercial real estate that finances the acquisition, development or construction of property, residential mortgages, and past due exposures.

Improved Capital And Better Disclosure--What's Not To Like?

Regulators impose minimum capital standards on the banks they supervise to limit potential claims on a deposit insurance fund (when one exists) or to avoid the need for government financial assistance. Bank management teams, in turn, usually aim to exceed regulators' minimum capital requirements to avoid regulatory interference aimed at correcting unsafe banking practices. Such interference can take management's resources away from the day-to-day operations of a financial institution. Meeting or exceeding minimum regulatory requirements is essential for a financial institution to operate as a going concern and to be able to grow. We monitor performance against regulatory measures, and any weaknesses in these measures can be an overriding factor in our ratings. Absent any breach of regulatory capital minimums, the main factor in our assessment of a bank's capital and earnings is our RAC framework, which offers an alternative, globally consistent measure of capital.

Related Research

Primary Credit Analyst:Rodrigo Quintanilla, New York (1) 212-438-3090;
Secondary Contacts:Devi Aurora, New York (1) 212-438-3055;
Matthew B Albrecht, CFA, New York (1) 212-438-1867;

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