Federal Reserve Governor Speaks on Minimum Capital Requirements

Inrna speech Friday on financial reform, Federal Reserve Governor Daniel K.rnTarullo, spoke about issues involved in implementing both Basel II and thernDodd-Frank Act, reforming minimum capital requirements and addressed the issuernof bank dividends. </p

Though long viewed as arnsupervisory tool, Tarullo said, U.S. bank regulators did not impose explicitrnminimum capital requirements until the 1980s when Congress saw the capitalrnratios of the largest banks declining while they faced enormous foreign loan losses.rnThe U.S. response ultimately led to the original Basel Accord. </p

Regulators came to regardrncapital requirements as a supple tool which as regulations eased, appeared to berna promising way to protect the public interest with a buffer against bankrnlosses where financial institutions had access to the Federal Reserve’srndiscount window and Federal Deposit Insurance. The idea also evolved that maintainingrna material equity value for the bank would disincentivize excessive risk-taking.  In the quarter century that followed, capitalrnrequirements largely became the dominant prudential regulatory tool. </p

The recent crisis showedrnthat this regulatory focus had caused the world to ignore other risks; thernimplications of the growth in size, leverage, and maturity transformationrnlevels of the shadow banking system for the balance sheets of commercial banksrnand for overall financial stability. The limitations of capital requirements asrna regulatory tool, such as the frequent lag between declines in asset valuesrnand reductions in bank capital, were also confirmed by experience during therncrisis.  But it was also evident thatrncapital requirements were not high enough or set with respect to particularrnassets and that some of the instruments that qualified as “Tier 1rncapital” were not reliable buffers against losses. </p

Tarullo said at the heightrnof the crisis counterparties and other market actors relied almost exclusively onrnthe amount of tangible common equity as a measure of the creditworthiness andrnoverall stability of those financial institutions, essentially ignoring thernTier 1 and total risk-based capital ratios.  The resulting widespread doubt about the stabilityrnsome institutions made investors and counterparties reluctant to deal with them,rnthus contributing to severe liquidity strains.  </p

Going forward, thernregulatory system will not be as dependent on capital requirements and Dodd-Frankrnitself is testimony to this fact. There will be increased emphasis on marketrndiscipline, liquidity regulation, activities restrictions, and more effectivernsupervision. But robust capital requirements should continue to be a centralrncomponent of the financial regulatory system. The U.S. banking agencies, andrnmost of our counterparts from countries represented in the Basel Committee onrnBanking Supervision, made strengthening the capital regime a high priority inrnthe latest financial reform agenda. </p

Basel III makes a number ofrnimportant changes to address deficiencies in the pre-crisis capital rules: </p<ul class="unIndentedList"<liIt creates new minimum common equity capital requirements and providesrna definition for the calculation of common equity that will prevent the inclusionrnof certain assets that could dilute its loss-absorbing character.</li</ul<ul class="unIndentedList"<liThe minimum common equity ratio will be set at 4.5% of risk-weightedrnassets, with an additional requirement for a 2.5% "conservationrnbuffer." The minimum ratio defines the amount of common equity needed forrna firm to be regarded as a viable financial intermediary; the conservationrnbuffer, a new feature of capital regulation, is intended to reflect the lossesrnthat a firm may suffer during periods of financial stress. </li</ul

The practical effect of therntwo-level approach is that banks under stress may let their common equity ratiorndrop below the 7% level that is the sum of the minimum and buffer requirements.rnHowever, restrictions on capital distributions will result, which will becomernprogressively more stringent as the common equity ratio drops closer to thern4.5% minimum. The buffer is thus designed to forestall banks from continuing tornpay dividends even as they come under stress </p<ul class="unIndentedList"<liBasel III changes the risk weights assigned to a financialrninstitution's traded assets and counterparty exposures. The changes in riskrnweights incorporate some elements of a macroprudential perspective as, forrnexample, in higher capital requirements on equity investments in otherrnfinancial firms and credit exposures to large financial firms </li</ul<ul class="unIndentedList"<liIt provides for a minimum leverage ratio, roughly similar tornrequirements already applicable under national law in the US and Canada. </li</ul<ul class="unIndentedList"<liThe US favored a significant transition period for Basel III but not therneight years now required. Most USrnbanking entities expect to meet the new requirements considerably sooner, but thernphase is between 2013 and 2019 was an important inducement for some countriesrnto agree to the new, much stronger standards. </li</ul

Tarullo noted that a numberrnof market analysts have said there is considerable apparent variation in thernrisk-weightings applied by different banks so the fed is urging the BaselrnCommittee to explore mechanisms for ensuring that these strengthened capitalrnstandards lead to a consistency in application, as well as in the provisions ofrnrelevant domestic regulations. </p

The GHOS agreed inrnSeptember that systemically important institutions should have loss absorbingrncapacity beyond the Basel III requirements. As this parallels a Dodd-Frankrnrequirement, the Federal Reserve thinks it best to develop our plans for domesticrnstatutory obligation in tandem with our participation in this internationalrnprocess. </p

As the financial system hasrnstabilized, Tarullo said some firms have indicated an interest in resuming orrnincreasing dividends, or repurchasing shares. Until Basel III was completed andrnDodd-Frank enacted, it was obviously difficult for any firm to provide arnforward looking demonstration that its capital position would be protected evenrnunder stressed conditions.  While thererncontinues to be a relatively high degree of uncertainty, the basic questionsrnsurrounding capital and regulatory reform have now been answered and thernFederal Reserve will soon be issuing supervisory guidelines applicable to dividendrnrequests from the largest holding companies. The Fed’s approach will be arnconservative one requiring firms to submit convincing capital plans thatrndemonstrate their ability to absorb losses over the next two years under anrnadverse economic scenario it will specify, and still remain amply capitalized. Firmsrnwill have a sound estimate of any significant risks that may not be captured byrnthe stress testing, such as potential mortgage putback exposures, and therncapacity to absorb any consequent losses. The firms will also be asked to showrnhow, even with their proposed capital distributions, they will readily andrncomfortably meet the Basel III requirements as they come into effect, as wellrnas to accommodate any business model changes that might be necessitated byrnDodd-Frank. </p

Inrnimplementing the Dodd-Frank Act, Tarullo said the Board of Governors will employrna transparent process that goes well beyond the usual notice and commentrnrequirements.  The Federal Reserve isrnentering into the public record a summary of all communications withrnnon-government groups and organizations and has joined with other regulatoryrnagencies in sponsoring joint forums to solicit views from industry, academics,rnconsumer groups, and others.</p

Tarullornalso addressed what he called the “mortgage foreclosure documentation imbroglio, the latest chapter in thernrecent sad history of mortgage finance in this country” and took aim atrnwhat he called a perverse set of incentives for homeowners with underwaterrnmortgages.   Homeownersrnwho try to get mortgage modifications are too frequently subject to delay andrndisappointment while those who simply stop paying their mortgages find they canrnoften stay in their homes for a year or more rent free.  This is not a good outcome from anyrnperspective, he said.  Regardless of therncauses of this situation, “it just cannot be the case that foreclosure isrnpreferable to modification – including reductions of principal” where therncosts are so high.  Tarullo said he hopedrnthat the servicers and investors will take this occasion not just to correctrnthe documentation flaws or to argue over who should bear the financial losses,rnbut to invigorate the modification process.

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