Changes in US Banking Regulation - Tier 1 Capital Requirements

An article by New York Institute of Finance Regulation & Compliance instructor Jack Foster

By far the greatest change forced on US banks since the crisis of 2008 is the increase in the quality and amount of Tier 1 capital.  Basel III required and US regulators implemented the changes requiring banks with deficient capital to be acquired or dramatically cut dividends, sell assets and issue new common equity.

As the economy has recovered, US banks have successfully recapitalized, but at substantial cost.  Smith Barney, Lehman Brothers, Wachovia and Washington Mutual were all liquidated or acquired by stronger banks.  In addition, US bank stocks for surviving banks, in many cases, declined substantially in value, due to the dividend cuts and dilution from the issue of new shares.  Citicorp’s common stock, for example, is currently selling at less than 10% of its value before the crisis; Bank of America and Morgan Stanley’s only 25%; and Goldman Sachs’ only 60%.  Only Wells Fargo and JP Morgan are selling at approximately 100% of their earlier value.

The 2008 crisis resulted in the reassessment by regulators of two fundamental principles that had guided there approach to regulation in the past.  The first was a change in focus on a Tier 1 capital that protected depositors in liquidation to a focus on Tier 1 capital that permitted the survival of a financial institution after a crisis.  The second was a recognition that large banks, which previously had been viewed as needing less capital than smaller banks because of the risk reduction of geographic, product and funding diversification, in fact, needed more capital because of their large securities portfolios and extensive  involvement in market making activities.

The mistaken assumption that Tier 1 capital could consist of interest paying instruments, such as trust preferred stocks, overlooked the fact that for large banks, failure of these instruments, in the eyes of the market place, would jeopardize the credit worthiness of the entire institution.  The market and the rating agencies viewed dividend payments on these instruments as lessening a bank’s ability to rebuild capital after losses and therefore survive as an on-going concern.  As a result, Basel III required banks to increase their minimum Tier 1 common equity portion of capital from 2½% to 4½% and allowed regulators to require up to an additional 2½% common equity capital conservation buffer to be built up on good times for a total of  7%).  An additional countercyclical buffer of between 0%--2½% of common equity or other fully loss absorbing capital will be permitted, depending upon national circumstances.

The mistaken assumption that diversified large banks required less capital than smaller banks overlooked the fact that the much of the risk of large banks was off the balance sheet in the form of asset securitizations.  In the 2008 crisis, regulators required banks to take back some of the asset securitizations they thought they had sold.

Most US banks have increased the common equity component of their capital. They now meet the standard risk weighted Tier 1 capital requirements.  As a result, they can now pay dividends.  However, the largest banks are still short of capital on the proposed 5% un-risk weighted asset based leverage ratios for bank holding companies and proposed 6% un-risk weighted asset based leverage ratios for banks.

These un-risk weighted asset based leverage ratios, if implemented, will result in greater efforts by money center banks to reduce the volume of repos, trading assets and securities.

In summary, the US regulators seem determined to require all banks to have better quality and larger amounts of common equity and to reduce the risk of “To big to fail” by requiring large financial institutions to have substantially more capital than traditional commercial banks.  

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