What Awaits Banks After the Leverage Ratio?

An article by New York Institute of Finance regulation & compliance instructor Mayra Rodriguez Valladares.

This article was originally published by The New York Times Dealbook on April 9th, 2014

The stronger leverage ratio approved by United States regulators on Tuesday is an essential component to the international banking rules of Basel III, which currently allow large banks a lot of flexibility and potential for data manipulation.

Yet it is not the last buffer for the world’s systemically important banks.

There are still quite a number of Basel guidelines, which the Basel Committee on Banking Supervision is expected to finalize later this year, at which point they would then probably be introduced by American bank regulators. The combination of all of these pending rules will affect banks’ business strategies significantly and will continue to influence how they strengthen their auditing and compliance teams for years to come.

Two sets of guidelines are still outstanding: the liquidity standard and the significant financial institutions surcharge. The liquidity standard is divided into short- and long-term buffers to ensure that banks are liquid.

The financial crisis started off as a credit crisis, but when panic ensued, it quickly became an illiquidity crisis. The main purpose of the liquidity standard — the liquidity coverage ratio — is to demonstrate to bank regulators and the market that large banks can survive for at least one month in a period of stress without government support.

In the United States, the proposed ratio is stricter than the Basel one finalized in January 2013 because banks can count fewer assets as high-quality liquid assets. For example, in the United States, unlike in Europe, banks cannot count municipal bonds as high-quality liquid assets. Large American banks will have to rely on cash, high credit quality bonds and gold to satisfy the stricter requirements.

The long-term part of the liquidity standard, the net stability funding ratio, was proposed only this January by the Basel Committee, so it probably will not be introduced in the United States until the fall. This purpose of this ratio is to make sure that banks rely less on short-term funding for their longer-term liabilities. The comment period for this rule ends on April 11.

Already, numerous banks in Europe and the United States have stated their concern that the net stability funding ratio may make it more difficult for them to participate in the repo market, an important bank borrowing market. But there is no regulatory appetite in the United States to weaken the ratio. Daniel K. Tarullo, a Federal Reserve governor and the leading regulatory voice at the Fed, for one, has long been a vocal advocate for reducing banks’ reliance on short-term funding.

Large global banks also face another capital buffer — the systemically important financial institution surcharge. Basel guidelines were introduced last summer, but have not been finalized. As it stands, this buffer would range from 1 to 2.5 percent of risk-weighted assets, depending on a bank’s size, interconnectedness to the financial sector and the complexity of its transactions. In the United States, the charge would apply to JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Wells Fargo, State Street and Bank of New York Mellon.

As if the different capital buffers were not enough of a challenge for banks’ risk managers and compliance officers, there are numerous guidelines remaining that will directly affect banks’ securities and derivatives portfolios. Last summer, the Basel Committee proposed that banks improve the way that they measure the credit risk of derivatives’ counterparties. Depending on whether banks trade derivatives directly with a counterparty over the counter or through a central counterparty, banks will have to allocate capital for the level of counterparty risk. The global financial crisis demonstrated banks’ need for more capital and collateral in derivative transactions.

Unfortunately, derivatives participants learned the hard way that sometimes it was the counterparty, like the giant insurer American International Group, that can suffer in credit quality before the asset underlying the derivative. Given other derivatives regulations, like the Dodd-Frank Act in the United States or the European Market Infrastructure Regulation, the Basel rules are making banks think twice about what derivatives are worth the risk.

Another guideline that will also significantly affect American banks will be one proposed in December to measure the risks posed by securitizations, no matter whether they are booked in the banking or trading book. When banks book transactions in the trading book, the capital for credit risk is less, since banks claim that they intend to sell those instruments. Given that American banks have increasingly re-entered the securitization market in the last two years, the proposed new rule would require banks to allocate capital for their securitization portfolio based on the level of credit, market and operational risks that the different instruments pose.

One of the most important and least discussed parts of Basel III is Pillar III, which sets disclosure guidelines for banks with the goal of strengthening market discipline. Both Sheila Bair, the former chairwoman of the Federal Deposit Insurance Corporation, and the F.D.I.C.’s current vice chairman, Thomas Hoenig, emphasized the importance of bank transparency at a symposium in Boston last week. The Basel Committee is expected to announce guidelines that would strengthen Pillar III sometime early this summer.

Unless banks are really compelled to be transparent about their risk exposures, especially about those that are off-balance sheet, like derivatives or repos, no amount of Basel rules will really help the public identify the level of banks’ credit, market, liquidity and exposure to risk.

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