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In order to strengthen the banking sector and mitigate the threats posed by big banks to the financial system as a whole, the Federal Reserve approved of stricter capital rules. These capital rules put into practice the Basel III accords as well as changes necessitated by the Dodd Frank Wall Street Reform and Consumer Protection Act in the U.S.

Going by the Fed’s decision, the capital rules will apply to all depository institutions, bank holding companies with total consolidated assets of $500 million or more, and banking organizations. Further, the rules are likely to gain the sanction of the Federal Deposit Insurance Corp (FDIC) and the Comptroller of the Currency (OCC) as well, in the coming week.

The banks have sufficient time to implement these new capital rules. These rules are scheduled to be implemented in a phased-in manner, starting 2014 through 2018.

The phase-in period for big banks start from Jan 2014, while for smaller, less complex banking firms the phase-in period will not begin until Jan 2015. Notably, at present, savings and loan holding companies with significant commercial or insurance underwriting activities will not be subject to the final capital rule.

The New Capital Rules

The capital rules suggest that U.S. banks would need to set aside more capital as buffer to tide over unexpected losses. Banks will be required to maintain a new minimum common equity tier 1 ratio of 4.5% of risk-weighted assets (RWAs) and a common equity tier 1 capital conservation buffer of 2.5% of RWAs applicable to all supervised financial institutions.

This comes to a total of 7%, which is well above the current requirement of about 2%. Notably, 90% of the financial institutions with less than $10 billion in assets are expected to meet this new capital requirement rule, as per Mar 31, 2013 data.

Additionally, the minimum ratio of tier 1 capital has been raised to 6% of RWAs from the present 4%. Moreover, minimum leverage ratio for all banking institutions has been pegged at 4%.

Further, for the largest, most internationally active banking organizations – including Bank of America Corp. (BAC - Analyst Report), Citigroup Inc. (C - Analyst Report), Goldman Sachs Group Inc. (GS - Analyst Report), Morgan Stanley (MS - Analyst Report) and JPMorgan Chase & Co. (JPM - Analyst Report) – the final capital rule includes a new minimum supplementary leverage ratio that takes off-balance sheet exposures into consideration.

Additionally, the new capital rule enhanced the methodology used for calculating RWAs, thereby improving the risk sensitivity. Banks and regulators employ risk weighting to assign varying levels of risk to different classes of assets, with riskier assets requiring higher capital cushions and less risky assets entailing smaller capital cushions.

Nevertheless, in a concession to large banks, the Fed has decided to remove a provision that would have necessitated the banks to hold different levels of higher capital against a wide range of riskier subprime and other types of residential loans. The existing provisions weigh residential mortgage securities in 2 categories of risk – 100% for primary mortgages and 50% for second lien loans.

Still a Long Way to Go

These rules might limit the flexibility of the banks with respect to investments and lending volumes. Moreover, such stringent capital rules may considerably slacken the pace of a worldwide economic recovery in the near term.

Moreover, higher capital requirements are a plausible concern for smaller banks, which are already finding it difficult to navigate through the current sluggish economic environment with increased regulations. While larger banks can counter such situations with their size, smaller banks whose business models have already been put to question, might be challenged while adhering to such capital norms.

A weak capital level is always a threat to the global economy. Needless to say, meeting new capital rules would act as building blocks for the still unstable economy. The capital rules will benefit the financial system in the long run. They will prevent bank failures and involve less of taxpayers’ money for the bailout of troubled financial institutions.

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