By Joseph Neu
Last month US prudential regulators issued their long-awaited notices of proposed rulemaking (NPRs) on bank capital consistent with the US application of Basel III and pertinent provisions in Dodd-Frank. They did so in three distinct NPRs:
1) The Basel III NPR—Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action.
2) The Standardized Approach (RWA) NPR—Regulatory Capital Rules: Standardized Approach for Risk-weighted Assets; Market Discipline and Disclosure Requirements.
3) The Advanced Approaches and Market Risk NPR—Regulatory Capital Rules: Advanced Approaches Risk-based Capital Rule; Market Risk Capital Rule.
Banks, their industry groups, and all other interested parties have until September 7 to comment on these proposals. Treasurers facing banks as counterparties should also take the time to inform themselves on what the NPRs will and will not do.
WON’T SET MINIMUM CAPITAL
The first thing they won’t do is set the minimum capital levels for US banks. The Basel III NPR, for starters, does set a new standard for tier 1 regulatory capital, defined more strictly as common equity tier 1, at 4.5 percent of risk-weighted assets (RWA), plus a 2.5 percent capital conservation buffer if a bank wants to pay dividends, buy-back stock, or pay senior executives bonuses. However, as it also makes clear “as a prudential matter, a banking organization is generally expected to operate with capital positions well above the minimum risk-based ratios and to hold capital commensurate with the level and nature of the risks to which it is exposed…
The last point comes under the section on Supervisory Assessment of Overall Capital Adequacy. Simply put, this means the bank regulators charged with supervising banks will determine how much capital a given bank should retain. Indeed, anyone who has been paying attention to the evolution of US bank regulation can tell you that the model has shifted from one defined by broad, risk-based capital ratios to one defined by supervisory assessments of a bank’s capital requirements given the make up of their assets and liabilities, their current and future plans and the risks to which they are exposed. These supervisory capital assessments, in turn, will be informed much more by the stress-tests and capital plan submissions that all US banks will eventually be subject to. The ratios set forth in the NPR are just broad-based starting points. Still, it is the ratios that will serve as reference points for the average market participant.
WILL SET RISK WEIGHTINGS
Those following the ratios being referenced eventually notice that the risk-weightings, or how the risk weightings are determined are the most meaningful variable in them. Thus content in the second and third NPR are critical to digest.
Generally speaking, RWA amounts “would be determined by assigning on-balance-sheet assets to broad risk-weight categories according to the counterparty, or, if relevant, the guarantor or collateral.” RWA for off-balance-sheet items would use a two-step process: “(1) multiplying the amount of the off-balance sheet exposure by a credit conversion factor (CCF) to determine a credit equivalent amount, and (2) assigning the credit equivalent amount to a relevant risk-weight category.“ Notable changes include:
- Replacing ratings with a formula-based approach for determining a securitization exposure’s risk weight;
- Raising the CCF for most short-term commitments from zero to 20 percent (e.g., commitments, contingent items, guarantees, certain repo-style transactions, financial standby L/Cs, and forward agreements);
- Removing the 50 percent risk weight cap for derivative contracts and providing preferential capital requirements for cleared derivative and repo-style transactions.
Larger banks would be subject to the third NPR which goes further with counterparty and credit-risk considerations along with market-risk weightings. They also would be subject to public disclosures “on the scope of application, capital, risk exposures, risk assessment processes, and, thus, the capital adequacy of the institution.”