Regulators have proposed an overhaul of the US capital framework in a long-awaited response to Basel III and Basel 2.5 - but there are differences to the European version of the rules.
In contrast, the European Union floor states that capital cannot fall below 80% of the level an individual firm would face under Basel I. Of the two, the Collins amendment may bite harder, says Walter. “There is a difference in terms of how the floors are calculated between the US and the rest of the world, but Basel sets minimum requirements – it doesn’t limit what countries can do to be super-equivalent. The US rules are more constraining in that they impose on advanced banks a floor equal to the capital requirements that will apply to the broader universe of banks,” he says.
The US proposals also omit the two liquidity ratios in Basel III. Those ratios are currently being revisited by the Basel Committee, and US regulators say they will be incorporated at a later date.
The proposals were issued jointly by the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency. At the same time, the three agencies finalised their December 2011 proposal implementing revised trading book capital rules known as Basel 2.5. Those rules came into force in the European Union at the start of this year, but implementation has been delayed in the US as regulators sought to adjust the rules in a way that reflects a Dodd-Frank requirement that references to credit ratings should be removed from regulation.
The Basel III proposals would implement a new minimum core Tier I ratio of 4.5% of risk-weighted assets (RWAs) and introduce a common equity Tier I capital conservation buffer of 2.5% of RWAs. Regulators are also tightening up the definition of capital in line with Basel III standards – a step that had caused friction in the US by preventing banks from counting mortgage servicing rights and deferred tax assets towards their capital ratio.
The rules retain the existing leverage ratios used by US regulators and add the new Basel III minimum Tier I leverage ratio of 3% as a supplement for sophisticated banks. Most US banks are subject to a minimum Tier I leverage ratio of 4%, which falls to 3% for the strongest firms. Unlike the US ratios, the Basel III measure includes off-balance-sheet exposures.
“The Basel III leverage ratio represents a significant change for larger institutions with a lot of off-balance-sheet commitments and derivatives. These banks would now be subject to two leverage ratios – the traditional one and the more comprehensive Basel III one,” says Ernst & Young’s Walter.
One of the three rules addresses the calculation of RWAs under the standardised approach – an attempt to implement elements of Basel II for less sophisticated firms – which also had to be modified to comply with the Dodd-Frank ban on the use of credit ratings. The attempt to remove ratings follows a similar approach to the approved Basel 2.5 rules.
The Basel 2.5 rules are largely unchanged from the agencies’ December proposals. They include a market risk charge based on value-at-risk, a stressed VAR charge, an incremental risk charge to capture default and credit migration risk, a standardised charge for securitisations and a comprehensive risk measure for correlation trading portfolios – a measure that is also subject to a minimum floor.
US regulators had struggled to introduce Basel 2.5 while satisfying the Dodd-Frank Act – the internationally agreed version of Basel’s securitisation charge relied on external ratings, so US regulators had to find an alternative approach. The December 2011 proposal suggested using a variety of measures in their place, including a so-called simplified supervisory formula approach. This has been retained in the final rules, although agencies claim the formula has been tweaked to make it more risk sensitive.
A patchwork of measures is used to mimic the effect of ratings elsewhere in the market risk rules. The US version of the standardised approach to sovereign debt, for example, incorporates a system of risk classifications from the Organisation for Economic Co-operation and Development (OECD) – an approach that had been sharply criticised when it appeared in the December proposals, with the OECD itself telling Risk that the classifications do not measure sovereign risk.