Basel Capital Rules May Prompt Banks to Shrink Trading, OCC's Dugan Says

Higher capital requirements that international regulators plan to impose on banks worldwide are likely to push firms to shrink trading activities in favor of lending, U.S. Comptroller of the Currency John Dugan said.

The new rules being negotiated by regulators in the Basel Committee on Banking Supervision would have a greater impact on the firms’ so-called trading books, which include stocks, bonds and other securities, Dugan said in an interview. Loans and other debt held until maturity in their banking books would be less affected.

Banks worldwide have opposed the proposed changes to the Basel rules by arguing that it will force them to cut lending because they won’t be able to raise capital needed to comply. The firms’ pressure led the Basel committee to soften some proposals last month, as a group of countries led by Germany were concerned that Europe’s economic recovery is stalling.

“One way to comply is shrinking your balance sheet, but it matters how you do so,” said Dugan, who’s leaving the OCC this month when his five-year term ends. “Many argue that it was the trading book that caused unanticipated losses during the crisis. To the extent that some bank shrinks those activities instead of bearing the increased capital charge, that may not be the worst thing in the world.”

The Basel committee said last week it agreed to continue allowing some assets, including banks’ minority stakes in other financial firms, to count in part as capital, reversing a plan to ban their use. It also eliminated a phrase that would make banks hold five times more capital for one type of market risk faced during trading securities. Still most of the section that increases capital charges on market risks has so far been left unchanged.

Not ‘Watering Down’

The tweaks in the original proposal, informally known as Basel III and released by the committee in December, shouldn’t be seen as “watering down,” Dugan said. Dugan, whose agency is one of the five U.S. institutions represented on the Basel committee, attended the group’s meetings last month.

“The first set of proposals was too conservative,” he said. “So all these are natural compromises, and they are by no means gutting it. We’ll still be coming out with a quite strong package.”

Other U.S. regulators have voiced concern that proposals may be softened too much. Sheila Bair, the head of the Federal Deposit Insurance Corp., told the Financial Times last month that some committee members were “succumbing somewhat to industry arguments” about the new rules hurting economic recovery. Her remarks were confirmed by the FDIC.

Capital Requirements

An analysis of U.S. lending rates and bank capital ratios between 1920 and 2009 revealed no significant correlation between the two, according to a July paper by professors Samuel Hanson, Jeremy Stein and Anil Kashyap. Hanson and Stein teach at Harvard University and Kashyap is at the University of Chicago.

While having agreed on the revised definitions of what counts as capital, the Basel committee hasn’t set the new minimum levels for it. Banks currently need to hold capital at least equal to 8 percent of risk-weighted assets. Half of that must be Tier 1, and half of the Tier 1 needs to be common stock. Tier 1 includes securities other than common shares that can help a lender cover unexpected losses.

The committee’s focus has shifted to common stock from Tier 1 as the most critical component of the required capital levels, Dugan said. Even as regulators weigh the possibility of hurting economic growth against the need for financial stability, there’s no doubt the ratio will be increased, he said.

“It’s not such a political jump to go above 2 percent,” the current ratio for common stock, Dugan said.

The committee might triple the common ratio requirement while doubling Tier 1, estimates Paul Miller, an analyst for FBR Capital Markets Corp.

To contact the reporters on this story: Yalman Onaran in New York at yonaran@bloomberg.net.

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