Fed ‘Punted’ on Capital, Liquidity Limits in Dodd-Frank Plan

The Federal Reserve’s plan to boost supervision for U.S. banks stopped short of setting minimum liquidity levels and delayed decisions on risk-based capital and leverage until international regulators weigh in.

While companies must conduct stress tests and set internal liquidity limits under the Fed guidelines released yesterday, regulators didn’t specify how much cash lenders must hold. The central bank said it would wait for the Basel Committee on Banking Supervision to implement capital surcharges. The industry will have a chance to comment on the proposal and may have more time to challenge rules.

“The Federal Reserve punted on its Dodd-Frank mandate to develop enhanced capital and liquidity rules for all systemically important financial firms,” Joe Engelhard, senior vice president of Washington-based investment advisory firm Capital Alpha Partners LLC, said in a note to clients yesterday. “This seems to have engendered a relief rally, but it will also mean some prolongation of regulatory uncertainty.”

The Fed, acting on a mandate of the Dodd-Frank Act, is developing standards geared toward averting another financial crisis and taxpayer bailout of the biggest financial firms. The rules target banks with assets of at least $50 billion -- such as Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC) -- and other firms deemed “systemically important.”

The KBW Bank Index (BKX) of 24 U.S. lenders climbed 4.1 percent yesterday, compared with a 3 percent gain for the broader Standard & Poor’s 500 Index. The bank index has slumped 30 percent this year and the S&P has slipped 1.3 percent.

Capital Surcharges

The Fed said it would implement capital surcharges for U.S. banks based on guidelines issued by the Basel committee. The so- called Basel III rules give global banks until 2019 to increase their core capital ratios to as much as 9.5 percent of risk- weighted assets.

It hasn’t been determined whether there will be a surcharge for U.S. banks with at least $50 billion in total assets that aren’t deemed global systemic institutions, according to a Fed official who spoke on the condition of anonymity. The Fed’s interpretation of Dodd-Frank’s intent was to design standards that are proportional to the systemic footprint of a financial institution, the official said.

Barbara Hagenbaugh, a Fed spokeswoman, declined to comment.

The strength of the central bank’s rulemaking hinges on how regulators react to public comment, former Fed Governor Randall S. Kroszner said in a telephone interview.

‘Phased-In Approach’

“While these rules will require considerable review and comment from the industry, we are pleased to see the Fed is taking a phased-in approach to a number of these measures,” Ken Bentsen, executive vice president for public policy and advocacy at the Securities Industry and Financial Markets Association, a trade group in Washington, said in an e-mailed statement.

The Fed said its liquidity rules will build on March 2010 guidance and require that banks run stress tests to determine if they can withstand four scenarios, including overnight, 30-day and one-year crises. Only “unencumbered” and “highly liquid” assets may be considered within the first 30 days. Regulators requested comments on the definition of those assets.

The Fed’s latest liquidity rules aren’t “a dramatic departure,” said Dwight C. Smith III, a partner in Washington at law firm Morrison & Foerster LLP. “There are elements that are new but they won’t force changes in the business.”

The Basel rules would require banks to keep enough cash or other easily liquidated investments on hand to survive a 30-day crisis, starting in 2015. The Basel committee stipulated the size of cash “outflows” banks should expect to experience in a crisis, including a minimum 5 percent of deposits and at least 10 percent of corporate credit lines.

‘Liquid Assets’

The Clearing House Association, a group that includes 17 of the world’s biggest banks including JPMorgan, Deutsche Bank AG and Banco Santander SA (SAN), wrote in a Nov. 2 letter to U.S. Treasury Secretary Timothy F. Geithner that the Basel rules “significantly understate the stock of liquid assets that firms could use to meet their short-term funding needs.”

It still “makes sense” for the Fed to delay rules until the central bank can better study the issue and align its thinking with international regulators, Darrell Duffie, a finance professor at Stanford University’s Graduate School of Business in California, said in a telephone interview.

“They don’t want to cause a migration of banking outside the U.S. until they understand the full implications,” Duffie said.

Systemically Important

The Fed gave specific guidelines for other rules, imposing curbs on dealings between a bank or other systemically important firm and a single counterparty. Regulators would limit a firm’s capital exposure to 10 percent if the company and the party on the other side of its transactions each have at least $500 billion of assets or are dubbed systemically important. This is stricter than Dodd-Frank, which has a 25 percent limit.

Goldman Sachs Group Inc. (GS), the fifth-biggest U.S. bank by assets, said in a regulatory filing that its credit risk to any single counterparty didn’t exceed 2 percent of the New York- based firm’s $948.9 billion in total assets as of Sept. 30.

Regulators will compel the biggest banks to follow a tougher standard for risk management and demand more rigid oversight by corporate boards. The rules would set triggers for regulatory enforcement toward weak firms.

“They are going to look at each institution to look at what is the appropriate scope of supervision they should exercise,” said Michael Bleier, a partner at law firm Reed Smith LLP and a former Fed lawyer. “They are going to try to not get too significantly involved in changing their business model.”

To contact the reporter on this story: Dakin Campbell in San Francisco at dcampbell27@bloomberg.net

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net.

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