July 3 (Bloomberg) -- The Federal Reserve has finally approved new rules that will require U.S. banks to finance their operations with more equity and less debt. Big global banks will have to meet even tougher capital requirements. And in the best-is-yet-to-come category, the Fed said a further tightening of the rules isn’t far off.
This is all good news. The rules, part of the accords known as Basel III, carry through the commitment to make banking safer after the global financial system buckled in 2008. Until recently, it seemed regulators would give way to bank lobbyists who have argued that tougher capital rules would harm the economy by forcing the industry to lend less.
Under the new arrangements, U.S. banks will have to maintain common equity (meaning shares plus retained earnings) equal to 7 percent of risk-weighted assets. They will also be held to a so-called leverage ratio of 3 percent of all assets, without adjusting for risk. The rules will be phased in, beginning in 2014 for large banks and 2015 for smaller ones. Other regulators -- the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency -- are expected to adopt similar changes next week.
The new standards aren’t as tough as they should be, even though some already surpass the Basel minimums. Regulators will take another step with a proposal, which the FDIC will publish next week, for a more demanding leverage ratio, possibly as high as 6 percent. In a few months, there will be a proposal specifying how much combined equity and long-term debt banks must have, allowing for the orderly dismantling of a bank that fails.
A third measure under consideration would require large banks that depend heavily on funding from money-market mutual funds, possibly including Goldman Sachs Group Inc. and Morgan Stanley, to hold additional capital.
The Fed dropped part of an earlier proposal that would have forced banks to set aside more capital for home loans. It also eased up on what it expects from community banks, including exempting them from making frequent adjustments to the value of securities on their trading books.
Large banks didn’t get that dispensation, probably because they are already complying with the new rules and don’t seem to be suffering as result. The Fed says that 90 percent of small banks (those with less than $10 billion in assets) and 95 percent of the rest meet the new minimum capital standard.
Good, but now regulators need to go further. Fed Governor Daniel Tarullo, who heads the central bank’s supervision efforts, said in a recent speech that Basel’s leverage ratio of 3 percent “may have been set too low.” He wins the prize for understatement. That figure means a bank would be insolvent if the value of its assets dropped just 3 percent.
Tarullo and other regulators also think that existing rules give banks too much leeway in sorting assets by risk. The process of risk-weighting allows banks to have less capital underpinning assets they judge to be less dangerous. History shows those judgments are hard to make.
Academics and lawmakers from both parties have joined the call for more capital. FDIC Vice Chairman Thomas Hoenig favors a 10 percent leverage ratio, made still more demanding because it would include more of the off-balance-sheet assets that the Basel rules leave out.
To comply with Hoenig’s proposal, the three largest U.S. banks -- JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. -- would have to stop paying dividends for about five years, according to data compiled by Bloomberg. And Hoenig’s plan isn’t the most demanding proposal in circulation.
Strengthening the industry against financial shocks is a work in progress. Strong capital rules won’t completely shield the banking system from another crisis like that of 2008. But they will help ensure that banks’ losses, when they occur, will be absorbed by owners, not by the wider financial system or worst of all by taxpayers.
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