U.S. Banks Facing Capital Hole Get No Leverage Relief From Basel

Global regulators weakened a proposed rule this month intended to keep banks’ borrowing in check. For eight of the biggest U.S. lenders, those changes won’t provide much relief.

That’s because the Basel Committee on Banking Supervision’s leverage standard is back to where it started four years ago after three rounds of revisions. With the latest changes in the definition of what counts as assets, U.S. firms will need to include more derivatives and fewer credit commitments. Those two adjustments cancel each other out, leaving the ratio of capital to assets for the eight companies almost unchanged.

The changes came as regulators worldwide struggled to balance political pressure to come up with tough rules to prevent another crisis against pushback from banks, which warned about harming the economic recovery. The leverage standard is among the most disliked by banks because it ignores their internal models for determining which investments are riskier -- a system regulators have said is easy to manipulate.

“Overall, the changes pretty much net to zero,” said Brian Kleinhanzl, an analyst at Keefe, Bruyette & Woods Inc. in New York, who has written reports about how banks would fare under different leverage formulas.

U.S. regulators, who led the push for a global leverage standard, proposed in July that the country’s largest banks maintain a capital-to-assets ratio of at least 5 percent, higher than the 3 percent level set by Basel. A 5 percent leverage requirement means a bank’s assets can’t exceed 20 times its equity. The 3 percent Basel ratio allows greater borrowing.

More Capital

The higher U.S. ratio would require the eight banks -- JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co., Goldman Sachs Group Inc., Morgan Stanley, Bank of New York Mellon Corp. and State Street Corp. -- to hold $63 billion more capital, regulators said at the time. Because firms have until 2018 to comply, they don’t need to raise capital immediately and can meet the new requirements by delaying share buybacks or dividend increases.

While the U.S. rule was based on the definition of assets spelled out by the Basel committee in 2009 and revised for the first time in 2010, U.S. banking supervisors said in July they would consider incorporating further changes to the methodology proposed by global regulators the previous month.

The final version of that proposal was agreed upon in Basel, Switzerland, this month. If the June changes had been incorporated into the U.S. rule, they would have widened the capital gap by about 50 percent because it would have added $2.5 trillion to the asset base of the eight lenders, according to analysts’ estimates compiled by Bloomberg.

Fed Delay

The Federal Reserve decided last year to delay completion of the U.S. rule until an agreement was reached on the global version. Regulators are now reviewing whether they can include the latest changes from Switzerland in the U.S. standard without having to publish their proposal for comments again, according to two people with direct knowledge of the discussions who asked not to be identified because the talks are private. U.S. law requires that public feedback be sought for material changes.

The Fed favored waiting until the Basel committee came up with a final version to simplify the process of incorporating the formula into the U.S. leverage rule, according to a person with knowledge of the central bank’s reasoning. The Fed also saw no reason to rush since the requirement doesn’t go into effect for four more years, the person said.

‘Go Backwards’

Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., one of the agencies involved in drafting the U.S. leverage rule, has urged adopting it without delay.

“We should lead the world in implementing a leverage ratio,” Hoenig said in an interview. “The U.S. should go forward as quickly as it can to adopt our version of the leverage ratio. Then we can look at the new Basel version and see if it is comparable or better and incorporate it later into ours if necessary. There’s no need to wait.”

Senators Sherrod Brown and David Vitter, who have proposed legislation for a 15 percent leverage ratio, echoed Hoenig’s call. Brown, an Ohio Democrat, and Vitter, a Louisiana Republican, wrote a letter Jan. 16 to the Fed, FDIC and the Office of the Comptroller of the Currency, voicing concern that delays could lead to weakening the U.S. standard. The changes in Basel shouldn’t give U.S. regulators “cover to go backwards on increasing capital,” Vitter said in a statement.

Complex Models

The Basel committee, which sets global banking standards, didn’t have a leverage requirement before 2009. Its capital rules, introduced in 1988, count assets based on how risky they’re deemed. That allows some of the safest assets, such as government bonds, to be funded fully by debt.

Basel regulations evolved to let large banks calculate the probability of losses using their own formulas, and therefore how much capital they need. As the models became more complex, policy makers including former FDIC Chairman Sheila Bair questioned their credibility, advocating a simpler leverage limit that doesn’t rely on risk-weighting.

The U.S. has had a national leverage rule for decades, one more narrowly defined than the current version. Bair pushed to include a large portion of banks’ off-balance-sheet commitments in the leverage calculation when she was a member of the Basel committee. Those include items such as derivatives, letters of credit and repurchasing agreements. The latest changes don’t weaken the ability to rein in leverage, according to Bair.

“It was disappointing that the committee retrenched from a very strong proposal,” Bair said in an interview. “But at the end of the day, this is still a much better standard than the 2010 agreement because it takes into account more credit derivative exposures.”

Netting Derivatives

The most recent Basel revisions, while having little impact on total bank assets, would change their composition. Fewer off-balance-sheet assets related to trade finance would be counted and less netting of derivatives allowed.

That would benefit banks such as San Francisco-based Wells Fargo because its business focuses more on direct lending and less on capital markets, according to KBW’s Kleinhanzl. The firm’s capital-to-assets ratio was almost 2 percentage points above the 5 percent minimum under the U.S. standard even before the latest revisions to the rule, Kleinhanzl estimates.

Some banks “will benefit due to their business mixture more than others,” he said.

JPMorgan, the largest U.S. lender by assets, said on a conference call Jan. 14 that its ratio would drop by about 0.1 percentage point under the latest Basel formula. Citigroup said it would get a bump of 0.1 percentage point, while Morgan Stanley said its ratio would be reduced by at least 0.2 percentage points. All three banks are based in New York.

Industry Lobbying

While the leverage ratio treats all assets including cash equally, it has been far from simple to determine what gets counted in the denominator of the equation. During the 2008 financial crisis, banks had to consolidate many assets that had been kept off balance sheets and suffered losses on them. The Basel committee has tried to include some of those commitments into the calculation of total assets.

Which ones are counted and how were at the heart of much industry lobbying in recent years.

The total assets of the eight U.S. banks were about $10 trillion at the end of last year, data compiled by Bloomberg show. The Basel leverage standard would have expanded that by as much as $7.5 trillion before it was softened this month, according to September estimates by the Clearing House, which lobbies on behalf of banks. When the denominator of a ratio is larger, it means a larger numerator, in this case the capital buffer, is needed to maintain the same proportion.

Credit Letters

The biggest change this month came in how to count letters of credit and other similar commitments banks provide their clients. In the original 2009 Basel standard, all of those would be added onto the balance sheet for the calculation of the leverage ratio. The final rule has a conversion ratio ranging from 10 percent to 50 percent. In other words, a $100 standby letter of credit would be counted as $50 or less depending on its maturity and other characteristics.

While the Basel committee also softened its approach to how derivatives are counted, it left intact some of the expansion that its June proposal had introduced, such as including a bigger proportion of credit default swaps.

The combined assets of the top U.S. banks would increase by about $1 trillion less than what KBW and the Clearing House had estimated with the changes in how credit letters are treated, while they would go up by about the same amount adding in the derivatives, data compiled by Bloomberg show.

Neither KBW nor the Clearing House has come up with a new forecast of how the Basel revisions will impact U.S. banks.

European Banks

If the U.S. adopts the latest Basel methodology, total assets of the largest banks will expand by $4 trillion to $5 trillion, about the same amount they would under the U.S. version proposed last year, data compiled by Bloomberg show.

The impact on European banks is similar, according to Andrew Stimpson, KBW’s European bank analyst. The latest Basel changes will cut in half the amount Deutsche Bank AG will have to add to its asset base, Chief Financial Officer Stefan Krause said on a conference call last week. That would reduce the Frankfurt-based firm’s leverage ratio by 0.3 percentage point, Stimpson estimates.

Cash Holdings

One change that banks lobbied for and didn’t win would have exempted cash and government bond holdings from the leverage calculation. That could have improved the ratios at the largest lenders by as much as 0.8 percentage point, according to Stimpson, who’s based in London.

“European banks still have to continue deleveraging to meet these requirements,” Stimpson said. “There was some relief, but the overall story hasn’t changed.”

In a report presented at the World Economic Forum in Davos last week, Zurich-based UBS AG reiterated banks’ criticism of shifting to simple leverage from risk-based capital.

“We caution against over-reliance on leverage ratios as a regulatory tool,” said UBS, Switzerland’s biggest bank. That “could lead to further deleveraging by banks and pose risks for financial stability.”

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