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Monday, September 24, 2012

U.S. Implementation of the Basel Capital Regulatory Framework

Darryl E. Getter
Specialist in Financial Economics

The Basel III international regulatory framework, which was produced in 2010 by the Basel Committee on Banking Supervision at the Bank for International Settlements, is the latest in a series of evolving agreements among central banks and bank supervisory authorities to standardize bank capital requirements, among other measures. Capital serves as a cushion against sudden financial shocks (such as an unusually high occurrence of loan defaults), which can otherwise lead to insolvency. The Basel III regulatory reform package revises the definition of regulatory capital and increases capital holding requirements for banking organizations. The quantitative requirements and phase-in schedules for Basel III were approved by the 27-member jurisdictions and 44 central banks and supervisory authorities on September 12, 2010, and endorsed by the G20 leaders on November 12, 2010. Basel III recommends that banks satisfy these enhanced requirements by 2019. The Basel agreements are not treaties; individual countries can make modifications to suit their specific needs and priorities when implementing national bank capital requirements.

In the United States, Congress mandated enhanced bank capital requirements as part of financialsector reform in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act; P.L. 111-203, 124 Stat.1376). Specifically, the Collins Amendment to Dodd- Frank (1) amends the definition of capital; (2) establishes minimum capital and leverage requirements for banking subsidiaries, bank holding companies, and systemically important nonbank financial companies; and (3) establishes an implementation timeline shorter than that agreed to in the Basel III Accord. In addition, Dodd-Frank removes a requirement that credit ratings be referenced when evaluating the creditworthiness of financial securities. Instead, the Federal Banking Regulators (i.e., the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation) are required to find other appropriate standards by which to determine the financial risks of bank portfolio holdings when enforcing the mandatory capital requirements.

On June 7, 2012, the Federal Banking Regulators announced the final rule for implementation of Basel II.5 and the proposed rule for the implementation of Basel III. As required by Dodd-Frank, the federal regulators implemented risk-weighting methodologies in both sets of rules that would replace credit ratings. Although smaller institutions with total assets under $500 million may still follow some of the regulatory requirements based upon the Basel I capital framework, all banks would be required to use the risk-weighting methodology established by federal regulators in the recent proposed rule. Banks must also increase capital holdings to withstand adverse macroeconomic and financial scenarios.

Although the financial crisis of 2007-2009 precipitated the call for higher capital requirements on the banking system, bank credit arguably could become more expensive for borrowers or even decline during a prolonged recovery. Whether higher capital requirements would result in a reduction of overall lending and systemic risk, however, is unclear. Prior to the financial crisis, banks maintained capital levels that exceed the minimum regulatory requirements and the economy still saw widespread lending. Bank capital reserves may not have been an effective financial risk mitigation tool while a significant amount of lending took place outside of the regulated banking system. Given that lending from non-bank sectors has since diminished, bank capital may grow more effective at mitigating lending risks in the economy, but credit availability may also become more contingent upon the transition to the higher capitalization levels.

Date of Report: September 20, 2012
Number of Pages: 23
Order Number: R42744
Price: $29.95

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