AT TODAY’S HOUSE FINANCIAL SERVICES JOINT COMMITTEE hearing on the “Impact of the Proposed Rules to Implement Basel III Capital Standards” questions were raised about the effects of the proposed rules put forth by the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC).
Members on both sides of the aisle raised concern over the potential unintended consequences of the proposals. Rep. Shelley Moore Capito (R- W. Va.) said that there was unanimous consensus that these proposals would apply to the large international banks, but confusion with its application to community banks. Many panel members agreed that a “one-size fits all” approach would be problematic when applied to the diverse financial system present in the U.S.
Rep. Carolyn Maloney (D – N.Y.) stated that she does not support the proposal in its current form and sees issues with the high level of complexity in the rule proposal. She was also concerned with the insurance companies with depository holdings being treated the same way as banks.
Rep. Jeb Hensarling (R – Texas) stated that there was “good case for higher quality and more capital” but a “poor case for more complex capital standards.” He added that it was still an open question whether Basel III should apply to community banks
In his opening statement, George French of the FDIC provided an overview of the federal banking agencies three separate Notices of Proposed Rulemaking (NPR) to implement Basel III. Noting that the comment period on the proposals closed on October 22, French said the FDIC received over 2,000 comment letters and that many of them expressed concern over the impact the rules will have on community banks as well as on risk weights and lending limits.
With regard to the Advanced Approaches proposal, French said the FDIC will address the rule’s reliance on banks’ models and risk estimates by placing a floor under the capital requirements. French added that the FDIC views the leverage ratio as a foundational measure of capital but the Basel III leverage ratios are mainly relevant for large institutions with extensive off-balance sheet activities and will thus be applied only to banks using the Advanced Approaches capital regulation. These Advanced Approach banking organizations are also required to hold additional capital as a “counter-cyclical buffer.”
On the Standardized Approach, French explained that the proposal would 1) reverse risk weights for residential mortgages; 2) increase capital requirements for past-due loans and high volatility commercial real estate exposures; 3) expand the recognition of collateral and guarantors in determining risk-weighted assets; 4) remove references to credit ratings; and 5) establish due-diligence requirements for securitization exposures.
French closed by stating the FDIC expects to make changes based on the comments received to avoid unintended consequences.
In his opening statement, Michael Gibson of the Federal Reserve stressed the key role that high level capital requirements play in protecting the banking system and ensuring losses are borne by shareholders rather than taxpayers.
Gibson noted that the proposals would introduce a supplementary leverage ratio, a countercyclical capital buffer, and raise the capital requirement for large internationally active organizations as well as subject savings and loan holding companies (SLHC) to consolidated capital requirements as per the Dodd-Frank Act.
Gibson mentioned that a cost benefit analysis to assess the impact of the rulemaking was performed by the Basel Committee on Banking Supervision which showed modest negative effects on gross domestic product (GDP) and the cost of credit, while significantly lowering the probability of a banking crisis. The study also showed that the vast majority of banking organizations already meet the proposed higher minimum capital requirements.
The Fed has received thousands of comment letters on the proposal, many of which stated concern about the treatment of accumulated other comprehensive income (AOCI), residential mortgages, compliance costs, risk weight methodology, and the impact on community banks. Gibson said that the Fed is taking these concerns very seriously into consideration with regards to their issuance of a final rule. He added that they do not expect to finalize the proposal by January 2013.
In his opening statement, John Lyons of the OCC said that fundamental issues have been raised about the applicability of the proposed standards to community banks, and that the “OCC recognizes the key role these small banks play in the economy.”
Lyons provided an overview of the three proposals outlined that the main concerns brought up in comment letters were 1) the overall complexity of the proposals and their application to community banks; 2) the proposed treatment of unrealized losses in regulatory capital; and 3) the treatment of real estate’s lending, partially residential mortgages.
He said the OCC did not adopt a “one-size fits all approach” in developing capital rules, but rather carefully evaluated each element of the framework and assessed to which banks they should be applied. Lyons also noted that community banks are largely exempt from many of the provisions contained in the proposal.
In his opening statement, Greg Gonzales, Commissioner of the Tennessee Department of Financial Institutions, said that bankers are concerned about losing flexibility to exercise their own judgment and that regulatory policy is limiting their ability to take prudent risks. He argued that the impact of the proposals have not been sufficiently analyzed or understood and warned that the rules may have a negative impact on credit availability and drive business away from the regulated and insured depository system.
Gonzales said Basel III was never intended to apply to the entire banking industry and that the framework the agencies proposed goes beyond the scope of the international agreement. He said state regulators find the complexity of Basel III proposals to be problematic and that further clarity is needed on treatment of securitizations and equity exposures.
Specifically, Gonzales opposed incorporation of gains and losses on available for sale (AFS) securities in the Common Equity ratio as well as the agencies proposals on trust preferred securities (TruPS) stating they would be detrimental to institutions and create volatility. He also expressed concern about the proposed treatment of residential mortgage assets and said the criteria for achieving Category 1 status is “excessively narrow, and pushes too many products into the punitively risk weighted Category 2.” Finally, Gonzales recommended that the Standardized Approach proposal be significantly revised or abandoned altogether.
In his opening statement, Kevin McCarty, President of the National Association of Insurance Commissioners (NAIC) said the Association’s belief that a “one size fits all approach to regulation does a disservice to consumers and companies, and that imposing bank centric regulatory rules on insurance legal entities is problematic.”
McCarty stated that insurance products are fundamentally different from banking products and that the “very nature of insurance reduces the potential of a run-on-bank scenario, with their diverse product mix, withdrawal penalties, additional taxes, and loan limitations.” He noted that the national state-based system of insurance regulation was specifically designed to address the unique nature of the products and adhere to strict standards in their financial oversight, including transparent insurer reporting and detailed disclosure requirements. McCarty warned that having global capital standards may end up creating systemic risk versus having diversity in regulation and they should not be applied to the insurance sector.
Panel I Q&A
When asked about the cost-benefit analysis conducted on the proposals, French stated that there would be “substantial” costs in implementation of the Standardized Approach for small institutions. However, Gibson claimed that the macro-level benefits outweigh the costs associated with implementation.
Rep. Carolyn Maloney (D – N.Y.) asked why regional and community banks and insurance companies are included in the proposals since the Dodd-Frank Act already establishes specific capital standards for these banks. Gibson replied that the reform package was significantly aimed at large banks but some provisions apply to all banking institutions, adding that the requirements in the Collins Amendment (Section 171 of Dodd-Frank) directed capital requirements to serve as a floor for insurance companies that hold depository institutions.
Rep. Judy Biggert (R – Ill.) stated her concern that the proposal would force banks to hold more capital when customers use less risky instruments, and Gibson responded that the finalized rule would favor central clearing to avoid this scenario.
In response to questioning by Rep. Maxine Waters (D – Calif.), French stated that the impact of risk weights on mortgages are of “great concern” to the FDIC and that they expect to make changes to the ruling based on comments they received on the proposal.
Rep. Scott Garrett (R- N.J.) asked if there is data to calibrate risk weights and what the government’s role will be moving forward. Gibson replied that risk weights were calibrated based on losses seen in the financial crisis and that they will consider how the weights interact with other government regulations moving forward.
Rep Blaine Luetkemeyer (R- Mo.) expressed his view of a lack of communication and coordination between the three agencies and questioned their ability to keep regulations up to speed with financial innovation.
Rep. Capuano (D –Mass.) stated that Basel III obscures the holdings of banks rather than providing more transparency.
Rep Duffy (R-Wis.) asked the panelists if they were concerned about consolidation of smaller banks. French replied that they do not want to finalize any rules that would force the consolidation of smaller banks due to compliance costs.
In her opening remarks, Professor Anat Admati of the Graduate School of Business, said that banks currently are not well capitalized and do not hold enough equity, and that the financial system is still weak and fragile. She also noted that due to accounting practices there often is a discrepancy between the book value and market value of equity.
On risk calibration, Admati states that the entire “scientific process” is problematic, because it ignores certain factors such as interest rate risk. She stressed that regulators should attempt to encourage lending to business that will benefit the economy and seek to reduce the amount of payouts to shareholders during the transition time.
In his opening remarks, Terrance Duffy, President of the CME Group, noted that the interim Basel framework treats all cleared derivatives as if they require margin to cover a five day period of risk, and that this blanket categorization is “unrealistic and market distorting.” Derivatives clearing houses, he added, recognize the distinction between highly liquid derivatives contracts and over-the-counter (OTC) contracts that are not liquid or transparently traded. He stated that the failure to base capital charges on properly measured risk could encourage the use of higher risk instruments.
He added that there is no risk management benefit to banks, brokers, or the financial system to imposing capital charges beyond the clearing level margin period of risk established for liquid contracts.
In his opening statements, James Garnett of Citi expressed concern that the cumulative capital levels from the Fed’s Basel III proposals will unnecessarily constrict credit for all but the most credit-worthy borrowers. He also noted that small businesses may be adversely affected since they do not have direct access to capital markets. Consequently, Garnett said he supports the industry’s call for a quantitative impact study of the proposed rules to find the right balance between higher capital and credit availability.
Further, Garnett said Citi believes the elimination of the filter for accumulated other comprehensive income (AOCI) in calculating Tier 1 Common Equity will negatively impact the ability of banks to extend new credit and may cause reduced investments in U.S. Treasury debentures and mortgage-backed securities (MBS). Garnett added that removal of the filter will 1) create inaccurate reports of actual capital strength; 2) cause banks to favor shorter duration securities; 3) reduce banks’ flexibility in managing liquidity; and 4) create an unlevel playing field between U.S. and foreign banks.
Garnett also expressed concern about the unequal application of capital and supervisory standards domestically and globally, and added that deviations in risk weighting should not be allowed.
In his opening statements, Marc Jarsulic of Better Markets said that the proposed capital rules do not require “too big to fail” banks to use sufficient equity to insure that they will remain solvent in the face of large asset price declines. He noted that this will continue to allow excessively high debt financing, which poses a serious risk of runs that may result in the need for future bailouts. He added that the proposals do not require banks with large broker-dealers to self-insure against the run risk posed by over-the-counter (OTC) derivatives or repo-financed trading books. Jarsulic suggested equity requirements should rise as trading operations increase their use of repo borrowing or securities lending to fund long maturity assets, as well as when gross derivatives exposures increase.
Jarsulic stated that there is no correlation between overall bank leverage and bank credit spreads. He added that the banking industry has overstated the costs of compliance with regulations and that there is no overall social cost to requiring banks to adequately self-insure against large asset price declines.
Jarsulic closed his remarks stating that consolidated capital requirements for insurance holding companies will enhance overall financial stability.
In his opening statements, William Loving of the Independent Community Bankers of America expressed concern that the proposed rules penalize customized lending without regard to asset quality, which strikes at the community banks’ advantage of relationship-based lending. He stated that high capital requirements are not viable for community banks due to their limited options of raising new capital from lack of access to the public markets and mutual banks would be disproportionately impacted because they hold more mortgage loans than other community banks.
Additionally, Loving said including accumulated other comprehensive income (AOCI) in regulatory capital will misrepresent and add volatility to community banks’ capital positions, as well as undermine community bankers’ ability to maintain stable capital levels.
The ICBA favors a full exemption from the rule proposals for banks with less than $50 billion in assets. But if that is not possible, they suggest 1) an exemption from the Standardized Approach; 2) a reduction of risk weights for balloon mortgages; 3) an exclusion of AOCI from calculation of regulatory capital; 4) a continuation of Tier 1 regulatory capital treatment of TruPS; 5) an exemption of all thrift holding companies under $500 million in assets from Basel III and the Standard Approach; 6) the inclusion of the entire allowance for loan and lease losses in total capital; 7) the subjection of mortgage servicing assets to higher deduction thresholds; 8) an exemption from the capital conservation buffer; 9) the simplification of proposed risk weights for equity investments; and 9) a standardized application of proposals to credit unions as well.
In his opening statements, Daniel Poston of the American Bankers Association (ABA) expressed concern that the Basel III proposals were too complex, capital measures were volatile, and risk weights were excessive and arbitrary.
The ABA believes that the proposals related to mortgages could lead to significant contraction in the mortgage market, upset home equity lending, and raise the cost of credit for borrowers. He added that some rules target safe products and services and drive up costs which will reduce bank lending. Poston believes that the proposal framework does not consider key underwriting factors, such as credit-worthiness, when assessing risk weight.
Poston stated that a transition period for implementation of flawed rules is not the answer. He said that the proposed Standardized Approach would redirect credit in an abrupt and harmful manner and should thus be withdrawn so that an empirical study can be undertaken. He was also concerned that the Standardized Approach mismatches risk among asset classes and weighs non-performing loans lower than some performing loans.
Speaking on unrealized gains, Poston said that excluding them from the proposals is critical to enabling banks to appropriately manage their overall interest rate and liquidity risk. He added that the ABA supports the grandfathered treatment of TruPSs as Tier 1 capital instruments as well as a delay in the application of Basel III on smaller banks until July 2015.
He concluded that banks should be required to hold similar capital for similar risks regardless of size and that the proposed rules should be withdrawn, studied, and re-proposed in a simpler form.
In his opening statements, Paul Smith of State Farm Insurance said that the Fed failed to adequately consider the issues unique to insurance-based SLHCs while it was formulating the Basel III implementation proposals, and that the bank-oriented proposed rules are “ill-fitting and structurally flawed” when placed upon insurers. He noted that the rules would not improve supervision over the financial strength of the insurance industry but would impose high costs and difficulty in record keeping, accounting and reporting.
He also stated that insurance risk-based capital (RBC) requirements are superior to the Basel framework for insurance-based SLHCs because they are tailored to the business model and strategies of insurers, and exhibit a high degree of uniformity across state regulatory systems. Smith suggested that the simplest approach would be to incorporate state-based capital, accounting, and reporting rules into the Proposals.
In her opening remarks, Virginia Wilson, Executive Vice President and CFO of TIAA-CREF, said TIAA-CREF said there is a discrepancy between the Collins Amendment in the Dodd-Frank Act and the Basel III proposals promulgated by the Fed because there is not a distinction between banking and insurance, which could have detrimental effects on insurance companies.
TIAA-CREF has developed two alternative solutions that would allow the Fed to meet the requirements stated in the Collins Amendment while utilizing the existing insurance capital standards, she said. The alternatives involve using the National Association of Insurance Commissioners’ risk-based capital framework (NAIC RBC).
The first alternative is an approached agreed to in Basel II and Basel III that would deduct the capital and assets of insurance subsidiaries. The Fed “could hold the subsidiaries to a prudent level of capital in excess of insurance regulatory minimums with such a standard measured in terms of NAIC RBC,” Wilson said.
The second alternative was proposed by the ACLI in a comment letter on Oct 12, 2012. It would calculate risk using NAIC RBC and a calibrated conversion process for risk-weighted assets. Only activities conducted under an insurance company would be subject to NAIC RBC, while non-insurance subsidiaries of SLHCs and thrifts would be subject to Basel III capital standards.
Panel II Q&A
Rep. Biggert asked if the Basel III proposals could negatively impact the insurance industry. Wilson replied that potential harm on policy holders would be indirect and could affect returns and increase risk.
Rep. Miller asked the panel if they were satisfied with process of “living wills.” The panel answered that they still see banks as being fragile and that developing dissolution plans is very difficult. They see the need for rules that require more equity to be held and accurate assessments of financial health to be made.
On risk weighting, the panel feels that the proposals have made the process overly complex, inaccurate, and will have a negative impact on the industry. They stated that the complexity of activities a bank engages in should be the focus rather than just looking at the size of the institution.
In closing questions the panel stated that the regulators have flexibility to adjust their treatment of insurance companies and noted that if the proposals were left in their current form some of these companies may cease their banking activities.
For testimony and a webcast of the hearing, please click here.
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