RegTech Intelligence

Fed locks down capital standards: how will Europe respond?

JWG analysis.

The Fed made some concessions in timing and scope, but pressed ahead with measures to insulate the US financial sector from future bailouts earlier this week.  The news stoked fears that European regulators may look to reciprocate, triggering a race to the highest common denominator when it comes to determining capital buffers, and potentially damaging ongoing dialogues around mutual recognition.

While understandable, given a risk-averse political agenda, the end result is simple: the price of doing business will go up.  Capital may be cheap from a historic perspective, but still comes at a cost.  And when combined with broader Basel III and CRD IV initiatives, institutions will be pressed to evaluate returns against the increased cost of allocating capital to fund operations in each jurisdiction where they operate.

Non-US banks who, until now, have counted on globally allocated capital to support their US operations, will feel the biggest impact from the Fed’s decision, although they have until 2018 to comply and can use retained earnings to plug existing shortfalls.  US bank holding companies will only have until 2016 to comply, although most have been working towards meeting the standards for some time.

The rule only applies to US banks that have $50 billion in assets and non-US banks with a minimum of $50 billion in total consolidated assets, but less than $50 billion in combined US assets (another concession made by the Fed, which had initially aimed to catch banks with at least $10 billion in assets).  However, the desires of large international banks with US operations, who have called for a more coordinated global approach to capital standards, have not been met.

While the new capital standards have grabbed the most headlines, the Fed’s new rules also cover other aspects of prudential oversight, including liquidity provisions and stress testing.  As such, it is not only the amount of capital that will be hurting the banks but also the nature of what qualifies as a legitimate capital instrument.  The Fed board has stated that only capital instruments that provide loss-absorbency during a time of financial stress will be allowed.

There is also the final mandate on the stress-testing requirements, which will affect short-term liquidity standards.  The finalised stress-test scenarios are to be conducted twice per year; one will be conducted in January, based on data from the previous September, and the other will be conducted in July, based on data from the previous March.  These stress test results are intended to be used as part of banks’ capital planning processes, when calculating a bank’s risk and exposure, and to use in the plans for the recovery and resolution of a bank.

In combination with international standards for capital and collateral requirements, the Fed’s rule is likely to spark some difficult decisions over the next couple of years.  Whereas extraterritorial differences in reporting requirements prompt operational challenges, tougher capital standards across jurisdictions will force firms to evaluate which lines of business actually clear the raised hurdles set out by respective regulators.

Equally, the issue of stress tests further complicates the equation, presenting both an operational challenge (simply to carry out the tests meted out by regulators across the globe) and, potentially, a capital one for those that do not pass muster.  As European banks are currently awaiting communication of the methodology for their upcoming summer stress tests, which the EBA is due to publish in April (with results due in October), one thing is for certain: the regulatory burden seems to grow greater and more complex at every turn.


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