Fed Eyes Steep Capital for Risky Financial Firms

By | June 6, 2011

The largest and riskiest U.S. financial firms could be forced to hold up to twice as much capital as called for in the international Basel III accord, under one plan the Federal Reserve is considering.

Fed Governor Daniel Tarullo said the additional buffer is needed to reduce the risk that the failure of a so-called “systemic” firm could wreak havoc in financial markets.

“The enhanced capital requirement implied under this methodology can range between about 20 percent to more than 100 percent over the Basel III requirements,” Tarullo said on Friday at the Peterson Institute for International Economics.

Basel III calls for banks to hold top-quality capital equal to 7 percent of their risk-bearing assets, more than triple the current standard.

Tarullo, responding to questions, said under the method the Fed is considering, U.S. systemic firms could face a capital requirement of between 8.5 and 14 percent.

Using this so-called “expected impact” methodology, the Fed would look at the amount of damage a firm’s failure could impose on the financial system when deciding how much of a buffer to require.

The Fed has not yet decided how exactly it will calculate the capital surcharge and is evaluating several approaches, including the “expected impact” methodology that so far has the most influence, Tarullo said.

Following a devastating financial system collapse in 2007-2009, that pushed the United States and other economies around the world into deep economic recessions, regulators are devising safeguards against a future meltdown.

“We cannot ignore the costs to society that the failures of SIFIs would cause the financial system and the economy more generally,” he said.

Last year’s Dodd-Frank law calls for the imposition of a capital surcharge on systemically important financial institutions, or SIFIs.

International regulators have also agreed to impose a capital surcharge on the riskiest firms. Some countries have floated more extreme proposals, including Switzerland which is considering a 19 percent capital requirement for UBS and Credit Suisse.

QUALITY, NOT JUST QUANTITY

Tarullo said the enhanced capital requirements should be met with high-quality capital, and rejected the use of hybrid debt-equity instruments to satisfy the requirement for extra capital.

“Our presumption is that this means common equity,” he said.

Alternatives, such as contingent capital instruments that convert from debt to equity in a crisis, could set a dangerous precedent that could lead to weaker capital requirements, Tarullo added.

Beyond capital buffers, Dodd-Frank requires the Fed to draw up tougher leverage and liquidity standards for large banks and financial companies which fit the systemically important description.

Fed Chairman Ben Bernanke told the Senate Banking Committee last month that the Fed will release proposed rules this summer on how to implement this part of the law.

The specifics of what the Fed proposes will be closely watched by large banks and financial firms because the heightened standards will likely prove expensive since they will have to hold onto capital they could otherwise lend.

U.S. regulators have yet to name which financial firms beyond the biggest banks will be named SIFIs, leaving many insurers, hedge funds and other big institutions guessing whether they will fall under the tougher regime.

(Reporting by Mark Felsenthal; Additional reporting by David C. Clarke, Editing by Andrea Ricci, Dan Grebler and Tim Dobbyn)

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