U.S. Weighs Doubling Leverage Standard for Biggest Banks

U.S. Weighs Doubling Leverage Standard for Biggest Banks

U.S. regulators are considering doubling a minimum capital requirement for the largest banks, which could force some of them to halt dividend payments.

The standard would increase the amount of capital the lenders must hold to 6 percent of total assets, regardless of their risk, according to four people with knowledge of the talks. That’s twice the level set by global banking supervisors.U.S. regulators last year proposed implementing the 3 percent international requirement for what’s known as the simple leverage ratio. Now the Federal Reserve and Federal Deposit Insurance Corp., under pressure from lawmakers, are weighing increasing that figure for some of the biggest banks, according to the people, who asked not to be identified because the discussions are private.

“The 3 percent was clearly inadequate, nothing really,” said Simon Johnson, an economics professor at the Massachusetts Institute of Technology and a former chief economist for the International Monetary Fund. “Going up to five or six will make the rule be worth something. Having a lot of capital is crucial for banks to be sound. The leverage ratio is a good safety tool because risk-weighting can be gamed by banks so easily.”

Five of the six largest U.S. lenders, including JPMorgan Chase & Co. (JPM) and Morgan Stanley, would fall under the 6 percent level, according to estimates by investment bank Keefe, Bruyette & Woods Inc. That means they would have to retain more of their earnings and withhold dividends to build capital. Only Wells Fargo & Co. (WFC) would meet the higher standard now.

Counting Assets

By going above the figure adopted in 2010 by the Basel Committee on Banking Supervision, the U.S. also could put pressure on Europe to affirm its commitment to the standard, which is seen as a tool to rein in risk in the financial system. Regulators in the U.K. and Switzerland told banks yesterday to increase their ratios of capital to total assets.

U.S. banks have had to comply with a simple leverage requirement of 4 percent for two decades. The new version, proposed last June, expands the definition of what counts as assets in calculating the ratio, incorporating some commitments such as lines of credit kept off balance sheets under current accounting rules. The draft is an attempt to bridge U.S. and international accounting standards.

Lenders in the U.S. and in more than 100 other countries already comply with Basel’s risk-based capital rules, which assign weightings to assets based on their riskiness. Corporate debt is given a heavier weight than government bonds, requiring that more capital be held against it. As more of the calculations shifted to complicated models designed by banks, the credibility of the risk-weightings has been challenged.

Hoenig Rule

FDIC Vice Chairman Thomas Hoenig has called for scrapping risk-based rules entirely in favor of a simple 10 percent leverage ratio, calculated to include even more off-balance-sheet assets than allowed under Basel and define capital more narrowly. To reach Hoenig’s requirements, the three largest U.S. banks — JPMorgan, Bank of America Corp. (BAC) and Citigroup Inc. (C) — would have to stop distributing dividends for about five years, according to FDIC data and analysts’ earnings expectations compiled by Bloomberg.

A bipartisan Senate bill introduced in April by David Vitter, a Louisiana Republican, and Ohio Democrat Sherrod Brown would set the leverage ratio at 15 percent. Banks have assailed the proposal. It “would limit an institution’s ability to lend to businesses, hampering economic growth and job creation,” the Securities Industry & Financial Markets Association, a Washington-based lobbying group, said at the time.

‘Too Low’

Fed Governor Daniel Tarullo, who heads the central bank’s supervision efforts, is leading the push for tighter regulation and higher capital requirements. Before joining the Fed in 2009, he published a book criticizing Basel rules for allowing banks to calculate their own capital requirements. Last month, in a speech in Washington, he said Basel’s leverage ratio “may have been set too low.” Governors Sarah Bloom Raskin and Jeremy Stein also have called for higher capital requirements.

The FDIC, prodded by Hoenig, is pushing for a leverage requirement even higher than 6 percent, according to four people with knowledge of the talks.

The Fed has resisted going beyond that figure. The central bank is concerned that relying on a measure that doesn’t take risk into account could result in banks making riskier investments, as they wouldn’t have to allocate more capital, one of the people said. It is studying the impact such an increase might have on bond markets and the economy, the person said.

Negotiations haven’t concluded, and the final ratio hasn’t been set, the four people familiar with the discussions said. It also hasn’t been decided which banks would be covered under the tougher rules.

Spokesmen for the Fed and the FDIC declined to comment.

Basel Requirements

While the final version of the proposal to implement Basel rules could be issued in the next few weeks, the increased leverage requirement might not be included, according to the people with knowledge of the talks. In that case, regulators would adopt the global 3 percent standard and then propose an increase later, allowing time for public comment, they said.

Rules promulgated by the Basel committee, which brings together regulators and central bankers from 27 countries, aren’t binding on members. Each nation must translate the standards into its own laws and rules. The committee asked that governments put the new leverage ratio into effect by 2018.

Revising Guidelines

The Basel committee has reopened discussion about what off-balance-sheet items should be included in the calculation of total assets, which could lead to revisions in the original guidelines. Members met this week in Basel to consider changes, according to two people briefed on the talks.

Based on the current version of Basel’s simple leverage ratio, which uses a similar definition of assets as the one outlined in the U.S. draft proposal, KBW analysts estimate that Morgan Stanley (MS)’s capital would be 3.8 percent of total assets, the lowest among the nation’s six biggest lenders.

That means Morgan Stanley’s assets are more than 26 times its Tier 1 capital, which includes common stock and some hybrid debt securities. While leverage typically is stated as a multiple of assets to capital, the regulatory standard flips the numerator and denominator to express the ratio as a percentage. A bank with a leverage ratio of 4 percent would see its equity wiped out if the value of its assets drops 4 percent.

Capital Shortage

Among the biggest U.S. banks, only San Francisco-based Wells Fargo, the fourth largest, would exceed the 6 percent threshold being considered, with a 7.3 percent ratio estimated by KBW in a report this week. JPMorgan and Citigroup would be at 4.5 percent, Goldman Sachs Group Inc. at 4.6 percent and Charlotte, North Carolina-based Bank of America at 5.1 percent. JPMorgan, Citigroup and Goldman Sachs are all based in New York.

Banks don’t report what their ratios would be under the new Basel method of calculating assets or the off-balance-sheet items that would go into the calculation. Spokesmen for the six companies declined to comment.

The Basel committee also increased the minimum capital requirements based on risk-weighted assets. The world’s two dozen largest financial institutions need to have common equity equal to 8 percent to 9.5 percent of those assets by 2019. The six biggest U.S. lenders either already meet that requirement or are close, with their risk-weighted capital ratios ranging from 8.4 percent to 9.7 percent at the end of March.

Bank Lobbying

The banking industry is pushing regulators to revise the calculation of leverage to include fewer off-balance-sheet assets and even exclude some balance-sheet items, two of the people with knowledge of the discussions said. In meetings with regulators earlier this month, lobbyists suggested exempting Treasury holdings and cash held at the Fed, they said. That would subtract hundreds of billions of dollars from each bank’s total assets, improving their ability to meet the new standard.

“What goes in the denominator and what doesn’t would make a big difference in what the capital requirement really means at the end,” said Brian Kleinhanzl, one of the KBW analysts who wrote the report.

The new Basel leverage rule also changes how derivatives are counted as assets. Under generally accepted accounting rules known as U.S. GAAP, JPMorgan’s derivatives holdings, which have a notional value of $71 trillion, appear on its balance sheet as only $71 billion of assets and $62 billion of liabilities. The new Basel rules would require the bank to add several hundred billion dollars of assets when calculating its leverage ratio.

“The notional derivative figures are in trillions, so any tweaking of definitions on how they’re included in the denominator can make a huge difference,” Kleinhanzl said.

Banks say that the notional amount is only used to calculate payments of a derivative contract and doesn’t represent money changing hands or the risk of loss.

Political Pressure

Senators Vitter and Brown have gone further than Basel in what should be included in the calculation of assets. While their bill has failed to gain much support, it has increased pressure on regulators to get tougher in their rule-making, the people with knowledge of the talks said.

As the U.S. weighs a higher leverage ratio, the European Union is wavering. The draft law to implement the new Basel rules, approved by EU governments yesterday, doesn’t include a binding leverage ratio. The EU has said it needs more time to study its impact on the economy.

European banks would fare even worse than U.S. counterparts under the new rule, KBW’s London analysts have estimated. Barclays Plc (BARC), Societe Generale SA (GLE), Deutsche Bank AG (DBK), UBS AG (UBSN) and Credit Suisse Group AG (CSGN) all would have leverage ratios below 3 percent, the minimum required under Basel, according to KBW. Paris-based BNP Paribas SA (BNP) barely would exceed 3 percent.

‘Highly Unstable’

The U.K. and Switzerland have backed the U.S. during Basel committee discussions about the introduction of a global leverage standard. Yesterday the two European countries urged their banks to improve capital positions to meet the new Basel requirements. The Bank of England asked five banks, including Barclays, to increase capital by a combined $21 billion. The Swiss National Bank said UBS and Credit Suisse need to focus on “capital-building” to improve leverage ratios.

The U.K. has taken a tougher stance on banking rules than its EU partners, according to Stefano Micossi, a visiting professor at the College of Europe in Bruges, Belgium. Switzerland, which isn’t an EU member, also has imposed higher capital standards on its biggest banks than required by Basel.

“The real problem is in Europe, because they’re still resisting de-levering their banking system,” said Micossi, who’s also director general of Assonime, an Italian trade association. “A banking system 33 times levered, as the Basel rule was set at, is still highly unstable.”

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net or @yalman_bn on Twitter