Banks Face More Oversight of Ability to Weather Credit Crunch

By Jesse Hamilton

U.S. regulators, closing in on their mandate to force financial firms to prove they can weather another credit crisis, are set today to finish two key rules governing the banks’ balance sheets.
The Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. are ready to issue a mandate that banks set aside enough easy-to-sell assets to survive a 30-day liquidity drought and wrap up rules on how much loss-absorbing capital must be held against total assets.
Ahead of a hearing next week before U.S. senators, who will ask about their progress on rules related to the Dodd-Frank Act, regulators are piling up a
stack of fresh work. The latest actions include another rule today dealing with swap margins and one yesterday scrutinizing how banks are managing risk.
Today’s capital and liquidity rules are based on accords reached by the 27-nation Basel Committee on Banking Supervision. They’re meant to keep banks running in a crisis, by limiting how indebted they can get and by demanding they hold plenty of stable assets such as Treasuries, corporate debt and public-company stocks.
The largest U.S. banks already hold big stockpiles of such assets, and most say they’re in easy reach of the demands outlined by the rule initially proposed last year. Memphis, Tennessee-based broker-dealer Vining Sparks issued a research report last week saying most big banks are within striking distance, though Bank of America Corp. and State Street Corp. (STT) may experience some earnings pressure as they work to catch up.

‘Largely Fine’

Jerry Dubrowski, a Bank of America spokesman, declined to comment, and Alicia Curran, a State Street spokeswoman, pointed to a company earnings calls that explained investments in higher-quality liquid assets have been a drag on revenue.
“The very biggest U.S. banks are largely fine with regard to the ratio, although the new standards raise significant strategic challenges in the context of current market conditions and the new leverage rules,” said Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics Inc., adding that the regulators’ demands are creating “a scarcity of eligible assets.”
As supplies of Treasuries and other high-quality assets run low, the need may open a new line of financial innovation, industry experts say.

Financial Innovation

“I would expect to see people trying to structure debt products so that they meet the high-quality liquid asset definition,” said Oliver Ireland, a regulatory lawyer at Morrison & Foerster LLP in Washington. “There will be pressure on the regulators to accept them. That’s the way it always turns out.”
Lee Schneider, a lawyer at Debevoise & Plimpton LLP in New York, said he also expects “more financial innovation” and said he anticipates that broker-dealers will launch debt securities that meet regulators’ requirements.
“The financial services sector gets creative when they think there are new opportunities to make money,” Schneider said, predicting that the next couple of years will see new products that carry hallmarks of security, such as guarantees. “If the industry and the regulators work together to create these instruments, that’ll be beneficial to everybody.”
While the liquidity rule calls for keeping safe assets on hand, the leverage rule demands a simple ratio of capital against total assets. The rule today will finalize adjustments for what qualifies as assets, matching it to the Basel Committee’s standard.

Swaps Market

The agencies will also vote on a revised proposal setting collateral requirements for swaps that are traded directly between buyers and sellers instead of guaranteed at a third-party clearinghouse. The rule, which will be open to further public comment, is designed to reduce risk in the $710 trillion global swaps market by requiring more collateral to back trades.
With the OCC having approved its risk-management constraints known as “heightened expectations” yesterday, the chiefs of the financial agencies will have fewer items left on their to-do list when they appear at a Sept. 9 hearing of the Senate Banking Committee examining “Wall Street Reform.”