Fed Submits New Rules for Banks - Analyst Blog

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Yesterday,the Federal Reserve came up with a series of new stringent rules for the largest U.S. banking institutions in order to stabilize the financial system. Fed proposed certain requirements, which the financial institutions need to fulfill to prevent another financial crisis.

The rules proposed by Fed will take under its purview not only the U.S. bank holding companies, but also other financial firms, which the U.S. regulators consider critically important for the functioning of the financial system. Moreover, systemically important non-bank financial institutions may also have to meet the new requirements.

However, Fed has not decided upon whether to include non-banks, such as insurance companies and hedge funds.

The rules form the part of new regulation proposed under the Dodd-Frank Act, which was passed in 2010 to revamp the financial system and limit practices, which resulted in 2008 financial crisis. The proposal outlines the measures related to capital, liquidity, credit exposure, stress testing, risk management and early remediation requirements. Further, the agency proposed new stringent rules on dealings between the big banks.

Under the newly proposed rules, the U.S. bank holding companies with over $50 billion in assets will be affected as they need to hold cash at least 5% of the value of their assets while protecting them from bad loans and investments.

Moreover, even stricter rules will be implemented for the companies with over $500 billion in assets including JPMorgan Chase & Co. ( JPM ), The Goldman Sachs Group Inc. ( GS ) and Citigroup Inc. ( C ) as they are restricted from entering credit exposure of not more than 10% with any other bank. Through this rule, the Fed will limit the overly interconnections between banks and minimize the risk exposed to a single financial institution as a percentage of the bank's regulatory capital.

Smaller banks with over $10 billion in assets have to undergo stress tests conducted by their regulators to test their adequacy to withstand an economic downturn.

Risk-based capital and leverage requirements will be implemented in two phases. In the first phase, the financial institutions would be exposed to the board's capital plan rule issued in November 2011. As per the rule, the firms would make annual capital plans, carry out stress tests and maintain adequate capital. Moreover, these firms have to keep Tier 1 common risk-based capital ratio greater than 5%, under both expected and strained conditions.

In the second phase, the Fed would issue a proposal for the implementation of risk-based capital surcharge based on the structure and method developed by the Basel Committee on Banking Supervision.

Previously, a global agreement, known as Basel III named after the city of Switzerland, was passed in July. Under the agreement, mega banks throughout the world would have to maintain an extra 1% to 2.5% of capital on their balance sheets in addition to the Basel III mandate of 7%. The percentage will vary depending on the size of their balance sheets. Based on a particular bank's importance and position in the overall financial system, the regulators will formulate a method to identify target banks.

The Basel Committee will give the target banks a period of three years (2016 to 2018) to meet the new capital requirements.

The oversight body of the Basel Committee on Banking Supervision is planning proactive actions to ensure that the world's largest banks are strengthening their capital and liquidity positions to confront another financial meltdown. The committee is all set to carry out on-site assessments of the bank's financial conditions.

However, Federal Reserve did not come up with any details about the implementation of such requirements on bank capital. We expect more details from Fed on the matter in the coming days as to when and how such measures will be executed.

A weak capital level is always a threat to the global economy. Needless to say, meeting new rules would act as building blocks of the still unstable world economy, with fewer bank collapses and less involvement of taxpayers' money for bailing out troubled financial institutions.

It has been intimated by Fed that violation of the rules would be subjected to punishments for banks. Though banks would be provided with early remediation process to correct their woes, failing on that would led to penalties, which includes prohibitions on capital distribution such as dividends and limits on managerial compensation.

It is anticipated that the new requirements will be implemented a year after the rules are finalized, incorporating public comments. Therefore, till March 31, 2012, public comments are awaited.

Mostly U.S. banks' officials including Jamie Dimon, CEO of JPMorgan are in the opposition of new rules. They opine such stringent rules will slow down the economic recovery as holding extra cash will limit the credit availability in the market. However, Fed believes that the stronger banking system incorporating these rules will be beneficial for the society and would offset the short term effects on credit availability or credit costs due to these new rules.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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