A bank's asset or lending portfolio may grow proportionately with its capital reserves, and guidelines for this proportion have been established by the Basel Committee on Banking Supervision (BCBS). In a further response to the financial crisis, the Basel III reform package revises the definition of regulatory capital and increases the amount that banks must hold. Basel III also would require banks to hold a greater percentage of their assets in cash or in assets that can easily be converted to cash. Basel III requires banks to satisfy all of these enhanced requirements by 2019. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act; P.L. 111-203 ) also addressed capital reserve requirements for banks. The Collins Amendment of the Dodd-Frank Act amends the definition of capital, establishes minimum capital and leverage requirements, and establishes an implementation timeline that is faster than what was agreed to in the Basel III Accord. In addition, Dodd-Frank removes the requirement that credit ratings be referenced when evaluating the creditworthiness of financial securities. Regulators are required to find other appropriate standards by which to determine the financial risks of bank portfolio holdings while enforcing the mandatory capital requirements. This statutory requirement can potentially complicate implementation of Basel II.5 and Basel III in the United States. This report discusses how the Basel Capital Accord framework has been modified to improve the methodology used to capture credit risk, and analyzes selected implementation issues in the United States. The next section explains how the BCBS incorporates credit ratings into the regulatory framework whereas the Dodd-Frank Act eliminates any references to credit ratings in federal financial regulation, and how this may complicate the adoption of Basel II.5 and Basel III. The report also summarizes the enhanced capital and liquidity requirements associated with Basel III and compares them to related provisions in the Dodd-Frank Act. In contrast to the four risk categories established under Basel I, the December NPR proposed the assignment of a specific range of risk weights to various types of asset holdings (or exposures) based upon the following seven categories of issuers (of financial securities):
sovereign entities (i.e., a central government or an agency, department, ministry, or a central bank of a central government); certain multilateral development banks (the December NPR provides a listing) and supranational entities (i.e., the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund); government-sponsored entities (i.e., the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Farm Credit System, the Federal Home Loan Bank System); depository institutions, foreign banks, and credit unions; public-sector entities (i.e., state, local authority or other government subdivision below the level of a sovereign entity); corporate entities (i.e., an entity that does not fall under the previously listed entities or meet the definition of a securitization) and a financial institution that satisfies the definition provided in the December NPR; and any financial securities that satisfy the definition of a securitization provided in the December NPR. The quantitative requirements and phase-in schedules for Basel III were approved by the 27-member jurisdictions and 44 central banks and supervisory authorities on September 12, 2010. Table 1 summarizes the Basel III minimum capital requirements and phase-in arrangements. Bank lending decisions and strategies may also ensue at a slower pace as a result of the challenges associated with the simultaneous implementation of Basel III and the Dodd-Frank Act.
The Basel III Capital Accord, which was produced by the Basel Committee on Banking Supervision at the Bank for International Settlements, is the latest in a series of evolving agreements among central banks and bank supervisory authorities from around the world to establish minimum capital requirements for financial institutions. Capital serves as a cushion against sudden financial shocks (such as an unusually high occurrence of loan defaults), which can otherwise lead to insolvency. The Basel III regulatory reform package revises the definition of regulatory capital and increases the amount that must be held by banking organizations. Basel III also recommends holding more assets that can easily be converted to cash to shield against temporary decreases in liquidity. The quantitative requirements and phase-in schedules for Basel III were approved by the 27-member jurisdictions and 44 central banks and supervisory authorities on September 12, 2010, and endorsed by the G20 leaders on November 12, 2010. Basel III requires banks to satisfy all of these enhanced requirements by 2019.
In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act; P.L. 111-203) also addressed capital reserve requirements for banks. The Collins Amendment of the Dodd-Frank Act amends the definition of capital; establishes minimum capital and leverage requirements for banking subsidiaries, bank holding companies, and systemically important non-bank financial companies; and establishes an implementation timeline that is shorter than the timeline agreed to in the Basel III Accord. In addition, Dodd-Frank removes the requirement that credit ratings be referenced when evaluating the creditworthiness of financial securities. In other words, bank regulators (e.g., the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation) are required to find other appropriate standards by which to determine the financial risks of bank portfolio holdings while enforcing the mandatory capital requirements. Regulators face challenges in their attempt to establish credit rating alternatives, which may delay the implementation of Basel III in the United States. Bank lending decisions and strategies, therefore, may also be delayed in anticipation of higher capital reserve requirements stemming from implementation of Basel III and the Dodd-Frank Act. Bankers may prefer knowing how much more capital they would need to hold before greatly expanding their lending portfolios with longer-term assets.
This report discusses how the Basel Capital Accord framework has been modified as well as subsequent implementation issues in the United States. The report explains how the Basel Committee on Banking Supervision incorporates credit ratings into the regulatory framework whereas the Dodd-Frank Act eliminates references to credit ratings in federal financial regulation, and how this may complicate the adoption of subsequent phases of the Basel framework, namely Basel II.5 and Basel III. The regulators issued a proposed rule in December 2011 for implementing Basel II.5, which may help to inform the future contours of Basel III implementation in the United States. The report also summarizes the enhanced capital and liquidity requirements associated with Basel III, related provisions in the Dodd-Frank Act, and some remaining implementation concerns.