Among other things,  capital acts as a financial cushion to absorb unexpected losses, promotes  public confidence in the solvency of the institution and the stability of the  banking sector, and provides protection to depositors and deposit  insurance funds. U.S. federal banking  regulators have adopted various risk-based capital regimes over the past  decades. Risk weights for mortgages and other mortgage-related assets have been  included in a number of these regulatory capital frameworks over the  years, including the following:
The Basel Capital Accord (Basel I), which was adopted in 1988 and  implemented in the United States in the early 1990s, established a  system of generally applicable risk weights for specific assets  (including mortgage-related assets) to calculate total risk-weighted  assets and defined a minimum total risk-based capital ratio (the ratio  of regulatory capital to risk-weighted assets) of 8 percent with limited  exceptions. In 2007, U.S. federal banking regulators adopted capital rules for  large internationally active banking organizations that were based on  a revised framework published by the Basel Committee in 2006  (Basel II). Other entities that hold mortgages and mortgage-related assets have  different capital requirements. The Basel III-Based Final Rule Changes the Risk Weights for Some Mortgage- Related Assets

The Basel III final rule adopted in 2013 by the U.S. federal banking  regulators and generally effective as of January 2015 incorporates higher  risk weights for certain mortgage-related exposures while leaving others  unchanged (see table 1). For example, the risk weights for most single- family residential mortgages are largely unchanged by the final rule. The advanced internal ratings-based approach requires banking  organizations to use a formula defined in regulation to determine the  capital requirements for residential mortgage exposures, which are  grouped into segments that have similar (homogeneous) risk  characteristics. I). This formula is unchanged since it went into effect in  2008. Under the standardized approach, residential MBS guaranteed by Ginnie  Mae have a risk weight of 0 percent, while residential MBS issued and  guaranteed by Fannie Mae and Freddie Mac have a risk weight of 20  percent—unchanged since Basel I. Securitization Exposure Calculations under the Standardized Approach

The Basel III final rule establishes two methods for calculating risk  weights for securitization exposures under the standardized approach:
The simplified supervisory formula approach relies on objective inputs  to calculate risk weights for securitization exposures using a formula. Risk Weights for Mortgage Servicing Assets Will Increase

The Basel III-based final rule changes the treatment of mortgage  servicing assets by (1) lowering the cap on the amount of mortgage  servicing assets that can be included in capital calculations, which  reflects, in part, the uncertainty regarding the ability of banking institutions  to realize value from these assets, especially under adverse financial  conditions, and (2) increasing the risk weights. Effects of Changes to Capital Requirements on Holdings of Mortgage- Related Assets Are Uncertain

The full impact of the changes to capital requirements for holdings of  mortgage-related assets remains uncertain because insufficient time has  passed since these changes took effect for both banks and nonbank  mortgage servicers, and for some assets the changes have not yet been  fully phased in. However, our past work suggested that—based on  analysis of data included in banks’ Consolidated Reports of Condition and  Income (commonly referred to as Call Reports) and Credit Union 5300  Call Reports—many lenders generally appeared to be participating in  residential mortgage lending much as they had in the past. But increased risk weights for some mortgage-related assets, among  other factors, can have potential implications for banks’ decisions about  securitizing and servicing mortgages and investing in MBS. Banks that exceed  the cap may need to hold more capital for these assets. Under current credit risk retention rules, banks must retain an interest  equal to at least 5 percent of the credit risk for mortgage-backed  securities they sponsor unless the security qualifies for an applicable  exemption, including being exclusively backed by mortgages that  meet the definition of a “qualified mortgage.” These residual  interests are included in risk-weighted assets and may carry higher  risk weights under the Basel III-based rules than under the previous  rules, depending on how they are structured. Finally, the Basel III-based final rule largely left unchanged the historically  lower risk weights of MBS guaranteed by the enterprises vis-à-vis other  mortgage-related assets, which can influence the demand for these  securities relative to whole loans and privately issued MBS. While  holdings of MBS guaranteed by Ginnie Mae retain a 0 percent risk weight  and holdings of MBS guaranteed by the enterprises retain a 20 percent  risk weight under the standardized approach (and their treatment under  the advanced approach has not changed), holdings of privately issued  MBS may face higher risk weights than under the prior rules.
Why GAO Did This Study

During the 2007–2009 financial crisis, many banking organizations lacked capital of sufficient quality and quantity to absorb substantial losses on mortgages and mortgage-related assets, revealing these assets to be riskier than previously thought. In response to the crisis, banking regulators around the world moved to strengthen requirements for capital adequacy. In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act introduced, among other things, new capital requirements for bank holding companies and savings and loan holding companies. Internationally, in December 2010 the Basel Committee on Banking Supervision (which had issued the Basel I and Basel II frameworks) issued the Basel III framework—a comprehensive set of reforms to strengthen global capital and liquidity standards—with the goal of promoting a more resilient banking sector. Under this framework, banks apply risk weights to different assets to determine the amount of capital they need to meet regulatory requirements.
GAO was asked to explain how capital requirements for a mortgage depend upon how it is financed and how the requirements have changed since the crisis. This report examines the risk weights for residential mortgages and certain other mortgage-related assets under the U.S. Basel III-based rule and how they compare to those in effect under prior capital regimes and for nonbank entities. GAO examined information on capital requirements from current and past rules.
GAO received technical comments from the banking regulators, which were incorporated as appropriate.

What GAO Found

Rules for capital adequacy require banks to hold a percentage of their assets as capital to act as a financial cushion to absorb unexpected losses. Under current rules, banks must hold capital equal to at least 8 percent of risk-weighted assets. Since the early 1990s, U.S. federal banking regulators have used a risk-weighting system under which banks multiply asset amounts by factors, known as risk weights, to calculate risk-weighted assets. Different types of assets have different risk weights that attempt to capture the assets' relative risk. The Basel III-based final rule adopted in 2013 by the U.S. federal banking regulators incorporates higher risk weights for certain mortgage-related assets while leaving others unchanged from prior capital regimes (Basel I and Basel II). Most banks use the standardized approach for calculating risk-weighted assets, but large internationally active banks use an advanced approach that relies on formulas established by the regulators and inputs from their internal systems.
Under the standardized approach, the risk weights for single-family residential mortgages are largely unchanged by the final rule. Similarly, the risk weights under this approach for residential mortgage-backed securities (MBS) guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac have not changed since Basel I.
Under the advanced approach, large internationally active banks use a formula defined in regulation to determine the capital requirements for residential mortgage exposures, which include whole loans as well as MBS guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac. This formula has not changed since it went into effect in 2008 under the Basel II-based rule.
For both approaches, the ways for determining risk weights for securitization exposures and mortgage servicing assets have changed under the final rule, which may increase these risk weights. As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the final rule eliminates the use of credit ratings for determining risk weights for securitization exposures, instead relying on regulator-established formulas. Also, the final rule reduces the cap on mortgage servicing assets that can be included in capital calculations and will raise the risk weight from 100 percent to 250 percent.
The Basel III-based final rule largely left in place the historically lower risk weights of MBS guaranteed by Fannie Mae and Freddie Mac vis-à-vis other mortgage-related assets, which can influence the demand for these securities relative to whole loans and privately issued MBS. However, the full impact of changes in risk weights for holdings of mortgage-related assets remains uncertain because insufficient time has passed since these changes took effect, and for some assets the changes have not yet been fully phased in. GAO's recent work suggested that many lenders generally appeared to be participating in residential mortgage lending much as they had before capital requirements changed. Also, data on mortgage debt outstanding and on banks' holdings of different assets indicate that trends in holdings of mortgage debt and mortgage-related assets that predate the changes in risk weights have continued. But increased risk weights for some mortgage-related assets may lead to changes in banks' decisions about securitizing and servicing mortgages.