U.S. regulators propose trading book capital rules

Financial regulators Wednesday moved closer to implementing updated Basel capital standards for U.S. banks by outlining a replacement for credit ratings in determining the riskiness of their trading books and which investments should face higher capital levels.

In unveiling the proposal, they said for the first time that most securitizations could face the most risky weighting. The proposal included regulators' plan to revise standards for evaluating foreign country obligations, including sovereign debt obligations. They also indicated that instruments tied to private companies or to public companies whose stock was regularly volatile could face higher capital standards.

The proposal aims to bring U.S. banks in line with the international Basel Committee's ongoing effort to revamp global capital standards for financial institutions. This plan would bring institutions here into compliance with the so-called Basel 2.5, which covers trading book capital levels and evaluation of market risk. Although it goes into effect next year, Basel 2.5 is overshadowed by the more well-known Basel III, which doesn't go into effect fully until 2017 and covers liquidity requirements and leverage limits.

FDIC Acting Chairman Martin Gruenberg called Wednesday's proposal "an important step in moving forward with U.S. implementation of the market risk rules." He said the new risk assessment regime will provide "transparent alternatives that yield consistent results from bank to bank" as Basel requires.

The new Basel 2.5 requirements are expected nearly to double what big banks have to set aside in reserves for certain kinds of trading book obligations. International regulators are acting now in response to the 2008 meltdown, which showed that existing set-aside requirements were too small and failed to account fully for the risk posed by many common investments. By more clearly reflecting risks, Basel negotiators hope to push financial institutions toward more stable investments.

The proposal, unveiled Wednesday by the Federal Deposit Insurance Corp. but also due to be adopted by the Federal Reserve and the Office of the Comptroller of the Currency, updates the regulators' proposal of last December to reflect some complications passage of the Dodd-Frank Act brought to U.S. implementation of the Basel 2.5 rules.

The international rule requires risk assessments being implemented next year to be based on credit ratings and U.S. regulators' 2010 proposal moved to do so. The Dodd-Frank Act required U.S. regulators to move away from using credit ratings as a basis of any government actions.

Gregory J. Lyons, co-head of the banking practice at Debevoise & Plimpton LLP, said the agency's new model could present some difficulty for banks.

"It could put a lot more burden on banks. It's a more subjective and burdensome formula," Lyons said. "It could open [banks] up to criticism."

He said banks, which have been able to rely on credit ratings, now will have to evaluate each investment based on a range of factors.

Regulatory officials said Wednesday that while the replacement model now applies only to the trading book regulations that impact only 16 big banks with more than $1 billion in trading activity or whose trading activity involves 10% of their assets, the same regime could be used to implement other regulations affecting far more financial players and asked for public comment. Regulators are due to propose Basel III implementation requirements next spring that could impact far more banks.

FDIC officials said Wednesday their replacement will have the same effect as the credit ratings.

Under the proposed rules, country risk generally would be determined by ratings from the Organization for Economic Cooperation and Development but with increased requirements if a country defaulted on obligations in the past five years. Additional standards would apply for the best rated countries.

Then the kind of individual obligation would be weighed.

For obligations from public but nonfinancial companies, the weight factor would come from tables that are based on the company's leverage, cash flow, ratio of earnings to market value and stock volatility. For financial companies or nonpublic, non-financial companies a standard risk weight would be applied.

Wednesday's rule also laid out how to assess securitizations -- a risk not much discussed in the 2010 rulemaking. While individual securitizations would be assessed based on underlying risk, the proposal offered a detailed formula for assessing that risk.