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Basel rules for riskiest trading could further raise bank's capital requirements

By Howard Schneider
Washington Post Staff Writer
Thursday, September 16, 2010; 8:50 PM

The panel of global regulators that recommended higher capital standards for banks last weekend has also approved a related set of regulations that could curb some of the riskier activities that contributed to the recent financial crisis.

The changes, on top of other new rules proposed by the Basel, Switzerland-based group, could force major banks to raise more capital than many analysts and regulators have recognized.

The measures also stand to shape the behavior of bank executives in undetermined ways, with some analysts suggesting the rules could lead to steep price hikes for some business and consumer services or push financial firms to pump more cash into government bonds and other low-risk investments.

The rules apply to an array of activities, from routine stock trading to commerce in complex securities and investments in other financial firms. These types of business would not be banned. But the regulations would force banks to set aside perhaps three or four times as much capital than had earlier been required as a cushion against possible losses from these activities.

"It is not a prohibition. It is a bias" against some types of bank activity that figured in the 2008 crisis, said Scott Talbott, spokesman for the Financial Services Roundtable, a financial industry group. "They are saying if you want to engage in this, go for it, but you have to set aside more."

How much more is only slowly becoming clear. The Basel group, which included Federal Reserve Chairman Ben S. Bernanke, made headline changes to a number of the key measurements used to regulate banks.

The committee, for example, raised to 7 percent the amount of capital banks have to hold against loans, investments and other assets.

The current level varies by nation but ranges between 2 and 4 percent. The group also narrowed what counts as capital, forcing banks to rely more on the sale of common stock or to set aside more out of its profits - considered secure buffers against a loss.

But a separate set of changes, still evolving after a year of work, overhauls the complicated formulas used to estimate the value of a bank's assets and the riskiness of different sorts of holdings or activities. By changing those formulas, or risk weights, the regulators have as much as quadrupled the amount of capital a bank must set aside as a cushion against losses on its riskiest ventures.

The new rules are still not fully fleshed out by the Basel group and have yet to be adopted by the United States and other governments. But some officials estimate that the rules governing asset values and risk weights could boost by as much as 20 percent the amount of capital required to be held by the largest U.S. banks - on top of other increases mandated by the Basel proposals.

The Basel group's recommendations are non-binding. But with representatives from 27 countries and the world's major central banks, the proposals carry immense weight and are expected to win the endorsement of the Group of 20 nations this fall.

The new regulations on risk, in a sense, supplant some of the grander ideas under discussion at Basel. Economists from the International Monetary Fund and elsewhere, for example, had proposed a variety of measures to try to cool economies during boom times in hopes of preventing a subsequent crash.

Some of those ideas remain under discussion but have proved politically and technically difficult for the Basel group to approve.

The new risk regulations, however, try to apply that same sort of discipline on a bank-by-bank basis - essentially leaving it up to company executives to decide whether the higher returns that might be generated by riskier investments are worth the higher price they would have to pay in the form of steeper capital set-asides.

In an investor presentation this week, J.P. Morgan Chase chief executive Jamie Dimon said the new risk formulas could cut the company's current capital cushion by as much as 25 percent.

In discussing the impact of Basel, analysts and regulators have generally considered U.S. banks to be well positioned to meet the new standards. However, those assessments have typically used the previous risk formulas, not the new ones.

Under the existing rules, Dimon said, J.P. Morgan's capital cushion stood at 12 percent. Using the new risk weights, the figure drops to 9 percent, still above, but much closer to, the Basel panel's 7 percent minimum.

"We think we can handle this very easily," Dimon said. But he added, "It will have an effect on the markets. We do think it will reduce credit."

The Basel recommendations are to be phased in over several years, giving banks time to raise capital or drop riskier investments or types of business.

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