The Federal Reserve Board will propose new rules today that would require banks that engage in riskier activities to have more capital than banks that pursue more conservative ventures, sources said.
The other two key bank regulatory agencies -- the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. -- are preparing to propose similar risk-based capital requirements on the institutions they supervise. All three agencies will request public comment on the changes.
For the last few years, regulators have been searching for formulas that would permit them to differentiate between banks that engage in risky activities and banks that do not.
Riskier loans, for example, generally carry higher interest rates and higher returns to the bank. But they also pose more of a threat to a bank's health because riskier investments, such as loans to oil drillers, are more likely to go bad and cause losses than are safe investments, such as Treasury securities.
"What we're saying is that banks engaging in low-risk activities should have a lower level of capital than those that engage in high-risk activities," according to one top federal bank regulator.
Capital is the financial cushion a bank maintains to absorb losses that are not covered by current earnings. Capital generally is composed of stockholder investment and profits the bank has kept in a reserve over the years rather than paid out to stockholders as dividends.
Sources said the Federal Reserve proposal would set up different categories of assets based on their perceived risk. Each of the categories would have a percentage capital requirement. The total amount of capital a bank would be required to maintain would be a weighted sum of the capital requirements for each category of assets.
For example, if a bank maintained one-half of its assets in government securities that required 2 percent capital set-aside and one-half of its assets in high-risk oil drilling loans that required a 10 percent set-aside, the bank would be required to maintain total capital equivalent to 6 percent of its assets. One percentage point would relate to the securities and 5 percentage points to the high-risk loans.
In reality, banks maintain a far more complex mix of assets.
A regulator said the risk-based capital requirements would permit banks with widely different asset mixes to maintain similar profitability -- profits as a percentage of capital.
Banks that shun risks -- and, as a consequence, pose few threats to the system -- generally earn less on their assets. But because they would be required to have less capital, they could earn a rate of return similar to that of a bank that makes riskier loans but is required to maintain more capital as a result.
In the 1970s, many banks began to make riskier loans than they had historically. To some degree, banks were forced to make loans for riskier ventures because the biggest and richest companies began to sell short-term securities directly to the public instead of borrowing from banks. But banks also sought out high-yielding loans in an attempt to boost their profits.
As loan losses and potentially bad loans began to mount in recent years, however, banks and their regulators have become more conservative. Last year, for example, banks put a large portion of their earnings in reserves, rather than paying them out as dividends to shareholders.