Will New Global Banking Rules Threaten Small Banks?

In a surprise move, the Federal Reserve announced last Thursday that even the smallest U.S. banks would have to adhere to Basel III, the global regulatory framework for banking agreed to in the aftermath of the financial crisis. Until now, it was believed the new rules would apply only to the country's biggest banks.

With small lenders already having difficulty getting by in a weak economy, will they be able to cope with the increased capital-reserve requirements?

What's a Basel?
The Basel III banking accords grew out of Basel I and Basel II, the world's first attempts to regulate the banking sector. The idea was to make banks safer and more reliable for depositors on an individual basis and also to strengthen the stability of the sector as a whole.

Overseeing the rulemaking was the Banking Committee on Bank Supervision, set up in 1974 and composed of central bankers from the Group of Ten countries, otherwise known as the "G10." Members of the G10 include the U.S., the U.K., Germany, Japan, and France.

The first accord, Basel I, came out in 1988. Basel II arrived in 2004. Basel III came out in late 2009. Specifically, Basel III attempts to:

  • Improve the banking sector's ability to deal with financial and economic stress.

  • Improve risk management and transparency.

  • Strengthen banks at the individual level to reduce the risk of systemwide shocks.

Basel III's regulatory teeth come in several forms, including increased capital requirements that have some small lenders worried.

A wake-up call
Basel III calls for banks to keep capital reserves of at least 4.5% of risk-weighted assets (the riskier the asset, the more capital needs to be held in reserve), and another 2.5% to be held as a "capital-conservation buffer" -- for total capital reserves of 7%.

According to the Financial Times, small U.S. lenders currently fall $10 billion short of the new requirements, and the largest 19 banks fall an estimated $50 billion short. Fed officials were quick to stress, however, that banks have until 2019 to meet the new capital reserve levels, and that by just retaining earnings they should be able to raise the needed capital by the deadline without having to dilute shareholders, i.e., raise capital through a stock offer.

For large institutions big enough and diverse enough to be making money even in a down economy -- like Bank of America (NYS: BAC) , Wells Fargo (NYS: WFC) , Citigroup (NYS: C) , Goldman Sachs (NYS: GS) , and Morgan Stanley (NYS: MS) -- this is almost surely the case. But for small lenders just trying to get by?

One analyst quoted in The Wall Street Journal called the Fed's action "a real wake-up call" for small lenders, adding that they will be "forced to confront yet another challenge to an already fragile business model."

The only good bank blowup is no bank blowup
In the long run, it's a good idea for all banks, no matter what their size, to have the comfortable capital reserves of Basel III. Even a small bank that blows up will have some negative economic impact.

But the point of Basel III, and the Dodd-Frank financial-reform act, is to prevent systemic risk, i.e., a big single-lender bankruptcy starting a cascading series of big lender bankruptcies that threatens the whole system. This is what happened in 2008, when Lehman Brothers' blowup almost took everyone else with it.

It was initially thought Basel III would apply only to U.S. banks with assets of $10 billion or more. Some speculated the floor might go as low as $1 billion, but certainly not below that. So is this new capital-reserve ratio for small lenders useful, or even realistic?

Let's just get this over with
The answer to both questions is "yes." A Tier 1 core capital cushion of 7% isn't asking too much. Some analysts have called for an even higher ratio. And as the banks have seven years to hit that 7%, they will probably just have to retain some earnings rather than go to the market and dilute shareholders. That's important.

And since 7% is reasonable, why not allow banks to start at it sooner rather than later? Given the economy-shattering repercussions caused by the 2008 bank crisis, it's better to be safe than sorry and to get every bank in America on this track right now. The country needs strong banks, not just for the economy overall but also for individual investors.

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At the time thisarticle was published Fool contributor John Grgurich thinks an all-expenses paid junket to London, Paris, or Tokyo -- or whatever exotic foreign capital the G10 is meeting in next -- is justifiably in order, but he owns no shares of any of the companies mentioned in this column. Follow John's dispatches from the bloody front lines of capitalism on Twitter, @TMFGrgurich. The Motley Fool owns shares of Citigroup, Wells Fargo, and Bank of America and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Goldman Sachs and Wells Fargo. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a positively gripping disclosure policy.

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