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The Federal Reserve’s New Rules for Banks

A couple of weeks ago, the Federal Reserve proposed new capital and liquidity rules for large US banks. And in all likelihood, bank executives breathed a sigh of relief.

The rules will be implemented in two phases. The first phase will be made up of policies that were already issued by the Fed…the stress test rules that were announced in November. With this phase, banks have to conduct annual stress tests that assume harsh economic conditions (like a steep market crash and 13% unemployment), and banks with over $50 billion in assets will have to maintain a 5% Tier-one capital cushion.

The second phase will be the Fed’s adoption of Basel III rules. The Basel III international bank regulatory agreement is, as the name suggests, the third of the Basel Accords. Basel III is an international set of standards for banks, and will bring the capital ratio requirement up to 7%…and add a surcharge of as much as 2.5%. Banks will also have to keep a certain amount of reserves as liquid assets…starting in 2015, they will need to keep enough cash on hand to survive a 30-day crisis.

The Fed’s new rules will also limit counterparty risk…meaning that one bank will only be allowed to have a certain amount of credit exposure to another institution. The idea is to make sure that a bank is not susceptible to failure as a result of its relationship with another bank (or corporation).

Ultimately, the Fed’s 173-page proposal is something of a victory for banks. The Fed doesn’t plan to impose stricter requirements than the Basel III rules. Going beyond the Basel III standards would have put US banks at a disadvantage as they compete globally. And the Fed is taking a measured, phased-in approach… which makes the requirements more palatable.

The proposal is open for comment through March… and may be revised based on those comments. And once the rules are finalized, banks will have a year to comply.

There are around 30 banks in the US with more than $50 billion in assets, and are subject to the Fed’s new rules. And they can use any break they can get from the Fed. 2011 was a tough year for the markets, and a very tough year for banks. Financials lagged behind all other sectors in 2011, down -18.8% for the year.

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