December 20, 2013 8:33 pm

Fed clamps down on bank moves to evade new capital rules

The Federal Reserve clamped down on bank moves to evade tougher capital rules on Friday, warning that transactions intended to reduce risk would be closely scrutinised during annual stress tests on bank balance sheets.

Banks around the world are being forced to meet higher capital levels under the new Basel III regime, which is due to be implemented by 2019. To help their ratio of equity to assets, banks have examined ways to reduce their stated assets without an outright sale.

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Some of these regulatory capital trades, which typically involve insurance offered by a third-party, are legitimate while others are evasion, the Fed indicated.

If the risks are shifted to a “thinly capitalised counterparty or affiliated entity of the firm, any residual risk is effectively captured in the firm’s internal capital adequacy assessment”, the agency said in its guidance note to large banks.

“Examiners will closely consider such transactions, and potential residual risks, when evaluating an institution’s capital adequacy,” the Fed said.

Banks are expected to maintain sufficient capital to account for such risks, regulators said. Companies are typically reluctant to divulge details of the trades, though some have come to light.

Blackstone last year insured Citigroup against initial losses on a pool of shipping loans. Though the assets stayed on Citi’s balance sheet, the insurance was designed to boost capital ratios.

In some cases, the Fed could decide not to recognise a transaction as a mitigating factor for risk-based capital, meaning a bank would have to find substitutes to meet those standards.

The Fed said bank staff should bring these kinds of transactions to the attention of senior management.

The Fed did not cite specific cases it was concerned about but mentioned instances in which a bank transfers a portfolio risk to an entity which is unable to absorb losses equal to the risk-based capital requirement for the risk transferred.

The Fed said the entity could be a thinly capitalised special purpose vehicle, such as a subsidiary that serves as a counterparty.

In March, the Basel Committee on Banking Supervision also addressed the issue to crack down on regulatory arbitrage. The committee, which sets global bank safety rules, said it would levy hefty charges on banks that use pricey credit default swaps to cut their capital requirements.

The committee was targeting banks that were buying credit protection on risky loans but deferring or spreading out the premiums for several years. The committee said it would require banks, under certain circumstances, to calculate the present value of what was paid for the credit protection in a specific way.

“The proposed changes are intended to ensure that the costs, and not just the benefits, of purchased credit protection are appropriately recognised in regulatory capital,” the committee said.

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