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Second Wind for Regulators Leaves Banks Feeling Bruised

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The past fortnight has been a potentially expensive one for banks on both sides of the Atlantic.

This week, the Federal Reserve unveiled details of the U.S. implementation of the international Basel III rule book on capital. Two weeks ago, the top eight UK banks were told how much additional capital they must find over the coming months.

In both countries, lenders are feeling bruised – in particular because of an unexpected shift of focus. They have spent the past few years accumulating capital to comply early with the Basel requirements relating equity to assets weighted for risk – the so-called core tier one capital ratio.

(Read More: Fed Approves Key Capital Rules for Banks)

Yet they are now being told they face additional, though blunter, leverage requirements relating equity to overall assets regardless of risk.

"The banks are feeling like regulators have found another stick to beat them with," says Simon Gleeson, partner at law firm Clifford Chance.

In some ways the shift of emphasis was predictable. Alongside full-year and first-quarter results between February and April, most big banks highlighted the fact they were already compliant with Basel III core tier one ratio requirements that will not be fully phased in until 2019.

But there was considerable skepticism among analysts about the way in which many banks were seen to have complied – few banks raised fresh equity, relying instead on "optimizing" risk-weighted asset numbers.

Downgrading the credit ratings of Barclays, Deutsche Bank and Credit Suisse this week, Standard & Poor's highlighted that all three continue to be highly leveraged institutions", with risks that are "not adequately captured by economic capital models or regulatory capital requirements".

(Read More: S&P Cuts Ratings of Credit Suisse, Barclays, Deutsche Bank)

A growing body of opinion, including the Basel Committee, believes a leverage ratio is a vital "backstop" measure. "Current risk-weights allowed financial institutions to become incredibly levered," Paul Tucker, the Bank of England deputy governor, said recently.

Last week the Basel committee that oversees those global rules, said banks should have to report leverage ratios according to a new formula from 2015, though banks would have another three years ahead of complying with a minimum 3 percent ratio.

In practice that means for every $100 a bank lends or otherwise puts at risk, it must be funded with at least $3 of equity. That standard, reformists on both sides of the Atlantic are now arguing, is far from satisfactory.

Regulators realized that relatively stable markets made it feasible to mount a second push on capital. "We saw a window," says one policy maker. "The market was relatively stable. There was an area of fertility."

(Read More: How It Happened: Markets, ECB and BoE Decisions)

Concerns raised at the Bank of England's Financial Policy Committee in March led to last month's surprise demand from the BoE's Prudential Regulation Authority that the UK's eight big banks should comply early with a new 3 percent leverage ratio.

U.S. reformists were eyeing far more extreme measures. David Vitter, a Republican senator, and Sherrod Brown, a Democrat, put forward a bill in April suggesting big U.S. banks should be forced to hit leverage ratios of as much as 15 percent.

Though the Brown-Vitter bill may never pass into law, it appears to have helped galvanize a fresh zeal in policy makers, such as Dan Tarullo, a governor at the Federal Reserve who said recently that Basel's 3 percent leverage ratio "may have been set too low".

This week's Fed document on Basel III endorsed the global leverage ratio. Though the U.S., unlike Europe and other parts of the world, has long had a ratio, it has been seen as ineffective.

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The Fed said it would not change the U.S. GAAP accounting measure by which the ratio is calculated, meaning that offsetting derivatives exposures will continue to be netted in the calculation. This represents a powerful break, in particular for the likes of Goldman Sachs and Morgan Stanley.

But the Fed will change how U.S. banks account for some assets, such as promised but undrawn lending commitments, which have traditionally been treated as "off-balance sheet" risk. This will inflate the asset total, requiring more capital.

If, as Mr Tarullo has hinted, the ratio is bumped up to 4 or 5 percent, that is likely to put pressure on policy makers elsewhere. In the UK, reformists believe the government would have to look again at its rejection of the 4 percent leverage threshold proposed by the Vickers Commission.

Other big bank economies have been less vocal on leverage but Switzerland signalled a fresh focus last month, when it criticised the ratios of UBS and Credit Suisse as being "low".

(Read More: German Banks an Accident Waiting to Happen: Expert)

The question, then, is what it means for banks. Regulators would like to see fresh equity raised, though for the time being only two significant banks have issued new shares in any volume – Deutsche Bank and Austria's Erste Bank. Analysts believe others are unlikely to follow. The option of bridging gaps with retained profits may be difficult, given the economic outlook.

The most likely outcome, therefore, is that banks will shrink their balance sheets. Barclays warned last week the UK leverage ratio requirement could mean a contraction in lending.

(Read More: Barclays CEO: We Aren't at Odds With Regulators)

Mr Gleeson at Clifford Chance says: "Where possible banks may remove from balance sheets exposures that attract relatively low capital charges from a risk-weighted point of view. That means blue-chip corporate lending, mortgage books, trade finance."

It is clear that regulators have found a second wind in their push to bolster bank safety. Good news as that might be for governments in risk terms, it will dash politicians' hopes that lenders can become powerful drivers of economic growth any time soon.

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